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Dolby Laboratories (NYSE:DLB)

Q3 2012 Earnings Call

August 02, 2012 5:00 pm ET

Executives

Alex Hughes

Lewis Chew - Chief Financial Officer and Executive Vice President

Kevin J. Yeaman - Chief Executive Officer, President, Director and Member of Stock Plan Committee

Ramzi Haidamus - Executive Vice President of Sales & Marketing

Analysts

Ralph Schackart - William Blair & Company L.L.C., Research Division

Steven B. Frankel - Dougherty & Company LLC, Research Division

Paul Coster - JP Morgan Chase & Co, Research Division

Perry Huang - Goldman Sachs Group Inc., Research Division

Corey Barrett

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Dolby Laboratories' Conference Call Discussing the Fiscal Third Quarter Financial Results. [Operator Instructions] As a reminder, this call is being recorded, Thursday, August 2, 2012. I would now like to turn the conference over to Mr. Alex Hughes, Senior Director of Investor Relations for Dolby Laboratories. Please go ahead, Mr. Hughes.

Alex Hughes

Thank you, Sarah. Good afternoon, and welcome to Dolby Laboratories' Third Quarter Fiscal 2012 Earnings Conference Call. Joining me today are Kevin Yeaman, Dolby Laboratories' President and CEO; Lewis Chew, Executive Vice President and Chief Financial Officer; and Ramzi Haidamus, Executive Vice President of Sales and Marketing.

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, 2012; market trends and developments for the industries in which we compete, and in the PC, online and portable machines, in particular, and our expectations and beliefs concerning how those trends and developments will affect our operating result, the capabilities and market acceptance of our products and technologies, expectations relating to licensing arrangements and our strategic and operational plan and objective. These statements are based on management's current expectations and assumptions that are subject to risks and uncertainties. Actual results may differ materially from those set forth in such statements. Important factors, such as general economic, PC, broadcast, consumer electronics or cinema market conditions, could cause actual results to differ materially from those in the forward-looking statements. These factors are addressed in the earnings press release that we issued today and under the section captioned Risk Factors and elsewhere in 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. During this call, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the two is available in our earnings release and in the Dolby Laboratories' Investor Relations data sheet on our Investor Relations section of our website.

Call participants are advised that the audio of this conference call is being broadcast live over the Internet and is also being recorded for playback purposes. An archive of the call will be made available on our website for approximately 1 year and is the property of Dolby. As for the structure of this call, Lewis will begin with a recap of Dolby's financial results and provide our fiscal 2012 outlook, and Kevin will finish with a discussion of the business.

And with that introduction behind us, I will now turn the call over to Lewis.

Lewis Chew

Thanks, Alex. Good afternoon, everyone. During my section of the call today, I'll start by providing some details on the Q3 revenue in the various markets that we serve. Then I'll briefly go over the margins and operating expenses, and I'll finish with an update on our outlook for fiscal 2012.

Total revenue for the third quarter was $207.9 million, down 5% year-over-year and 20% sequentially. Within that total, Q3 licensing revenue was $178.4 million, down 2% year-over-year and 21% sequentially. The year-over-year decrease was primarily attributable to our Consumer Electronics and PC markets, and this was partially offset by growth we saw in broadcast. The sequential decline was mainly due to seasonality since the increased shipment activity during the holiday period are reflected in our fiscal Q2 revenues.

Looking at licensing revenue by market. Third quarter broadcast revenue grew 10% year-over-year on increased revenue from set-top box, as well as from TV. Our TV attach rate was higher, offset partially by lower TV unit shipments. Sequentially broadcast revenue declined 19%. Third quarter PC revenue declined 10% year-over-year, primarily on lower revenue from ISV and 11% down sequentially. Third quarter revenue from our Consumer Electronics market was down 19% year-over-year, driven by declines in regular DVD and Blu-ray, and sequentially, revenue from Consumer Electronics declined 32%. Third quarter revenue from our Other markets category, which includes mobile devices, Gaming, Automotive and Via, increased 14% year-over-year and declined 26% sequentially. The year-over-year increase was driven primarily by growth in mobile and the sequential decline was due to a combination of normal seasonality in Gaming and timing of royalty streams from a large licensee of mobile.

Third quarter product revenues were $22.1 million, down 22% year-over-year and 19% sequentially. The year-over-year decline was primarily due to lower shipments of our 3D systems. Revenue declined sequentially as our second quarter benefited from $5 million of Digital Cinema revenue related to achievement of DCI compliance which did not repeat in Q3. Third quarter Services revenue was $7.3 million, down from $7.7 million in the second quarter and from $8.8 million in Q3 of last year.

So let me move on to margins and the rest of the income statement. Gross margin on the GAAP basis in the third quarter was 89.9% and 90.8% on a non-GAAP basis. Within that, licensing gross margin was 98.4% in the third quarter on a GAAP basis, and 99.1% on a non-GAAP basis. GAAP product gross margin was 34.4% in the third quarter, down 80 basis points sequentially and non-GAAP product gross margin was 37.2%, down 40 basis points sequentially.

Year-over-year, Q3 product gross margins increased about 6 points on both the GAAP and a non-GAAP basis. Third quarter GAAP operating expenses were $118.7 million, up $3.1 million sequentially. Non-GAAP operating expenses were $107.5 million, up $5.4 million from the previous quarter. The increase in operating expenses was due to a combination of increased sales and marketing programs along with higher investment in research and development. During the quarter, the company did increase its headcount to support these efforts.

Third quarter operating income of $68.1 million on a GAAP basis or 32.8% of revenue, and $81.3 million on a non-GAAP basis or 39.1% of revenue. The effective tax rate for the third quarter was 26.9% on a GAAP basis and 27.3% on a non-GAAP basis. Third quarter GAAP net income was $51.5 million, or $0.48 per diluted share, compared to $61.7 million or $0.55 per diluted share for the third quarter of 2011. Third quarter non-GAAP net income was $60.8 million or $0.57 per diluted share, compared to $72.8 million or $0.65 per diluted share for the third quarter of 2011.

Cash flow from operations was $98 million in Q3 and Dolby finished the third quarter with nearly $1.3 billion in cash reserves consisting of cash, cash equivalents and marketable securities. Some of these are classified as long-term investments on our balance sheet.

In the third quarter, we repurchased approximately 2.5 million shares of our common stock for $103.8 million, but we ended the quarter with approximately $276 million remaining available under our approved stock repurchase program.

Now I'd like to provide an update to our fiscal 2012 outlook. We now estimate that total revenue for the year will range from $900 million to $920 million. Within that, we anticipate licensing revenue of $780 million to $790 million, and products and services revenues of $120 million to $130 million. Here are the key assumptions that we have embedded into this latest outlook. In our broadcast market, we anticipate that global TV attach rates will increase by 4 to 5 points, while also assuming that worldwide TV unit shipments will be down about 3%.

In our PC market, we are now assuming PC unit growth of 2% to 3% for the year. We expect to finish fiscal 2012 with approximately $70 million to $75 million in ISV revenue, and that compares to about $80 million in fiscal 2011.

In our Consumer Electronics market, we are anticipating year-over-year revenue to decline in the high-single- to low-double-digits range, primarily due to DVD and Blu-ray combined.

Gross margins are expected to be approximately 90% on a GAAP basis and 91% on a non-GAAP basis. Within that, product gross margins are expected to range from 37% to 38% on a GAAP basis and 40% to 41% on a non-GAAP basis.

Operating expenses are expected to range from $467 million to $473 million on a GAAP basis and $415 million to $420 million on a non-GAAP basis. And other income is expected to be approximately $7 million. And our effective tax rate is estimated to be about 28% on both the GAAP and non-GAAP basis. So based on everything I just went over, diluted earnings per share would range from roughly $2.35 to $2.43 on a GAAP basis, and $2.75 to $2.83 on a non-GAAP basis.

So let me now turn the call over to Kevin. Kevin?

Kevin J. Yeaman

Thank you, Lewis. Good afternoon, everyone. As Lewis noted, we are seeing underlying softness in some of the product categories we license due to general weakness in the global economy. While this impacted our third quarter results and full year outlook, we continue to make progress in many of our key initiatives to better position us for long-term growth. We expect this growth to come from platforms like cloud-based delivery and digital broadcast.

Today over half of our revenue already comes from devices tied to these platforms and that do not support optical disc playback such as television, set-top boxes and smartphones, and we continue to see growth in these areas. While the remainder of our licensing revenue comes from devices that include optical disc playback such as Blu-ray players, PCs or Gaming consoles, these are devices that now receive content from mobile and online networks as well. Our progress extending Dolby formats to the online and mobile use cases is creating reasons to include our technologies in these devices beyond optical disc, as is the case with the adoption of Dolby Digital Plus in Windows 8.

We believe that the trends in digital broadcast and cloud-based delivery will enable us to grow our core audio business and I would like to spend a moment talking about each. In broadcast, we continue to be encouraged by what we see. Last quarter, I said we expect to increase our TV attach rate for the year by 4 to 5 percentage points, and we continue to expect this. This increased attach rate is more than offsetting weakness in global TV shipments. We continue to make progress working with the broadcast ecosystem around the world including standards bodies and commercial providers in cable, satellite and IPTV. In the Asia Pacific region, we have 26 of 46 high-definition channels broadcasting in China with Dolby technology. And in India, we have 12 HD channels. In the EMEA region, South Africa mandated our multichannel audio technology into its final specification, while both Austria and Turkey have done the same in their draft specification.

In addition, 7 new operators adopted our multichannel audio technologies across the region. The premium experience of Dolby Surround Sound is becoming an expected feature of high-definition content around the world, and much of the world's transition to digital broadcast is still in front of us. As we pursue this remaining opportunity, there are a couple of additional trends that are helping us, including the desire by some global TV manufacturers to standardize on Dolby's formats for worldwide TV shipments. This is helping to grow our attach rate to TVs in Asia Pacific, Eastern Europe and Latin America. In addition, the progress we have made in extending our formats to online content services such as VUDU and Netflix is creating another reason for manufacturers to incorporate our technologies to connected televisions.

Turning to our efforts in online and cloud-based delivery. We continue to extend our formats across this ecosystem. We believe the delivery of online content in our format to portable devices with our decoding technologies delivers a richer audio experience for mobile users. In the third quarter, we increased the percentage of smartphones that license our multichannel audio technologies year-over-year, and we remain on track to finish the fiscal year with an attach rate to smartphones in the low- to mid-teens.

We continue to make good progress across the Android ecosystem. Our multichannel technologies are on 35 handset models from Samsung, including its new flagship GALAXY 3S (sic) [GALAXY S III] and GALAXY Note. In addition, Huawei launched 6 new smartphone models with Dolby Digital Plus, while ZTE launched 2 models using our technologies.

Our progress in the Android ecosystem gives us confidence that we can continue to add value to other existing and new mobile ecosystems. We also have a growing library of online content encoded in our format. With our multichannel technologies adopted by leading online service providers such as Netflix, VUDU, HBO Go, Amazon and the Rovi Entertainment Store Solution.

Finally, we are also focused on introducing additional technologies that further enhance the entertainment experience. In June, we launched our next-generation audio technology, Dolby Atmos, in conjunction with the release of Disney-Pixar's Brave. Dolby Atmos is a new platform that enables artists to create and deliver a more realistic and enveloping audio experience. Artists and exhibitors have responded to Atmos enthusiastically and we expect additional films to be released in our new format, and to expand the number of theaters globally deploying Dolby Atmos.

In summary, while the global economy is producing near-term challenges, we remain focused on our key initiatives to drive long-term growth. We are pleased with the progress we are making at expanding our audio solutions into cloud-based delivery and digital broadcast and in introducing new technology platforms such as Dolby Atmos.

And with that, I'll turn it over to questions.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question today from Ralph Schackart with William Blair.

Ralph Schackart - William Blair & Company L.L.C., Research Division

Maybe I should start with Kevin. Kevin, you talked about the attach rates on mobile being low- to mid-teens this year. I guess from your exiting the year to higher rate? Can you sort of give us maybe a little bit more color what you're seeing on the attach market -- I'm sorry, on the attach rate as you exit this fiscal year? And how we should think about that revenue stream continuing to grow?

Kevin J. Yeaman

Sure. So they said we're low- to mid-teens this year, that's up from -- as you know, we didn't have our multichannel technologies in smartphones 2 years ago, so significant progress over the last couple of years. I would say we're still -- at the same time, even with this growth, we're still in a phase of really building the foundation. We have significant progress in the Android ecosystem with the GALAXY line up, as well as the recent Huawei and ZTE wins I referred to. And we believe that we can continue to drive that success into additional ecosystems. It's I think early for me to give any specific guidance for 2013, but our progress so far gives us a lot of confidence that this is a meaningful market opportunity for us. It's obviously the fastest-growing device category. And in addition to the foundation we're building with our current line up, it's the source of a lot of innovation in the company targeted at these devices and these use cases.

Ralph Schackart - William Blair & Company L.L.C., Research Division

Great. And one more, if I can, I'm not sure if this is for you or Lewis. But just as I sort of work through the numbers here quickly on the outlook, it looks like most of the softness was in CE, if I'm not mistaken. Can you give a sort of a sense of what's going, anything specific -- issue there? And if I'm not mistaken, ISV looked like it was maybe a little bit better than we anticipate at the beginning of the year. Sort of any update there and how should we think about that in '13?

Lewis Chew

Ralph, this is Lewis. I'll take the first part about that. I love questions where you've already answered it yourself. I wouldn't say anything different. ISV did come in a little bit better than we thought and we're encouraged by the fact that, that's got a future ahead of it. And CE is definitely soft right now. And you've heard that across the board from a number of different companies well before our call. And we've also seen in the news that the broad economy certainly doesn't seem like it's kicking a** right now, so that is affecting us. But maybe -- Kev, do you want to comment more on the future path on ISV at all or...

Kevin J. Yeaman

What I would add on ISV, 2 points. First of all, we have begun to see OEMs focusing their sights on Windows 8. And so they're not as focused on making changes for their Windows 7 model. So we have seen that stabilize somewhat. The other thing is that where there has been strength, at least relative to consumer PC, in the business PC which is where we had a better relative position as it relates to ISV. And so that mix change has also benefited us somewhat compared to what we thought coming into the year.

Operator

Next we'll hear from Steven Frankel, Dougherty & Company.

Steven B. Frankel - Dougherty & Company LLC, Research Division

Kevin, I wonder if you have any thoughts on how you might counter the shift towards simple pass-through streaming devices and away from Blu-ray players. Is there something you can do to try to get more value in those simple devices so that, that's not a headwind?

Kevin J. Yeaman

Well, I'll let Ramzi comment on this as well, but I mean, I guess I would start by saying that our focus is to make sure that every consumer experience, every consumer entertainment experience gets the benefit of the highest quality audio experience and that it is easy to move content around between these devices in the highest-quality experience. So I can't say that we're focused specifically on whether there are pass-through devices. What we're confident in is that the number of devices through which people are enjoying entertainment is increasing. We continue to make progress across each category, and while we can't predict when consumer spending will return, we are confident that when it returns and however it returns, we're going to be there to make it a better experience.

Ramzi Haidamus

Yes. At current course and speed the R&D investment in our current technology is focused on the performance of those types of devices when you decode in device. So pass-through device might make sense if you just have a simple decoder and make it through, but what we have been focusing on is a total experience. So to Kevin's point, you combine our decoding technology along with our Pulse process technology and that is what really gets you the best entertainment experience. And you can only achieve that if you were to decode in these devices. And we've been showing this and demonstrating it for sometime, and we believe that's the value that will continue to have companies see the value in decoding in these devices.

Steven B. Frankel - Dougherty & Company LLC, Research Division

And as a follow-up to that, maybe you could update us on your progress of being successful with that pitch in the ultrabook market?

Ramzi Haidamus

So currently, we are licensing what we call the PCEE v4 program into the ultrabooks. We also have a new technology combination that combines DD+ and Pulse processing. And we have an increased number of SKUs and products in the marketplace. However, I will counter that by also saying that in the marketplace today, the market has seen some softness in the high-end PCs, where you see attachment of these technologies. So for the time being we see that softness, but we also predict it will pick up when consumer spending picks back up.

Steven B. Frankel - Dougherty & Company LLC, Research Division

Okay. And what if anything can stop the deterioration in the product business? Or is your market share in 3D just on the decline and it will take some kind of new product cycle like Atmos to turn that around?

Kevin J. Yeaman

Our market share in 3D is -- we're maintaining our market share. But as you know, the Digital Cinema cycle is more than halfway through its deployment. 3D is actually ahead of the Digital deployment cycle because there was such a high attach rate of 3D Systems to the initial wave of Digital Cinema deployment. But the refresh is going to be driven by new technologies. And we're really excited about Dolby Atmos and the reception its gotten on initial launch. We think it redefines what the cinema experience going to be. And so we think that, for our business, is ultimately going to be a refresh of the product cycle. But that wave is probably still a year ahead of us.

Operator

Next from JPMorgan, we'll hear next from Paul Coster.

Paul Coster - JP Morgan Chase & Co, Research Division

Kevin, you've made a tremendous step forward with winning the Windows 8 platform for all PCs. Are you seeking a similar kind of platform standard status with iOS on Apple and Android rather than just sort of proceeding on a product and OEM basis?

Kevin J. Yeaman

Yes. We're focused on adding value to every major ecosystem across the PC and mobile environments. Our most significant progress to date is with the Windows 8 agreement that we discussed last quarter. With the Android ecosystem, some of the data points I shared on the call. And we are, of course, a part of the Apple PC ecosystem. And beyond that, yes, we're focused on every new and existing PC and mobile operating system.

Paul Coster - JP Morgan Chase & Co, Research Division

Are you in active dialogue with Google and Apple directly on that platform status for Dolby Digital?

Kevin J. Yeaman

I don't want to comment on specific customer engagements. But obviously, those are 2 players that are important to interact with. We have cooperation with them on a number of fronts. But beyond that, we'll keep doing what we do and looking to add value.

Paul Coster - JP Morgan Chase & Co, Research Division

Okay. And my last question is on R&D. It continues to be pretty intense activity. Where are you allocating it at the moment, please?

Kevin J. Yeaman

Sure. So we talked about this a fair bit coming into the year, and the fact that the bulk of our focus this year is in fact in the core audio business and on new technologies to help drive long-term growth. And the focus has been on digital broadcast, cloud-based delivery and new offerings. And we believe we've made a lot of progress in each of those. As it relates to digital broadcast, it is important to note that we're in between major adoption cycles. In other words, the developed world has gone through its digital broadcast adoption cycle, the emerging markets digital broadcast adoption cycle is in front of us, but we have continued to make great progress in terms of being in a position with operators and standards bodies around the world to be well positioned as emerging markets move forward with that upgrade cycle. We're pleased with the progress we're making in mobile and with the Windows 8 agreement. Those are not without investment, we're out engaging with PC OEMs and supporting the new implementation of our technologies. But we think that is an investment that is very valuable. And finally, I'd point out that in terms of new the technology, Dolby Atmos is another example of how Dolby continues to redefine the audio experience. We've been doing it for 45 years, we intend to do it well into the future and we think it's going to be something that provides value across many, many growth opportunities.

Operator

Next, we'll hear from Perry Huang, Goldman Sachs.

Perry Huang - Goldman Sachs Group Inc., Research Division

I was hoping to ask a question about headcount. It looks like it increased by about, I think, 60 heads sequentially. How should we think about headcount levels as you kind of close out fiscal '12? Is the necessary headcount largely already in place with planned sales and marketing programs and R&D investments? Or maybe are there any additional programs that might require more headcount?

Kevin J. Yeaman

Sure. That's I guess a good follow-up from the last question having just gone through where we're investing our resources and the progress we're making against that. And we're going to continue to be disciplined and monitor our progress across each investment we're making. But our decisions are going to be guided based on where we see those opportunities and the investments required to be successful in the long run. But it's too early for us to give any guidance for 2013 at this stage.

Operator

[Operator Instructions] Next, we'll hear from Corey Barrett, Pacific Crest Securities.

Corey Barrett

First, if end markets remain challenged like they are, what should we expect to see on the OpEx side? Would do we expect to see you rein in expenses at all?

Kevin J. Yeaman

Well again, you should expect us to be disciplined, but for us to weigh our investment decisions based on the opportunities we see in front of us and the investments that it takes to pursue them. Again, just to use the example of the digital broadcast rollout. We have put ourselves in a really good position around the world, as emerging markets prepare to go through an upgrade cycle. It's very difficult to predict exactly when the inflection point occurs, exactly when governments and operators decide to start rolling this out. But we know they're going to and we know that we're in a good position to benefit from it, and I think we have a good track record of putting ourselves in a position for those types of cycles. And so that's our primary criteria when we think about where and how to invest.

Corey Barrett

Okay. And does the current environment change at all your position on acquisitions or whether you would consider those in search of growth or new opportunities?

Kevin J. Yeaman

Well, I think that we're always looking for opportunities for acquisitions that can accelerate our opportunity in any of the areas we have highlighted or create new growth opportunities. We will continue to do that and we will continue to be disciplined on our approach.

Corey Barrett

And then lastly, it looks like you were a little more aggressive this quarter in your buybacks. Is that an indication of a change in strategy at all or what should we expect there?

Lewis Chew

This is Lewis. No, I don't think there's any change in strategy. We've been pretty clear about the base strategy being that we do generate excess cash flow. We try to keep dilution down to a minimum, if not none. We've got plenty of flexibility going forward. But no, there's no fundamental change in strategy. I don't think you should assume that it just keeps accelerating from this point forward. You look over the last several quarters and there's sort of a mean number you can look at that probably reflects our model.

Operator

[Operator Instructions] I show no further questions at this time. Mr. Yeaman, I would like to turn the conference back over to you for any additional or closing comments.

Kevin J. Yeaman

Well, thank you for joining us today. Again, it's a soft consumer spending environment but we're really focused on investing those areas that can drive long-term growth, digital broadcast, cloud-based delivery, new offering such as Dolby Atmos, which we're really pleased with the reception there and confident that we're in the process of setting a new standard for audio in the cinema. And we look forward to speaking with you again next quarter.

Operator

That does conclude today's conference. We thank you all for joining us.

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