Reading the Risk Factors section of a 10-K is boring, particularly the boilerplate language added by lawyers. However, a careful reading can often lead to a better understanding of a company's business model, and sometimes raises significant red or yellow flags to investment. Let's explore one such case with Dolby Laboratories (DLB).
As many of you know, licensing revenue contributed approximately 86% of Dolby's revenues fiscal YTD and even greater percentage of profits. Obviously, Dolby's ability to continue to receive these revenues on an ongoing basis is critical to its success. Nothing new here you say? Well let's take a quiz.
Q: How many patents does Dolby have?
A: Nearly 2,700 issued and 2,500 pending in 90 jurisdictions. You read the recent 10-Q after all, including the Risk Factors section.
Q: When do their patents expire?
A: At various times between now and 2032. You might even note patents on Dolby Digital technologies expire between now and 2017 and Dolby Digital Plus between 2018 and 2026.
Q: How will Dolby deal with these patents as they expire?
A: Innovation of new technology and new applications of its existing technology. Dolby is a leader in its field, is highly innovative and regularly applying for and receiving new patents. Besides, they have a lot of time before their patents expire.
Q: Great, and thank you for your patience. One last question. How much of Dolby's licensing revenues comes from Dolby Digital technologies that expire in 2017?
That last question stumped us to. Dolby does not breakout its licensing revenues by technology type. Investors relying on Dolby's SEC filings do not know what percentage of licensing revenues come from Dolby Digital, Dolby Digital Plus or one of their newer technologies. This is analogous to Pfizer not disclosing to investors how much revenue came from Lipitor prior to expiration. Regardless, Dolby does provide us a clue, and that is why I underlined "careful" in the second sentence of this article.
"Patents relating to our Dolby Digital technologies, from which we principally derive our licensing revenue, have begun to expire and the remaining patents relating to this technology generally expire between now and 2017 ." [Emphasis added.] Document here.
This quote comes from the same risk factor that includes the number of patents and their expiration dates discussed above and that you likely already noted as an investor (from DLB's 10-Q filed August 8, 2012). However, in the context of our current conversation, clearly the meaning of the word "principally" becomes a bit perplexing, no? Let us think this through. If 5-30% of revenues were from Dolby Digital technologies would they not say a "substantial" or "significant" portion rather than "principally"? As an investor with limited time and resources, we must take the word "principally" at face value. In other words, in absence of better information we must assume the worst case that a majority of Dolby's licensing revenues still comes from Dolby Digital technologies that expire in 2017.
Let's take the analysis a step further. Earlier we agreed that continued "innovation" was critical for Dolby successfully maintaining and growing its licensing revenues. Can we really view a company as "innovative" if a majority of their revenue comes from a technology that was first used in the movie Batman Returns when it premiered in 1992? (Think Keaton not Bale!) After all, Dolby itself is telling us that its licensing revenues "principally" come from technology that is over 20 years old.
This report is not meant to suggest that there is an impending problem at Dolby, and is certainly not a call to short the stock. In fact, the company is cash flow rich and the situation may be less dire than outlined here. Dolby today may very well turn out to be a fantastic investment. We get that. However, we believe that buying or owning shares of DLB without deeper research into this issue is merely speculation. So I ask, are you accidentally speculating in Dolby's stock? This case study nicely illustrates two core pillars of our value focused investment philosophy:
1) To be a successful investor, you must recognize what you know and do not know. You must stay within your circle of competence. We recognize that this patent issue is something that we do not understand or have complete information regarding. We must be willing to let this potential investment pass by and stick within our circle of competence.
2) Do your homework - each and every time. A careful reading of DLB's SEC filings raised this yellow flag. The only place where this problem was addressed within DLB's financials was this one particularly Risk Factor. If you had skipped it because it was boring, than you might not have raised the issue. Reading financials and annual reports is step 1 of the diligence process.
For completeness, we have included the entire quoted risk factor below (from Dolby's 10-Q filed August 8, 2012):
"If we do not obtain new patents or proprietary technologies as our existing patents expire, our licensing revenue could decline.
We hold patents covering much of the technologies that we license to system licensees, and our licensing revenue is tied in large part to the life of those patents. Our right to receive royalties related to our patents terminates with the expiration of the last patent covering the relevant technologies in a particular country. Accordingly, to the extent that we do not replace licensing revenue from technologies covered by expiring patents with licensing revenue based on new patents and proprietary technologies, our revenue could decline.
As of June 29, 2012 , we had nearly 2,700 individual issued patents and over 2,500 pending patent applications in over 90 jurisdictions throughout the world. Our issued patents are scheduled to expire at various times through November 2032 . Of these, 3 patents are scheduled to expire in the remainder of calendar year 2012, 30 patents are scheduled to expire in calendar year 2013 and 91 patents are scheduled to expire in calendar year 2014. Patents relating to our Dolby Digital technologies, from which we principally derive our licensing revenue, have begun to expire and the remaining patents relating to this technology generally expire between now and 2017 . Additional patents relating to our Dolby Digital Plus technologies, an extension of Dolby Digital, expire between 2018 and 2026 . In addition, the remaining patents relating to Dolby Digital Live technologies, an extension of Dolby Digital, are scheduled to expire between now and 2021."