Dolby Laboratories, Inc. F2Q08 (Qtr. End 03/31/08) Earnings Call Transcript

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Dolby Laboratories Inc. (NYSE:DLB) Q2 FY08 Earnings Call May 1, 2008 5:00 PM ET

Executives

Kevin Yeaman, - EVP and CFO

N.W. (Bill) Jasper, Jr., - President, Director, and CEO

Ramzi Haidamus - EVP, Sales and Marketing

Tim Partridge, - EVP, Products and Technologies

Analysts

Ingrid Chung - Goldman Sachs

Ralph Schackart - William Blair & Company

Mike Olson - Piper Jaffraay

Paul Coster - JP Morgan

Brian Thackray - Deutsche Bank

Andy Hargreaves - Pacific Crest

Daniel Ernst - Hudson Square Research

Hunter DuBose - Morgan Stanley

Alan Davis - DA Davidson

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Dolby Laboratories Conference Call Discussing Fiscal Second Quarter 2008 Results. During the presentation, all participants will be in a listen-only mode. Afterwards, you will be invited to participate in a question-and-answer session. [Operator Instructions]. As a remainder, this call is being recorded, Thursday May 1st, 2008.

I would now like to turn the conference over to Kevin Yeaman, Chief Financial Officer for Dolby Laboratories. Please go ahead Mr.Yeaman.

Kevin Yeaman - Executive Vice President and Chief Financial Officer

Thank you operator and good afternoon everyone. Welcome to Dolby Laboratories' second quarter fiscal 2008 earnings conference call. Joining me today is Bill Jasper, Dolby Laboratories' President and CEO. In addition, Tim Partridge, Executive Vice President of Product and Technologies: Ramzi Haidamus, Executive Vice President of Sales and Marketing and Marty Jaffe, Executive Vice President of Business Affairs are here to participate in today's Q&A.

On this conference call, we will be making forward-looking statements that include projections of future operating results for a fiscal year ending September 26th, 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. 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 and any subsequently filed quarterly reports 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. As for the structure of this call, Bill will begin with an overview of business, and I will follow with a rundown of Dolby's financial results.

So with that introduction behind us I will now turn the call over to Bill.

N.W. (Bill) Jasper, Jr., - President, Director, and Chief Executive Officer

Thank you Kevin. Good afternoon everybody. Thank you for joining us today. I'm happy to report strong financial results with fiscal second quarter year-over-year growth of 34% of revenue and 44% in earnings per share. During the quarter, we continue to benefit from the inclusion of Dolby technologies in a wide array of entertainment platforms.

On today's call, I will discuss, how we continue to position Dolby for a number of near-term opportunities including PC-based entertainment, digital broadcast and next generation DVD and gaming as well as for longer-term opportunities with Dolby Volume, Dolby Mobile and Digital Cinema. In our PC market, we are benefiting from the inclusion of Dolby technologies and widely used software, while we continue to position Dolby for the trend towards media-centric PCs. Today, consumers are increasingly using notebook PCs as portable media centers for the playback of music and video. We are continuing to work with PC OEMs to incorporate additional Dolby technologies that enhance the audio experience from their PC, regardless of the input source.

To address this trend, we released our second generation PC entertainment experience program in March. PCEE enables PC makers to integrate the same audio features, performance and flexibility found in many of the most popular consumer electronics devices. In addition, to offering more audio technologies, it supports surround sound and includes a PC control center offering, a user friendly graphic interface, that makes it easier to configure and control the listening experience. Moreover, our PC market remains strong as many PC shipped with Microsoft's Vista Home Premium or Ultimate editions, as well as with third party DVD playback software, all containing Dolby Technology.

In our broadcast market, we continue to position Dolby for worldwide growth of digital television. In North America, we remain well positioned with Dolby Digital as the mandated audio standard for digital terrestrial broadcast, the standard for the U.S. Cable industry and that the fact of multichannel standard for satellite providers. As a result, we benefit from digital television, and digital set-top box shipments in the United States to contain a digital tuner.

Dolby Digital is also included in the U.S. Digital converter box specification, which is aimed at households who don't plan to upgrade their analogue televisions. The Government is offering up to $240 coupons for households to put towards converter boxes. Already some have begun to arrive on store shelves and are priced in the $50 to $70 range. In the digital converter box category, we expect to receive the majority of our licensing revenue in fiscal 2009.

In the EMEA region, we are well positioned for HD Television in Europe with a number of broadcasters including Dolby Digital and their HD set-top box shipments. A number of manufacturers are including Dolby Digital Plus in their European digital TV shipments. In the Asia-Pacific region, we are benefiting on a number of geographic areas. And South Korea has adopted the ATSC Standard. Dolby Digital is included in South Korean TV shipments containing a digital tuner. In Japan, the Government has adopted AAC as its audio format for digital television and as one of the licensors of AAC, Dolby receives a portion of the AAC royalties.

Finally, the addition of aacPlus to our technology portfolio enables us to provide international broadcasters with a wider range of multichannel solutions that meets their specific requirements. Given aacPlus's efficient compression, we believe it is well suited for broadcasters looking to improve bandwidth efficiency.

Turning to high-definition DVD and gaming, we remained well positioned for an upgrade cycle in each. In the DVD category, Dolby Technology has mandated in the Blu-ray format. Now, that Toshiba has announced, that it will no longer develop, manufacture and market HD DVD players, they will no longer be competing formats, and as a result a major obstacle to consumer adoption has been removed. This increases the potential for improved progress in number of Blu-ray titles released by studios and in the number of Blu-ray players shipped by manufacturers at better price points. We believe these developments should help the adoption rate of Blu-ray overtime.

On the gaming site, Dolby remains well positioned with technologies incorporated in the PS3 and Xbox 360. The second fiscal quarter marked a strong period for gaming, as we saw robust licensing growth from the sale of the PS3 and Xbox 360 platforms. Beyond these near-term opportunities, we continue to make progress in new audio and imaging initiatives. On the audio side we remain focused on delivering Dolby Volume to the television and ABR markets and Dolby Mobile to the handset market.

Toshiba has incorporated Dolby Volume into two new models of HD Televisions, expected to launch in Japan this month. Dolby Volume allows consumer electronics products to deliver consistent volume levels from various audio sources while enhancing dialogue intelligibility and improving overall clarity of the audio content at lower volume levels. In November, Sharp incorporated Dolby Mobile into two handset models shipping in Japan. In addition to working with Sharp, we are demonstrating Dolby Mobile to carriers, handset manufacturers and software providers across the mobile ecosystem.

In our imaging initiatives, we're focused on positioning ourselves for the transition to digital cinema and digital 3D as well as on the development of our HDR technology for next generation LCD displays. We were encouraged by our meetings with major providers of digital cinema while at the Show West conference in March. And we believe that our digital cinema server is well positioned for this market. We also believe that we provide a compelling 3D solution, which delivers an extremely clear 3D image and offers increased flexibility to exhibitors by utilizing the standard white screen in auditoriums today. Beyond cinema, we remain focused on developing our high dynamic range technologies for next-generation LCD displays. Dolby's high dynamic range technologies provide dramatically enhanced contrast with extended brightness and dynamic range for LCD televisions with LED backlighting technology. This results in truer black, brighter white and a vivid image.

In summary, we continue to pursue additional opportunities while we benefit from the inclusion of Dolby technologies in a wide range of entertainment products. As we pursue these opportunities, Dolby’s dedicated and passionate employees, global brand and industry-wide position will be key assets.

With that, I'll turn it over to Kevin.

Kevin Yeaman - Executive Vice President and Chief Financial Officer

Thank you, Bill. I'd like to discuss Dolby's overall financial performance and highlight some of the major drivers for the quarter. Revenue for the second quarter was $172.6 million, up 34% year-over-year and 15% sequentially. Second quarter licensing revenue was $149.6 million, an increase of 40% year-over-year and 22% sequentially. Growth was primarily driven by strong results from our PC market as well us from our gaming and broadcast markets. After excluding $7.7 million of prior period PC royalties recorded in the second quarter of fiscal 2007, licensing revenue from our PC market doubled year-over-year this quarter. The year-over-year performance was primarily driven by shipments in PCs with Microsoft Vista Home Premium or Ultima editions and/or third party DVD playback software each containing Dolby technologies. Licensing revenue from our PC market experienced strong sequential growth in the second quarter of fiscal 2008, which we attribute to increased PC shipments and a continued strength of Microsoft Vista.

Our broadcast market grew over 20% year-over-year on demand for digital televisions containing our technologies. Sequentially, broadcast grew on increased revenue from digital television and set-top box shipments. Our CE market experienced mid-single digit growth year-over-year and sequentially on higher reported revenue from standard-definition DVD and Home Theatre in a Box. Our other markets category had very strong sequential growth and nearly doubled year-over-year led by revenue from gaming and from the addition of our mobile market with the acquisition of Coding Technologies in the first quarter of fiscal 2008.

Second quarter product sales were $15.6 million, up 1% year-over-year and down 22% sequentially. Product sales declined sequentially due to a reduction in shipments of our cinema audio processors and because we sold more of our digital 3D systems in the first quarter driven by the release of Bewolf. Second quarter services revenue was $7.3 million, an increase of 6% year-over-year and a decline of 6% sequentially.

Turning to margins, our licensing gross margin was 96% in the second quarter. Our products margin was 45% in the second quarter of fiscal 2008, an increase of 3 points sequentially. Product margins increased as a result of higher 3D related revenue in the first quarter of fiscal 2008 as compared to the second quarter. Our 3D products carry a lower margin than our traditional cinema products. At the end of the second fiscal quarter, we had approximately $20 million in deferred revenue related to digital cinema. As you may recall, we have been expecting to recognize this revenue in the second half of fiscal 2008.

However, we now expect to recognize this revenue in the first half of fiscal 2009. To recognize this revenue certain engineering work needs to be completed in order to meet the recently agreed upon DCI’s facts. Following that, we need to get the third party certification process completed. We believe we are on track to meet our internal engineering target to be fully DCI compliant in fiscal 2008. However, the third party certification process is not yet in place and it is unlikely that we can obtain this certification in time to recognize this revenue in the second half of fiscal 2008.

Turning to services, services gross margin was 57%, down 4 points sequentially resulting from lower revenue. Operating expenses were $70.8 million in the second quarter of fiscal 2008, up 9% from the prior quarter. SG&A was $55.3 million, an increase of $4.3 million sequentially while R&D was $15.7 million, an increase of $1.8 million sequentially. Both SG&A and R&D rose as a result of higher personnel expenses due to increased employee bonuses, annual merit increases and increased headcount.

Other income was down primarily because of the decrease in interest income from the lower cash balance following the acquisition of Coding Technologies, and other expenses of approximately $1 million. We expect other income to approximate interest income and for interest income to run at just under $4 million per quarter in the rest of fiscal 2008.

Turning to tax, our tax rate for the second quarter of fiscal 2008 was 34% and we continue to expect our tax rate for the year to be approximately 35%. Fiscal second quarter net income was $57 million or $0.49 per diluted share compared to $39 million or $0.34 per diluted share for the second quarter of fiscal 2007. Net income reflects stock-based compensation charges of $6.1 million for the second quarter of fiscal 2008 and $4.8 million for the second quarter of fiscal 2007. Net income also reflects charges related to the amortization of intangibles of $4.1 million for the second quarter of fiscal 2008 compared to $550,000 for the second quarter of fiscal 2007.

Turning to the balance sheet, Dolby finished the quarter with approximately $540 million in cash, cash equivalents and marketable securities. We added approximately $35 million in cash flows from operations in the second quarter. In the second quarter, cash flow from operations trailed net income by approximately $20 million due to a timing change in our quarterly tax payments which resulted in both tax payments for the first half of fiscal 2008 following in our second quarter and as a result of the payout of the company's annual employee bonus. On a year-to-date basis cash flow from operations was approximately $110 million, which is slightly above net income for the same period.

We have approximately $80 million in auction rate certificate securities. We believe our auction rate portfolio is of high credit quality as 100% carry AAA or AA credit rating and have minimal history of default and 85% of securities are collateralized by the Federal Financial Education Lending Program. However, given the current lack of liquidity in the auction rate market, we concluded that the fair value is no longer equal to the par value for these securities and recorded an unrealized loss of $3.5 million on the consolidated balance sheet. Additionally we reclassified these securities from short-term investments to long-term investments due to the lack of short-term liquidity available for these securities. We deem this decline in fair value to be temporary and it’s partly on our ability and intent to hold this investment until liquidity returns to the market.

Let me turn to outlining our expectations for fiscal 2008. For licensing, we now anticipate revenue of between $495 million and $515 million in fiscal 2008 as we have increased our expectations for the PC market. For products and services, we now anticipate revenue of between $90 million and $100 million. Gross margin for product-related revenue is now expected to be around 45%, product margins are higher than we previously guided for, because lower margin deferred revenue related to our digital cinema systems is no longer included in our 2008 outlook.

In summary, we now expect fiscal 2008 revenue to be approximately $585 million to $615 million. We now expect net income for fiscal 2008 to be approximately $170 million to $182 million, and earnings per diluted share to be approximately at $1.47 to $1.57. We now expect stock-based compensation expense for the full year to be approximately $22 million and for amortization of intangibles to be approximately $13 million.

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

Question and Answer

Operator

Thank you. [Operator Instructions]. We'll take our first question from Ingrid Chung with Goldman Sachs.

Ingrid Chung - Goldman Sachs

Hi, good afternoon. Thanks and great quarter. So, if I’m doing my math right, it looks like at the midpoint of revenue guidance, that you have to do about 11% growth in terms of revenue in the second half. I was just wondering if that is... if you're reluctant to raise revenue guidance, something you're seeing in the macro environment or is it, the lapping of Vista sales or something else that you’ve been saying. And then secondly, on PCEE, I was wondering with the new version that you launched in March, whether you've seen some increased penetration with Acer and Lenovo and Toshiba?

Kevin Yeaman - Executive Vice President and Chief Financial Officer

Sure. So, and Ingrid you’re focused on total revenue, right.

Ingrid Chung - Goldman Sachs

Yes.

Kevin Yeaman - Executive Vice President and Chief Financial Officer

So, if you break that down into licensing versus product and services, you'll see that the licensing range of guidance for the second half equates to about 13% to 23%, whereas products and services is down to... slightly up but, on the low side down double-digits and that's on the products and services, that's because of our pushing the digital cinema revenue into the beginning of '09. On the licensing side, the 13% to 23% revenue growth, our outlook has been raised because of our view of the PC market, we entered the year, I think with what we thought were reasonable estimates for PC market growth, and as you know, an element of caution around whether the ISV attach rate would continue along with the shipments of Vista Premium.

As the year is going on, we have continued to see that attach rate hold firm, we're halfway through the year, so we're increasingly confident that will continue. But, even though we do see Vista lapping in the third and fourth quarters, in other words comparing Vista quarters to Vista quarters, we do see a number of elements that will drive higher revenue growth than the overall PC unit growth rate. We still have good year-over-year comps in the second half on PCEE. We still have good year-over-year comps on the percentage of PC units that are shipping with Microsoft Vista Premium or Ultimate, and we still see the notebook part of the market driving most of the growth as opposed to desktops, which of course works in our favor. So why don't I turn it over to Ramzi for a color on how we're progressing on the PC88.

Ramzi Haidamus - Executive Vice President, Sales and Marketing

The PC88 program has shown continued growth, we're pretty excited. The three companies you named Acer, Lenovo and Toshiba are the leaders in terms of skilled option. They have grown from last year to this year. And also looking at positive adoption for the second generation of PCEE for these three companies and beyond which include the PCEE next-generation includes surround sound, Dolby headphone and we are seeing similar market acceptance to that. So overall, the trend looks fairly encouraging.

Ingrid Chung - Goldman Sachs

Okay, great. Thanks.

Operator

We'll take our next question from Ralph Schackart with William Blair & Company.

Ralph Schackart - William Blair & Company

Hi, good afternoon. Another great set of results guys. Bill, I was wondering if you could help us sort of frame this PC market opportunity that you have, that continues to be pretty robust maybe in a pretty high level sense. Question I get all the time is what's the penetration rate with Dolby. What is the sustainability of this growth rate? May be you could give to us in a baseball analogy what inning are you in and the sort of growth trajectory with the PC business today?

N.W. (Bill) Jasper, Jr., - President, Director, and Chief Executive Officer

I like your framing of the question, Ralph.

Ralph Schackart - William Blair & Company

Making it easy for you Bill.

N.W. (Bill) Jasper, Jr., - President, Director, and Chief Executive Officer

We still see a lot of growth. Obviously the whole industry is moving much more towards the use of notebooks as media centric PCs are well positioned there. We still see growth coming from Microsoft going forward. We think there is continued, as Kevin pointed out, continued attach rates for second ISPs, Dolby Digital decoders and PCs. So we remain fairly well optimistic. We have factored in greater confidence that many PCs will shift through fiscal 2008 with the DVD playback software, and overall we are comfortable with our unit growth assumptions. We expect plus or minus 10% unit growth worldwide again mainly on notebook computers. So we think we're very positive in future. Kevin, you want to add anything.

Kevin Yeaman - Executive Vice President and Chief Financial Officer

I just want to add is that... and actually Ramzi covered it as well, but we’re just beginning to see PC units shipped with Blu-ray players. So that... well that's very early days for us and probably not a factor in '08 it is over the... over the longer term another reason to believe that there is strength in the ISV market for DVD players.

Ralph Schackart - William Blair & Company

Great. That was helpful. And one more for Kevin, if I could Kevin, I have to ask the consumer question here. I mean these set of results obviously don't show it, but are you seeing any other consumer headwinds start to work the way into the business. And I think last quarter you said you had visibility to about half of the yearly numbers and so far no consumer rolling in the business. Just wonder if you can give us an update there? Thanks.

Kevin Yeaman - Executive Vice President and Chief Financial Officer

Yes. So far we haven't seen any tangible signs of it. And at this point, we obviously half our year done more one quarter in arrears obviously in terms of the reports we receive but we do look to industry analyst data, we look to the results of other companies and ecosystems that are relevant to our markets. We speak to our customers and we triangulate all of that when we come up with a market growth assumption for the unit categories that are particularly important to our revenue growth rates. And we think we take a conservative view of those data points but we haven't seen any intangible signs of slowdown. And I guess the other thing that I would emphasize that we... we emphasized last quarter but still holds true for the rest of the year and that’s for two of our largest growth markets, PC and broadcast, the growth is being driven largely by increased attach rates relative to the prior year quarters where we're on… we have more technologies in PCs this year than we did a year ago, because of the increasing attach rate of Vista Premium, the continued strength of ISVs, the PCW initiative, we run more televisions and set-top boxes around the world because of the fact that in North America any TV shipping with the tuner has to have a digital turner, due to the fact that in Europe, you're announcing television shipping with Dolby Digital to take advantage of the HD services which are also driving set-top box growth in Europe. So, those are the primary drivers, and as for the consumer we read everything eagerly as you do, but haven’t seen anything specific yet.

N.W. (Bill) Jasper, Jr., - President, Director, and Chief Executive Officer

I think one thing to remember Ralph is the fact that we are global, we are out there not just in North America, but many, many countries around the world. So, I think to the extent that U.S. does slide slightly, we're well positioned in rest of the world.

Ralph Schackart - William Blair & Company

Right. Thanks guys.

Operator

We will take our next question from Mike Olson with Piper Jaaffray.

Mike Olson - Piper Jaffraay

Thanks, good afternoon. A couple of quick questions, as far as the gross margin for the year, I guess with the change in revenue mix for the year, what do you think gross margin could be for the remainder of the year, given it was 90% this quarter, can it stay at that level?

Kevin Yeaman - Executive Vice President and Chief Financial Officer

So, yes it can stay at about that level, because we're going to see... we're going to continue to see a similar mix until we start recognizing the digital cinema revenue in the beginning of next year. And then we'll start to see a shift back towards more balance on the product side.

Mike Olson - Piper Jaffraay

Okay. And then as far as Dolby Volume, that seems like that could be a pretty huge opportunity and can you just talk about the kinds of royalty rates for looking at, I would guess it’s less than the $1 average royalty for the company. But, is it significantly lower?

N.W. (Bill) Jasper, Jr., - President, Director, and Chief Executive Officer

Much with like the other technologies, we have not announced obliviously the royalty ASPs on specific technologies. But, to your earlier comment it is, it continues to look like a good opportunity for us. Right now, we are at the phase were a series of integrated circuit and implementation chips are getting tested and certified. Our goal is to have several of those be in the marketplace as we speak and as we edge towards the end of the fiscal year. And the next phase of course is the product uptake by televisions and receivers and we saw the Toshiba announcement were the first two televisions test is certified and will be shipping in Japan. So we are on the right track, it's the track that we're expected to be on, so it's looking fairly good.

Mike Olson - Piper Jaffraay

Okay. And then just one last quick one, I understand that Dolby is becoming more of a defect of standard in Europe on the digital TV side. Is there any chance, European countries adopt ATSC for Digital TV and you become mandatory.

N.W. (Bill) Jasper, Jr., - President, Director, and Chief Executive Officer

The switch to ATSC in Europe is pretty unlikely. The European Community is very comfortable with its performance of the DVD standard and in other areas where it's not, it will be such as satellite bay and broadcast of course those are their own standards. So, we do not see that shift, nevertheless we're very happy with the uptake of Dolby Digital... Dolby Digital Plus and ATSC on those regions.

Mike Olson - Piper Jaffraay

Okay. Thanks a lot.

Operator

We will take our next question from Paul Costaer with JP Morgan.

Paul Coster - JP Morgan

Thank you. Is there any way in which you can quantify the importance of the increased attach rate as a revenue driver by product category?

Kevin Yeaman - Executive Vice President and Chief Financial Officer

Well, I guess I would say that we've been, the first half of the year as we've said each of those quarters we doubled the revenue from the PC category. So the increased attach rate in the form Vista Premium and Ultimate and the increased attach rate of PCEE is the primary driver of that revenue growth over and above PC unit growth and the shift towards notebook so it's the largest driver.

Paul Coster - JP Morgan

What about in the other categories?

Kevin Yeaman - Executive Vice President and Chief Financial Officer

And in broadcast again, we've been growing at a healthy clip that was... it was just over 15% of revenue in 2007 and it will be between 15% and 20% in 2008. And it's been again the largest driver. I mean we're planning for more growth in the mid-single digits for worldwide TV shipment. So really where a lot of the growth is coming from is the increased attach rate both in North America and Europe. In the consumer electronics market, that's where for the largest product category in that market for our standard DVD, the attach rate is not particularly a driver there so it is very much a matter of unit growth. We are expecting a decline in unit growth around the world in standard DVD players. What's offsetting that is the… our [inaudible] increases. But also increased attach rates and inclusion of technologies and some of the smaller but in some cases growing categories such as digital camcorders, home-theater-in-a-box systems etcetera.

Paul Coster - JP Morgan

How long will we have to wait before Mobile becomes a sort of material subset of your licensing?

Kevin Yeaman - Executive Vice President and Chief Financial Officer

Well, it's a meaningful part of our other category between... with the addition of Coding Technologies, the revenues from the inclusion of HEAC on many multimedia handsets around the world as part of that other category. I wouldn't venture a guess yet as to when we might be breaking that out as a separate category from other.

Paul Coster - JP Morgan

Okay, great. Thank you.

Operator

We'll take our next question from Brian Thackray with Deutsche Bank.

Brian Thackray - Deutsche Bank

Thanks guys, good quarter. If we look at Europe and television broadcast market, can you give us a sense of your penetration has increased significantly at all in the last three months? Where do you expect that to go over say the next six months?

Kevin Yeaman - Executive Vice President and Chief Financial Officer

I'm sorry. I missed the very beginning of your question. Was it?

Brian Thackray - Deutsche Bank

If you look at your penetration of Europe and the television broadcast markets, where do think that can go in the six months, has it changed at all materially in the last three?

Kevin Yeaman - Executive Vice President and Chief Financial Officer

Well, first of all, the data, which we get on this ourselves gives us a pretty good ability to get measurements on that on an annual basis. But in increments of a quarter or two that's more difficult for us to address. What I can tell you is that there has been a significant increase in the attach rate year over... in '08 over '07 and we think there is considerable growth available to us over the next couple of years as digital television continues to adopt Dolby Digital and HEAC.

Brian Thackray - Deutsche Bank

Okay. And I may have missed this on the PCEE... the second gen PCEE, is there any royalty change at all with that technology? And can you also talk about potential other potential OEMs adopting PCEE in addition to the three major ones you have now?

Tim Partridge - Executive Vice President, Products and Technologies

Let me answer your second question first, the PCEE continues to see a new adoption or continually seeing, certainly over last year an increased adoption both in terms of SKUs and company, number of companies adopting it, and we will be looking over the next 12 months at adding more companies and SKUs, to take on the PCEE second generation. So, overall it is on a growth trajectory both from the perspective of SKUs as well as the number of companies adopting technology.

Kevin Yeaman - Executive Vice President and Chief Financial Officer

Yes. In terms of the ASP question, we're not going to get into breaking out the ASPs by technology, but if I would say that the greater significance of pointing out the next generation of PCEE continues to be that we are at stage where we're out getting lots of design wins getting on more SKUs, and that's really the... that should be the primary focus in terms of revenue drivers at this stage in the cycle.

Brian Thackray - Deutsche Bank

Thanks.

Tim Partridge - Executive Vice President, Products and Technologies

It's not cheaper than the first version.

Brian Thackray - Deutsche Bank

Okay. And then, Kevin, I think, you mentioned that the gaming vertical was particularly strong this quarter. How much of that was seasonal, do you think and how much of that is sustainable moving into the back half of your year here?

Kevin Yeaman - Executive Vice President and Chief Financial Officer

Well, we are assuming that, in our guidance that it's largely seasonal, we... I think we saw a very, well we did see a very strong increase in the fiscal second quarter. We are assuming that tails off in the second half due to seasonality.

Brian Thackray - Deutsche Bank

Okay. Thanks, guys. Good quarter.

Operator

We'll take our next question from Andy Hargreaves with Pacific Crest.

Andrew Hargreaves - Pacific Crest

Hi, guys. First of all, I didn't realize you guys got COLA [ph] licenses, or COLA increases, it must be nice to get 90% margins and COLA increases. But, wondering, if you narrow, down again back on the PCEE, you went through all the reasons it’s so strong but, wondered if you could help us, I guess breakdown how much of the increase that you're referring to in a license guidance increase is coming from our performance in Q2 versus higher expectations for Q3 and Q4?

Kevin Yeaman - Executive Vice President and Chief Financial Officer

So, in total we raised licensing guidance by about $25 million and as you can see, we guided on annual basis, but relative to consensus expectations we can see that it was approximately $15 million over the second quarter. As we do look at it on an annual basis, and on that annual basis, it was predominantly PC and then to a much lesser extent gaming, because of that really strong seasonal performance in Q2. And so, it is spread throughout the year, it’s not concentrated in just in Q2. And it's partly because we had very strong performance in Q2, and it's partly because we're that much closer to Q3 and Q4 now, that we at least have some data points on how others and the ecosystems have done and we also have greater confidence about the continued success of the ISV providers of getting embedded into units in cases where there… in cases when there is also Vista Premium and of course another cases whether the only DVD player and that as we look beyond this year, I think they stand about a bit from the Blu-ray upgrade cycle.

Andrew Hargreaves - Pacific Crest

Okay. And then on the product side, is most of the delay in product sales are weakness in the product sales, whatever you want to refer to it, related specifically to continued lagging from the DCIP, it was a fairly same as movie producers that had been complaining about that fairly publicly recently or is it broader than the DCIP?

Kevin Yeaman - Executive Vice President and Chief Financial Officer

Let me first clarify and then turn over to Tim. Let me first clarify that we were not referring to lag in product sales. If anything... our product sales in the digital cinema space are doing a little better than what we had thought when we first came into the provided guidance. But what has changed is our revenue guidance because we don't plan on recognizing the revenue from those sales until the first half of 2009. We used to be expecting it in the second half of 2008. But in terms of your question on where the market stands...

Tim Partridge - Executive Vice President, Products and Technologies

We… Andy, we have said in the past that as digital cinema takes off, it could negatively impact our traditional cinema products and we continue to see a little bit of that. But as Kevin said, it’s mostly about the digital cinema servers, which are selling a little bit now, but we are waiting for this ramp up. As you know, the whole industry is talking about a major real lout [ph] and the other exhibitors talking about that happening in the second half of this year. So, that’s what we’re giving up for. We think we are well positioned for it and because of the delay in DCI selecting agencies around the world to provide certification that a particular server is DCI compliant, that’s why we are having to delay our own revenue recognition. So we do think we are well positioned for the real lout when it happens and we still believe that it will happen in the second half of this calendar year.

Andrew Hargreaves - Pacific Crest

Great, thanks.

Operator

We will go next to Daniel Ernst with Hudson Square Research.

Daniel Ernst - Hudson Square Research

Yes, good evening. Thanks for taking the call. Two questions, if I may. On the embedded, single… or mid-single digit growth in the traditional Consumer Electronics, was DVD still positive? And then if not, do you think in your sort of 12 months to 18 month forecast, would Blu-ray start to make up for that, and make the category, DVD players and Blu-ray combined, a positive trend again?

N.W. (Bill) Jasper, Jr. - President, Director, and Chief Executive Officer

We've continued to see single digit. We've continued to see slight revenue growth from the DVD category in the first half. As we look to the second half, we continue to base our guidance on declines in DVD volumes, and that’s for just standard DVD. We factored in very little contribution from Blu-ray stand-alone DVD players in this fiscal year, obviously, they have to ship by June 30 to hit this fiscal year. And not prepared to give any guidance on 2009. But, I'm sure Ramzi could add some color on our thoughts around Blu-ray generally.

Ramzi Haidamus - Executive Vice President, Sales and Marketing

Blu-ray, as I mentioned earlier, since Toshiba stopped making and manufacturing and promoting HD, it did clear up the way for almost all CE manufactures to rally around the Blu-ray format. So, instead of having competition between two formats of course, now have competition on one format, but on price, which is ideally what we really would like to see. So, in this new world, we're looking at the latest prices of Blu-ray disk covering around $299 price points, $399 price points is the general Sony's… have their $399 price point on the Web. So, it's not at the magical $199 that you would like to see for mass adoption, but I would say that trend is going in the right place. I think 2009 will be the year that we will see Blu-ray take off as we also look at the PC side of it, and we start to look at the high-end PC... laptop starting to ship for a premium price with Blu-ray disk such as HP, Dell, Acer and Lenovo all for $200 to $300 will add a blue Blu-ray disk player and drive. So, the trend overall looks to be fairly positive and I'd say '09 will be the right year where it will take off.

Daniel Ernst - Hudson Square Research

Great. That's very helpful. As a follow-up question, you mentioned a lot of positive trends on your exposure on international broadcast either as a standard or as an obvious upgrade embedded in the standard. How about on the IPTV side, which is pretty… very [inaudible] from Deutsche Telekom to Apple TV… and maybe Apple TV because it’s a little more relevant as of today with their ability to get day-and-date releases of digital at opportune time as DVD. But, can you comment on your positioning in the IPTV world?

N.W. (Bill) Jasper, Jr. - President, Director, and Chief Executive Officer

IPTV is a very compelling application, the ones that we have seen and whether you look at [inaudible], it is quite a compelling offering. But, frankly I would say the entire industry has not seen the uptake that we hope and thought would happen. So, where… I think it now has a critical mass of adoption at this point, and we're still waiting to see it take-off to see what kind of content and technologies will be used in these type of solutions. So, I would say other than a few large companies trying to push it, it’s still not the critical mass so who really make large observation about the trend and day-in with DVD or large releases.

Ramzi Haidamus - Executive Vice President, Sales and Marketing

But, we think we're well positioned with aacPlus.

Marty A. Jaffe - Executive Vice President, Business Affairs

Dolby Digital Plus is another technology that Dolby has been pushing. So, between HE-AAC as well Dolby Digital Plus from a technology perspective, Dolby is certainly working with all the key players on making sure that our technologies are being used for stereo and multi-channel use.

Daniel Ernst - Hudson Square Research

Great. Thank you.

Operator

We'll take our next question from with Hunter DuBose

with Morgan Stanley.

Hunter DuBose - Morgan Stanley

Thank you. My first question is, can you give us some idea of the proportional contribution to total PC revenue, license revenue from PCEE this quarter, and some indignation of how that's ramped over the last few quarters? And my next question is, obviously, you have made clear you reluctant to discuss specific of ASPs from technology to technology, but it would be useful for helping to size up the opportunity and quantify the opportunity from some of your newer technologies just to get a sense of relative proportionality? For example, if a new market internationally were to select aacPlus versus Dolby Digital for its broadcast technology there. Is Dolby agnostic to that from an ASP point of view or would one represent a better opportunity than the other? Thank you.

N.W. (Bill) Jasper, Jr. - President, Director, and Chief Executive Officer

On PCEE, I'm not prepared to break out the PC market by product category. I would just say that it was… as we said before, there was very little revenue in 2007, it's been growing through '08, and it's a meaningful contributor to the growth in the second half as a percentage of absolute dollar growth. So, it’s doing well. On ASPs, it really varies by new technology. Ramzi, if you have any perspective on that?

Ramzi Haidamus - Executive Vice President, Sales and Marketing

To your PCEE question, we have… I can add a little bit more texture to what I have said earlier. The PCEE opportunity tends to find itself… the proliferation seems to be in three areas, notebooks, desktops and motherboards. In that order. So, the largest prevalent uptake is on the notebook, which we would like to see, because that's where we have the lead compliance issues, us as second, and a motherboard from Intel is a distant third in terms of volume. As I mentioned earlier, we have seen significant uptakes in the number of skews, adopting them and we're looking at more companies looking forward. We have not broken out the ASP on PCEE nor… but your second question on how agnostic we are on the technologies out there, Dolby Digital and Dolby Digital Plus are somewhat of a different piece from a likely perspective than HE-AAC. Prior to Dolby acquiring Coding Technologies, Dolby Digital and Dolby Digital Plus were a full licensing package, which include trademark know-how on patents, which commanded a royalty commensurate with previous historical royalties that the company has collected from manufacturers. HE-AAC prior to the acquisition of CT was strictly a patent licensing program and by its nature it does command a lower royalty because you don't know how the trademark or the know-how that comes along with it. As Bill and Kevin had mentioned on previous calls, the synergies between the CT acquisition and Dolby, should they play out the way we plan to, will hopefully command an additional stream from branding and from know-how, but we haven't realized those at the time, given that… because the acquisition didn't happen that long ago. So, looking forward, we would like to be at the point where we can say we are agnostic between the two.

Hunter DuBose - Morgan Stanley

Okay. Thank you.

Operator

We'll take our next question from Alan Davis with DA Davidson.

Alan Davis - DA Davidson

Yes, thanks. Just a couple of questions here guys. Following up on that last question on the perhaps increased revenue stream we can create from Coding Technologies, can you just comment on what kind of premium or what they were getting that you could possibly command as premium?

N.W. (Bill) Jasper, Jr. - President, Director, and Chief Executive Officer

It's a bit early to comment on that. The product roadmaps are all being completed and communicated under NDAs to our potential licensees. It’s suffice to say that we are looking at compatibility… we're looking at creating a product line, which will prove to be compactable with existing receivers. So, we are looking at the use of HE-AAC plus Dolby Digital and/or Dolby Digital Plus to make sure that while we take advantage of an efficient transition line using HE-AAC, the compatibility at the receiver and player side is preserved and that offers us the opportunity to take advantage of both technologies, within was branding opportunity on top of that. So, clearly there is value out here for the broadcasters in terms of efficient use of their pipelines and bandwidth and for the consumer viz-a-viz compatibility with existing consumer electronic that they’ve purchased. The delta and ASP has not finalized yet, since we are still in the heart of finalizing the product roadmap.

Alan Davis - DA Davidson

Okay. And then just one point of clarification here. Given Microsoft's 5% growth in client unit volume last quarter, in the March quarter, and your increased outlook in the PC space, sounds like the biggest delta there in your prior guidances and increase in your view on premium mix of Vista?

N.W. (Bill) Jasper, Jr. - President, Director, and Chief Executive Officer

It is also that… remember that coming into the year, we had some caution built-in around whether the ISV attach rate would continue to be strong, given all the shipments of Microsoft Vista and we’ve continued to see that hold firm and now that we are further through the year, our guidance represents more confidence in that.

Alan Davis - DA Davidson

Okay. And, you mentioned your expectations declined in the standard definition DVD market royalties in the second half. Are those constant or have you changed your outlook there in the second half at all?

N.W. (Bill) Jasper, Jr. - President, Director, and Chief Executive Officer

We haven't changed it significantly. We came in, I think, with a pretty conservative view of DVD growth or I should say DVD declines. We did probably a little better in the first half than we were assuming coming into the year, but that hasn't changed our view on the second half, which is to expect declines in that category.

Alan Davis - DA Davidson

Okay. And then early days, but update on traction you're getting with TrueHD, and Blu-ray players?

N.W. (Bill) Jasper, Jr. - President, Director, and Chief Executive Officer

The content with TrueHD, it’s not as prevalent as Dolby Digital Plus and Dolby Digital. It is something that is high on our priority in terms of marketing and encouraging its uptake. What we have seen in Blu-ray players is that you will see TrueHD in all high-end Blu-ray players. So, the Sony players and other players which we considered high-end, i.e. $500 plus, you're going to see a Dolby Digital Plus and TrueHD multi-channel decoder. On the lower end players, you're going to see a bare-bone player, and not just on the Dolby perspective, from all technology… all premium technology perspective. So, today, the way I will categorize it is, TrueHD is being shipping in high-end players. As the price for these players do go down and content becomes more prevalent from a TrueHD, we do foresee higher penetration of TrueHD over time.

Alan Davis - DA Davidson

Okay. And therefore some premium over which [inaudible] players?

N.W. (Bill) Jasper, Jr. - President, Director, and Chief Executive Officer

That is correct.

Alan Davis - DA Davidson

Okay. And then lastly, just wondering if you are willing to share… I'd have missed it, your expectations in terms of percentage of licensing revenues for each of the four categories, product categories you talk about.

N.W. (Bill) Jasper, Jr. - President, Director, and Chief Executive Officer

Yes, I walked through our assumptions for each category, but I haven't yet punctuated it with our expectations or composition. It nets out to expecting PC to rise from around what was just about 35% in '07, we see that rising to probably getting… approaching 40% for the full year '08. with the offset primarily being the CE market. Again, it's growing slightly, but it will probably fall from around 35% to around 30% of the market, with broadcast and other markets holding around with good strong growth and being broadcast probably between 15% and 20% and other markets, which are comprised of gaming, automotive, mobile, and our via licensing services, making up the other markets, and making up the difference. That's what we have seen so far.

Alan Davis - DA Davidson

Okay.

Operator

There are no further questions at this time. Mr. Jasper, I'll turn the call back over to you.

N.W. (Bill) Jasper, Jr. - President, Director, and Chief Executive Officer

Okay. Thank you very much. Thank you all for participating today. Thank you for your excellent questions. Thank you to everybody in Dolby for another very, very good quarter. And we look forward to speaking with you all the next quarter. Thank you very much.

Operator

This does conclude today's conference call. We appreciate your participation. You may disconnect at this time.

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