INVESTMENT THESIS
Dolby Laboratories (DLB, Financial) is a wonderful company with excellent business economics and prospects. Although a technology company, it’s a simple to understand business model, a highly profitable and value-creating business engine with a capable management team. They are the leaders of immersive audio, have a moat, generate plenty of free cash flow as a result of very low capital expenditure requirements, and have no debt. They currently trade at a modest discount to fair value, which I estimate at $58.
COMPANY PROFILE
Dolby Labs is the global leader in original technologies and products used throughout the entertainment industry to produce immersive and enjoyable experiences for the listener. Their technologies are ubiquitous and are designed for cinema, home audio, home theater, in-car audio, broadcast, games, TVs, DVD players, mobile devices, and personal computers. Dolby has a history of introducing innovations designed to significantly improve audio entertainment, ie. noise reduction for the recording and movie industries and surround sound for cinema and home theater entertainment. Chances are, if you can listen to it, the sound is being processed through one of Dolby’s technologies. These technologies are used in each step of the entertainment life-cycle—creation, distribution, and playback. It allows the creator, producer, and distributor to develop and present their content to the end consumer in the way they intended. The Dolby brand has become synonymous with a superior entertainment experience. The company makes approximately 75% of its revenue from licensing of its technology. The remainder of revenue comes from equipment sales to professional producers, and from audio engineering services.
COMPANY HISTORY
The company’s patriarch, Ray Dolby, founded the company in Britain in 1965 moving it later to San Francisco in 1976. The first product, Type A Dolby Noise Reduction (DNR), was a method to reduce hiss from tape playback and marketed to record companies. The second generation, Type B, was marketed to consumers in 1968. From the start, Dolby didn’t manufacture consumer products outright. Instead, he licensed the technologies to consumer electronics manufacturers.
Dolby also set out to improve film sound by reducing background noise and improving dialogue intelligibility. Their cinematic showcase was the 1971 movie A Clockwork Orange which introduced DNR on all pre-mixes and masters. In 1975, they released Dolby Stereo which combined DNR with multiple audio channels for left-center-right sound (LCRS). The first true LCRS movie was A Star is Born in 1976. By the mid-1980s, 6000 cinemas around the world were equipped to use Dolby Stereo. Dolby then used this system as the basis for home theater and created Dolby Surround and Dolby Pro Logic. From there, they created a cinematic digital surround sound compression scheme, Dolby Stereo Digital (or Dolby Digital) which was first used on the 1992 release of Batman Returns. It is now found in the HDTV standard of the US, DVD players, and many satellite-TV and cable-TV receivers. They have a vast array of products, and chances are if you can hear something, their technology is behind the scenes. Their technology spans the gamut: analog audio noise reduction, audio encoding/compression, audio processing, video processing, digital cinema and 3D, and live sound.
The company went public in 2005, under the symbol DLB, and is also listed as #17 in the Forbes “100 Best Small Companies of 2010” list.
INDUSTRY INFORMATION
In order to understand Dolby’s business model, it’s necessary to spend a few moments understanding the basic nature of the technology. These technologies are used to enhance the entertainment experience by being engaged in all aspects of the media life-cycle—creation, distribution, and playback.
Noise reduction (NR) technologies process a signal to remove, or lessen the degree, of noise which is annoying and detracts from your entertainment experience. All recording and playback devices are susceptible to noise, which is either white noise with no coherence (due to the random movement of electrons), or coherent noise introduced by a device’s processing functions. Media also plays a role in noise as a result of the grain structure and particle size of the material used. For more information, see this article on Noise Reduction.
Compression processes reduce the data rate or storage size required of information, analog or digital. These devices enable the proverbial storage of “10 pounds of stuff in a 5 pound bag.” There is a tradeoff between signal quality and transmission/storage requirements—listen to compressed audio over the internet to get a sense of this tradeoff. To listen to the signal in its original dynamic range it must be de-compressed. Compressed signals appear to sound louder than an uncompressed signal as a result of having a higher average volume level--TV commercials have highly compressed audio. For more information, see this article on Compression.
Encoders, or codecs (coder/de-coder), are devices that encode and decode a stream of digital information. Once processed the information can be transmitted, stored, or encrypted. After decoding, the information can be used for playback or editing. A simple example is a digital video camera’s converters which process analog video, code it into digital information, and store it on tape or memory cards. To see the video, the opposite process is accomplished. For more information, see this article on Encoding.
What’s critically important to understand about all of these technologies is that once a signal is processed you must de-process it to be able to hear/see the signal as it was originally intended.
Additionally, these processes and technologies are covered under patent rights enabling monopoly rights for a lengthy period of time.
Standards setting agencies exist in the consumer electronics industry to define technical standards, such as the HDTV format. This allows us to buy equipment made by different manufacturers and see/hear an end result as intended in an environment of compatibility. These standards can either be explicit standard (mandated by the agencies themselves), or standards can evolve (aka de-facto standards) from the widespread use of a particular product. An example of a de-facto standard is Adobe’s PDF.
Imagine what happens when a company can: create a proprietary technology/process; maintain monopoly rights to use it or license it; provide products and services related to their technologies; and establish it as an explicit or de-facto standard everywhere…
BUSINESS MODEL
Since the beginning, their strategy has been to focus on technologies in sound that enhance the listening experience, patent it, and then set them as industry standards. This business model leads to very high gross and operating margins and return on capital. Dolby has a virtual chokehold on movie theater and home audio equipment sound technologies. Almost every major movie soundtrack uses their encoding systems, in addition to all DVD players. Their technologies are also used to preserve sound quality when working with the limitations of certain storage capacity and distribution systems. Once a standard is established, Dolby receives patent royalties on the equipment used to store and view/listen to the content—design patent rights last for 14, 17, or 20 years, depending on type of design and date filed.
Dolby works directly with standards setting agencies in an attempt to have their technologies adopted in technical specifications, ensuring a common standard across devices improving the overall customer entertainment experience. For example, Dolby Digital is the standard audio technology for digital televisions in North America, while Dolby Digital is mandated in all DVD and Blu-Ray disc players worldwide. Alternatively, many European HD broadcasters began broadcasting in Dolby Digital or Dolby Digital Plus, creating a de-facto standard in the process, and led manufacturers to include these technologies in their televisions and set-top boxes for the European market.
Dolby primarily generates revenue by licensing its technologies to manufacturers of consumer electronics (CE) products and to software vendors. They additionally generate revenue by selling products and related services to entertainment content creators and distributors.
Licensing: Their licensing arrangements entitle them to receive a specified royalty for each product shipped using their technologies. Dolby also collects fees for administering joint patent licensing programs, aka patent pools, on behalf of third parties. They have three licensing models:
Two-Tier Licensing:
· Implementation licensees: are manufacturers that incorporate Dolby technologies into their integrated circuits (ICs), aka “chips.” They pay a one-time administrative fee per license in exchange for a licensing package containing useful information for implementing Dolby technology into their chips. Once the chip is built, a sample is sent to Dolby for quality control evaluation. If the implementation design is approved by Dolby, the licensee is permitted to sell the chipset only to the system licensees
· System licensees: are manufacturers of CE products. They pay an initial fee for the technologies they choose to license from Dolby. In exchange, they receive a licensing package which includes useful information for using the technologies in their products. System licensees are required to provide Dolby with prototypes of products for quality control. If the design is approved, the licensee is permitted to purchase ICs from any Dolby implementation licensee and to sell approved products to retailers, distributors, and consumers. Sales of CE products incorporating Dolby technologies are royalty-bearing, usually based on the quantity of units shipped by the CE manufacturer.
Integrated Licensing Model: Dolby licenses their technologies as embodied in software to operating system vendors, independent software vendors, and other CE manufacturers that act as a combined implementation/system-licensee. These licensees then incorporate Dolby’s technologies in their software and mobile applications, or in ICs they make themselves and include in their own CE products. In this model, the licensee pays an initial administrative fee in exchange for a licensing package. Once built, the product sample is sent to Dolby for approval, upon which the licensee may sell their product to retailers, distributors, and consumers. Royalties are generated for each unit shipped.
Licensing of Patent Pools: Via Licensing, Dolby’s wholly-owned subsidiary, administers joint patent licensing programs on behalf of third parties. Some of these patents include Dolby patents. These pools allow product manufacturers streamlined access to certain essential patents to standardized technologies in the fields of audio coding, interactive television, digital radio, and wireless technologies.
Products: Dolby designs and manufactures video and audio products for the film production, movie, and television industries. These products are used in the content life-cycle to enhance entertainment experience: enhanced images and sound quality, surround sound, and efficiency of sound storage/distribution. Sales are derived from digital 3D products in addition to sales of digital cinema servers that load, store, decrypt, and decode encrypted digital film for presentation on digital projectors. Revenue is also derived from sales of traditional cinema processors.
Services: Dolby generates revenue by providing services to support film production, television broadcast, and music production. Their engineers work with these content producers to create and reproduce the content they envision. Dolby enters into service arrangements with motion picture studios and filmmakers and provides them with support on preparation of a Dolby soundtrack, such as equipment calibration, mixing room alignment, and equalization. Other services include print quality control, professional film mastering services to prepare movies for digital release, and theater system calibration for premier screenings, film festivals, and press screenings. Their engineers additionally provide training, system design consultation, and on-site technical support and expertise to cinema operators worldwide.
COMPETITION
This industry is highly competitive—Dolby faces competitive threats and pricing pressure in their markets. Their competitors are listed for each revenue source:
· Licensed technologies: Audyssey Labs, DTS, Fraunhofer Institute for Integrated Circuits, Microsoft, Philips, RealNetworks, Sonic Solutions, Sony, SRS Labs, and Thomson
· Products: Barco, Doremi, GDC, IMAX, MasterImage 3D, NEC, Panavision, QSC Audio Products, Qube Cinema, REAL D, Sony, Technicolor, Texas Instruments, USl, and XpanD
· Services: DTS and Sony
Dolby is often mistakenly categorized as a media company. As can clearly be seen from the business model and primary source of revenue, licensing, they are a technology idea company. More appropriate competitors in this space are DTS and SRS Labs.
INTELLECTUAL PROPERTY PORTFOLIO
Dolby maintains a substantial base of intellectual property: patents, trademarks, copyrights, and trade secrets. They actively pursue new patents to expand their portfolio to address new technology changes and are active in protecting their intellectual property rights domestically and internationally.
As of the quarter ended Sept 24, 2010, Dolby had approximately 1,900 issued patents and over 2,050 patents pending throughout the world. The issued patents are schedule to expire at various times through July 2029: one expired in 2010; 34 expire in 2011; 52 expire in 2012; and 31 expire in 2013.
Dolby Digital patents, the principal source of licensing revenue, have begun to expire and the remainder generally expire at various time through 2017. Dolby Digital Plus and Dolby Digital Live patents expire between 2018-2026 and 2021, respectively.
Dolby maintains over 990 trademarks throughout the world which are an integral part of their licensing program. Licensees usually place these trademarks on their products to let consumers know that their products use Dolby technology and meet their quality specifications.
RISKS TO BUSINESS MODEL
There are some identifiable risks for Dolby going forward, they are:
· Expiration of patents: as the patents for their older technologies expire it could reduce revenue from these sources. Consequently, Dolby must continually innovate.
· Intellectual property protection: costs could rise in the future to protect and enforce its intellectual property rights in countries that don’t offer the same protection as the US, such as China.
· Competition: Increased competition could compress margins
· Blu-Ray: Dolby no longer has a monopoly—they must share a duopoly with DTS
· Open-source standards: these openly available standards are beginning to emerge and could alter the dynamics of Dolby’s business model as there would no longer be exclusivity. It remains to be seen if these get any traction—it’s the technology equivalent of the Linux/Windows wars.
· Corporate governance: Ray Dolby and his family effectively control 91% of the combined voting power of outstanding stock. For the foreseeable future, Ray, his affiliates, and his family members and descendants will have significant influence over the affairs of Dolby even if they come to own considerably less than 50% of the total share count.
· Content distribution: there’s no longer a single distribution mechanism that lasts for years, ie. LP, CD, etc. Multiple delivery methods exist to bring HD content to the consumer and will make it more challenging to integrate Dolby’s proprietary technologies into all of them.
The following section of the report provides a high-level review of the important metrics of the business quantitatively to arrive at a qualitative assessment and an estimate of intrinsic value. The review will quickly illustrate that DLB has a durable competitive advantage, or moat.
THE $1 PREMISE
To begin the financial analysis, we’ll review the “$1 Premise.” In Warren Buffet’s 1983 Owner’s Manual for Berkshire shareholders he stated that earnings retention must, in the long run, deliver at least $1 of market value for every $1 retained in the business. It’s a simple and easy acid test to determine whether a company is value-creative, or value-destructive.
Dolby has clearly delivered value to shareholders, delivering $3.77 for every $1 retained in the business.
CAPITAL STRUCTURE
DLB is capitalized with no bonds, no preferred stock, and 112M shares of common stock at a market capitalization of approximately $5.7B. There is a dual class stock structure—Class A & Class B. Class A common stock is entitled to one vote per share, where Class B is entitled to 10 votes per share. Ray Dolby owns 100 shares of Class A and 58.9M shares of Class B.
The company went public with 104M shares of stock in 2005 which rose to 115M shares by 2008, where it has remained. Additionally Dolby had $12M in long-term debt in 2005—they have since eliminated it as of 2010.
The company has a healthy balance sheet with $433.6M in cash and $270.6M in short-term investments.
REVENUE, PRE-TAX PROFIT, AND OWNER EARNINGS
A visual review of Dolby’s sales, pre-tax profit, and owner earnings curves on a logarithmic graph will quickly illustrate the stability of its operations. Owner earnings are charted, instead of GAAP accounting earnings, as it is the cash that a business can actually generate for its owners, and is calculated as:
Owner Earnings = Net Income + Depreciation & Amortization + Non-cash charges – Capex
A “wonderful” company will have curves that parallel each other and rise to the right—a visual indication of excellent management, cost control, and the presence of a competitive advantage. A not-so-wonderful company (ie. those built on commoditized products) will have choppiness in these financial figures, and the curves will be erratic.
The chart clearly shows Dolby generates consistent sales, has control over its cost structure, and has rising owner earnings over time. This is a visual indication of an efficiently run business. (Note: when this analysis is performed for SRS Labs and DTSI, the resultant chart is erratic, an indication of companies that might not be as well run as Dolby.)
Turning to growth rates, the company has enjoyed strong double-digit revenue growth since going public in 2005, which accelerated slightly within the last year. This strength in sales translated to the bottom line driving equally strong GAAP-accounting earnings, but more importantly driving strong growth in owner earnings and book value. This is a company that knows how to make money.
SALES AND COST STRUCTURE
Dolby generates the majority of its sales from licensing, approximately 75%-80%, and have the impressive ability to generate sales from multiple sources on a single standard. The remainder of sales comes from products and services as detailed below.
Their business model has extremely favorable economics which drive very large gross margins. Below is a breakout of gross margins by revenue source. Clearly the licensing business model generates superior margins; however, products and sales margins are favorable as well. All of this is due to the low capital expenditure requirements of their operations…they are an idea company predominantly, and essentially outsource the risk of product manufacture, and the resulting thinner margins, to someone else.
As the table below illustrates, Dolby has been containing costs and improving them over time as the graph of pre-tax profit above indicates. However, these figures will most likely move slightly higher in the future as Dolby invests more in R&D and Sales & Marketing to continue their dominant advantage and capturing new markets.
MANAGEMENT EFFECTIVENESS
The table below summarizes a variety of metrics to illustrate management performance and competence in making money for their shareholders. It helps us answer the question: are they efficient allocators of capital?
Cash Return on Invested Capital (CROIC) tells us how efficiently a business’ operations and management can allocate capital into the business to create even more cash for other re-investment projects. In the short-term growth can happen at any rate. But over the long-term, a business will generally grow at the rate it can generate owner earnings. This growth depends on how much cash it generates based on total cash invested by shareholders and bondholders. In short, it can be viewed as the sustainable upper limit to a company’s growth.
Dolby clearly generates copious cash and has the management acumen to generate a high ROE & CROIC. For every $100 invested, Dolby generated $21 in owner earnings on average.
BASIS OF COMPETITIVE ADVANTAGE
This financial overview illustrates that Dolby has a durable competitive advantage, or moat, working in its favor. They’ve become the undisputed kings at what they do, are everywhere, and are in everything and are ruthless about making quality sound products. Their brand is synonymous with quality. Their extensive patent portfolio, brand recognition, culture of innovation, and long-term customer relationships form the bedrock of their moat. Their moat is structurally built on:
· Real product differentiation: they create superior technology for immersive audio/video
· Perceived product differentiation: their brand stands for quality, innovation, and superior, immersive sound experiences
· Locking in customers: It’s difficult to displace their technology at the consumer level, even though competing standards are available, because consumers demand backward compatibility to support their existing investment in media. Additionally, many of their technologies are explicit standards, with the rest being de-facto standards, across the world
· Locking out competitors: Dolby creates exclusivity as a result of their patents and pursuit of their technologies becoming industry standards
· “Toll booth” business model: Every time someone wishes to use the technology, or the name, there’s a fee
VALUATION
This section will value Dolby based on two methods: a discounted cash flow (DCF) approach, and an Equity-Bond approach. No valuation method is exact since the future is unknowable, we only have history and our sense of the future to make a judgment. The more consistent a company is, the closer the estimate will be. It’s better to be approximately right than precisely wrong and overpay.
Warren Buffett described the concept of owner earnings as the cash that a business can generate for its owners. He additionally considered owner earnings, not accounting earnings, to be the relevant item for valuation purposes. If one owned the business completely, the amount of cash that could conceivably be pulled out of the business without hurting its competitive position or ability to maintain operations is what’s of value—the owner earnings.
To value Dolby with DCF, we’re interested in our expectation of future owner earnings through time, an appropriate growth rate, and a discount rate (or our required rate of return based on those expected owner earnings cash flows). My basic DCF equation is:
Fair Value = Growth Value (Years 1-10) + Terminal Value (Years 11-20) + Tangible Book Value
Since there are some future risks, and cost increases due to expected increased competition, I don’t expect Dolby’s growth to be as high as it was, but somewhere between 1-Yr Owner Earnings growth (11%) and average CROIC (20%). The following assumptions are used in the model:
· Growth-Years 1-3 = 12% (defaulted to low end of above range)
· Growth-Years 4-7 = 10.8% (10% decay rate)
· Growth-Years 8-10 = 9.7% (10% decay rate)
· Terminal-Years 11-20 = 3% (average inflation rate)
· Discount rate = 9% (required rate of return)
· Margin of Safety = 25%
· Initial Owner Earnings (2010) = $288M
· Tangible BV (2010) = $1142M
Projection of future Owner Earnings
[Note: all figures in $Millions]
DCF Fair Value = $58 (Current price = $50.83)
IRR = 11% (If purchased at the current price, the expected internal rate of return (IRR) for the above projection of owner earnings is the expected CAGR an investor would potentially make during the life of the investment.)
To value Dolby based on an Equity-Bond model, the company’s owner earnings, compared to the price paid for those earnings (aka Owner Earnings Yield), are evaluated against the risk-free investment—the 10 year T-bill. In this view, a stock can be compared against a bond. The stock would have a growing “coupon” (owner earnings) through time roughly at the book value growth rate (11%), whereas a bond would have a static coupon. The Owner Earnings Yield is calculated as:
Owner Earnings Yield (OEY) = Owner Earnings (TTM) / Market Cap
OEY = 6.66% (by comparison, 10-year T-bill = 3.4%)
The DCF analysis indicates DLB is undervalued by 13% at $50.83. The Equity-Bond analysis indicates DLB is also undervalued relative to the 10-year T-bill—by almost 2:1, with an owner earnings yield of 6.66%. This appears to be a fair price to pay for Dolby’s growth going forward.
CATALYSTS
Dolby has many opportunities ahead of it to capitalize on and provide opportunities for growth. They have a culture of innovation and have been able to adapt to each technological change in audio through the years. Catalysts for continue growth include:
· Their reputation as the undisputed kings of the home theater ecosystem provides a platform to branch off from into other markets.
· As DVDs fade, the next generation of content delivery provides growth as it moves on-line with cable, fiber optic, satellite, and real-time delivery.
· They are positioned to capitalize on new opportunities—they have a strong history of innovation and brand strength.
· Dolby is the established US standard for digital broadcast TV, cable, and satellite. They are gaining momentum internationally in many countries (France, South Korea, Brazil) as they institute standards. Half of the world’s TVs still need to transition to digital broadcast.
· The mobile device market is ripe for the picking and they can capitalize on it with Dolby Mobile and Dolby Pulse. Digital products are proliferating across the globe
· The video market is untapped territory
· Cinematic 3D is on the rise
SUMMARY
I’ve provided a top-level review of Dolby Labs, the undisputed kings of immersive and quality audio. Of course do your own due diligence, but I’m sure you’ll find them to be a wonderful company selling at a fair price.
Dolby Laboratories (DLB) has excellent business economics and prospects for future growth. Although a technology company, they have a simple to understand business model. Additionally, they are highly profitable, and have a value-creating business engine with a capable management team. They have a moat, generate plenty of free cash flow as a result of very low capital expenditure requirements, and have no debt. They currently trade at a 13% discount to fair value, which is $58.
DISCLOSURE
I currently own no shares of DLB, but do plan on purchasing.
Update: Long DLB as of April 15, 2011
Dolby Laboratories (DLB, Financial) is a wonderful company with excellent business economics and prospects. Although a technology company, it’s a simple to understand business model, a highly profitable and value-creating business engine with a capable management team. They are the leaders of immersive audio, have a moat, generate plenty of free cash flow as a result of very low capital expenditure requirements, and have no debt. They currently trade at a modest discount to fair value, which I estimate at $58.
COMPANY PROFILE
Dolby Labs is the global leader in original technologies and products used throughout the entertainment industry to produce immersive and enjoyable experiences for the listener. Their technologies are ubiquitous and are designed for cinema, home audio, home theater, in-car audio, broadcast, games, TVs, DVD players, mobile devices, and personal computers. Dolby has a history of introducing innovations designed to significantly improve audio entertainment, ie. noise reduction for the recording and movie industries and surround sound for cinema and home theater entertainment. Chances are, if you can listen to it, the sound is being processed through one of Dolby’s technologies. These technologies are used in each step of the entertainment life-cycle—creation, distribution, and playback. It allows the creator, producer, and distributor to develop and present their content to the end consumer in the way they intended. The Dolby brand has become synonymous with a superior entertainment experience. The company makes approximately 75% of its revenue from licensing of its technology. The remainder of revenue comes from equipment sales to professional producers, and from audio engineering services.
COMPANY HISTORY
The company’s patriarch, Ray Dolby, founded the company in Britain in 1965 moving it later to San Francisco in 1976. The first product, Type A Dolby Noise Reduction (DNR), was a method to reduce hiss from tape playback and marketed to record companies. The second generation, Type B, was marketed to consumers in 1968. From the start, Dolby didn’t manufacture consumer products outright. Instead, he licensed the technologies to consumer electronics manufacturers.
Dolby also set out to improve film sound by reducing background noise and improving dialogue intelligibility. Their cinematic showcase was the 1971 movie A Clockwork Orange which introduced DNR on all pre-mixes and masters. In 1975, they released Dolby Stereo which combined DNR with multiple audio channels for left-center-right sound (LCRS). The first true LCRS movie was A Star is Born in 1976. By the mid-1980s, 6000 cinemas around the world were equipped to use Dolby Stereo. Dolby then used this system as the basis for home theater and created Dolby Surround and Dolby Pro Logic. From there, they created a cinematic digital surround sound compression scheme, Dolby Stereo Digital (or Dolby Digital) which was first used on the 1992 release of Batman Returns. It is now found in the HDTV standard of the US, DVD players, and many satellite-TV and cable-TV receivers. They have a vast array of products, and chances are if you can hear something, their technology is behind the scenes. Their technology spans the gamut: analog audio noise reduction, audio encoding/compression, audio processing, video processing, digital cinema and 3D, and live sound.
The company went public in 2005, under the symbol DLB, and is also listed as #17 in the Forbes “100 Best Small Companies of 2010” list.
INDUSTRY INFORMATION
In order to understand Dolby’s business model, it’s necessary to spend a few moments understanding the basic nature of the technology. These technologies are used to enhance the entertainment experience by being engaged in all aspects of the media life-cycle—creation, distribution, and playback.
Noise reduction (NR) technologies process a signal to remove, or lessen the degree, of noise which is annoying and detracts from your entertainment experience. All recording and playback devices are susceptible to noise, which is either white noise with no coherence (due to the random movement of electrons), or coherent noise introduced by a device’s processing functions. Media also plays a role in noise as a result of the grain structure and particle size of the material used. For more information, see this article on Noise Reduction.
Compression processes reduce the data rate or storage size required of information, analog or digital. These devices enable the proverbial storage of “10 pounds of stuff in a 5 pound bag.” There is a tradeoff between signal quality and transmission/storage requirements—listen to compressed audio over the internet to get a sense of this tradeoff. To listen to the signal in its original dynamic range it must be de-compressed. Compressed signals appear to sound louder than an uncompressed signal as a result of having a higher average volume level--TV commercials have highly compressed audio. For more information, see this article on Compression.
Encoders, or codecs (coder/de-coder), are devices that encode and decode a stream of digital information. Once processed the information can be transmitted, stored, or encrypted. After decoding, the information can be used for playback or editing. A simple example is a digital video camera’s converters which process analog video, code it into digital information, and store it on tape or memory cards. To see the video, the opposite process is accomplished. For more information, see this article on Encoding.
What’s critically important to understand about all of these technologies is that once a signal is processed you must de-process it to be able to hear/see the signal as it was originally intended.
Additionally, these processes and technologies are covered under patent rights enabling monopoly rights for a lengthy period of time.
Standards setting agencies exist in the consumer electronics industry to define technical standards, such as the HDTV format. This allows us to buy equipment made by different manufacturers and see/hear an end result as intended in an environment of compatibility. These standards can either be explicit standard (mandated by the agencies themselves), or standards can evolve (aka de-facto standards) from the widespread use of a particular product. An example of a de-facto standard is Adobe’s PDF.
Imagine what happens when a company can: create a proprietary technology/process; maintain monopoly rights to use it or license it; provide products and services related to their technologies; and establish it as an explicit or de-facto standard everywhere…
BUSINESS MODEL
Since the beginning, their strategy has been to focus on technologies in sound that enhance the listening experience, patent it, and then set them as industry standards. This business model leads to very high gross and operating margins and return on capital. Dolby has a virtual chokehold on movie theater and home audio equipment sound technologies. Almost every major movie soundtrack uses their encoding systems, in addition to all DVD players. Their technologies are also used to preserve sound quality when working with the limitations of certain storage capacity and distribution systems. Once a standard is established, Dolby receives patent royalties on the equipment used to store and view/listen to the content—design patent rights last for 14, 17, or 20 years, depending on type of design and date filed.
Dolby works directly with standards setting agencies in an attempt to have their technologies adopted in technical specifications, ensuring a common standard across devices improving the overall customer entertainment experience. For example, Dolby Digital is the standard audio technology for digital televisions in North America, while Dolby Digital is mandated in all DVD and Blu-Ray disc players worldwide. Alternatively, many European HD broadcasters began broadcasting in Dolby Digital or Dolby Digital Plus, creating a de-facto standard in the process, and led manufacturers to include these technologies in their televisions and set-top boxes for the European market.
Dolby primarily generates revenue by licensing its technologies to manufacturers of consumer electronics (CE) products and to software vendors. They additionally generate revenue by selling products and related services to entertainment content creators and distributors.
Licensing: Their licensing arrangements entitle them to receive a specified royalty for each product shipped using their technologies. Dolby also collects fees for administering joint patent licensing programs, aka patent pools, on behalf of third parties. They have three licensing models:
Two-Tier Licensing:
· Implementation licensees: are manufacturers that incorporate Dolby technologies into their integrated circuits (ICs), aka “chips.” They pay a one-time administrative fee per license in exchange for a licensing package containing useful information for implementing Dolby technology into their chips. Once the chip is built, a sample is sent to Dolby for quality control evaluation. If the implementation design is approved by Dolby, the licensee is permitted to sell the chipset only to the system licensees
· System licensees: are manufacturers of CE products. They pay an initial fee for the technologies they choose to license from Dolby. In exchange, they receive a licensing package which includes useful information for using the technologies in their products. System licensees are required to provide Dolby with prototypes of products for quality control. If the design is approved, the licensee is permitted to purchase ICs from any Dolby implementation licensee and to sell approved products to retailers, distributors, and consumers. Sales of CE products incorporating Dolby technologies are royalty-bearing, usually based on the quantity of units shipped by the CE manufacturer.
Integrated Licensing Model: Dolby licenses their technologies as embodied in software to operating system vendors, independent software vendors, and other CE manufacturers that act as a combined implementation/system-licensee. These licensees then incorporate Dolby’s technologies in their software and mobile applications, or in ICs they make themselves and include in their own CE products. In this model, the licensee pays an initial administrative fee in exchange for a licensing package. Once built, the product sample is sent to Dolby for approval, upon which the licensee may sell their product to retailers, distributors, and consumers. Royalties are generated for each unit shipped.
Licensing of Patent Pools: Via Licensing, Dolby’s wholly-owned subsidiary, administers joint patent licensing programs on behalf of third parties. Some of these patents include Dolby patents. These pools allow product manufacturers streamlined access to certain essential patents to standardized technologies in the fields of audio coding, interactive television, digital radio, and wireless technologies.
Products: Dolby designs and manufactures video and audio products for the film production, movie, and television industries. These products are used in the content life-cycle to enhance entertainment experience: enhanced images and sound quality, surround sound, and efficiency of sound storage/distribution. Sales are derived from digital 3D products in addition to sales of digital cinema servers that load, store, decrypt, and decode encrypted digital film for presentation on digital projectors. Revenue is also derived from sales of traditional cinema processors.
Services: Dolby generates revenue by providing services to support film production, television broadcast, and music production. Their engineers work with these content producers to create and reproduce the content they envision. Dolby enters into service arrangements with motion picture studios and filmmakers and provides them with support on preparation of a Dolby soundtrack, such as equipment calibration, mixing room alignment, and equalization. Other services include print quality control, professional film mastering services to prepare movies for digital release, and theater system calibration for premier screenings, film festivals, and press screenings. Their engineers additionally provide training, system design consultation, and on-site technical support and expertise to cinema operators worldwide.
COMPETITION
This industry is highly competitive—Dolby faces competitive threats and pricing pressure in their markets. Their competitors are listed for each revenue source:
· Licensed technologies: Audyssey Labs, DTS, Fraunhofer Institute for Integrated Circuits, Microsoft, Philips, RealNetworks, Sonic Solutions, Sony, SRS Labs, and Thomson
· Products: Barco, Doremi, GDC, IMAX, MasterImage 3D, NEC, Panavision, QSC Audio Products, Qube Cinema, REAL D, Sony, Technicolor, Texas Instruments, USl, and XpanD
· Services: DTS and Sony
Dolby is often mistakenly categorized as a media company. As can clearly be seen from the business model and primary source of revenue, licensing, they are a technology idea company. More appropriate competitors in this space are DTS and SRS Labs.
INTELLECTUAL PROPERTY PORTFOLIO
Dolby maintains a substantial base of intellectual property: patents, trademarks, copyrights, and trade secrets. They actively pursue new patents to expand their portfolio to address new technology changes and are active in protecting their intellectual property rights domestically and internationally.
As of the quarter ended Sept 24, 2010, Dolby had approximately 1,900 issued patents and over 2,050 patents pending throughout the world. The issued patents are schedule to expire at various times through July 2029: one expired in 2010; 34 expire in 2011; 52 expire in 2012; and 31 expire in 2013.
Dolby Digital patents, the principal source of licensing revenue, have begun to expire and the remainder generally expire at various time through 2017. Dolby Digital Plus and Dolby Digital Live patents expire between 2018-2026 and 2021, respectively.
Dolby maintains over 990 trademarks throughout the world which are an integral part of their licensing program. Licensees usually place these trademarks on their products to let consumers know that their products use Dolby technology and meet their quality specifications.
RISKS TO BUSINESS MODEL
There are some identifiable risks for Dolby going forward, they are:
· Expiration of patents: as the patents for their older technologies expire it could reduce revenue from these sources. Consequently, Dolby must continually innovate.
· Intellectual property protection: costs could rise in the future to protect and enforce its intellectual property rights in countries that don’t offer the same protection as the US, such as China.
· Competition: Increased competition could compress margins
· Blu-Ray: Dolby no longer has a monopoly—they must share a duopoly with DTS
· Open-source standards: these openly available standards are beginning to emerge and could alter the dynamics of Dolby’s business model as there would no longer be exclusivity. It remains to be seen if these get any traction—it’s the technology equivalent of the Linux/Windows wars.
· Corporate governance: Ray Dolby and his family effectively control 91% of the combined voting power of outstanding stock. For the foreseeable future, Ray, his affiliates, and his family members and descendants will have significant influence over the affairs of Dolby even if they come to own considerably less than 50% of the total share count.
· Content distribution: there’s no longer a single distribution mechanism that lasts for years, ie. LP, CD, etc. Multiple delivery methods exist to bring HD content to the consumer and will make it more challenging to integrate Dolby’s proprietary technologies into all of them.
The following section of the report provides a high-level review of the important metrics of the business quantitatively to arrive at a qualitative assessment and an estimate of intrinsic value. The review will quickly illustrate that DLB has a durable competitive advantage, or moat.
THE $1 PREMISE
To begin the financial analysis, we’ll review the “$1 Premise.” In Warren Buffet’s 1983 Owner’s Manual for Berkshire shareholders he stated that earnings retention must, in the long run, deliver at least $1 of market value for every $1 retained in the business. It’s a simple and easy acid test to determine whether a company is value-creative, or value-destructive.
2010 | 2003 | Change | |
Retained Earnings | $1136M | $85M | $1051M |
Market Value | $5756M | $1785M | $3971M |
Dolby has clearly delivered value to shareholders, delivering $3.77 for every $1 retained in the business.
CAPITAL STRUCTURE
DLB is capitalized with no bonds, no preferred stock, and 112M shares of common stock at a market capitalization of approximately $5.7B. There is a dual class stock structure—Class A & Class B. Class A common stock is entitled to one vote per share, where Class B is entitled to 10 votes per share. Ray Dolby owns 100 shares of Class A and 58.9M shares of Class B.
The company went public with 104M shares of stock in 2005 which rose to 115M shares by 2008, where it has remained. Additionally Dolby had $12M in long-term debt in 2005—they have since eliminated it as of 2010.
The company has a healthy balance sheet with $433.6M in cash and $270.6M in short-term investments.
REVENUE, PRE-TAX PROFIT, AND OWNER EARNINGS
A visual review of Dolby’s sales, pre-tax profit, and owner earnings curves on a logarithmic graph will quickly illustrate the stability of its operations. Owner earnings are charted, instead of GAAP accounting earnings, as it is the cash that a business can actually generate for its owners, and is calculated as:
Owner Earnings = Net Income + Depreciation & Amortization + Non-cash charges – Capex
A “wonderful” company will have curves that parallel each other and rise to the right—a visual indication of excellent management, cost control, and the presence of a competitive advantage. A not-so-wonderful company (ie. those built on commoditized products) will have choppiness in these financial figures, and the curves will be erratic.
The chart clearly shows Dolby generates consistent sales, has control over its cost structure, and has rising owner earnings over time. This is a visual indication of an efficiently run business. (Note: when this analysis is performed for SRS Labs and DTSI, the resultant chart is erratic, an indication of companies that might not be as well run as Dolby.)
Turning to growth rates, the company has enjoyed strong double-digit revenue growth since going public in 2005, which accelerated slightly within the last year. This strength in sales translated to the bottom line driving equally strong GAAP-accounting earnings, but more importantly driving strong growth in owner earnings and book value. This is a company that knows how to make money.
Growth rates | 1 Yr | 3 Yr | 5 Yr |
Revenue | 28.2% | 24.2% | 23.0% |
Operating Income | 18.1% | 31.9% | 38.6% |
Net Income | 16.6% | 25.0% | 37.5% |
Owner Earnings | 11.1% | 26.1% | 41.5% |
Book Value | 11.6% | 22.0% | 24.2% |
SALES AND COST STRUCTURE
Dolby generates the majority of its sales from licensing, approximately 75%-80%, and have the impressive ability to generate sales from multiple sources on a single standard. The remainder of sales comes from products and services as detailed below.
Sales ($K) | 2008 | 2009 | 2010 | MRQ | % of Sales |
Licensing | $537,363 | $594,697 | $710,474 | $188,176 | 81.3% |
Products | 72,284 | 95,967 | 180,402 | 46,027 | 14.6% |
Services | 30,584 | 28,839 | 31,837 | 8,509 | 4.0% |
Total Sales | 640,231 | 719,503 | 922,713 | 242,712 |
Their business model has extremely favorable economics which drive very large gross margins. Below is a breakout of gross margins by revenue source. Clearly the licensing business model generates superior margins; however, products and sales margins are favorable as well. All of this is due to the low capital expenditure requirements of their operations…they are an idea company predominantly, and essentially outsource the risk of product manufacture, and the resulting thinner margins, to someone else.
Gross Margins | 2008 | 2009 | 2010 | MRQ |
Licensing | 97% | 101% | 98% | 98% |
Products | 45% | 40% | 50% | 52% |
Services | 59% | 56% | 56% | 65% |
As the table below illustrates, Dolby has been containing costs and improving them over time as the graph of pre-tax profit above indicates. However, these figures will most likely move slightly higher in the future as Dolby invests more in R&D and Sales & Marketing to continue their dominant advantage and capturing new markets.
Operating Expenses | 2008 | 2009 | 2010 | MRQ |
R&D | 12% | 11% | 11% | 12% |
Sales & Marketing | 17% | 14% | 14% | 16% |
G&A | 15% | 15% | 13% | 15% |
MANAGEMENT EFFECTIVENESS
The table below summarizes a variety of metrics to illustrate management performance and competence in making money for their shareholders. It helps us answer the question: are they efficient allocators of capital?
Cash Return on Invested Capital (CROIC) tells us how efficiently a business’ operations and management can allocate capital into the business to create even more cash for other re-investment projects. In the short-term growth can happen at any rate. But over the long-term, a business will generally grow at the rate it can generate owner earnings. This growth depends on how much cash it generates based on total cash invested by shareholders and bondholders. In short, it can be viewed as the sustainable upper limit to a company’s growth.
Efficiency & Profitability | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | Average |
CROIC | 23.2% | 22.4% | 10.8% | 16.1% | 18.6% | 26.3% | 24.0% | 23.8% | 20.6% |
FCF/Sales | 14.6% | 13.1% | 15.5% | 25.0% | 29.9% | 33.0% | 36.1% | 31.3% | 24.8% |
ROA | 15.3% | 15.2% | 8.9% | 12.1% | 14.4% | 14.9% | 15.4% | 16.6% | 14.1% |
ROE | 33.0% | 27.8% | 11.3% | 15.1% | 17.9% | 19.0% | 18.1% | 19.2% | 20.2% |
Dolby clearly generates copious cash and has the management acumen to generate a high ROE & CROIC. For every $100 invested, Dolby generated $21 in owner earnings on average.
BASIS OF COMPETITIVE ADVANTAGE
This financial overview illustrates that Dolby has a durable competitive advantage, or moat, working in its favor. They’ve become the undisputed kings at what they do, are everywhere, and are in everything and are ruthless about making quality sound products. Their brand is synonymous with quality. Their extensive patent portfolio, brand recognition, culture of innovation, and long-term customer relationships form the bedrock of their moat. Their moat is structurally built on:
· Real product differentiation: they create superior technology for immersive audio/video
· Perceived product differentiation: their brand stands for quality, innovation, and superior, immersive sound experiences
· Locking in customers: It’s difficult to displace their technology at the consumer level, even though competing standards are available, because consumers demand backward compatibility to support their existing investment in media. Additionally, many of their technologies are explicit standards, with the rest being de-facto standards, across the world
· Locking out competitors: Dolby creates exclusivity as a result of their patents and pursuit of their technologies becoming industry standards
· “Toll booth” business model: Every time someone wishes to use the technology, or the name, there’s a fee
VALUATION
This section will value Dolby based on two methods: a discounted cash flow (DCF) approach, and an Equity-Bond approach. No valuation method is exact since the future is unknowable, we only have history and our sense of the future to make a judgment. The more consistent a company is, the closer the estimate will be. It’s better to be approximately right than precisely wrong and overpay.
Warren Buffett described the concept of owner earnings as the cash that a business can generate for its owners. He additionally considered owner earnings, not accounting earnings, to be the relevant item for valuation purposes. If one owned the business completely, the amount of cash that could conceivably be pulled out of the business without hurting its competitive position or ability to maintain operations is what’s of value—the owner earnings.
To value Dolby with DCF, we’re interested in our expectation of future owner earnings through time, an appropriate growth rate, and a discount rate (or our required rate of return based on those expected owner earnings cash flows). My basic DCF equation is:
Fair Value = Growth Value (Years 1-10) + Terminal Value (Years 11-20) + Tangible Book Value
Since there are some future risks, and cost increases due to expected increased competition, I don’t expect Dolby’s growth to be as high as it was, but somewhere between 1-Yr Owner Earnings growth (11%) and average CROIC (20%). The following assumptions are used in the model:
· Growth-Years 1-3 = 12% (defaulted to low end of above range)
· Growth-Years 4-7 = 10.8% (10% decay rate)
· Growth-Years 8-10 = 9.7% (10% decay rate)
· Terminal-Years 11-20 = 3% (average inflation rate)
· Discount rate = 9% (required rate of return)
· Margin of Safety = 25%
· Initial Owner Earnings (2010) = $288M
· Tangible BV (2010) = $1142M
Projection of future Owner Earnings
Year | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 |
Earnings | $323 | $361 | $405 | $434 | $481 | $533 | $591 | $606 | $665 | $729 |
Year | 2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 |
Earnings | $751 | $774 | $797 | $821 | $845 | $871 | $897 | $924 | $952 | $980 |
[Note: all figures in $Millions]
DCF Fair Value = $58 (Current price = $50.83)
IRR = 11% (If purchased at the current price, the expected internal rate of return (IRR) for the above projection of owner earnings is the expected CAGR an investor would potentially make during the life of the investment.)
To value Dolby based on an Equity-Bond model, the company’s owner earnings, compared to the price paid for those earnings (aka Owner Earnings Yield), are evaluated against the risk-free investment—the 10 year T-bill. In this view, a stock can be compared against a bond. The stock would have a growing “coupon” (owner earnings) through time roughly at the book value growth rate (11%), whereas a bond would have a static coupon. The Owner Earnings Yield is calculated as:
OEY = 6.66% (by comparison, 10-year T-bill = 3.4%)
The DCF analysis indicates DLB is undervalued by 13% at $50.83. The Equity-Bond analysis indicates DLB is also undervalued relative to the 10-year T-bill—by almost 2:1, with an owner earnings yield of 6.66%. This appears to be a fair price to pay for Dolby’s growth going forward.
CATALYSTS
Dolby has many opportunities ahead of it to capitalize on and provide opportunities for growth. They have a culture of innovation and have been able to adapt to each technological change in audio through the years. Catalysts for continue growth include:
· Their reputation as the undisputed kings of the home theater ecosystem provides a platform to branch off from into other markets.
· As DVDs fade, the next generation of content delivery provides growth as it moves on-line with cable, fiber optic, satellite, and real-time delivery.
· They are positioned to capitalize on new opportunities—they have a strong history of innovation and brand strength.
· Dolby is the established US standard for digital broadcast TV, cable, and satellite. They are gaining momentum internationally in many countries (France, South Korea, Brazil) as they institute standards. Half of the world’s TVs still need to transition to digital broadcast.
· The mobile device market is ripe for the picking and they can capitalize on it with Dolby Mobile and Dolby Pulse. Digital products are proliferating across the globe
· The video market is untapped territory
· Cinematic 3D is on the rise
SUMMARY
I’ve provided a top-level review of Dolby Labs, the undisputed kings of immersive and quality audio. Of course do your own due diligence, but I’m sure you’ll find them to be a wonderful company selling at a fair price.
Dolby Laboratories (DLB) has excellent business economics and prospects for future growth. Although a technology company, they have a simple to understand business model. Additionally, they are highly profitable, and have a value-creating business engine with a capable management team. They have a moat, generate plenty of free cash flow as a result of very low capital expenditure requirements, and have no debt. They currently trade at a 13% discount to fair value, which is $58.
DISCLOSURE
I currently own no shares of DLB, but do plan on purchasing.
Update: Long DLB as of April 15, 2011
