Dolby Laboratories, Inc. (NYSE: DLB) develops and markets audio and video technology. The company earns the bulk (~80% or more) of its revenue from licensing its intellectual property to OEMs and software companies. This segment is also the greatest source of profits, with a gross margin of around 97% in recent years. Uncertainty over this segment has sent the company’s share price into a tailspin, falling more than 30% since the company made this announcement on its recent quarterly conference call (emphasis added):
In the PC market, the broad adoption of optical drives has driven the inclusion of Dolby technologies on many of the world’s PC shipments.The possibility of not being included in Windows 8 is quite scary. Analysts latched onto this in the Q&A session, devoting significant airtime to the ramifications.
We work with operating system providers, ISVs and OEMs to support DVD on the PC. In recent years, our mix of PC licensing revenue has increasingly shifted towards the operating system as our technologies are included in 4 editions of Windows 7. However, we have recently learned that our technologies are not currently included in the Windows 8 operating system under development. If our technologies are not included in the commercial version of Windows 8, we expect to support DVD playback functionality by increasingly licensing our technologies directly to OEMs and ISVs, and we will seek to extend our technologies to further support online content playback.
John Vinh – Collins Stewart LLCKey point: According to the company, if Microsoft (NASDAQ: MSFT) does not include DLB’s technology in Windows 8, this will affect DLB’s licensing revenue only in 2013.
[D]o you expect as you transition to Windows 8 that most of your revenues with Microsoft are going to be at risk? Are there other revenues that you get paid currently by Microsoft that you still would expect to persist through Windows 8?
Well, we work with Microsoft in a number of fronts including the Xbox 360, and we’re engaged with them across a number of divisions with a number of technologies. As it relates to Microsoft 8, if the commercial release doesn’t include our technologies, then we’re going to continue to work with OEMs and ISVs to make sure that we’re supporting the consumer use case for DVD playback, which we believe is still a very important one. And we’re also going to be looking at that as an opportunity to work with them to expand our technologies to be really improving the online content delivery. And so that’s how we see it going forward.
John Vinh – Collins Stewart LLC
Okay. And then as a follow-up to that, at this point then, if Windows 8 does not use your codecs within it, would you expect that your third-party revenues would increase as I would imagine if the OEMs would obviously have to start ramping third-party attach rates higher? And then I was just wondering if you could maybe comment or are you able to handicap in terms of whether you think that could make up for your loss revenues on Windows 8?
Well, I think that, first of all, we don’t think this has a significant discernible impact on 2012 when we’re still going to be on a Windows 7 year. We see Windows 8 coming into play during 2013. Once we are at Windows 8 adoption, if Windows 8 does not include our technologies, then we would expect the world to migrate to a place where there is one Dolby Digital decoder per PC, which is, of course, something the world had begun migrating to, but we still have certain revenue that is related to the second decoder on a PC. That’s probably best represented today by the ISV revenue, which we’ve told you is about $80 million to $90 million. Most of that is second decoder revenue. But we think that the primary market for decoding Dolby Digital Plus is still an important one, both for DVD playback. We think that it really improves the online content experience as well. But the mix of that revenue will shift toward OEMs and ISVs to the extent that Windows 8 continue to go down this path.
John Bright – Avondale Partners, LLCKey point: According to the company, only a maximum of $80 – 90 million of licensing revenue is at risk if MSFT does not include DLB technology. This would be the reduction in the situation where the company cannot find any offsetting revenues through transition to decoder cards.
Can you put Windows 7 in an order of magnitude for us for FY ’11?
Well, I think — so I can start by pointing out that our PC revenue for FY ’11 is about $240 million. That’s a combination of decoding for Dolby Digital Plus for optical drives and online content as well as our post-processing PCEE technologies. So I think the thing to focus on is the second decoder revenue because we think that’s what stands to decline if — as this rolls out. And the best indicator of that right now is our current ISV revenue that’s about $80 million to $90 million, which we think is primarily driven by second decoders. We don’t have perfect information on that, but we do believe most of that represents second decoder revenue. The remaining revenue would be what we think is the primary decoder as well as our other technologies.
Barbara Coffey – Brigantine Advisors LLCKey point: The company is aware of the risk and is working with other parties to find solutions to keep DLB’s IP in new computers.
I actually have 2 questions. It sounded like you weren’t exactly sure if you were or were not going to be in Windows 8. Has a definite decision been made on that?
Well, that’s ultimately Microsoft’s decision to make. What we know today is that we’re not in the current build of the software. And so we are planning for a scenario where we’re not in Windows 8. And that would mean for us working more extensively with OEMs and ISVs, each of whom we work with today, but working with them more extensively not only to support DVD playback but to really make for the best online experience.
These points are important considerations for valuing DLB. I’ll discuss in general terms the process I used for valuing DLB, though feel free to skip the next few paragraphs to the punchline.
First, revenues. For each of DLB’s divisions, I projected revenues out five years, looking both at historical growth rates and then adjusting for whichever scenario I was modeling at the time (i.e. base, bull, bear). In even my bullish scenarios, I assume growth far less than historical trends.
One more point on revenues: For the licensing segment, in all but my bullish scenario, I assumed the company was being too conservative in assuming $80 – 90 million at risk from losing the Windows 8 exposure. I assumed a $150 million decline in licensing revenue beginning in 2013 in both my base and bear scenarios.
Second, expenses. For each year in the forecast horizon, I projected expenses as a percentage of revenues (either by segment or overall). I projected returns to historical expense ratios, which had the effect of reducing margins (e.g. Gross Margins declined by 610bp over the investment horizon). The company may have the ability to maintain its current high margins, but I would rather not invest based on this hope. Better to be pleasantly surprised if the company outperforms than in despair when the company’s margins revert to the mean.
I worked my way down to EBIT, and then derived free cash flows based on assumptions about depreciation and capital expenditures (again, based on historical trends). My estimates of free cash flow are all well below recent historical highs. It is important to underscore the fact that I am not using generous assumptions. Rather, I am “bracing for impact” and seeing how the company’s current value stacks up.
Once I calculated forecast free cash flows and a terminal value, I derived the company’s market value of equity on a per share basis. The result? Even if the company loses a significant amount of its licensing revenue by not being included in Windows 8, it is still undervalued by more than 20%. This margin of safety is not enough to cause me to invest, though it is important to note that this is only one potential outcome. In the event the company’s technology is included in Windows 8, DLB is worth significantly more.
Whether MSFT will include DLB’s technology in Windows 8 is anyone’s guess. I would prefer to invest at a price that provides a sufficient margin of safety even in the negative situation. So far we aren’t there, but given the recent markets, we might be soon.
Some points about DLB to leave you with. The company trades for less than $28/share, has zero debt and more than $10/share in cash. The company has historically had extremely strong returns, averaging more than 20% ROE and more than 60% ROIC (ROIC subtracts cash from the denominator). Further, the company’s free cash flows have grown in lockstep with revenues (which have experienced strong growth historically) and have been consistently high, suggesting low capital demands. Companies that growth revenue consistently while maintaining strong returns and free cash flows and eschew debt in the process tend to make good investments – at the right price!
What do you think of DLB?
Author Disclosure: No position.