Investment Thesis
Dolby Laboratories (DLB, Financial) is a company with excellent business economics. Although classified as a technology/media/broadcast company, it has a simple-to-understand business model, a highly profitable and value-creating business engine with a capable management team, and ROE averaging 20%. They are the leaders of high quality and immersive audio, have a moat, generate plenty of free cash flow as a result of very low capital expenditure requirements, and have no debt.
On Aug. 5, 2011, DLB shares plummeted 18% after the quarterly earnings call on the statement that their codecs weren’t currently in the Windows 8 build. Although potentially not insignificant news, I believe this was a wholesale overreaction, as the current market price implies a zero-growth rate scenario going forward. I believe an investment in DLB at these prices now presents a patient, long-term investor the opportunity to pick up DLB’s growth for free.
Company Overview
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 find their way into many places: 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 quality and entertainment, i.e., 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.
They have a long history in the entertainment industry, setting 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, 6,000 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 U.S., 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 No. 17 in the Forbes 100 Best Small Companies of 2010 list.
Technology Information
To appreciate Dolby’s business model, let’s spend a few moments understanding the basic nature of the technology, which is used in all aspects of the media life-cycle: creation, distribution and playback. Dolby’s technologies generally fall into three buckets, which are used to enhance the entertainment experience. They are: noise reduction, compression/decompression, and codecs (coder/decoder).
Noise reduction technologies process a signal to remove, or lessen the degree, of noise which is annoying and detracts from your audio/video entertainment experience. All electronic 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. Additionally, noise is an ever-present problem in our environment and will always find its way into electronic devices. Physical media also plays a role in noise as a result of the grain structure and particle size of the material used. If you’ve ever heard hiss, buzz, hum, pops, or seen “snow” on a TV, you’ve experienced noise.
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. If you’ve ever come across a TV commercial, you’ve experienced highly compressed audio with no decompression — they sound louder due to a higher average volume level from compression. A data example of compression in our everyday lives are ZIP files. Unpacking a ZIP file decompresses it.
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. Another example that most people are familiar with is Surround Sound technology, which encodes into the information stream the speaker position where each sound should be played. The receiving unit then decodes this information and plays it at the proper speaker to get the intended effect.
Technology Key Points
There are some additional aspects to consider in understanding these technologies and how they assist the business model.
(1) Once a signal is processed with any of the methods above, it must be undone to be able to hear/see the signal as it was originally intended to be from the media creator. This fact creates “stickiness” and the ability to cover technologies and processes with patents, enabling monopoly rights for a lengthy period of time.
(2) These technologies are implemented in software and hardware. Neither domain has exclusivity.
(3) Noise is ever-present in the environment, and will always find its way into electronics. This is a physics reality and there is no escaping it. Hence there will always be a need to have noise reduction technologies.
(4) The demand for increased bandwidth always seems to outstrip the bandwidth supply, resulting in a continuing need to deal with constrained channels, which affects both the provider and the consumer. For example, a cable provider would like to be able to extract the maximum amount of bandwidth possible out of their existing infrastructure before starting capex upgrades to increase it.
Additionally, the consumer has a long history of requiring ever-faster download speeds (remember when 300/1200 baud modems were “fast”?) Hence, there will be a continuing need for compression/decompression technologies. As more people stream video, this will be increasingly important.
(5) When it comes to mobile bandwidth, you should expect furthered constraints in the future. Mobile phones operate in the finite spectrum controlled by the Federal Communications Commission (FCC). It’s been overcrowded for years. To deal with the overcrowding, the FCC has been chopping up the spectrum into finer blocks, which requires devices to operate in successively narrower bands — the very definition of a “constrained channel.” In a future where mobile phones proliferate, providers will want to ensure download speeds to the phone are acceptable. The net result? A continuing need for compression/decompression technologies because of bandwidth constraints.
(6) Standards-setting agencies exist in the consumer electronics industry to define technical standards, such as the HDTV format. This allows consumers 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.
(7) Consumer products don’t last as long as they used to anymore — manufacturers design and plan for obsolescence. This creates an eventual demand for replacements and upgrades.
Understanding Dolby’s Business Model
Let’s see how DLB makes money.
Imagine what happens when a company can: create a proprietary technology/process; maintain monopoly rights to its use; license it; provide products and services related to their technologies; and establish it as an explicit or de-facto standard everywhere…
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 choke-hold 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: there are two types of licensees under this construct.
· Implementation licensees: 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: 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 some pricing pressure in their markets. Their competitors are listed for each revenue source:
I believe Dolby is often mistakenly categorized as a media/broadcast company. As can clearly be seen from the business model and primary source of revenue, licensing, they are a technology idea company —the business risk of manufacturing belongs elsewhere. SRS and DTS are the more direct competitors in the licensed technologies space.
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 an example, Dolby recently filed suit against Research In Motion (RIM) who used Dolby technology without paying for the licensing.
As of the quarter ended July 1, 2011, Dolby had approximately 2,200 issued patents and over 2,300 patents pending in over 60 jurisdictions throughout the world. The issued patents are schedule to expire at various times through February 2030. Of these, seven are scheduled to expire this year, 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 times through 2017. Dolby Digital Plus patents expire between 2018-2026, while and Dolby Digital Live patents expire between now and 2021.
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.
Now let’s take a look under the hood of their business engine.
The $1 Test
In Warren Buffett’s 1983 Owner’s Manual for Berkshire shareholders, he described the “$1 Test” to determine whether a company creates value, or destroys it. In short, on a five-year rolling basis, earnings retention must, in the long run, deliver at least $1 of market value for every $1 retained in the business.
Dolby has clearly delivered value to shareholders, delivering $1.55 for every $1 retained in the business over the last five years.
Balance Sheet and Capital Structure
As can be seen from the balance sheet snapshot below, DLB currently has about $595 million of cash in-hand, no debt, $309 million in short-term investments, and another $280 million in longer-term investments. These investments don’t appear to be “exotic,” including things such as: corporate bonds, commercial paper, municipal debt, U.S. agency securities, and U.S./foreign government bonds.
DLB is capitalized with no bonds, no preferred stock, and 112 million shares of common stock at a market capitalization of approximately $3.1 billion. 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 58.9 million shares of Class B. There’s a small risk that the interests of minority shareholders will take second place to those of Ray Dolby — in effect it’s a “family-owned” business. Although it doesn’t follow the textbook corporate governance rules, I feel this places Ray in a position of having significant “skin in the game” since he has significant personal wealth tied up in the company.
Although they have a long company history dating back to 1965, they went public with 104 million shares of stock in 2005. The share count rose to 115 million shares by 2008, where it has remained. Additionally Dolby had $12 million in long-term debt in 2005 — they have since eliminated it as of 2010.
Sales, Pre-Tax Profit and Earnings
A visual review of DLB’s sales, pre-tax profit, net income and owner earnings curves on a logarithmic graph will quickly illustrate the stability of its operations. Owner earnings are additionally charted along with GAAP net income, since it is the cash that a business can actually generate for its owners that I’m interested in.
A “wonderful,” consistent company with excellent business economics will have straight curves on this chart that parallel each other and rise to the right, like railroad tracks — a visual indication of excellent management, cost control, and the presence of a competitive advantage. A “not-so wonderful” company will have choppiness in these financial figures, and the curves will be erratic, bouncing up and down. I prefer reviewing it this way since it tells me a lot very quickly. As can be seen, DLB has enjoyed steady sales, pre-tax profit, GAAP earnings, and owner earnings growth curves.
Dolby generates on average 80% of its sales from licensing, and has 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.
If we focus in on the licensing revenue stream, we see it was broken out this way for fiscal year 2010:
Dolby is expecting slower growth in the PC segment to be sure; however, their fastest growing category is the mobile market, coming in at 26% year-over-year, followed by broadcast. I’ll discuss the Windows 8 issue a bit later.
Turning to historical 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 double-digit GAAP-accounting and owner earnings growth. This is a company that knows how to make money.
Margins and Cost Structure
Their business model has extremely favorable economics which drives 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. From their most recent 10-K, their overall gross margin was 87.2%. The licensing margin was 97.7%; product margin was 28.4%; and services margin was 60.1%. 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 continues to invest more in R&D and Sales & Marketing to continue their dominant advantage and capturing new markets going forward.
Management Effectiveness
The chart below summarizes a variety of metrics to illustrate management performance and competence in making money for their shareholders.
Their eight-year average ROE is 20%; ROA is 14%; and CROIC is 17%. CROIC tells me how efficient a business’ operations and management can allocate capital into the business to create even more cash. 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. When assessed over multi-year periods, I view CROIC as the upper limit to a company’s ability to grow. CROIC has averaged 17% over the last eight years, with the 2010 CROIC at 18.7% and TTM CROIC at 18.3%.
They clearly generate cash and have the management acumen to allocate capital efficiently and generate double-digit ROE & CROIC. For every $100 invested in the company, DLB generated $17 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, 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. I believe 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”-style business model: Every time someone wishes to use the technology, or the name, there’s a fee due to the licensing arrangements.
GROWTH CONSIDERATIONS
Keeping the concepts in the “Technology Key Points” section above, let’s step back and look at the big picture a second. As I led in with, and as you’ll see in the valuation section, it looks to me as if DLB is currently priced for 0% growth going forward. Is this a rational concept? I don’t think so. Here’s why.
First of all, we’ve established that their technologies are essential, as I pointed out earlier. There’s just no getting around the need for noise reduction and compression/decompression when operating in bandwidth constrained environments.
Secondly, I believe there’s a floor of growth driven by broadcast and mobile that’s being overshadowed by the Windows 8 issue.
As far as broadcast, recall that digital TV is the standard in the U.S. and increasingly the standard across the globe — over half of the world’s TVs haven’t converted yet. They are expecting 5% worldwide TV unit growth. Dolby Digital Plus has already been adopted as a standard for HDTVs in many countries such as the UK, India, France, Sweden, Poland and most recently China. DLB’s technology will be encoded into China’s national Digital Terrestrial Multimedia Broadcasting receiver specification which has already been adopted by most Chinese broadcasters as well as over 50 HDTV and set-top box manufacturers. This initiative begins Nov. 1, 2011. In China alone, there’s a market with at least 400 million households and counting. And I would expect this number to grow over time since China now has a rising, and affluent middle class that wants the finer things in life.
As DLB pointed out in their recent 10-K, mobile is their fastest growing segment in percentage terms. Current estimates show the market for handsets and tablets is over 1.4 billion units. They are working across the entire ecosystem, including content providers and distributors, technology platform providers and portable device makers to grow technology adoption. They’re incorporated into over 130 handset models and 23 tablet models. As far as content providers and distributors, their audio formats have been adopted by Netflix, VUDU, Amazon, Apple, and CinemaNow. Additionally, they’ve worked with IC suppliers to the mobile industry, including Texas Instruments, Analog Devices, and Qualcomm.
What about Windows 8?
Is the lack of inclusion in the current build of Windows 8 a big deal? I don’t really think so.
The codecs were there to support DVD playback. Recall that DVD is dying and is being replaced by Blueray and streaming content, and I suspect that’s the reason Microsoft isn’t including native support for it — why include support for dying technology? This would’ve been something DLB would’ve had to plan for anyway — and they have been, as the previous paragraph points out. DLB’s technology is established in Blueray and the ecosystem to support streaming content. In effect, DLB will be trading one revenue stream for another.
Additionally, Windows 8 is in build status — it’s not released. So to the extent that native support is desirable, there’s time to fix it. But even if it doesn’t find its way into the final release, the codecs can be built into the OEM hardware, or supplied as separate drivers, which is DLB’s stated fallback plan by the way. Remember, there was a time in earlier versions of Windows where native support wasn’t there and we had to load OEM drivers separately.
Valuation
(Note: The date of analysis was Sept. 7, 2011, when the closing price was $33.49.)
Price Multiples: The chart below highlights various price-based multiples. DLB trades under all of these ratios' eight-year averages.
According to this Gurufocus chart, DLB is trading in the lower end of its P/E band.
This next section derives fair values based on: DCF, the Graham Number, EPV, and various yields.
DCF: This approach used a two-stage discounted cash flow model based on owner earnings growth through time for 20 years with a discount rate of 9%. Each stage is a decade with the initial growth rate assumption at 11%, tapering 10% every few years during the first decade. When picking this rate, I chose the lower end of their historical performance. I then compared this to analyst expectations which were roughly 15% (Morningstar and Yahoo consensus estimates for EPS growth are 15.5% and 15.2%, respectively). I believe my rate (a 25% reduction from analyst expectations) should account for a scenario dealing with a permanent loss of Windows 8 revenue.
The second decade assumes a 3% growth rate to pace inflation. Intrinsic value using this approach is $54.27. The sensitivity matrix below illustrates varying initial growth rates with discount rates. The optimistic scenario is at 15%, while the pessimistic scenario is at 7%.
According to this approach, DLB is undervalued.
Reverse DCF: I conducted a reverse-DCF to see what the current market price told me using the variables above in the DCF model. It indicates a zero-growth scenario for the next 20 years. With the broadcast market as a minimum-growth driver, and the gaming/mobile device market expanding, I see this as an irrational conclusion to draw simply from the Windows 8 issue.
Graham Number:this approach used Ben Graham’s formula based on average earnings power to arrive at an intrinsic value of $106.78. Using Graham’s typical 66% margin of safety, the “buy under” price is $36.31. Using this view, DLB is under-priced.
EPV: this approach used the Earnings Power Value approach to arrive at a zero-growth intrinsic value, which is $32.92. Using EPV, like the reverse-DCF above, this method also indicates a zero-growth environment.
The net reproduction cost represents the per-share price a competitor would need to duplicate the business, or $11.19. The difference between these two figures represents the value created, or competitive advantage, DLB enjoys — which suggests that DLB has a moat.
Owner Earnings Yield: this method used the bond-parity principle and views the stock as an “equity bond” where the owner earnings are a steadily growing “coupon” over time. It’s then compared against prevailing bond interest rates to determine relative valuation and attractiveness.
When compared to the corporate bond rate (prevailing avg. redemption yield) of 4.5%, the 8.4% owner earnings yield would DLB is under-valued. The bond-parity price at 4.5% would be $62.44/share. As a cross-check, to achieve this price with DCF, DLB would have to grow at 14%, which is slightly slower than analyst expectations of 15% (see DCF section above).
Valuation conclusion: Taking all of the above into consideration, I believe DLB is undervalued by at least 33% using the pessimistic scenario above.
Catalysts and Tailwinds
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 include:
· Due to the very nature of physics, noise is ubiquitous and ever-present — there will always be a need for noise reduction.
· Transmission medium bandwidth demand, almost always exceeds supply (people always want their data faster) leading to continual constrained bandwidth, hence always a need for compression/decompression.
· Mobile transmission bandwidth will continue to be constrained as the FCC sub-divides the spectrum into smaller increments.
· 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 U.S. 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. China and Poland have also recently adopted it as their digital TV standard.
· 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; current market estimates are 1.4 billion devices.
· Digital cinema conversion and cinematic 3D are on the rise.
· The board approved a $250 million addition to its stock repurchase program.
· Gurus that own: Joel Greenblatt, Magic Formula portfolio.
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 U.S., 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, i.e., 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. Dolby now has multiple end-devices to concentrate on now.
Summary
Dolby Laboratories (DLB) is a company with excellent business economics. Although classified as a technology/media/broadcast company, it has a simple-to-understand business model, a highly profitable and value-creating business engine with a capable management team, with ROE averaging 20%. They are the leaders of high quality and immersive audio, have a moat, generate plenty of free cash flow as a result of very low capital expenditure requirements, and have no debt.
The current market price has dropped to the point where it indicates a zero-growth scenario going forward on the news that DLB’s technology wasn’t currently in the Windows 8 build. A zero-growth scenario isn’t rational, given that their noise reduction, compression and decompression technologies are needed and relevant, and that at a minimum broadcast and mobile growth will provide some kind of floor for growth going forward.
I believe an investment in DLB at these prices now presents a patient, long-term investor the opportunity to pick up DLB’s growth for free.
Disclosure: Long DLB.
DISCLAIMER: This analysis is provided for informational and entertainment purposes only and is the opinion of the author. The information and content contained herein should not be construed as a recommendation to invest or trade in any type of security. Neither the information, nor any opinion expressed, constitutes a solicitation of the purchase or sale of any security or investment of any kind. Conduct your own research and due diligence.
Dolby Laboratories (DLB, Financial) is a company with excellent business economics. Although classified as a technology/media/broadcast company, it has a simple-to-understand business model, a highly profitable and value-creating business engine with a capable management team, and ROE averaging 20%. They are the leaders of high quality and immersive audio, have a moat, generate plenty of free cash flow as a result of very low capital expenditure requirements, and have no debt.
On Aug. 5, 2011, DLB shares plummeted 18% after the quarterly earnings call on the statement that their codecs weren’t currently in the Windows 8 build. Although potentially not insignificant news, I believe this was a wholesale overreaction, as the current market price implies a zero-growth rate scenario going forward. I believe an investment in DLB at these prices now presents a patient, long-term investor the opportunity to pick up DLB’s growth for free.
Company Overview
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 find their way into many places: 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 quality and entertainment, i.e., 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.
They have a long history in the entertainment industry, setting 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, 6,000 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 U.S., 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 No. 17 in the Forbes 100 Best Small Companies of 2010 list.
Technology Information
To appreciate Dolby’s business model, let’s spend a few moments understanding the basic nature of the technology, which is used in all aspects of the media life-cycle: creation, distribution and playback. Dolby’s technologies generally fall into three buckets, which are used to enhance the entertainment experience. They are: noise reduction, compression/decompression, and codecs (coder/decoder).
Noise reduction technologies process a signal to remove, or lessen the degree, of noise which is annoying and detracts from your audio/video entertainment experience. All electronic 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. Additionally, noise is an ever-present problem in our environment and will always find its way into electronic devices. Physical media also plays a role in noise as a result of the grain structure and particle size of the material used. If you’ve ever heard hiss, buzz, hum, pops, or seen “snow” on a TV, you’ve experienced noise.
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. If you’ve ever come across a TV commercial, you’ve experienced highly compressed audio with no decompression — they sound louder due to a higher average volume level from compression. A data example of compression in our everyday lives are ZIP files. Unpacking a ZIP file decompresses it.
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. Another example that most people are familiar with is Surround Sound technology, which encodes into the information stream the speaker position where each sound should be played. The receiving unit then decodes this information and plays it at the proper speaker to get the intended effect.
Technology Key Points
There are some additional aspects to consider in understanding these technologies and how they assist the business model.
(1) Once a signal is processed with any of the methods above, it must be undone to be able to hear/see the signal as it was originally intended to be from the media creator. This fact creates “stickiness” and the ability to cover technologies and processes with patents, enabling monopoly rights for a lengthy period of time.
(2) These technologies are implemented in software and hardware. Neither domain has exclusivity.
(3) Noise is ever-present in the environment, and will always find its way into electronics. This is a physics reality and there is no escaping it. Hence there will always be a need to have noise reduction technologies.
(4) The demand for increased bandwidth always seems to outstrip the bandwidth supply, resulting in a continuing need to deal with constrained channels, which affects both the provider and the consumer. For example, a cable provider would like to be able to extract the maximum amount of bandwidth possible out of their existing infrastructure before starting capex upgrades to increase it.
Additionally, the consumer has a long history of requiring ever-faster download speeds (remember when 300/1200 baud modems were “fast”?) Hence, there will be a continuing need for compression/decompression technologies. As more people stream video, this will be increasingly important.
(5) When it comes to mobile bandwidth, you should expect furthered constraints in the future. Mobile phones operate in the finite spectrum controlled by the Federal Communications Commission (FCC). It’s been overcrowded for years. To deal with the overcrowding, the FCC has been chopping up the spectrum into finer blocks, which requires devices to operate in successively narrower bands — the very definition of a “constrained channel.” In a future where mobile phones proliferate, providers will want to ensure download speeds to the phone are acceptable. The net result? A continuing need for compression/decompression technologies because of bandwidth constraints.
(6) Standards-setting agencies exist in the consumer electronics industry to define technical standards, such as the HDTV format. This allows consumers 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.
(7) Consumer products don’t last as long as they used to anymore — manufacturers design and plan for obsolescence. This creates an eventual demand for replacements and upgrades.
Understanding Dolby’s Business Model
Let’s see how DLB makes money.
Imagine what happens when a company can: create a proprietary technology/process; maintain monopoly rights to its use; license it; provide products and services related to their technologies; and establish it as an explicit or de-facto standard everywhere…
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 choke-hold 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: there are two types of licensees under this construct.
· Implementation licensees: 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: 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 some pricing pressure in their markets. Their competitors are listed for each revenue source:
Revenue Source | Competitor |
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 |
I believe Dolby is often mistakenly categorized as a media/broadcast company. As can clearly be seen from the business model and primary source of revenue, licensing, they are a technology idea company —the business risk of manufacturing belongs elsewhere. SRS and DTS are the more direct competitors in the licensed technologies space.
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 an example, Dolby recently filed suit against Research In Motion (RIM) who used Dolby technology without paying for the licensing.
As of the quarter ended July 1, 2011, Dolby had approximately 2,200 issued patents and over 2,300 patents pending in over 60 jurisdictions throughout the world. The issued patents are schedule to expire at various times through February 2030. Of these, seven are scheduled to expire this year, 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 times through 2017. Dolby Digital Plus patents expire between 2018-2026, while and Dolby Digital Live patents expire between now and 2021.
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.
Now let’s take a look under the hood of their business engine.
The $1 Test
In Warren Buffett’s 1983 Owner’s Manual for Berkshire shareholders, he described the “$1 Test” to determine whether a company creates value, or destroys it. In short, on a five-year rolling basis, earnings retention must, in the long run, deliver at least $1 of market value for every $1 retained in the business.
Dolby has clearly delivered value to shareholders, delivering $1.55 for every $1 retained in the business over the last five years.
Balance Sheet and Capital Structure
As can be seen from the balance sheet snapshot below, DLB currently has about $595 million of cash in-hand, no debt, $309 million in short-term investments, and another $280 million in longer-term investments. These investments don’t appear to be “exotic,” including things such as: corporate bonds, commercial paper, municipal debt, U.S. agency securities, and U.S./foreign government bonds.
DLB is capitalized with no bonds, no preferred stock, and 112 million shares of common stock at a market capitalization of approximately $3.1 billion. 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 58.9 million shares of Class B. There’s a small risk that the interests of minority shareholders will take second place to those of Ray Dolby — in effect it’s a “family-owned” business. Although it doesn’t follow the textbook corporate governance rules, I feel this places Ray in a position of having significant “skin in the game” since he has significant personal wealth tied up in the company.
Although they have a long company history dating back to 1965, they went public with 104 million shares of stock in 2005. The share count rose to 115 million shares by 2008, where it has remained. Additionally Dolby had $12 million in long-term debt in 2005 — they have since eliminated it as of 2010.
Sales, Pre-Tax Profit and Earnings
A visual review of DLB’s sales, pre-tax profit, net income and owner earnings curves on a logarithmic graph will quickly illustrate the stability of its operations. Owner earnings are additionally charted along with GAAP net income, since it is the cash that a business can actually generate for its owners that I’m interested in.
A “wonderful,” consistent company with excellent business economics will have straight curves on this chart that parallel each other and rise to the right, like railroad tracks — a visual indication of excellent management, cost control, and the presence of a competitive advantage. A “not-so wonderful” company will have choppiness in these financial figures, and the curves will be erratic, bouncing up and down. I prefer reviewing it this way since it tells me a lot very quickly. As can be seen, DLB has enjoyed steady sales, pre-tax profit, GAAP earnings, and owner earnings growth curves.
Dolby generates on average 80% of its sales from licensing, and has the impressive ability to generate sales from multiple sources on a single standard. The remainder of sales comes from products and services as detailed below.
Sales ($K) | 2008 | 2009 | 2010 | YTD | YTD % of Sales |
Licensing | $537,363 | $594,697 | $710,474 | $584,593 | 82.1% |
Products | 72,284 | 95,967 | 180,402 | 100,769 | 14.2% |
Services | 30,584 | 28,839 | 31,837 | 26,375 | 3.7% |
Total Sales | 640,231 | 719,503 | 922,713 | 711,737 |
If we focus in on the licensing revenue stream, we see it was broken out this way for fiscal year 2010:
Dolby is expecting slower growth in the PC segment to be sure; however, their fastest growing category is the mobile market, coming in at 26% year-over-year, followed by broadcast. I’ll discuss the Windows 8 issue a bit later.
Turning to historical 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 double-digit GAAP-accounting and owner earnings growth. This is a company that knows how to make money.
Margins and Cost Structure
Their business model has extremely favorable economics which drives 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. From their most recent 10-K, their overall gross margin was 87.2%. The licensing margin was 97.7%; product margin was 28.4%; and services margin was 60.1%. 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 continues to invest more in R&D and Sales & Marketing to continue their dominant advantage and capturing new markets going forward.
Management Effectiveness
The chart below summarizes a variety of metrics to illustrate management performance and competence in making money for their shareholders.
Their eight-year average ROE is 20%; ROA is 14%; and CROIC is 17%. CROIC tells me how efficient a business’ operations and management can allocate capital into the business to create even more cash. 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. When assessed over multi-year periods, I view CROIC as the upper limit to a company’s ability to grow. CROIC has averaged 17% over the last eight years, with the 2010 CROIC at 18.7% and TTM CROIC at 18.3%.
They clearly generate cash and have the management acumen to allocate capital efficiently and generate double-digit ROE & CROIC. For every $100 invested in the company, DLB generated $17 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, 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. I believe 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”-style business model: Every time someone wishes to use the technology, or the name, there’s a fee due to the licensing arrangements.
GROWTH CONSIDERATIONS
Keeping the concepts in the “Technology Key Points” section above, let’s step back and look at the big picture a second. As I led in with, and as you’ll see in the valuation section, it looks to me as if DLB is currently priced for 0% growth going forward. Is this a rational concept? I don’t think so. Here’s why.
First of all, we’ve established that their technologies are essential, as I pointed out earlier. There’s just no getting around the need for noise reduction and compression/decompression when operating in bandwidth constrained environments.
Secondly, I believe there’s a floor of growth driven by broadcast and mobile that’s being overshadowed by the Windows 8 issue.
As far as broadcast, recall that digital TV is the standard in the U.S. and increasingly the standard across the globe — over half of the world’s TVs haven’t converted yet. They are expecting 5% worldwide TV unit growth. Dolby Digital Plus has already been adopted as a standard for HDTVs in many countries such as the UK, India, France, Sweden, Poland and most recently China. DLB’s technology will be encoded into China’s national Digital Terrestrial Multimedia Broadcasting receiver specification which has already been adopted by most Chinese broadcasters as well as over 50 HDTV and set-top box manufacturers. This initiative begins Nov. 1, 2011. In China alone, there’s a market with at least 400 million households and counting. And I would expect this number to grow over time since China now has a rising, and affluent middle class that wants the finer things in life.
As DLB pointed out in their recent 10-K, mobile is their fastest growing segment in percentage terms. Current estimates show the market for handsets and tablets is over 1.4 billion units. They are working across the entire ecosystem, including content providers and distributors, technology platform providers and portable device makers to grow technology adoption. They’re incorporated into over 130 handset models and 23 tablet models. As far as content providers and distributors, their audio formats have been adopted by Netflix, VUDU, Amazon, Apple, and CinemaNow. Additionally, they’ve worked with IC suppliers to the mobile industry, including Texas Instruments, Analog Devices, and Qualcomm.
What about Windows 8?
Is the lack of inclusion in the current build of Windows 8 a big deal? I don’t really think so.
The codecs were there to support DVD playback. Recall that DVD is dying and is being replaced by Blueray and streaming content, and I suspect that’s the reason Microsoft isn’t including native support for it — why include support for dying technology? This would’ve been something DLB would’ve had to plan for anyway — and they have been, as the previous paragraph points out. DLB’s technology is established in Blueray and the ecosystem to support streaming content. In effect, DLB will be trading one revenue stream for another.
Additionally, Windows 8 is in build status — it’s not released. So to the extent that native support is desirable, there’s time to fix it. But even if it doesn’t find its way into the final release, the codecs can be built into the OEM hardware, or supplied as separate drivers, which is DLB’s stated fallback plan by the way. Remember, there was a time in earlier versions of Windows where native support wasn’t there and we had to load OEM drivers separately.
Valuation
(Note: The date of analysis was Sept. 7, 2011, when the closing price was $33.49.)
Price Multiples: The chart below highlights various price-based multiples. DLB trades under all of these ratios' eight-year averages.
According to this Gurufocus chart, DLB is trading in the lower end of its P/E band.
This next section derives fair values based on: DCF, the Graham Number, EPV, and various yields.
DCF: This approach used a two-stage discounted cash flow model based on owner earnings growth through time for 20 years with a discount rate of 9%. Each stage is a decade with the initial growth rate assumption at 11%, tapering 10% every few years during the first decade. When picking this rate, I chose the lower end of their historical performance. I then compared this to analyst expectations which were roughly 15% (Morningstar and Yahoo consensus estimates for EPS growth are 15.5% and 15.2%, respectively). I believe my rate (a 25% reduction from analyst expectations) should account for a scenario dealing with a permanent loss of Windows 8 revenue.
The second decade assumes a 3% growth rate to pace inflation. Intrinsic value using this approach is $54.27. The sensitivity matrix below illustrates varying initial growth rates with discount rates. The optimistic scenario is at 15%, while the pessimistic scenario is at 7%.
According to this approach, DLB is undervalued.
Reverse DCF: I conducted a reverse-DCF to see what the current market price told me using the variables above in the DCF model. It indicates a zero-growth scenario for the next 20 years. With the broadcast market as a minimum-growth driver, and the gaming/mobile device market expanding, I see this as an irrational conclusion to draw simply from the Windows 8 issue.
Graham Number:this approach used Ben Graham’s formula based on average earnings power to arrive at an intrinsic value of $106.78. Using Graham’s typical 66% margin of safety, the “buy under” price is $36.31. Using this view, DLB is under-priced.
EPV: this approach used the Earnings Power Value approach to arrive at a zero-growth intrinsic value, which is $32.92. Using EPV, like the reverse-DCF above, this method also indicates a zero-growth environment.
The net reproduction cost represents the per-share price a competitor would need to duplicate the business, or $11.19. The difference between these two figures represents the value created, or competitive advantage, DLB enjoys — which suggests that DLB has a moat.
Owner Earnings Yield: this method used the bond-parity principle and views the stock as an “equity bond” where the owner earnings are a steadily growing “coupon” over time. It’s then compared against prevailing bond interest rates to determine relative valuation and attractiveness.
When compared to the corporate bond rate (prevailing avg. redemption yield) of 4.5%, the 8.4% owner earnings yield would DLB is under-valued. The bond-parity price at 4.5% would be $62.44/share. As a cross-check, to achieve this price with DCF, DLB would have to grow at 14%, which is slightly slower than analyst expectations of 15% (see DCF section above).
Valuation conclusion: Taking all of the above into consideration, I believe DLB is undervalued by at least 33% using the pessimistic scenario above.
Catalysts and Tailwinds
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 include:
· Due to the very nature of physics, noise is ubiquitous and ever-present — there will always be a need for noise reduction.
· Transmission medium bandwidth demand, almost always exceeds supply (people always want their data faster) leading to continual constrained bandwidth, hence always a need for compression/decompression.
· Mobile transmission bandwidth will continue to be constrained as the FCC sub-divides the spectrum into smaller increments.
· 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 U.S. 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. China and Poland have also recently adopted it as their digital TV standard.
· 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; current market estimates are 1.4 billion devices.
· Digital cinema conversion and cinematic 3D are on the rise.
· The board approved a $250 million addition to its stock repurchase program.
· Gurus that own: Joel Greenblatt, Magic Formula portfolio.
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 U.S., 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, i.e., 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. Dolby now has multiple end-devices to concentrate on now.
Summary
Dolby Laboratories (DLB) is a company with excellent business economics. Although classified as a technology/media/broadcast company, it has a simple-to-understand business model, a highly profitable and value-creating business engine with a capable management team, with ROE averaging 20%. They are the leaders of high quality and immersive audio, have a moat, generate plenty of free cash flow as a result of very low capital expenditure requirements, and have no debt.
The current market price has dropped to the point where it indicates a zero-growth scenario going forward on the news that DLB’s technology wasn’t currently in the Windows 8 build. A zero-growth scenario isn’t rational, given that their noise reduction, compression and decompression technologies are needed and relevant, and that at a minimum broadcast and mobile growth will provide some kind of floor for growth going forward.
I believe an investment in DLB at these prices now presents a patient, long-term investor the opportunity to pick up DLB’s growth for free.
Disclosure: Long DLB.
DISCLAIMER: This analysis is provided for informational and entertainment purposes only and is the opinion of the author. The information and content contained herein should not be construed as a recommendation to invest or trade in any type of security. Neither the information, nor any opinion expressed, constitutes a solicitation of the purchase or sale of any security or investment of any kind. Conduct your own research and due diligence.
