Dolby's Performance over the YearsDolby (DLB) has slowed down. I wish it didn't but like all companies, it's growth phase is now gone.
It's true that PC sales are down and the future PC sales doesn't look any brighter, but despite the fears that DLB will be hit hard with the slowdown in the PC industry, DLB hasn't suffered as bad as Wall Street has been predicting.
Here's a breakdown of its actual revenues as of the second quarter 2013.
PC is actually the second best category in DLB's lineup.
I recall when the market slammed DLB because it wasn't going to be included in Windows 8. In the end the market overreacted and priced it as if the PC segment of the business was going bust.
But Windows 8 sucks. The sales numbers show and the adoption has been slow. That's why you see a flat line for the PC segment.
Broadcast Segment Is in DangerThe growth in the broadcast segment however, is a nice surprise.
Originally, my line of thought is that the TV industry is saturated. People also tend to replace their TVs less often that PCs.
So is this growth just a pump fake, or something that the company can actually grow from?
I see viable growth here.
While the PC industry is very mature, it has only been a few years since TV companies started to introduce more features and bang into TV designs.
Just up to 5 years ago, a TV was just a picture displaying box.
Now it's a multimedia platform. Sure 3D TV's were a fad, but that's just one of the ways you see TV's expanding into different spaces.
You can now surf the internet, stream movies directly, play games, and it is being connected to more and more multimedia devices.
Growth isn't light speed, but for the industry, the 3% growth in the broadcast segment DLB has seen compared to the previous comparable quarters is welcoming news.
Slow But Consistent
Now if you own DLB, you aren't holding it in hopes that it is the next Facebook.
The entire premise of owning DLB is that it is a consistent and profitable business that operates a killer business model.
One that is profitable and spits out cash.
Here's a look at DLB comparing its performance over a five-year and 10-year period.
(Numbers, graphs and following valuations were performed using the stock valuation tools at Old School Value.)
A couple of evident points.
- Shareholders equity has suffered
- Growth has slowed
- The rest of the business has remained consistent despite slowing growth
- Drop in FCF growth
What Happened to FCF?
Since DLB is invested based on the idea that it is a cash cow and will continue to generate free cash flow, FCF was the lowest since 2007 despite revenue being 100% higher in 2012 than in 2007.
Digging into the income statement, you see that the main culprits are SG&A expenses and increases in R&D expenditure.
In the TTM, SG&A is close to the all time peak of 40% while R&D is at its highest at 17% TTM.
When you consider that from 2003 to 2009, R&D expense was only average 9%, this is a huge increase.
DLB clearly understand that they cannot stand still and become a dinosaur.
When you consider that DLB is operating at its highest expenditure levels, there will be room for improvement and cost cutting in a couple of years.
Valuation: Discounted Cash FlowMethod 1: Find out what assumptions the market is pricing into the stock.
The simplest way is to perform a reverse DCF. Rather than to immediately come up with assumptions, looking at the bigger picture of what the market is expecting will provide a good guide on where to start with the DCF.
In this case, lowering the TTM FCF to $200m to with a discount rate of 9% shows the market is pricing in 7% growth for DLB.
Looking at the sensitivity matrix below, here are the range of possibilities using a 9% discount rate.
- $26 target if DLB shrinks further to 3% FCF growth
- $32 if DLB meets the expected 7% growth
- $40 target for a growth rate of 11%
If this was a bad business, then the lower scenario could be a high possibility, but given the strength, margins and predictability of the business, I don't see the lower scenario playing out.
For now, DLB is at fair value with the potential to break out to the $40 range provided that mobile penetration and market share increases.