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Robert Abbott
Robert Abbott
Articles (863)  | Author's Website |

Dolby: Wally Weitz Sees 'Additional Upside Optionality'

That's one of the ways in which the guru explained his purchase of Dolby shares

October 12, 2020 | About:

In the second quarter of 2020, guru Wally Weitz of Weitz Investment Management took a leap into Dolby Laboratories Inc. (NYSE:DLB) with the purchase of 50,000 shares.

What was the rationale? In comments accompanying the Hickory Fund second-quarter 2020 results he wrote, "Given the unknowns, we believe a cautious posture is still warranted. In terms of new investments, we continue to favor higher-quality businesses that have strong balance sheets and the wherewithal to weather COVID-19 specific risks, a potentially prolonged recession, and/or another bout of capital market turbulence."

He added that Dolby is increasingly recognized as the gold standard for audio in movie theaters and it provides the "pervasive technologies" underpinning the audio in a wide range of electronic devices, from television sets to soundbars and mobile phones. Weitz expects Dolby will benefit if consumers, affected in part by health issues, shift their sights to "in-home, immersive audio entertainment." He also said "the company's nascent video technology and substantial net cash position create additional upside optionality."

According to its 10-K for 2019 (the fiscal year ended Sept. 27, 2019), Dolby began with noise reduction technologies for analog tape recordings and has since morphed into multiple technologies for delivering digital, immersive sound.

Technical solutions continue to drive its sales: "Today, we derive the majority of our revenue from licensing our audio technologies. We also derive revenue from licensing our consumer imaging and communication technologies, as well as audio and imaging technologies for premium cinema offerings in collaboration with exhibitors. Finally, we provide products and services for a variety of applications in the cinema, broadcast, communications, and home entertainment markets."

It also reported it faced "aggressive" competition in all facets of its business. Dolby lists numerous competitive factors, including adherence to industry standards, technological performance and brand recognition and loyalty. Notably, price is a factor but comes at the bottom of the list.

Investors lost confidence in the first half of the decade, then regained it in the second half:

Dolby 10 year price chart

Note that the price has been generally flat, or rangebound, over the past two years. Should we expect more of the same over the next five or 10 years? Or does Dolby have the resources and management team to grow the company and its share price?

Financial strength

Dolby financial strength

Management has done an excellent job on the financial side; very few companies receive a financial strength rating of 9 out of 10 or above. That's largely because it has taken on little debt.

On the first five lines of the table, all relating to debt, Dolby outperforms the competition in the Media – Diversified industry. It has done better on a couple of metrics when compared to its history, but overall, it is very safe from a financial meltdown.

That's consistent with its high ranking on the Altman Z-Score and the financially stable rating for the Piotroski F-Score.

At the other end of the scale, we see Dolby is also cash-rich, with $1.04 billion in cash, cash equivalents and marketable securities at the end of the second quarter.

At the bottom of the table, we see its weighted average cost of capital is less than half of its return on invested capital.

Profitability

Dolby profitability

We can trace that high ROIC back to its high margins. These suggest that Dolby has at least a narrow moat or competitive advantage. That moat, in turn, would be based on its industry-leading technology, its ubiquity in high-end audio and its brand.

It also enjoys a double-digit return on equity. This metric is calculated by dividing its net income attributable to common stockholders by its average total stockholders' equity during the quarter that ended in June 2020.

In dollar amounts, the annualized net income for the quarter was $269 million while its shareholders' equity was $2.4 billion.

Similarly, its return on assets was nearly into double digits. That's calculated by dividing its annualized net income for the quarter ($269 million again) by the average total assets held during the quarter ($2.924 billion).

On the three growth lines at the bottom of the table, we see rather pedestrian rates, suggesting that Dolby has become a mature, slow-growth company. Still, give management credit for increasing the average earnings per share growth rate to 10.5% over the past three years, even though the average rate of revenue growth was roughly half that much at 5.8%.

Valuation

GF Value

While the GF Value line comes up with a "fairly valued" assessment, its price-earnings ratio is significantly higher than the industry median. Dolby's current price-earnings ratio is 28.31, well above the industry median of 21.21 over the past decade and its own median of 23.67.

The PEG ratio, which provides a relationship between the price-earnings ratio and a stock's Ebitda growth rate, is absurdly high at 141.5 (fair valuation is 1.0). Why so high? Because the five-year average Ebitda growth rate is very low at 0.20% per year; that's also much lower than the three-year Ebitda growth rate we saw in the profitability section (an average of 3.9% per year).

Dolby's profitability slumped badly early in the decade and did not recover until the later years, affecting longer-term metrics. It also helps explain why the stock price was depressed mid-decade. Here's the price chart again:

Dolby 10 year price chart

In a related vein, the changes in Ebitda and earnings per share from mid-decade until now also produced a low predictability rating, just one star out of a possible five. That means the discounted cash flow analysis will be unreliable and of little help in determining valuation.

With the current share price roughly midway between recent highs and lows, I would argue the fair valuation shown by the GF Value line is the best-guess estimate.

Dividends and stock buybacks

Dolby dividend and share buybacks

As the table shows, Dolby pays a small dividend, one that's below the S&P 500 average (1.75% to 2%). There is room to grow, though, since the dividend payout ratio is just 35%.

Additionally, the three-year dividend growth rate of more than 16% is very healthy. Indeed, we might expect buy-and-hold investors to see their dividend yield double every four years and four months at that rate (based on the Rule of 72). However, the three-year dividend growth rate is unduly weighted by a spike earlier this year (when the share price was pulled down by the market-wide plunge in March):

Dolby dividend yield

Essentially, the dividend yield has been flat since 2016. That's reflected in the five-year yield on cost, which is identical to the current yield. The forward dividend yield is also at 1.28%, indicating there has been no dividend increase in the past year (it did pay its regular dividend in August).

Bottom line: Don't expect a dividend that pays much more than a bank savings account in the next few years.

Turning to share buybacks, the company has been repurchasing them in modest amounts. This chart shows how the number of shares outstanding has come down in the past decade:

Dolby shares outstanding

As a result, net income is distributed among fewer shares, pushing up earnings per share.

Gurus

The investing legends have been of two minds about Dolby in the past couple of years. In early (calendar) 2019, they were enthusiastic. In the last quarter, they made an abrupt reversal:

Dolby guru buys and sells

Five gurus held Dolby shares at the end of the second quarter:

Conclusion

Was Weitz on the right path when he jumped into Dolby Laboratories stock? After reviewing the company's fundamentals, we would have to agree it is one of those companies that are, in his words, "higher-quality businesses that have strong balance sheets."

And there have certainly been improvements since mid-decade when earnings and the share price were depressed. But for the last two years, share prices have been rangebound, leaving investors to wonder about future capital gains.

Value investors may look at Dolby cautiously; it has no debt, but also has no margin of safety. Income investors will pass it by because the dividend yield is low and prospects of growth are not bright. Growth investors will want to wait until the share price begins to climb again.

Disclosure: I do not own shares in any of the companies named in this article.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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