Bonus Report: This is the last report I wrote before starting this blog. The numbers are a little outdated, but nothing fundamental has changed. Most importantly, I've been reviewing DLB recently, and it still looks attractively valued. Their year ends in September, and I plan on posting an update that digs into the numbers with a re-worked model after the 10K is out. But in the meantime this is a good background on what DLB does.
Dolby Laboratories’ (DLB) core business is the development of computer algorithms that code and decode sound files with the goal of maximizing sound quality while minimizing the need for data storage or high information transfer rates. While the stock has only been publicly traded since 2005, “Dolby” has been a household name for many years. The next largest competitor, DTS Inc. (DTSI), has one-tenth the revenue and technologically equivalent products as far as most experts are concerned. On a relative basis, Dolby is the biggest in the industry and advantageously positioned for the future. In absolute terms, Dolby has been highly profitable and financially transparent.
The technology produced by companies such as DLB and DTSI are incorporated into hardware, software, and media, but do not generate revenue as a function of media sales. Media consumers benefit from this technology when the media they are consuming and the playback hardware they are utilizing are compatible. DLB has benefited from consumers upgrading to higher quality home entertainment systems, demanding higher quality audio on secondary media playback devices such as home computers or video-game systems, and making use of portable media devices such as MP3 players or cell-phones. DLB has also attempted to enter markets for 3D movie theater equipment and technology to improve visual aspects of next-generation high-definition televisions.
Because DLB earns revenue as a function of unit sales reported by the companies that utilize its technology, DLB has no control over sales. It cannot offer incentives in a bad quarter or run promotional advertisements. The hands-off nature of its business makes Dolby dependent on the volume and product mix of consumer purchases. Whether consumers purchase a DVD player from Best Buy or Wal-mart for 7% less, it doesn’t affect DLB. But consumer downgrades to lower-tech products that license fewer or cheaper technologies from DLB does impact revenue.
DLB classifies revenue into three segments: Licensing, product sales, and services. Licensing is the most significant portion of revenue (84% LTM) and it has a 97% margin. In an initiating report from Thomas Weisel published on October 6, 2008, the analyst breaks licensing revenue into personal computers, consumer electronics (home theater systems and DVD players), broadcast TV devices (TVs and set-top boxes), and an “other” category (video game systems and mobile devices). The report does a great job of detailing what the technology is and how sales are translated into revenue for DLB. It’s a solid 60 pages before the charts and worth reading if you’re interested.
Licensing Revenue FY07 Market Size Attach Rate ASP Revenue
PC 361 64% $0.59 $135.50
Consumer Electronics 155 99% $0.68 $104.80
Broadcast 194 53% $0.60 $61.90
Other $0.69 $42.60
Presently, consumer electronics is the largest contributor to licensing revenue. The data above shows CE as a smaller segment than the PC market because it excludes Blu-ray sales which were negligible for FY07 and some other segment data for which we have no total market size figures to establish an attach rate from, such as audio receivers. Actual revenue from the CE segment was $147.1 million in FY07. The good news is that “Dolby Digital has been selected as a mandatory audio standard and Dolby Digital Plus and Dolby TrueHD have been selected as optional audio standards in the Blu-ray Disc format” according to DLB. However, analysts don’t expect volume to increase because DLB was already mandatory in red-laser DVD players. Revenue is expected to grow in this segment as Blu-ray DVD players take market share, but concerns exist about the relationship between higher ASPs at lower volume.
The PC market is an important segment for DLB. The market size number above includes global PC unit sales for desktop and laptop systems. Revenue includes licenses to Microsoft for inclusion in two versions of Vista, as well as revenue from integrated software vendors (ISV) and Dolby’s PC entertainment experience (PCEE) license. This means that some computer units might generate license revenue for DLB more than once despite the fact that licenses are sometimes redundant. It is possible, for example, for only 100 million of the 361 million computers sold in 2007 to have included DLB technology. But the attach rate is 64% because some systems were packaged with the same technology twice, both generating revenue. If ISVs begin to see their margins squeezed, excluding DLB licenses in software designed to work with MSFT’s higher-end operating systems is certainly possible, but in my opinion not probable. In general, the growth in use of computers as entertainment centers has led analysts to expect continued growth in this segment, eventually overtaking consumer electronics.
The broadcast market in particular is expected to grow in the near-term as TV signals are converted to digital forcing consumers to purchase digital set-top boxes where Dolby is a mandatory technology. The Advanced Television Systems Committee (ATSC) has made Dolby Digital the mandatory standard, meaning DLB technology is included in every TV and digital converter box in North America and Korea. France has also adopted DLB as a mandatory standard, although it is not part of ATSC. Brazil and Japan are requiring the HE-ACC sound format for digital TV signals, which DLB earns revenue from. And any other country that has adopted TV broadcast standards has included DLB technologies as optional except those operating under the DMB-T/H agreement. DMB-T/H countries include China, Iraq, Jordan, Syria, Venezuela, Nicaragua, and Cuba.
Long-term, the PC, video-game console, and hand-held markets are expected to grow more quickly than consumer electronics. Compression technology on these devices is arguably more important as streaming data squeezes every bit of performance out of the software. Dolby technology has traditionally been credited with greater compression (about 3x more) than competing DTS technology. However, experts argue that it is unrealistic to believe that the Dolby codec is actually 3x more efficient than the DTS codec, leading to the conclusion that DTS sound quality must be higher. The argument is reasonable, but there is no evidence that listeners can tell the difference. Even the notoriously vocal online communities have no opinion.
The product sales segment contributed 11% of revenue with a 47% margin LTM. This is mostly sales of projection equipment to movie theaters, and is projected to be a very low-growth piece of the business. A big part of the problem is that Dolby and DTS were standard sound formats on film. Audio on digitally recorded movies is provided by open standard algorithms that DLB doesn’t own proprietary rights to. Conversion to digital systems has been very slow because theaters have traditionally been responsible for purchasing/maintaining projectors, while movie production companies have been responsible for producing and distributing film reels with development costs baked in. As a result, theaters don’t want to make a capital investment to benefit production companies, and growth will remain slow until a new business model is adopted. Other product sales include broadcasting equipment and encoding software.
Growth in the product sales segment is effectively contingent upon adoption of Dolby’s 3D projection technology, which has not proven to be popular compared to the competitor product RealD. The main technological disadvantage for DLB compared to RealD is the glasses. RealD glasses are cheap enough to be disposable, compared to DLB glasses that cost approximately $30 each (after significant reductions in recent months). The expensive glasses require theater operators to collect glasses after each presentation for cleaning and reuse. This seems to be a larger concern in the US where movie viewers are more prone to break, steal, or loose the glasses. However, the DLB system can be projected onto a normal screen (compared to RealD which requires a special silver screen), and “Dolby 3D requires no postproduction color correction and no corrective preprocessing, meaning distributors are able to master and distribute one digital file for both 3D and 2D viewing” according to Lloyd Walmsley from Thomas Weisel. Overall, the total cost of operation is lower for the Dolby system. It also seems as though Dolby has produced a 3D technology that could eventually find it self at use in home theaters. The higher cost and disposability of glasses would be less of a concern, and the post-production simplicity would make it a solid choice for DVD distribution. Also, the RealD technology relies on polarization of light, which cannot be reproduced on television screens. A report by Jim Slater from Cinema Technology Magazine describes the Dolby technology:
“the system doesn’t depend on the use of polarized light, but instead uses a technique based on the wavelength of light. Dolby uses a “wavelength triplet” technique… [in which] the red, green, and blue primary colors used to construct the image in the digital cinema projector are each split into two slightly different shades. One set of primaries is then used to construct the left eye image, and one for the right.”
Bringing 3D to the home is completely unsubstantiated speculation on my part. Dolby hasn’t announced any plans or intentions to market 3D technology for home theaters. I don’t fully understand the technology, but if porting 3D to home theaters is possible, it’s the next logical step for DLB. This is in contrast to the audio-focused DTSI strategy.
The services segment is the smallest portion of revenue (4.8% of revenue, 59% margin). Examples include services to media producers who need assistance using the coding technology and theaters trying to maximize sound quality for special events such as movie premiers.
Costs of good sold, SG&A, and R&D have all come down as a percentage of revenue over the past few years. COGS have decreased mostly as a result of changes in the licensing segment, where DLB no longer pays royalties on patents it owns. The only cost still accounted for in the revenue segment is D&A of acquired technology. SG&A and R&D margins have shown nominal but consistent improvement. With the R&D budget far surpassing the nearest competitors, I would imagine that DLB will have room in the future to expand EBIT margins simply by growing R&D at a slower rate than revenue as continued incremental improvements to COGS become more difficult to achieve.
Coding Technologies - $253 million
Audio compression technology including HE-ACC v.1 and v.2 already in use in the broadcast market as discussed above. This technology should also apply to mobile and internet applications.
Brightside Technologies - $30.2 million
LED backlighting of LCD screens is Dolby’s foray into visual technology. Brightside does not have a stand-alone website, but the link above does a good job of explaining the concept behind the technology.
DLB has two good comparison companies that compete in the sound technology licensing business. DTSI directly competes with DLB in the sound codec market, and is a mandatory standard in Blu-ray DVDs. On traditional film reels, DTS time stamps were included alongside Dolby Digital sound bytes so that a CD could be synchronized with the movie. SRS Labs (SRSL) also creates proprietary sound technology to be licensed out, but its technology is designed to simply enhance sound quality. It is not integral to the code-decode process.
The sound codecs that DLB and DTSI develop are compared across four main technical specifications:
Sample Rate – the number of samples per second, measured in hertz (Hz) taken from a continuous sample to create a discrete representation. Higher sample rates are associated with higher quality sound. At constant frequency, a sample rate of only twice the frequency is necessary to reproduce the tone. However a higher sample rate is necessary to accurately reproduce the sound if we care about amplitude and/or if the frequency is changing.
Bit-Rate – Bits per second (bit/s) is a measurement of the data transfer rate. Higher bit-rates are associated with higher quality audio, but good compression software can allow an equivalent audio quality at lower bit-rates. 64 kbps of HE-AAC is approximately equivalent to 128 kbps mp3 in terms of sound quality.
Sample Depth – (x-bit) the number of bits of data recorded for each sample. Higher sample depth is associated with higher audio quality.
Channels – The number of discrete speaker signals that a sound file can reproduce. 2 channels would be standard stereo speakers. 5.1 surround would include, a center, front-left, front-right, rear-left, rear-right, and a subwoofer channel.
Actually comparing technologies based on these specifications is difficult because they often vary as a function of each other. For example, the DTS-HD Master Audio technology allows for 192 kHz sampling at 24-bit depth in two channel stereo, but only 96 kHz @ 24-bit depth when 8 channels are utilized. Dolby TrueHD supports 192 kHz @ 24-bit on up to 6 channels, with the same 96 kHz @ 24-bit in 8 channels, but it also supports up to 18 channels. Eventually it boils down to user satisfaction, and this is probably as much a function of brand image as technical specifications. From the reviews I’ve read online, there is surprisingly little passion in the comparative discussions, with a consensus that the technologies all perform well and deliver high quality sound.
One technology that is interesting to compare side-by-side is the surround sound headphone technology each company is developing. I won’t discuss my impression of these because I don’t want to bias your opinion. In no particular order:
For this one, you need to scroll to the bottom of the page and click on the last demo. It’s a trailer for Planet of the Apes presented in SRS Headphone.
A concert with two drummers from DTS Surround Sensation.
There are a few links at the bottom of this page. The ‘Dolby Headphone demo’ is definitely worth experiencing; it features a host simply walking around the listener in a circle and then a video clip from a speedway. The MacBreak clips are also interesting because the hosts are set up in a semi-circle in front of the listener with a crowd and ambient noise coming from behind.
Dolby has also taken steps to differentiate itself from DTS and SRS Labs by venturing into the visual aspects of digital entertainment with the 3D business and research being done to enhance LED backlit LCD screens as discussed above.
Company Name Ticker Price Hi Lo Shares Out.
Dolby Laboratories, Inc. DLB $33.15 $53.63 $24.86 115.096
DTS, Inc. DTSI $18.73 $35.99 $15.25 18.174
SRS Labs, Inc. SRSL $4.81 $7.25 $2.75 15.783
Company Name Cap. Debt Cash Value
Dolby Laboratories, Inc. $3,827 $9.38 $514.43 $3,322
DTS, Inc. $340 $ - $85.50 $255
SRS Labs, Inc. $76 $ - $46.72 $29
LTM LTM LTM Average P/E
Company Name P/Sales EPS P/E (Bloomberg)
Dolby Laboratories, Inc. 6.0x $1.74 19.1x 31.8x
DTS, Inc. 5.8x $0.60 31.2x 39.8x
SRS Labs, Inc. 4.3x $0.07 68.7x 50.2x
Enterprise Value Market Cap.
as a Multiple of as a Multiple of
Company Name Revenue EBIT NI FCF
Dolby Laboratories, Inc. 5.2x 11.6x 19.2x 15.3x
DTS, Inc. 4.3x 17.9x 16.6x 44.4x
SRS Labs, Inc. 1.6x -37.0x 64.9x 16.1x
EPS Figures (Bloomberg) and Multiples
Fiscal Year Fiscal Yr Fiscal Yr Fiscal Yr
Company Name EPS ('08) Multiple ('08) EPS ('09) Multiple ('09)
Dolby Laboratories, Inc. $1.79 18.5x $1.95 17.0x
DTS, Inc. $0.56 33.4x $0.71 26.4x
SRS Labs, Inc. $0.14 34.4x $0.36 13.4x
Company Name EBIT Net Income R&D
Dolby Laboratories, Inc. 44.8% 31.2% 9.7%
DTS, Inc. 24.2% 34.9% 11.8%
SRS Labs, Inc. -4.4% 6.6% 19.5%
Earnings for SRSL are low because of what seems to be higher than normal sales and marketing expenses. Part of the reason for this is that SRSL lost some of its key customers recently, leaving Samsung responsible for 40% of licensing revenue compared to 25% last year. Cash flow from operations or FCF is a better estimate of present earnings. Analyst estimates of $0.36/share seems like it would require substantial growth from LTM earnings of $0.07/share. However, 2007 earnings were $0.32/share. More importantly, SRSL has $48 million of current assets of which $47 million can be considered cash, against $3.3 million of total liabilities, half of which is deferred revenue. This puts cash per share at a $2.69, compared to a 52-week low of $2.75. EV/FCF is only 6.2x.
DTSI is has been focusing exclusively on sound technology since 2007 when it sold the cinema and digital image businesses. This led to impairment charges that I left out of the earnings numbers above. Compared to just the licensing revenue of DLB, DTSI is earning 1/10th the revenue. However, Blu-ray sales are expected to fuel revenue growth for DTSI more so than DLB because DTS was only an optional standard on red-laser DVD players. More importantly, there is a discrepancy between CFO and NI that doesn’t seem to be coming from the disposition, and I can’t reconcile it without devoting more time than it seems worth at this point. But regardless of which numbers are most relevant, it’s unlikely that DTSI offers the best value. DLB is a better company and SRSL is trading near cash.
Tax assets have grown significantly in recent years. In 2008, tax assets were 10% of total assets reported on the balance sheet, and the cost of these tax assets reduced cash flow by 20%. Note 6 in the most recent K details where the assets are coming from in terms of the difference between reported asset and liability values for financial and tax purposes, but I’m still confused. It doesn't explain what is causing the difference to arise, or what would reverse it. DTSI seems to be experiencing a similar trend also without an explanation. There is no reserve or write-down allowance; DLB (and DTSI) expect to realize their tax assets in the near future.
Ray Dolby, the founder, is effectively in control of all the voting shares. He has done a great job of running the company, but I’m not sure how good of a job his surviving family members will do. This doesn’t have any impact on my valuation, but it’s a risk to be made aware of.
Looking at the S&P 500, it’s incredible to see how far the market has fallen in a year. But 52-week highs are a terrible indicator of how much “value” the market has lost and an even worse indicator of how much value the market has left to lose. Is it value that was lost or is it value that never really existed? A better indicator of value is the price/(10-year average earnings) index assembled by Robert Shiller, author of “Irrational Exuberance”, the book that predicted both the internet and sub-prime housing bubbles before they popped. A frequently updated excel file can be downloaded from his website at Yale. Shiller’s data was current up to August 2008, so I added the January 2nd S&P index price of 932. This resulted in a current S&P P/E of 15.2x, compared to an average since 1871 of 16.3x and a minimum of 4.8x in December of 1920.
These numbers can be confusing to think about because we’re used to seeing P/E as a function of the LTM earnings. Earnings should be lower from the 10-year average assuming earnings have been able to grow. However, in the case where current earnings are lower than the 10-year average, the Shiller index should report a lower multiple than the analysts would see at the time if they were using the standard P/E ratio as a guide. I also believe that the average P/E ratio should rise over time as the economy depends more heavily upon R&D and other intangibles. The fact that R&D is expensed instead of capitalized pushes current term earnings down, but the growth rate of earnings up. In the dividend discount model, these factors should even out and result in an equivalent P/E ratio. But the dividend discount model doesn’t work with the P/(10-year average E) ratio.
The Shiller numbers give us and idea of a) how much stock market value could ultimately be lost by comparing today’s value to the historic minimum (15.2x vs. 4.8x), and b) how over/under-valued the market might be today in reference to an average historical P/E (15.2x vs. 16.3x) indicating what people are generally willing to pay for earnings and growth. This doesn’t indicate that companies are destroying or loosing value. It just indicates that the market could temporarily value earnings, and especially growth, at a lower rate in the near future, despite how much the S&P has already fallen in an absolute sense. This comparison to history indicates that we’re far from in the clear, and possibly just scratching the surface of undervaluation.
I want to avoid rationalizing the market with expectations that it will reflect a logical valuation anytime soon. The market might be stuck in a positive feedback cycle where decreasing valuations are causing liquidations, which are causing decreasing valuations. George Soros’ reflexivity hypothesis enters the picture as another positive feedback cycle pushing prices lower. As valuations decrease, the cost of capital becomes higher for companies, making capital-intensive operations more difficult or risky to continue, which further decreases valuation. A strong cash position that can be used to repurchase shares is the only thing a company can do to counteract these two positive feedback cycles. Companies able to provide liquidity to their own market are protecting their investors from the need for further liquidations and capitalizing on the higher investment returns offered at lower prices. They’re also less threatened by the reflexivity problem if there is no need to raise capital. The cash position of DLB combined with its ability to maintain margins without the use of debt is a strength seemingly undervalued in the market right now.
Under normal circumstances it would be difficult to value DLB with growth in EPS at a spectacular arithmetic average of 38.2% over the past 5 years. Even in Dolby’s 4Q08 that ended September 26th, year over year EBIT for the quarter was up 33% and EPS was up 9.6%. EPS was up less than EBIT because of an unusually low tax provision four quarters ago. Earnings are lower than any reasonable measure of cash flow, and the market cap. is higher than the enterprise value, so the most conservative multiple the market can put on DLB is a simple P/E of 19.1x. This is for a clear market leader with R&D completely expensed, a sizeable cash position, and very transparent financial statements. If growth was expected to be zero forever, this is a discount rate of 5.2%. Comparatively, EV/FCF is 13.2.
While I feel that a fair price for investors who can withstand short-term volatility would be higher than 15x earnings, in today’s environment other factors take precedent. As discussed above, I think a greater emphasis should be placed on dividends or ability and willingness to repurchase shares. Establishing a price floor is my major concern with DLB. Without dividends or share repurchases, I think the next best estimate of an absolute price floor must be some function of cash.
In my model and previous discussions of DLB, I have excluded the “Long-term Investments” line item from measures of cash. As auction-rate securities became less liquid, DLB transferred these items from short-term to long-term investments, increasing long-term investments from $33 million in 2006 to $73 million in 2007, and finally $181 million in 2008. If counted as cash, this increases total cash to $695 million, raising cash per share to $6.04 and increasing the attractiveness of DLB on an enterprise valuation basis.
DLB is a leader in its field and economies of scale allow it to maintain both a larger R&D budget and wider margins than the competition. Cash flow is strong too, with free cash flow (measured simply as CFO-CapEx) slightly leading earnings every year since the initial public offering by about 4%. Both earnings and cash flow are valid measures of performance with capitalization of R&D the only major adjustment I would consider making. Since my thesis is that DLB is a good investment, capitalization of R&D has been included in a separate page of my model (which I would be happy to share), but is not used in my valuation because it would raise earnings and CFO.
Analyzed in isolation, DLB satisfies most requirements I could think of for a great investment opportunity. Margins are wide, the gap between DLB and its closest competitors is wide, financial position is strong, and management is patient with acquisitions. Revenue may decline in a recession (although it has not yet) as consumers buy less of the hardware that DLB earns licensing revenue from, but DLB is gaining market share as it becomes a mandatory standard in more consumer electronics around the world. But most importantly, DLB has negligible debt and enough cash to cover all liabilities or SG&A two times over with no effect on margins. This puts it in an optimal position to employ capital in the most effective ways possible through an economic downturn.