Dolby Offers the Magic Formula

By Tom Gibbs - May 9, 2012 | Tickers: DLB, DTSI, MSFT, SRSL | 0 Comments

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As explained in a recent article, there is no investing technique that works successfully (with known certainty) in every market situation.  There are, however, certain ways to think about investing that tend to lead to higher-than-average returns over the long run.  Joel Greenblatt's Magic Formula Investing strategy, for example, actively seeks out efficient assets -- those that generate higher-than-average returns -- and seeks to purchase those assets inexpensively. 

Greenblatt's own track record at Gotham Capital, which returned over 40% on an annualized basis between 1985 and 2005 using this similar value-mindset, offers some meaningful tangible evidence of the formula's so-called "magic."  These results are enviable enough to take a closer look at a recent Magic Formula stock screen search result: Dolby Laboratories (NYSE: DLB).  There are several key Magic Formula criteria that might make DLB an intriguing investment opportunity over the mid-term.

Efficient Assets

Any screen of the company's basic efficiency ratios will yield very positive results, both relatively and absolutely.  Illustrated below is the corporation's past six year operating history.  As depicted, it has not simply been Dolby's increase in sales at a near 20% CAGR over the period, but its continual growth in residual earnings on its core assets that has generated significant shareholder value. 

Methodology

• Average NOA - Average net operating assets, defined as [(Total Assets - Financial Assets) - (Total Liabilities - Financial Liabilities)].  Averaged over 2 years.
• Average CSE - Average common shareholders' equity over 2 year period
• ROCE = return on common equity, defined as (Net Income / Average CSE)
• RNOA = return on net operating assets, defined as (Post-Tax Operating Income / Average NOA)
• ReOI = residual operating income, defined as [(RNOA - Cost of Capital) * Average NOA].  12% cost of capital requirement assumed, diluted shares used for ReOI per share.

The reduced RNOA over the illustrated period is due to a two-fold effect.  First, the corporation has drastically increased its financial asset balance over the six years, and now possesses over $1.2 billion in cash and short and long term investments.  Although this offers a nice price floor for the stock ($10.84 per share in these assets), it can also be argued that the corporation can utilize these assets for higher-returning projects.  The increased level of assets not deployed in the core, high-returning business has acted to reduce overall returns.

Similarly, excess returns will tend to naturally gravitate toward a certain mean over time due to competitive forces and the law of large numbers.  Not many firms are immune to this phenomenon, and only those that possess a significant competitive advantage can continue to earn supremely high (although sometimes decreasing) returns over the long run -- as Dolby has.

The reduced return on net operating assets would be a cause for significant concern if the corporation was not swiftly growing its residual earnings (27.4% CAGR over the illustrated time period).  The corporation's return on its core assets, as well as the growth in its residual earnings, drastically outweighs that of the competition.

Although competitor DTS Inc. (NASDAQ: DTSI) has also experienced significant revenue growth over the past six years, it has not utilized its core asset base as efficiently.  On average net operating assets of $38.9 million in 2007, the corporation only generated $7.9 million in post-tax operating income (20.3% RNOA).  The corporation has subsequently grown RNOA to 25.1% in the most recent operating year, but its residual operating income over the six years has remained relatively flat -- growing a very modest 1.7% CAGR over the past six years.

"But DTS is reinvesting a significant portion of its annual revenues in research and development activities!" Well yes, and so has Dolby, at an almost equivalent rate.  The three year average R&D/Sales ratio for DTS has been 12.5%, compared to 12.0% for Dolby.  The secret, of course is efficient asset use, made more prevalent for Dolby through economies of scale via higher sales volumes.

Cheap Assets

When comparing several of DLB's key pricing metrics with those of its competitors, as well as with its own historic multiples, it appears Mr. Market may be making a short term pricing miscalculation.

• Enterprise Value (TTM)
• Dolby: 8.00
• Dolby Historic: 11.45
• DTSI: 11.87
• SRS Labs (NASDAQ: SRSL): 57.79
• Price/Book
• Dolby: 2.75
• Dolby Historic: 4.08
• DTSI: 3.43
• SRSL: 2.49

"Dolby Historic" Methodology explained in footnote

Using the second Magic Formula criteria -- relative asset cost -- Dolby's high-returning assets appear even more attractive. The upcoming Windows 8 release by Microsoft (NASDAQ: MSFT) also offers a suitable catalyst for growth over the mid-term.  The two firms' prior arrangement under the current Windows generation, did comprise a significant boost to Dolby's top line -- between 2008 and 2010 Windows licensing fees made up more than 10% of its revenue.  As the technology is already developed and licensing revenue will soon flow in, it is very reasonable to project that Dolby's impressive residual earnings per share growth will not falter.

Footnote - Dolby Historic

• EV/EBITDA -- Quarterly enterprise values were established using the quarter's median market price.  This figure was compared with a four quarter EBITDA run.   The median EV/EBITDA ratio between September 2007 and September 2011 was used in the table.
• Price/Book -- Quarterly per share book values between September 2007 and September 2011 were compared to the quarters' corresponding median market price.
• Price/NCAV -- Quarterly per share net current asset values between September 2007 and September 2011 were compared to the quarters' corresponding median market price.

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