Dolby - A Solid Brand With Solid Fundamentals
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I remember when I was about 17 years old my dad gave me my first car. It was an '88 Oldsmobile Cutlass Calais, the family car that he had decided to hand down to me when he went and bought a new one. I remember it had an AC Delco radio with a Dolby (NYSE: DLB) cassette player in it. I remember how good the sound was coming out of the speakers. I remember listening to the Dolby sound systems in some of the theaters, as well. In time I began to associate the Dolby emblem with sound quality. This brand recognition, coupled with excellent fundamentals, will make this company a superior long-term investment.
Dolby is about more than just building a superior sound system; they are an audio technology company. They license their technologies, design and build video and audio products for the entertainment and cinema industries, and offer consulting services for their technologies. Licensing comprised the largest segment of their revenue at 83% in 2011. They are also looking into new ways to transmit higher sound quality through mobile devices and over the internet. They research and design anything pertaining to delivering superior sound quality through any means of distribution.
The fundamentals of this company are excellent. Dolby has a total debt to equity ratio of only 11% as of the most recent quarter. It has a return on equity of around 18% based on 2011 revenue. Its cash and marketable securities make up 61% of its equity base (MRQ) and its free cash flow has grown 20% per annum from 2009-2011. Companies with fundamentals like these are rare among those I have been researching over the last four months. My only concern with these fundamentals is that the operating margin has declined from 51% in 2009 to 45% in 2011. Interestingly, like Google, Dolby has a dual capital structure. They have a Class B share, which has 10 votes, and a Class A share, which has only one vote. A look at the proxy tells you that the Dolby family is clearly in charge. Ninety four percent of the Class B shares are controlled by the Ray Dolby Trust. The Ray Dolby Trust and David Dolby together effectively control Dolby, with 92% voting power.
Weighing the Risks
Dolby has a P/E Ratio of around 14. Its free cash flow per share in 2011 was $3.20, giving it a free cash flow yield of 8% as of 07/16/12. This means that Dolby has low market price risk and low fundamental risk. This is a rare duality in my opinion. Dolby does get 68% of its revenue from international markets, exposing the company to political risk.
Coin Tosses
The way I see it there are some coin tosses as to Dolby’s future:
1.) Microsoft licensing agreement - Microsoft (NASDAQ: MSFT) has entered into an agreement to include Dolby Technology in their Windows 8 PCs and tablets; this includes a per device royalty payment. My concern here is that Windows 8 and Microsoft’s new tablets will flop, thus jeopardizing Dolby’s future growth prospects. Both companies have the fundamentals to pull through if Windows doesn’t live up to expectations, but it could hurt mid-term stock performance.
2.) Dolby’ underperformance in its product division could continue - Dolby’s product revenue declined 26%, according to its latest quarterly report, compared to the year prior. The cinema industry is upgrading to digital cameras, and Dolby is having a difficult time getting its technology into these new systems. The product division does not comprise the majority of Dolby revenue, but it is enough to put a mathematical crimp on future growth if it doesn’t reverse the trend.
3.) Increasing competition from DTS, Inc. - Dolby is not alone in producing sound technologies. DTS, Inc. (NASDAQ: DTSI) commands a huge share of the market. According to DTS’s 2011 Form 10-K, Nielsen said that “86% of the top 100 Blu-ray titles sold in 2011” were encoded with their technologies. DTS also decided to become more focused on their technologies by exiting cinema digital processing units in 2007. Their fundamentals are also strong, with cash and marketable securities comprising 52% of the equity base (MRQ). Its total debt to equity is only 10% (MRQ). Dolby did have a higher return on equity at 18%, versus 13% for DTS, as of the end of 2011. I think Dolby has superior brand recognition, which should help in this regard.
4.) Obsolescence - As a technology company Dolby faces obsolescence in the devices that house Dolby technology. Today (07/17/12) DTS came out with with lower guidance of $21 to $22 million in revenue due to weaker sales in Blu-ray and consumer electronics and higher costs related to the purchase of SRS Labs, Inc. This event dragged DTS down 25%. Dolby, which also makes audio technology for consumer electronics, was down 7% in trading on 07/17/12. DTS sees significant gains in "network connected markets." Dolby will have to keep up its technologies for the new mobile internet revolution while keeping it proprietary.
I think Dolby’s license agreement with Microsoft will bode well if there is a high rate of adoption for the next Windows platform and Microsoft tablets. I also think it would help if they made inroads in incorporating their technology in the new digital projectors being implemented in the cinema industry. Overall, I think Dolby with its superior fundamentals, brand recognition and low valuations should make for a superior long-term investment.
Foolish Sources:
Dolby Offers the Magic Formula by Tom Gibbs
Other Sources:
Dolby Form 10-Q Filed May 8, 2012
Dolby Form PRE 14A Preliminary Proxy Statement Filed December 14, 2011
DTS Form 10-Q Filed May 9, 2012
Microsoft Selects Dolby to Create Immersive Entertainment
DTS Warns on Q2; Weak Blu-Ray Player Sales; Shares Slump
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