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Is Dolby as Cheap as it Seems?

Steve is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As a starting point in my continuous search for new ideas, I often look for companies with strong earnings yields and great returns on invested capital.  Why?  Companies with high returns on invested capital generally possess durable competitive advantages and demonstrate a knack for creating value for shareholders.  When these companies also sport good earnings yields, they represent great potential opportunities for investors to beat the market.  

Skeptical?  You don't have to take my word for it; I'm not the only one who believes in the merits of using this methodology.

This in mind, Dolby Laboratories (NYSE: DLB) has finally piqued my interest.  Of course, Dolby isn't exactly a new idea; the undervalued 47-year-old audiophile has occupied a spot in my screens for the better part of 2012 thanks to persistent worries about declining revenue in several of its core segments. 

Before we dig further, let's have a look at some of Dolby's key metrics next to its closest publicly-traded competitor, DTS (NASDAQ: DTSI):

<table> <tbody> <tr> <td> </td> <td><strong>Dolby Labs</strong></td> <td><strong>DTS</strong></td> </tr> <tr> <td><strong> Market Capitalization </strong></td> <td> $3.6 billion</td> <td> $304 million</td> </tr> <tr> <td><strong> Debt-to-Equity Ratio </strong></td> <td> 0.00</td> <td> 0.17 </td> </tr> <tr> <td><strong> Current Ratio</strong></td> <td> 6.20 </td> <td> 4.60 </td> </tr> <tr> <td><strong> Current P/E Ratio</strong></td> <td> 14.3</td> <td> N/A </td> </tr> <tr> <td><strong> Estimated Forward P/E Ratio</strong></td> <td> 16.1</td> <td> 14.7</td> </tr> <tr> <td> <strong>Gross Margins</strong></td> <td> 88%</td> <td> 90.5%</td> </tr> <tr> <td><strong> Net Margins</strong></td> <td> 28.5%</td> <td> -8.7%</td> </tr> <tr> <td><strong></strong><strong> Return on Invested Capital</strong></td> <td><span> 15.4%</span></td> <td><span>-4.2% </span></td> </tr> </tbody> </table>

Dolby sports a sterling balance sheet with no debt and nearly $492 million in cash and equivalents and more than $600 million in short-term and long-term investments.  The company is solidly profitable with gross margins of 88% and net margins at 28.5%, and its ROIC of 15.4% shows it has no trouble finding ways to create shareholder value by reinvesting that capital in its business.  In addition, its current price to earnings ratio of 14.3 gives it a decent earnings yield of 7%.  

So what gives? 

Interestingly, Dolby is currently trading 23% below its 52-week-high set last May.  Why, then, would investors shun a company with a decent earnings yield, strong margins, great returns on invested capital, no debt, and a mountain of cash?

In short, with a mobile and tablet boom firmly under way, investors fear Dolby will be unable to transition out of its current state of reliance on the stagnant PC, television, and DVD player markets.

At first glance in looking at the table above, the comparison between Dolby and DTS doesn't seem very fair; Dolby's $3.5 billion market capitalization dwarfs DTS at $294 million, and DTS is coming off its own difficult quarter during which it posted a $19.1 million loss despite a total year-over-year revenue increase of 8%. However, the loss was primarily attributed to the accounting treatment of DTS's July acquisition of privately-held competitor SRS Labs.  It's a safe bet, then, DTS and SRS Labs are acutely aware of the significant size advantage held over them by Dolby and, when the affects of the acquisition wear off, their combined efforts could potentially give their larger rival a run for its money.  Dolby also faces strong competition from privately-owned THX, which for the last thirty years has been the audio-processing favorite of Disney's newly-aquired subsidiary, Lucasfilm.

The Brand

Dolby has spent nearly fifty years building a rock-solid brand and is widely considered the 800 pound gorilla of audio technology.  While it's doubtful many of us are aware of the full extent of Dolby's business, chances are most people know its name is synonymous with great sound.  Despite its currently-slowing PC, DVD, and television segments, Dolby continues to increase investments in R&D and boasts a number of catalysts to drive its business going forward.

The Movies

In the cinema, we've already seen some of the fruits of Dolby's research with its next-generation Dolby Atmos technology, which can incorporate up to 64 independent speaker outputs and allows filmmakers to place specific sounds anywhere in the room -- even above your head.  Atmos has already been incorporated in nine titles across five studios, including Disney Pixar's "Brave," DreamWorks' "Rise of the Guardians," Warner Brothers' "The Hobbit: An Unexpected Journey,"  and Viacom subsidiary Paramount's "Star Trek into Darkness." 

Mobile Opportunities

While Dolby is working on driving industry acceptance for Atmos in the cinema, its top priority remains pushing further into mobile markets.  Though mobile is still a relatively new segment for Dolby, CEO Kevin Yeaman noted during their most recent earnings call "In the Android ecosystem, Dolby audio formats are now in approximately 25% of smartphone shipments [...] and almost 30% of tablet shipments," thanks in large part to Qualcomm's early 2012 decision to integrate support for the Dolby Digital Plus platform directly into its Snapdragon mobile chips.

Amazon.com (NASDAQ: AMZN) is also using Dolby's technology as a differentiator for its Kindle Fire HD devices.  Amazon recently named its Kindle Fire HD as its "#1 selling product across all of Amazon worldwide," which not only bodes well for its own future high-margin digital sales, but also helps dispel the notion people shouldn't expect decent sound from their mobile devices.

International Expansion

Never content to rest on its laurels, Dolby continues to make new inroads with international expansion.  While Dolby has already been adopted as the audio standard by half of China's high-definition TV channels, the company is actively pursuing inclusion as the audio standard for digital television specifications in India, Southeast Asia, Singapore, South Africa, Austria, and Turkey.  

To be sure, the emerging markets opportunity in television is huge for Dolby; these markets receive more than half the world's set top box shipments and contain the majority of the population.  As Yeaman notes, "While it is too soon to say when these countries will convert to digital television, we are confident that they will and that we're well positioned to benefit from this transition."

In addition, as fellow Foolish blogger Joseph Harry pointed out recently, Dolby announced a partnership last week with China Mobile (NYSE: CHL) to integrate its Dolby Pulse technology into the mobile giant's hi-fidelity music download services beginning next month.  While Dolby will obviously benefit from the new revenue stream, its superior audio compression algorithms will also serve to substantially reduce China Mobile's bandwidth expenses.

That Massive Special Dividend

Shares of DLB initially popped nearly 8% on its announcement of a $4 per share special dividend, then gradually fell into the afternoon as the excitement waned.  As an aside, it's interesting to note the dividend's $408 million dollar price tag dwarfs the entire market capitalization of Dolby's rival, DTS.  While some might worry the cost is excessive, Dolby's remaining cash reserves and strong cash flows leave it more than enough money to fund operations and maintain its market leading position through continued investments in R&D.  In addition, this should be seen as a strong indication of management's confidence in the Dolby's future.

The Foolish Bottom Line

In the end, given its massive cash hoard, strong brand, significant business catalysts, and shareholder-friendly attitude, there's a lot to love about shares of DLB at current levels.  Even if Dolby's current core markets continue to deteriorate, long-term investors can sleep sound knowing the company has laid the foundation for its success in new markets going forward.

symie5 has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and China Mobile. Motley Fool newsletter services recommend Amazon.com and Dolby Laboratories. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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