Does Opportunity Knock in Surround Sound?

By Michael Finarelli - January 26, 2012 | Tickers: AAPL, DLB, MSFT | 0 Comments

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If you’ve stepped inside of a movie theater in the past decade here in the US, then you are likely familiar with the customary ear popping experience thanks to the leader in audio enhancement technology, Dolby (NYSE: DLB). What the company may be less well known for is the dominance of the Dolby Standard encoded across PCs, digital TVs, set-top boxes, and numerous other devices. 

Despite being the long-standing market leader, Dolby’s stock has bombed over the last year falling from a high of $68.88 to its current $35-ish price tag. The reason is twofold: First, the traditional PC market, which has been the bread and butter of Dolby’s business, continues to be mired in decline as other devices rise in popularity. Certainly, Apple’s (NASDAQ: AAPL) stellar fiscal 2012 first quarter results, which reflected record sales of both iPads and iPhones, didn’t do Dolby any favors.

However, despite rapid growth in mobile streaming devices, the sound coming from the PC industry is one of transition rather than a few final breaths. Ultimately, many believe that this change provides DLB with the opportunity to focus directly on licensing relationships with the content providers to harness the widespread adoption of online streaming, an area of huge growth potential.

The second driver behind the stock’s drop relates to the fact that Microsoft (NASDAQ: MSFT) may not continue to license Dolby’s technology in its upcoming Windows 8 release, which will undoubtedly hurt the top line in the near term.  However, here as well, this breakup will actually enable Dolby to deal direct with customers (the Original Equipment Manufacturers in this case), thereby building a closer relationship.

Is Mr. Market Tone Deaf?

In order to give some basis of the relative cheapness of Dolby’s stock price, let’s take a look at a historical comparison of the company’s enterprise value to EBITDA multiple. Although price multiples do not give us the whole picture of valuation nor should they be used as the definitive buy or sell criteria, they do provide a perspective on how the market has valued the business in the past.  The table below illustrates this perspective.

I prefer to use EV/EBITDA as opposed to a traditional P/E since EBITDA generally provides a clearer picture of a company’s earnings strictly from operations, whereas the net income used in the P/E can be subject to greater distortion.  As one can easily see from the basis of history, the market has been considerably downbeat on Dolby’s stock over the past year. 

Although this analysis sheds light on Mr. Market’s current mood in regards to DLB, the real questions are how will Dolby's earnings fare in the future and what multiple will Mr. Market place on those earnings going forward. Will Dolby overcome the current headwinds battering its ship and eventually restore the market’s confidence, or will they succumb to forceful technological shifts, rapidly changing consumer preferences, and intensifying competition?

Only time will truly tell, but in the meantime feel free to weigh in. It may take some time, but I believe that Dolby will ultimately find its way back into Mr. Market's good graces!

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