Dolby Laboratories is a $3.2Bn market cap company that develops technology and products that improve audio quality across various platforms (i.e. surround sound technology and noise reduction for recording, movie, and home entertainment industries).  Dolby’s technology can be found in almost any DVD and Blue-Ray player, PCs, TVs and set-top boxes and has recently been embedded in mobile phones, Kindle Fire, Netflix and Ultraviolet streaming systems.  Dolby is the leader in the market with an estimated market share of 85%. 

Over 85% of the revenue is generated from licensing agreements.  Most of the licensing revenue comes in two forms; (i) one-time fee paid by semiconductor/software companies where Dolby’s technology is embedded in the hardware/software, (ii) royalty payments based on number of consumer electronic units sold (royalty is paid when PC with Windows 8 OS that has Dolby Technology is sold).  The remaining revenue comes from product sales (i.e. digital cinema servers) and services. 

The licensing business produces gross margins of 98% while products segment generates 35% in gross margins and services ~55%.  Given its reliance on licensing business model which is stable and high margins with low capex needs, company generates a substantial amount of free cash flow, average of ~$300MM per year resulting in a FCF yield of ~10%.  Company has a very strong balance sheet with ~$750MM in cash and short/long-term investments with no long-term debt, which represents ~25% of the company’s market cap.   At the end of 4Q12, company actually paid out a special dividend of $400MM and repurchased $50MM of stock in 1Q13. 

Despite its leading global brand and solidly profitable business, Dolby has been put in the penalty box recently as the stock has dropped from its high of $67/s in the beginning of 2011 to ~$30/s today.    This drop is mainly attributed to concerns and uncertainty pertaining to slowing revenue growth across its optical business line, specifically the PC and DVD segments.  PC segment makes up 28% of all licensing revenues (down from 36% in 2010) and consumer electronics segment (i.e. DVD) is 18% of licensing revenues (down from 22%). 

The concerns that the PC business is in terminal decline and FCF will disappear are overblown; the slowdown of the PC business is already priced in the stock at $30/s.  The market cap has dropped by over 50% while PC revenues have only dropped by 10% since 2010.  In fact, revenues on a consolidated basis have actually grown as Dolby has been able to increase other parts of the licensing business, diversifying its revenue model and thus reducing its reliance on the PC segment, thus actually de-risking its revenue profile. 

Growth has come from the non-optical side of the business, specifically the broadcast and mobile segments.  Broadcast has grown its revenue by 35%+ and Mobile by 70%+ since 2010.  Broadcast is mainly driven by sales of TV and set-top boxes and mobile from sales of mobile phones and tablets.  In the US and Europe, Dolby’s technology is already widely adopted in most TVs and set-top boxes.  The growth potential comes from emerging markets where majority of broadcast technology is still in analog form and is just transitioning to digital broadcasts.  Dolby is capitalizing on this transition; for example in China, a TV production company announced production of new shows in Dolby technology, in India, satellite providers have added additional HD channels in Dolby while Singapore’s IPTV launched an additional two channels.  Dolby has ~70% of total revenues already coming from outside the US, thus additional penetration from these growth markets will increase this share. On the mobile front, Dolby technology is in ~25% of Android smartphone and Tablet shipments and all Windows 8 tablets.  Dolby has increased its presence through licensing deals through Samsung Galaxy SIII and Amazon’s Kindle Fire.  Additionally, Dolby has increased its exposure to emerging technologies, especially in the streaming video segment (which offsets cyclicality in sales from optical DVD/Blue-Ray segments).  It has a licensing deal with Netflix as well as with Warner Brothers, Disney, and Universal on the Ultraviolet cloud-based system.  This will ultimately lead to increase in online content in the mobile segment.  

Taking all these issues into account, the stock is still trading at depressed valuations for a high margin business that generates stable revenues, has low capital intensity and produces consistent cash flows. Current market expectations do not incorporate any operational leverage from additional growth from the mobile/broadcast segments.  Taking into account the growth in these businesses, FCF should grow to about $400MM in 2-3 years resulting in a 30% upside potential in the share price for a business that is low risk, is generating 10% current FCF yield, and has a conservative balance with excess cash. Additionally, the capital structure is under-levered for an asset that generates recurring and predictable cashflows, which places Dolby as a prime candidate for an LBO.