Description

Summary

We recommend a long position in Dolby Laboratories (DLB).

The company's primary business is the licensing of audio, video, and voice technologies for entertainment and communication purposes. Dolby is best known for its digital signal processing, noise reduction and multi-channel output technologies (aka surround sound) that enhance audio experiences. The company benefits from a licensing model that produces notably high gross margins, all the while enjoying a strong strategic position in the migration from analog to digital broadcast in the emerging markets. With a substantial amount of intellectual property (over three thousand patents issued and a couple thousand more pending) the company is in possession of a decent sized moat that will continue to allow Dolby, which for a company of its size has minimal capex, to generate significant free cash flow.

Today Dolby operates with a debt-free balance sheet and a sizeable net cash balance of close to $800mm, or about 20% of the current market value. It's our expectation that in 2015 the company will able generate close to $300mm of free cash, and management will be compelled to pursue new ways to return capital to shareholders beyond the upsizing of its share buyback program and the initiation of a quarterly dividend program just this month.

When you back out the huge cash position, I think DLB shares represent decent value.  With an EV of $3.5bn, the valuation implies investor sentiment that is ambivalent to slightly negative about a company that's generally been a steady earner and returner of capital.  The market is concerned about the company's exposure to PC sales going forward and punitive about the secular decline of optical media devices, while not fully recognizing the continued growth potential in broadcast.  We expect continued growth from broadcast licensing, a stabilization in PC sales, and a longer term opportunity to reduce the company's somewhat bloated R&D (representing $180mm in FY 2014 and close to 20% of sales), will grow free cash flow generation by the company closer to $425mm in the next 18 months. Modeling a cash build of $600mm during over that period time, and valuing the company at 10% free cash flow yield we see the potential for Dolby shares to rise to $55. Such a move would represent about a 30% increase from today's price.

Details

Most have a passing familiarity with the Dolby brand. It's probably the first company that comes to mind when you hear the words "surround sound." (Trivia: The first film to feature Dolby noise reduction technology was A Clockwork Orange). The company creates audio, video, and voice technologies that transform entertainment and communications at the cinema, in the home, office, and on mobile devices.  

The majority of the revenue generated by Dolby comes from the licensing of technologies it holds under patent. I've included the revenue mix below.

28% of revenue is from the U.S. and the 72% is international.

As for the mix of licensing revenues:

To expand on what exactly goes into these categories a bit: Broadcast principally refers to products licensed by OEM's of televisions and set-top boxes, and this represent Dolby's single largest end market and is growing at a reasonable clip (~10% per annum) and is the main driver of topline growth for the company. In the PC segment the main products are tied to the Microsoft Window's operating system and DVD software players. The Consumer Electronics segment encapsulates products like DVD and Blu-Ray players/recorders but also audio/video receivers, and home-theater systems. Mobile is mostly smartphones, and Other includes automotive (in-car audio systems) and video game consoles.

I alluded to high gross margins earlier. I might have modify that. The licensing-heavy model Dolby uses results in exceptionally high margins, even for a technology company. Gross margins run in the 90% range. Here are some numbers:

(N.B. I'm GAAP numbers above.  in 2014 RSU dividend and stock based compensation together was about $70mm.)

A look at Dolby's Licensing Structures:

So how does the Dolby's business work? What allows this company to generate 90%+ gross margins? For the most part Dolby employs 3 different types of licensing agreements. The below is a little dry and mostly cribbed from the company's 10k.

1) The Two-Tier Licensing Model .   Most consumer entertainment licensing business consists of a two-tier licensing model whereby Dolby's decoding technologies are first provided under license to a semiconductor manufacturer. The manufacturer then incorporates Dolby's technologies into its integrated circuits. Licensed semiconductor manufacturers, whom the company refer to as “implementation licensees,” sell their ICs to OEMs of consumer entertainment products, which the company refer to as “system licensees.” System licensees separately obtain licenses from Dolby that allow them to make and sell finished end-user products that incorporate its technologies in ICs purchased from its implementation licensees.

Implementation licensees pay a one-time, up-front fee per license. In exchange, the licensee receives a licensing package, which includes information useful in implementing its technologies into their chipsets. Once implemented, the licensee sends a sample chipset to Dolby for quality control evaluation and if the company validates the design, the licensee may sell the chipset for use solely by its system licensees.

System licensees are required to provide prototypes of products that incorporate its technologies for which they are licensed for quality control evaluation, or under certain circumstances, with self-test results for its review. If the prototype or test results are approved, the licensee is permitted to buy ICs from any Dolby implementation licensee with a license for the same Dolby technology, and to sell approved products to retailers, distributors, and consumers. For the use of its technologies, its system licensees pay an initial licensing fee as well as royalties, which represent the majority of the revenue recognized from these arrangements. The amount of royalties the company collect from a system licensee on a particular product depends on a number of factors including the mix of Dolby technologies used, the nature of the implementations, and the volume of products incorporating its technologies that are shipped by the system licensee.

2) Integrated Licensing Model . The company also license its technologies to software operating system vendors and independent software vendors ("ISVs"), and to certain other OEMs that act as combined implementation and system licensees. These licensees incorporate its technologies in their software used on PCs, in mobile applications, or in ICs they manufacture and incorporate into their products. As with the two-tier licensing model, the combined implementation and system licensee pays Dolby an initial licensing fee in addition to royalties as determined by the mix of Dolby technologies used, the nature of the implementations and the volume of products incorporating its technologies that are shipped, and is subject to the same quality control evaluation process.

3) Patent Licensing.     the company license its patents directly to manufacturers that use its intellectual property in their products. the company also license its patents indirectly through patent pools, arrangements between multiple patent owners to jointly offer and license pooled patents to licensees. Finally, the company generate service fees for managing patent pools on behalf of third party patent owners through its wholly owned subsidiary, Via Licensing Corporation. The Via Licensing patent pools enable product manufacturers to efficiently secure patent licenses for audio coding, interactive television, digital radio and wireless technologies.

Customers and Segment Trends

Samsung is Dolby's large licensees and accounts for about 12% of Dolby's sales (and consist primarily of licensing revenue from its mobile and broadcast market). Dolby's significant gains in broadcast and the incorporation of its intellectual property into digital standards of many international markets (India, China, and West Africa) imply that Samsung will likely remain Dolby's largest customer for the foreseeable future.

Over the past five years Dolby has been able to strengthen its position as the adopted standard in digital television and high definition content in North America and throughout much of Europe. At the same it has demonstrated a lot of success in deploying its technologies in a number of emerging markets, which is important since this is where the company is realizing growth as most of its traditional markets are in various stages of decline. In China, most operators have adopted Dolby Digital Plus in their set-top boxes and the company estimates that Dolby technologies are deployed in over half of the High Definition channels on air in China. India appears to be following a similar trend. The company also has been successful in Nigeria, Brazil, Malaysia, Vietnam, and the Philippines in getting Dolby Digital Plus adopted in their set-top boxes.

Microsoft historically was a major customer for Dolby although its share of the company's revenue has fallen from 14% to now under 10% in the past few years. Declining PC sales have been the main driver of that reduction. The company's technologies are in the majority of PCs sold today due to their incorporation in Microsoft Windows 8 for disc and online content playback and, for versions prior to Windows 8, primarily because of their inclusion in DVD and Blu-ray Disc playback functionality. Historically, Dolby would license its technologies to a range of PC licensees, including independent software vendors, PC OEMs, and operating system providers. Revenues from the PC market depends on several factors, including underlying PC unit shipment growth, the extent to which its technologies are included on computers, through operating systems or otherwise, and the terms of any royalties or other payments the company receive. This is a challenged segment since purchasing trends are moving away from traditional PCs and toward computing devices without optical disc drives, such as chromebooks and tablets that do not use Dolby's technologies.

The consumer electronics segment has also been declining in recent years. With the proliferation of mobile content delivery methods, Dolby has seen a shift away from demand for optical disc media to which has resulted in what's likely to be a secular declines in revenue from DVD and Blu-ray Disc players.

Dolby's role in mobile is also somewhat of a challenged position. Over the past few years the company has recognized significant growth in this segment, but pricing and competition have lead to considerable volatility. Mobile devices have much shorter product lifecycles, and it's much easier for mobile device OEMs to remove Dolby's technologies when the price isn't right from mobile devices than it historically was for PC OEMs. The mobile markets are characterized by intense competition, evolving industry standards and business and distribution models, disruptive software and hardware technology developments, frequent product and service introductions and short life cycles, and price sensitivity on the part of consumers, all of which result in downward pressure on pricing or the removal of technologies by OEM providers. So while mobile has the potential to remain a growth avenue for Dolby, the company has acknowledged that it's not a sure thing and is likely to continue to confront experiencing pricing pressure in the future.

Is there a long-term moat here?

I think this is where the debate on whether you go long or short the stock rests. Apart from broadcast, the rest of the end-markets seem to be on thin ice. How sustainable are Dolby's licensing margins? Existing patents in the portfolio will eventually expire, and it's unlikely new patens will replace them in exactly the same way. The company's important Dolby Digital patent, also known as AC-3, expires in the U.S in 2017. A little later Dolby will see the expiration of its Dolby Digital Plus patents take place between 2018 and 2026. How serious is this? It's hard to say. Unlike pharma, management doesn't breakdown here how much of its licensing revenues actually comes from these patents. The company only describes the amount as "a significant part." Here's the frustrating language from last year's annual report:

"In particular, some of its patents relating to Dolby Digital technologies, from which the company derive a significant part of its licensing revenue, have expired and others will expire over the next several years. the company have transitioned a number of its Dolby Digital licensees, and continue to make progress in transitioning other Dolby Digital licensees, to Dolby Digital Plus technologies, an extension of its Dolby Digital technologies, whose patents generally expire later than the Dolby Digital patents. The company still derives a significant part of its licensing revenue from Dolby Digital Plus. To be successful, the company must continue to transition licensees to Dolby Digital Plus, and discourage licensees of Dolby Digital Plus to transition back to Dolby Digital as its original patents covering this technology expire."

So clearly this is where things get a little challenging. The quality of the disclosure is a little maddening. They don't provide much detail either on the pace or the rate of the transition to new patented products. Dolby's reluctance to state just how much is exactly "significant" is concerning, and I think it should give even the most ardent long a long pause. It's somewhat concerning that a technology first developed in the early 90's potentially remains a meaningful part of the company's revenues. It also makes one wonder just how effectively the company has spent some $1 to 2bn in R&D over the past 23 years given just a handful of patents may still represent Dolby's main intellectual property. Ameliorating this concern perhaps is the fact that most of the emerging market broadcast gains have been tied to the Dolby Digital Plus licenses which has another decade of runaway. Dolby certainly is one of the biggest beneficiary of established US standards for digital broadcast TV, cable, and satellite. Additionally they've been incredibly successful internationally (e.g. India, China, Nigeria, Brazil) as those markets institute their own standards. Beyond this half of the world’s TVs still need to transition to digital broadcast. So they got that going for them as well. The size of the market for Dolby's licenses will continue to increase and that should will probably more than make up for the (modest) declines in PC, (less modest) consumer electronic markets, and pricing and competitive pressure in mobile. But there is this patent wall with an inadequate amount of disclosure that bears somewhat unquantifiable risk and needs to be recognized with increasing caution the closer we get to 2017. Based on the quality of the disclosure in the 10k which should be realized in a couple weeks, DLB maybe turn out to be one of those situations that is arguably a long in the short term, but a short in the long term.

Catalyst

Increased share buyback
1 time special dividend
Reduction in bloated R&D budget ($180mm per year, ~20% of sales)
Release of 10k which provides details on expiration of Doby Digital Patent