Dolby’s growth story relies on two new technologies, Dolby Atmos and Dolby Vision. The company has seen some momentum in their business by the increasing adoption of both technologies with new partners, for which they earn licensing fees and royalties.
Dolby’s business is protected by patents, which should provide the company with some barriers to entry. However, we find that over the last 10 years, Dolby’s return on investment and profitability has been weakening. Their annual report signals to us, that Dolby lacks any competitive advantages.
We estimate their intrinsic value per share at $29 and we are putting this stock on our watchlist.
Dolby Laboratories (DLB) could be described as an audio and visual tech company with a high margin royalty licensing business model.
The company got started in 1965 by Ray Dolby when he invented the technology that led to the development of noise-reduction systems for analog tape recordings. The Dolby family is still the controlling shareholder, with 85.2% of the voting power. The company has a dual-class share structure with Class B share having 10 votes per share compared to only 1 vote per Class A share. All the Class B shares belong to the Dolby family.
Dolby licenses its technology to a variety of industries but mostly classifies and reports revenues under 5 main categories: Broadcast, Mobile, Consumer Electronics, Personal Computers, and Other.
The company has a wide array of technologies in the audio and visual group:
The highlighted technologies are the main focus of the company and where they believe their growth drivers lie ahead. Out of the three, Dolby Voice is still in a very premature phase, however, Dolby Atmos and Dolby Vision have acquired some interesting licensees, like Apple (AAPL), Netflix (NFLX), and Vizio to name a few.
Dolby Atmos is the new surround sound technology from Dolby. It adds a more immersive sound experience. If you think of a home-theater system, the audio will usually come from a 5.1 system, meaning there are 5 channels (left, right, center, rear left, rear right) and one sub-woofer. When a movie gets made, all the different sounds will get grouped into specific channels, so depending on what is being displayed, different sounds will come out from different channels. What Dolby Atmos does, it mostly eliminates the use of channels and instead allows filmmakers to assign sounds to locations:
Dolby Atmos is more about software than hardware, which makes the technology scalable. It would depend on how well the market adapts Dolby’s technology, however, as there are not alone in the market.
Dolby Vision is a type of High Dynamic Range format. Their proprietary technology allows the onscreen picture to be adjusted on a scene by scene basis, making you see more details and better colors. The open-source version of a technology like Dolby Vision is called HDR10. The difference between the two, however, relies on Dolby Vision supporting a much wider range picture brightness by a factor of 10 if compared to HDR10. There is also more color accuracy. Again the success of the technology depends on market adoption, not just in movie theaters but on TV sets as well.
Dolby makes the majority of sales by licensing its technology. They have 4 main licensing models but for most of them, Dolby charges un upfront fee and subsequent royalties would depend on the volume of products using Dolby technologies. Licensing revenue accounts for 90% of total revenues with the other 10% coming from products (audio and imaging products use in cinema, tv, broadcast and entertainment industries)
The company reported its first-quarter numbers for fiscal 2020 at the end of January. First-quarter revenues came in a bit soft at $292M compared to $299M in Q4 2019 and $302M in Q1 2019. Total operating expenses for the quarter came in at $206M compared to $201M in Q4 2019 and $195M in Q1 2019. The increase in operating expense was due to a continued investment in sales and marketing expenses which increased by 10% on a year-over-year basis and to a lesser extend a slight increase in general and administrative expenses.
During their Q1 conference call, the company gave guidance to their Q2 results as follows: revenue range from $370M to $390M compared to $338M in last year’s second quarter, implying revenue growth of 9% to 15% higher. Gross margins of 89% and operating expenses of $213M to $219M compared to $198M in Q2 2019. Operating expenses are expected to increase by 7.5% to 11%.
If one looks at Dolby’s 10-year historical results, the company has been facing some competitive pressures:
Looking at Dolby’s historical results, we find there is a degree of cyclicality and unpredictability in their operating results. Profitability measures and return measures have been deteriorating for the last 10-years.
We believe the downtrend in profitability and returns to be the result of weak competitive advantages, especially any sort of customer captivity with Dolby’s technology. Investors could argue that Dolby is the standard in audio quality, which in some ways it is true. Over the years, Dolby has developed a brand name synonymous with audio, and it seems their logo is in the credits of every movie. However, we believe Dolby is victim of product cycles and a lack of pricing power.
The company has a very detailed risk disclosure in its annual report. In their risk disclosures, the company states that their license agreements are typically non-exclusive and generally do not have minimum purchase commitments, meaning that if product manufacturers licensing Dolby’s technology sells less inventory, Dolby receives a lower royalty payment. With Dolby’s focus on increasing their share in the mobile device market, the risk lies in the rapid product cycle within the industry. With every new product introduction, Dolby could risk being replaced by a competitor. In that way, we think Dolby lacks pricing power and customer captivity:
The unpredictability of earning is due the Dolby’s operating leverage. For the last three years, the company’s R&D and G&A has average around 62% of total operating expenses, with the rest allocated to selling and marketing expenses. Normally, R&D and G&A are mostly fixed costs investments, and in the case of R&D, we could argue that it is a necessary expense. With selling and marketing expenses the same could be said, as the company needs to market its technology to potential customers or risks being replaced by competing technologies. What this translates into is top-line growth acceleration or deceleration is going to impact the bottom line significantly due to the degree of operating leverage. The lack of competitive advantages plus high operating leverage is something investors need to look out for.
Quick Financial Overview
Dolby has a very strong balance sheet. As of their last reported number, the company had zero financial debt. Their liquidity position is excellent as well, with almost $1B in their balance sheet composed of $741 in cash and the rest in short- and long-term investments. Cash alone can cover their total liabilities of $554M.
The company also produces healthy cash flows from operations, but that would depend on how you would classify stock-based compensation. If you classify stock-based compensation as a non-cash expense, then Dolby generated $328M in their fiscal 2019 and $31.1M in their Q1 2020. For us, however, we classify compensation expenses as a real expense, especially since it accounts for almost 25% on average of operating cashflows. Adjusting operating cash flows to exclude compensation expense, we get $251M in 2019 and $8.5M in Q1 2020. Using those adjusted operating cash flows, we estimate FCF around $231M as the company has an average CAPEX of $20M. Out of the $231M in FCF, Dolby pays $22M in dividends for a payout ratio out of FCF of 9%. The company can comfortably sustain its dividend payments.
Dolby also has a repurchase program, but we see it more as to prevent dilution from compensation expense than an actual return of cash to shareholders:
From the table above, we see how their repurchase of shares closely matches the amount issued due to stock awards to employees. In that sense, we don’t put too much importance on their share buyback program.
To perform a reverse DCF analysis, we first need to get the consensus view about sales growth and operating margins:
In the table above we find that the consensus view is for sales to grow to $1.4B by 2022 from the $1.2B in 2019. That would be an average growth rate of 5.6% per year. We also note an expansion of operating margins from a current 20.7% to 33.1% by 2022 as well.
Following the consensus view, we built our reverse DCF model reflecting such growth rates. Since Dolby has no financial debt, we use a cost of equity of 7.3%, reflecting the drop in yields in the 10-year treasury notes to 0.67% and an equity risk premium of 6.65%. The tax rate is set at 21%. Doing so, we get the following result:
Source: author estimates
The results of our reverse DCF model shows us that at a current share price of $54.74, the market is in-line with analyst expectations of future growth. Another way to look at it, is that embedded in the recent share price, the market is discounting only one year of future growth.
We estimate Dolby’s intrinsic value per share at $29 by using a 10-year average EPS, adjusted for non-recurring charges of $2.17, and capitalizing it at a 10% required rate of return. We are not valuing the shares using a growth rate since we believe the company is cyclical and a lack of competitive advantage could see their growth being competed away. The reason behind the 10-year average is to adjust for the business cycle.
Growth and momentum investors might become interested in Dolby’s growth story. If their new technologies become the standard, recent prices could be a good entry point. Operating leverage can cut both ways, so an increase in sales in going to give EPS a higher boost, and possibly a higher valuation multiple.
We are on the sidelines, for now, hoping the market could give us a better entry point in this volatile environment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.