Dolby’s Market Cap Takes A Hit

During its third quarter earnings call, Dolby (NYSE:DLB), the industry leader in audio technology, announced that Microsoft will not be including Dolby’s technology in Windows 8. Dolby says this would affect its licensing revenue only in 2013, but its shares have plunged 30% since the announcement. Let’s take a closer look.

In August, Dolby reported third quarter revenue of $219 million, down 5% y-o-y. Net income was $61.7 million or $0.55 per share compared to $71.1 million or $0.62 per share. Analysts expected earnings of $0.54 per share on revenue of $215.5 million. Gross margin was 87.2% compared to 82.6% last year. The company ended the quarter with about $1.184 billion in cash, cash equivalents, and market securities after it repurchased shares for $67.4 million.

Licensing revenue for the third quarter was $181.8 million, up 7%, driven by strong growth in broadcast revenue. Broadcast revenue, which accounts for about 30% of its licensing revenue, grew 26% because of increased revenue from set-top boxes and TVs. In Asia Pacific, China finalized its national digital TV standard, which includes Dolby Digital Plus as an optional format. It recently signed agreements with two Chinese TV OEMs, TCL and Skyworth. In India, Dolby’s technologies have been adopted by Tata Sky, Airtel digital TV, and Star TV.

Revenue from the PC market declined 11% owing mainly to lower revenue from independent software vendors (ISVs). Consumer electronics revenue increased 5% as increases in certain product categories including audio/video receivers, home-theater-in-a-box and camcorder more than offset declines in DVD.

Dolby sued RIM in June for using its audio compression technology in BlackBerry phones and PlayBook tablets without any licensing agreement in place. It withdrew its lawsuit in September after entering into a licensing agreement with RIM through Via Licensing, a subsidiary of Dolby.

Revenue from other markets segment, which includes mobile, gaming, automotive, and Via, increased 26% primarily on growth from mobile. Third quarter product revenue was $28.4 million, down 46% driven by lower prices for its 3D and Digital Cinema products. Third quarter services revenue was $8.8 million, up 21%.

For fiscal year 2011, Dolby, with annual revenue of $922.7 million in 2010, expects revenue of $930 million to $955 million. It expects EPS of $2.61 to $2.70. Non-GAAP EPS is expected to be $2.87 to $2.96. Gross margin is expected to be 88%. Licensing revenue is expected in the range of $775 million to $790 million, including approximately $15 million in Q4 revenue from back royalties related to a license agreement signed between Via Licensing and RIM. The stock is trading around $28.56 with market cap of about $3 billion. Its 52-week range is $25.70-$69.69.

The Windows 8 Announcement

The Windows 8 announcement has had a drastic effect on Dolby’s shares despite the third quarter results beating estimates. During the earnings call, Dolby said

“We work with operating system providers, ISVs and OEMs to support DVD on the PC. In recent years, our mix of PC licensing revenue has increasingly shifted towards the operating system as our technologies are included in 4 editions of Windows 7. However, we have recently learned that our technologies are not currently included in the Windows 8 operating system under development. If our technologies are not included in the commercial version of Windows 8, we expect to support DVD playback functionality by increasingly licensing our technologies directly to OEMs and ISVs, and we will seek to extend our technologies to further support online content playback.”

Why Microsoft has decided not to include Dolby in Windows 8 is not known but Alex Wilheim reasons that

“It could be that as optical drives slowly fade, at the prodding of Apple’s laptop design choices, cloud software, and streamed movies, that DVD playback technologies are simply too expensive to license, and Microsoft wants to cut fat from Windows 8. Another possibility is that, with Microsoft’s exceptionally close ties to Netflix, and that company’s push towards streaming, the Redmond giant simply doesn’t see the need to continue focusing on the playing of physical storage mediums.”

What impact does the announcement have on its revenues? Dolby says the impact would kick in only in 2013. Microsoft started shipping Dolby technology in Windows in 2007. Windows licensing revenue accounted for 12% of its revenue in 2010, up from 10% in 2008 and 2009. Its annual revenue in 2010 was $922.7 billion and the Windows licensing revenue amounts to $110.7 million in 2010.

Frank Voisin on SeekingAlpha says that

“Even if the company loses a significant amount of its licensing revenue by not being included in Windows 8, it is still undervalued by more than 20%. This margin of safety is not enough to cause me to invest, though it is important to note that this is only one potential outcome. In the event the company’s technology is included in Windows 8, DLB is worth significantly more.

Whether MSFT will include DLB’s technology in Windows 8 is anyone’s guess. I would prefer to invest at a price that provides a sufficient margin of safety even in the negative situation. So far we aren’t there, but given the recent markets, we might be soon.

Some points about DLB to leave you with: The company trades for less than $28 a share, has zero debt and more than $10/share in cash. The company has historically had extremely strong returns, averaging more than 20% ROE and more than 60% ROIC.”

To conclude, Dolby has strong financial fundamentals and a sound technology that has potential for strong growth in broadcasting market that could offset the setback from the Microsoft Windows 8 announcement.