3 Reasons To Own Dolby Labs

By Will Ashworth | April 18, 2011 AAA

Dolby Labs (NYSE:DLB) is synonymous with sound quality. Since 1965, it's been an entertainment industry innovator and until recently, its stock was red-hot. Then the company announced first-quarter earnings in early February that were good but included a downward revision in fiscal 2011 revenue. The share price fell off a cliff, dropping 26% in just two months. DLB's stock hasn't been this low since late 2009. Investors seem to be saying the San Francisco-based company has lost its way. This is a bump in the road and business will pick up in 2012. In the meantime, here are three reasons why now is a great time to buy.
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Perspective
When considering any investment, it's important to look at things from several different angles, as it gives a perspective that isn't tied to short-term performance. In Dolby's case, we'll compare the state of the company when it went public in February 2005 to today. This will help identify whether the company's going in the right direction.

Dolby's year-end is September, so we'll compare the 2004 and 2010 fiscal years. In 2004, revenues were $289 million and operating profits $68 million. The gross and operating margins were 68.3% and 23.5%, respectively. In 2005, the IPO valued the company at $1.75 billion or six times revenue. In 2010, Dolby's revenues were $923 million and operating profits $429 million. The gross and operating margins were 85.7% and 46.5%, respectively. Based on its stock price of September 24, 2010, its market cap was $7.12 billion or 7.7 times revenues.

In the span of five years, Dolby has improved revenues by 219%, operating profits by 531%, gross margins by 1740 basis points and operating margins by 2300 basis points. And for this, it had a price-to-sales multiple in September that was only slightly higher than in 2005. Today, that multiple is lower than at the IPO. Perspective tells me something isn't right.

Dolby Labs and Peers

Company P/S EV/EBITDA
Dolby Labs 5.41 9.03
DTS (Nasdaq:DTSI) 8.38 21.65
SRS Labs (Nasdaq:SRSL) 3.81 25.64
Imax (Nasdaq:IMAX) 8.02 32.99

Dolby Family
I'm a big believer in family-controlled businesses. Publicly traded family businesses often do better than their peers do because the sense of mission is much deeper. Even though Ray Dolby is no longer involved in the daily operation of the business, his son David is. As an investor, it's good to know that the Dolby family, who control 92% of the votes and have an economic interest of 52%, have someone on the inside keeping an eye on things. David Dolby might not be in every meeting (he's only 33), but he is on the board and his presence undoubtedly reminds employees whose name is on the front door. When so many companies stand for so little today, this is a significant advantage.

Products Segment
Approximately 20% of Dolby's revenues come from actual products as opposed to licensing revenue. The gross margins are 50% compared to 98% for licensing, which generates 77% of total revenue. In the past two years, product revenue has gone from 11% to 20% of total revenue, a positive sign indeed. But is it enough? It's plenty. Since it's gone public, its operating expenses have increased between 20% and 30% annually. With over $1 billion in cash at the end of December combined with operating cash flow over $300 million, it will never be empty handed.

Motley Fool contributor Travis Hoium suggested February 3 that Dolby acquire Imax to bring together two companies improving the movie-going experience. It's not a bad suggestion. Unfortunately, Imax's enterprise value is currently 33 times EBITDA. That's too expensive. But he's on the right track. If Dolby wants to expand the products side of the business, it needs to go out and find itself a tuck-in acquisition or two. These take time. In the meantime, it continues to make lots of money. (To learn more, see Investment Valuation Ratios: Enterprise Value Multiple.)

Bottom Line
Dolby's been steadily buying its stock in recent quarters. In Q1, it spent $46 million repurchasing its shares at an average price of $62.72. Trading 28% lower than what it paid in the first quarter, I have to believe it's been buying its stock the past three months by the boatload. There might be a little downside left but that shouldn't scare value investors from buying. Dolby's on sale.

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