Dolby Laboratories, Inc. (DLB) Q4 2012 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the Dolby Laboratories' conference call discussing the fiscal fourth quarter and year-end financial results. [Operator Instructions] As a reminder, this call is being recorded, Thursday, November 8, 2012. I would now like to turn the conference call over to Alex Hughes, Senior Director of Investor Relations for Dolby Laboratories. Please go ahead, Mr. Hughes.

Thank you, Elizabeth. Good afternoon. Welcome to Dolby Laboratories' Fourth Quarter and Fiscal 2012 Earnings Conference Call. Joining me today are Kevin Yeaman, Dolby Laboratories' President and CEO; Lewis Chew, Executive Vice President and Chief Financial Officer; and Ramzi Haidamus, Executive Vice President of Marketing and Business Development. On this conference call, we will be making forward-looking statements that include projections of future operating results for our fiscal year ending September 28th, 2012; market trends and developments for the industries in which we compete, and in the PC, online and portable industries in particular; and our expectations and beliefs concerning how those trends and developments will affect our operating results; the capabilities and market acceptance of our products and technologies; expectations relating to licensing arrangements; and our strategic and operational plans and objectives. These statements are based on management's current expectations and assumptions that are subject to risks and uncertainties. Actual results may differ materially from those set forth in such statements. Important factors, such as general economic, PC, broadcast, consumer electronics or cinema market conditions, could cause actual results to differ materially from those in our forward-looking statements. These factors are addressed in the earnings press release that we issued today and under the section captioned Risk Factors and elsewhere in our most recent quarterly report on Form 10-Q available at www.sec.gov or on our website at www.dolby.com, under the Investor Relations section. Dolby disclaims any obligation to update information contained in these forward-looking statements, whether as a result of new information, future events or otherwise. During this call, we will discuss GAAP and non-GAAP financial measures. The reconciliation between the 2 is available in our earnings release and in the Dolby Laboratories' Investor Relations data sheet on our Investor Relations section of our website. As to the structure of this call, Lewis will begin with a recap of Dolby's financial results and provide our fiscal 2013 outlook, and Kevin will finish with a discussion of the business. So with that introduction behind us, I will now turn the call over to Lewis.

Thanks, Alex, and good afternoon. During my section of the call today, I'll cover 3 main topics. One, I'll cover Q4 revenue by market. Two, I'll go over our operating expenses and our margins. And three, I'll give a forward outlook as we head into fiscal 2013. So let me start with a revenue discussion. Total revenue in the fourth quarter was $224.8 million. Within that total, Q4 licensing revenue was $191.2 million, down $14.6 million year-over-year or about 7%. Now one of the big factors impacting this year-over-year comparison is a significant amount we received from a settlement with RIM in the fourth quarter of last year that was not a repeating item in this year's Q4. And if you set aside that one factor, which affected the comparison by roughly $15 million, our Q4 revenue from other markets, primarily mobile devices, was up substantially year-over-year and was enough to offset a decline in PC and consumer electronics revenues. Sequentially, our Q4 licensing revenue increased by $12.7 million or about 7%. This improvement was also driven by higher activity in the mobile devices area. So let me provide some additional details regarding the various markets that we participate in. In the broadcast market, fourth quarter revenue was down 4% year-over-year as we saw a decline in the TV TAM, although our attach rate improved slightly over the same period. Sequentially, broadcast revenue increased by around 3%. Fourth quarter PC revenue declined 6% year-over-year as the anticipation of the upcoming Windows 8 transition resulted in the lower volume of PC activity. Sequentially, our PC revenue was down slightly from Q3 about 1%. In the consumer electronics market, our Q4 revenue was down 10% year-over-year, mainly due to Blu-ray and DVD. And on a sequential basis, consumer electronics revenue was up by about 3%. Fourth quarter revenue from other markets, which includes mobile devices, gaming, automotive and Via, was down year-over-year by about 10%. But this includes the RIM settlement that I explained a minute ago. Excluding that item, we saw notable increases both year-over-year and sequentially, driven predominantly by growth in mobile device revenue in both those timeframes. Fourth quarter Product and Services revenue combined were $33.6 million, down 12% year-over-year, but were up about $4 million sequentially or about 14%. The year-over-year decline was seen in film-based cinema products, professional broadcast products and in 3D. But the sequential increase in Q4 over Q3 was mainly driven by a new cinema product, which achieved DCI compliance and was released during the fourth quarter. Let me now move on to margins and the rest of the income statement. Total gross margin in the fourth quarter was 88% on a GAAP basis and 89% on a non-GAAP basis. Within that, Product gross margin on a GAAP basis was 26.6% in the fourth quarter, down nearly 8% sequentially from 34.4% in Q3. On a non-GAAP basis, Product gross margin was 30.5%, down sequentially from 37.2% in Q3. Year-over-year, Q4 Product gross margins were down in both GAAP and in non-GAAP basis. The declines I mentioned were due to a combination of lower ASPs and shifts in product mix. Fourth quarter GAAP operating expenses were $126.2 million, up $7.5 million sequentially. Non-GAAP operating expenses were $112.2 million, up $4.8 million from the previous quarter. We made additional investments in research and development, as well as sales and marketing programs. And these programs and investments are aimed not only at growing revenue and core businesses, but also extending our reach into newer markets and newer applications. Fourth quarter operating income was $71.5 million on a GAAP basis or 31.8% of revenue, and $87.9 million on a non-GAAP basis or 39.1% of revenue. The effective tax rate for the fourth quarter was 28.7% on a GAAP basis and 28% on a non-GAAP basis. Fourth quarter GAAP net income was $51.5 million or $0.49 per diluted share, which was down about $27.6 million year-over-year, but was roughly flat sequentially. Fourth quarter non-GAAP net income was $63.8 million or $0.61 per diluted share, which was also down year-over-year, but was up about $2.9 million sequentially. We generated about $77 million in cash flow from operations during Q4, and we finished the fourth quarter with over $1.1 billion in total cash reserves, which would include cash and cash equivalents, as well as both short-term and long-term marketable securities. In the fourth quarter, we repurchased about 2.2 million shares of common stock for approximately $78 million, and we ended the quarter with about $198 million remaining available under our approved stock repurchase program. Now I would like to provide an outlook for the new fiscal year 2013. My comments will address both the full year and the first quarter. I'd like to start by highlighting a few key items that can and will likely play into our revenue for the full fiscal year. First is the transition of Windows 8. Based on past history, we know that it's hard to estimate with any precision the timing and impact on Dolby's revenue whenever a new PC operating system becomes available. Businesses are often slower to fully adopt as compared to consumer. So for the year, we are estimating that PC revenue will be down. Second is the mobile device market. Some industry research sources are estimating that the smartphone market will grow by more than 20% in 2013. Tablets are also expected to grow significantly. Because this is still a relatively newer area for us, our growth in mobile devices is dependent not only on the growth in market TAM, but also on the success of devices that we are designed into. And lastly is the topic of consumer spending and the underlying health of the general economy, which impacts our broad-based consumer electronics revenue. Based on what see today, including the variability that comes from the notable items I mentioned above, we currently estimate that total revenue for fiscal 2013 will range from $900 million to $950 million, of which Licensing revenue would be $785 million to $825 million. We don't anticipate any significant changes in our overall gross margin for the year. With respect to operating expenses, we currently anticipate about $550 million for the year on a GAAP basis, plus or minus, and around $490 million on a non-GAAP basis, plus or minus. Moving on to discuss the first quarter. For Q1 of fiscal 2013, we anticipate the total revenue will range from $215 million to $225 million. Within that range, we estimate that Licensing revenue could increase sequentially by up to $5 million, while Product and Services revenues are projected to decline. Q1 gross margin is estimated to be approximately 91% on a non-GAAP basis and 90% on a GAAP basis. Operating expenses in the first quarter of 2013 are projected to be around $120 million on a non-GAAP basis and around $135 million on a GAAP basis, plus or minus. The increase in Q1 over Q4 is due to a combination of higher investment in R&D, sales and marketing programs such as Dolby Atmos, and higher personnel costs. And although we have been on an increasing trend in operating expenses over the last several quarters, we anticipate that this trend will level out during the course of fiscal 2013. We are looking to hold quarterly spending at a rate that normalizes somewhere between $100 million to $125 million in operating expenses per quarter on a non-GAAP basis. Other income in Q1 of fiscal 2013 is expected to be approximately $2 million. And our effective tax rate for the quarter is estimated to be about 28% on both GAAP and on non-GAAP basis. Based on all elements combined, diluted earnings per share in the first quarter are projected to range from $0.42 to $0.48 on a GAAP basis and $0.54 to $0.60 on a non-GAAP basis. So with that, let me now turn the call over to Kevin.

Thank you, Lewis. Good afternoon, everyone. We came into 2012 focused on diversifying our revenue across mobile, online and broadcast, as well as bringing new technologies to market. Since we are closing out the year, I'll recap our priorities and discuss how we did against them and then share our priorities for 2013. Our first priority was to drive the adoption of Dolby technologies across the mobile market. We came into the year targeting low to mid teens attach rate to smartphones and finished at 15%. This is up from just 4% the prior fiscal year. In the Android ecosystem, Dolby audio formats are now in approximately 25% of smartphone shipments, including the leading Samsung GALAXY S III, and almost 30% of tablet shipments. In the Amazon ecosystem, the Kindle Fire HD family of devices now incorporates Dolby's next-generation audio solution, which provides a best-in-class audio experience on the device, combined with a fully certified end-to-end solution that delivers the artist's intent to the consumer. This holistic approach ensures the best possible consumer experience. Moving to the Windows ecosystem. We extended Dolby's technology to all versions of Windows 8 for support of online content in PCs and tablets. With this milestone, we can now focus on bringing Dolby-enabled applications and services to the Windows 8 platform in order to provide consumers a superior audio experience. Our second priority coming into the year was to grow our attach rate to global TV and set-top box shipments and to set ourselves up for additional success in emerging markets. We achieved our goal to grow our TV attach rate by 4 to 5 points while also achieving a set-top box attach rate of 50%. In addition, we continue to grow the adoption of Dolby technologies internationally. In China, more than 50% of high-definition channels on air use the Dolby audio format, and it has been adopted as an option in China's terrestrial digital TV standard. In India, 12 channels on air use our technologies, and we continue to make progress working with the broadcast ecosystem to position them in India's standards. In Southeast Asia, Singapore has included our technologies in its draft specification for digital television. And in the EMEA region, South Africa mandated our technologies into its final specification, while both Austria and Turkey have done the same in their draft specification. Our third priority coming into the year was to introduce Dolby's next-generation audio format, Dolby Atmos, in the cinema and to grow support throughout the industry. In June, we successfully showcased Dolby Atmos in conjunction with the release of Pixar's Brave, which generated a very positive reaction in the industry. Dolby Atmos enables artists to create and deliver a far more realistic and immersive audio experience. As a result, 9 titles across 5 major studios have incorporated Dolby Atmos. Some of the films released or to be released in Dolby Atmos include 20th Century Fox's Taken 2, Life of Pi and Chasing Mavericks, in addition to Warner Bros.' upcoming film, The Hobbit: An Unexpected Journey, DreamWorks' Rise of the Guardians and Paramount's Star Trek into Darkness. We are targeting 100 screens of Dolby Atmos by the release of The Hobbit. Finally, we came into the year focused on introducing new technologies in adjacent areas. One of the new technologies we have been working on is Dolby Voice, which will enable service providers, such as British Telecom, to provide a conference call experience that sounds more like an in-person meeting. In September, British Telecom announced it would collaborate with us to deploy Dolby Voice in order to achieve this, and it now expects to launch the service in 2013. We look forward to continuing our work with British Telecom and to keeping you posted on our progress. With that, let me turn to discussing our priorities for fiscal 2013, starting with mobile. We continue to focus on growing the adoption of our technologies across mobile devices, including smartphones and tablets. For fiscal 2013, we are looking to increase our attach rate to these fast-growing devices by approximately 5 points. In addition, we are now focused on providing consumers the ultimate mobile audio experience by connecting Dolby-encoded content from Dolby-supported services, such as Netflix and HBO Go, to Dolby-enabled devices. This will continue to ensure that consumers don't have to sacrifice quality for convenience and enable us to expand our technologies across existing ecosystems and into new ones. In broadcast, we're focused on repeating the strategy that has worked for us in the U.S. and in Europe. That is to work with country-specific operators and standards bodies across the emerging markets to adopt our technologies. We believe the emerging markets opportunity is a significant one, given that they receive over 1/2 of the global TV and set-top box shipments and contain the majority of the world's population. While it is too soon to say when these countries will convert to digital television, we are confident that they will and that we're well positioned to benefit from this transition. In the meantime, we're forecasting an attach rate increase to televisions and set-top boxes of approximately 3 points in fiscal 2013. In cinema, we're targeting Dolby Atmos on 500 screens globally by summer and for more than 20 films by the end of calendar 2013. Finally, in our new initiatives, we expect to launch Dolby Voice commercially in conjunction with British Telecom's service to deliver premium conference calls. We also expect to bring our consumer 3D technology to market and sign a leading TV OEM. In summary, the world has changed dramatically over the last few years, and Dolby's investments have allowed us to significantly diversify our revenue base and extend our presence into the many new ways consumers enjoy entertainment content, including online, mobile and digital broadcasts. We made a lot of progress during 2012, and the milestones we achieved tell us that we are headed in the right direction. As we enter fiscal 2013, we plan to continue to invest wisely and build upon this momentum to position us for future revenue growth. And with that, operator, I'll turn the call over to questions.

[Operator Instructions] We'll go first to Steven Frankel with Dougherty & Company. Steven B. Frankel - Dougherty & Company LLC, Research Division: First of all, could you address the expense growth? Granted you're investing in all of these initiatives, but it looks fairly aggressive given the revenue outlook. Is there -- if revenues remain stagnant, would you consider scaling back that investment during the year? Or this is kind of your base case?

Well, we do see this as another year of investment for us. We don't take that lightly. I think it's important to keep in mind that the composition of our revenue has changed dramatically and continues to change dramatically in the sense that the increasing amount of that revenue is coming from devices that are supporting online and mobile content, content over digital broadcast networks. And so we do find ourselves with a number of early-stage cycles that we're investing in, in emerging market digital broadcast, in the mobile and online ecosystem and in the new initiatives, some of which we are now bringing to market, such as Dolby Atmos, Dolby Voice and consumer 3D. And so we have a number of early-stage investment cycles here. We think that it sets us up well for the future, and so we think it's important to continue to invest in them. Steven B. Frankel - Dougherty & Company LLC, Research Division: Okay. And if I can sneak in a follow-up. What do you think it takes for Atmos to become a standard feature of premium formats like Regal's RPX?

Well, I think more of what we're doing. We have major releases now signed up from 5 major studios. We've got 9 titles on the way. And it's all about content, and we have great enthusiasm from the creative community in terms of really taking advantage of Dolby Atmos to have a truly differentiated cinema-going experience. And then it's about, of course, bringing more people into the cinema. And we've been working closely with our cinema partners as we have had our first few releases in the market. And we like what we're seeing, and we think we're on track for good adoption. Like I said earlier, we're aiming for 100 screens by The Hobbit, and we're aiming for 500 screens by the summer.

We'll take the next question from Paul Coster with JPMorgan. Paul Coster - JP Morgan Chase & Co, Research Division: Kevin, I've asked this before, but I just want to get an update on your strategy with regards to Android and iOS platforms. Are you going to attack them in the same way as you did Windows 8? Or is it a slightly different way of trying to win over those ecosystems?

Well, as I said earlier, on Android, we're on 25% of smartphones now and 30% of tablet shipments. And the approach is a little bit different from the Windows 8 approach, where we're licensing to the -- we're included in the operating system, albeit now paid directly from the OEMs. In Android, we've done it by working directly with device manufacturers, working with all the supporting players, whether that's the operating system or integrated circuits, and increasingly working to now connect services to devices, which is what we think really increases the value proposition, is having those Dolby-supported services sending content to these devices. And in fact, one of the things we're still excited about with the Amazon win this quarter, in fact, that we're now in the Kindle Fire HD lineup, is that we're able to deliver the fullest experience we have to offer, from content to playback. Paul Coster - JP Morgan Chase & Co, Research Division: Got it. Lewis, in your remarks, you said that broadcasts were down. Is it -- I might have misheard this, but it sounded like you're referencing the TAM. Did I hear that correctly? And if so, can you just elaborate a little bit? Because, I mean, I would the TAM is actually expanding at the moment.

Yes, I did say that the TAM was down slightly. This is a fourth quarter revenue comparison, so that wasn't a full year comparison. I would say that, that is -- I wouldn't be too alarmed by that. It's a one-quarter data point. Are you concerned about the volume of TVs going down? Because I think what we see going forward is there's actually growing opportunities for us in the part of the world that hasn't yet adopted digital broadcast standards. But in this quarter, we did see a year-over-year decline in the TV TAM. But our attach rate was up a little. Paul Coster - JP Morgan Chase & Co, Research Division: Okay. I mean, I guess it's just definition. I thought that the emerging market is an expansion of your TAM, and independent of shipment volumes. But it's okay. Let's move on.

But you bring up a good point. So I think I'd like to do one little messaging moment and say that from a strategy standpoint, we absolutely agree with that little bit of soft ball you see. At the end is that we do see this as being an expanding opportunity for us going forward. So this is a fairly narrow data point that I'm trying to explain what we saw in the drill, specifically the fourth quarter revenue.

Our next question comes from Perry Huang with Goldman Sachs.

I was hoping to ask a question about the mobile segment and sort of like the growth for next year. I think you talked about increasing the attach rate by 5 points? Should we think about this as driven more by attached to the Android and smartphone and tablets? Or is Windows 8 coming to market -- a sort of a key driver for the mobile segment, sort of with Surface and the other Windows tablet?

Well, 2 key drivers are the recent wins that have just come into the market recently. And so those would be the Kindle Fire family and Windows 8. But we're looking to expand our presence across each of the major mobile ecosystem than to extend into new ones. And we have, of course, a pipeline of potential design wins that we're working. Paul Coster - JP Morgan Chase & Co, Research Division: Got you. That's helpful. And if I could, just a quick follow-up. If I just compare the PC licensing revenue growth in the quarter, it was down, I think, 6% year-over-year, you mentioned, Lewis.

Yes.

Versus PC shipments, I think it was down 2% year-over-year in the June quarter. So that's sort of 4-point differential. Should we kind of think of that -- as we think about the PC licensing revenue next year, should we think about that gap as sort of remaining steady?

Well, I would say that those are still relatively precise tolerances that you're talking about there, market measurement of 2 versus 6. I'll say this, baked into the range of guidance that we gave, the $900 million, $950 million, we are anticipating that we'll see a continuing slight drop-off in our PC revenue for next year. But I don't know that I would go insofar to say there's a 4-point, percentage point, delta between market and Dolby. I'll be a little bit careful about extending that too far.

We'll move next to Andy Hargreaves with Pacific Crest.

Can you just extend on that? Actually, in your 2013 outlook, can you just give us any more detail on what your expectations are for market growth in PCs and TVs and the relative segments?

Well, I will have a long walk through every segments. So PC was the question that the gentleman just asked before. I think the market data out there speaks just right now that it's a relatively flattish year. I think the TAM numbers are in the neighborhood of 1.5. I would say right now, even that is a hard number to guess. We've seen a lot of bumping around with PC TAM number just in this last month or so. But baked into our outlook for next year would be a middle of the fairway assumption that tied to what the market assumptions are, and we didn't try to go way out of bounds from that.

Okay. Can you comment on TVs as well?

I could. Okay. So for TVs, the TAM is relatively flattish. For our consumer electronics, we're expecting both Blu-ray and DVD to continue to decline, mainly because we don't see any reason for that to reverse itself. And then probably the thing that's really emerging for us, because I want to stop talking about things going down and talk about things going up, is in our other markets category included mobile phone. And I would say it would be fair to anticipate that sometime next year, we will start breaking that out separately because we're seeing that nicely growing. And I think I said in my prepared comments that, external analysts see that market growing 20% plus, and we don't have any reason to disagree with that.

Okay. And then just extending on that, is that what you guys are expecting to be the sequential growth driver in Q1? Mobile phones, meaning.

Yes, oh, yes.

[Operator Instructions] We'll go next to the Ralph Schackart with William Blair.

This is Kris Barney in for Ralph Schackart. Just had 2 quick questions. With the Dolby Voice product, can you detail what the revenue model that you guys anticipate with this will be relative to the traditional licensing model? And then second, as this is kind of one of your first forays into the enterprise market. Can you detail if you have your eyes kind of set on incremental enterprise markets over the next couple of years, and if so, what those markets would be?

Sure. So I guess the first thing I'd say is that, moving into Voice, we believe we have a lot of value to offer by continuing to do what we do best, and that's by focusing on differentiating the quality of the experience from capture to playback. I think it's a little early for us to talk about the revenue model where -- I think we'll talk more about that when we have the service in market, which we expect to be this year. In terms of adjacencies in that regard, we do believe that the business conferencing market that this technology is targeted at is a very attractive one, and that the quality of the audio experience is something that is long overdue for a significant transformation. And we can -- we see other applications of Voice technologies that we can say the same about. So we're really excited about this initiative. And right now, we're focused on making this initial engagement successful.

We'll go next to Sean Leahy with Barrington Research.

I'm just trying to roughly size up the Atmos opportunity beyond your immediate targets that you guys laid out. I was wondering what sort of commitment and exhibitors have to make in order to make their theaters compatible with the system. Is this a technology that can be easily implemented in most theater sizes? Or is it kind of limited to kind of premium theater configurations? And then relatedly, I was wondering if the lag in digital conversion internationally helps or hurt your ultimate value proposition there?

Well, the first thing that I'd like to remind everybody about is really, to Dolby Atmos, is that it's a very scalable system. So as you know, there's a variety of layouts in cinemas, a variety of speaker counts. And what we're doing is capturing where the creative team wants the sound to be rendered in the screening room. And we can adapt to a variety of speaker counts and configurations to do that. And what our technology does, in fact, is calibrate for the best experience given the investment you've made. Now having said that, there are a few things that needs to be done. In addition to having our processor, they do need to make sure that those speakers are individually amped and powered because we're no longer grouping them into a number of channels. Some of the premium cinemas that are in the market today have already done that, others have not. So that's one thing -- that's something that needs to be done in any event. The second thing is on overhead speakers. And from there, there's a certain amount of flexibility exhibitors have to decide how far they want to take it and how many speakers they want to take it to. Certainly, what we're seeing in early-stage adoption is that you are seeing them tend to go into these premium screens that a number of chains have, and those tend to be better equipped from a starting point than your average screen.

[Operator Instructions]

By the way, operator, while we're waiting for another question to poll, I'd like to make one small -- whatever would be the verbal version of our typographical error, when I was going over my script, right at the end, when I said that we're looking to hold quarterly spending at a rate and I said, I believe, $100 million to $125 million, I meant to say between $120 million to $125 million, which would make more sense since I gave guidance for this quarter to be $120 million.

We'll take the next question from Steven Frankel with Dougherty & Company. Steven B. Frankel - Dougherty & Company LLC, Research Division: Just a follow-up on Voice. Is this an exclusive arrangement with BT for some period of time where this just happens to be your first partner that's ready to go to market?

So right now, we're engaged with them in bringing the service up and running. And it's really early for me to go into the details of the arrangement. And again, we're expecting to launch the services here. Steven B. Frankel - Dougherty & Company LLC, Research Division: All right. And this is something that runs in network as opposed to in hardware, correct? Or you want to give me a [indiscernible], help me understand kind of where...

Yes, absolutely. Yes, our technology is integrated into their infrastructure. Steven B. Frankel - Dougherty & Company LLC, Research Division: And do you have a longer-term vision of some kind of components that might run in endpoints like smartphones?

I think there's a number of possibilities that opens up in the future, but probably early for us to talk about at this stage.

And at this time, we have no questions remaining. I'll turn the call back over to Kevin Yeaman for any additional or closing comments.

Great. Well, thank you all for joining us, and we look forward to speaking with you throughout the quarter.