Dolby Laboratories, Inc. (DLB) Q3 2013 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the Dolby Laboratories conference call discussing fiscal third quarter results. [Operator Instructions] As a reminder, this call is being recorded, Thursday, July 25, 2013. I would now like to turn the conference call over to Alex Hughes, Senior Director of Investor Relations for Dolby Laboratories. Please go ahead, sir.

Thank you, Heather. Good afternoon. Welcome to Dolby Laboratories Third Quarter Fiscal 2013 Earnings Conference Call. Joining me today are Kevin Yeaman, Dolby Laboratories' President and CEO; and Lewis Chew, Executive Vice President and Chief Financial Officer. On this conference call, we will be making forward-looking statements that include projections of future operating results for our fourth quarter and fiscal year ending September 27, 2013; market trends and developments for the industries in which we compete and in the broadcast, PC, consumer electronics, mobile and cinema 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 electronic, mobile or cinema market conditions could cause actual results to differ materially from those in the 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 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. A 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 for the structure of this call, Lewis will begin with a recap of Dolby's financial results and provide our fiscal 2013 outlook. 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. Good afternoon, everyone. During my segment of the call today, I'll provide comments on the third quarter that we just completed and also provide an outlook for the fourth quarter of the fiscal year. And let me start that off by discussing our revenue for the quarter we just finished. In the third quarter, total company revenue was $207 million. And within that, licensing revenue was $184.7 million, which was down $41.8 million sequentially from Q2 of fiscal 2013, and up $3.8 million year-over-year from Q3 of fiscal 2012. In general, the sequential decline in licensing revenue was driven by seasonality, while the year-over-year improvement was driven by increases in mobile and broadcast, offset partially by declines in PC and consumer electronics. And here's some additional detail on our licensing revenue on the various end markets that we serve. Broadcast represented about 38% of total licensing in the third quarter. Revenues in this category were down about 19% sequentially, but were up about 10% over last year's third quarter. The sequential decline was mainly attributable to seasonality as well as a modest decline in the TAM for set-top boxes. The year-over-year increase was primarily due to higher attach rates for set-top boxes. Our PC revenues comprised about 22% of total licensing in Q3. They were down about 31% sequentially and about 25% compared to last year's third quarter. The sequential decline was driven by lower unit volume that was attributable to seasonality as well as declining market trends. And the year-over-year decrease was primarily driven by declining unit trends in market. I should note that although our PC decline in Q3 standalone was noticeably larger than the decline in the overall PC market, some of this is due to timing between quarters as well as other factors. If you look at all 3 quarters this year combined, the gap between our decrease and the market decrease is much smaller. Consumer electronic revenues in Q3 made up about 15% of total licensing. They decreased sequentially by about 17% and by about 12% over Q3 of last year. The sequential decline was mainly due to seasonality, while the year-over-year decrease was driven primarily by lower unit volume trends in the market. Mobile device revenues represented about 12% of licensing in the third quarter. They were down about 9% sequentially, and up by more than 80% compared to last year's third quarter. The sequential decline was attributable to timing of royalty streams from a large licensee offset partially by increased revenues from tablets, which included amounts recognized that had previously been deferred. The year-over-year increase was due to a combination of higher market volume of smartphones, higher revenues from tablets, and higher amounts recorded related to back payments. Revenues in other markets, which primarily include gaming and automotive, represented approximately 13% of total licensing in Q3. They were about flat sequentially, and up about 25% over last year. This increase was due to onetime licensees for the use of certain of our imaging technologies and applications that are outside of our typical core markets. Product and Services revenue was $22.4 million in Q3, which was down about $0.5 million sequentially, and down $7 million year-over-year. The year-over-year decline was driven by lower unit volume and ASPs from mature cinema products, offset partially by products associated with our newest cinema technology, Dolby Atmos, which began shipping and generating revenues during the third quarter just completed. Now, I'd like to discuss margins and the rest of the income statement. Total gross margin in the third quarter was 88.2% on a GAAP basis, and 89.5% on a non-GAAP basis. Product gross margin on a GAAP basis was 6.4% in the third quarter, compared to 25.5% in Q2 and 34.4% in last year's third quarter. On a non-GAAP basis, product gross margin was 14.1% in the third quarter, compared to 33% in Q2 and 37.2% in last year's Q3. The gross margin percentages in this year's third quarter include about 20 points of unfavorable impact from charges incurred during the quarter, mostly for obsolescence of products and, to a lesser extent, some manufacturing cost variances due to lower volume of production, as we reduced our inventory during the quarter. We anticipate that gross margins will return to more typical levels in the fourth quarter. Operating expenses in the third quarter on a GAAP basis were $145.8 million, compared to $141.9 million in the second quarter. On a non-GAAP basis, operating expenses for Q3 were $122.7 million compared to $124.1 million in Q2. And the difference was primarily attributable to lower expenses associated with variable compensation plans. Operating income in the third quarter was $36.9 million on a GAAP basis, or 17.8% of revenue, and $62.7 million on a non-GAAP basis, or 30.3% of revenue. The effective tax rate for the quarter was 19.4% on a GAAP basis, and 23.3% on a non-GAAP basis, as we benefited during the quarter from discrete items. Net income in the third quarter was $30.2 million on a GAAP basis, or 14.6% of revenue, and was $48.5 million on a non-GAAP basis or 23.4% of revenue. Diluted earnings per share in Q3 were $0.29 on a GAAP basis, compared to $0.60 in Q2 and $0.48 in Q3 of last year. On a non-GAAP basis, Q3 diluted earnings per share were $0.47 compared to $0.74 in Q2 and $0.57 in Q3 of last year. During the third quarter, we generated about $85 million of cash flow from operations. And as of the end of Q3, we had about $853 million in total cash reserves, which would include cash and cash equivalents, as well as both short- and long-term marketable securities. During the third quarter, we repurchased about 250,000 shares of common stock for $8.7 million, aimed at offsetting dilution, and we ended the quarter with about $124 million remaining available under our approved stock repurchase program. Looking forward, here is our outlook for Q4 and for the year as a whole. In the fourth quarter, we estimate that total revenue will range from $205 million to $215 million. Within that, we anticipate that licensing will range from $180 million to $190 million, with Product and Services totaling about $25 million, plus or minus. This means that for the full fiscal year 2013, we estimate that our revenue will range from $900 million to $910 million. This compares to our prior estimate of $910 million to $940 million. Within the new range for the full year, we anticipate that licensing will range from $795 million to $805 million, and Product and Services together will be about $105 million, plus or minus. We have lowered the high end of our licensing revenue range to adjust for current weakness in consumer spending, which affects most of our end markets. We have also lowered our range for Product revenues to reflect the activity levels we are currently seeing in digital cinema equipment adoption cycle that I alluded to a few minutes ago. Gross margin in the fourth quarter is projected to be about 90% on a GAAP basis, and around 91% on a non-GAAP basis. We estimate that operating expenses in the fourth quarter will be around $142 million on a GAAP basis, and about $124 million on a non-GAAP basis, plus or minus. Other income in the fourth quarter is expected to be approximately $1 million, and our effective tax rate for the fourth quarter is estimated to range from 27% to 28% on both a GAAP and non-GAAP basis. So based on the combination of the factors I just went over, fourth quarter diluted earnings per share are projected to range from $0.30 to $0.36 on a GAAP basis, and from $0.45 to $0.51 on a non-GAAP basis. Full year 2013 operating expenses are estimated to be around $574 million on a GAAP basis and $496 million on a non-GAAP basis, plus or minus. We estimate that full year gross margins will be around 90% or 91%, other income is estimated to be around $5 million, and the effective tax rate for the full year is anticipated to range from 27% to 28%. So now, I'd like to turn the call over to Kevin Yeaman. Kevin?

Thank you, Lewis, and good afternoon, everyone. The third quarter came in as we expected. We continue to see significant headwinds in CE and PC. And while those have largely been offset by strength in broadcast and mobile, we are adjusting our outlook for the remainder of the year. As we finish fiscal 2013, we remain focused on diversifying our revenue and returning Dolby to a path of long-term growth. To achieve this, we are focused on 3 priorities: driving the adoption of our technologies internationally in broadcast; expanding our technologies across the mobile ecosystem; and bringing new solutions to market, such as Dolby Atmos, Dolby Voice and Dolby 3D for the home. On today's call, I'll briefly cover our progress in each of these areas. In broadcast, we continue to drive the adoption of our technologies internationally, especially in the area of set-top boxes. In the Asia Pacific region, 7 new operators adopted Dolby Digital Plus in their set-top boxes, including 4 in China, as well as operators in Malaysia, Vietnam and the Philippines. In India, Digicable and UCN Cable Network have chosen Dolby Digital Plus for their high-definition set-top boxes as the country begins its shift to digital cable. In Europe, Austria began broadcasting all of its digital TV signals in Dolby Digital Plus, while Serbia Broadcasting Corporation began broadcasting high-definition content in our format. In the U.K., Virgin Media upgraded its set-top box to include Dolby Digital Plus. And in North America, Time Warner has upgraded its set-top box to include Dolby Digital Plus, as well as Dolby Volume. Turning to mobile, we continue to expand the use of our technologies across the mobile ecosystem. In the Windows ecosystem, we continue to make progress, extending our format to content aimed at Windows 8 devices. In the third quarter, PPTV began distributing movies with Dolby Digital Plus to its Windows 8 application in China. Likewise, in the Amazon ecosystem, Amazon Instant Video is distributing movies and TV shows with Dolby Digital Plus soundtracks to the Kindle Fire HD. With that, let me move on to discussing the progress we are making in bringing new solutions to market, including Dolby Atmos, Dolby Voice and Dolby 3D for the home. Dolby Atmos continues to have strong momentum with studios, postproduction facilities and exhibitors. Within a year of launch, Dolby Atmos is now in 60 titles worldwide, including 7 of the top 10 grossing titles this year. All of the major Hollywood studios have released Dolby Atmos titles, and 35 postproduction facilities worldwide are now mixing in Dolby Atmos. With exhibitors, Dolby Atmos is now deployed in nearly 200 screens worldwide. In the third quarter, leading cinema chains around the world began deploying Dolby Atmos, including Wanda Cinema Line, China's leading exhibitor and owner of AMC theaters. Wanda plans to deploy Dolby Atmos in its X-Land premium screens. Likewise, one of the leading exhibitors in India announced it would deploy 37 systems across its main theaters in key cities. And in North America, Regal began installing Dolby Atmos in 20 of its RPX screens, its premium theater experience. Turning to our other new solutions, we remain on track to bring to market Dolby Voice and Dolby 3D for the home. Through our partnership with BT, Dolby Voice is expected to be available in the fourth quarter. Dolby Voice provides a conference call experience that sounds more like an in-person meeting, aimed at greatly improving productivity and the user experience. Feedback on the technology has been very positive. Finally, Dolby 3D for the home, which delivers a full resolution 3D experience without the need for glasses, continues to be well received. Last quarter, the Cameron Pace Group and The Foundry both announced that they would integrate the format into their 3D video production workflows. And since then, we've made progress further integrating the solution into the TV OEM supply chain. We believe glasses-free 3D is the best way forward for 3D consumption in the home. We expect to see products on display with Dolby 3D for the home at the consumer electronics show in January. In summary, we continue to grow our presence in mobile devices and in broadcast around the world, which is further diversifying our revenue base. In addition, we continue to gain traction bringing new solutions to market, giving us confidence that we can return to long-term growth. And with that, I'll turn it over to Q&A.

[Operator Instructions] We'll go first to Paul Coster with JPMorgan. Paul Coster - JP Morgan Chase & Co, Research Division: Kevin, can you talk a little bit about the mobile category, obviously, many of us are seeing a slowdown in the smartphone space at the moment, and to what extent that weighs on things moving forward? And then just looking beyond the next quarter, what has to happen, do you think, for growth to resume for Dolby?

Sure. Thanks, Paul. First of all, we did, as we reported, have another outstanding quarter in terms of mobile growth year-over-year. We continue to see quite a lot of opportunity in the market. We have seen reports from others that indicate the growth rates might be slowing down a little bit in the high end of the market, but we still see a lot of opportunity to continue to penetrate in that area. And also, to move our solution into -- and begin to penetrate the mid- and lower-tier devices, whereas we're mostly concentrated in high end today, which is what's allowed us to build up a very significant position with 25% of devices in the Android ecosystem, of course the Amazon ecosystem and beginning to penetrate the Windows ecosystem through our inclusion in Windows 8. In terms of moving forward and returning to growth, I think it really comes back to the 3 priorities I outlined, Paul. The -- you know a big focus of ours over the last couple of years has been making sure that we continue to extend our presence in broadcast and international markets, emerging markets, as they go live with digital broadcast and penetrating the mobile ecosystem. And in doing so, we've transformed the composition of our business, so that this quarter, about 70% of our revenue was coming from non-optical sources, with about 30% coming from optical, which is nearly the reverse of what we saw a few years ago. So that's really important, because while there are still headwinds in PC and kind of broadly across CE categories, a lot of that's concentrated in that -- in those -- in that 30% category. We continue to see attach rate growth opportunities in both the mobile and the emerging market broadcast. And so really hard, Paul, to predict exactly what CE trend, consumer spending is going to be over the mid to long term. But when we look at all that, we still think there's an opportunity to get our core audio business back to growth. Now to get to the double-digit growth that we aspire to, we are looking to our newer initiatives, and those are the initiatives like Dolby Atmos, like Dolby Voice, like Dolby 3D for the home. And we're really pleased with how that's progressing. We're hitting our targets for this year to getting commercial milestones. And we expect to begin seeing some revenue from those things in the coming year. Paul Coster - JP Morgan Chase & Co, Research Division: Kevin, just a quick follow-up. Now you've got Atmos, Voice and 3D kind of up and running, can we expect the rates of increase in R&D to moderate, if not even come down?

Well, I guess I would take that at the kind of overall company level. We have been very regularly shifting our investments within the overall spending envelope between -- as initiatives move into different stages of maturity or from research to commercialization. And so we're being pretty dynamic about shifting our investments to reflect the stages of this portfolio of investments. As we've said throughout the year, we've -- we came into the year saying that it was a year of investment, but that we were going to hold that to about $120 million to $125 million of OpEx a quarter, on a non-GAAP basis, we've done that. We're going to -- we think it's really important to continue to invest in the business. At the same time, while we're not going to give guidance for next year, we don't see operating expenses increasing at the kind of rates we saw year-over-year this year.

[Operator Instructions] At this time, we'll go next to Corey Barrett with Pacific Crest Securities.

So first, I guess I just wanted to touch back on your guidance. I was hoping maybe you could provide a little more detail on why we're going to see a sequential decline there heading into the fourth quarter. I'm sorry, a deceleration in year-over-year growth.

Yes, maybe I just highlight 2 things that impact that. One is that because we're typically a little lagging trends in the market, we are continuing to see headwinds in PC and consumer electronics broadly in Q4, which offsets a little bit of what you might say, historically, Lewis, wouldn't we see a little seasonal pick-up. And then also, we've dialed back a little bit our broad expectations for revenue in Products and Services just based on the current activities. As you probably know, whenever you go through one of these transitions where 1 cycle is tailing off and a new technology is being adopted, that overlap is not that easy to predict accurately. So we're just making some adjustments. But we are very happy with the current pace of adoption. For example, Dolby Atmos, which as Kevin said, is now up to nearly 200 screens out there and growing. So I'd say those 2 factors: a dialing back of Products and Services; and then broadly, these headwinds we see in the PC, consumer electronics markets that we, quite frankly, can't do a lot about, because we're driven a lot by what's the happening in the marketplace.

Okay. And was there really a greater offset to the growth you've seen in Atmos than you anticipated heading in the quarter? I mean, I think we anticipated stronger product revenue than what you saw. And I'm just trying to differentiate between sort of what you're seeing in Atmos and what you're seeing in the legacy business.

Yes, I'd say the legacy business, I would blame more of it on that, if that's what you're asking. In other words, the scale of drop-off, when these cycles start to come to an end, you try to predict what that slope looks like, but I would say that, that drop-off was steeper this quarter than what we had anticipated even maybe a few months back.

Okay. And then just 2 more quick ones. Can you tell us what the mix of optical revenue was in the quarter? I think you've divulged that in the past?

Yes, 70% non-optical and 30% optical. I think that adds up to 100.

Yes. Okay, perfect. And then lastly, have you considered an accelerated cash return program, given your strong cash position?

Well, we've not only considered things like that, but just 6 months ago, we did return about $408 million to the shareholders, one fell swoop. So yes, we're not going to be doing one of those every quarter.

I just didn't know if -- I was asking more about sort of an ongoing -- on an ongoing basis.

Yes. Well, even prior to that, Corey, it's fair to say the company was pretty steadily buying back stock. At the time we did the dividend, I think what we tried to tell investors was if you look at our cash flow generation, this is obviously much more than 1 quarter's worth of cash flow, and give us a little bit of leeway. But we pay very close attention to our cash balances and what we do with those. And I would say the company is actually been pretty responsible in watching that and we'll continue to watch that closely as well.

We'll go next to John Bright with Avondale Partners.

Kevin, can you talk -- give us your current thoughts about commercialization of Atmos, Dolby Voice and Dolby 3D, maybe a time frame of when you think that's going to happen and what that might look like?

Sure, let me start with Dolby Atmos, since we're well under way. As we said in our prepared remarks, we're nearly 200 screens today. And what we're doing is we're going through, as is the usual case with these kinds of adoption cycles, it's the top grossing screens, often the premium format screens of the exhibitors, where these are going in. And that will be the focus certainly here for the rest of the year, to continue to roll that out. And to continue to focus on titles. 60 titles now, 7 of the top 10 grossing, and so we're pleased with how that's progressing, and so Dolby Atmos is well under way. As it relates to Dolby Voice, as you know, we announced our partnership with BT to get our enterprise audio conferencing solution in market. We've been working with them very closely to integrate it. It's been a great partnership. We're really excited that, that's going -- we're expecting that to go live this quarter. So by the next time I speak with you, I expect us to have some real experience with end-users having used the solution. And so that's next on deck. And then as it relates to Dolby 3D for the home, we have a deep engagement throughout the supply chain and the ecosystem. I mentioned earlier that some of the leading postproduction houses, especially those that are focused on 3D, are integrating our solution into their workflow. We're really involved at every point in the supply chain to bring this to life. And we expect to have -- we expect to see commercial products on display at CES in January.

And can you talk about how you're going to get paid for each?

Well, in the case of Dolby Atmos, it's a product sales model. In the case of Dolby Voice, this is a solution that's integrated deeply into the BT service, and then can also include soft client integrations into various endpoints. And we will get paid based on the scale of implementation and the scale of usage of the system. And then as far as Dolby 3D for the home, that's a traditional -- we see that being our traditional model on a per device.

And then, were you paid for Dolby Atmos this quarter?

Pardon me?

Were you paid for Dolby Atmos deployments this quarter?

Yes.

[Operator Instructions] We'll go next to Jim Goss with Barrington Research.

I just had a question about what you just said about Dolby Atmos as a product sales model. Did you also give consideration to possibly either paying for the installation and collecting royalties or doing a hybrid version or something of that nature to try to get past the barrier of what the exhibitors seem to have of how are they going to get paid? Will people pay a higher ticket price or something like that and therefore, why would they do it unless they're building a brand-new auditorium? And as a way to answer those questions and maybe have a continuing relationship with them -- with that particular product and service.

We have considered a range of options for the best business model, with a focus on what works best for the exhibitors, our paying customers. And I would say that over the long term, we haven't ruled anything out. But to date, the 200 -- the nearly 200 screens that are in market, this is the model that our exhibitor customers have responded to.

And maybe just one other thing. Given the size of Dolby at this stage, how many different initiatives do you think you need to have going simultaneously to restore the type of momentum you've been able to achieve when you were much smaller and maybe 1 or 2 things would work? I would imagine the math works differently now, given the more substantial size of the company.

Yes, that's a great question. We've really increased the pipeline of new offerings coming to market over the last several years. And you're beginning to see them come to market now in the form of commercial offerings, whether it's Dolby Atmos, whether it's Dolby 3D for the home, whether it's Voice for audio conferencing, which is interesting, because it opens up an entirely new enterprise market for us, new customer base to a substantial industry that we're serving there. I would say that those are just -- those are the ones that are visible and coming to the market now. And behind that, we see significant opportunity. As we look at the increase in the amount of audiovisual content and the role it plays in entertainment and communications, combined with increasing bandwidth and technological capabilities, we just -- whether we're talking to content partners, communication providers, OEMs, there's a real demand to continue to up-level that experience and to really differentiate. And we see that with artists as well. And so when you combine that with our experience of being able to provide the technologies and the palette for artists to better tell their stories, to better capture communication experiences, and in particular, our ability to work across very complex ecosystems to ensure that, that's delivered to any device, any time, however people want to enjoy it, that intersection leads to, we think, a rich set of opportunities for Dolby. And the ones we're talking about today and are very focused on are the ones that you can see coming to market in the near term. But we believe that behind those are a good pipeline of opportunities.

Is it still true that you have sort of a rolling 3-year cycle of R&D that whatever is going to happen now probably developed several years ago, and that you are -- and that's what you're talking about with this transition, such that you're just starting to hit a period where several of these initiatives are starting to come into play?

There's certainly, for any given opportunity or investment area, there is a period of time between investment and bringing products to market. I would say that varies a little bit within each of our different markets. But it is true that -- it's about 3 years ago that you could see that we began really reinvesting in R&D. And yes, you are beginning to see the fruits of that investment. And we think that we have developed some -- a rich set of IP combined with some great relationships in the market. We've developed very deep relationships throughout the mobile ecosystem. We're now entering the enterprise voice market. And we think that, that leads to a number of opportunities. And we expect that pipeline to continue to flow going forward.

And at this time, I'd like to turn things back to Kevin Yeaman for closing remarks.

Great. Well, thank you for joining us today. And we look forward to talking to you again next quarter. Thank you.

Again, that will conclude today's conference. Thank you all for joining us.