Dolby Laboratories, Inc. (DLB) Q4 2013 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by, and welcome to the Dolby Laboratories conference call discussing fiscal fourth quarter results. [Operator Instructions] As a reminder, this call is being recorded, Tuesday, October 29, 2013. I would now like to turn the conference call over to Elena Carr, Director of Corporate Finance and Investor Relations for Dolby Laboratories. Please go ahead, Elena.

Good afternoon. Welcome to Dolby Laboratories Fourth 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 fiscal year ending September 26, 2014, the market trends and developments for the industries in which we compete and our expectations and beliefs concerning on how these trends and developments will affect our operating results. Our statements will also incorporated -- incorporate projections on the capabilities and market acceptance of our products and technologies, expectations related -- 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 these 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 under the section captioned Risk Factors and elsewhere in our most recent quarterly Form 10-Q available on our website, www.dolby.com, under the Investor Relations section, as well as www.sec.gov. Dolby disclaims any obligations to update information contained in these forward-looking statements, whether or not 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 the Investor Relations section of our website. As for the content 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 would now turn the call over to Lewis.

Thanks, Elena, and good afternoon, everyone. During the call today, I will discuss the results of the fourth quarter just completed and recap the numbers for the full year. I will also provide an outlook for fiscal 2014. And later on, Kevin will talk more broadly about the company's priorities. So let's start by reviewing revenue activity. In the fourth quarter, total company revenue was $216.7 million. Within that, licensing revenue was $191 million, which was up $6.3 million sequentially from Q3 and nearly the same as the $192 million we had in Q4 of last fiscal year. There are a number of trends and factors worth highlighting, and it's probably easier to go through those points by end market, so here we go. Broadcast represented about 37% of total licensing in the fourth quarter. Revenues in this category increased about 1% sequentially and about 8% over the last year's fourth quarter. In the sequential trend, we had higher revenue from TVs as our attach rate improved modestly quarter-over-quarter. The year-over-year increase was driven by higher revenues from TVs and set-top boxes. This came from a combination of several factors, including higher amounts for back payments and higher attach rate for TVs, offset partially by flat to down TAMs. PC revenues represented about 21% of total licensing in Q4. They were relatively unchanged from last quarter, but they were down about 25% compared to last year's fourth quarter. PC unit volume in the market was down in Q4, but our year-over-year decrease was due more to the change in our revenue structure under the Windows 8 arrangement, which we had anticipated. Looking forward, we estimate another 2 quarters of headwinds similar to what we experienced in Q4. And after that, the gap between our PC trend and the market trend should narrow, all else held equal. These factors have been incorporated into our forward revenue outlook, which I will discuss in a few minutes. Consumer electronic revenues in Q4 made up about 17% of total licensing. They increased sequentially by about 13% and were about level with Q4 of last year. The sequential growth came primarily from increased unit volume in a variety of consumer devices, including DVD and Blu-ray as we benefited from seasonal improvement compared to Q3. Mobile device revenues represented about 17% of licensing in the fourth quarter. They were up about 48% sequentially and about 34% compared to last year's fourth quarter. The sequential increase came from a number of factors, including higher smartphone unit volumes, higher amounts related to timing of royalty streams from a large licensee and higher tablet volumes, and the year-over-year increase was mainly due to higher market volume in smartphones and higher revenues from tablets. Revenues in other markets, which primarily includes gaming and automotive, represented approximately 9% of total licensing in Q4. They were down about 31% sequentially and about 7% from last year's Q4. The sequential comparison was heavily impacted by onetime impending fees' licensees that we recorded in Q3. It was also affected by lower revenue from gaming consoles as new models from Microsoft and Sony were recently announced for this holiday season. The year-over-year decline was driven by lower revenues from gaming and automotive due to lower unit volumes. Product and services revenue was $25.6 million in Q4, which was up $3.2 million sequentially and down $8 million year-over-year. The sequential increase was driven by higher unit volume in digital cinema equipment across a range of different products. The year-over-year decline was driven by lower unit volume and ASPs from mature cinema products, offset partially by new revenue from Dolby Atmos equipment, which was released for commercial shipments during last quarter Q3. Let's move onto margins and the rest of the income statement for Q4. Total gross margin in the fourth quarter was 89.2% on a GAAP basis and 90.4% on a non-GAAP basis. Product gross margin on a GAAP basis was 18.5% in the fourth quarter compared to 6.4% in Q3 and 26.6% in last year's fourth quarter. On a non-GAAP basis, product gross margin was 25.2% in the fourth quarter compared to 14.1% in Q3 and 30.5% in last year's Q4. We saw some improvement from Q3 to Q4 as obsolescence charges were lower. Year-over-year, however, gross margin was down, mainly because of lower average selling prices on mature products and higher manufacturing variances. Operating expenses in the fourth quarter on a GAAP basis were $136.1 million compared to $145.8 million in the third quarter. On a non-GAAP basis, operating expenses in Q4 were $120.2 million compared to $122.7 million in Q3. Expenses related to some marketing programs, as well as trade shows and travel, were lower in Q4. And I should note that expenses in these categories will tend to fluctuate from quarter-to-quarter depending on timing of events. Operating income in the fourth quarter was $57.1 million on a GAAP basis or 26.4% of revenue and $75.6 million on a non-GAAP basis or 34.9% of revenue. The effective tax rate for the quarter was 21.7% on a GAAP basis and 23.6% on a non-GAAP basis, as we benefited during the quarter from discrete items. Net income in the fourth quarter was $45.8 million on a GAAP basis or 21.1% of revenue and was $58.8 million on a non-GAAP basis or 27.2% of revenue. Diluted earnings per share in Q4 were $0.44 on a GAAP basis compared to $0.29 in Q3 and $0.49 in Q4 of last year. On a non-GAAP basis, Q4 diluted earnings per share were $0.57 compared to $0.47 in Q3 and $0.61 in Q4 of last year. During the fourth quarter, we've generated about $67 million of cash flow from operations. We also repurchased about 250,000 shares of common stock for $8.1 million in Q4, and we ended the quarter with about $116 million remaining available under our approved stock repurchase program. As of the end of the year, we had just over $900 million in total cash and investments, which would include cash and cash equivalents, as well as both short- and long-term marketable securities. Before I dive into the forward outlook, let's do a brief recap of the full year fiscal 2013 results. For fiscal 2013, total revenue was about $910 million, down from $933 million in fiscal 2012. Within that, our licensing revenue grew from $801 million in fiscal '12 to $807 million in fiscal 2013. This was driven by growth in mobile and broadcast revenues, offset partially by declines in revenue from PC and consumer electronics. Products and services revenues decreased quite a bit this year, as we experienced the downslope of a Digital Cinema deployment cycle. Full year net income was $189.3 million on a GAAP basis and was $250.1 million on a non-GAAP basis. And diluted EPS, that was $1.84 on a GAAP basis and $2.43 on a non-GAAP basis for the year. Looking forward into fiscal 2014, here is our outlook for the first quarter and the full year. In the first quarter, we estimate that total revenue will range from $205 million to $215 million. Within that, we anticipate that licensing will range from $185 million to $195 million, with product and services revenue estimated to be about $20 million, plus or minus. Gross margin in the first quarter is projected to range from 90% to 91% on a GAAP basis and 91% to 92% on a non-GAAP basis. We estimate that operating expenses in the first quarter will be around $145 million on a GAAP basis and about $127 million on a non-GAAP basis, plus or minus. Other income in the first quarter is expected to be approximately $1 million, and our effective tax rate for the first quarter is estimated to range from 27% to 28% on both a GAAP and non-GAAP basis. Based on a combination of the factors I just went over, first quarter diluted earnings per share are projected to range from $0.28 to $0.36 on a GAAP basis and from $0.42 to $0.50 on a non-GAAP basis. For the full fiscal year 2014, we estimate that our total revenue will range from $900 million to $930 million. Within that range, we anticipate that licensing will range from $810 million to $825 million, and products and services together will range from $90 million to $105 million. Our outlook assumes that PC market volume will drop in fiscal '14 by about 5 points, and our PC revenue will decline in dollars and as a percent of total licensing. Growth opportunities in broadcast and mobile and Dolby Atmos and new initiatives like Dolby Voice are anticipated in the aggregate to more than offset the projected decline in PC revenue. Fiscal 2014 operating expenses on a GAAP basis are estimated to range from $590 million to $600 million. On a non-GAAP basis, operating expenses are estimated to range from $520 million to $530 million. We estimate that full year gross margins on a GAAP basis will range from 90% to 91%, with non-GAAP gross margins roughly about 1 point higher. Other income is estimated to be around $4 million for the year, and the effective tax rate for fiscal 2014 is anticipated to range from 27% to 28%. And now, I would like to turn the call over to Kevin Yeaman. Kevin?

Thank you, Lewis, and good afternoon, everyone. Thank you for joining the call today. What I'd like to today is address the key areas we have been focusing on to drive long-term revenue growth for the company. First, let's discuss mobile. We continue to make progress across the Android, Amazon and Microsoft ecosystems. We have established a strong position in high-end smartphones and tablets, and that is what drove our mobile revenue to grow by over 40% in 2013. Mobile now represents 12% of licensing revenue. The Android ecosystem is the largest in the market, and we have licensed our technologies to 7 out of the top 10 smartphone makers. Dolby technologies are included on about 22% of Android smartphones and tablets. Even as there continues to be room for us to broaden our presence at the high end, a lot of the growth in Android is now coming from low- to mid-tier smartphones. As more of these devices access online content, we have an opportunity to enhance the users' experience just as if we have done for the high-end smartphones. Therefore, in fiscal 2014, we will focus on expanding the adoption of our technologies across a broader range of mobile devices. In the tablet space, we have licensed our technology to 6 of the top 10 tablet makers. Most recently, we have been included in Amazon's HDX line of tablets and Microsoft's Surface 2. Part of our strategy is to increase the usage and number of streaming services that provide content in Dolby. Our technologies are deployed in Netflix, Amazon, iTunes, VUDU and CinemaNow, which represent 5 of the 7 most used over-the-top services in the U.S. This quarter, Target launched our technology in their Target Ticket service. In China, Dolby technologies are now included in 5 of the 7 most popular over-the-top services. 2 of these, ITE and Wasu, were launched in Q4. An increasing number of these services are now streaming to mobile devices. Some examples include Amazon Instant Video to the Kindle Fire HD and HDX, Netflix to certain Win 8 tablets, as well as the SK planet in Korea, Web-TV and PPTV in China to Android devices. In broadcast, we saw our revenues grow 9% year-over-year. Overall, Dolby technologies were included on approximately 68% of global TV shipments, which represents a 4-point increase over 2012. In this market, we have an already strong and established position in North America and Europe. We built this position by working with operators and standards bodies to adopt our technologies. In the emerging markets, where consumption of TVs is significant and the transition to digital TV broadcast is still in the early stages, we continue to see opportunity for growth. In China and India, we continue to drive increased adoption of Dolby technologies on air. Our technologies are currently used in over 1/2 of high-definition channels in both of these countries. And during 2013, our TV attach rates increased. This represents a significant growth opportunity, which we will continue to focus on in 2014. In other countries, we continue to partner with standards bodies to incorporate our technologies in new broadcast specifications. For example, during the year, Austria, Greece, Ghana, Turkey, Bahrain and Namibia incorporated our solutions in their high-definition terrestrial TV standards. Globally, we continued to drive the inclusion of Dolby Digital Plus in set-top boxes throughout the year. In fiscal 2013, over 30 additional pay-TV operators have included Dolby Digital Plus in their set-top boxes. And currently, over 100 pay-TV operators ship Dolby Digital Plus in their equipment. Looking forward, we believe that the emerging markets will continue to convert to digital broadcast. While the timing of the conversion is uncertain, we believe we are well positioned to benefit from this transition. In fiscal 2014, we anticipate that our attach rates will increase similar to the growth we achieved in 2013. In the cinema market, we announced Dolby Atmos a little over 1 year ago. Since that time, approximately 85 titles have been released or announced in Dolby Atmos, including titles from all of the major studios. Many of these were among the highest grossing titles for the year. Today, there are over 300 screens committed to Dolby Atmos, of which over 230 are already installed. Content creators are giving high praise to Dolby Atmos. Most recently, the director of Gravity, Alfonso Cuaron, told journalists that seeing Gravity in Dolby Atmos was as important as seeing it in 3D and described the system as a dream come true. Looking forward to 2014, our main focus is to grow the number of Dolby Atmos screens significantly. Let me turn to our efforts to bring new solutions to the market. Last September, we announced that BT was incorporating Dolby Voice into their suite of audio conferencing products and services. This month, BT formally launched BT MeetMe with Dolby Voice, a solution aimed at significantly improving the quality of audio conferences. Initial reactions from prospective users have been enthusiastic, and we expect to begin generating revenue from this initiative. This is a new source of revenue for us and is notable because it is an enterprise solution addressing a space where we haven't previously participated. In fiscal 2014, we will be focused with BT on increasing the adoption of Dolby Voice. We will continue to update you on our progress during the year. Another opportunity we are focused on is enhanced imaging. One example of this involves our efforts on glasses-free 3D for the home. During the year, the Cameron Pace Group endorsed our 3D technology. In 2014, our goal is to have TVs available in the market with our glasses-free 3D technology before the end of our fiscal year. We also continue to explore other opportunities that leverage our imaging expertise. In summary, we continue to significantly diversify our revenue base and extend our presence into the many new ways that consumers enjoy content. During 2013, we saw a significant revenue growth from both mobile and broadcast. While there are still headwinds in the PC markets, we continue to enjoy a strong position in that important market, even as it becomes a smaller portion of our business as a result of diversification. Looking forward into 2014, we will be looking to broaden our strong position in smartphones and tablets. We also remain focused on driving increased broadcast adoption of our technologies in emerging markets like China and India. Finally, we will continue to invest in innovation to introduce new solutions that further help drive our long-term growth. With that, I'll turn it over to Q&A.

[Operator Instructions] And first we'll go to Paul Coster with JPMorgan. Paul Coster - JP Morgan Chase & Co, Research Division: I think in this fourth quarter -- well, December quarter of last year, you paid a special dividends. Is that likely this year? And also, with the passing of the founder, does it change anything in terms of capital allocation, policies, strategy or, for that matter, are you anticipating any shares coming to market as a result of any sort of inheritance taxes or similar?

Hey, Paul. This is Lewis. Let me address the dividend question, and I'll turn it to Kevin to talk about the more high-level question about strategy and capital allocation. Yes. As you mentioned, we did declare a fairly large dividend last December. Cash usage and resources continue to be a topic we look at very closely. I could not say to you right now what the future plans might be. But certainly, things like dividends and buybacks are always part of that conversation.

Yes, to the second part of your question. Yes, losing Ray was difficult for all of us here at the company. At the same time, the spirit of Ray and his values are very much alive and well at the company. And the strategy remains the same, which is to continue to invest in innovation, to make a difference in the market and, in particular, to improve the way people experience and interact with their communications and entertainment content, every device with which they enjoy those experiences. In terms of capital structure and other things, it doesn't affect the company's plans and strategies. And I can't really comment on the plans of any shareholders.

And the next, we'll go to Steven Frankel with Dougherty & Company. Steven B. Frankel - Dougherty & Company LLC, Research Division: Kevin, I wonder if you might begin by giving us an idea of how many Atmos theaters do you have installed today? And what should we be thinking about in terms of an ASP as you move forward in that business on a per theater business?

So today, we have 230 screens that are installed. And as I said earlier, we've had about 85 titles. And so we released it just over a year ago. We have a total of 300 committed, including those 230. So the remainder are those that are in installations. And we're looking to significantly increase that this year. We are not disclosing at this time the average price for those units. Steven B. Frankel - Dougherty & Company LLC, Research Division: Okay. And then on the broadcast business, would you care to share a goal for increased penetration in 2014?

Yes. So overall, we expect that -- this year, our attach rate went up about 4 points. And we're expecting, all else held equal, to be about the same. And as I've said in the past, there still is a significant opportunity in emerging markets like China and India. It's always difficult to predict when the real -- the heavy part of that transition kicks in. So until further notice, we're still predicting the steady progress that we saw over the last year. Steven B. Frankel - Dougherty & Company LLC, Research Division: And in China, where you were part of the option, you were an option rather than a mandate. Has that changed how you've rolled out there so far? Or were -- have you kind of ramped up in the way that you would've anticipated?

It hasn't changed our strategy. Our strategy in each of these markets has always been to, in parallel, work with the pay-TV operators, the broadcasters, the entire broadcast ecosystem, right down to the TV manufacturers and set-top box manufacturers to get adoption of our formats. And yes, in China, we felt like it was a good position to be in to be included as an optional part of the standard because it gave us the leeway to go do what we do best, and that's establish our value with those who want to bring high-quality services with the rollout of digital television. Steven B. Frankel - Dougherty & Company LLC, Research Division: And then the last question. You talked about expanding your Android market share towards the lower-end devices. Will that mean a sacrifice in ASPs? Or do you think your ASPs can hold even after you go attack less expensive handsets?

I think we have a couple of opportunities. I still think we have opportunities to increase our penetration in the high end of the market. But we do see low- and mid-tier as an opportunity where people care about quality. I think it's too early for me to comment about what the pricing implications might be in the low- to mid-tier, except to say that it's -- there's a lot of units there, and we still consider it to be a nice growth opportunity on top of the position we've built, which now amounts to 12% of our licensing revenue.

And next, we'll go to Andy Hargreaves with Pacific Crest Securities.

So just a couple of kind of category questions. On CE, it was the first growth quarter, I think, in quite a bit or flattish quarter on a year-over-year basis. Is there something that is changing in the trend line there? Or was there just something unusual in the quarter that drove that?

Hey, Andy. This is Lewis. I would not say that there's anything changing in the trend line. What you see there is just there's going to be fluctuations quarter-on-quarter, and it's become a relatively smaller percent of our total company. So it's more sensitive to those. But no, there's nothing major we would say going on in CE that drives that.

Okay. And then on the flip side, mobile was really quite strong after a few quarters of flattish kind of sequential numbers. Is -- are we seeing -- there's just typical seasonality in that business, or again, was there something unusual in the quarter that drove that?

No, that's -- there -- we have a lot of different things that affect our mobile business. I would say that as a broad comment, yes, there is some element of seasonality, the timing of when we get our revenues. We have relationships with a lot of the different handset manufacturers. And as Kevin mentioned, right now, the large portion of our revenue comes from the higher end. So at the end of the day, there's a lot of different things that affect those transitions. But yes, we were happy with what mobile did this quarter.

And then lastly, just on Dolby Voice. Is there a material amount of revenue that you guys are expecting in fiscal '14? And I apologize, but can you just remind me what is the business model there? Are you guys charging the carrier, or are you charging end customers for using the service?

So we are expecting to begin generating revenue this year. It's not big enough for us to break out, but we are expecting to generate revenue. Again, we're bringing this -- in terms of the solution, we're bringing this to market with BT. And what they've launched is we have integrated our solution into their service, which results in much more lifelike, natural conversations over audio conferencing. It solves a lot of the problems that frustrate so many of us when we participate in conference calls, including the fact that it's like having discussion over a walkie-talkie. You have to take turns talking. You can't naturally break in. It's hard to pick up on natural audio cues, so that someone's not over-answering a question and going on when you have an important clarification to make. It spatializes the conversation, all of which allows for you to have a much more intelligent interaction and concentrate on what you should be concentrating on. The business model is that we get paid as the scales implementation increases. There's a purport fee. And we also share in the minutes revenue that takes advantage of Dolby Voice.

Got it. Okay. And sorry one last one, just on the increase in OpEx that you guys are looking for. Is that primarily sales and marketing to support development in these new categories?

Hey, Andy. There's a -- well, there's probably increases going on in both R&D and sales and marketing. But from a trend line standpoint, you may remember, it was all the way even at Q1 of this year when I say we would try to level out in the $120 million to $125 million range, which we did do for the year. And what you see here is just a little bit of that momentum carrying into next year in terms of people we've hired and normal salary inflation as we go through a year of focal adjustments and stuff like that.

[Operator Instructions] Moving on to Jim Goss with Barrington Research.

Kevin, I believe you began your discussion talking about the advancements in mobile and enhancement of user experience for Android phones and tablets. I was wondering if you could discuss a little of the nature of the enhancement in terms of how their product is used. Is it more as a media brick or headphones? How are they able to take advantage of the Dolby Digital Plus enhancement? Or how do you see the experience generally being used?

Sure. So first of all, I would start by saying that, that can vary by smartphone maker and how they choose to take advantage of our suite of technologies. But the full suite of our technologies includes the ability to receive the multichannel audio. It comes along with the work we do from the start of the chain and working with all the service providers I talked about to make sure that you're getting the highest-quality audio stream to start with to that device, getting advantage of the multichannel mix and that includes our post-processing technologies, which apply whether you're listening to the speakers on the device or over headphones. It -- we work to -- it comes together to optimize that experience. And the result is a difference in the audio experience and the consistency of quality in the audio experience that when we demonstrate that full suite of technologies, nobody fails to immediately notice that it's a much better experience.

Okay. And as you -- and obviously, Android, Amazon and Microsoft, you mentioned all of those. As you get into a playground that sort of the majority of the technology users in that area, does it -- do you think it puts some pressure on Apple to potentially try in a higher level than they have generally tended to do? Or is that just something that's going to be a sort of fruitless search?

Well, I think that we've shown that we have a value proposition in the space. We've gone from not having any attach rate of Dolby Digital Plus in the post-processing technologies 3 years ago to a significant presence today and growing to 12% of our revenue, which is a long way of saying, I think we've shown that we have a value proposition here. And we view it as incumbent upon us to go and demonstrate that value proposition to Apple, and we're going to keep endeavoring to do that.

Okay. And Steve brought up Atmos. And I saw one of the installations the other day at the -- and there was a theater that was being built, and there was a pretty impressive bank of equipment, I think, that all related to Atmos. Is the economic model that you are selling all of that equipment and technology as a direct sale to them? Or is it -- is the economic model going to involve some share of the continuing value that you're being -- you're generating?

Yes, the installations we have today are all our traditional cinema model. We're selling the processing equipment into the exhibitor.

And how long before the revenue base you generate will become meaningful? Is there a pretty quick ramp-up you are foreseeing, given how aggressive you describe you're becoming?

Well, I think our focus right now is on significantly growing the number of screens this year. I think we would like to at least double the presence. And we think with the momentum we have and the creative community, the titles coming out, the increasing number of locations that consumers can begin to appreciate the benefit of the experience, we think that, that -- those are all the ingredients to go out and increase the presence.

Okay. And lastly, in the broadcast area. In a post set-top and over-the-top environment, does your role change? Or does the method of securing revenues change? How do you fit in something where you don't have the same sort of devices that will need your decoding?

Well, we just continue to serve the entire industry of those that are creating content, delivering content and delivering devices of playback content. And so, in your example, we continue to work with pay-TV operators and broadcasters around the world. But at the same time, we're working with all the -- with major OTT providers, as I've said in the script, we're -- we are working with 5 of the 7 most used over-the-top services in North America. We're working with 5 of the top 7 over-the-top services in China. And so our goal is to make sure that we're providing value in every way in which this type of content is delivered and played back, and in that -- and so we're evolving with the industry.

And we have no further questions. So I'll turn the call back over to our speakers for any additional or closing remarks.

Well, thank you for joining us today, and we look forward to keeping you updated as we go through the year. Thank you.

[indiscernible] concludes today's conference. We do thank you, all, for your participation.