Dolby Laboratories, Inc. (DLB) Q1 2017 Earnings Report, Transcript and Summary

Welcome to the Dolby Laboratories conference call discussing Fiscal First Quarter Results. [Operator Instructions]. As a reminder, this call is being recorded Wednesday, January 25, 2017. 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' first quarter 2017 earnings conference call. Joining me today are Kevin Yeaman, Dolby Laboratories' President and CEO; and Lewis Chew, Executive Vice President and Chief Financial Officer. As a reminder, today's discussion will include forward-looking statements. These statements are subject to risks and uncertainties that may cause actual results to differ materially from the statements made today. A discussion of some of these risks and uncertainties can be found in the earnings press release that we issued today under the section captioned risk factors, as well as in our most recent report on Form 10-K. Dolby assumes no obligation and does not intend to update any forward-looking statements made during this call as a result of new information or future events. During today's call we will discuss GAAP and non-GAAP financial measures. A reconciliation between the two is available in our earnings press release and in the Dolby Laboratories' investor relations datasheet 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 2017 outlook. Then Kevin will finish with a discussion of the business. So with that introduction behind us, I will now turn the call over to Lewis.

Okay. Thanks, Elena. Good afternoon, everyone. Let's get right into the first quarter numbers. Revenue for Q1 came in at $266 million and this was about $25 million higher than last year's Q1. From an overall perspective, the growth this quarter was largely driven by new initiatives, broadcast and cinema products. And here's more details of some of the trends we saw in the markets that we serve. Broadcast represented about 46% of total licensing in the first quarter. Revenues in this market were up sequentially by about 1% as higher volume from set-top boxes and TVs were mostly offset by lower recoveries. Broadcast year-over-year increased by about 5% due mainly to higher volume in set-top boxes offset partially by lower recoveries. PC; PC comprised about 15% of total licensing in the first quarter. PC licensing was up sequentially by about 16% and year-over-year by about 5%. And both of these increases were due primarily to higher recoveries and higher volume. Mobile devices represented approximately 10% of licensing in the first quarter. Mobile increased sequentially by about 26% and year-over-year by around 16%. This was driven mostly by higher revenue from our patent licensing programs as we're now seeing new customers adopting these programs. Consumer electronics in the first quarter represented about 12% of total licensing. They were up about 5% sequentially due to higher volume from DMAs and sound bars and A/VRs, while Blu-ray was relatively flat. On a year-over-year basis, consumer electronics were down about 5%, driven by lower volume in DVD, Blu-ray and home theater in a box, offset partially by higher revenue from DMAs and sound bars. Licensing in other markets comprised about 17% of total licensing in Q1. They were up sequentially by over 70% and year-over-year by over 45%, as Q1 of 2017 benefited from higher recoveries in automotive along with growing revenue from Dolby Voice and Dolby Cinema. We also saw an uptick in revenue from gaming consoles in anticipation of the holiday season. Product and services revenue was $33.6 million in Q1 which was a few million higher than Q4. Several big-name movie titles were released this past holiday season and we benefited from cinema customers upgrading theaters in anticipation of those big releases. Let's review margins and operating expenses. Total gross margin in the first quarter was 88.7% on a GAAP basis and 89.8% on a non-GAAP basis. Product gross margin on a GAAP basis was 37.2% in the first quarter compared to 29.1% in Q4. Product gross margin on a non-GAAP basis was 42.6% in the first quarter compared to 35% in Q4. The improvement in Q1 was driven by a combination of lower warranty-related costs, lower excess in obsolescence and higher utilization. Operating expenses in the first quarter on a GAAP basis were $170.2 million compared to $173.7 million in the fourth quarter. Operating expenses on a non-GAAP basis were $151.8 million in Q1 compared to $157 million in the fourth quarter. And operating income in the first quarter was $66.1 million on a GAAP basis or 24.8% of revenue and $87.2 million on a non-GAAP basis or 30.8% of revenue. The effective tax rate for the first quarter was 20.8% on a GAAP basis and 22.4% on a non-GAAP basis which includes a positive impact from discrete items resolved during the quarter. Net income. Our net income in the first court was $53.4 million on a GAAP basis or 20% of revenue and was $68.7 million on a non-GAAP basis or 25.8% of revenue. Diluted earnings per share in the first quarter on a GAAP basis were $0.51 compared to $0.23 in the fourth quarter and $0.30 in Q1 of last year. On a non-GAAP basis, first quarter diluted earnings per share were $0.66 compared to $0.37 in Q4 and $0.48 in Q1 of last year. During Q1, we generated nearly $70 million in cash from operations and ended the quarter with over $1 billion in cash and investments. We bought back about 530,000 shares of our common stock in Q1. We announced today that the Board of Directors has approved an additional $200 million in stock repurchase authorization. With that latest approval, we now have about $227 million of stock repurchase authorization available as we go forward. We also announced today a cash dividend of $0.14 per share payable on February 15, 2017, to shareholders of record on February 6, 2017. I will now provide the outlook for Q2 FY '17 as well as for the full year. We estimate that total revenue in Q2 will range from $265 million to $280 million. Within that, we estimate that licensing revenue will range from $240 million to $250 million, while product and services revenue is expected to range from $25 million to $30 million. When I look at a year-over-year comparison to the second quarter, the midpoint of the Q2 revenue outlook I just gave is about even with last year's Q2 revenue of $274 million. There are a couple of things worth noting about that comparison. First, we do expect higher revenues year-over-year in Q2 from new initiatives and some core audio growth areas. But at the same time, we have certain revenues that will be lower this quarter because of timing of payments and lower recoveries. But having said that, we're raising our revenue outlook for the full year and I'll cover that in a minute. In the meantime, let's go over the rest of the P&L outlook for Q2. Gross margin in the second quarter is projected to range from 88% to 89% on a GAAP basis and 89% to 90% on a non-GAAP basis. Operating expenses in the second quarter are expected to range from $177 million to $181 million on a GAAP basis and from $158 million to $162 million on a non-GAAP basis. Other income in the second quarter is projected to range from $1 million to $2 million and our effective tax rate for the second quarter is estimated to range from 24% to 25% on both a GAAP and non-GAAP basis. Based on a combination of the factors I just went over, diluted earnings per share in the second quarter are projected to range from $0.43 to $0.49 on a GAAP basis, from $0.58 to $0.64 on a non-GAAP basis. Let's move on to the full year. For the full-year FY '17, we're raising the upper end of our revenue outlook by $10 million and therefore we now expect our revenue for the year to range from $1,060 million to $1.1 billion. Within that, we estimate that revenue from licensing will range from $950 million to $980 million while products and services will range from $100 million to $120 million. Key factors baked into the outlook are growth from new revenue initiatives, such as Dolby Cinema, Dolby Voice and consumer imaging programs, along with higher revenue from mobile. And this is partially offset by declines in PCs, DVD/Blu-ray and home theater equipment. Also, last quarter I had noted previously that broadcast could be relatively flat this year. We anticipate lower recoveries coming off a stronger than typical FY16 and these lower recoveries are offsetting other growth drivers in broadcast. Here's the rest of the full-year outlook before I turn it over to Kevin. Gross margin is expected to range from 88% to 89% on a GAAP basis and about 1 point higher on a non-GAAP basis. Operating expenses are projected to range from $700 million to $710 million on a GAAP basis and from $625 million to $635 million on a non-GAAP basis. Nonoperating income should be $4 million to $6 million on both a GAAP and non-GAAP basis. And the effective tax rate is estimated to range from 24% to 25%. So that's it on the numbers. Let me turn it over to Kevin.

Thank you, Lewis and good afternoon, everyone. We recently wrapped up CES. We were happy to see some of you there and our focus was on Dolby Atmos and Dolby Vision at CES. And Dolby Atmos and Dolby Vision were highlighted by partners all across the show floor, even as we hosted hundreds of customers and partners at our demo suite. I couldn't help but reflect on how far we've come. A year ago Dolby Vision was available on one high-end TV. Today we're shipping on all OLEDs and super-UHD TVs from LG, on three out of five lines from Visio and on four lines from TCL. This year, Sony announced support for Dolby Vision and in total we now have 10 TV OEM partners. At the same time, I was struck by the level of interest and focus from major CE companies on the audio experience and this comes at a time when Dolby Atmos adoption is accelerating. LG's 2017 OLED TVs will feature both Dolby Vision and Dolby Atmos, meaning that for the first time consumers can get a combined experience from a single product. A year ago, the first Dolby Atmos sound bar came to market. Today there are four sound bars in the market, including two models from Samsung and new products were announced by LG, Sony, Onkyo, Pioneer and Xiaomi. Now let me put this into some context as it relates to our goal of expanding our leadership in audio entertainment, growing revenue from new initiatives and ultimately returning to sustainable double-digit growth. As it relates to audio entertainment, the increasing availability of Dolby Atmos in sound bars and now LG's OLED TVs will significantly broaden the base of consumers that can enjoy the most immersive home audio experience. Of course, Dolby Atmos started in the cinema, where it is now installed or committed in over 2,700 screens with over 650 Dolby Atmos titles released or announced. This compares to about 1,600 screens and 400 Dolby Atmos titles a year ago. We're also broadening the use case beyond film and TV. At CES, Lenovo announced a Legion gaming PC which will be the first PC to support Dolby Atmos. Last month, Microsoft announced support for Dolby Atmos on the Xbox One and Windows 10. Beginning this month, BT in the UK will be delivering all of its premier football league coverage in Dolby Atmos. And Comcast is beginning to deliver content in Dolby Atmos. In the meantime, we continue to focus on expanding the presence of Dolby audio in broadcast and emerging markets and to mobile devices. We had a strong quarter in our core broadcast business which grew 5% and in mobile which grew 16%. The broadening presence of Dolby Atmos and the continued execution in areas like broadcast and mobile give us confidence that we can continue to expand our leadership in audio entertainment and grow revenue. In terms of new initiatives, let me come back to Dolby Vision. In addition to expanding our relationships with partners like LG, Visio and TCL and bringing new partners onboard like Sony and Philips, we continue to build support for Dolby Vision content. Our first route to market came via our OTT partners, Netflix, Amazon, Vudu and recently Tencent in China. We now have more than 90 movie titles and over 100 hours of original TV content available through our streaming partners. At CES, the first UHD Blu-ray players that support Dolby Vision were on display from LG, Philips and Oppo. So far, three major studios have committed to release Dolby Vision titles on UHD Blu-ray, Lionsgate, Universal and Warner Bros. It has been exciting to see the Dolby Vision ecosystem come to life over this last year. Dolby Vision is gaining broad support and we're just getting started. This is on the strength of years of focus on enabling the highest quality experience across the entire chain of content creation, distribution and playback. Now let me say a few things about Dolby Cinema. Earlier this month, we announced a significant milestone. We now have 50 Dolby Cinema at AMC locations in operation. This keeps us on pace to deliver 100 by the end of calendar 2017 with AMC and 160 by 2018. We also have 10 sites open with Wanda, the largest exhibitor in China. Wanda expects to roll out 100 Dolby Cinema locations by the end of 2018. In total, we have over 70 Dolby Cinema locations open today with over 300 open or committed. We expect to exit the year with over 140 Dolby Cinema locations in operation. And the content pipeline is strong. There are about 60 theatrical titles with Dolby Vision and Dolby Atmos announced or released and that includes participation from every major studio. During the 2016 calendar year, 9 out of the top 10 highest grossing films were optimized for Dolby Cinema. And by the way, this is the first full year for the Dolby Cinema program. The number of Chinese movies in Dolby Vision also continues to grow, as five films have been optimized for Dolby Cinema. The reception we're getting from content creators, exhibitors and consumers is outstanding and we look forward to working with our partners to make the best moviegoing experience more broadly available. Let me wrap up. We had strong numbers this quarter. The year is off to a great start with good momentum across both our audio business and the progress with our new initiatives and we look forward to updating you next quarter. And with that, let's turn it over to Q&A.

[Operator Instructions]. Your first question will come from Steven Frankel with Dougherty & Company.

Lewis, I am a little puzzled on the expense guidance and the total guidance for Q2. Last year expenses declined sequentially. This year they are ramping up. Can you walk us through why the year is playing out a little differently?

Yes. There are two main reasons for that, Steve. Last year our Q1 included an extra week of payroll because it was a 53-week year. And then two, this year is a more normal transition, because really three things driving the increased from Q1 to Q2. One is all of our annual focals went effective January 1, so everyone around the table is happy about that. Number two, we have some marketing programs that were lower in Q1 and shifted into Q2 and some into Q3. And then three, we have significantly more trade shows in Q2 than we have in Q1. So we're very comfortable. And you'll notice in my full-year guidance we kept OpEx guidance the same even though we raised revenue. So, we're comfortable with that pattern.

And then a couple questions on the business. You mentioned the Windows 10 inclusion of Atmos. Does that create another premium SKU that you get paid on incrementally? Or how does that produce revenue?

Well so, right now or as it relates to Windows 10 and also Xbox One - Microsoft announced this in November - today, this is available to their premium Xbox program - the insider program, they call it which is a program you can sign up for. That's already been made available to them as a pass-through to home theater devices. And beyond that, there's going to be more details available at the launch which we're expecting in a couple of months.

Okay. And then on Vision, congratulations. You really have made significant progress there. Would you hazard a ballpark figure for what percent of UHD sets you think would be Vision enabled at holiday 2017? Is that a quarter of the sets that you have between these 10 manufacturers?

I don't have the exact figure, but I'm pretty comfortable saying that yes, we'll be on a quarter, if not better. We're on a healthy percentage of the premium TVs. And it's worth noting that our - LG has done really well in the premium category over the last year. And now that we're adding Sony, along with Visio and TCL and others, we're feeling really good about where we're in the premium market. And of course we will turn our sights toward continuing to go deeper into these TV lineups. And as I've always said, I see opportunities for Dolby Vision outside of TVs, so we're also focused on that.

Next we will hear from Jim Goss with Barrington Research.

I was wondering if you are seeing interest from other theater operators beyond AMC and its owner Wanda for the sort of relationship you have built with them in terms of Dolby Cinema.

First and foremost, I'll repeat that we're really focused on the fact that we have this opportunity to roll out 160 with AMC by 2018, 100 by the end of this year and 100 with Wanda by 2018. And we're working heads down with them to get those open and you can see that. We had 40 open when I spoke last quarter and now we've got 70 around the world. We do have other partners, as you know, Cineplexx, Vue and Jackie Chan. And yes, we're engaged around the world with other potential partners and I think we've - I think with the partners we have and I mean all of our partners, we're really pleased with the results. We think the industry is pleased with the results. And so we will focus on bringing additional partners on board over the next coming quarters.

No, it seemed a very strong partnership and they seemed very pleased. That seems great. I'm wondering, too, with other now at 17%, are you getting to a point of breaking out another vertical, so to speak? And is this that vertical, the Dolby Cinema type products? Or are there other things that are getting closer to being a 10% factor?

Jim, this is Lewis. First of all, yes; the other category for us in terms of other markets currently does include both Dolby Cinema and Dolby Voice revenues. And yes, I look forward to the day when they get big enough to be broken out separately. And we've said in the past that we've done that before. There was a time when mobile, for example, was lumped in with Other and we eventually broke that out when it got to 10% of revenue. So yes, down the road when it gets big enough we will. But for right now we've included into Other mainly because of size.

From William Blair, Ralph Schackart.

First question, just on guidance. The last couple of years you've had pretty consistent - a guidance pattern of providing a range. And I don't think you really updated it, with the exception of maybe Q3 last fiscal year. Just curious, Lewis or Kevin, why the change in the guidance philosophy. And obviously a very positive sense, but just curious what's really driving that between the new revenues. And if you could contrast that with some of the headwinds that you called out in PC and Blu-ray, that would be helpful.

Yes, maybe I'll start, Ralph and then I'll kick it over to Kevin. At a really high level we did get off to a good start in Q1. Some of that was timing. Specifically we saw some gaming revenues come in this quarter that might have landed in next quarter because they were getting ready for the channel. But overall, we didn't really change our philosophy. When we look at guidance we try to give a reasonable range. And based on what we saw the score we felt comfortable raising the top end for the year.

Okay. Maybe just one more, then, on mobile specifically, I'm not sure if this is new, but you talked about new customers adopting a patent licensing program. And just looking at the numbers outside of Q3 last year, I think it's your strongest growth in mobile in the last seven or eight quarters. Just curious, is this a broad-based licensing program, all customers or is it one major customer doing this? Just any color on that would be great.

Yes, well, in both our audio and our imaging initiatives, in addition to the likes of Dolby Atmos and Dolby Vision, we do have a portfolio of patents and we do have patent licensing programs. I think you are familiar with, for instance, the HAZ program which is very broadly adopted across mobile devices. So yes, one of the drivers this quarter was that team had a really strong quarter bringing on board some licensees.

Yes. And I would say I'd probably steer it more towards it's broadly spread. I wouldn't characterize it as being from one big customer.

Great. Let me sneak in one more for Kevin. I think last call, Kevin, you talked about the $30 million in new revenue in 2016, the ability to double or triple going forward. Now that you went through CES and obviously had some pretty good traction with some of the new products, can you give us an update on that metric? And maybe how you are thinking about it as you enter the New Year?

Yes. I did say last quarter we did $30 million from these new initiatives last year. And I said we believe that we have the opportunity to grow that 2 or 3X each of the next couple of years. And yes, CES was a great event for us and certainly a lot of the things that needed to happen to put us in a position to do that were in place. I mean, getting - keeping the momentum going with Dolby Vision, adding Sony, adding UHD Blu-ray support. And again, I talked about this in the prepared remarks, but I was really struck by the level of interest and focus on audio. It was greater than I'd experienced in several years. And thus a lot of interest in Dolby Atmos and the other things we're bringing to life in audio. And so a big uptick in sound bars in particular and really excited to have the first Dolby Vision/Dolby Atmos product with LG. That's really cool. So yes, Ralph, a shorter version of answering your question is yes, we hit a lot of great milestones this quarter which give us the opportunity to keep focusing on growing new revenue. And we're still targeting that 2 to 3X a year for the next couple of years.

From B. Riley we will hear from Eric Wold.

Two questions, one, as you think about the goal of getting to double digit revenue growth on a sustainable basis and all the kind of drivers you think about to get there, what would you call out as maybe the segment or product you think is going to have the biggest positive impact of getting there? And what's one that you maybe have the most level of concern about that may be a headwind if things don't maybe pan out as you expect?

Well, I think if I break that down into the audio business and the new initiatives, I think in audio we still, as we have said, we still see opportunities for growth in mobile. We still see opportunities for growth in broadcast. And where you have headwinds have been the last couple of years in PC and some of the more traditional home theater products. But net-net we do see the opportunity to continue to grow that business over the long term. That in and of itself, the audio business in and of itself, is not something we see driving double-digit growth. And that's where the new initiatives come in. Like I said, we're seeing a lot of great wins come together. And that's what gives us the opportunity to go grow new initiatives revenue we think 2 to 3X a year for the next couple of years. And that's spread across Dolby Vision, Dolby Cinema and Dolby Voice.

Perfect. And then just maybe a follow-up for Lewis, on the tax rate, looking back over the past four or five quarters, the guidance has consistently been in the 24% to 26% range and it's come in in the 19% to 22% range every quarter. Is there one thing that maybe consistently drives the better tax rate versus expected? And is it expected to creep up to 24% to 26% and it just hasn't gotten there yet? Or is that just conservativism on the guidance?

Well, I wouldn't call it conservative on the guidance. Our organic rates typically lands in that level. Some of the things that we've had are the things all companies have, resolution of multiyear audits. So I wouldn't want to characterize - we won't get one of those every quarter. Last year, for example, the government had delayed the R&D tax credit reinstatement and we got a full year's benefit from that. So yes, I think when I give the guidance on the tax, that is a rate that we expect. And then as you know, under the accounting rules, there may or may not be things that get resolved that are really not forecastable until they are actually resolved.

[Operator Instructions]. From JPMorgan we will go to Paul Chung.

Can you give us an update on Dolby mobile penetration in Android? A big theme at CES was virtual reality and we know Atmos complements VR quite well. So what's the firm's strategy to expand beyond existing partners? And what are the main hurdles there?

Well, let me take those in turn. With virtual reality, we were demonstrating Dolby Atmos in with virtual reality. And it's very compelling because in a world where you can look in any direction, creatively it's valuable to have cues of where to look. And the Dolby Atmos experience integrating into VR provides that. Our model there actually has been to work with the content providers. That's obviously both an emerging and a pretty fragmented environment right now, but we have some relationships in place where we're working with the content providers and making our technology available through an app, so that's a little bit different than our traditional model. So, over time we've seen examples where that kind of a model creates more demand for native support in mobile devices. But in the meantime, our device licensing strategy continues to be driven largely by our Dolby Audio and Dolby Atmos value propositions. That's what - Dolby Audio is what Apple adopted into iOS last year. Some of our notable licensees are LG, Lenovo, Amazon and we continue to look to bring on additional partners for that experience as well.

And Kevin, can you expand on potential use cases for Vision outside of TVs? As you have alluded to in the past, panel prices continue to come down, so where you see the largest opportunities, whether it be in the home, car, elsewhere? What is your go to market strategy for that space? Thank you.

Well, I think that anywhere there is an entertainment screen, there's going to be the opportunity to bring a more compelling experience through both resolution and high dynamic range, contrast, better range of colors; all the things that Dolby Vision can bring on the contrast and color side. And that pretty much relates to all the markets that we're pursuing today on the audio side. So it's a space we're very familiar with. And so, we've been very focused on establishing our presence in the premium television space, but we're focused on looking beyond that and looking for the early adopters. Because I think eventually this is going to be an experience that people are going to - consumers are going to come to expect across all entertainment experiences.

Next question will come from Steven Frankel with Dougherty & Company.

Two quick ones. Kevin, maybe some metric updates on voice, either progress in terms of users or building out the reseller network?

Lewis in his remarks did note that voice was one of the drivers of the Other category, so revenue grew. PGI which we announced last quarter, has brought up Dolby Voice on its iMeet service, so we're expanding our availability through that. And other than that, we're still looking to convert that into more Dolby Voice sales and looking for additional partners and we're optimistic about our ability to do that.

And how is BT doing in growing the number of customers that they've had on the platform?

They continue to migrate their platform. So, I think that two things we see with these partners is, first of all, they migrate their existing customer base to having the Dolby Voice capability. And then the second way of looking at that is that, while for the most part, what I have is probably largely anecdotal, I have a lot of compelling anecdotes about how our partners believe that Dolby Voice is a significant differentiator in winning new business.

And then, Lewis, on the timing issue comment that you made, was that just related to gaming consoles? Or were there other things that were timing-related moving between Q1 and Q2?

There is slightly other things. So without getting into a lot of details, we do have timing of some revenues that would have been there in Q2 last year that we don't have this year due to timing of contracts that's not related to gaming. I think the gaming is more of a timing and seasonality. I think by the time we get to the end of FY '17, hopefully I won't have as many of these because we're still working our way through that chain of events as we work our way through FY '17.

And we will go back to Jim Goss with Barrington Research.

Just one clarification, do I have it correct that when you look at the Vision and Atmos concepts and technologies, that the theatrical part of it goes into the product sales and that the television parts would go into licensing? Or is there another distinction? And what does the mix look like right now? And how do you think that rolls out as you grow those businesses?

Jim, this is Lewis. On the theatrical side, Vision and Atmos combined would be Dolby Cinema. And for right now think of that as landing in licensing revenue as well. And then on the side that Kevin mentioned which was the first LG TVs that will feature both Vision and Atmos, those also will land in licensing.

Okay. So everything is in licensing then, that product?

For the most part, yes. Down the road there could be changes, but right now that's where it's landing.

Okay. And the model you are using in the theatrical space is I thought somewhat similar to what IMAX is doing, where there would be installation of the product and you would get a share of revenue. Is that the basis you would pursue or are there a variety of other things?

For the most part, we do install our technology and then we depreciate that into cost of sales and then we share from the partner a share of their ticket revenues. And that's what comes in as licensing revenues.

And does it matter if it's in Vision or just Atmos? Do you get an extra fee?

No.

No? Okay.

In general, without getting into specific customer arrangements, if they're getting traffic into Dolby Cinema then we share in the revenue.

[Operator Instructions]. And at this time there are no other questions.

Okay. Well thanks, everybody, for joining us and we look forward to speaking with you soon. Thank you.

Ladies and gentlemen, that does conclude today's presentation. We do thank everyone for your participation.