Dolby's IPO: Are the Numbers Distorted?

Hindsight, we all know, is 20-20. It's also frustratingly ineffective. Despite much mature retrospection, I can't unsay those mean comments to Mom, undo what 18 years of smoking did to my lungs, nor unwrite the cringe-inducing history of my high school social life. If only I were selling stock to the public.

What prompts this wistful detour is the initial public offering of stock in Dolby Laboratories, the San Francisco audio-engineering company whose handiwork in the 1970s made cassette tapes worth hearing. After that, its work on film soundtracks surrounded us at almost every movie (up soon, DreamWorks' next animated feature, Madagascar). Sales of home-theater gear are boosting the royalties Dolby gets on sales of DVD players and such, which use its software. For the future, it's counting on helping Hollywood switch from celluloid to digital films. Closely held since its founding in 1965, Dolby aims soon to go public in a $399 million deal.

Expect Dolby to get a warm reception. With a history of innovation and its recent performance -- 33% sales growth in fiscal 2004 ended September, to $289 million; operating profit up 39%, to $105 million -- the company is as well seasoned as technology IPOs come. If the deal comes at the estimated $14.50 a share, then Dolby would command a market value of 22 times its past four quarters' profit. That's hardly a Googlacious (136 times) multiple, and it's sharply below the 28 times earnings of a leading rival, Digital Theater Systems (DTSI ). Fair minds might argue that Dolby's better-known brand and its size -- revenues run six times DTS' -- merit a higher multiple.

Yet the first question -- and here's where Dolby's 20-20 retrospection comes in -- is: Just what were the earnings? To see what I mean, you might search Dolby's latest registration statement for the key words "restatement" and "hindsight." Two curiosities emerge. First, after consulting with its underwriters, Dolby found that its own assessments of the company's value, made in close consultation with an independent appraiser in July, 2003, and again last July, were way low. Second, Dolby changed how it reckoned the cost of its employee stock options -- in the process boosting past and future profits.

Dolby in fiscal 2004 granted nearly 5.4 million stock options at an exercise price of $2.08 a share. Based on its outside appraiser's reports, it at the same time declared that $2.08 a share was the company's fair value. Private companies can be worth less since their stock isn't easily traded, but $2.08 is obviously way below the $14.50 Dolby's underwriters think the stock will fetch in the IPO. So, the accountants had to figure out how much of that gap should be recognized as pay and be deducted from earnings. When it filed its first set of pre-IPO financials in November, Dolby put that cost at nearly $59 million.

Now, Dolby has changed its mind. It decided to alter the assumptions and methods used by its valuation consultant. On Jan. 31, it issued new financials showing fiscal 2004 stock options costing $38 million, a drop of more than $20 million. Because accounting rules require that expense to be spread over the years that the options vest, Dolby's fresh estimate of its value lowered its fiscal 2004 compensation costs by $7.3 million. In the current and the next two fiscal years, Dolby's revision could add perhaps a nickel a share to net income.

Dolby may have good reasons for this lucky accounting change. A spokesman, however, told me that ahead of the IPO it's resting on its securities filings. There, Dolby noted, "reassessed values are inherently uncertain and highly subjective." So are its earnings.

By Robert Barker

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