Dolby Labs Cranks Up the Earnings Surprises

As investors enter the fall earnings season with rising hopes, their expectations for Dolby Laboratories (DLB) are loud and clear.

Over the past five years, no company in the broad Russell 3000 stock index has exceeded Wall Street forecasts more often than Dolby.

Last quarter, the inventor of surround sound and other audio technologies posted earnings per share of 62 cents, 24 percent higher than a year ago. Dolby beat the estimates of analysts surveyed by Bloomberg by 17 percent.

For its fourth quarter ended Sept. 24, analysts estimate Dolby can boost earnings 33 percent. "We would be buyers of the stock in front of earnings," Deutsche Bank (DB) analyst Brian Thackray wrote Oct. 3.

Dolby's stellar track record means it has a lot to live up to. Bloomberg assigns a "surprise score" to companies based on how often and by how much they have beaten analyst estimates over the last 20 quarters.

Dolby's average quarterly earnings-per-share surprise over the past five years is 39.7 percent. Its surprise score is 84.1, the highest in the Russell 3000, followed by Amphenol (APH) at 83.1 and Apple (AAPL) at 82.1. The average score of the Russell 3000 is 38.9.

Dolby Laboratories, founded by inventor and audio engineer Ray Dolby in 1965, now has a market value of $6.8 billion. The company reported $719.5 million in sales in its 2009 fiscal year, with net income of $243 million.

A key Dolby competitor in audio technology, Calabasas (Calif.)-based DTS (DTSI), had revenues of $78 million last year.

Conservative Guidance

Analysts have been consistently so surprised by Dolby for two reasons, says Andy Hargreaves, an analyst at Pacific Crest Securities in Portland, Ore.

When executives provide guidance for future quarters, "they tend to be pretty darn conservative," he says. Also, the company has "had pretty unique revenue drivers that it took people a long time to catch up to."

Dolby spokesman Sean Durkin declined to comment.

Dolby is paid, in the form of licenses or royalties, whenever its technology is incorporated in other companies' products, including movie-theater sound systems, computers, DVDs, video games, and digital television and cable.

Recently Dolby has been particularly helped by the inclusion of its technology in new Microsoft (MSFT) Windows operating systems—both Windows Vista and Windows 7—and by the growth of digital television, Hargreaves says.

Dolby shares are up 26 percent so far in 2010, but their performance has been mixed over the past quarter. The stock hit an all-time high of 69.37 on June 15. Shares then fell 22 percent from July 26 to Aug. 24, a decline William Blair analyst Ralph Schackart, in an Aug. 27 report, attributed to data indicating the "PC and TV end-markets are slowing."

Indeed, on Sept. 15, International Data Corp. projected U.S. household spending on consumer electronics will fall 17 percent in 2010 compared with 2009, the largest estimated decline among 20 countries surveyed by IDC.

Nonetheless, just as the broader stock market has rebounded, so have Dolby shares, which are up 12 percent since their recent low on Aug. 24.

Investor Hopes

The recent rise in major U.S. stock indexes is a sign of higher investor hopes for the third-quarter earnings season, says Robert Bacarella, portfolio manager of the Monetta Mutual Funds. The Russell 3000 index is up 13 percent since the end of August, and the large-cap Standard & Poor's 500-stock index has advanced 12 percent.

"The runup is partly due to the feeling that this earnings season is going to be decent, and companies are going to continue to surprise us on the upside," Bacarella says. "If that doesn't materialize we could have a pullback."

For most companies, the third quarter ended Sept. 30. Alcoa (AA) kicked off earnings season on Oct. 7; Dolby's results are expected in early November.

Deutsche Bank's Thackray upgraded Dolby to a buy rating on Sept. 22. He's one of 11 analysts who have assigned the stock that rating—a total of 69 percent of those surveyed by Bloomberg. Just one analyst, Goldman Sachs' (GS) Ingrid Chung, gives Dolby a sell/neutral rating, and the remaining four analysts rate Dolby a hold.

"Several catalysts should alleviate some of the concerns on the stock," Thackray wrote Oct. 3. Dolby technology is being incorporated in mobile phones, including smartphones by Nokia (NOK) and HTC. Mobile phones could be "another $100 million market opportunity for the company," he said.

Some investors have worried about whether Dolby will lose out as consumers start accessing media by streaming it over the Internet, rather than through DVDs or other media supported by Dolby. But, according to Thackray's Oct. 3 note, these concerns would be alleviated by the adoption of new online streaming standards that include Dolby, or by a deal with Netflix (NFLX) to use Dolby's audio technology when streaming content on that site.

Such a deal was announced on Oct. 14, when Netflix said it would use Dolby Digital Plus surround sound for movies and television shows streamed from the site.

Meanwhile, he said, Dolby continues to benefit from a "revenue tsunami" from both the adoption of Windows 7 by corporate buyers and the conversion of the large Chinese television market to digital.

Last quarter, revenues were 34.5 percent higher than a year earlier. Hargreaves, who has a sector perform rating on Dolby, says this can't continue forever. "Our concern has to do with slowing growth," he says.

In fact, he believes Dolby investors could be disappointed this quarter, even if the company can maintain its long track record of surprising Wall Street. He says the company could once again come through with better-than-expected earnings while, at the same time, executives offer gloomier-than-expected projections for future quarters. That may be one set of mixed signals even Dolby's famed engineers may not be able to fix.

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