Surround Sound for the Earbud Generation

Bob Walters, head of the 300-member Bay Area Audiophile Society, has spent around $50,000 buying stereo equipment for the dedicated listening room in his home. But Walters, 53, can't persuade his nine-year-old daughter to ditch her more modern setup. "She doesn't want to listen to the song on my system," he says. "She wants to watch the YouTube (GOOG) video."

Walters' daughter is representative of a generation content to listen to low-fidelity digital tracks on cheap earbuds. That's a challenge for Dolby Laboratories, the San Francisco company famous for its theatrical surround sound, which made its debut in Francis Ford Coppola's Apocalypse Now in 1979. Dolby's latest release—a software program that converts low-quality PC audio to surround sound—is an effort to bring its technology to a new audience and train those listeners to appreciate high-quality sound.

The fourth iteration of Dolby's software for PCs, released on Jan. 4, is included in operating systems such as Microsoft's (MSFT) Windows 7. No matter how tinny the laptop speakers or low-quality the audio, the software turns stereo recordings into 5.1- or 7.1-channel sound—meaning the audio seems to come from different places, creating virtual surround sound. It also promises to make movie dialogue clearer, keep volume levels consistent, and minimize distortions caused by weak speakers.

Dolby is confronting a market that each year has fewer and fewer audiophiles like Walters. "I don't see people sitting around somebody's shag rug room, smoking a joint, listening," says Faith Popcorn, chief executive officer of marketing consultancy Faith Popcorn's BrainReserve. Sony's (SNE) Walkman, introduced more than 30 years ago, trained consumers to prioritize convenience over sound quality. Apple's (AAPL) iPod and other MP3 players have accelerated the trend, Popcorn says.

The numbers bear her out. The Consumer Electronics Assn. (which runs the Consumer Electronics Show held this month) estimates that more than a third of the $2.91 billion spent on home audio equipment last year went to docking stations for iPods, iPhones, and other devices that play highly compressed files with sound quality that isn't as good as compact disks or records. Sales of so-called home theaters in a box, or surround sound systems that include five speakers, a subwoofer, and a receiver, declined 9 percent, according to the CEA. Dolby is "trying to position themselves for online media, whether it's streaming music or movies," says Kerry Rice, an analyst with Wedbush Securities. "But I don't know if that propels demand—'Oh my gosh, I've got to go out and get this new PC that has this 7.1 surround sound.' "

It may not matter: Dolby doesn't sell directly to consumers. It licenses its software for use in Windows and other operating systems. Dolby's push into PCs so far has been successful. The PC software, first announced in 2005, now accounts for 36 percent of total licensing revenue. The division's sales were up 19 percent, to $710.5 million, last year, helping send the stock up 40 percent.

Mary Anderson, the director of marketing for Dolby's PC business, agrees that people's behavior has changed. She adds: "Just because your behavior changes doesn't mean you don't expect the same quality."

The bottom line: Although Dolby's new PC software brings virtual surround sound to laptops, many consumers put convenience over quality.

    Before it's here, it's on the Bloomberg Terminal.