Home-Gadget Boom Music to Dolby Investors' Ears

That insatiable need for digital self-medication is good news for Dolby Laboratories (DLB). Its audio technology can be found as a required standard in all those gadgets and more. Although the stock may look pricey at first glance, booming demand for electronic goodies could prove to be music to investors' ears.

"I think Dolby is a lovely way to play consumer electronics for the holiday season because they're embedded into so many different devices," says Barbara Coffey, an analyst with Kaufman Bros., who has a Buy call on the stock. "You don't have to bet on whether it's going to be a flat-panel-TV Christmas or a next-generation DVD Christmas. You don't have to be concerned if there's more discounting this year than there was last year."

Dolby has a large portfolio of audio and video technologies, one of the more ubiquitous being Dolby Digital. That's surround sound, where two-channel audio (think two-speaker stereo) gets split into five channels, or four speakers plus a subwoofer. It's a standard found in DVD-Video, HDTV, digital cable and direct broadcast satellite systems. And every time a consumer buys one of those gadgets employing Dolby Digital technology, the company collects a royalty. That means Dolby doesn't care if Best Buy (BBY) and Circuit City Stores (CC) beat each other's brains and margins out with price cuts this holiday season. It doesn't even care if a gadget is sold at deep-discounter Wal-Mart Stores (WMT). Dolby gets a check regardless.

"Dolby's almost a de facto monopoly in a lot of ways," says Alan Davis, an analyst with D.A. Davidson, who has a Neutral rating on the shares because of valuation. "They have huge brand equity and they've been great at leveraging their brand and history and getting built into standards."

Nearly 80% of Dolby's revenue is generated from licensing. The remainder comes from selling professional audio and video technology and services. The royalty stream affords very high gross margins, more than 90%. The pro business's margins are lower, but the total mix still makes for a handsomely profitable model. Dolby's gross margins top 80% and its operating margins top 35%. "The only company that's better than that is probably Microsoft (MSFT)," Davis says with a chuckle.

The company's margins and growth profile — analysts' average long-term growth forecast stands at nearly 19% a year, according to Thomson Financial — as well as its brand equity and market dominance argue for the stock to boast a premium. The question is at what point does that premium get a little too rich.

Shares have gained 12% year-to-date to $34.77 as of Tuesday's close, beating the tech-heavy Nasdaq Composite Index by more than 8 percentage points. It's also made the valuation start to look a bit stretched. With a forward price/earnings multiple of nearly 29, shares trade at a significant premium to peers and at almost twice the broader market. The forward price/earnings-to-growth, or PEG, ratio, at 1.5, also offers significant premiums to peers and the S&P 500 index. (PEG measures how expensive a stock is relative to its growth prospects.)

Still, of the 12 analysts covering the stock, Buy ratings outnumber Holds by two to one, according to Thomson, while the mean price target of $42 implies an upside of 21% in the next 12 months or so. Moreover, Dolby has beaten the Street's earnings and sales estimates for at least eight consecutive quarters. For its most recent period, the fiscal third quarter ended June 29 (reported Aug. 1), the company topped analysts' average estimate by six cents a share, helped by PC sales driven by Microsoft's new Vista operating system. That lends support to the long-term case for Dolby, one that stretches past the holiday selling season, notes Deutsche Bank analyst Brian Thackray, who has a Buy rating on the stock and sees Dolby as a core holding.

"[Vista] was the largest upside driver to the quarter as Dolby begins to experience the benefit of the Vista cycle," the analyst wrote in an Aug. 1 report. "PC-related royalties are growing at approximately 50% year-over-year in fiscal 2007 and we believe this vertical will get stronger over the course of the next six to nine months." PC revenue represented about a quarter of total June-quarter sales.

Still, there's that pesky valuation, but there is a strategy to play it. Dolby's a fairly volatile stock, partly because of its ownership structure. The company has a market cap of $3.8 billion on about 110 million shares outstanding, but those figures are a bit deceptive. The company has two classes of stock with Ray Dolby, founder and company chairman, owning nearly all the Class B shares. That not only gives him more than 90% of the votes (and control of the company), but means the company's float, or number of shares actually trading in the market, is a somewhat thin 49 million. Davis, of D.A. Davidson, says a 75-cent price swing in the stock on any given day is expected.

That should allow investors a chance to buy on the dip. Given that Dolby will not only be nearly omnipresent this holiday season, but is also the standard in digital TV, which will become mandatory in 2009, the company's technology looks secure in our living rooms and home offices for many years to come. Although the valuation may be a little daunting in the shorter term, Dolby certainly sounds like sweet music for investors with longer horizons.