Dolby Gets Dissed

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People make mistakes. Investors are people. Therefore, investors make mistakes -- like the one they made when they sold off Dolby Labs (NYSE: DLB) on Friday.

By all indications, this Motley Fool Stock Advisor recommendation had a fabulous third quarter, yet the stock is down nearly 4% on the news. (Although it's still up an average of 75% from the three times we've picked it.) Was the sell-off justified? You be the judge:

• Dolby grew its sales 29% from last year's Q3, booking more than $154 million.
• The gross margin amped up 600 basis points to 89.6%; that's still short of rivals SRS Labs (Nasdaq: SRSL) and DTS (Nasdaq: DTSI).
• Operating margins added to the good news, tacking on 1,070 basis points to end up at 44.2% (way ahead of SRS and DTS, not to mention Philips (NYSE: PHG) and Sony).
• All of which boosted Dolby's profits 54% to $0.40 per share.

The numbers bested Wall Street's estimates for the 12th quarter in a row. And Dolby raised guidance for the rest of this year, predicting fiscal 2008 sales of $605 million to $625 million, with $1.57 to $1.65 in per-share profits. So was that sell-off warranted?

Nope!
The market's reaction was unjustified. Searching through the earnings report, I found only one item bearing even a hint of disappointment: The fact that Q3 sales growth of 29% was a bit slower than the 35% pace Dolby has set over the year to date. (Even with this quibble, Q3 profit growth is basically on track.)

But if it is sales that investors are worried about, I have to wonder if they listened to the conference call, and in particular the bits about what Dolby sees as future catalysts for growth. For example, the advent of Sony's (NYSE: SNE) Blu-ray DVD players: 

Recently Wal-Mart (NYSE: WMT) offered a $100 rebate for an in-store purchase bringing the price below $200. In addition, as new manufacturers enter the Blu-ray market, prices may come down over time. Similarly in gaming, Microsoft (Nasdaq: MSFT) reduced the price of the Xbox 360 to $299 [and] ... we are well positioned if price cuts lead to volume growth.

Valuation
Could it be the price? Perhaps. A few months back, I thought Dolby priced for perfection at 30 times trailing free cash flow. Today, with free cash flow mimicking net profit almost perfectly, we can go straight to a PEG analysis: Dolby carries a 23 P/E, versus 16% projected growth.

Make no mistake: That's still expensive. But given the company's bright prospects and lackluster competition, it almost seems worth paying.