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Shares of audio technology developer Dolby Laboratories (NYSE: DLB ) plunged as much as 13% in Thursday's after-hours action. The numbers were brutal, but we'll get to the unexpected silver lining in just a few paragraphs.
In the third quarter, Dolby beat the Street's earnings target by 12% by reporting non-GAAP income of $0.57 per share, but fell 4.5% short of revenue targets with just $208 million in sales. Worse, management slashed its full-year revenue guidance from roughly $935 million to about $910 million.
Ouch! What happened?
Management was quick to pin the slow sales on a weak global economy, but that's not the whole story. The deeper truth is actually a lot more interesting if you've been following the transition from physical to all-digital media formats. In a conference call with analysts, CFO Lewis Chew explained that license sales to consumer electronics firms fell 19% on weak demand for DVD and Blu-ray players.
CEO Kevin Yeaman chimed in, noting that Dolby is growing its license sales for digital download and streaming services as optical discs fall out of fashion.
The future of entertainment is digital, and there are no ifs and buts about it. Netflix (Nasdaq: NFLX ) raised hackles across the nation last year when it tried to separate its DVD and Blu-ray rentals from digital streams with an ugly machete named Qwikster. Dolby just provided yet another piece of evidence that Netflix was doing the right thing -- just a year or two too early, and with all the finesse and elegance of an arthritic rhino.
Like Netflix, I fully expect Dolby to bounce back from the loss of physical disc customers as digital media players become even more mainstream. Don't forget that every movie service worth discussing supports Dolby's surround sound encoding under license.
Where's the beef?
Music services seem less interested in Dolby's advanced solutions, as neither Pandora (NYSE: P ) nor Spotify support Dolby formats today. Sirius XM Radio (Nasdaq: SIRI ) seems to break the mold as many Sirius receivers do support Dolby encodings -- but only one XM station currently broadcasts in a Dolby-style surround sound format. Apple (Nasdaq: AAPL ) iTunes takes a Dolby Pro Logic license for movie content but not for music.
That gap leaves headroom for Dolby to grow into the audiophile music market. Songs can't play in simple stereo formats forever, right?
There will be plenty of digital revenue coming Dolby's way in the future, and these licenses already supply over half of the company's revenue. But there will also be blood as optical discs drop off the map. DVD has earned a solid chapter in the chronicles of entertainment technology while Blu-ray is becoming a mere footnote.
The Foolish takeaway
So I don't believe that Dolby is fundamentally broken, even if Mr. Market seems to disagree. This long-term growth story should pick right back up again in the next year or two, and I see tremendous long-term value in this technology veteran. It's no wonder that the stock garners a perfect five-star score in our CAPS system, including an unwavering thumbs-up CAPScall by yours truly.
The Dolby story runs parallel to Netflix in many ways. Learn more about the future of digital media by grabbing our brand-new premium report on Netflix. Alongside a current in-depth analysis, you also get a year's worth of totally free updates as Netflix streams up the digital future. Get started right now by clicking here.