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This Just In: The DVD Is Dying

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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.

Fool contributor Anders Bylund owns shares of Netflix with a bull call spread position sitting atop those shares, but he holds no other position in any of the companies mentioned. Check out Anders' holdings and bio, or follow him on Twitter and Google+. The Motley Fool owns shares of Apple and Netflix. Motley Fool newsletter services have recommended buying shares of Apple, Netflix, and Dolby Laboratories. Motley Fool newsletter services have also recommended creating a bull call spread position in Apple. The Motley Fool has a disclosure policy.

We Fools may not all hold the same opinion, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (5) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 03, 2012, at 1:20 PM, stockdissector wrote:

    The company has plenty of cash on its balance sheet and a low total debt to equity ratio. Its operating margin has been on the decline in recent years though. However I am a believer in the stock because I recently bought shares before the sell off.

  • Report this Comment On August 03, 2012, at 1:32 PM, SwiperFox wrote:

    You seem to imply that Dolby "owns" surround sound. Dolby owns one method of compressing, meta-tagging and playback for surround sound.

    In the new, fun world of audio, anyone can compress 5.1 audio into an AAC track. Surround sound is all over the internet without Dolby. I don't think they'll catch up.

  • Report this Comment On August 03, 2012, at 2:25 PM, mikecart1 wrote:

    "The future of entertainment is digital, and there are no ifs and buts about it."

    Disagree mostly. The best entertainment requires a medium of some type or a download of some type. Streaming technology is insufficient to produce anything close to HD quality movies with 5.1 sound coming from a Blu-Ray or higher resolution video. DVDs still have their place in cars since you can't really find a Blu-Ray in-dash player for cars yet. DVD is also preferred for those without Blu-Ray.

    The future of entertainment is not digital, it is more resolution and higher definition.

  • Report this Comment On August 03, 2012, at 2:58 PM, wino80 wrote:

    If anyone is wondering look up sales made by insider stock holders at the stock's top just about the time that Fools recommended DLB.

    What is wrong with DLB? It seems that every time the stock reaches new highs insiders sell like there is no tomorrow. After 40 years the company has paid no dividends, had no stock splits.

    Maybe there is a future for stockholders here but I'm not waiting.


  • Report this Comment On August 04, 2012, at 3:17 PM, 48ozhalfgallons wrote:

    DTS is still not streamed. Digital Theater Systems encoding is to Dolby as 20/20 vision is to myopia.

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