The way acoustic entertainment specialist Dolby Labs (NYSE:DLB) has turned up the volume this past year with profits and earnings growth far outstripping prior-year results, you might be tempted to think that it's going to be wall-to-wall sound in 2007.
Things are rarely that simple in investing, and even when they are, it's not happenstance but rather because of carefully thought-out planning. Let's look at how things can shape up for the company whose name is synonymous with surround sound.
Challenges
Despite Dolby being the premier player in the digital sound arena, it's not the only one, and according to some audiophiles, it's not even the best.
DTS (NASDAQ:DTSI), which stands for "digital theater systems," is but a fraction of the size of Dolby, yet its digital sound systems are nearly as ubiquitous. Look at most sound equipment today and not only will you see the double D of Dolby, but you'll usually find DTS imprinted there as well.
The difference between the two systems comes down to DTS compressing data less while doing so at higher bit rates. The company -- and some people with a pretty keen ear, apparently -- say it produces clearer, richer sounds than Dolby's compression algorithms.
While there are a couple of upstarts in the field, tiny companies trying to gain a foothold -- like SRS Labs (NASDAQ:SRSL) and QSound (NASDAQ:QSND) -- they haven't made an impact yet and simply work on the periphery. Potentially more problematic would be a company like Sony (NYSE:SNE), which has the financial wherewithal to enter the market and has made an effort with its Dynamic Digital Sound systems.
Perhaps one of the biggest concerns facing Dolby, though, is the maturation of the home DVD player market. For years, consumer electronics, including DVD product sales, have made up 50% or more of Dolby's revenues, but the company recognizes that DVD growth will not produce the exponential rates it once did. The new, next-generation DVD formats are coming out -- Blu-ray and HD-DVD -- and with deep-pocket backing on both sides and neither wanting to give any quarter, their introduction has been delayed for several seasons.
Still sounds good to me
While DTS has surprised many with its staying power -- it was supposed to be a temporary solution to digital conversion -- Dolby is still the leading provider of digital sound in theaters. The technological acclaim for Disney's (NYSE:DIS) movie Chicken Little (which didn't receive much critical acclaim) has helped spur Dolby to install more digital theater systems around the country.
Movie theaters are simply going to have to make the transition to digital at some point. The larger markets have already begun, and the hinterlands will follow soon enough.
Home theater systems may very well become the new DVD market for Dolby. By March, televisions must have new tuners installed that can receive high-definition signals. That will include Dolby's digital technology, which is included as a standard in the tuners. Regardless of whether it's an LCD, plasma, or DLP system, it will include Dolby Digital.
And we haven't even talked about the home entertainment market for video games and their respective consoles, where once again Dolby is the sound system standard.
So while people might not end up buying as many DVDs, opting instead to download their movies on demand to their TVs, the movies themselves will also be recorded in digital sound with equipment made by Dolby. And whatever standard emerges from the next-generation DVD players, Dolby will also be included as the industry standard on both Blu-ray and HD-DVD.
That echo you hear
Dolby has been enjoying the fruits of its labors. After it reported fourth-quarter earnings back in November, the stock rose 20% on the report of 22% higher revenues and 47% higher pro forma earnings -- double analysts' estimates. Not only that, but Dolby gave higher guidance for 2007 as well. Management forecast 15% revenue growth in the new year, which also happened to outstrip consensus estimates.
The question for investors, though: Is Dolby's price still a good buy now?
By traditional metrics -- price-to-earnings, price-to-sales, enterprise value-to-EBITDA -- it looks richly valued. Wall Street analysts certainly view it that way and have even rated the stock a sell because of it.
When Dolby was originally recommended to Motley Fool Stock Advisor subscribers in September, Tom Gardner put a market value of about $6 billion five years out on it. Dolby's capitalization is only a little more than half of that now, just as digital technologies are coming to the fore. You can almost hear the chorus of analysts lamenting yet another missed opportunity.
Motley Fool CAPS players aren't lamenting. They've sounded off and given the stock a four-star rating, with 96% of them believing the company will outpace the market in the future. Nothing succeeds like success, and Dolby has succeeded in beating analysts before. That's not to say you can't expect some static every now and then, but I don't think Dolby will be turning down the volume anytime soon.
Check out the other companies featured in "The Motley Fool's 2006 in Review and 2007 Preview" special.
A 30-day guest pass gives you full access to Stock Advisor's recommendations, which are beating the market by 39 percentage points.
Foolanthropy is celebrating its 10th year! To learn more about our five Foolish charities or to make a donation, visit www.foolanthropy.com.
Fool contributor Rich Duprey owns shares of Dolby, but does not own any of the other stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.
