10 Core Stocks for Your Portfolio: Dolby Labs

This week and next, we're presenting 10 core stock ideas -- stocks our writers believe can serve as the foundation for a long-term-focused portfolio.

Did you watch CNBC this morning? Did you listen to Bloomberg radio? Heck, did you see the latest Lindsay Lohan flick at the theater? If you've done any of these activities, you've no doubt heard what's so special about Dolby Labs, the leading purveyor of sound technology.

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The business
While anyone with a stereo is probably familiar with the double-D logo, Dolby has extended its reach far beyond making listening to music a quality-time experience. The leading sound system license is now found in your computer, in movies, and increasingly on your mobile handset. It's also reached into digital cinema, bringing you better-quality viewing along with leading 3-D technology expertise.

In its core field of crystal clear sound, however, it has little in the way of competition. DTS (Nasdaq: DTSI) and SRS Labs do offer competing technologies, and some audiophiles will even go so far as to say DTS's quality surpasses that of Dolby (though my average tin ear can't tell the difference). But at just a fraction of the size, and with a similarly small percentage of revenues, these peers are not a threat to Dolby's dominance of the marketplace.

From ear to ear, Dolby's sound technology is not only included but is also one of the standards manufacturers abide by. The big-screen TV sales bulge brought on by conversion from analog signals to digital broadcasts caused a similar bulge in Dolby's revenues that more than offset the supposed death of the DVD. Along with Netflix (Nasdaq: NFLX), we're still waiting for DVDs to become a thing of the past, and while Dolby does mention it as a risk (see below), the transition to streaming video is taking longer than the experts expected.

Why it's a core stock
Dolby is the standard of standards. Its technology is needed in just about every piece of audio equipment that exists in your local electronics superstore, but is also part and parcel of your movie viewing experience, no matter if that's on the big screen or the little one in your living room. The players and the disks themselves carry Dolby's codecs.

The licensing of its codecs provides Dolby with some huge margins: Gross margins exceed 85%, operating margins are close to 50%, and net margins exceed 30%. Those are numbers similar to what you'll find Microsoft (Nasdaq: MSFT) producing, and with Dolby included in virtually every version of the software giant's Windows 7 operating system (and XP and Vista before that), Dolby benefits as Microsoft grows. Returns on invested capital are very high as sales have grown at a torrid pace.

Yet if all Dolby had was the U.S. market, there might be some concern with saturation eventually eroding its profit potential. International markets, however, are providing Dolby with its next leg up in expansion. Attach rates for Dolby's technology with European TV sales are expected exceed 80% this year, and are starting a similar ramp up in Asia as those countries adopt Dolby formats for digital TV standards. In a few years, China will also force its citizens to migrate to a digital signal. Today, Dolby claims to be found on half of the world's TV shipments. The other half provides the sound system specialist with potentially huge growth possibilities.

Risks
The risks to a Dolby investment are more short term in nature than long term. Intel (Nasdaq: INTC) has warned of a coming slowdown in PC sales, and the iPad from Apple (Nasdaq: AAPL) is expected to cannibalize the PC market to a growing extent. Yet it's a normal cycle for the industry, one Dolby has been through many times and will likely survive this time as well.

There's also the eventual demise of the DVD. Yes, sooner or later, the disk will be largely supplanted by streaming video in all its iterations. It seems doubtful now that Blu-ray will stem the losses (and Dolby's a standard on those hi-def disks, too), but Dolby's presence in TV, set-top boxes, and in the movies themselves will ensure that it remains relevant no matter how we receive our pictures.

Finally, there's the large overhang of Ray Dolby's ownership interest. At age 77, he may start to convert more of his class B shares, which represent a 53% ownership interest in the company, for publicly traded class A shares for liquidity or estate planning purposes. But with such a large slug of stock still in his possession, the founder's interests are closely aligned with those of current shareholders.

In sum
From audio and TV to digital cinema and mobile handset technology, Dolby Labs is part of the experience. Its technology is being found in more and more mobile handsets belonging to Nokia (NYSE: NOK), LG, and NTT DoCoMo. The games we play, the movies we watch, and the sounds we hear are all made better through Dolby magic.

At 24 times last year's earnings, though, Dolby's not exactly cheap. While it makes money hand over fist, it's expected that as the industry leader, it will always carry a premium. But there's no reason an investor needs to take a full helping of the stock at this price. Nibbling here and there and waiting for the stock to sound some further opportunistic depths would be a better way to turn up the volume on Dolby stock.