There's no two ways about it: Dolby Labs (NYSE: DLB) disappointed investors last week. Second-quarter earnings were anemic -- sales up 3%, but profits down 3%, at just $0.72 per share. Worse, management held out little hope that things will improve any time soon. Dolby walked back guidance for the second time in as many quarters, this time reducing both revenue and earnings expectations 3%.

According to CEO Kevin Yeaman, "Strong performance from broadcast, mobile, and gaming led to higher than expected licensing revenue …" And yet, shouldn't growth in high-margin licensing revenue have helped profits grow faster than revenues? In fact, the opposite happened. So what's the deal with Dolby?

Yeaman answered that question, but you had to listen between the lines to hear it. According to the CEO, Dolby "technologies [are already] included in a wide range of entertainment devices." Meanwhile, Dolby remains "focused on extending these technologies into new geographies and new devices." And that's the problem in a nutshell. If Dolby "remains focused" on doing something, this implies that Dolby hasn't done it yet.

What Dolby hasn't done
The "something" that Dolby must do: Get its audio technology into the multiple mobile devices now crowding into the market. As anyone in the entertainment biz can tell you, DVD sales are fast going the way of the dinosaur -- and DVD players with them. Whatever you think of Coinstar's recent results, it won't be able to reverse this trend single-handed.

Lamenting the fact on the pages of Monday's Wall Street Journal, execs from Time Warner (NYSE: TWX) and CBS (NYSE: CBS) indicated that they're starting to place their chips on video streamers like Netflix (Nasdaq: NFLX) and Amazon.com (Nasdaq: AMZN). This being the case, Dolby's traditional sales to manufacturers of DVD players and player-equipped PCs show little prospect for growth.

What Dolby must do
Thus, while Dolby still has its technology in key mobile platforms like the iPhone and iPad, licensing fees from these devices are worse than those seen in traditional entertainment offerings. Dolby must continue searching for ways to keep getting higher-revenue bearing technologies into emerging mobile platforms. Right now, Wall Street is pricing Dolby for failure, charging about 19 times earnings for the shares, and predicting sub-16% long-term earnings growth. I think that's a sucker's bet. In a recent report, Wedbush Securities pointed out that: "There are currently only a couple of tablets with Dolby technology today." But "several dozen [such devices will] hit the market in 2011. It's still early in the game … but Dolby has the opportunity to be a dominant player in the tablet and mobile market."

I agree. It may take some time, but Dolby will deliver.

 

Will Dolby deliver? Add the stock to your Watchlist and find out.