Can Dolby Turn Up the Volume?

Dolby Laboratories Inc. (NYSE: DLB) is a developer and manufacturer of audio and video products and technologies for the entertainment industry. The company has seen steady growth and consistently high margins for years. But it's been the victim of a sell-off recently, following an outlook weaker than analysts expected.

Dolby's primary revenue source is licensing its technologies for use in audio-video equipment. It enjoyed a monopoly during the DVD wave as the exclusive audio format available for DVD playback, receiving royalties from every DVD player sold. It also had a licensing agreement with Microsoft Corp. (Nasdaq: MSFT), earning royalties from every copy of Windows Vista Home Premium or Ultimate sold.

Looking forward to the permeation of Blu-Ray, Dolby lost its monopoly. However, it is still part of a duopoly with its main competitor, DTS Inc.(Nasdaq: DTSI), because both technologies come standard with Blu-Ray movies. Dolby scaled down its forecasts for the first time in December 2010 and again in February this year, instigating a major sell-off that dropped share prices down more than 30% YTD.

I would call that a reality check, and a much-needed correction. But I also believe the pendulum swung too far. Dolby is still a name brand with thorough market penetration. It's not going anywhere. It just has a little competition now.

From a valuation perspective, we can't just extend the (stellar) historical numbers, but instead scale back the growth rate and margin to accommodate the competition in the licensing segment. At the same time, Dolby's product segment grew 88% last fiscal year, thanks to increased sales in 3D and digital cinema products. If this piece continues to contribute a larger percentage of revenues, we can expect a lower overall margin (it's hard to beat 98% gross margins on royalties). But product sales are by no means losing money at a 50% gross margin, as we can see in the Dolby 10-K filing.

Using a discounted cash flow valuation model, I arrived at a near-term, baseline valuation of $50.49/share, with room to increase to the optimistic, longer-term target of $55.32. This model incorporates those downward revisions in growth rate and margins mentioned above.

Right now, we see the stock is beaten down, trading below its baseline value, as a result of the barrage of downgrades and price target reductions by analysts to catch up to the new outlook. This presents a buying opportunity, as the sting wears off and buyers come back to dip their toes in Dolby waters.

Technically, we see support around this $45 mark, and gravity at the baseline valuation around $50.50. As investors regain optimism, I would even expect the price to retake the $55 level.

While we continue to see the theater experience brought into the home as cinemas fight to give patrons an even higher-end experience, I believe Dolby is poised to outgrow its current price level. Now is a great time to get on board.