Elena Carr - Director of Corporate Finance and IR Kevin Yeaman - President and CEO Lewis Chew - EVP and CFO

Ralph Schackart - William Blair Steve Frankel - Dougherty Eric Wold - B. Riley Jim Goss - Barrington Research Paul Chung - J.P. Morgan

Ladies and gentlemen, thank you for standing by. Welcome to the Dolby Laboratories Conference Call Discussing Fiscal Third Quarter Results. During the presentation, all participants will be in a listen-only mode. Afterwards, you will be invited to participate in a question-and-answer session. [Operator Instructions] As a reminder, this call is being recorded, Tuesday, July 25, 2017. I would now like to turn the conference call over to Elena Carr, Director of Corporate Finance and Investor Relations for Dolby Laboratories. Please go ahead, Elena.

Good afternoon. Welcome to Dolby Laboratories third quarter 2017 earnings conference call. Joining me today are Kevin Yeaman, Dolby Laboratories' President and CEO; and Lewis Chew, Executive Vice President and Chief Financial Officer. As a reminder, today's discussion will include forward-looking statements. These statements are subject to risks and uncertainties that may cause actual results to differ materially from the statements made today. A discussion of some of these risks and uncertainties can be found in the earnings press release that we issued today under the section captioned Risk Factors as well as in our most recent report on Form 10-Q. Dolby assumes no obligation and does not intend to update any forward-looking statements made during this call as a result of new information or future events. During today's call, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the two is available in our earnings press release and in the Dolby Laboratories' Investor Relations data sheet on the Investor Relations section of our website. As for the content of this call, Lewis will begin with a recap of Dolby's fiscal results and provide our fiscal 2017 outlook, and Kevin will finish with a discussion of the business. So with that introduction behind us, I will now turn the call over to Lewis.

Thank you Elena and good afternoon everyone. Total revenue in our third quarter was $305.7 million which is about $28 million above last year's Q3. Most of that growth came in licensing, but we also had growth in our products and services revenue. Within licensing, we saw year-over-year growth in all of our key market categories except for PC, which was down slightly. So let me go through the details in each of those market categories starting with broadcast. Broadcast represented about 37% of total licensing in the third quarter. Revenues in this market were down about 4% sequentially, driven mainly by seasonality. Broadcast year-over-year was up by around 3% due to higher volume in set-top boxes. PC, PC represented about 17% of total licensing in the third quarter. PC was up sequentially by about 28% down year-over-year by about 1%. The sequential increase was mostly due to timing of revenue and anticipate that we will see a similar pattern like this again next year all else held equal. Mobile devices were approximately 20% of licensing revenue in the third quarter, nearly double what they were in Q2 and about 18% higher than Q3 of last year. The sequential increase was mainly due to timing of revenue, but was also helped by higher recoveries, which those higher recoveries by the way also drove the year-over-year increase. Consumer electronics represented about 14% of total licensing in third quarter. CE licensing was up sequentially by about 6% and up year over year by around 15%. The sequential increase of mainly due to timing of revenue, while the year over year increase was driven by higher revenue in DMAs and sound bars. Licensing in other markets represented about 12% of total licensing in the third quarter. They were up sequentially by about 5% and up year-over-year by around 33%. Both the sequential increase and the year over year increase benefitted from higher recoveries, along with higher revenue from Dolby Cinema offset partially by lower revenue from gaming. Product and services revenue was $27.6 million in Q3 compared to 25.8 million in Q2 and 24.5 million in last year's Q3 as we're seeing higher demand from exhibitors for our digital cinema products, including some of our newer offerings. I will now discuss margins and operating expenses. Total gross margin in the third quarter was 89.5% on a GAAP basis and 90.2% on a non-GAAP basis. Product gross margin on a GAAP basis was 33.9% in the third quarter compared to 32.5% in Q2. Product gross margin on a non-GAAP basis was 40.6% in the third quarter compared to 39.6% in Q2. Operating expenses in the third quarter on a GAAP basis were $177.6 million compared to $177.2 million in the second quarter. And operating expenses on a non-GAAP were $161.5 million in Q3 compared to $160.1 million in the second quarter. So that means operating income in the third quarter was $95.9 million on a GAAP basis or 31.4% of revenue and it was $114.3 million on a non-GAAP basis or 37.4% of revenue. The effective tax rate for the third quarter was 20.9% on a GAAP basis and 22% on a non-GAAP basis reflecting some discrete benefits that we realized during the quarter. Net income in the third quarter was $76 million on a GAAP basis or 24.9% of revenue and was $89.2 million on a non-GAAP basis or 29.2% of revenue. Diluted earnings per share in the third quarter on a GAAP basis were $0.73 that compared to $0.49 in the second quarter and $0.62 in Q3 of last year. And on a non-GAAP basis, third quarter diluted earnings per share were $0.86 compared with $0.63 in Q2 and $0.76 in Q3 of last year. During Q3, we generated over $130 million in cash from operations and ended the quarter with over a $1 billion in cash and investments. We bought back about 485,000 shares of our common stock in Q3 and ended the quarter with about $175 million of stock repurchase authorization still available. We also announced today a cash dividend of $0.14 per share payable on August 15, 2017 to shareholders of record on August 7, 2017. So let me move on now to the forward outlook. For the full-year FY '17, we're keeping the midpoint of our revenue guidance the same as it was coming into the call today, which is $1.080 billion. And with one quarter left to go, the range is defined by what we anticipate for Q4, so let me provide that now. We estimate that total revenue in Q4 will range from $230 million to $250 million and within that we estimate that licensing revenue will range from $205 million to $220 million while products and services revenues expected to be around $25 million to $30 million. Gross margin in the fourth quarter is projected to range from 87% to 88% on a GAAP basis and 88% to 89% on a non-GAAP basis. Operating expenses in the fourth quarter are projected to range from 176 million to 180 million on a GAAP basis and from 158 million to 162 million on a non-GAAP basis. Other income in the fourth quarter is projected to be around $2 million and our effective tax rate for the fourth quarter is estimated to range from 24% to 25% on both the GAAP and non-GAAP basis. So based on a combination of the factors that I just covered, diluted earnings per share in the fourth quarter are projected to range from $0.22 to $0.28 on a GAAP basis and from $0.36 to $0.42 on a non-GAAP basis. Now here's the rest of the full-year outlook beyond the revenue estimate that I gave earlier. Gross margin is expected to range from 88% to 89% on a GAAP basis and about a point higher on a non-GAAP basis. Operating expenses are projected to be around 706 million on a GAAP basis and around 635 million on a non-GAAP basis. Non-operating income is projected to be 6 million to 8 million in both the GAAP and non-GAAP basis and effective tax rate for the year is expected to be around 24%. So that's all I have let me turn it over now to Kevin.

Thank you Lewis and good afternoon everyone. This quarter, we continued to make progress in expanding our leadership in audio entertainment solutions and in bringing our new audio visual experiences to the market. We expanded the content ecosystem for both Dolby Atmos and Dolby Vision and grew our Dolby Cinema footprint by adding Pathé as a partner in Europe. I usually start off by talking about the adoption of our technologies on devices. Content is of course essential to the Dolby experience and so today I'll start there. As you know, Netflix was one of our initial partners for Dolby Vision content, all HDR original content on Netflix is mastered is Dolby Vision. This quarter, Netflix started streaming in Dolby Atmos for the first time. Netflix Original Film Okja is available in Dolby Atmos and Dolby Vision globally. Netflix's support of Dolby Atmos marks a significant step in the expansion of the Dolby Atmos ecosystem and shows the strengthening of our partnership. Netflix joined VUDU in delivering content in both Dolby Vision and Dolby Atmos. This quarter Disney announced it will be releasing Guardians of the Galaxy 2 in Dolby Visio and Dolby Atmos for digital distribution. This is Disney's first UHD release for the home and built on their strong support for Dolby Vision and Dolby Atmos in the cinema. Disney joins other major Hollywood studios such as Warner Brothers and Paramount to name a few in creating Dolby Vision content for the home. Also this quarter, the first UHD Blu-ray discs with Dolby Vision were released. Initial releases were from Universal, Lionsgate and Sony, and we expect to see titles from Warner Brothers and Paramount. We are also seeing the beginning of Dolby Atmos in live sports. For example, BT has been broadcasting Premier League soccer matches in Dolby Atmos. Most recently, the Champions League Soccer finals in Europe was broadcast in Dolby Atmos which is one of the highest watched events in Europe. This broadcast was also picked up in Dolby Atmos for further redistribution outside of the UK. In France, the French Open was broadcast in Dolby Atmos, AC-4 and Dolby Vision by France Television. Also this quarter, RTV in Spain did its first public trial in AC-4 and Dolby Vision. And finally, we saw the first Dolby Vision game come out this quarter, Mass Effect: Andromeda, EA's blockbuster game title was updated to support Dolby Vision. On the device side, Huawei launched two MateBook PCs with Dolby Atmos this quarter. We also partnered with Huawei on the layout of the subsystem and speaker design and the result is that it sounds spectacular. This quarter, Sony's first Dolby Atmos sound bar came to market and there are now 12 Dolby Atmos sound bars on the market globally. Microsoft launched HDMI support for Dolby Atmos on Windows and Xbox One that enables playback on downstream Atmos devices such as sound bars and AVRs. This quarter we launched Dolby Atmos for headphones, which delivers Dolby Atmos over any set of headphones through an app purchase. OEMs can prepurchase Dolby headphone and bundle this into their offerings. Plantronics has announced that its most recent gaming headsets will include prepaid vouchers to download Dolby Atmos for headphones on Windows and X Box. As we released the Dolby Vision, TCL started shipping Dolby Vision TVs in North America this quarter. TCL joins other partners such as VIZIO and LG in shipping Dolby Vision TVs at price points below $1,000. Earlier I noted the first Dolby Vision Blu-rays have been released and this coincides with the market availability of the first UHD Blu-ray players with Dolby Vision from OPPO. We made a lot of great progress on Dolby Atmos and Dolby Vision content and devices and I look forward to continuing with this momentum. Now let's turn to Dolby Cinema, this quarter we announced our newest partner in Europe Pathé Cinemas. Pathé is the largest cinema chain operation in France, The Netherlands and Switzerland and plans to open ten Dolby Cinema screens. Pathé Cinemas joins a growing list of partners for Dolby Cinema. The number of locations has grown rapidly over the last year, with 105 now opened compared to about 30 a year ago. We think we'll end the year with about 120 to 125 screens, and in total, we have over 325 Dolby Cinema locations opened or committed around the world. And the content pipeline for Dolby Cinema continues to grow, with over 100 titles in Dolby Vision and Dolby Atmos announced or released. Over 40 of these were in this calendar year and recent releases include Spider-Man: Homecoming, War of The Planet of the Apes and Dunkirk. The reception we are getting from the industry and consumers is outstanding and we look forward to working with our partners to make the best movie going experience more broadly available. Let we quickly turn to Dolby Voice. We are excited for the upcoming launch with our newest partner BlueJeans. Our integrated solution with BlueJeans positions Dolby Voice to provide great experiences in the hurdle room which is a rapidly growing market. So let me wrap up, I'm pleased with our results this quarter, we are seeing continued momentum in both the content and devices for Dolby Atmos and Dolby Vision. We've added a new Dolby Cinema partner and we continue to expand the availability of Dolby Voice. All of this creates opportunities for increased revenue growth and broadens the number of people that will enjoy Dolby experiences. I look forward to updating you next quarter and with that I'll turn it over to Q&A.

[Operator Instructions] Our first question will come from Ralph Schackart with William Blair.

First question is for Lewis. Lewis, the second half guide at the midpoint implies growth roughly around 7% or so versus first half licensing growth around 4%. Just curious, how much of the acceleration second half was driven maybe by the contractual payment shifts or normal seasonality versus perhaps some of the new product initiatives really starting to impact the revenue.

Hey Ralph, this is Lewis, which sounds logical since you directed the question at Lewis. I think it's a blend of a variety of factors. I don't think I would identify any one thing. I think as a company we have is our objective to continue increasing the rate of our growth going. The item you mentioned the contractual payments if you will, I wouldn't attach a lot of the growth to that one particular item. But we do, this year we do see growth actually in some of our core businesses like set-top box area has been growth for us. Obviously, in the second half of the year we do have growth from our new initiatives, especially coming off the beginning base of some of these items like Dolby Cinema which only started maybe a year and a half ago in terms of real revenue. So I would say it's a combination of factors. I don't know if I would attach it to any one item.

And then, Kevin I think you had in the prepared remarks talked about 120 to 125 screens for Dolby Cinema. Is that an update from I think maybe historically you were talking around 100 screens as a goal for 2017.

No. I think that was the goal for - specifically as it relates to AMC, we were targeting 100 screens by the end of calendar '17.

And then just one more, maybe back to Lewis, for Q4 revenue guide, was there any pull through of Q4 revenue into Q3 that you observed or sort of Q4 come in I guess on the guidance you would have anticipated.

Yeah. I think if I look at Q2, Q3 and Q4 altogether, there are going to be some amounts that are timing differences between the quarters. In fact, last quarter, I cited that as a factor and what ended up being our result for the last quarter. So yeah, I think for the full year, I started my outlook by saying that we're holding our guidance for the year at the midpoint at $1.80 million, which is consistent with what we've been saying since the end of Q1 and therefore, between Q3 and Q4, some of that is timing. And as you know, coming into the quarter, because of the nature of our business, not all of it is fully predictable and we do have some amount that we can see coming in early in the quarter, but much of it gets reported late in the quarter.

We'll take our next question from Steve Frankel with Dougherty.

Kevin, maybe you could start by giving us some high level comments on the AC-3 to AC-4 and kind of what you think the timing of that is and do you see AC-4 replacing AC-3 in AVR and set-top boxes that are, in addition to going into TVs.

Sure. So AC-4 is, so first of all, I want to point out that we have our first shipments of TVs with Samsung and LG. Sony has announced that they will be supporting AC-4 televisions. I think we put ourselves in a good position with the ATSC and the DVB in terms of our position within those specifications. And we think we have a great value proposition in terms of the increased efficiency, but also some of the new value propositions that it enables. So we do see this being, over the long term, broadly adopted across a wide range of devices, but at the same time, I expect to be a grateful rollout So I don't think this is going to be a major factor in the foreseeable future, but keep watching for things like early product adoption and also the, I gave some examples in the remarks about some of the public broadcast that have already occurred with AC-4. So all of that is pointing in the right direction and ultimately, we would see the industry migrating AC-4 because of higher efficiency, better meeting the operational needs of the way the delivery environments are working today and some new value propositions.

Great. And let me sneak in a follow-up. As Ralph said, your guidance for the year looks very conservative, both on the top line and on gross margins. So maybe, little specifically, what changes mix wise in Q4 that might drop the gross margins that much sequentially?

Yeah. Maybe I could scoop up to a higher level on what changes it going forward is, for the most part, as we see revenues coming in from items beyond pure licensing, whether that be product revenues or even in the case of things like Dolby cinema, these are items that do not carry the very high 90s margin that we will typically get from pure licensing. And we do see overtime, part of our growth story is an evolving mix there, and that's probably as much as I can give you. We try to bake all of those factors into the margin guidance we give you, so we've netted that out, but we don't break it down piece by piece.

And kind of what's the delta between the low end of OpEx spend and the high end of spend, how much of that is discretionary or kind of how do you think that plays out?

Sure. I think when we look at our OpEx like many companies, a good chunk of it is fixed, but we do have programs going on, there can be a variety of marketing programs, there is variable compensation for our various operating targets. Yeah. So, I think there is some amount of variability. Our range that we guide to tends to be fairly tight and we typically stay within that range, so I think that's about as much as I give you. We do have some amount of variability, it's not all fixed.

We'll now take our next question from Eric Wold with B. Riley.

Two questions. One on vision and one on cinema. On vision, as you've seen kind of the ecosystem grow for the technology, kind of where are the discussions with the TV OEM has gone in terms of how far they're thinking about taking this down the price scale and how widespread or maybe I guess, maybe how low do you think that price reach can be for vision over the next couple of years. And then on cinema, obviously you're still sitting with a pretty - very healthy backlog and outlook in to installs. In terms of new discussions you've had with exhibitors either expanding deals that are in place or looking to take cinema for the first time, maybe kind of frame how the discussions have been over the past few months, have you seen any pause at all from what's been a weak summer box office or do those exhibitors tend to understand that the box office weaknesses is likely temporary and wouldn't impact your long-term plans. Thank you.

Sure. So we'll start with Dolby Vision. So as you know, our strong or where we have strength is in the high-end of the UHD television market. We are seeing some models come in at lower price points. I mentioned the TCL television that shipped this quarter. So that's a good sign. In terms of where - what the plans are for television makers, I would say they're in the middle of their decisioning process. And too early for me to speculate on how far they're going to be going down in their '18 lineups. Over the long term, we see Dolby Vision as applicable across a broad range of devices and we think that the key to that is marrying our solution, which is proven in the market and getting great reviews. With more and more contact and that was, that's an area where we're making some progress as I talked about in my opening remarks. As it relates to Dolby Cinema, so first, I'll say we're thrilled to add Pathé, a very important partner in Europe and we continue to have a strong pipeline as you pointed out, over 325 screens, including one 105 we have installed today. And of course, we're in a number of discussions with a number of partners around the world. I would say for the most part that the first decision point is what is the exhibitors' kind of view on the world? Are they - are they of a mind that investing in the experience is going to bring more box office or are they looking to invest in other ways to bring people to theaters. And I don't think that near-term fluctuations in box office tend to shake people in terms of what their world view is and I think we're seeing a lot of evidence that investing in the experience is what gets people to come to the cinema. And so far, both objectively and subjectively, the results are showing that Dolby Cinema is performing very well. So that's obviously a help for us now that we have some data to go on.

We'll go next to Jim Goss with Barrington Research.

Thank you. The Paramount transaction you announced last week, is this somewhat of a template of what you are hoping to develop with each of those studios, because I think one of the challenges has been the [indiscernible] if you will and this could help somewhat of a revival there. Is this maybe taking a look at that way?

Well, I mean, as I said, a big emphasis for us right now is content. We have just a lot of - we've talked a lot about our device momentum and our content momentum, but we saw a lot of things coming together this quarter on the content side and so Paramount joins a list of partners who have now support for Blu-ray, but is also supporting us in a number of other areas.

Are you getting to a point that you might now break out this vision and Atmos has another category? It looks like you're at 12% in total in the latest quarter and actually a little less than in the first couple of quarters in the other category and how will you be looking at a breakout? Is it then combined as cinema or what are your plans in that regard?

Hey, Jim. This is Lewis. It's more fair to say that today, when you think about Vision and Atmos, those tend to be embedded in categories not in order. So for example, if Atmos was being put onto an AVR that we're selling that would be in consumer electronics and for the current time, it's our plan to leave that as it is because we think of Vision and Atmos, not as separate devices, but as other solutions and offerings we have that get embedded. So in the near term, I wouldn't want you to think that we somehow have a category called Atmos revenue. Now with respect to Vision, as Kevin has said before, we currently are focused on the TV, but we do see Vision starting to creep in to other devices like the OPPO Blu-Ray player and also a while back we mentioned that it was in the this Google Chromecast Ultra. And so it's a same type of situation where Vision becomes an offering we have that gets embedded in a lot of different devices and currently we don't anticipate breaking out a revenue category called Vision.

Okay. And maybe just one related thing, the plus 15% percent on consumer electronics. What would you tie that to the greatest extent.

Yes. We're looking at the year-over-year increase. We had growth, two categories that we see some strength in. One is DMAs, which is the broad category of the Apple TVs of the world and those types of devices and also sound bars that embed the Dolby Audio technology. We're seeing growth there. So both DMAs and sound bars are classified in our consumer electronics category and both of those were growing year-over-year.

We'll take our next question from Paul Chung with J.P. Morgan.

Hi. Thanks for taking my question. So wanted to touch on the smart speaker market. So is Dolby on track to participate meaningfully in this market, for example, will Dolby Solutions extend to all Amazon Alexa related products and should we expect Dolby to spend to the upcoming Apple HomePod. Essentially, how should we think about sizing this market and Dolby's potential in what royalty rate should we think about?

Sure. So I mean certainly you've seen us extend the presence of Dolby Atmos over the last several years, starting with ABRs moving into up-barring [ph] speakers and sound bars, mobile devices and certainly the smart speaker market is an interesting category. I do believe that we can provide value there, but I don't have any specifics to offer today.

Okay. Thanks. And then, just follow - Lewis, you mentioned on previous calls, you expect operating margins to expand beyond fiscal year '17, assuming new initiatives accelerate. So are we still on track? Is there anything we should expect from the cost side that can get you there as well? Thank you.

Hey, Paul. It's Lewis. Yeah. I think there are a couple of things that Kevin and I've said consistently in the last year-and-a-half, two years is that we expect to - or our objective as a team is to grow revenue faster than OpEx. I have said that depending on the rate of revenue growth, we think there is an opportunity to expand operating margin, but our primary focus right now is getting traction with these new initiatives, which really helps drive our growth beyond the more sort of low-single digits we're getting out of the normal ongoing core business. But, yeah, I think there's always opportunity to expand, but right now, our focus is to continue driving that revenue growth and holding operating expense growth in line with that, so that we can maintain our operating margins.

We'll now take a question from Steve Frankel with Dougherty.

Kevin, is double digits revenue growth something that you still feel like you can sustain with the current product set or does something else have to happen to get you to a sustainable double digit revenue growth rate?

No. I still believe that we can get to sustainable double digit growth and that we have a strategy in place to get us there. You're familiar with our major growth initiatives in the broader sense. We're expanding from the realm of audio entertainment licensing to audio imaging entertainment and communication experiences and that's a much bigger place for us to play and the roadmap for doing that is continuing to execute on expanding our leadership in audio, following growth in broadcast, penetrating mobile, transitioning people to Dolby Atmos and then growing these initiatives and that's what it's going to take to keep increasing the rate of revenue growth and ultimately to get to double digit growth.

And would you care to offer an update on the likely penetration rate of Vision in the TV market by this holiday?

So on the last call, I was asked whether we'd be over 25% and I responded by saying that in the category of UHD TVs, over $750 I thought would be an exit rate of about 50%. I tell you that fluctuates a little bit and the reason is because some of those models that I was counting as over 750 are now under 750, which actually I think is good news, but it means that it will probably end up somewhere between those two numbers. So we continue to do well on the premium end, beginning to see some of those price points come down and we're really focused on expanding our presence deeper into those lines and getting beyond TVs.

And then thinking one last one, related to the smart speaker market, are there technologies that you haven't really talked about yet that they're in the lab that get Dolby involved in this whole voice of the primary interface, which seems to be where more and more devices are going. You have IP that you can apply in that space?

Well, obviously we have a substantial role in audio entertainment. We have an emerging role in voice technology, in particular, capture and playback as applied to our enterprise partners. And one thing to be sure of is we always have a lot of things going on our labs and clearly it's an interesting market, but I don't have anything more specific to say than that and we're very focused on executing on the initiatives and priorities that we've talked about today.

[Operator Instructions] And it appears there are no further questions at this time. I'd like to turn the conference back to Kevin for any additional or closing remarks.

Okay. Well, thank you, everybody for joining us and we work forward to speaking to you again soon. Thank you.

This concludes today's call. Thank you for your participation. You may now disconnect.