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

Steven Frankel - Dougherty Ralph Schackart - William Blair Michael Olson - Piper Jaffray Paul Chung - JPMorgan Jim Goss - Barrington Research

Welcome to the Dolby Laboratories Conference Call discussing Fiscal First Year Quarter Results. [Operator Instructions] As a reminder, this call is being recorded, Wednesday, January 24, 2018. 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 first quarter 2018 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-K. 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 our Investor Relations section of our website. As for the content of this call, Lewis will begin with the recap of Dolby’s financial results and provide our fiscal 2018 outlook, and Kevin will finish with a discussion of the business. So, with that behind us, I would turn the call over to Lewis.

Okay. Thanks, Elena, and good afternoon everybody. I think I'll just get right to the numbers. Total revenue in the first quarter was $288 million, of which $258 million came from licensing and $30 million came from our products and services. The licensing revenue in the quarter did exceed the high-end of our guidance by more than $20 million and while this was tiny because in Q1 we finalized a large recovery that we were expecting this year, but sometime after Q1. But it is nice to start the year on a positive note and we are raising full year guidance for FY '18 and I'll discuss that in a few minutes. But first, let me give you my comments on licensing trends in the end markets that we serve. I'll start with broadcast. Broadcast represented about 40% of total licensing in the first quarter, and revenues in this market increased about 1% sequentially or down about 4% year-over-year, and the sequential increase was driven mainly by higher revenue in TVs, while year-over-year decline was mainly due to some lower volume in set-top boxes along with lower recovery, but that was partially offset by growth from our consumer imaging programs. Mobile devices represented approximately 23% of total licensing in the first quarter, as mobile was the category that benefited from the large recovery that I mentioned earlier. Mobile revenue increased by more than 200% sequentially and 150% year-over-year, driven mostly by the large recovery, but beyond that we also saw higher revenue from -- mostly from tablets. Consumer electronics represented about 11% of total licensing in the first quarter. Licensing in this area increased sequentially by about 8%, driven by higher volumes in DMAs and sound bars, as well as higher patent licensing from a broad portfolio of consumer electronic devices. Consumer electronics year-over-year was up by about 3%, driven by similar reasons as what I just discussed for the sequential increase. Let's do PC. PC represented about 10% of total licensing in the first quarter. PC was down about 13% sequentially and about 24% year-over-year. In both cases, the decline was driven by lower recoveries, along with lower average pricing due to mix. Licensing in other markets represented about 16% of total licensing in the first quarter. They increased by about 11% on a sequential basis, and that was driven by seasonally higher revenue from gaming consoles, offset partially by lower recoveries in automotive. From a year-over-year perspective, although licensing increased slightly, that was driven by higher revenue from Dolby Cinema and from via, and that was partially offset by lower recoveries in automotive. Products and services revenue was $29.8 million in Q1 compared to $28.7 million in Q4 and $33.6 million in last year's Q1. Our product revenue this quarter was about $5 million below what we have projected, mainly because some of our cinema products did ramp as quickly in Q1 as we had anticipated. Let's move on to margins and operating expenses. Total gross margin in the first quarter was 89.3% on a GAAP basis and 89.8% on a non-GAAP basis. Product gross margin on a GAAP basis was 31.7% in the first quarter compared to 38.5% in Q4. And product gross margin on a non-GAAP basis was 35.1% in the first quarter compared to 43.3% in Q4. Operating expenses in the first quarter on a GAAP basis were $174.7 million compared to $189.5 million in the fourth quarter. And as a reminder, the fourth quarter total included a $12.9 million charge for severance-related costs. Operating expenses in Q1 on a non-GAAP basis were $155.9 million compared to $159.9 million in the fourth quarter. The operating income in the first quarter was $82.2 million on a GAAP basis or 28.6% of revenue, and $102.6 million on a non-GAAP basis or 35.7% of revenue. Now for income taxes. Let me spend next minute or two on that topic. As you know, U.S. tax reform, in other words the Tax Cuts and Jobs Act was adopted into law in late December. And we like so many other companies are immediately impacted by certain aspects of the new rules. And the two most notable items that affected us this quarter are, one, we had to approve a mandatory tax on our undistributed foreign earnings. For us, the vast majority of these undistributed foreign earnings is held in cash and will be taxed at the rate of 15.5%. Under the new rules, this tax assessment is payable over the next eight years and those payments are more heavily weighted towards the later years. Two, we have to write-down the carrying value of our deferred tax assets to reflect the fact that the standard federal tax rate for corporations was 35% and is now 21%. And this change reduces the value of deferred tax assets currently on our books, because those assets essentially represent future tax deductions. So as a result of these two items, we booked an estimated $155 million of discrete tax expense in Q1. Beyond the tax reform, we also have in Q1 a tax benefit of approximately $6 million due to a new accounting treatment required for the tax impact of stock compensation. This item used us to flow through the equity section of the balance sheet, but now must flow through the quarterly income tax rate. And in future quarters, the amount will fluctuate and could be either expense or benefit depending on circumstances in that quarter. So if I sum all this up, our total GAAP tax expense in the first quarter was $166.3 million or an effective tax rate of 196%. I guess, you could say you don't see that too often. So when we calculated our non-GAAP tax rate this quarter, we not only adjusted for the usual non-GAAP items, we also excluded the $155 million discrete expense for the new tax law and the $6 million tax benefit for the new stock comp treatment. And ultimately, where it lands is, the non-GAAP effective tax rate for the quarter was 20%, which brings us to net results. On a GAAP basis, we had a net loss for the quarter of $81.6 million or $0.80 per diluted share. And of course, this includes the tax items I just mentioned. On a non-GAAP basis, using the adjusted income tax rate of 20%, we had net income of $84.1 million in Q1 or 29% of revenue. Non-GAAP diluted earnings per share was $0.79 in the first quarter compared with diluted earnings per share of $0.45 in Q4 and $0.66 in Q1 of last year. During Q1, we generated about $17 million in cash from operations and ended the quarter with over $1.1 million in cash and investments. We bought back about 495,000 shares of our common stock in Q1 and ended the quarter with a little over $120 million of stock repurchase authorization still available. We also announced today a cash dividend of $0.16 per share, which will be payable on February 14, 2018, happy Valentine's Day, to shareholders of record on February 5, 2018. So now let me provide the outlook for the full year and for Q2. For the full year, FY '18 we now estimate that total revenue will range from $1.150 billion to 1.180 billion. Within that revenue total, we estimate that licensing will range from $1.20 billion to 1.50 billion, while products and services are estimated to be around $130 million. Here are some of the factors that are incorporated into this annual outlook. We anticipate that broadcast revenues will be flat to modestly up, as higher revenues from consumer imaging will be somewhat offset by lower recoveries. Mobile is expected to be up year-over-year due to higher revenue from audio and consumer imaging, as well as the positive impact from Q1 recovery. PC licensing is projected to be down, while CE, consumer electronics, is projected to be up modestly. The other licensing categories projected to be down because of lower recoveries, thus partially offset by revenue growth from Dolby Cinema. And then, we do expect to see growth in products revenue from Cinema and from Dolby Voice. Gross margin for the year is projected to be around 88% plus or minus on a GAAP basis and about 89% plus or minus on a non-GAAP basis. Operating expenses are projected to range from $727 million to $742 million on a GAAP basis, and from $655 million to $670 million on a non-GAAP basis. Other income is estimated to range from $10 million to $12 million for the year. And the effective tax rate for the remaining three quarters of the year is expected to range from 20% to 23%. Adding that to the actual tax for the quarter in Q1, would yield a full year tax rate on a GAAP basis of about 68% plus or minus. For Q2 of FY '18, we anticipate that total revenue will range from $295 million to $305 million. Within that, we estimate that licensing will range from $265 million to $275 million, while products and services is projected to be around $30 million. Q2 gross margin on a GAAP basis is estimated to be around 89%, and the non-GAAP gross margin is estimated to be around 90%. Operating expenses in Q2 are projected to range from $183 million to $187 million on a GAAP basis, and from $166 million to $170 million on a non-GAAP basis. Other income is projected to range from $2 million to $3 million for the quarter, and the effective tax rate for the quarter is estimated to range from 20% to 23%. Based on the combination of the factors that I just covered, we estimate that Q2 diluted earnings per share will range from $0.60 to $0.66 on a GAAP basis and from $0.74 to $0.80 on a non-GAAP basis. So with that, let me turn it over to Kevin.

Thank you, Lewis, and good afternoon, everyone. We are off to a strong start to 2018, as we continued to focus on growth by expanding our leadership in audio entertainment solutions and by bringing our new Dolby experiences to market. Our momentum with Dolby Vision and Dolby Atmos was once again on display at CES this year, as our partners highlighted Dolby experiences across the show. We're seeing widespread industry adoption of Dolby Vision and Dolby Atmos, and these experiences are moving to the mainstream. Let me start with Dolby Atmos. Both Sony and LG announced their new Dolby Atmos sound bars. And what's significant about these new sound bars is that they appeal to a larger consumer base with price point starting below $600. In addition, to being more affordable, Sony's new Dolby Atmos sound bar was awarded tech radars pick for best audio accessory at CES. The number of TVs with Dolby Atmos is also growing. Last year at CES, LD announced its first Dolby Atmos TV. And this became the first time the consumers to get a combined Dolby Vision and Dolby Atmos experience in one product. This year, LG announced that it would expand this experience to all of its 2018 OLED and super UHD TV's. At the same time, both TCL and Skyworth announced that they would be bringing Dolby Atmos to TVs this year. Let me turn to Dolby Vision. I'm excited that the first PCs with Dolby Vision have now been announced. They are part of Lenovo's new ThinkPad XOne line and XOne Carbon at the that's Dolby Vision was named best new PC buying gadget at CES. We also saw an expansion of the number of TVs that will incorporate Dolby Vision. We now have over 10 TV partners, all of whom announced their 2018 Dolby Vision TVs. Many are expanding Dolby Vision into the mainstream lines with price point starting as low as $500. We also saw further adoption in Blu-ray players with Sony and Panasonic announcing their first Dolby Vision players, joining LG, Phillips and OPPO. Just two years ago, we launched with the two TV partners and since then we've expanded Dolby Vision experience into smartphones, tablets, DMA's, set-top boxes and now PCs. Content is also a key part of building Dolby Atmos and Dolby Vision ecosystems. Apple and Netflix have been providing Dolby Vision content to IoS since the release of iPhone 10, iPhone 8, iPad Pro and Apple 4K TV, with Dolby Vision earlier in first quarter. More recently, Tencent began streaming Dolby Vision content to these devices. In addition, we've added a few new OTT partners to our roster. Rockit on one of the largest services in Europe announced it will support both Dolby Vision and Dolby Atmos content and OPPO, the largest provider of premium VOD content in Russia began delivering Dolby Atmos content just this quarter. Today, over 200 movies are available in Dolby Vision on iTunes compared to 100 last quarter, and Netflix has over 200 hours of original content in Dolby Vision. Major Hollywood studios, including Disney, Lionsgate, Paramount, Sony Pictures, Universal and Warner Brothers support Dolby Vision and Dolby Atmos content for the home. And we continue to expand beyond premium movie and TV content to gaming and live broadcast. In gaming, there are now six Dolby Atmos games available for Xbox, including assassin's Creed Origins, and Final Fantasy 15. Also this quarter, EAs Battlefield One was updated with support for Dolby Vision. While we continue to broaden the availability of the Dolby Atmos in live sports, our broadcast partners are expanding into new types of content. This quarter, Sky TV delivered the season finale of Sing in Dolby Atmos. In China, two Tier 1 TV stations broadcast the New Year's Gala in Dolby Atmos, including Hunan TV which is one of the most-watched channels in China. Most recently, Canal+ announced their first Dolby Atmos set-top box and content will be available in the next few weeks. Looking forward, Comcast had just announced that they'll be delivering the winter Olympics in Dolby Atmos. Now let's turn to Dolby Cinema. We added about 20 screens this quarter, bringing the total to 133 Dolby Cinemas open around the world with over 360 committed. When we talk to last quarter, Pathé in Europe had just opened its first screen. Today, they now have five screens open. I'm pleased with the speed of adoption this quarter and we are on track to open about as many screens this year as we did in fiscal 2017. The content pipeline for Dolby Cinema continues to grow with about 130 titles in Dolby Vision and Dolby Atmos released or announced with participation from every major studio. During calendar year 2017, all 10 of the top 10 highest grossing films in the U.S. were optimized for Dolby Cinema. We look forward to working with our partners to make best movie going experience more broadly available around the world. So to wrap up. We continue to see great momentum for our newest Dolby experiences across new use cases and in new geographies. Dolby Vision and Dolby Atmos are becoming available to the mainstream and Dolby Cinema continues to grow. 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] And the first question comes from Steven Frankel with Dougherty.

Very strong quarter and I wonder what you're thinking about the company's return to double-digit revenue growth given the strong licensing growth you saw in the quarter?

Well, look, we - that is our - continues to be our goal, returning to sustainable double-digit growth. The way we're doing that is we continue to be focused on expanding our leadership in audio solutions. We of course are very focused on bringing our new Dolby experiences to more people around the world. And yes, we had a good quarter and we are able to raise the outlook for the year. We saw some strength on audio side, which was good. And it's all another step in the right direction.

Dolby Voice, you talked a couple of quarters ago about focusing in on huddle room market. And I wonder, whether that’s had any impact on the ramp of that business? And if not, what are the next steps there?

Yes. So we are excited about the shift towards the huddle room market. And the reason you might remember is that, that is a high-growth market. People are investing more of their space in these types of rooms. They expect to have a cloud-based collaboration, and there is demand for a quality audio experience. We launched with BlueJeans during our first quarter. So while it's still early days, we are very pleased with the progress. And so we will continue to focus on that, and we think that's a good market for us. We think we're at a high-growth market. So we feel good about that.

And if I could speak one more quickly. [Indiscernible] any implications does the Tax Reform Act have on capital allocation; pace of buybacks, repatriation of cash, et cetera?

Well, I think, as you know, we had a program in place where we returned cash to shareholders through a combination of dividends and buybacks. Of course, as a result of these reforms, substantial amount of cash that is offshore will become available. My understanding from Luis is that there is a process to go through for that that probably won't actually become available for three to six months. So that will factor into our calculus going forward. We don't have any specific plans to announce around that.

Our next question comes from Ralph Schackart with William Blair.

Two questions, if I could. First on the new ATSC 3.0 standard, where I believe some of your technologies were referenced as it relates to HDR. Can you sort of give us some perspective in terms of what you think what that could do for the business going forward? And then, secondly, maybe along Steve’s question. Historically you talked about new products revenue being able to double year-over-year. Just curious is that still your current thinking for 2018? Thank you.

So to start off with ATSC 3.0. Well, you might remember our AC-4 audio technology was included earlier, the development as it relates to Dolby Vision is that they have included some of the foundational components within the specification which are important for the adoption of Dolby Vision. So the way to think of it is, is that it enables the right conditions to be in place for customers and would be customers of Dolby Vision to adopt it in the context of ATSC. And so that's great for us because, of course, our focus always is, we're working throughout the ecosystem, OEMs, streaming providers and really the whole ecosystem. So having what's required in ATSC 3.0 for them to be able to follow through on that and bring the Dolby Vision experience to consumers is a great development for us. As it relates to our new revenue initiatives, which you remember, what we include in that is consumer imaging, which includes both our patent licensing programs as well as Dolby Vision, Dolby Cinema, Dolby Voice. Yes, we do believe that we're focused on doubling revenue again this year from the combination of those programs.

If I can sneak one more in. On the royalty recover in Q1, just so I understand was that something that was contemplated within the 2018 guidance, just occurred faster in Q1, so the first question? Maybe a follow-up, the full year outlook was not raised as much as sort of the overachievement in the Q1. Was that just sort of related to the onetime nature of that royalty recovery or anything else you could add to that? Thanks.

Probably obvious, since I don't sound like Kevin. So it sounds like there is two halves to that question so let me address them both. First one is essentially yes. It was a recovery that we had modelled in for sometime this year, but not necessarily for Q1, so it's great to get that done in Q1. Two, on the question regarding the guidance. A lot of things go into a range when we come out beginning the year, but coming off of Q1 we do feel some strength in that audio licensing part of our business. Some of that also falls into mobile and that's not all related to recovery. And so it's based on all of that calculus that made us feel comfortable we could bump the guidance by 10.

Our next question comes from Michael Olson with Piper Jaffray.

I missed the very beginning of the call, so apologies if this was discussed. But it sounds like revenue upside in the quarter was largely driven by CE and mobile, and could you just talk about what specific devices or types of devices are driving upside particularly in CE? It sounds like sound bars was one area, was that the primary category?

Yes. I think CE, in general, Mike, we continue to see both sound bars and DMAs as our areas of strength, when you just talk about CE.

So that was reflected - it was also - as it relates to the future, one of the things we talked about was on display at CES is we continue to see a great uptake in Dolby Atmos for sound bars, and we're really focused on bringing those experiences to more price points and more consumers.

And then on mobile, you obviously had huge wins with Apple recently. Are you seeing that translate into interest from other device makers, as, I guess, Apple serves as a strong reference customer in the space or do you think it will just take some time to drive interest from others in the space on mobile?

Yes, I guess, I would start by observing that we've developed a really healthy Dolby Vision ecosystems And when you think back two years ago, when we were at CES announcing our first couple of TV partners, two today where we have over 10 partners, we have Apple devices, we announced our first PC, we have content coming from iTunes, from Netflix and increasing roster of partners. I think that, that is always going to be one of the questions this next stage of adoption. I mean obviously in the beginning you are going after people who want to -- who see the opportunity to bring these two markets first and we really believe. And as time goes on, ecosystem build, it begins to answer more questions that the others might have. And I think that it would be - I think it is clear that Apple was an exclamation point on that, and it flows through to content providers as well, because anybody whose thinking about investing and making Dolby Vision content available, in particular, if they are thinking about making available to mobile devices these answers another question someone's line. So I think that overall, I would start with we are really pleased with the health of the ecosystem and how it's expanding. And certainly, Apple is really important part of that.

Our next question comes from Paul Chung with JPMorgan.

So just a follow-up on the recovery in mobile, so is it fair to assume that for F 3Q '17, it was considerably understated and given the back payment in Q1. Just getting a sense that expectations for that big payment in F 3Q '18 or do you expect another big back payment in 1Q of '19? How does that work?

There are a couple of different. Paul, this is Lewis. There are couple of different elements to your question. Let me try to break that down. First, I would not say that for any of our recoveries, you could ever make any one assumption about where it's related to. We have a very broad business spread across a lot of different markets and industries. So I would very much say this was to put in more even worse, this was revenue that we should have gotten last year we got this year wouldn't think that way. At a high level, recoveries are part of our businesses. And in any given year, we tend to have a certain amount where we tend to see some movements in which market segment it lands in. Like, for example, this year I have been very clear that we expect recoveries more lower in broadcast segment and thus headwinds there. But that's still would not imply and that this is simply revenue last year we got this year. So we'll continue to address recoveries as they come in, but say that. Now in terms of on a recurring basis, typically when we have a recovery like this, then we would not say all in Q1 of next year, Paul, I would get this recovery again, I would not say that. But that's true for any of our recovery, I would not say that. So I hopefully I have answered both halves of your questions.

Yes, thanks for that. And then jump in AR is probably temporary relates that back pace you see that cash in F2Q queue?

Correct. I would say, in general, we tend to have a very strong, very clean balance sheet and while that is just timing of when things are important to us. This is when we get collected. And you look at previous quarters where this has happened, typically by the very next quarter we collected those amounts.

And then last question is on cinema. Can you give us a sense on unit economics now? You guys got to material amount of locations opened. Just trying to get a sense of revenue per screen, maybe operating margin per screen will be helpful? Thank you.

Yes. Paul, first of all, Dolby Cinema is making great progress. Kevin mentioned that we're now to 130 screens open this quarter. I think that's still well short of the 360 we have in our pipeline. So my net answer is, no it's still too early to give you unit economics right now, because only a subset of those 132 have been running for a full year. And I think we will need to get to a point where a larger critical mass will have run for full year before we get there. But we'll keep monitoring that and when the time is appropriate we will share that information with you.

[Operator Instructions] And our next call comes from Jim Goss with Barrington Research.

I was wondering if you have a sense that your success with Dolby Vision has spread some additional competition, competitive response or it's a creative more of a mode for you as like the only standard in the branded space?

Well, I would say that, I think that with Dolby Vision we are playing into and leading the way on one of the most important and impactful elements of the UHD experience. And I would say that same is true for Dolby Atmos as it relates to immersive audio. And so I think that what we've seen is that, over time that we've really built a very strong ecosystem and that's self-reinforcing, because it is all about the ecosystem. You will get the benefit of these experiences unless you have a breadth of content and service providers and ways to enjoy it. And so I think that what we're seeing is that clearly HDR is a very important aspect of the next generation experience. And we've been obviously investing in this ecosystem for a long time. So we have a robust ecosystem that meets the needs of broad range of partners and we continue to focus on extending that into ever more use cases. And as I said earlier, we are really excited to be able to show the first Dolby Vision PC from Lenovo.

And Kevin, with LGs interest in spreading throughout their HDR product line. Does that -- are they viewing that as a very strong competitive element that probably will be merited by others?

Well, I think that our partnership with LG, the foundation of that partnership is a shared passion for providing the very best visual experience. And there is, of course, a lot of element that go into providing that, and we are very proud to be part of it with the Dolby Vision experience. And so we're always looking to add value for our partners. And of course, that's why they are working with us.

With separate issue, with the taxes, the tax changes, will there be any impact on your operating strategy in terms of physical locations in which you are operating? How does that seem to impact at your operations?

Yes. At the current time, there is nothing that I would say has changed. It would take sometime of course to work the new tax law changes through the system. As part of that, we will look at things like tax strategies. But I think it's fair to say that we like so many companies would say this new tax law has been in place for barely a month. It's too early to know whether or not we would have any significant changes. So we will keep you posted on that if anything changes.

And one last thing, product margin pressure in the first quarter doesn't seem to be repeated in the guidance going forward. What was the issue in the first quarter and why will it would be different?

So one of the things I highlighted in my prepared comments was that we did miss our target this quarter in product revenue. And when that happens, of course, we have to be prudent about how much we build and how much volume we run. And that typical is a kind of thing that that we’ll first go through the gross margin. We've held our guidance for the year to hopefully make up some of that difference as we go along. But we will keep monitoring that. But as you know, Jim, product margin has a relatively minor impact on companies overall margin. And certainly the products we are looking to sell all seem like they are great new products that are exciting it's the matter of how good they ramp up. But we will obviously pay attention to that going forward.

Thank you. And at this time we have no further questions. I would like to turn the conference back to Kevin Yeaman for any closing remarks.

Great. Well, again thank you, everybody for joining us today, and we look forward to keeping you updated. Thank you.

Thank you. This does conclude today's presentation. We thank you for your participation.