What's Wrong With This Top Stock?


Dolby Labs (NYS: DLB) is a longtime Fool favorite. A three-time recommendation of our flagship Stock Advisor newsletter dating all the way back to 2006, the audio technology expert runs an extremely profitable licensing business model. The company is protected by a wide moat of patented technologies and household-name branding. The stock has provided market-beating returns over the last five years, despite a 41% year-to-date decline leading into last night's earnings report.

And today, Dolby is trading down by another 18%. What's going on here?

What's so darn scary?
By the numbers, Dolby did better than all right: Sales fell 5% year-over-year to $219 million but Wall Street had expected a steeper 6.4% swoon. Earnings held steady at $0.55 per share, slightly above Wall Street's $0.54 target. The year-ago quarter was boosted by a one-time change in revenue recognition practices, and Dolby has lowered prices on its range of 3-D and digital cinema products.

In other news, the share buyback program was running out of cash and was redoubled with an additional $250 million authorization. That's a shareholder-friendly move that often bumps stock prices even before the buybacks begin. Furthermore, management raised its full-year earnings guidance to overlap with analyst estimates.

And if that was the whole story, Dolby might have been all right. But it isn't the whole story.

On the analyst call, CEO Kevin Yeaman noted that Microsoft (NAS: MSFT) currently doesn't include Dolby Digital technologies in its working versions of the upcoming Windows 8 system. What seemed like an offhand comment got the attention of analysts and, subsequently, share sellers.

Calm down, everybody
Yeaman explained that the revenue going into PC systems should shift from billing Microsoft directly to a mix of system builders, DVD-playing software makers, and other third parties. But the market is taking the news as if Dolby will lose that market altogether. And it's an important cash cow: PC-related revenue in 2011 is about $240 million or around a quarter of Dolby's total sales.

About $80 million of that annual revenue comes from the market portion where Microsoft would show up, leaving about 8% of total revenues up for discussion. If Dolby is successful in shifting the majority of that onto Dell (NAS: DELL) , Hewlett-Packard (NYS: HPQ) , and Lenovo, then this becomes a tempest in a teapot.

If not, well, an 18% drop seems overdone anyhow, particularly since Windows 8 won't be a meaningful market player until 2013. Management has plenty of time to figure out a strategy here. Microsoft won't kill Dolby, though chief Dolby rival DTS (NAS: DTSI) might gain a window of opportunity to steal some market share.

These ghosts aren't real
Besides, tablet computers and smartphones are eating into the traditional PC market. How likely are you to buy a full-blown PC the next time you're looking for a home-entertainment hub? Chances are, not very. And Dolby is busy opening markets among the mobile device makers as well, not to mention its established strength in set-top consumer electronics.

And if you're worried that the future will be so darn digital that Dolby won't matter anymore, you should know that important online-media players including both Apple (NAS: AAPL) and Netflix (NAS: NFLX) have adopted Dolby standards for their delivery of digital entertainment.

What now?
I think that this panic is downright silly, and that Dolby shares have never looked more attractive. The company is expertly positioned in the ever-changing entertainment industry, and what Dolby might lose on the PC will come back to tablets and digital media hubs.

To take advantage of this mispricing, I just added a long-term "outperform" rating on Dolby in our CAPS system, where I expect it to boost my all-star ranking for years to come. If you're not quite ready for that kind of commitment, you should have a gander at this short video where our finest Foolish analysts compiled a laundry list of reasons why Dolby should double or even triple in the near future. By pushing down harder on the stock, Mr. Market just loaded Dolby's spring for an even stronger bounce. Watch the video now -- it's totally free, so you've got nothing to lose -- and maybe then you'd want to come back to follow my lead in CAPS.

At the time thisarticle was published Fool contributorAnders Bylundowns shares of Netflix but holds no other position in any of the companies discussed here. The Motley Fool owns shares of Microsoft and Apple.Motley Fool newsletter serviceshave recommended buying shares of Dolby Laboratories, Microsoft, Apple, and Netflix.Motley Fool newsletter serviceshave recommended creating a covered collar position in Microsoft, as well as a bull call spread position in Apple and buying puts in Netflix. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. You can check outAnders' holdings and a concise bio, follow him onTwitterorGoogle+, or peruseour Foolish disclosure policy.

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