Ladies and gentlemen, thank you for standing by. Welcome to the Dolby Laboratories conference call discussing fiscal third quarter results. (Operator Instructions) As a reminder, this call is being recorded, Thursday, July 29, 2021.

I would now like to turn the conference call over to Jason Dea, Senior Director of Finance and Investor Relations for Dolby Laboratories. Please go ahead, Jason..

Good afternoon. Welcome to Dolby Laboratories Third Quarter 2021 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, including our fourth quarter, second half and fiscal 2021 outlook and our assumptions underlying that outlook. These statements are subject to risks and uncertainties that may cause actual results to differ materially from the statements made today.

In particular, the extent of the continued impact of COVID-19 on our business remains uncertain at this time.

A discussion of these and additional risks and uncertainties can be found in the earnings press release that we issued today under the section captioned Forward-Looking Statements as well as in the Risk Factors section of our most recent quarterly 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 today's call, Kevin will start with a discussion of the business.

And Lewis will follow with a recap of Dolby's financial results and provide our fourth quarter, second half and fiscal 2021 outlook. So with that introduction behind us, I will now turn the call over to Kevin.

Kevin?.

The Fast Saga that were both available in Dolby Cinema. We continue to see moviegoers seeking to enjoy these movies in the best way possible with box office skewing more towards Dolby Cinema and premium experiences compared to pre-pandemic levels.

And we are now bringing Dolby expertise and innovations that create the best way to enjoy content to a much broader range of experiences and real-time interactions through Dolby.io. We are very excited to have welcomed Marie Huwe to the Dolby team this quarter to lead our Dolby.io efforts.

Marie brings strong leadership experience and a track record of leading engagement with developer communities, including most recently at DocuSign, where she established the company's first-class developer experience.

During our first year with Dolby.io in market, our focus has been on building our engagement with the developer community, learning from these interactions and continually evolving our offerings to best meet the needs of developers. Since launch, we have seen strong demand for higher-quality, real-time experiences.

We have now begun to roll out a significant update that will enable larger scale interactions with more participants. We have positive feedback from current customers who are now live with this release, and we are actively engaging a significant pipeline of potential customers that these increased capabilities can directly address.

We see engagement across a variety of use cases, including podcasting, remote collaboration tools, virtual meetings and online education. We are excited by the many ways developers are engaging with our APIs, and we are just at the beginning of what Dolby.io can enable in creating higher-quality, everyday audiovisual experiences.

So to wrap up, Dolby is available to a much larger audience across a wider range of content today than ever before. As we build upon our presence in movie and TV content with more Dolby experiences in music, gaming and live events, we increase the reasons for deeper adoption of Dolby across devices.

And with Dolby.io, we are building the momentum to bring the Dolby magic to a wide range of use cases and experiences. All of this gives us confidence in our ability to drive revenue and earnings growth into the future. And with that, I'd like to hand it over to Lewis to take us through the financials..

And as Kevin said in his opening comments, we did have another solid quarter. So let me go through the Q3 numbers, and then I'll walk you through the outlook for Q4. So starting off with revenue.

Revenue in the third quarter was $287 million, which was at the higher end of our guidance range and included a true-up of about $14 million for Q2 shipments reported that were above the original estimates, and that item is not uncommon.

On a year-over-year basis, third quarter revenue was about $40 million above last year's Q3 as we benefited from higher market TAMs, along with greater adoption of our Dolby technologies.

And then on a sequential basis, revenue was down from Q2, mainly due to timing of revenues from contracts and from patent licensing programs, and both of these topics were anticipated when we gave guidance. So Q3 revenue was comprised of $272 million in licensing and $15 million in products and services.

So let's discuss the trends in licensing revenue by end market, starting with broadcast. Broadcast represented about 46% of total licensing in the third quarter. Broadcast revenues increased by about 40% year-over-year, and that was driven by higher market volume, higher recoveries and higher adoption of our Dolby technologies.

And then on a sequential basis, broadcast increased by about 18%, and that was due mostly to higher recoveries. In the mobile space, mobile represented about 18% of total licensing in Q3. Mobile declined by about 36% year-over-year, mainly due to lower recoveries, and that was offset partially by higher market volume.

And then on a sequential basis, mobile was down by about 24%, due mostly to timing of revenue under contracts, and we did anticipate that. Consumer electronics represented about 14% of total licensing in Q3.

And on a year-over-year basis, CE licensing increased by about 86%, driven by higher market volume, higher adoption of Dolby and higher recoveries. On a sequential basis, CE went down by about 22%, and that was due mainly to timing of revenue under contracts. PC. PC represented about 9% of total licensing in the third quarter.

PC was higher than last year by about 6%, due to higher market volume, along with increased adoption of Dolby Vision and Dolby Atmos, offset partially by lower recoveries.

And sequentially, PC was down by about 51%, due mostly to timing of revenue, and that lines up with some of the comments I made last quarter about its increase that quarter because of timing. Other markets represented about 13% of total licensing in the third quarter.

They were up about 42% year-over-year, and that was driven by higher revenue from Dolby Cinema, via admin fees and gaming. And on a sequential basis, other markets increased by about 4% due mostly to Dolby Cinema and to gaming.

So if I go beyond licensing, our products and services revenue was about $15.2 million in Q3 compared to $16 million in Q2 and $11.8 million in last year of Q3. The year-over-year increase reflects just modestly higher demand in the cinema industry. So now I'd like to discuss Q3 margins and our operating expenses.

Total gross margin in the third quarter was 89% on a GAAP basis and 89.7% on a non-GAAP basis.

Products and services gross margin on a GAAP basis was minus $3.9 million in Q3 compared to minus $345,000 in the second quarter, and products and services gross margin on a non-GAAP basis was minus $2.6 million in Q3 compared to a positive $1.1 million in the second quarter.

Both GAAP and non-GAAP product gross margins were lower than what I had guided, and that was due to write-downs we took during the third quarter for conferencing hardware.

Operating expenses in the third quarter on a GAAP basis were $199.1 million compared to $204 million in Q2, and our operating expenses in the third quarter on a non-GAAP basis were $173.6 million compared to $178.4 million in the second quarter.

Now operating expenses were below guidance in Q3, and that was mainly due to some of our marketing programs that shifted in timing from Q3 into Q4. And you will see that sort of mirrored back and reflected in our Q4 expense guidance, where the delta from Q3 to Q4 will be driven mostly by our marketing programs.

And then our operating income in the third quarter was $56.1 million on a GAAP basis or 19.6% of revenue compared to $34.1 million or 13.8% of revenue in Q3 of last year. Operating income in the third quarter on a non-GAAP basis was $83.6 million or 29.1% of revenue compared to $60.5 million or 24.5% of revenue in Q3 of last year.

Income tax in Q3 was 7.7% on a GAAP basis and 13.7% on a non-GAAP basis. So net income. Net income on a GAAP basis in the third quarter was $54.6 million or $0.52 per diluted share compared to $67.3 million or $0.66 per diluted share in last year's Q3.

Now I'd like to point out as a reminder, last year's Q3 net income, and that's both GAAP and non-GAAP, included $36 million of discrete tax benefits, which does affect the year-over-year comparisons.

So our net income on a non-GAAP basis in the third quarter was $74.8 million or $0.71 per diluted share compared to $87.5 million or $0.86 per diluted share in Q3 of last year. And again, that benefits -- the last year number benefits from that onetime tax credit.

For both GAAP and non-GAAP, net income in the third quarter was above guidance due to revenue landing at the higher end of our range and expenses coming in below the range. During the third quarter, we generated $172 million in cash from operations compared to $134 million generated in last year's third quarter.

We ended the third quarter with about $1.3 billion in cash and investments. During the third quarter, we bought back about 400,000 shares of our common stock and ended the quarter with about $37 million of stock repurchase authorization available.

Today, we announced that the Board of Directors has approved an additional $350 million of stock repurchase authorization. So if I combine that new approval with the remaining balance that was at the end of June, means that as of today, we have $387 million of stock repurchase authorization available going forward.

We also announced today a cash dividend of $0.22 per share. The dividend will be payable on August 19, 2021, to shareholders of record on August 11, 2021. So now let's discuss the forward outlook. Last quarter, when I discussed guidance for Q3, I laid out a scenario that said our second half revenue could range from $560 million to $600 million.

Now with Q3 under our belt and having landed in the range, we are updating the second half revenue range to $570 million to $600 million, in other words, bumping up the lower end by $10 million, which means we are anticipating Q4 revenue to range from $280 million to $310 million.

Within that, licensing could range from $265 million to $290 million, while products and services could range from $15 million to $20 million.

With respect to market conditions and industry analyst reports that look out over the horizon, there's still a fair amount of uncertainty out there, and so we are maintaining similar assumptions as what we talked about last quarter, namely that PC TAMs in the second half could be higher on a year-over-year basis, while TAMs for TVs and other consumer devices could be down in the second half.

We also continue to anticipate that we'll see organic growth on a year-over-year basis from broader adoption of Dolby technologies across various markets.

And we also anticipate some higher revenue from Dolby Cinema as that industry looks to improve, which we have seen some signs of in recent times, and Kevin made a couple of comments about that with some of the titles that came out. So let me move on to the rest of the P&L outlook for Q4.

Q4 gross margin on a GAAP basis is estimated to range from 88% to 89%, and the non-GAAP gross margin... (Technical Difficulty) Q4 gross margin on a GAAP basis is estimated to range from 88% to 89%, and the non-GAAP gross margin is estimated to range from 89% to 90%.

Within that, products and services gross margin is estimated to range from about breakeven to $1 million on a GAAP basis and from about $1 million to $2 million on a non-GAAP basis.

Operating expenses in Q4 on a GAAP basis are estimated to range from $216 million to $226 million, and operating expenses in Q4 on a non-GAAP basis are estimated to range from $190 million to $200 million.

As I mentioned earlier, the increase from Q3 to Q4 would be driven primarily by specific marketing programs, some of which shifted in timing from Q3 into Q4. But in total, Q3 plus Q4 marketing is expected to land at a similar amount as we were thinking last quarter.

And to repeat a comment I made last quarter, marketing expenses for the full year FY '21 would be similar to what they were last year or maybe a bit lower depending on how Q4 turns out. So let's finish up the Q4 guidance.

Other income is projected to range from $1 million to $2 million for the fourth quarter, and our effective tax rate for Q4 is projected to range from 19% to 20% on both a GAAP and non-GAAP basis.

Based on a combination of the factors I just covered, we estimate that Q4 diluted earnings per share could range from $0.25 to $0.40 on a GAAP basis and from $0.47 to $0.62 on a non-GAAP basis. And now that we've provided guidance for Q4, here's a full year outlook that would correspond to that.

FY '21 revenue is anticipated to range from $1.28 billion to $1.31 billion, with gross margin ranging from 89% to 90% on a GAAP basis and 90% to 91% on a non-GAAP basis. Total operating expenses for the year are estimated to range from $810 million to $820 million on a GAAP basis and from $710 million to $720 million on a non-GAAP basis.

And full year diluted earnings per share are estimated to range from $2.79 to $2.94 on a GAAP basis and from $3.57 to $3.72 on a non-GAAP basis. So with that, let me move on to Q&A and turn it over to the operator. So operator, hopefully, my phone is working okay now. Can you queue up the first question? Thank you..

[Operator Instructions] Your first question comes from Ralph Schackart with William Blair..

First question is on io. Kevin, in the prepared remarks, you talked about a significant update. I think you said more specifically, it allows larger interactions with more participants.

Just curious, was this sort of a limitation of the io offering and does this sort of widen the aperture for new customers? Just trying to gauge how significant this update is..

Well, it significantly increases the number of participants we can support in audio/video events, and so we launched with our APIs about a year ago. We started out with a number of features that improve capture qualities. We have, of course, Dolby Voice embedded in the service.

And yes, we began engaging with customers who had greater needs for more participants. And so the significance of this release is that it's going to enable us to engage with more developers for larger events and more usage. So we're excited to bring this to life..

Great.

I guess now that you have the new release and then you've had, I guess, another quarter or two with partnerships such as Box, can you maybe just sort of help us understand the monetization opportunities? And I know it's tough to put a number on the market opportunity, but any sort of methods or methodologies you sort of help us think about how to gauge this opportunity, I think, would be helpful..

Well, starting at the very highest level, Ralph, there's hundreds of billions of audio/video interactions going on every month, and there's hundreds of billions of minutes of media content in the cloud.

And we strongly believe at Dolby that people want to have the best quality experiences, and that's what we're seeing from the developers that are engaging with us today. So we're confident that there's a very large addressable market.

And so today, what we're focused on is continuing to evolve the platform based on what we're hearing and bringing on more developers and getting more usage. We've seen some really great use cases developing. And so the monetization model, as you know, is a usage basis, and that's -- we're seeing that now.

So it's all about getting more adoption and more usage..

Great. Last one, and I'll turn it over.

Just curious if there's any updates on the CFO search?.

Well, we are in the process. I'm confident that there's a lot of great candidates out there. We also have a great team here at Dolby. So we're progressing, and we'll keep you updated..

The next question is from Steven Frankel with Collier Securities..

So a follow-up on the last question on io.

Can you maybe give us an update on what kind of changes Marie [Technical Difficulty] that you have in new leadership in that group?.

Yes. So thanks, Steve, you were cutting out quite a bit, not quite as silent as Lewis went on me, but I think I got the gist of your question. Just to confirm, you're asking about new -- Marie joining and kind of what the focus is.

Is that the essence of the question?.

Yes, what [Technical Difficulty].

Yes. So well, look, I think first and foremost, she's diving right into the road map we have. Like I said, this was a big release for us, which obviously was in the works even as Marie joined.

And she's working with the team to look at the road map for our platform, to look at areas that we can accelerate, those that we think will create the most engagement with developers and increased usage. She also has spent decades involved in businesses that are centered around developer communities.

So you can expect to see us engaging in stepping up our efforts to market this to developers, engage with developers and build that community..

Okay. And congratulations on the progress of live events in Atmos and Vision.

Are there any on this [Technical difficulty] that need to be updated before this really scales out rather than a one-off of the Olympics [Technical Difficulty] place?.

I'm sorry, Steve, you're really cutting in and out, but I gathered that the question is centered around live broadcast of the Olympics. And I think your question was about kind of what work has to be done in the future to accelerate that. Is that kind of -- keep that moving? Is that the -- I was getting the -- more parts, but not all of them.

Now you've cut out altogether?.

Yes.

How do you make this a more commonplace?.

How do we make it more commonplace, I think that's what you just said, right?.

Right..

Right. Okay. Good. Well, look, first of all, of course, we're thrilled that Comcast is making the Olympics available in both Vision and Atmos, and as we've been working with Comcast for some time. Look, each event like this is a step towards making it more commonplace.

It's a matter of making sure that the supporting cast that is supporting these live events some of them are obviously doing it for the first time. They're getting the right equipment and software in place. So each time that we go through an event like this, that's another step toward getting more events. So we're excited about that.

We're excited about the other events we talked about in Dolby Atmos, and it's a big focus for our organization. So yes, there's definitely a certain amount of work that goes along with people doing it for the first time, but high-profile events like this are a really big step forward.

And of course, you get people who will move from this event to other events, and so you'll get people who are familiar -- who aren't doing it for the first time..

The next question is from James Goss with Barrington Research..

I'd like to start with Dolby Music. You've talked about a lot of devices and services, where there's availability and people can sample this.

Now I'm wondering if you could synthesize it into, first, like what is required then for individuals to be able to take advantage of the service? And what do you think would be a currently enabled TAM, if you will, in taking advantage of music? And are there unit sales beyond the existing sales of AV receivers, sound bars, PCs that would be a benefit from the music development?.

Sure. Yes. Thanks for the question. Well, anybody who is a subscriber of one of our service partners that has a Dolby Atmos device that supports that service is able to get the benefit of the Dolby Atmos experience. And of course, I've been through the names, but since you brought it up, we're very excited to have Apple Music.

We've added Naver Vibe, which -- in South Korea. So you’ll notice we've had a regional focus as well with companies like Hungama and Anghami. So the number of people that can support the service is growing -- that can receive the service is growing significantly.

The significance, Jim, is that in the mobile phone and PC space, I mean you've seen us continue to garner wins at the high end that start with the movies and TV value proposition, it's being bolstered by our progress in mobile gaming.

Music has very broad appeal, and we think it really expands the addressable market of mobile devices and PCs that are going to see value in supporting Dolby Atmos.

In terms of new categories, which is where you, I think, ended your question, I would point to the automotive space because automotive is an experience where artists, service providers, everybody is really focused on that as a really important experience in the realm of music.

And so we think that this really gives us an opportunity to make some headway in the automotive space..

And in that regard, are you developing relationships at the OEM level in the way SiriusXM would to try to get in the new systems and cars? Is that part of it?.

Yes, that's right. So you saw that we last quarter announced that Lucid Air would be bringing the Dolby Atmos music experience to life, and we are engaged across the industry looking to bring Dolby Atmos to more cars..

Okay. And one other thing. In cinema, obviously, you're in the middle of all of the windows issues and that sort of thing with Dolby Cinema. And today, there is a lawsuit with Scarlett Johansson trying to look at Disney to maybe pull back a little bit on the day and date and maybe help a business like yours and IMAX with the theatrical window.

I wonder if you might comment on any reaction you have. It's a relatively expanding event, but perhaps you have some thoughts..

I don't think so. I mean, honestly, I had not seen that news, but our belief is that for these blockbuster movies that are the ones that show in Dolby Cinema that people are going to want to see them in the big screen experience.

And that what we've seen is that as we begin to see box office return, we have seen the percentage of box office trending toward premium experiences in Dolby Cinema specifically commanding more of the box office than it was pre-pandemic. And I believe that stands reasoning.

I think as people come back to the cinema, they want to have the best experience possible..

The next question is from Paul Chung with JPMorgan..

So your free cash flow has been very strong this year driven mostly by strong net income. So I don't really see any real kind of working cap benefits this year. So your free cash flow margin is kind of hitting levels last seen in 2011.

Is this the new normal moving forward? Is this the baseline of free cash flow at $400 million plus kind of moving forward?.

You want me take that one, Kevin?.

Yes, please..

I guess the first wonder was whether my phone is working. I guess you're always very focused on the free cash flow. So a couple of comments I would make is, one, you see now that our cash flow generation is now running fairly consistent with the business operations. Obviously, there's ebb and flow to working capital quarter-to-quarter.

But you'll also notice that this year, our operating margins are very strong, and part of that is because our gross margins have ticked up a little bit, and the gross margin improvement is because the mix of our revenue has been stronger than maybe what we would have anticipated at the beginning of the year.

So I think that all ties together in the sense that we do believe that as a business, we will continue to generate a high degree of cash flow relative...

[Technical Difficulty] Can you guys still hear me? Yes, no?.

Okay.

We can hear you now, Lewis?.

Okay, good. The funny thing about this, Paul, is believe it not, I'm on a landline. So I'm not sure why it's cutting in and out because I'm looking at my phone and it says it's connected. So we'll have to -- I don't know that I'll ever be able to figure it out.

Anyway, I'll wrap up by saying that the strong cash flow that you see is very heavily linked to our operating performance. Obviously, the timing from quarter-to-quarter does depend on when we collect those receivables.

And also the fact that this year, you see that our gross margins have ticked up and our operating margins are stronger than they've been historically. So I think that all ties together. I think it's a very good story right now..

And your OpEx levels are kind of in this 55% range of sales. Is that the right level to kind of think about -- I mean it's ranged anywhere between the mid-50s to 60s. So....

Yes. A couple of comments on that. One is that we, like so many companies, we are seeing some expenses that are lower because of pandemic, the most obvious thing being travel. And I don't think you should expect that to remain so low forever and [Technical Difficulties] other companies progress forward.

I'm not sure if -- are you hearing me okay on this phone call right now?.

Yes..

Paul, okay, good. The second thing I'd like to point out to is just as a side note that FY '22, every 6 years or so, we have a 53-week year like many companies do, and we'll have a 53rd week next year. So that will be a little onetime blip next year in expenses.

And so I think the OpEx to revenue range that you see right now is probably at the lower point of what we would normally run. But Kevin and I have talked quite a bit about the fact that we've always committed to keeping operating margins at or above that sort of 31% level.

And now this year, with the improvement in gross margin, we see that ticking up a little bit. So probably some of that will come back a little bit, Paul, in terms of the OpEx ratio, not all of it. And think about it as just being this a little bit of a bounce back from COVID.

But also, next year, we'll have that extra week, which also then in the following year, that will go away. So a lot of things to think about. I know we're not ready to give FY '22 guidance yet, but your question kind of almost goes beyond Q4. So I thought it'd be worth getting you thinking about that..

Great. And then Kevin, on Vision, where are you on adoption rates in TVs today? Update there would be nice.

And kind of what's your penetration rate kind of trending in PCs and smartphones? Do you see opportunities in auto? And then separately, Atmos in auto, given kind of the longer sales cycle, would adoption really take time for Atmos to take off in car speakers?.

Yes.

So well, I guess, at the highest level, I would start by saying that with the wins we've garnered throughout this year around music, around gaming, around services like Bilibili, more recently, live sport, we feel really good about the sales proposition we have to continue to bring the Dolby experience to more devices across all of the areas that you just went through.

We have continued to increase the penetration on TVs with Dolby Vision and with Dolby Atmos. You've heard me today and throughout the quarters talk about a number of wins in PC and mobile, and automotive is an area where we expect to make progress.

And I mean, of course, there's a lead time to implementation that lead time has come down from what it might have been 3 to 5 years ago. And especially, in the pure-play electric vehicle players, that can be much faster. And even with the traditional car manufacturers, you can get time frames that are within a year or so, I think, from when.

I mean, obviously, mileage varies, but a lot of what we're going to be doing is through the software. So it will vary, but we're out there engaged. We think it's a really compelling experience, and we'll keep you updated as we go..

And then last housekeeping question.

What was the segment in which the back payment came in from Q2 would be helpful?.

The back payment that came in Q2.

Can you give me a little more color on that question?.

I thought you recognized the back payment in Q3 from Q2 shipments.

Is that not the case?.

Oh, I'm sorry. Yes, you talked about the true-up. We don't break out the true-up by category generally, although I would say that our strongest segment -- market segment, if you will, is broadcast, and broadcast did benefit from that true-up. Yes. So sort of TV, the TVs and set-top boxes would have benefited significantly from that true-up..

[Operator Instructions] There are no additional questions waiting at this time. I will now pass the conference back to Kevin Yeaman for closing remarks..

Well, thank you, everybody, for joining, and we look forward to keeping you updated on our progress. Thank you..

That concludes the conference call. Enjoy the rest of your day..