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Dolby Faces Akamai Syndrome


A mix of very high expectations against an increasingly difficult operating environment should have investors red flagging Dolby


Many moons ago Akamai's (AKAM) stock got shelled as it dared to simply "meet" Street expectations. The company had in no way "missed" guidance or estimates, but after a seemingly endless string of "beating and raising", the sell-side viewed its management as a "guidance sandbagger". When AKAM did not sandbag it, the market took no prisoners. Last week a very similar dynamic ended up costing Apple (AAPL) a quick $20.

Friday I Buzzed about taking a new short position in Dolby Systems (DLB), the holder of the homonymous sound technology found in virtually all audio gadgets. There were two triggers for that move: the significant slowdown in consumer electronic spending seen by Cypress Semi (CY) and confirmed by AAPL's relatively weak iPod sales, and the following sentence from Morgan Stanley's downgrade of DLB's stock on January 22:

"We believe [current estimates] reflect buy side expectations that DLB will continue to beat consensus estimates and raise guidance during fiscal year '08, as the company did for fiscal 4Q '06 through fiscal 4Q '07." (Emphasis added.)

The Morgan's analyst lays out in excruciating details (and I mean excruciating) virtually all aspects of, and the extent to which, DLB's business could be impacted by a macro/consumer slowdown; so there's a very firm quantitative reason to be pessimistic about DLB's stock. But in my humble opinion, nothing makes a better argument for shorting the stock than the above quote, for hell knows no wrath like the scorn of a disappointed momentum investor.

Let me also add to the red flags the following:

  • The stock traded for a multiple in the mid 30's against long term growth expectations of 19%.
  • There is growing competition from a slew of companies, including heavyweights RealNetworks (RNWK) and Microsoft (MSFT).
  • Certain patents on Dolby Digital begin to expire this year (although I can't quantify a financial risk tied to that).
  • The company lacks patents for the China and India markets.

It all adds up to a mix of very high expectations against an increasingly difficult operating environment.

As it is always the case of course, this short position carries its share of dangers, not least of which is that DLB has earned its reputation for "beating and raising" through a long series of such reports; and, as you can see from the screens below, the "surprise" factor was often rather large and followed by hefty stock moves.

Click to enlarge

Click to enlarge

Bottom line, I am going into the January 31 earnings release fully aware that DLB may well add another quarter to its long string of positive surprises, and I have sized my position for such a risk. But I am also convinced that tailwinds from the last several years of relentless consumer spending are now blowing squarely in DLB's face and the stock does not seem priced for any kind of slowdown.

P.S.: Current fiscal 1Q '08 estimates are for revenue of $134 mln, net income of $37.40 mln, and EPS of $0.34.

Current fiscal year '08 estimates are for revenue of 587 mln net income of $165.3 mln and EPS of $1.39.


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Positions in AKAM, DLB, CY, MSFT
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