Dolby Laboratories Inc (DLB) 2006 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Dolby Laboratories conference call discussing the fiscal third quarter 2006 results. During the presentation, all lines 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 Wednesday, August 2, 2006.

I would now like to turn the conference over to Kevin Yeaman, Chief Financial Officer for Dolby Laboratories. Please go ahead, sir.

Thank you. Good afternoon everyone. Welcome to Dolby Laboratories third-quarter fiscal 2006 earnings conference call. Joining me today is Bill Jasper, our President and CEO; In addition, Tim Partridge, General Manager of the Professional Division; Ramzi Haidamus, General Manager of the Consumer Division; and Martin Jaffe, Executive Vice President of Business Affairs are here to participate in today's Q&A.

On this conference call, we will be making forward-looking statements that include projections of future operating results for our fiscal year ending September 29, 2006; expectations for revenue growth in our fiscal year ending September 28, 2007; market trends for the industries in which we compete and our expectations concerning how those trends will affect our operating results; our ability to expand our presence in existing markets and to penetrate new markets; the impact of inclusion of our technologies in certain HD and DVD technology standards; DVD player sales and sales of our professional broadcast products; our expectations regarding the success of our Digital Cinema initiatives; the capabilities and market acceptance of our products and technologies; and our strategic and operational plans. Important factors could cause actual results to differ materially from those in the forward-looking statements. These factors are detailed under the section captioned risk factors in our annual report on Form 10-K and our most recent quarterly report on Form 10-Q available at www.SEC.gov. Dolby disclaims any obligation to update information contained in these forward-looking statements whether as a result of new information, future events or otherwise.

In this call we may describe certain pro forma financial measures which should be considered in addition to and not in lieu of comparable actual financial measures. Please refer to our earnings release for the third quarter of fiscal 2006 results on our website at www.dolby.com under the Investor Relations section for the most directly comparable actual financial measure and related reconciliation.

As for the structure of this call, Bill will begin with an overview of the quarter and I will follow with a rundown of Dolby's financial results. With that, I will turn the call over to Bill.

Thank you, Kevin. Good afternoon everyone. This quarter we made excellent strides in our professional and consumer divisions as we progressed toward our long-term objective of being an essential element in the best entertainment technologies used by professionals and consumers.

In our professional division, we made significant progress working with exhibitors, broadcasters and artists through our Digital Cinema, broadcast and live sound initiatives. To date, more than 50 digital movies have been screened on more than 160 Dolby Digital Cinema systems deployed worldwide. We continue to work closely with exhibitors and studios to provide innovative technologies that enhance the movie going experience and support the transition to Digital Cinema.

On Monday, we announced our plans to develop a high-quality and practical Dolby Digital Cinema 3-D system. With Hollywood's renewed interest in 3-D, this will enable exhibitors to provide audiences with stunning 3-D images from a flexible system that comes with Dolby's trusted reliability and easy integration while further differentiating the Dolby Digital Cinema system.

In addition, we have been very pleased with our ongoing trials with various exhibitors of our JPEG 2000 Digital Cinema system. We have also introduced new tools for theater operators. The Dolby Show Library is an additional component of the Dolby Digital Cinema suite of products that enables exhibitors to move digital content from screen to screen within a networked multiplex. And the second generation Dolby media adapter connects Digital Cinema and alternative content sources to their existing cinema sound systems more cost effectively.

We made similar strides in professional broadcasting as we introduced several new products at NAB that enabled broadcasters and content producers to create and manage their Dolby bit streams more effectively.

In the live sound market, we launched the new Dolby Lake Processor to be used at live concerts for advanced control of complex speaker systems. Eighth Day Sound, one of the largest sound reinforcement companies in the U.S., recently purchased 40 units to enhance the sound on the major concert tours it is supporting this summer.

Turning to our consumer division, we continue to position ourselves to benefit from growth in the many markets into which we license. Technology progress in HD broadcast, flat panel displays, bandwidth and next-generation DVD is complementing consumer appetite for a more immersive entertainment experience and greater portability. We are focused on these trends and through Dolby's industry relationships, technology portfolio and global brand; we are diversifying into newer markets and delivering premium technologies that further enhance the consumer entertainment experience.

In our consumer electronics market, we continue to demonstrate our technologies and work with manufacturers as they release their next-generation DVD players. In both the United States and Japan, we demonstrated Dolby true HD technology for next-generation DVD formats which provides Dolby an opportunity to a deliver richer surround sound experience matching the quality of the high-definition picture and offering consumers a more immersive entertainment experience.

In concert with this effort, our professional division introduced the Dolby Media Producer which will enable the encoding of movie titles in Dolby Digital plus and True HD by studios and content creators. Some studios are beginning to release movie titles in HD DVD and Blu-Ray formats. Recently Warner Studios released 10 titles in HD DVD, four of which were encoded in Dolby True HD. We are seeing initial shipments of Toshiba's HD DVD player and Samsung's Blu-Ray player and with our technologies and data standards in both formats, we are positioned to benefit from growth when it occurs.

In the PC market, we are beginning to see some new media centric PCs by certain manufacturers that include next-generation DVD playback capabilities and enhanced Dolby technologies. While media centric PCs are still a very small part of the overall PC market, we are seeing initial offerings by manufacturers. For instance, Sony recently introduced its Vaio AR Series of notebooks and RC Series of desktop PCs both aimed at entertainment and containing Blu-Ray technology.

Toshiba is shipping a Qosmio notebook PC with HD DVD playback and Dolby Home Theater technology which includes Dolby Prologic 2, Dolby Headphone and Dolby Virtual Speaker technologies. Its keyboard even has a Dolby button. In addition, several new PC products were announced featuring Dolby Digital Live technology including motherboards for AMD processors from Foxconn and Universal ABIT, an Acer notebook PC and the Scirocco wireless audio bridge which is the first wireless PC solution with Dolby Digital Live.

In the broadcast market, demand for digital television has been growing with the increasing supply of HD content, declining prices of flat panel displays and the approaching FCC mandated switchover to digital television. The recent FIFA World Cup was a strong catalyst for many stations particularly in Europe to prepare for HD broadcast. In Europe, 96 stations are broadcasting on Dolby Digital 5.1 and over 20 stations showed the World Cup in Dolby Digital 511.

In Asia, the China central TV HD channel broadcast the World Cup in Dolby Digital 5.1 and HD. HDTV prices continue to decline with the average selling price of the 32 inch LCD display declining 24% in the first 18 weeks of the year according to third-party research. Many HDTVs shipped with the ATSC tuner which includes our mandated Dolby Digital decoder so we benefit as they become more affordable to consumers. Furthermore, the FCC has mandated that as of March of 2007, any television that contains a tuner must contain the ATSC tuner. As a result, Dolby should be included in a growing percentage of digital televisions.

In the gaming market, our technologies are included in all major existing platforms including the Xbox 360 and over 600 titles. Like all of you, we are anticipating the release of Sony's PS 3 in November and expect our technologies to be included in the PS 3 platform's Blu-Ray drive.

In the automotive market, we benefit from the addition of rear seat entertainment from our Prologic 2 technology. Last month, Land Rover demonstrated its 2007 LR2 model automobile which offers Dolby Prologic 2 technology as does the recently released Aston Martin VH Vantage.

In summary, there are many new market opportunities and with our strong industry relationships, rich technology portfolio and global brand, we are well -- (technical difficulty) --

-- production services revenue. One customer accounted for 10% of our third-quarter revenue.

In the technology licensing segment, revenue was approximately $69 million an increase of 14% year-over-year driven primarily by strength in our PC and consumer broadcasting markets. The CE portion of our licensing business returned to the levels we expected following the second quarter's exceptional performance from strong holiday sellthrough. We saw a general sequential decline for all consumer electronics in the CE portion of our business but continue to expect CE revenue to be flat to slightly up for the full fiscal year on strong first half demand. CE composed just over 50% of our consumer division's revenue in fiscal 2005 and as we stated coming into this year, we see it making up less than 50% in fiscal 2006 as we diversify our revenue stream and the standard DVD market matures.

In our PC market, year-over-year growth was robust on strong laptop and desktop shipments by brand-name OEMs and was roughly flat sequentially. In our other markets, we saw strong growth from broadcast as a result of the continuing shift towards HD broadcast related products and modest year-over-year growth from gaming although down sequentially.

In the product and services segment, revenue for the third quarter was up 30% year-over-year on increased cinema product orders from several customers in anticipation of an announced price increase and strong demand by broadcasters in preparation for their HD programming.

Turning to the details of the P&L for the quarter, licensing gross margin was 91% which was flat sequentially. Products gross margin was 46% which was negatively impacted by approximately $1 million due to a few unrelated issues including a write-down of our Cinema inventory, the market value of certain early Digital Cinema installations related to the Disney rollout that were in inventory, and impact of meeting the lead-free deadline in Europe.

Services gross margins was 52%, down 8 points sequentially as we had lower third-quarter revenue from what is often a slow quarter for motion picture services in the United States and increased costs associated with the depreciation of some of our cinema services equipment.

SG&A expense was slightly down sequentially in dollars but was 41% of revenue, up 4 points sequentially as a result of lower third-quarter revenue. R&D expense was 10% of revenue for the third quarter, up 2 points sequentially due to lower revenue and increased spending of $700,000.

Dolby's effective tax rate for the quarter was 38%. Net income for the quarter was $19.1 million or $0.17 per diluted share compared to $14.8 million or $0.13 per diluted share for the third quarter of fiscal 2005. Per share calculations are based on 112 million diluted shares in the third quarter of fiscal 2006. Net income also includes stock-based compensation charges of $4.7 million for the third quarter of 2006 compared to $3.2 million for the third quarter a year ago.

Turning to the balance sheet, Dolby finished the quarter with approximately $470 million in cash, cash equivalents and marketable securities. In the third quarter, we diversified a portion of cash into a portfolio of municipal and government agency securities having an average duration of significantly less than a year and with a policy of no instrument having a maturity greater than three years. From operations, we added $16.5 million in cash during the third quarter and capital expenditures were $1.8 million.

Before I cover the guidance section of my presentation, an aspect of our business model that we want to continue to stress is the lack of a predictable quarterly pattern in our results. Our revenues are lumpy, different quarters are higher in different years. Secondly, we licensed our technologies to consumer electronics manufacturers and software developers who use them in products. Our licensees are required to report to us between 30 and 60 days after the end of the quarter in which they ship their products. Since the licensing royalties comprise roughly three-quarters of our revenue, our overall revenue can fluctuate quarter-to-quarter as a result of the timing of our receipt of those royalty reports.

In addition, it is not uncommon for royalty reports to include corrective or retroactive royalties that cover extended periods of time. This could cause our results to vary from forecasts.

As of June 30, 2006 we estimate that there is approximately $10 million due from two existing licensees relating to new products that have been shipped by these licensees over the past nine quarters. We do not expect to recognize revenue with respect to these shipments until certain contractual matters have been resolved. We cannot estimate when this will occur. To be clear, this royalty amount is not included in our guidance.

Turning to guidance coming into the third quarter, we were cognizant of the effect from a particularly strong holiday season for our licensees in the first half of the year and therefore expected single digit year-over-year revenue growth in the second half of the year. As anticipated, third quarter revenue growth slowed significantly from the second quarter but still registered 18% year-over-year growth. In light of this, we now expect revenues to be in the range of 370 and $375 million for fiscal 2006.

Additionally, we expect fiscal year net income to be in the range of $74 million and $77 million. We expect diluted earnings per share to be in the range of $0.66 to $0.69. While under FAS 123(R) stock-based compensation expense may vary based on factors such as stock price or volatility. We continue to expect stock-based compensation expense for the full year to be between 19 and $21 million.

Coming into the year, we expect fiscal 2006 revenue growth of single digits. While we are pleased with our stronger than expected performance to date and our growth opportunities going forward, we are still working through our 2007 numbers. In addition to growth factors, we will be considering the anticipated slow adoption of next-generation DVD given the competing formats and high initial price points. Also we are conscious of the fact that in the PC market, OEMs and ISVs are under pricing pressure which may cause them to evaluate whether or not to bundle DVD playback software into base models. This could have some effect on the growth rate from our PC market.

We will offer formal fiscal 2007 guidance next quarter but believe that on a preliminary basis that it is appropriate to expect mid to high single digit revenue growth which is similar to what we had expected coming into fiscal 2006.

With that, I would like to turn the call over to the operator for the Q&A portion of our call.

(OPERATOR INSTRUCTIONS). Ralph Schackart, William Blair.

Two questions for you. First and foremost can you sort of talk about your Chinese enforcement activities and the progress that you are making there? And additionally too as you sort of looked out over the horizon into fiscal '07, did you factor in the consumer into that type of guidance? Were you taking a conservative stance there and can you sort of give us an update on any implications of the slowdown with consumers affecting on the business?

This is Marty. I will take the compliance side of this and then I will pass off the consumer side to the next. Compliance program continues to remain a very top high priority for us. And over the last several quarters, we have augmented our compliance team and as we move forward, we will continue to increase our intention efforts and resources in that area. And this includes moving our more licensed -- more account managers to China and other parts of the world to be closer to our licensees and the IC manufacturers. We will continue to improve on our tracking of technologies by focusing on the information rights under our license agreements and by better analyzing the information that is available to us and increasing our enforcement activities.

So that is including everything from licensing audits to being tough with known offenders to working with local authorities and other parties to identify under licensing manufacturers -- unlicensed manufacturers. So as I said, it is a high priority. We will continue to work on this and we will take some time and continue to improve over time. I think with that, I'll turn it over to Kevin.

In terms of the second part of your question, Ralph, so again we are pretty pleased with year-to-date where we have come in growthwise for '06. But as we said, we think it's appropriate to model it mid to single high digits going into '07. Part of that is the factors we referred to and part of that is yes, we are aware of general reports about or speculation about what might happen with consumer spending. We are really in the stage of working through the '07 numbers at this juncture. So other than the few factors I highlighted in the script, I don't think we have a lot else to say in that regard.

Okay. Just to clarify. Is that mid single high digits for the consolidated business or one specific revenue line item such as licensing?

That is for the consolidated business.

Steve Lidberg, Pacific Crest Securities.

With regards to I guess the outlook for the September quarter or the yearly guidance provided, it would seem to imply an uptick in expenses and I was curious as to kind of what was the driver behind that?

I don't know if I would point to any one thing. I think that we do as we do going into most quarters have some additional headcount built in there. This is also the final quarter in our run-up to 404 compliance so there are normal fees that are associated with that. Other than that, I wouldn't point to any other factors that stand out.

And then on the royalty I guess the $10 million outstanding royalties, you highlighted there were some issues that needed to be addressed. I guess are those on your side or the customer or a combination of both and what are the prospects for them?

I don't want to get into the details of the issues. It is something that we are mutually working through. While we can't predict which quarter it will come in, I guess I can point out that since it is two licensees, it may come in in two chunks over two different quarters or it may come in all at once during one quarter. While we're not in a position to predict which quarter, we do think that we can resolve it sometime by the end of the first half of 2007.

Was there any reason to spell out these two licensees versus kind of your ongoing normal activity in royalty enforcement?

Well just that I think you've all asked on occasion what a normal portion is for us and what we have always said is that it is a routine part of our business. But if there is anything that we think is large enough that we think you need to understand, that we will point it out and this falls in that category. So we're just giving you a heads-up that we see this on the horizon.

Steven Frankel, Canaccord Adams.

You mentioned a total of 96 stations in Europe that are broadcasting in 5.1. Could you to scale that for me in terms of what the reasonable opportunity is in the next couple of years? Are you one-third of the way through that penetration? Just give us some hints there.

Steve, are you talking about at the broadcaster level or at the consumer level?

No at the broadcaster level.

I will maybe let Tim add a little bit to this, but in Europe the 96 stations we have all the premier channels there. You have to remember that the broadcasting equipment is not a huge percentage of our total product sales which is only 25% in total. So it is not a huge factor but we have already made great penetration there but we do know that there are additional premium channels coming on board. We continue to get some all the time but we have had great penetration already. I think that is without going into actual total number of stations, some will never go 5.1, but we think that we have got a very, very good percentage of the premium channels that are there but there is still some room for growth. Tim?

In terms of the overall opportunities, Steven, while we're doing really well in Europe with all those channels the opportunity remains beyond Europe as well. So we're working hard within Asia and in other countries that have not yet adopted HD in the same way that Europe and the U.S. is beginning to.

And then a Digital Cinema question. You announced this 3-D initiative. Is this complementary to real 3-D or competitive to what was used for Chicken Little?

This would be a competitive system, Steve, and we have seen that 3-D has attracted a lot of interest in the industry both in Hollywood and the exhibition community. We have seen that the consumers are willing to pay more to go see movies in 3-D so there is clearly a demand there. As you know, the theater showing Chicken Little and recently Monster House outgrossed the 2-D theaters by some say 3 to 1. So at the same time exhibitors are looking for a way to offer something new and to generate additional revenue streams and we always saw 3-D as a great opportunity for that. If you'll remember we've always said that we felt that Digital Cinema was a great opportunity for Dolby to provide new technologies going forward to the exhibition community and we felt 3-D was one of those.

In terms of the opportunity, obviously we have got a large footprint on the audio side, a very large market share for digital surround sound and now we can come to exhibitors as they are transitioning to Digital Cinema and offer them yet another innovation that could potentially generate additional revenue. And in terms of the system itself, you know we have looked long and hard at all the drawbacks of the offerings of the last few decades as well as current ones and while the current ones offer great quality, there are a couple of drawbacks and we hope to offer a system that will be more flexible and affordable than the alternatives.

The big difference, Steve, being that we don't require a silver screen for our system whereas systems out there to date do and we found that the exhibition community does not like having to change their screens out.

Ben Swinburne, Morgan Stanley.

First up, I wanted to go back to the PC business and just to make sure I heard you, Kevin, you said PC was flat sequentially?

That's correct.

Just curious because the global PC sales I think were down about 12% in the March quarter from December. The implication being that the growth in revenue per PC or the growth in Dolby technology per PC is increasing. I'm just trying to sort of connect the dots with your then expectations going forward on PC that you might get some kind of pushback on additional technologies. It seems like things are going very well in that segment. Maybe I'm missing something. If you could add a little more color there that would be helpful.

On the dots you are trying to connect, I'll make one comment and then I may pass it over to Ramzi for some color on the PC market. But there is probably not a direct correlation between the PC sales numbers as we are getting paid at the time the OEM or the ISV makes the sale. So there might not always be a direct correlation. So that might be part of the issue there. But I'll -- and it is on a quarter lag as Bill points out. A.

That was the March quarter versus December?

But in terms of color on what is going on in that market, I would turn it over to Ramzi.

We feel pretty good about the PC market. One trend in the PC market of course is to add additional multimedia experiences and to add a lot of the PC entertainment elements that we have seen and we have introduced ourselves into the marketplace. And to balance that, we also have seen a trend towards more customization on the side of the customer meaning should somebody log online and try to purchase a system they do have now the opportunity to either take out or leave in a DVD entertainment system which could affect the revenue to us.

We also have seen another trend in the operating system choice of operating system companies releasing several SKUs some of which do not include entertainment technologies which also could affect our revenue to the extent that those operating systems might be geared towards the corporate environment. So on balance, we are optimistic, however, we do see some choice in the long-term that some corporate entities might leave out entertainment experience out of the choices.

That's very helpful. So I guess looking forward, your mid to high single digit growth -- I realize it is a consolidated number -- but it sounds like you're baking in maybe some kind of decrease in the percentage of PCs sold with DVD software players going into next year? Is that accurate?

Yes. As I said, of course it's preliminary so this is early thinking but in our mid to high single digits we are factoring in that all of these factors that Ramzi has mentioned could net out in a lower growth rate in PC than what we have been experiencing of late.

I should also add that as part of this experience when a customer does try to either leave out or leave in the technologies, we do look at this as an upside or an opportunity for us to add our attached premium technologies. So again, we see an opportunity to sell our premium technology as opposed to our standardized technologies.

Great. And if I could ask just one last follow-up on the product sales. You had your best year-on-year growth in this quarter in years I know there was some early buying from anticipation of price increase. Can you give us any kind of quantification of what the growth rate might have been if you had X-ed that out so we get sort of a normalized view of that segment?

I don't know that we have any scientific way of knowing how many of the orders were associated with the price increase. Part of the growth was also due to broadcasts which is a continuation of broadcasters gearing up for HD programming and the World Cup as Bill points out.

We know, Ben, that a couple of customers who have come into the end of their fiscal year were doing that prebuy before the price announcement so it remains to be seen how long that will affect us going forward.

Daniel Ernst, Hudson Square.

Thanks for taking my call. Two questions, just looking again at the prior question and your exceptional growth rate on the professional product side. Maybe it would be helpful if you could give us some breakout between broadcast, theater, production services or production products for Hollywood and then maybe talk about what the [lake] concert -- your audio contribution was relative that made it not be a contribution last year.

And then second on the consumer side, you know you talked about the deceleration on the DVD. Can you give us an update about where DVD as a percentage of the consumer lies and what that year-on-year or sequential growth in DVD was? Thanks.

We don't break the products and services out. Our Q has products and services in there in total and we haven't gotten down to the granularity of breaking out basically the three elements of the product sales which are regular, traditional film, digital film, and broadcast. And then of course services is a fourth element of that. I will let Kevin address the others.

I would just say as we said in our script, there was good growth in both cinema, products, the traditional audio cinema products as well as broadcast. It was a good quarter for both.

I would just say that the largest growth was definitely the broadcast sector but of course that is also possibly the smallest dollar volume. So it didn't have an enormous -- as big an impact as the growth we had in cinema which was slightly less but still very strong but of course that is our major product line. As far as the lake products, that is something that we have been waiting to get out there into the market. This is the first product we have launched since that acquisition and it is performing very well in the marketplace with the concept guys.

Just to drill down a little bit further, is the broadcast side a material portion at least of the product side -- maybe the smallest but the weakest material?

Well, the largest are the cinema products and I think the next largest after that would be the broadcast.

And then the second question was on the consumer side where DPVD was as a percentage of consumer?

Yes, so traditional DVD players as opposed to PC playback or DVDs in automobiles makes up much of our consumer electronics market that we break out and as we said, it was just over 50% in 2005. But we continue to have good growth in the other markets so we do see that making up less than half of our licensing business (technical difficulty) mix. So we continue to see that. We've also said that while we expected it to be flat to slightly down coming into the year, we now see it flat to slightly up and that was really on a strong holiday season. So it came back down to where we expected this quarter.

In terms of what we are seeing in terms of DVD or next-generation DVD, I would turn that over to Ramzi.

We do see several dynamics happening in the DVD market. On the traditional DVD side obviously, we all realize that the traditional DVD video red laser is reaching maturity however to balance that, we are looking forward to both formats, the Blu-Ray and the Hi-Def taking over the market. Now had there not -- what is interesting here is that if you take a look at the broadcast side which is exposing a lot of consumers to high-definition experiences, that is acting as a sort of a pull into the Hi-Def DVD world. If we didn't have high-definition broadcast experiences, the uptake of Hi-Def DVD might be slower but the exposure to high-definition broadcast could act as a catalyst to accelerate either the Blu-Ray or the HD. To balance that clearly two competing formats do not help the marketplace. As you know, we are in both formats and we look forward to see how that market pans out.

(OPERATOR INSTRUCTIONS). Sam Doctor, JPMorgan.

This is Sam Doctor on behalf of Paul Koster. A couple of questions for you. First of all, can you give us a hint of the catch-up royalties in the current quarter and how do they compare in terms of magnitude relative to the $10 million that you were talking about earlier?

Yes, so we don't break out catch-up royalties in any given quarter. It's a normal part of our business. To the extent that there is anything that is significant enough that we think it is important to understand the trends historically or going forward, then we will point it out. And that is why we did point out that we see $10 million of royalties accumulated that we are looking to try to resolve sometime by the end of the first half of 2007. That was what that was about. Other than that, we don't break it out.

Could give us a bit of an update on the Digital Cinema and what kind of risk do you see for ASPs, to the extent that there is an unbundling of hardware and software and there is pressure for open standards, what does that do to your ASPs? And does (indiscernible) open you up at some point to competition from somebody like a Yamaha or Dennon or somebody like that? You know, where you are going away from on the traditional film side, a three horse race whether it is you, [GDS or DTS] and could Digital Cinema be opening yourselves up to a lot of other potential competition?

Yes Sam. This is Tim. The competitive landscape in Digital Cinema is already quite different to that which we have experienced before in traditional cinema. Right now I think at the last count at the trade show there was something between 10 and 15 different people competing in this market for the product that we are currently building. And very few of those people have ever been in the cinema industry before so that there are many and varied competitors in there right now. Obviously that is leading to pressure on pricing but the market is still very nascent. As you know there are a few hundred screens out there, very few people actually deploying those screens and lots of decisions to be made right now.

And hopefully you may have seen one announcement referring to us in the last quarter which was a cinema chain in Belgium called Kinepolis, and they are moving forward with Technicolor who are one of the major deployment agencies and they announce that they intend to deploy Dolby Digital Cinema systems. So we are still in very early stages and yes there is price pressure but we believe we have designed the right system for the market and we believe with our brand name and the reputation for reliability and service, that we will be able to be successful in the marketplace.

And we think we have designed a product which builds upon our 30 plus years of experience in the film industry. We think we have got a very good working relationship both with the studios and the exhibitors. We think we have a decent understanding, an excellent understanding if you will, of what is needed in order to make Digital Cinema a success and we think that in the long run that is going to pay off.

So you aren't seeing a lot of pressure in terms of unbundling of hardware and going with off-the-shelf Dell or HP servers and then buying the software separately? Are you seeing that as a competitive threat?

Absolutely. That is what many people in the industry felt would happen as Digital Cinema was first being discussed a number of years ago and indeed we looked to see if we could do that obviously to save costs and take advantage of larger businesses by taking an off-the-shelf computer. But when we seriously looked at those pieces of equipment, we just didn't feel that they met the needs of the marketplace in terms of reliability to perform day in/day out in a projection room in Beijing as well as Mumbai, as well as Hollywood. That is a very harsh environment and we didn't think the off-the-shelf equipment would be able to be reliable in that environment.

And then there is the issue of content security. We didn't think the off-the-shelf equipment would provide the kind of security of the content that the studios are looking for in Digital Cinema. And finally, there is the issue of ease-of-use. As we know these cinemas are being operated by not particularly technical people, the film industry's projectionists have a lot on their plate in terms of running the whole cinema so the Digital Cinema system has to be very easy to operate and typically off-the-shelf computers or broadcast servers are not designed for that kind of user.

So that is what led us to believe we needed to design something specifically for the industry both in terms of reliability, security and ease-of-use. And while some people may indeed try to deploy the off-the-shelf computers that you talk about, we just don't think that they will meet the needs of the industry.

Murray Arenson, Ferris, Baker Watts.

First I just wanted to clarify, make sure I got you right. The $10 million is not included in the '07 guidance in the preliminary '07 guidance?

That is correct.

Even though you do expect, you do believe you will be able to clean it up by the first half or by the halfway through the year roughly?

We do. But since we don't know when it might get cleaned up between now and then, we haven't included it in either our '06 guidance or our preliminary '07 outlook.

Okay. Great. HD DVD and Blu-Ray, I have been hearing a little bit recently about you looking at some of the licensing strategies. Are you involved in that? Is that something we need to be looking at?

Dolby at this point is not involved in that.

And lastly just on a housekeeping note. Can you tell us how to be looking at taxes going into fourth quarter or next year?

Our effective rate for the third quarter was 38%. That is probably about the appropriate rate for '06. And we haven't really given any guidance for '07 yet.

Great. Thank you.

Scott Kessler, Standard & Poor's Equity.

I am relatively new to your story so please indulge me. Consumer electronics market has been relatively soft. PC segment, it has been in decline. The video game area has been plagued by an upcoming major transition to new consuls and the box office with a few exceptions, it really hasn't generated a lot of new excitement. Now I know you guys have been talking about this in response to questions but I guess what I'm trying to get at is notwithstanding all the things I just said, you guys generated 18% revenue growth in the quarter which is well above analyst expectations. So I am wondering if you guys could kind of point to maybe the one or two or three contributors to that upside? Thanks.

Well first of all, the 18% year-over-year growth is coming off what was a pretty rough Q3 for us last year. But second, I guess secondly, I would point to for the reasons we have discussed we had good growth in products both due to in the cinema side and due to people preparing for broadcast. In the PC segment while it is flat sequentially, we do have very good year-over-year growth in that segment. CE has been flat to slightly up. Gaming has been a good year as well. We did have a strong holiday season and the release of the Xbox.

So those are some of the things that have contributed to the strong year-to-date over year-over-date date growth. I don't know if you have anything to add on some of those comments, Ramzi?

We are fairly diversified across most of the market. While you might see some higher level trends as you might point out, I would say that we have a fairly significant diversification strategy. We're not only diverse in our own market but we're fairly diversified within most of the active geographies in this field which I think is leading to some positive contribution in most of these markets. As Kevin said, our PC market has been very solid. We have been fairly pleased with in the CE market even with the Hi-Def stories that we have been hearing. And with the uptick of broadcast and this March 2007 deadline coming up for folks to switch over their manufacturing habits, we are really looking forward to a strong broadcast market.

I think you have to remember, as Kevin pointed out, that our third quarter last year was almost the lowest of the year, the third and fourth quarters last year were our two lowest quarters. And even though we are up sequentially over the June last year we are also down from the March '06 quarter by around 10%. So it is not that 18% you can't just apply to the whole big picture and say hey everything is fantastic.

I think we reiterate that lumpiness point that we made that no one quarter is as high as any one year so it is hard to predict.

The big picture level, Scott, I would also add that in any environment but particularly in the environment that you just described, people have got to compete really hard and therefore to do so they are offering premium technologies that provide premium experiences. So on the product side, we are seeing high-definition broadcasting take off. Their competitor is DVD and DVD looked great so therefore they have got to provide an experience that competes with a DVD experience which is great pictures, i.e., high-definition and of course Surround Sound. And in the cinema despite or maybe even because of the environment that you describe, they have got to provide a premium experience and that means today 5.1 Surround Sound and therefore Dolby Digital has become a standard for any new cinema opening.

That's great. Thanks a lot.

[Mark Anderson], [Axial Capital].

I was wondering if you could comment on any traction you are getting in the smart phone market given that your technology has been embedded in PCs and other different devices? I wonder if you could comment on your ability to embed it in the smart phones?

Our first play in these types of phones whether they be smart phones or just the multimedia phones have been as you know our AAC technology which is licensed through our via licensing subsidiary. We have had several design wins in AAC being the codec of playback choice whether it be some of the Nokia phones or other similar type phones.

Clearly moving forward, Dolby sees this market as a strategic one as an important one. We see opportunities for technologies such as Dolby headphone where you can see some form of surround experience even just with a pair of headphones. We are considering of course increasing our efforts in this marketplace on the Dolby side but so far it has been mostly the AAC design wins that we are trying to leverage into different areas.

Are those just design wins that have yet to be implemented in the broader market or are they actually out there in the marketplace now?

They are in the market right now and they are increasing with each new generation of these smart phones being introduced.

That does conclude today's question-and-answer session. I'd like to turn the conference back over to Bill Jasper for any additional or closing remarks.

Thank you for much. Well we appreciate everybody attending today's conference. We've had we think a reasonable year-to-date. We anticipate talking to you in three months time to report on our full-year results and at that point in time as Kevin pointed out, we will be giving you guidance for 2007. Thank you for participating and take care.

Ladies and gentlemen, that does conclude today's conference. We thank you for participating. Have a great day.