Thursday, August 9, 2012

Absolute Value: LNKD vs DLB


On Friday, August 3rd, the shares of Dolby Labs and LinkedIn Corp each moved roughly 15%.  Unfortunately for Dolby, the respective price movements were in opposite directions.  And DLB shares were the ones taking a hit.  That's what a “disappointing” earnings report and negative revisions gets you! 

 At that same time, LNKD shares were basking in the continued glow of rapid revenue growth causing CEO Jeff Weiner to say that his company is “not like other social networks.”  One possible translation is that LNKD is more professional than social.  Another translation?  LNKD shares go up. Take that, Facebook (FB).   

Indeed, if Mr. Market is correct, LinkedIn will enjoy a very bright and future.  It is a growth story after all... and I'm told that those tend to have happy endings.  This is in stark contrast to Dolby, a company that has committed the cardinal sin of slow to no growth. 

Despite these divergent perceptions, DLB and LNKD have a few similarities.  Both are tech companies, based in California (oddly enough), with dual share structures that grant insiders super-voting powers.  They don’t sell physical products, but rather sell access to intellectual property.  And currently, quarterly revenue for both companies is over $200 million a quarter.  So coincidentally, DLB and LNKD should each post some $900 million of 2012 revenue.

These similarities came to mind as I read Friday's earnings reports and came to the exact opposite conclusion(s) as the crowd.

What struck me first?  Despite similar current sales levels, LinkedIn is valued at $11 billion in the market, while Dolby’s valuation is just $3.5 billion.  In a world of relative measures, I sometimes wonder if people look at these absolute measures.  The disparity is enormous.  Such is the power of perception and high growth expectations.  And these are notions that LinkedIn works hard to cultivate in their earnings release.  Who can blame the company for pointing out 89% growth in quarterly revenue compared to the same quarter a year ago?  It is remarkable.

LinkedIn loves these relative measures for good reason.  It tells a story of success.  The first absolute number mentioned in the recent earnings release is 175 million - the number of LinkedIn members.  It is another monster number and management is rightly proud of it.  But all these numbers seem a bit small when measured against an $11 billion market value. 

And how about a few other rather important numbers?  LinkedIn earned $2.8 million for the quarter and $7.8 million for the last reported 6 months.  Compared to the numbers above, these look woefully inadequate.  It is hard to turn members into revenue.  It is harder still to turn $1 of sales into a profit. Perhaps this is why the company doesn’t put the same emphasis on absolute profit numbers as it does on relative measures like revenue growth?

It takes a bit of calculation to see that shares outstanding are also up approximately 10% year over year.  That’s a pretty big hole your friends on LinkedIn have cut in your pocket!  You gotta love stock options.  Not surprising, this is a growth rate that the company doesn’t highlight.   Indeed, with dilution like that, it doesn’t take long for EPS growth to go negative despite robust revenue growth. 

So the next time you hear about a growth company, it might help to find out WHAT is growing and if the growth is accruing to shareholders or taking away from them.  Revenue growth is great, but it is not necessary or sufficient to create shareholder value.  So this brings us to Dolby.

Dolby is a company that is far from perfect.  Chief among these is the issue of governance.  You really must read the proxy if only for its comedic value.  The lengths controlling shareholders will go in order to nickel and dime their corporate offspring is staggering.  Make no mistake, this is Ray Dolby’s company and he does what he wants with it.  The company rents from him (from offices to condos).  Employees park in his parking lots.  There are the expected salaries, fees, and perks (office space and laboratory access).  But my favorite: The family can use the corporate screening rooms up to 10 times a year for personal use.  

If I ever become a billionaire, please remind me to build my own screening room to avoid embarrassing disclosures like this!  

Either way, as proxies go, Dolby’s is very fun to read.  But you can’t help being bit depressed when doing so, especially if you are an outside shareholder.  It really is Pyrrhic victory for controlling shareholders, but they never seem to learn.  Sooner or later, the market takes note.  And Mr. Market has certainly marked down DLB shares.  Governance has got to be an aggravating part of that equation. Dolby would control DLB with or without his dual shares and "related transactions", but in exercising this extra bit of control, he's cost himself and other shareholders dearly. 

Nonetheless, for all its warts, the company is still wildly profitable… and undervalued.  This is in stark contrast to its much cooler and faster growing Golden State neighbor.  LinkedIn has similar warts but without a bargain basement price to compensate for the risks.

In a “disappointing” quarter (according to the headlines), Dolby (the company) made over $60 million in the most recent quarter.  Free cash flow generation averages $80-$100 million a quarter.  The cash flows quarter after quarter after quarter.   It’s enough to make my cold, dead, capitalist heart jump for joy. The result: $1.3 billion in cash and investments on the corporate balance sheet. 

By comparison LinkedIn has $600 million or so in cash.  Not bad, but there is that issue of price again.  Neither company has any debt to speak of.  They don’t need it.  Dolby is awash in free cash flow of $300+ million a year and, well, LinkedIn can just issue stock.

Dolby and LinkedIn provide a stark illustration that absolute numbers matter little in the current investing environment. Looking at the numbers in their totality, few people would assign a value of $11 billion to a company that barely makes a profit.  Only when the name “LinkedIn” is added do people lose their collective minds.  Similarly, remove the name “Dolby” from the top of DLB financial statements and the price of $3.5 billion seems absurdly low. 

At the current growth rate(s), one has to wonder when LinkedIn will reach $1.3 billion in cash and $300+ million in annual free cash flow?  Will it ever? 

It seems that insiders at both companies are clearly aware of the difference between perception and reality.

Thanks to stock repurchases, Dolby’s shares outstanding are 5% lower than they were a year ago and 7% over the last 2 years.  Nice to see that Dolby isn’t content to turn itself into a glorified savings account just yet.  They have grudgingly put some of this cash to work.  All that cash is a first-class problem that LNKD and plenty of others would love to have.

Ironically, LinkedIn insiders seem perfectly content to sell shares in sizable quantities. So perhaps LNKD is not so different from the other social networks after all.   


Disclosure: Long DLB, Short LNKD.

7 comments:

  1. I like your analysis of the stark differences between the two, and it was nice to see a refresher of DLB after I had studied them last year.

    One question I seemed to keep coming to with DLB is how sustainable is their business model and where do the profits come from? They create music & auditory technologies and license them to all sorts of different customers, and they say their business doesn't rely on any one patent, but I'd argue there's very little disclosure as to whether they're "widening the moat" or the moat is narrowing every year. Their earning power could very well dry up next year if their profitable patents go away. But they may not- maybe they've been very busy the past 5 years and have all sorts of new profitable patents that they can license the next 20 years. I'm not sure. And I don't think anyone can be certain of it, except the insiders unless they decide to share.

    Either way, I was just frustrated by the lack of disclosure over their patents & technologies so I passed on the stock.

    I agree with you, they're cheap based on their numbers, but those numbers seemed suspect to me just because I couldn't verify the longevity to their business model.

    I'd be curious to hear what you think of that?

    And I agree 100% of shorting LNKD.

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    1. As I illustrate above, I don't like the company's governance in any way. DLB is not my largest holding, but I think it is worth a small position at this price.

      You raise an excellent point. We don't know. When will the cash machine shut off? Not that long ago people started saying that it would be soon as evidenced by MSFT's decision to exclude DLB from Windows 8... well, so much for that.

      Honestly, the world is not short of people (anonymous and otherwise) saying that DLB is dying. I can only point to the free cash flow and the balance sheet.

      I keep thinking of how many ways I can die with a smile on my face. If DLB is dying then it is doing so with a giant smile on its face.

      So I can't prove it to you one way or the other. The question is: when do the patents lose their potency?

      The market is obviously making an assumption in that regard. The translation (via the stock price) - Fairly soon.

      I simply don't agree with the market's timeline. And the underlying assumptions don't have to change much in order for me to do well. That (to me) is the essence of value investing.

      There is something "wrong" with everything we buy. The issue is magnitude and I think the market has overdone this one. Thanks to folks like Mr. Anonymous below.

      Hope this helps.

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  2. Nice post, comparing two companies, as you do, is a refreshing way to look at things

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    1. Investing is all about comparisons, so I'm not sure how others do it, but there doesn't seem to be any other way that makes sense to me. If I have $1000 to invest do I want Company A or Company B. Obviously this is a simplified case, but the process is the same.

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  3. Why do u feel. that a company in decline at 10x free cash flow is such a bargain?

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    1. Wow, this is more of a commentary than a question. And I love Anonymous posts! So let me answer by saying that I disagree with your premise and your obvious conclusion.

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  4. Hi - I love your blog, and I wish you posted more.

    Just a comment on DLB. In this case, I don't think looking at the historical financials is instructive. 55% of gross profit comes from optical-drive, which is in secular decline. In the most recent quarter, PC revenue was down 10% and CE revenue was down 19%.

    The company hopes to replace optical-drive revenue with streaming/mobile revenue. Unfortunately, the company's moat in this area is not nearly as strong as optical-drives, where DLB technologies was absolutely mandatory based on industry standards. In streaming, there is no standard. You can see the difference in moat between the royalties that Dolby has earned. In optical, it's been $1-1.50 per device. In mobile/streaming, Dolby is luck if it can get $0.25 per device.

    Stepping back, why are you trying to jump over this 10-foot fence? IMHO, Loews is a 2-foot fence.

    Post more often. :-)

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