Friday, May 4, 2012

Dolby: Half time post-mortem

I bought a stake in Dolby (DLB) a year ago at ~$50. That was before Dolby revealed its Dolby Digital Plus technology was not included in the initial Windows 8 builds. When that news was eventually announced in Aug 2011, DLB free fell to around $29. Since then, it has crawled back some of the lost and was close at $37.63 yesterday.

After market close, DLB announced its 2nd quarter result with this paragraph in the press release:
"Microsoft(R) will incorporate Dolby Digital Plus in all versions of its Windows(R) 8 operating system for PCs and tablets for online and file-based content, and leading providers of cloud-encoding solutions, such as Microsoft's Azure,, Zencoder(TM), Digital Rapids(R), Nativ, and LinkoTec will also adopt Dolby Digital Plus in their platforms."
DLB jumped 23% to $46 in after-hours trade session. In this post, I'd like to reflect on this short journey, explore what mistakes and right choices I've made. At the time of writing, I'm still holding onto my stake.
Key points:
  • The key to succeed in investing is more about avoiding costly mistakes.
  • An investment case with the reasonings right but not the facts is a weak investment case.
  • Without the conviction, you won't be able to take advantage of cheaper price to average down.
  • Anchoring rears its ugly head anytime, anywhere without warning.
  • When the downside has protection, but uncertainty is high and visibility is low, the best course of action is to wait, not to sell.
What's gone wrong?

Here is an excerpt of  what I wrote in my private blog that I shared with a couple of close friends in Aug 2011 shortly after the big fall:
Since I bought DLB, it has lost a mighty 42% of its value. This makes my original thesis looks foolish. Two things contribute to the horrible performance: (1) they lowered the earning estimation the 2nd time in a row 6 months. (2) But biggest blow was they announced last week Dolby technologies was not included in current build of Windows 8. (Current build? pre-alpha?)

It's really painful looking at it. But I better make the lost worthwhile by taking an honest look to see what I can learn from it:

  • [It's a huge drag on my portfolio performance.] This confirms the widsom: the key to be successful in investing is not that much about making big wins; it's more about avoiding costly mistakes. 
  • My original thesis was: (1) [Downside protection:] Windows 7 commercial editions include DLB technologies. OS upgrade cycle at corporations is a long-tail process. I was expecting increasing revenues throughout the next 2 years to compensate for the lost of revenues from DVD players. (2) [Upside:] DLB is well positioned to cover the mobile market and online streaming market. [However,] the issue here is, I thought through it qualitatively, not quantitatively. Meaning, I didn't have the hard figures to back up my claims. Now at a much lower price, I don't have the conviction to add to the position.
  • My initial purchase was a knee jerk reaction of the 25% fall from Jan to March.
  • The thought that DLB won't be included in Win has never come across my mind. This is pretty much a black swan event to me. That means my edge (that I understand/know something the market doesn't) is either not here or not that big as I thought. Thinking in terms of [position sizing], in the light of this, my initial position was too big. Now I wouldn't want to add more to it even if I had the conviction.
All that said, it's still too early to tell if DLB is a write-off. Its potential in the mobile and streaming market is still huge. The problem I have now is I don't have the conviction to add more to my position. 
That has pretty much summed up my mistakes. My original thesis was weak on quantitative front. I fooled myself my downside protection was solid. But it was not, because I didn't have the needed data to backup my thesis. I have only worked out the big picture and competition dynamics. I didn't have the cash flow calculation.

Now when I look back, this was not that different from the dot-com mania! The 3,000 feet birdeye view that internet would change the world was and is still correct. But no one took an honest look at the numbers. Same here with DLB. While the big picture is still valid, I didn't have the access to the essential data. Yet I fooled myself I had a strong investment case. Besides, anchoring was also to blame for initial knee-jerk reaction to buy DLB. Meaning, I have mistaken a fall of market price as an indication of value.

Without a really solid valuation, I didn't have the conviction to average down. Thus, I missed the opportunity to make money back.

Anything's gone right? 

Has anything gone right? In my view, yes: I didn't panic under uncertainty. I held onto my position.

At time, I reexamined my initial thesis: While my downside protection was not as solid as I believe, DLB indeed had reliable toll-booth-like streams of revenues at literally 100% gross margin and without any need of capex. After the big fall, DLB was trading at ex-cash P/E multiples priced as if it were a definite declining business. The increase of revenue from continuous Windows 7 rollout at corporations was not priced in. The opportunity (or the option value) that it could expand into the streaming market and mobile market was also not priced in at all. The market was at its greatest pessimism because of the uncertainty with the Windows 8 platform plus the fear of the losing the DVD revenue stream.

I concluded DLB was mispriced. But as I said before, my conviction wasn't high.

When the downside has protection -- in this case, some protection -- but uncertainty is high and visibility is low, the best course of action is to do nothing.

What now?

First, I have to admit DLB's recovery because of the latest Windows 8 news was blind luck. (It's better to be luck than skillful!) I didn't expect that at all. As such, DLB is actually now stronger that what I expected. It has also advanced on the online streaming front. That's also not expected. I originally thought it had better chance to make Dolby omnipresence on all mobile phones just like what it did to Walkmans in the old days.This is still early days to tell if it can or cannot.

All in all, I'll hold onto my stake. Well, not with very strong conviction. But less action is better than more.

(Disclosure: Long DLB, without too high a conviction.)

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