Dolby Laboratories, Inc.
System.Net.ConnectStream Dolby Laboratories, Inc. (Form: S-1, Received: 11/19/2004 06:17:00)    
 
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As filed with the Securities and Exchange Commission on November 19, 2004

Registration No. 333-            


SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM S-1

REGISTRATION STATEMENT

Under

The Securities Act of 1933

 

DOLBY LABORATORIES, INC.

(Exact name of registrant as specified in its charter)


Delaware   6794, 3861, 3663, 7819   90-0199783

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

100 Potrero Avenue

San Francisco, CA 94103-4813

(415) 558-0200

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)


N. W. (Bill) Jasper, Jr.

President and Chief Executive Officer

Dolby Laboratories, Inc.

100 Potrero Avenue

San Francisco, CA 94103-4813

(415) 558-0200

(Name, address, including zip code, and telephone number, including area code, of agent for service)


Please send copies of all communications to:

 

Larry W. Sonsini, Esq.

Thomas C. DeFilipps, Esq.

Herbert P. Fockler, Esq.

Mark B. Baudler, Esq.

Wilson Sonsini Goodrich & Rosati

Professional Corporation

650 Page Mill Road

Palo Alto, CA 94304-1050

(650) 493-9300

  

Mark S. Anderson, Esq.

Phyllis T. Solomon, Esq.

Dolby Laboratories, Inc.

100 Potrero Avenue

San Francisco, CA 94103-4813

(415) 558-0200

  

Paul C. Pringle, Esq.

Eric S. Haueter, Esq.

Sidley Austin Brown & Wood LLP

555 California Street

San Francisco, CA 94104-1715

(415) 772-1200


Approximate date of commencement of proposed sale to the public:     As soon as practicable after this Registration Statement becomes effective.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act, check the following box.   ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.   ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.   ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.   ¨

 
If delivery of the prospectus is expected to be made pursuant to Rule 434,  
check the following box.   ¨


Calculation of Registration Fee


Title of Each Class of Securities to be Registered   

Proposed Maximum Aggregate

Offering Price

   Amount of Registration Fee

Class A common stock, $0.001 par value

   $460,000,000    $58,282

The registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 



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The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any jurisdiction where the offer or sale  
is not permitted.

 

Prospectus (Subject to Completion)

Issued November 19, 2004

 

                     Shares

 

LOGO

 

CLASS A COMMON STOCK

 


 

Dolby Laboratories, Inc. is offering                      shares of its Class A common stock, and the selling stockholders are offering                      shares of Class A common stock. We will not receive any proceeds from the sale of shares by the selling stockholders. This is our initial public offering, and no public market currently exists for our shares. We anticipate that the initial public offering price will be between $             and $             per share.

 


 

Following this offering, we will have two classes of authorized common stock, Class A common stock and Class B common stock. The rights of the holders of Class A common stock and Class B common stock are identical, except with respect to voting and conversion. Each share of Class A common stock is entitled to one vote per share. Each share of Class B common stock is entitled to ten votes per share and is convertible at any time at the option of the holder into one share of Class A common stock.

 


 

We have applied to list our Class A common stock on the New York Stock Exchange under the symbol “DLB.”

 


 

Investing in our Class A common stock involves risks. See “ Risk Factors ” beginning on page 8.

 

 

 

PRICE $              A SHARE

 


 

     Price to Public

  

Underwriting

Discounts and

Commissions


  

Proceeds to

Dolby

Laboratories


  

Proceeds to

Selling

Stockholders


Per Share

   $                $                $                $            

Total

   $                    $                    $                    $                

 

We have granted the underwriters the right to purchase up to an additional              shares to cover over-allotments.

 

The Securities and Exchange Commission and state securities regulators have not approved or disapproved these securities, or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

Morgan Stanley & Co. Incorporated expects to deliver the shares to purchasers on             , 2005.

 


 

MORGAN STANLEY   GOLDMAN, SACHS & CO.

 

    JPMORGAN    

 

ADAMS HARKNESS   WILLIAM BLAIR & COMPANY

 

                    , 2005


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TABLE OF CONTENTS

 

     Page

Prospectus Summary

   1

Risk Factors

   8

Special Note Regarding Forward-Looking Statements and Industry Data

   31

Use of Proceeds

   32

Dividend Policy

   32

Capitalization

   33

Dilution

   34

Selected Consolidated Financial Data

   35

Pro Forma Unaudited Consolidated Statements of Operations Data

   37

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   38
     Page

Business

   60

Management

   87

Certain Relationships and Related Party Transactions

   100

Principal and Selling Stockholders

   102

Description of Capital Stock

   104

Shares Eligible for Future Sale

   108

Underwriters

   110

Legal Matters

   113

Experts

   113

Where You Can Find Additional Information

   113

Index to Financial Statements

   F-1

 


 

You should rely only on the information contained in this prospectus. We have not authorized anyone to provide you with information different from that contained in this prospectus. We are offering to sell, and seeking offers to buy, shares of our Class A common stock only in jurisdictions where offers and sales are permitted. The information in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or any sale of shares of our Class A common stock. Except where the context requires otherwise, in this prospectus the “Company,” “Dolby,” “Dolby Laboratories,” “we,” “us” and “our” refer to Dolby Laboratories, Inc., a Delaware corporation, and, where appropriate, its subsidiaries.

 

This offering is only being made to persons in the United Kingdom whose ordinary activities involve them in acquiring, holding, managing or disposing of investments (as principal or agent) for the purposes of their businesses or otherwise in circumstances which have not resulted and will not result in an offer to the public in the United Kingdom within the meaning of the Public Offers of Securities Regulations 1995 or the UK Financial Services and Markets Act 2000 (“FSMA”), and each underwriter has only communicated or caused to be communicated and will only communicate or cause to be communicated any invitation or inducement to engage in investment activity (within the meaning of section 21 of FSMA) received by it in connection with the issue or sale of the shares of Class A common stock in circumstances in which section 21(1) of FSMA does not apply to us. Each of the underwriters agrees and acknowledges that it has complied and will comply with all applicable provisions of FSMA with respect to anything done by it in relation to the shares of Class A common stock in, from or otherwise involving the United Kingdom.

 

The shares of Class A common stock may not be offered, transferred, sold or delivered to any individual or legal entity other than to persons who trade or invest in securities in the conduct of their profession or trade (which includes banks, securities intermediaries (including dealers and brokers), insurance companies, pension funds, other institutional investors and commercial enterprises which as an ancillary activity regularly invest in securities) in the Netherlands.

 

Until                     , 2005 (25 days after the commencement of this offering), all dealers that buy, sell or trade shares of our Class A common stock, whether or not participating in this offering, may be required to deliver a prospectus. This delivery requirement is in addition to the obligation of dealers to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions.

 

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PROSPECTUS SUMMARY

 

This summary highlights information contained elsewhere in this prospectus and does not contain all of the information you should consider in making your investment decision. You should read this summary together with the more detailed information, including our financial statements and the related notes, elsewhere in this prospectus. You should carefully consider, among other things, the matters discussed in “Risk Factors.”

 

DOLBY LABORATORIES, INC.

 

Dolby Laboratories develops and delivers innovative products and technologies that make the entertainment experience more realistic and immersive in theatres, homes, cars and elsewhere. Since Ray Dolby founded Dolby Laboratories nearly 40 years ago, we have been at the forefront of developing sound technologies that enhance the entertainment experience for audiences and consumers. Our objective is to be an essential element in the best entertainment technology by delivering to both professionals and consumers innovative and enduring technologies that enrich the entertainment experience. Our technologies are used in sound recording, distribution and playback to faithfully recreate the original audio experience and enable digital audio and surround sound in applications such as movie soundtracks, DVDs, television, satellite and cable broadcasts, video games and personal computers. Our technologies have been adopted as standards throughout the entertainment industry. For example, virtually all major movie soundtracks throughout the world are encoded using our technologies, and virtually all DVD players incorporate our technologies.

 

Our products, services and technologies are used throughout the entertainment chain—from content creation, to distribution for large-scale playback, such as movie theatres, to repackaging and distribution for consumer media, such as DVDs, to consumer playback, such as DVD players and home theatre systems. We have built strong, long-lasting relationships with industry professionals at every link in the entertainment chain, including filmmakers, motion picture studios, broadcasters, film distributors, cinema operators, DVD producers, manufacturers of a broad array of consumer electronics products and software developers. Industry professionals and consumers rely on Dolby to ensure consistent quality as content moves through the chain. Moreover, we believe that the use of our technologies by professionals in the creation and distribution of content increases demand for the adoption of our technologies for use in consumer applications. We believe that we are a trusted vendor for professionals and consumers alike, and that the Dolby brand is recognized globally for quality, excellence and innovation.

 

The following graphic illustrates our participation in this entertainment chain with respect to content for movies:

 

LOGO

 

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We develop technologies for both professional and consumer applications.

 

On the professional side, we derive revenue from sales of products and production services to filmmakers, broadcasters, music producers, video game designers and cinema operators. Our products and production services are used by artists and content creators to help them record and reproduce the sound they envision. For large-scale playback in theatres, cinema operators use our products to play back to audiences rich, realistic soundtracks the way the filmmakers intended. Television, satellite and cable broadcasters use our encoders and decoders to transmit audio encoded with our technologies throughout the broadcast infrastructure and into consumers’ homes. Our professional products are distributed in over 50 countries and we have sold over 73,000 cinema processors worldwide. Our products and technologies have been used in the production of over 16,000 movies, tens of thousands of DVD titles and hundreds of video game titles worldwide. Virtually all movies made by major studios include soundtracks encoded with Dolby SR or Dolby Digital technologies. In addition, over 40 television shows are currently produced using our sound encoding technologies. We manufacture our professional products in our Brisbane, California and Wootton Bassett, England manufacturing facilities, where our own manufacturing techniques and rigorous test procedures help ensure our products meet customer requirements. Sales of professional products and production services accounted for $77.6 million, or 27% of our total revenue, in fiscal 2004.

 

On the consumer side, we derive revenue from royalties collected from licensees who manufacture consumer electronics products that include our technologies. When entertainment content is produced for playback on consumer media, DVD producers use our professional encoders to capture the source audio, so that the original soundtrack can be delivered to the consumer as faithfully as possible. To enable consumers to experience the realistic entertainment intended by the content creators, we license our sound technologies to manufacturers of a wide range of consumer electronics products, including DVD players, home theatre systems, television sets, set-top boxes, video game consoles, portable audio and video players, personal computers and in-car entertainment systems, comprising substantially all of the consumer playback devices for surround sound. We work with over 40 semiconductor manufacturers, helping them incorporate our technologies into their integrated circuits, or ICs. These manufacturers then sell their ICs to our approved licensees for incorporation into consumer electronics products. We also license our technologies to software developers who implement our technologies for use in personal computer software DVD players. Our licensing arrangements typically entitle us to receive a royalty for every product incorporating our technologies sold by approximately 500 consumer electronics product manufacturers and software developer licensees located in nearly 30 countries. Over 1.6 billion consumer electronics product units sold worldwide have incorporated our licensed technologies, including over 500 million consumer electronics product units since the beginning of fiscal 2002. Our Dolby Digital technologies alone have been incorporated in over 240 million DVD players and over 50 million audio/video receivers and set-top boxes. Our licensing engineers and support staff work closely with our licensees throughout the world to ensure that their products meet our technical and quality standards. Licensing revenue accounted for $211.4 million, or 73% of our total revenue, in fiscal 2004.

 

While we initially focused on sound technologies, in recent years we have expanded our business to include other technologies that facilitate the delivery of digital entertainment, such as technologies that process digital moving images or protect content from piracy. We are also developing and providing products and services to facilitate the change in the cinema industry from 35 mm film projection to digital cinema, an all digital medium for the distribution and exhibition of movies. In addition, we are continually exploring areas where we may be able to develop and deliver technology solutions that enhance the entertainment experience in other ways.

 

Key Dolby Strengths

 

We believe that the following key strengths uniquely position Dolby to develop and deliver innovative technologies to both professionals and consumers to enrich the entertainment experience:

 

  ·   Our culture of innovation .    We address technology challenges and create and deliver practical technology solutions for the entertainment industry that make a perceptible difference to audiences and consumers, and have done so repeatedly throughout our nearly 40 year history.

 

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  ·   Our longstanding relationships with industry participants throughout the entertainment chain .    Our longstanding relationships enable us to collaborate closely with entertainment industry participants, ensuring our products and technologies are designed and used to deliver consistent, high quality sound to audiences and consumers throughout the entertainment chain.

 

  ·   Adoption of our technologies as industry standards .    Our technologies are worldwide explicit or de facto industry standards for many types of professional and consumer applications. Industry standards are “explicit” when technologies are mandated by an industry standards-setting body, and “de facto” when technologies are widely adopted even though not specifically mandated by a standards-setting body.

 

  ·   Our global market leadership .    We believe we are the global market leader for the delivery of surround sound technologies for both professional products and consumer applications.

 

  ·   Our neutrality .    We believe that by not aligning ourselves exclusively with any particular industry participant we have become a trusted participant in the entertainment industry, promoting the adoption of our technologies and enabling us to maintain strong relationships with a variety of companies that often compete against one another.

 

  ·   The strength of our brand .    We believe the Dolby brand is recognized globally and is synonymous with quality, excellence and innovation.

 

  ·   Our high quality management team and employee base .    We have assembled a strong, experienced management team and a highly skilled engineering team with technical knowledge in a broad range of scientific disciplines that are focused on developing innovative and enduring technologies for the entertainment industry.

 

Our Strategy

 

Our objective is to be an essential element in the best entertainment technology. Key elements of our strategy include:

 

  ·   Expanding markets for surround sound .    We intend to continue to promote the expansion of markets for surround sound.

 

  ·   Continuing to address the needs of industry professionals .    We intend to continue to collaborate with industry professionals at each link in the entertainment chain to develop new technologies that facilitate and improve content recording, distribution and playback, and, where possible, we intend to adapt these technologies for use in consumer applications.

 

  ·   Developing system solutions for digital cinema .    We are committed to developing and delivering sound and image technologies for digital cinema.

 

  ·   Developing technologies for the entertainment industry beyond sound .    We intend to develop and deliver technology solutions that enrich the entertainment experience in areas beyond sound, including technologies that process digital moving images and protect content from piracy.

 

  ·   Continuing to promote adoption of our technologies as industry standards .    We intend to continue to develop, maintain and strengthen our relationships with entertainment industry participants, professional organizations and standards-setting bodies throughout the world to help facilitate the adoption of our technologies as industry standards.

 

  ·   Building on the strength of the Dolby brand .    We intend to continue to enhance and build on the strength of the Dolby brand and our reputation as a trusted provider of entertainment technologies for use in both professional and consumer products.

 

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Industry

 

The global entertainment industry is in the midst of a transition from analog to digital technologies. Advancements in digital technologies have led to enhanced consumer entertainment experiences through higher fidelity sound; more dynamic sound effects; discrete surround sound; higher resolution video images; smaller file sizes and reduced storage costs; greater portability; simpler, faster and higher capacity means to distribute content; and greater interoperability across a variety of playback devices. New digital media formats and products, such as DVD players, DVD recorders, HDTV, digital cable and personal computer-based video, music and game systems, have been introduced over the past several years. These technological advances have affected a broad range of entertainment formats, including movies, broadcasts, music, video games, personal computers and personal audio and video players, as well as a wide variety of playback environments, including theatres, homes and automobiles.

 

Consumers are helping to drive the transition to digital entertainment through their rapid adoption of new digital consumer electronics products that allow them to play back audio and video in their homes, cars and elsewhere. Growth in sales of digital-based consumer electronics products has increased significantly in recent years. According to the October 2004 report “Worldwide and U.S. DVD Player Forecast and Analysis, 2004-2008” and the December 2001 report “U.S. DVD Player Market Forecast, 2000-2005” of independent market research firm International Data Corporation, or IDC, worldwide DVD player shipments increased from approximately 13.5 million in 2000 to approximately 89.9 million in 2003, resulting in a compound annual growth rate of approximately 88%. In its October 2004 report, IDC expects worldwide DVD player shipments to grow at a compound annual growth rate of 16.4% from 2003 through 2008, with such growth coming primarily from DVD recorders, home-theatre-in-a-box systems and portable DVD players. The large installed base of digital-based home theatre systems with surround sound capabilities enables television broadcasters to offer programming with digital audio that is comparable to or exceeds the quality available on DVDs. Governments worldwide are playing an important role in driving digital broadcasting by mandating that broadcasters transition to digital signals. Currently, all local terrestrial, or over-the-air, television stations in the United States are supposed to broadcast with a digital signal. According to IDC’s May 2004 report, “Worldwide and U.S. Digital TV 2004-2008 Forecast,” there are approximately 275 million television sets in the United States, 9.2 million of which are digital. Personal computers have also been an important factor driving the adoption of digital technology for multi-media applications. This growth in sales of digital-based consumer electronics products has coincided with increased consumer spending on electronic entertainment generally. According to the Consumer Electronics Association, or CEA, the average annual spending on consumer electronics per household in the United States has increased from approximately $600 in 1990 to approximately $1,100 in 2003. CEA defines consumer electronics to include consumer video products, home audio products and computers, peripherals and software, as well as video game hardware and software, portable audio products, mobile electronics, telephone and home office products, and blank media and accessories.

 

Corporate Information

 

We were founded in London, England in 1965 and incorporated as a New York corporation in 1967. We reincorporated in California in 1976 and reincorporated in Delaware in September 2004. Our principal executive offices are located at 100 Potrero Avenue, San Francisco, California 94103, and our telephone number is (415) 558-0200. Our web site address is www.dolby.com. The information on our web site is not part of this prospectus.

 

Dolby, Dolby Digital, Dolby Headphone, Dolby SR, Dolby Surround, EQ Assist, MLP, Surround EX and the double-D symbol are registered trademarks of Dolby Laboratories in the United States and other countries. This prospectus also includes other registered and unregistered trademarks of Dolby Laboratories and trademarks of other persons.

 

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THE OFFERING

 

Shares of Class A common stock offered:

         

By us

                        shares     

By the selling stockholders

                        shares     

Total

                        shares     

Shares of common stock to be outstanding after this offering:

         

Class A

                        shares     

Class B

                        shares     

Total

                        shares     

Use of proceeds

   General corporate purposes, including working capital, and possible acquisitions of complementary businesses, technologies or other assets. We will not receive any of the proceeds from the sale of shares by the selling stockholders. See “Use of Proceeds.”

Proposed NYSE symbol

   DLB     

 

The number of shares of Class A and Class B common stock that will be outstanding after this offering is based on the number of shares outstanding at September 24, 2004, and excludes:

 

  ·   12,599,820 shares of Class B common stock issuable upon the exercise of options outstanding at September 24, 2004, at a weighted average exercise price of $1.61 per share;

 

  ·   780,750 shares of Class B common stock issuable upon the exercise of options granted after September 24, 2004, at an exercise price of $6.28 per share; and

 

  ·   6,000,000 shares of Class A common stock available for future issuance under our 2005 Stock Plan.

 

Unless otherwise indicated, all information in this prospectus assumes:

 

  ·   A five-for-one split of our common stock that will occur prior to the completion of this offering;

 

  ·   That all currently outstanding shares of our common stock are converted into shares of Class B common stock prior to the completion of this offering; and

 

  ·   That the underwriters do not exercise the over-allotment option to purchase                      additional shares of Class A common stock in this offering.

 

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SUMMARY CONSOLIDATED FINANCIAL DATA

 

The following tables summarize consolidated financial data regarding our business and should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and the related notes included elsewhere in this prospectus. Our fiscal year is a 52- or 53-week period ending on the last Friday in September. The fiscal years presented include the 52-week periods ended September 27, 2002, September 26, 2003 and September 24, 2004, respectively. Ray Dolby, our founder, will contribute to us prior to the completion of this offering all of the rights he holds in intellectual property related to our business, which he currently licenses to us in exchange for royalty payments. Upon the completion of this asset contribution, all of our licensing arrangements with, and related royalty obligations to, Ray Dolby will terminate. The following summary pro forma unaudited consolidated statements of operations data give effect to the asset contribution to be made by Ray Dolby, as well as the effects of a previous change in certain licensing arrangements with Ray Dolby in June 2002, as though such transactions had been completed prior to the beginning of fiscal 2002. There will be no material change to our balance sheet as a result of the asset contribution. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Pro Forma Presentation.”

 

     
Actual

    Pro Forma

 
    Fiscal Year Ended

    Fiscal Year Ended

 
    Sep 27,
2002


    Sep 26,
2003


    Sep 24,
2004


    Sep 27,
2002


    Sep 26,
2003


    Sep 24,
2004


 
    (in thousands, except per share data)  

Consolidated Statements of Operations Data:

                                               

Revenue:

                                               

Licensing

  $ 106,640     $ 157,922     $ 211,395     $ 113,361     $ 157,922     $ 211,395  

Product sales

    41,377       44,403       57,981       41,377       44,403       57,981  

Production services

    13,851       15,147       19,665       13,851       15,147       19,665  
   


 


 


 


 


 


Total revenue

    161,868       217,472       289,041       168,589       217,472       289,041  
   


 


 


 


 


 


Cost of revenue:

                                               

Cost of licensing

    25,063       40,001       53,838       8,685       14,875       20,070  

Cost of product sales (includes $0.2 million in stock-based compensation for fiscal 2004, actual and pro forma)(1)

    26,694       26,684       30,096       24,281       24,190       27,007  

Cost of production services (includes $0.1 million in stock-based compensation for fiscal 2004, actual and pro forma)(1)

    5,960       6,958       7,643       5,960       6,958       7,643  
   


 


 


 


 


 


Total cost of revenue

    57,717       73,643       91,577       38,926       46,023       54,720  
   


 


 


 


 


 


Gross margin

    104,151       143,829       197,464       129,663       171,449       234,321  

Operating expenses:

                                               

Selling, general and administrative (includes $12.7 million in stock-based compensation for fiscal 2004, actual and pro forma)(1)

    64,269       76,590       113,477       70,297       76,590       113,477  

Research and development (includes $1.2 million in stock-based compensation for fiscal 2004, actual and pro forma)(1)

    15,128       18,262       23,884       15,128       18,262       23,884  

Settlements

    24,205             (2,000 )     24,205             (2,000 )

In-process research and development

          1,310       1,738             1,310       1,738  
   


 


 


 


 


 


Total operating expenses

    103,602       96,162       137,099       109,630       96,162       137,099  
   


 


 


 


 


 


Operating income

    549       47,667       60,365       20,033       75,287       97,222  

Other income (expenses), net

    (747 )     (57 )     229       (747 )     (57 )     229  
   


 


 


 


 


 


Income (loss) before provision for income taxes and controlling interest

    (198 )     47,610       60,594       19,286       75,230       97,451  

Provision for income taxes

    11       16,079       25,039       7,884       26,714       39,267  
   


 


 


 


 


 


Income (loss) before controlling interest

    (209 )     31,531       35,555       11,402       48,516       58,184  

Controlling interest in net (income) loss

    104       (562 )     (929 )     104       (562 )     (929 )
   


 


 


 


 


 


Net income (loss)

  $ (105 )   $ 30,969     $ 34,626     $ 11,506     $ 47,954     $ 57,255  
   


 


 


 


 


 


Basic net income (loss) per common share

  $ 0.00     $ 0.36     $ 0.40     $ 0.14     $ 0.56     $ 0.67  

Diluted net income (loss) per common share

  $ 0.00     $ 0.36     $ 0.36     $ 0.14     $ 0.56     $ 0.59  

Shares used in the calculation of basic net income (loss) per share

    85,008       85,009       85,556       85,008       85,009       85,556  

Shares used in the calculation of diluted net income (loss) per share

    85,008       85,983       96,525       85,010       85,983       96,525  

 

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(1) Stock-based compensation recorded in fiscal 2004 was classified as follows:

 

     
Actual and Pro Forma

    Fiscal Year Ended
September 24, 2004


Cost of product sales

  $ 157

Cost of production services

    55

Selling, general and administrative

    12,711

Research and development

    1,215
   

Total stock-based compensation

  $ 14,138
   

 

The consolidated balance sheet data table below presents a summary of our balance sheet as of September 24, 2004, on an actual basis and on an as adjusted basis to give effect to the receipt of net proceeds from the sale of              shares of Class A common stock by us in this offering at an assumed initial public offering price of $             per share, after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us, as set forth under “Use of Proceeds” and “Capitalization.”

 

      
As of September 24, 2004

     Actual

   As Adjusted

     (in thousands)

Summary Consolidated Balance Sheet Data:

             

Cash and cash equivalents

   $ 78,711    $             

Working capital

     82,450       

Total assets

     261,897       

Total debt

     14,870       

Total stockholders’ equity

     145,374       

 

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RISK FACTORS

 

You should carefully consider the risks described below before making an investment decision. Our business, prospects, financial condition or operating results could be materially adversely affected by any of these risks, as well as other risks not currently known to us or that we currently deem immaterial. The trading price of our Class A common stock could decline due to any of these risks and you may lose all or part of your investment. In assessing the risks described below, you should also refer to the other information contained in this prospectus, including our consolidated financial statements and the related notes, before deciding to purchase any shares of our Class A common stock.

 

Our business and prospects depend on the strength of our brand, and if we do not maintain and strengthen our brand, our business will be materially harmed.

 

Maintaining and strengthening the “Dolby” brand is critical to maintaining and expanding both our products and services business and our technology licensing business because our continued success is due, in part, to our reputation for providing high quality products, services and technologies across a wide range of entertainment industries, which we define to include the consumer electronics product industry. If we fail to promote and maintain the Dolby brand successfully on either the professional products and production services or the licensing sides of our business, our overall business and prospects will suffer. Moreover, we believe that the likelihood that our technologies will be adopted as an industry standard in various markets and for various applications depends, in part, upon the strength of our brand, because professional organizations and industry participants are more likely to accept as an industry standard technologies developed by a well-respected and well-known brand. In addition, if we fail to maintain high quality standards for our professional products, and if we fail to maintain high quality standards for the products that incorporate our technologies through the quality-control certification process that we require of our licensees, our brand could be adversely affected. Furthermore, we believe that our ability to enter new markets as we expand our business beyond sound technologies is dependent, in part, upon the strength of our brand and our reputation as a trusted provider of entertainment technologies for use in both professional and consumer products. Maintaining and strengthening our brand will depend heavily on our ability to continue to develop innovative technologies for the entertainment industry and to continue to provide high quality products and services, which we may not do successfully.

 

We are dependent on the sale by our licensees of consumer electronics products that incorporate our technologies, and a reduction in those sales would adversely affect our licensing revenue.

 

We derive most of our revenue from the license of our technologies to consumer electronics product manufacturers. We derived 66%, 73% and 73% of our total revenue from our technology licensing business in fiscal 2002, 2003 and 2004, respectively. We do not manufacture consumer electronics products ourselves. Our licensing revenue from these manufacturers results primarily from royalties paid to us on shipments of their consumer electronic products, such as DVD players, DVD recorders, home theatre systems, video game consoles, personal audio and video players and in-car entertainment systems that incorporate our licensed technologies. We cannot control these manufacturers’ product development or commercialization efforts or predict their success. In addition, our license agreements, which typically require manufacturers of consumer electronics product and software developers to pay us a specified royalty for every consumer electronics product shipped that incorporates our technologies, do not require these manufacturers to include our technologies in any specific number or percentage of units, and only a few of these agreements guarantee us a minimum aggregate licensing fee. Moreover, we have a widespread presence in certain markets for consumer electronics products, such as the markets for DVD players, audio/video receivers and other home theatre consumer electronics products, and, as a result, there is little room for us to further penetrate such markets. Accordingly, if our licensees sell fewer products incorporating our technologies, or otherwise face significant economic difficulties, our revenue will decline. Lower sales of products incorporating our technologies could occur for a number of reasons. Changes in consumer tastes or trends, or changes in industry standards, may adversely affect our licensing revenue. Demand for new consumer electronics products could also be adversely affected by increasing market saturation, durability of products in the marketplace, new competing products and alternate consumer entertainment options. In addition, our licensees, for whatever reason, may not choose to or may not be able to incorporate our future technologies into their products.

 

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We do not expect sales of DVD players to continue to grow as quickly as they have in the past. To the extent that sales of DVD players and home theatre systems level off or decline, or alternative technologies in which we do not participate replace DVDs as a dominant medium for consumer video entertainment, our licensing revenue will be adversely affected.

 

Growth in our revenue over the past several years has been the result, in large part, of the rapid growth in sales of DVD players and home theatre systems incorporating our technologies. However, as the markets for DVD players mature, we do not expect sales of DVD players to continue to grow as quickly as they have in the past. To the extent that sales of DVD players and home theatre systems level off or decline, our licensing revenue will be adversely affected. In addition, if new technologies are developed for use with DVDs or new technologies are developed that substantially compete with or replace DVDs as a dominant medium for consumer video entertainment, and if we are unable to develop and successfully market technologies that are incorporated into or compatible with such new technologies, our revenue will be adversely affected.

 

If we fail to develop and deliver innovative technologies in response to changes in the entertainment industry, our business could decline.

 

The markets for our professional products and the markets for consumer electronics products utilizing our licensed technologies are characterized by rapid change and technological evolution. We will need to expend considerable resources on research and development in the future in order to continue to design and deliver enduring, innovative entertainment products and technologies. Despite our efforts, we may not be able to develop and effectively market new products, technologies and services that adequately or competitively address the needs of the changing marketplace. In addition, we may not correctly identify new or changing market trends at an early enough stage to capitalize on market opportunities. At times such changes can be dramatic, such as the shift from VHS tapes to DVDs for consumer playback of movies in homes and elsewhere. Our future success depends to a great extent on our ability to develop and deliver innovative technologies that are widely adopted in response to changes in the entertainment industry and that are compatible with the technologies or products introduced by other entertainment industry participants.

 

If our products and technologies fail to be adopted as industry standards, our business prospects could be limited and our operating results could be adversely affected.

 

The entertainment industry depends upon industry standards to ensure the compatibility of its content across a wide variety of entertainment systems and products. Accordingly, we expend significant efforts to ensure that our products and technologies either meet, or, more importantly, are adopted as, industry standards across the broad range of entertainment industry markets in which we participate, as well as the markets in which we hope to compete in the future, including digital cinema. It is important to our business and prospects that we continue to develop products and technologies that have the necessary capabilities and are of sufficient quality and acceptable cost such that the entertainment industry adopts them as industry standards. It is also important that those of our technologies that have already been adopted as industry standards continue to have that status. To have our products and technologies adopted as industry standards, we must convince a broad spectrum of professional organizations throughout the world to adopt them as such and to ensure that other industry standards are consistent with our products and technologies. In this regard, maintaining our long-standing relationships with our major customers and licensees is critical to our ability to have our technologies adopted as industry standards. If our technologies are not adopted or do not remain as industry standards, our business, operating results and prospects could be materially and adversely affected. We expect that meeting, maintaining and establishing industry standard technologies will continue to be critical to our business in the future. For example, we expect that the development of the market for digital cinema will be based upon industry standards. In addition, the market for broadcast technologies has traditionally been heavily based upon industry standards and we expect this to continue to be the case in the future. In the broadcast industry, governments or other regulatory bodies often set industry standards. If our technologies are not chosen as industry standards for broadcasting in a geographic area, this could adversely affect our ability to compete in these markets.

 

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Increasingly, standards-setting organizations are adopting or establishing technology standards for use in a wide-range of consumer electronics products. As a result, it is more difficult for individual companies to have their technologies adopted wholesale as an informal industry standard. We call this type of standard a “de facto” industry standard, meaning that the standard is not explicitly mandated by any industry standards-setting body but is nonetheless widely adopted. In addition, increasingly there are a large number of companies, including ones that typically compete against one another, involved in the development of new technologies for use in consumer entertainment products. As a result, these companies often license their collective intellectual property rights as a group, making it more difficult for any single company to have its technologies adopted widely as a de facto industry standard or to have its technologies adopted as an exclusive, explicit industry standard for consumer electronic products.

 

Even when our technologies are mandated for a particular market by a standards-setting body, which we call an “explicit” industry standard, our technologies may not be the sole technologies adopted for that market as an industry standard. Accordingly, our operating results depend upon participants in that market choosing to adopt our technologies instead of competitive technologies that also may be acceptable under such standard. The continued growth of our revenue from the broadcast market will depend upon both the continued adoption of digital television generally and the choice to use our technologies where it is an optional industry standard.

 

The licensing of patents constitutes a significant source of our revenue. If we are unable to replace expiring patents with new patents or proprietary technologies, our revenue could decline.

 

We hold patents covering much of the technology that we license to consumer electronics product manufacturers. Our licensing revenue is tied in large part to the life of those patents. Our right to receive royalties related to our patents terminates with the expiration of the last patent covering the relevant technologies. However, many of our licensees choose to continue to pay royalties for use of our trademarks and know-how after our patents have expired, but at a reduced royalty rate. Accordingly, to the extent that we do not continue to replace licensing revenue from technologies covered by expiring patents with licensing revenue based on new patents and proprietary technologies, our revenue could decline.

 

The 775 patents we currently hold are scheduled to expire at various times through April 2023. Of these, ten patents are scheduled to expire in calendar year 2005, 66 patents are scheduled to expire in calendar year 2006, and 44 patents are scheduled to expire in calendar year 2007. Patents relating to our Dolby Digital technologies expire between 2008 and 2017, and patents relating to our Dolby Digital Plus technologies, an extension of Dolby Digital, expire between 2019 and 2020.

 

In addition, we have relatively few or no issued patents in certain countries, including China and India. For example, in China we have only limited patent protection, especially with respect to our Dolby Digital technologies. In India, we have no issued patents. As such, growing our licensing revenue in developing countries such as China and India will depend on our ability to obtain patent rights in these counties for existing and new technologies, which is uncertain. Moreover, because of the limitations of the legal systems in many of these countries, the effectiveness of patents obtained or that may in the future be obtained, if any, is likewise uncertain.

 

We are, and may in the future be, subject to intellectual property rights claims, which are costly to defend, could require us to pay damages and could limit our ability to use certain technologies in the future.

 

Companies in the technology and entertainment industries own large numbers of patents, copyrights, trademarks and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. We have faced such claims in the past, we currently face such claims and we expect to face similar claims in the future. For example, Lucent has asserted that we infringe certain patents held by them, prompting us to file a complaint for declaratory judgment of non-infringement and invalidity of such Lucent patents. These patents generally involve a process and means for encoding and decoding audio signals. Lucent contends that products incorporating our AC-3 technology infringe those patents. A determination against us in the Lucent litigation could materially impact our technology licensing business, which may seriously harm our financial condition and results of operations. As we face increasing competition and as we attempt to enter new markets, the possibility of new intellectual property rights claims against us grows. Our technologies may be vulnerable to third-party rights or claims against their use. Any intellectual

 

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property claims, with or without merit, could be time-consuming, expensive to litigate or settle and could divert management resources and attention. For example, in the past we have settled claims relating to infringement allegations and agreed to make payments in connection with such settlements. An adverse determination could require that we pay damages or stop using technologies found to be in violation of a third party’s rights and could prevent us from offering our products and services to others. In order to avoid these restrictions, we may have to seek a license for the technology. This license may not be available on reasonable terms, could require us to pay significant royalties and may significantly increase our operating expenses. The technologies also may not be available for license to us at all. As a result, we may be required to develop alternative non-infringing technologies, which could require significant effort and expense. If we cannot license or develop technology for the infringing aspects of our business, we may be forced to limit our product and service offerings and may be unable to compete effectively. In addition, at times in the past, we have chosen to defend our licensees from third-party intellectual property infringement claims even where such defense was not contractually required, and we may choose to take on such defense in the future. Any of these results could harm our brand, our operating results and our financial condition.

 

Primarily in connection with the licensing of our Dolby Digital technologies, in certain cases we license to our customers intellectual property such as patents that we have licensed from third parties in addition to our own intellectual property. Under our agreements with these third parties, in many cases we are required to pay them a royalty based on a percentage of the portion of the licensing revenue we receive from our customers related to their intellectual property. We believe we properly allocate these parties’ respective shares of the licensing revenue we receive from our customers. However, these third parties could challenge the basis on which we share our licensing revenue with them. Any successful challenge could increase the amount of royalties we have to pay to these third parties, decrease our gross margins and adversely affect our operating results. Such challenges could also impair our ability to continue to re-license the intellectual property of such third parties, which could adversely affect our business and prospects.

 

Our relationships with entertainment industry participants are particularly important to our professional products and production services and our technology licensing businesses, and if we fail to maintain such relationships our business could be materially harmed.

 

If we fail to maintain and expand our relationships with a broad range of participants throughout the entertainment chain, including motion picture studios, broadcasters, video game designers, music producers and manufacturers of consumer electronics products, our business and prospects could be materially harmed. Relationships have historically played an important role in the entertainment industries that we serve, both on the professional and consumer sides of our business. For example, our products and services business is particularly dependent upon our relationships with the major motion picture studios and broadcasters, and our technology licensing business is particularly dependent upon our relationships with consumer electronics product manufacturers, software developers and integrated circuit, or IC, manufacturers. If we fail to maintain and strengthen these relationships, these entertainment industry participants may be more likely not to purchase and use our products, services and technologies, which could materially harm our business and prospects. In addition to directly providing substantially all of our revenue, these relationships are critical to our ability to have our technologies adopted as industry standards. Moreover, if we fail to maintain our relationships, or if we are not able to develop relationships in new markets in which we intend to compete in the future, including markets for new technologies and expanding geographic markets such as China and India, our business, operating results and prospects could be materially and adversely affected. In addition, if major industry participants form strategic relationships that exclude us, whether on the professional products and production services side or the licensing side of our business, our business and prospects could be materially adversely affected.

 

We rely on the timeliness and accuracy of our licensees’ royalty reports for reporting and collecting our licensing revenue, and if these reports are untimely or inaccurate, our revenue could be delayed, inaccurately reported or materially adversely affected.

 

Our licensing revenue is generated primarily from consumer electronics product manufacturers and software developers who license and incorporate our technologies in their products. Under our existing arrangements,

 

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these licensees typically pay us a specified royalty for every consumer electronics product they ship that incorporates our technologies. We rely on our licensees to accurately report the number of units shipped as we calculate our license fees, prepare our financial reports, projections and budgets, and direct our sales and product development efforts based on these reports. However, it is often difficult for us to independently determine whether or not our licensees are reporting shipments accurately. This is especially true with respect to software incorporating our technologies because software can be copied relatively easily and we oftentimes do not have easy ways to determine how many copies have been made. Most of our license agreements permit us to audit our licensees’ records, but audits are generally expensive and time consuming and could harm our customer relationships. In particular, we have experienced in the past, and expect to continue to experience, problems with Chinese consumer electronics product manufacturers failing to report or underreporting shipments of their products that incorporate our technologies. To the extent that our licensees understate or fail to report the number of products incorporating our technologies that they ship, we will not collect and recognize revenue to which we are entitled, which would adversely affect our operating results. In addition, because we recognize license revenue only after we receive royalty reports from our licensees regarding the shipment of their products that incorporate our technologies, the timing of our revenue is dependent upon the timing of our receipt of those reports. Our quarterly operating results may fluctuate as a result of inaccurate royalty reports we receive from licensees that are ultimately corrected, or as a result of late or sporadic royalty reports we receive from licensees. Our licensees are required to report to us within 30 to 60 days following the end of the quarter in which they ship the product incorporating our technologies. Accordingly, even in the best of circumstances, there is a time lag between when our licensees ship their products and when they report those shipments, and pay the related royalties, for those products. Sometimes this time lag can be significant. In the past we have experienced lags greater than one year in certain cases. In addition, it is not uncommon for royalty reports to include corrective or retroactive royalties that cover extended periods of time. Also, there have been times in the past when we have recognized an unusually large amount of licensing revenue from a licensee in a given quarter because not all of our revenue recognition criteria were met in prior periods. This can result in a large amount of licensing revenue from a licensee being recorded in a given quarter that is not necessarily indicative of the amounts of licensing revenue to be received from that licensee in future quarters, thus causing fluctuations in our operating results.

 

Our licensing revenue depends in large part upon IC manufacturers incorporating our technologies into ICs for sale to our consumer electronics product licensees and if, for any reason, our technologies are not incorporated in these ICs or fewer ICs are sold that incorporate our technologies, our operating results would be adversely affected.

 

Our licensing revenue from consumer electronics product manufacturers depends in large part upon the availability of ICs that implement our technologies. IC manufacturers incorporate our technologies into these ICs, which are then incorporated in consumer electronics products that utilize our technologies. We do not manufacture these ICs, but rather depend on IC manufacturers to develop, produce and then sell them to licensed consumer electronics product manufacturers. We cannot control the IC manufacturers’ decision whether or not to incorporate our technologies into their ICs, and we cannot control their product development or commercialization efforts nor predict their success. As a result, if these IC manufacturers are unable or unwilling, for any reason, to implement our technologies into their ICs, or if, for any reason, they sell fewer ICs incorporating our technologies, our operating results will be adversely affected.

 

Our future success depends, in part, upon the growth of new markets for surround sound technologies and our ability to develop and adapt our technologies for those new markets. If such markets fail to grow or we are unable to develop successful products for them, our business prospects could be limited.

 

We expect that future growth of our licensing revenue will depend, in part, upon the growth of, and our successful participation in, new markets for surround sound technologies, including:

 

  ·   Digital broadcasting;

 

  ·   HDTV;

 

  ·   Broadband Internet;

 

  ·   Home DVD recording;

 

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  ·   DVD-Audio;

 

  ·   Video games;

 

  ·   Personal audio and video players, including Internet music applications; and

 

  ·   In-car entertainment systems.

 

The development of these markets depends on increased consumer demand for surround sound products, which may not occur. Any failure of such markets to develop or consumer demand to grow would have a material adverse effect on our business and prospects. For example, only a small number of automobile manufacturers currently offer in-car entertainment systems incorporating our surround sound technologies, and those that do typically limit those systems only to certain models. Additional manufacturers may not offer surround sound entertainment systems, and, even if they do, the car models on which surround sound may be offered are likely to be, at least initially, limited to the high end of these manufacturers’ lines. Similarly, whether our revenue from digital broadcast networks and broadband Internet services increases depends upon the expansion of digital broadcast technologies and broadband Internet as a medium of entertainment, which may not occur. In addition, even when our technologies are adopted as industry standards for a particular market, such market may not be fully developed. In such case, our success depends not only on whether our technology is adopted as an industry standard for such market, but also on the development of that market, which may not occur. For example, while our technologies have been adopted in many countries as a mandatory or optional industry standard for broadcast audio for digital television, many television broadcasters around the world do not yet broadcast digital television. Demand for our technologies in any of these developing markets may not continue to grow, and a sufficiently broad base of consumers and professionals may not adopt or continue to use these technologies. Demand and market acceptance for recently introduced services and products are subject to a high level of uncertainty. Our business could be limited if demand for products and services such as those described above do not expand as we expect, or if our technologies are not adopted by licensees for use with such products and services. In addition, our ability to generate revenue from these markets may be limited to the extent that service providers in these markets choose to provide certain technologies and entertainment for little or no cost, such as many of the services provided in connection with broadband Internet services. Moreover, some of these markets are ones in which we have not previously participated and, because of our limited experience, we may not be able to adequately adapt our business and our technologies to the needs of customers in these fields.

 

We also expect that growth in our licensing revenue will depend, in part, upon the growth of sales of consumer electronics products incorporating our technologies in other countries, including China and India, as consumers in these markets have more disposable income and are increasingly purchasing entertainment products with surround sound capabilities. However, if our licensing revenue from the use of our technologies in these new markets or geographic areas does not expand, our prospects could be adversely affected.

 

We face significant competition in various markets, and if we are unable to compete successfully, our business will suffer.

 

The markets for entertainment industry technologies are highly competitive, and we face competitive threats and pricing pressure in all of these industries. Our competitors on the professional side of our business include Avica, Digital Theater Systems, EVS, GDC, Kodak, Microsoft, NEC, Panastereo, Sony and UltraStereo. Competitors on the consumer side of our business include Coding Technologies, Digital Theater Systems, Fraunhofer Institute for Integrated Circuits, Microsoft, Philips, RealNetworks, Sony, SRS Labs and Thomson. In addition, other companies may become competitors in the future. The quality of sound produced by some of our competitors’ technologies may be perceived by some people as equivalent or superior to that produced by ours. In addition, some of our current and/or future competitors may have significantly greater financial, technical, marketing and other resources than we do, or may have more experience or advantages in the markets in which they compete. For example, Microsoft and RealNetworks may have an advantage over us in the market for Internet technologies because of their greater experience and presence in that market. In addition, some of our current or potential competitors, such as Microsoft and RealNetworks, may be able to offer integrated system solutions in certain markets for sound or non-sound entertainment technologies, including audio, video and rights management

 

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technologies related to personal computers or the Internet, which could make competing technologies that we develop unnecessary. By offering an integrated system solution, these potential competitors also may be able to offer competing technologies at lower prices than our technologies, which could adversely affect our operating results. We also face competitive risks in situations where our customers are also current or potential competitors. For example, Sony is a significant licensee customer and is a significant purchaser of our professional products and production services, but Sony is also a competitor with respect to certain of our professional and consumer technologies. Sony’s plan to acquire Metro-Goldwyn-Mayer, which is also a significant purchaser of our professional products and production services, is expected to increase this potential competitive risk. In addition, Universal, which is a purchaser of our professional products and production services, also has had an ownership interest in Digital Theater Systems, one of our competitors. Further, many of the consumer electronics products that include our sound technology also include sound technologies developed by our competitors. As a result, we must continue to invest significant resources in research and development in order to enhance our technologies and our existing products and services and introduce new high-quality products and services to meet the wide variety of such competitive pressures. Our business will suffer if we fail to do so successfully.

 

In addition, the market for the consumer electronics products in which our technologies are incorporated is intensely competitive and price sensitive. Retail prices for consumer electronics products that include our sound technology, such as DVD players and home theatre systems, have decreased significantly, and we expect prices to continue to decrease for the foreseeable future. In response, manufacturers have sought to reduce their product costs, which can result in downward pressure on the licensing fees we charge our customers who incorporate our technologies into the consumer electronics products that they sell. A decline in the licensing fees we charge would materially and adversely affect our operating results.

 

We believe that the success we have had licensing our surround sound technologies to consumer electronics product manufacturers is due, in part, to the strength of our brand and the perception that our technologies provide a high-quality solution for surround sound. However, as applications that incorporate surround sound technologies become increasingly prevalent, we expect more competitors to enter this field with other solutions. Furthermore, to the extent that these solutions are perceived, accurately or not, to provide the same advantages as our technologies, at a lower or comparable price, there is a risk that sound encoding technology such as ours will be treated as a commodity, resulting in loss of status of our technologies, decline in their use, and significant pricing pressure. To the extent that our audio technologies become a commodity, rather than a premium solution, our business, operating results and prospects could be adversely affected.

 

Awareness of our brand depends to a significant extent upon a decision by our customers to display our trademarks on their products, and if our customers do not display our trademarks on their products, our ability to increase our brand awareness may be harmed.

 

We engage in relatively little direct brand advertising, and we do not currently plan to increase our direct brand advertising activities in the future. Instead, the promotion of our brand depends upon entertainment industry participants displaying our trademarks on their products that incorporate our technologies. Although we do not require our customers to place our brand on their products, we actively encourage them to do so. For example, we license our trademarks to motion picture studios, broadcasters and distributors for placement in film prints, television programming, DVD packaging and promotional materials, such as movie posters, to signify that the content has been made utilizing high-quality Dolby Laboratories sound technologies, which we believe is very important to consumers. We also rely on consumer electronics product manufacturers that license our technologies to display our trademarks on their products in order to promote our brand. If our customers choose for any reason not to display our trademarks, our ability to maintain or increase our brand awareness may be harmed, which would have an adverse affect on our business and prospects.

 

We face a number of risks in conducting business in China.

 

The percentage of our licensing revenue from Chinese consumer electronics product manufacturers grew from 11% in fiscal 2002 to 16% in fiscal 2004. We expect this trend to continue in the future, as consumer electronics product manufacturing in China continues to increase due to the lower manufacturing cost structure

 

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there as compared to other industrial countries. We also expect that our sales of professional products and production services in China will expand in the future to the extent that the use of digital surround sound technologies increases in China, including in movies, broadcast television and video games. We further expect that the sale of consumer electronics products incorporating our technologies will increase in China to the extent that Chinese consumers become more affluent. However, we face many risks in China, in large part due to China’s historically limited recognition and enforcement of intellectual property and contractual rights. In particular, we have many times experienced, and expect to continue to experience, problems with Chinese consumer electronics product manufacturers failing to report or underreporting shipments of their products that incorporate our technologies or incorporating our technologies and trademarks into their products without our authorization and without paying us any licensing fees, which adversely affects our operating results. We may also experience difficulties in enforcing our intellectual property rights in China, where intellectual property rights are not as respected as they are in the United States, Japan and Europe. In addition, we have only limited patent protection in China, especially with respect to our Dolby Digital technologies, which may make it more difficult for us to enforce our intellectual property rights in China. We believe that it is critical that we strengthen existing relationships and develop new relationships with entertainment industry participants in China to increase our ability to enforce our intellectual property and contractual rights in China without relying solely on the Chinese legal system. If we are unable to develop, maintain and strengthen these relationships, our revenue from China could be adversely affected. However, developing, maintaining and strengthening relationships in China is especially difficult because of the multiple Chinese cultures and resulting fragmented nature of the Chinese economy. As a result, we must develop, maintain and strengthen relationships at each step of the entertainment chain in many different regions of China in order to successfully enforce our intellectual property and contractual rights in China.

 

We face diverse risks in our international business, which could adversely affect our operating results.

 

We are dependent on international sales for a substantial amount of our total revenue. For fiscal years ended 2002, 2003 and 2004, our sales outside the United States were 64%, 60% and 59%, respectively, of our professional products and production services revenue, and royalties from licensees outside the United States were 76%, 80% and 80%, respectively, of our licensing revenue. We expect that international and export sales will continue to represent a substantial portion of our revenue for the foreseeable future. This future revenue will depend to a large extent on the continued use and expansion of our technologies in entertainment industries worldwide. Increased worldwide use of our technologies is also an important factor in our future growth.

 

Due to our reliance on sales to customers outside the United States, we are subject to the risks of conducting business internationally, including:

 

  ·   Our ability to enforce our contractual and intellectual property rights, especially in those foreign countries that do not respect and protect intellectual property rights to the same extent as do the United States, Japan and European countries, which increases the risk of unauthorized, and uncompensated, use of our technology;

 

  ·   United States and foreign government trade restrictions, including those which may impose restrictions on importation of programming, technology or components to or from the United States;

 

  ·   Foreign government taxes, regulations and permit requirements, including foreign taxes that we may not be able to offset against taxes imposed upon us in the United States, and foreign tax and other laws limiting our ability to repatriate funds to the United States;

 

  ·   Foreign labor laws, regulations and restrictions;

 

  ·   Changes in diplomatic and trade relationships;

 

  ·   Difficulty in staffing and managing foreign operations;

 

  ·   Fluctuations in foreign currency exchange rates, including risks related to any hedging activities we undertake;

 

  ·   Political instability, natural disasters, war and/or events of terrorism; and

 

  ·   The strength of international economies.

 

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We expect that the percentage of our licensing revenue from consumer electronics product manufacturers in China and other developing countries, such as India, will continue to grow due to the lower cost structure in those countries as compared to other industrialized countries. As with consumer electronic product manufacturers in China, we expect to experience problems in these countries with manufacturers failing to report or underreporting shipments of their products that incorporate our technologies or incorporating our technologies into their products without our authorization. If we are unable to successfully identify and stop unauthorized use of our intellectual property and ensure compliance and accurate reporting by these manufacturers, we could experience increased operational and enforcement costs, and our revenue could be impaired. Moreover, because of the limitations of the legal systems in many developing countries, our ability to enforce claims based upon failures to pay royalties is limited. In this regard, we believe that it is critical that we strengthen existing relationships and develop new relationships with manufactures and distributors in developing countries, as well as other participants in the product distribution chain, to increase our ability to enforce our intellectual property and contractual rights. If we are unable to develop, maintain and strengthen these relationships, our revenue from developing countries could be adversely affected. In addition, we have relatively few or no issued patents in certain developing countries, which could prevent or substantially limit our ability to enforce intellectual property claims in those countries.

 

A loss of one or more of our key customers or licensees in any of our markets could adversely affect our operating results.

 

From time to time, one or a small number of our customers or licenses may represent a significant percentage of our professional or licensing revenue. Although we have agreements with many of these customers, these agreements typically do not require any minimum purchases or minimum royalty fees and do not prohibit customers from purchasing products and services from competitors. A decision by any of our major customers or licensees not to use our technologies, or their failure or inability to pay amounts owed to us in a timely manner, or at all, whether due to strategic redirections or adverse changes in their businesses or for other reasons, could have a significant effect on our operating results.

 

Our licensing of industry standard technologies can be subject to limitations that could adversely affect our business and prospects.

 

When our technologies are adopted as explicit industry standards by a standards-setting organization, we generally must agree to license such technologies on a fair, reasonable and non-discriminatory basis, which could limit our control over the use of these technologies. In these situations, we must often limit the royalty rates we charge for these technologies, which could adversely affect our gross margins. Furthermore, we may be unable to limit to whom we license such technologies, and may be unable to restrict many terms of the license. From time to time we may be subject to claims that our licenses of our industry standard technologies may not conform to the requirements of the standards-setting body. Private parties have raised this type of issue with us in the past. Allegations such as these could be asserted in private actions seeking monetary damages and injunctive relief, or in regulatory actions. Claimants in such cases could seek to restrict or change our licensing practices or our ability to license our technologies in ways that could injure our reputation and otherwise materially and adversely affect our business, operating results and prospects.

 

In fiscal 2002, we began licensing some of our patents through our wholly-owned subsidiary Via Licensing Corporation in “patent pools” with other companies in an effort to ensure that our technologies are compatible with other technologies in the entertainment industry and to promote our technologies as industry standards. These patent pools are comprised of a group of patents held by a number of companies, including us in some cases, and administered by Via Licensing, that allow product manufacturers streamlined access to certain foundational technologies. This is a different business model for us and we cannot predict all of the challenges we may face or whether we will be successful. For instance, Via Licensing licenses patents into areas such as wireless markets in which we have not competed previously. As a result, our control over the license of our technologies from these patent pools may be limited as compared to our traditional business model in which we license our patents as bundles of technologies and interact directly with our customers. In addition, our control over the application and quality control of our technologies that are included in these pools may be limited.

 

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In addition, standards setting bodies may require the use of so-called “open standards,” meaning that the technologies necessary to meet those standards are freely available without the payment of a licensing fee or royalty. The industry standards developed for digital cinema will be open standards. The use of open standards may reduce our opportunity to generate revenue by licensing our proprietary technologies and may also reduce, perhaps substantially, barriers to entry for our competitors, both of which could adversely affect our business and prospects.

 

We may be unable to significantly expand our current professional product sales in the cinema industry because our professional products are already used by the vast majority of major cinema operators and major motion picture studios in the United States and much of the rest of the world. If the cinema industry does not expand, or if it contracts, the demand for our professional products will be adversely affected.

 

Our ability to further penetrate the market for motion picture sound technologies is limited because of the widespread use of our current professional products by major motion picture content creators, distributors and cinema operators. As a result, our future revenue from our professional products for the cinema industry will depend, in part, upon events and conditions in that industry—specifically, the continued production and distribution of motion pictures, and the construction of new theatres and the renovation of existing theatres, using our products and services. For example, in the late 1990s cinema operators in the United States built a large number of new cinema megaplexes. This initially resulted in increased sales of our cinema processors, but also resulted in an oversupply of screens in some markets. This oversupply led to significant declines in new theatre construction in the United States in the early 2000s, resulting in a corresponding decline in sales of our cinema processors. As a result, future growth in sales of our existing cinema products may be limited, and may decrease in the future, as the number of new cinemas being built and the number of existing cinemas without our products continues to decline.

 

Events and conditions in the motion picture industry may affect sales of our professional products and production services.

 

Sales of our professional products and production services tend to fluctuate based on the underlying trends in the motion picture industry. In part, this is because our products have been so widely adopted in this industry. When box office receipts for the motion picture industry increase, we have typically seen sales of our professional products increase as well, as cinema owners are more likely to build new theatres and upgrade existing theatres with our more advanced cinema products when they are doing well financially. On the other hand, our production services revenue, both in the United States and internationally, is tied to the number of films being made by studios and independent filmmakers. The number of films that are produced can be affected by a number of factors, including strikes and work-stoppages within the motion picture industry as well as by the tax incentive arrangements that many foreign governments provide filmmakers to promote local filmmaking.

 

The construction of new screens and the renovation of existing theatres, as well as the continued production of new motion pictures, are also adversely impacted by the growth in piracy of motion pictures. Technological advances and the conversion of motion pictures into digital formats have made it easier to create, transmit and “share” high-quality unauthorized copies of motion pictures, including on pirated DVDs and on the Internet. If cinema operators decide to close a significant number of screens in the future or cut their capital spending as a result of piracy, demand for our playback systems and cinema processors will decline, which could negatively impact our operating results.

 

If the market for digital cinema does not develop, or if we are unable to compete successfully in this market, our future prospects could be limited and our business could be adversely affected.

 

Digital cinema is a term used to describe movies that are delivered to and stored in movie theatres in electronic form rather than on film, and that are projected on theatre screens using digital projectors. The cinema industry is in the early stages of the adoption of digital cinema for the distribution and exhibition of movies. We are committed to helping the motion picture industry develop system solutions for digital cinema; this is our major initiative in our products and services segment. However, the conversion of movie theatres from film to digital cinema will be a

 

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significant expense, and we cannot predict how quickly digital cinema will become widely adopted, if at all. There are at present only a very limited number of movie theatres that have been converted to digital cinema and we expect that the conversion of theatres to digital cinema technologies, if it occurs, will be a long-term process due to both technological and financial obstacles. Digital cinema may require a significant investment per screen by cinema operators. If the market for digital cinema fails to develop, or develops more slowly than expected, or if there is significant and sustained resistance by the motion picture industry or cinema operators to this technology or the cost of implementation, we may not realize significant returns on our investment in this area, which could adversely affect our operating results. In addition, because the conversion from film-based to digital cinema is in the early stages, it is impossible to predict accurately how the roles and allocation of costs among various industry participants may develop, if or how quickly digital cinema will be adopted and what, if any, industry standards may be adopted. In addition, it is possible that if a large number of cinema owners decide to convert their theatres to digital cinema over a relatively short period of time and our products are selected for these conversions, we may see an initial increase in professional product sales that will not likely be sustained over time.

 

Even if the market develops, we may not be successful in selling our products, technologies and services in this market. Our effort with respect to digital cinema is one of the areas where we are expanding our business beyond sound technology. As a result, our relative lack of experience in this area may harm our ability to compete successfully. A number of competitors and potential competitors, including Avica, EVS, GDC, Kodak, NEC, QuVis and Sony, are developing similar or alternative solutions for digital cinema, some of which may provide technological or cost advantages over our products, technologies and services. In addition, our products, technologies and services may not be compatible with the products and technologies developed by other companies for digital cinema. Moreover, it is possible that we will be selling components or technologies that will be incorporated into products sold by other companies, which would be a departure from our traditional business of manufacturing our own professional products and could limit our ability to control the distribution and use of our professional products. In addition, we are building components of the digital cinema delivery solution that are not solely related to sound and we do not have a long track record of providing these types of products, which may adversely affect our ability to compete in the digital cinema market. In this regard, our competitors may develop entire system solutions for digital cinema, which could make the technologies that we develop for incorporation in digital cinema systems unnecessary. It is also possible that the professional products used for digital cinema will be sold pursuant to large, long-term contracts at a fixed price, which will be bid upon by potential suppliers. This would be a departure from our traditional model of selling our professional products pursuant to one-time contracts, and could expose us to various risks we have not faced in the past, including an inability to adjust the prices we charge for such services if our costs were to increase. This model also could subject us to potentially higher warranty and intellectual property rights claims.

 

Furthermore, digital cinema will be based upon non-proprietary technology platforms, or “open standards,” in which no one company maintains ownership over the dominant technologies that develop. The use of open standards may reduce our opportunity to generate revenue by licensing our proprietary technologies and may also reduce, perhaps substantially, barriers to entry for our competitors, both of which could adversely affect our business and prospects. The products, technologies and services we expect to market may not achieve or sustain market acceptance, may not meet the needs of the movie industry, and may not be widely adopted. In addition, we expect that our digital cinema products, technologies and services may not be priced as low as those of our competitors, which may make it more difficult for us to compete or have our products and technologies become widely adopted. If we are unsuccessful in selling our products, technologies and services in the market for digital cinema, our business could be materially adversely affected. In addition, although we believe that many of the technological advances we may develop for digital cinema may have applicability in other areas, such as broadcasting or consumer electronics products, we may not ever be able to achieve these anticipated benefits in these other markets.

 

If the film industry broadly adopts digital cinema, the demand for our current professional products and production services could decline. Such a decline in our products and services business could also adversely affect our technology licensing business, because the strength of our brand and our ability to use professional

 

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developments to advance our consumer licensing technologies would be impaired. If, in such circumstances, we are unable to adapt our professional products and production services or introduce new products for the market for digital cinema successfully, our business could be materially adversely affected.

 

If we are unable to expand our business into non-sound technologies, our future growth could be limited.

 

Our future growth will depend, in part, upon our expansion into areas beyond sound technologies. For example, in addition to our digital cinema initiative, we are exploring other areas that facilitate delivery of digital entertainment, such as technologies for processing digital moving images and content protection. We will need to spend considerable resources on research and development in the future in order to deliver innovative non-sound technologies. However, we have limited experience in these markets and, despite our efforts, we cannot predict whether we will be successful in developing and marketing non-sound products, technologies and services. In addition, many of these markets are relatively new and may not grow as we currently anticipate. A number of competitors and potential competitors may develop non-sound technologies similar to those that we develop, some of which may provide advantages over our products, technologies and services. Some of these competitors have much greater experience and expertise in the non-sound fields we may enter. The non-sound products, technologies and services we expect to market may not achieve or sustain market acceptance, may not meet the needs of the movie industry, and may not be accepted as industry standards or as an industry standard. If we are unsuccessful in selling non-sound products, technologies and services, the future growth of our business may be limited. In addition, our efforts to enter or strengthen our positions in non-sound markets may be tied to the success of specific programs. For instance, our subsidiary, Cinea, is currently involved in a program to provide DVD players incorporating technologies intended to prevent the copying of DVDs to members of the Academy of Motion Picture Arts and Sciences for screening of Oscar nominated motion pictures before these DVDs are released to the general public. However, due to delays in our delivery of these DVD players to Academy members, we have received, and expect that we may continue to receive, negative publicity related to this program. If this program is not successful or there is continued adverse publicity associated with it, our reputation may be harmed and our ability to enter the market for content protection technologies, or markets for other non-sound technologies, could be adversely affected.

 

Fluctuations in our quarterly and annual operating results may adversely affect the value of our stock.

 

A number of factors, many of which are outside our control, may cause or contribute to significant fluctuations in our quarterly and annual revenue and operating results. These fluctuations may make financial planning and forecasting more difficult. In addition, these fluctuations may result in unanticipated decreases in our available cash, which could negatively impact our operations. As discussed more fully below, these fluctuations also could increase the volatility of our stock price. Factors that may cause or contribute to fluctuations in our operating results and revenue include:

 

  ·   Fluctuations in demand for our products and for the consumer electronics products of our licensees;

 

  ·   Fluctuations in the timing of royalty reports we receive from our licensees, including late, sporadic or inaccurate reports;

 

  ·   Sporadic payments we may be able to recover from companies utilizing our technologies without a license;

 

  ·   Introduction or enhancement of products, services and technologies by us and our competitors, and market acceptance of these new or enhanced products, services and technologies;

 

  ·   Rapid, wholesale changes in technology in the entertainment industries in which we compete;

 

  ·   Events and conditions in the motion picture industry that affect the number of theatres constructed and the number of movies produced and exhibited, including box office receipts, the popularity of motion pictures generally and strikes by motion picture industry participants;

 

  ·   The financial resources of cinema operators available to buy our products or to equip their theatres to accommodate upgraded or new technologies;

 

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  ·   Consolidation by participants in the markets in which we compete, which could result among other things in pricing pressure;

 

  ·   The amount and timing of our operating costs and capital expenditures, including those related to the expansion of our business, operations and infrastructure;

 

  ·   Variations in the time-to-market of our technologies in the entertainment industries in which we operate;

 

  ·   Seasonal product purchasing patterns by customers of our professional products and seasonal product sales patterns by our consumer electronics product licensees;

 

  ·   The impact of, and our ability to react to, political instability, natural disasters, war and/or events of terrorism;

 

  ·   The impact of, and our ability to react to, interruptions in the entertainment distribution chain, including as a result of work stoppages at our facilities, our customers’ facilities and other points throughout the entertainment distribution chain;

 

  ·   Widespread illnesses such as the SARS illness and Avian Influenza, or Asian Bird Flu, in Asia that could impact our operations, or that could impact the operations of our professional products and production services customers or our consumer electronics product manufacturer licensees—for example, in the past our ability to visit our consumer electronics product manufacturer licensees in Asia was limited by travel restrictions imposed in response to SARS;

 

  ·   Changes in business cycles that affect the markets in which we sell our products and services or the markets for consumer electronics products incorporating our technologies;

 

  ·   Fluctuations in foreign currency exchange rates or our ability to hedge foreign currency risks;

 

  ·   Adverse outcomes of litigation or governmental proceedings, including any foreign, federal, state or local tax assessments or audits; and

 

  ·   Costs of litigation and intellectual property protection.

 

One or more of the foregoing or other factors may cause our operating expenses to be disproportionately higher or lower or may cause our revenue and operating results to fluctuate significantly in any particular quarterly or annual period. Results from prior periods are thus not necessarily indicative of the results of future periods.

 

The loss of or interruption in operations of one or more of our key suppliers could materially delay or stop the production of our professional products and impair our ability to generate revenue.

 

Our reliance on outside suppliers for some of the key materials and components we use in the manufacture of our professional products involves risks, including limited control over the price, timely delivery and quality of such components. We have no agreements with our suppliers to ensure continued supply of materials and components. Although we have identified alternate suppliers for most of our key materials and components, any required changes in our suppliers could cause material delays in our production operations and increase our production costs. In addition, our suppliers may not be able to meet our future production demands as to volume, quality or timeliness. Moreover, we rely on sole source suppliers for some of the components that we use to manufacture our professional products, including certain charged coupled devices, light emitting diodes and digital signal processors. These sole source suppliers may become unable or unwilling to deliver these components to us at an acceptable cost or at all, which could force us to redesign certain of our products. Our inability to obtain timely delivery of key components of acceptable quality, any significant increases in the prices of components, or the redesign of our professional products could result in material production delays, increased costs and reductions in shipments of our products, any of which could increase our operating costs, harm our customer relationships or materially and adversely affect our business and operating results.

 

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Revenue from our professional products may suffer if our production processes encounter problems or if we are not able to match our production capacity to fluctuating levels of demand.

 

Our professional products are highly complex, and production difficulties or inefficiencies can interrupt production, resulting in our inability to deliver products on time in a cost effective, competitive manner. If production is interrupted at one of our two manufacturing facilities, we may not be able to shift production to the other facility on a timely basis, and customers may purchase products from our competitors. Likewise, we may be unable to respond to fluctuations in customer demand. A shortage of manufacturing capacity for our professional products could adversely affect our operating results and damage our customer relationships. In addition, because we cannot quickly adapt our manufacturing capacity to rapidly changing market conditions, at times we underutilize our manufacturing facilities as a result of reduced demand for certain of our professional products, which may adversely affect our gross margins.

 

Our professional products, from time to time, experience quality problems that can result in decreased sales and higher operating expenses.

 

Our professional products are complex and sometimes contain undetected software or hardware errors, particularly when first introduced or when new versions are released. In addition, our professional products are sometimes combined with or incorporated into products from other vendors, sometimes making it difficult to identify the source of a problem. These errors could result in a loss of or delay in market acceptance of our professional products or cause delays in delivering them and meeting customer demands, any of which could reduce our revenue and raise significant customer relations issues. In addition, if our professional products contain errors we could be required to replace or reengineer them, which could increase our costs. Moreover, if any such errors cause unintended consequences, we could face claims for product liability. Although we generally attempt to contractually limit liability for defective products to the cost of repairing or replacing these products, if these contract provisions are not enforced or are unenforceable for any reason, or if liabilities arise that are not effectively limited, we could incur substantial costs in defending and settling product liability claims.

 

We are subject to various environmental laws and regulations that could impose substantial costs upon us and may adversely affect our business, operating results and financial condition.

 

Some of our operations use substances regulated under various federal, state, local and international laws governing the environment, including those governing the discharge of pollutants into the air and water, the management, disposal and labeling of hazardous substances and wastes and the cleanup of contaminated sites. Certain of our products are subject to various federal, state and international laws governing chemical substances in electronic products. We could incur costs, fines and civil or criminal sanctions, third-party property damage or personal injury claims, or could be required to incur substantial investigation or remediation costs, if we were to violate or become liable under environmental laws. Liability under environmental laws can be joint and several and without regard to comparative fault. The ultimate costs under environmental laws and the timing of these costs are difficult to predict.

 

The European Parliament has recently finalized the Waste Electrical and Electronic Equipment Directive, or WEEE Directive, which makes producers of electrical goods financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. As a producer of electronic equipment, we will incur financial responsibility for the collection, recycling, treatment or disposal of products covered under the WEEE Directive. In addition, the European Parliament has enacted the Restriction on Use of Hazardous Substances Directive, or RoHS Directive, which restricts the use of certain hazardous substances in electrical and electronic equipment that are vital components in products we manufacture, including mercury, lead, cadmium and hexavalent chromium. We may need to redesign or reformulate products containing hazardous substances regulated under the RoHS Directive to reduce or eliminate those regulated hazardous substances in our products. For some products, substitutions for regulated hazardous substances may be difficult or costly to obtain or redesign efforts could result in production delays. Individual European member states are required to enact

 

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legislation to implement the two Directives. Although the United Kingdom has not yet enacted legislation to implement these two Directives, we are continuing to review the applicability and impact of both Directives on the manufacturing of our professional products in our Wootton Bassett, England facility. We expect to incur increased manufacturing costs or production delays to comply with future legislation which implements these Directives, but we cannot currently estimate the extent of such increased costs or production delays. However, to the extent that such cost increases or delays are substantial, our operating results could be materially adversely affected. In addition, similar legislation may be enacted in other countries, including federal and state legislation in the United States, the cumulative impact of which could significantly increase our operating costs and adversely affect our operating results.

 

The WEEE Directive and the RoHS Directive likely will impact some customers who license our technology and pay us royalties upon the sale of electronic products. If the Directives result in fewer licensed consumer electronics products being sold, whether due to price increases, production delays, compromised product performance due to reformulation or redesign, or for other reasons, then we will receive less revenue in royalties. If the Directives materially impair or inhibit such sales, the reduction in licensing revenue could adversely affect our operating results.

 

We also expect that our operations, whether manufacturing or licensing, will be affected by other new environmental laws and regulations on an ongoing basis. Although we cannot predict the ultimate impact of any such new laws and regulations, they will likely result in additional costs, or decreased licensing revenue, and could require that we redesign or change how we manufacture our products, any of which could have a material adverse effect on our business.

 

Any inability to protect our intellectual property rights could reduce the value of our products, services and brand.

 

Our business is dependent upon our patents, trademarks, trade secrets, copyrights and other intellectual property rights. We derived 66%, 73% and 73% of our total revenue from licensing revenue in fiscal years 2002, 2003 and 2004, respectively. Effective intellectual property rights protection, however, may not be available under the laws of every country in which our products and services and those of our licensees are distributed. Also, the efforts we have taken to protect our proprietary rights may not be sufficient or effective. Any significant impairment of our intellectual property rights could harm our business or our ability to compete. In addition, protecting our intellectual property rights is costly and time consuming. We have taken steps in the past to enforce our intellectual property rights and expect to continue to do so in the future. However, it may not be practicable or cost effective for us to enforce our intellectual property rights fully, particularly in certain developing countries or where the initiation of a claim might harm our business relationships. For example, we have many times experienced, and expect to continue to experience, problems with Chinese consumer electronics product manufacturers incorporating our technologies into their products without our authorization. If we are unable to successfully identify and stop unauthorized use of our intellectual property, we could experience increased operational and enforcement costs both inside and outside China, which could adversely affect our financial condition and results of operations.

 

We generally seek patent protection for our innovations. It is possible, however, that some of these innovations may not be protectable. In addition, given the costs of obtaining patent protection, we may choose not to protect certain innovations that later turn out to be important. Moreover, we have limited or no patent protection in certain foreign jurisdictions. For example, in China we have only limited patent protection, especially with respect to our Dolby Digital technologies, and in India we have no issued patents. Furthermore, there is always the possibility, despite our efforts, that the scope of the protection gained will be insufficient or that an issued patent may later be found to be invalid or unenforceable. We also seek to maintain certain intellectual property as trade secrets. These trade secrets could be compromised by third parties, or intentionally or accidentally by our employees, which would cause us to lose the competitive advantage resulting from them.

 

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We may become subject to a personal holding company tax, which could materially and adversely affect our operating results and financial condition.

 

For United States federal income tax purposes, a corporation is generally considered to be a “personal holding company” under the United States Internal Revenue Code if (i) at any time during the last half of its taxable year more than 50% of its stock by value is owned, directly or indirectly, by virtue of the application of certain stock ownership attribution rules set forth in the Internal Revenue Code for purposes of applying the personal holding company rules, by five or fewer individuals and (ii) at least 60% of its adjusted ordinary gross income, as defined for United States federal income tax purposes, is “personal holding company income.” Personal holding company income is generally passive income, including royalty income, subject to certain exceptions such as qualifying software royalties. A personal holding company is subject to an additional tax on its undistributed after-tax income, equal to a statutory tax rate, which is currently 15%. Since the personal holding company tax is imposed only on undistributed income, a personal holding company can avoid or mitigate liability for the tax by paying a dividend to its stockholders.

 

Before this offering, more than 50% of the value of our stock was held by Ray Dolby and stockholders considered affiliated with him pursuant to the stock ownership attribution rules applicable to personal holding companies. We expect this will continue to be the case immediately after this offering. In addition, a significant portion of our income is from licensing fees, which may constitute personal holding company income. We believe, however, that neither we nor any of our subsidiaries are currently subject to, or liable for, the personal holding company tax. Moreover, we do not believe that we or any of our subsidiaries have previously been subject to, or liable for, the personal holding company tax.

 

However, the Internal Revenue Service may assert that we and any of our subsidiaries are currently, or previously have been, subject to, or liable for, the personal holding company tax. In addition, we and our subsidiaries may be subject to, or liable for, the personal holding company tax in the future. The treatment of certain items of our income, and the income of our subsidiaries, for purposes of the personal holding company tax may be subject to challenge. In the event that we or any of our subsidiaries were determined to be a personal holding company, or for prior taxable years, to have been a personal holding company, we could be liable for substantial additional taxes. In addition, we believe that there exists a meaningful risk that in the relatively near future the mix of our revenue will change so that more of our adjusted ordinary gross income may be classified as personal holding company income. In such event, it is possible that we or one of our subsidiaries could become subject to the personal holding company tax, assuming the ownership test continues to be met. In that case, we or our subsidiary, as the case may be, may be required to pay additional tax or, alternatively, we may choose to declare a dividend to our stockholders to avoid or mitigate liability for the tax. We are currently exploring options to reduce our exposure, and the exposure of our subsidiaries, to the personal holding company tax in the future.

 

If we or any of our subsidiaries were to pay personal holding company tax, this could significantly increase our consolidated tax expense and adversely affect our operating results. In addition, if the statutory tax rate increases in the future, the amount of any personal holding company tax we or any of our subsidiaries may have to pay could increase significantly, further impairing our operating results. In that regard, the statutory tax rate, which is currently 15%, is scheduled to return to ordinary income tax rate levels for tax years beginning on or after January 1, 2009. If we are deemed to be a personal holding company and, instead of paying the personal holding company tax, we elect to pay a dividend to our stockholders in an amount equal to all or a significant part of our undistributed personal holding company income, we may consume a significant amount of cash resources and be unable to retain or generate working capital. This would adversely affect our financial condition. As a result, if we pay such a dividend, we may decide to seek additional financing, although that financing may not be available to us when and as required on commercially reasonable terms, if at all.

 

Failure to comply with applicable current and future government regulations could have a negative effect on our business.

 

Our operations and business practices are subject to federal, state and local government laws and regulations, as well as international laws and regulations, including those relating to consumer and other safety-

 

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related compliance for electronic equipment, as well as compulsory license requirements as a prerequisite to being included as part of the industry standards, such as the United States HDTV standard. Any failure by us to comply with the laws and regulations applicable to us or our products could result in our inability to sell those products, additional costs to redesign products to meet such laws and regulations, fines or other administrative actions by the agencies charged with enforcing compliance and, possibly, damages awarded to persons claiming injury as the result of our non-compliance. Changes in or enactment of new statutes, rules or regulations applicable to us could have a material adverse effect on our business.

 

Acquisitions could result in operating difficulties, dilution to our stockholders and other harmful consequences.

 

We have evaluated, and expect to continue to evaluate, a wide array of possible strategic transactions and acquisitions. For example, we consider these types of transactions in connection with our efforts to expand our business beyond sound technologies, such as in digital cinema and other technologies related to the delivery of digital entertainment. Although we cannot predict whether or not we will complete any such acquisition or other transactions in the future, any of these transactions could be material in relation to our financial condition and results of operations. The process of integrating an acquired company, business or technology may create unforeseen difficulties and expenditures. The areas where we may face risks include:

 

  ·   The need to implement or improve internal controls, procedures and policies appropriate for a public company at businesses that prior to the acquisition lacked these controls, procedures and policies;

 

  ·   Diversion of management time and focus from operating our business to acquisition integration challenges;

 

  ·   Cultural challenges associated with integrating employees from acquired businesses into our organization;

 

  ·   Retaining employees from businesses we acquire;

 

  ·   Possible write-offs or impairment charges resulting from acquisitions;

 

  ·   Unanticipated or unknown liabilities relating to acquired businesses; and

 

  ·   The need to integrate acquired businesses’ accounting, management information, manufacturing, human resources and other administrative systems to permit effective management.

 

Foreign acquisitions involve unique risks in addition to those mentioned above, including those related to integration of operations across different geographies, cultures and languages, currency risks and risks associated with the particular economic, political and regulatory environment in specific countries. Also, the anticipated benefit of our acquisitions may not materialize. Future acquisitions could result in potentially dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities or amortization expenses, or write-offs of goodwill, any of which could harm our operating results or financial condition. Future acquisitions may also require us to obtain additional equity or debt financing, which may not be available on favorable terms or at all.

 

The loss of members of our management team could substantially disrupt our business operations.

 

Our success depends to a significant degree upon the continued individual and collective contributions of our management team. A limited number of individuals have primary responsibility for managing our business, including our relationships with key customers and licensees. We have a number of key executives and senior technical people who have been with us for a number of years, including over 150 employees who have been with us for over 10 years. These individuals, as well as the rest of our management team and key employees, are at-will employees, and we do not maintain any key-person life insurance policies. Losing the services of any key member of our team, whether from retirement, competing offers or other causes, could prevent us from executing our business strategy, cause us to lose key customer or licensee relationships, or otherwise materially affect our operations.

 

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We rely on highly skilled personnel, and if we are unable to retain or motivate key personnel or hire qualified personnel, we may not be able to maintain our operations or grow effectively.

 

Our performance is largely dependent on the talents and efforts of highly skilled individuals. Our future success depends on our continuing ability to identify, hire, develop, motivate and retain highly skilled personnel for all areas of our organization. In this regard, we currently plan to hire a significant number of employees prior to the end of calendar 2005 in response to our growth and our current initiatives and if we are unable to hire and train a sufficient number of qualified employees for any reason, we may not be able to implement our current initiatives or grow effectively. However, competition in our industry for qualified employees is intense, and we are aware that certain of our competitors have directly targeted our employees. We have in the past maintained a rigorous, highly selective and time-consuming hiring process. We believe that our approach to hiring has significantly contributed to our success to date. However, our highly selective hiring process has made it more difficult for us to hire a sufficient number of qualified employees, and, as we grow, our hiring process may prevent us from hiring the personnel we need in a timely manner. In addition, the high cost of living in the San Francisco Bay Area, where our corporate headquarters and a significant portion of our operations are located, has been an impediment in attracting new employees and retaining existing employees in the past, and we expect that this high cost of living will continue to impair our ability to attract and retain employees in the future. Furthermore, for much of our history we have relied upon cash compensation arrangements, such as cash bonuses, rather than option grants, to motivate our employees. In recent years, we have granted options to key employees. Nonetheless, there is no assurance that either of these approaches will provide adequate incentives to attract, retain and motivate employees in the future. If we do not succeed in attracting excellent personnel and retaining and motivating existing personnel, our existing operations may suffer and we may be unable to grow effectively.

 

If we cannot maintain our corporate culture as we grow, we could lose the innovation, teamwork and focus that we believe our culture fosters, and our business may be harmed.

 

We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, teamwork and a focus both on developing and strengthening long-term relationships with entertainment industry participants and on developing practical, enduring technology solutions for the entertainment industry. As we grow and change in response to the requirements of being a public company, we may find it difficult to maintain important aspects of our corporate culture, which could negatively affect our future success. We intend to continue to focus on developing technologies for the entertainment industries that provide long-term benefits, and we intend to keep our focus on long-term results.

 

We will incur increased costs and demands upon management as a result of complying with the laws and regulations affecting public companies, which could affect our operating results.

 

As a public company we will incur significant legal, accounting and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with recently adopted corporate governance requirements, including requirements under the Sarbanes-Oxley Act, as well as new rules implemented by the SEC and the NYSE. In addition, our management team will also have to adapt to the requirements of being a public company, as none of our senior executive officers has significant experience in the public company environment. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly. We also expect these new rules and regulations may make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage than used to be available. As a result, it may be more difficult for us to attract and retain qualified individuals to serve on our board of directors or as our executive officers.

 

If we fail to maintain proper and effective internal controls, our ability to produce accurate financial statements could be impaired, which could adversely affect our operating results, our ability to operate our business and investors’ views of us.

 

We have a complex business organization that is international in scope. Ensuring that we have adequate internal financial and accounting controls and procedures in place to help ensure that we can produce accurate

 

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financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. We are in the process of documenting, reviewing and, if appropriate, improving our internal controls and procedures in connection with Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our independent auditors addressing these assessments. Both we and our independent auditors will be testing our internal controls in connection with the Section 404 requirements and could, as part of that documentation and testing, identify areas for further attention or improvement. Implementing any appropriate changes to our internal controls may require specific compliance training of our directors, officers and employees, entail substantial costs in order to modify our existing accounting systems, and take a significant period of time to complete. Such changes may not, however, be effective in maintaining the adequacy of our internal controls, and any failure to maintain that adequacy, or consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and could materially impair our ability to operate our business. In addition, investors’ perceptions that our internal controls are inadequate or that we are unable to produce accurate financial statements may seriously affect our stock price.

 

Issues arising from the implementation of our new enterprise resource planning system could affect our operating results and ability to manage our business effectively.

 

We are currently implementing a PeopleSoft enterprise resource planning, or ERP, system over a three-year period ending in 2007 that is critical to our accounting, financial, operating and manufacturing functions. Implementing a new ERP system raises costs and risks inherent in the conversion to a new computer system, including disruption to our normal accounting procedures and problems achieving accuracy in the conversion of electronic data. Failure to properly or adequately address these issues could result in increased costs, the diversion of management’s attention and resources and could materially adversely affect our operating results and ability to manage our business effectively. In addition, we do not know whether or not the pending Oracle acquisition bid for PeopleSoft will affect the implementation and future use of our ERP system. To the extent that this acquisition delays, complicates or prevents the full implementation, future use or service of our ERP system, our operating results and financial condition could be adversely affected.

 

Calamities, power shortages or power interruptions at our San Francisco and Burbank offices or our Brisbane manufacturing facilities could disrupt our business and adversely affect our operations, and could disrupt the businesses of our major professional products and production services customers.

 

Our principal operations are located in Northern California, including our corporate headquarters in San Francisco and one of our manufacturing facilities in Brisbane, California. Many of our motion picture production services operations are located in Burbank, California. In addition, many of our major professional products and production services customers in the motion picture and broadcast industries are located in Burbank and other Southern California locations. All of these locations are in areas of seismic activity near active earthquake faults. Any earthquake, terrorist attack, fire, power shortage or other calamity affecting our facilities or our customers’ facilities may disrupt our business and substantially affect our operations.

 

Accounting for employee stock options using the fair value method could significantly reduce our net income.

 

There has been ongoing public debate whether stock options granted to employees should be treated as a compensation expense and, if so, how to properly value such charges. Currently, we account for options using the intrinsic value method, which, given that we have generally granted employee options with exercise prices equal to the fair market value of the underlying stock at the time of grant, results in no compensation expense. If, however, we had used the fair value method of accounting for stock options granted to employees using a Black-Scholes option valuation formula, our net income would have been reduced to $31.9 million, rather than the $34.6 million reported, for the fiscal year ended September 24, 2004. If in the future we elect or are required to record expenses for our stock-based compensation plans using the fair value method, we could have on-going accounting charges significantly greater than those we would have recorded under our current method of accounting for stock options, which could have a material adverse affect on our operating results.

 

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We are exposed to foreign currency and interest rate risks.

 

We maintain sales, marketing and business operations in foreign countries, most significantly in the United Kingdom, and have exposure to adverse changes in exchange rates associated with operating expenses of our foreign operations. We are also exposed to interest rate risks on our facility debt obligations. We use various strategies to manage these risks. For example, our profit margins and competitive position in foreign markets are affected by the strength of the United States dollar versus the strength of the currencies in those countries where we manufacture and sell our products and services. From time to time we review our foreign currency exposure and evaluate whether we should enter into hedging transactions. Additionally, our investment portfolio is diversified and consists primarily of investment grade securities with maturities less than 90 days in order to minimize credit risk; we also use interest rate swap agreements to hedge our interest rate risks in the event of unexpected increases in interest rates. Nevertheless, we cannot completely hedge the foreign currency and interest rate risks we face. Adverse results with respect to these risks could therefore harm our financial condition and operating results.

 

Holders of our Class A common stock, which is the stock we are selling in this offering, are entitled to one vote per share, and holders of our Class B common stock are entitled to ten votes per share. The lower voting power of the Class A common stock may negatively affect the attractiveness of our Class A common stock to investors and, as a result, its market value.

 

Upon consummation of this offering, we will have two classes of common stock: Class A common stock, which is the stock we are selling in this offering and which is entitled to one vote per share, and Class B common stock, which is held primarily by Ray Dolby and persons and entities affiliated with Ray Dolby and which is entitled to ten votes per share. Except in certain limited circumstances required by applicable law, holders of Class A common stock and Class B common stock vote together as a single class on all matters to be voted on by our stockholders. As of September 24, 2004, 86,547,910 shares of Class B common stock are outstanding, and 12,599,820 shares of Class B common stock are issuable upon the exercise of outstanding options. Therefore, assuming the exercise of all outstanding options as of September 24, 2004, after completion of this offering approximately     % of the total voting power of our outstanding shares will be held by the Class B common stockholders. Accordingly, our Class B common stockholders constitute, and are expected to continue to constitute, a significant portion of the shares entitled to vote on all matters requiring approval by our stockholders. The difference in the voting power of our Class A common stock and Class B common stock could diminish the market value of our Class A common stock if investors attribute value to the superior voting rights of our Class B common stock and the power those rights confer. There is no threshold or time deadline at which the shares of Class B common stock will automatically convert into shares of Class A common stock.

 

For the foreseeable future, Ray Dolby or his affiliates will be able to control the selection of all members of our board of directors, as well as virtually every other matter that requires stockholder approval, which will severely limit the ability of other stockholders to influence corporate matters.

 

Immediately following the completion of this offering, Ray Dolby and persons and entities affiliated with Ray Dolby will own approximately         % of our Class B common stock, representing         % of the combined voting power of our outstanding Class A and Class B common stock. Under our charter, holders of shares of Class B common stock may generally transfer such shares to family members, including spouses and domestic partners, and descendants without having the shares automatically convert into shares of Class A common stock. Because of this dual class structure, Ray Dolby, his affiliates, and his family members and descendents will, for the foreseeable future, have significant influence over our management and affairs, and will be able to control virtually all matters requiring stockholder approval, including the election of directors and significant corporate transactions such as mergers or other sales of our company or assets, even if they come to own considerably less than 50% of the total number of outstanding shares of our Class A and Class B common stock. Moreover, these persons may take actions in their own interests that you or our other stockholders do not view as beneficial. There is no threshold or time deadline at which the shares of Class B common stock will automatically convert into shares of Class A common stock. Assuming conversion of all shares of Class B common stock held by persons not affiliated with Ray Dolby, so long as Ray Dolby and his affiliates continue to hold shares of Class B

 

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common stock representing approximately 9% or more of the total number of outstanding shares of our Class A and Class B common stock, they will hold a majority of the combined voting power of the Class A and Class B common stock. See “Description of Capital Stock.”

 

An active, liquid and orderly trading market for our common stock may not develop.

 

Prior to this offering, there has been no public market for shares of our Class A common stock. We and the representatives of the underwriters will determine the initial public offering price of our Class A common stock through negotiation. This price will not necessarily reflect the price at which investors in the market will be willing to buy and sell our shares following this offering. In addition, the trading price of our Class A common stock following this offering is likely to be highly volatile and could be subject to wide fluctuations in response to various factors, some of which are beyond our control. These factors include:

 

  ·   Quarterly variations in our results of operations or those of our competitors;

 

  ·   Our ability to develop and market new and enhanced products on a timely basis;

 

  ·   Announcements by us or our competitors of acquisitions, new products, significant contracts, commercial relationships or capital commitments;

 

  ·   The emergence of new markets, such as digital cinema, that may affect our existing business or in which we may not be able to compete effectively;

 

  ·   Whether we are successful in establishing our technologies as part of industry standards in new markets;

 

  ·   Commencement of, or our involvement in, litigation;

 

  ·   Changes in governmental regulations or in the status of our regulatory approvals;

 

  ·   Changes in earnings estimates or recommendations by securities analysts;

 

  ·   Any major change in our board or management;

 

  ·   General economic conditions and slow or negative growth of our markets; and

 

  ·   Political instability, natural disasters, war and/or events of terrorism.

 

In addition, the stock market in general, and the market for technology companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Broad market and industry factors may seriously affect the market price of companies’ stock, including ours, regardless of actual operating performance. These fluctuations may be even more pronounced in the trading market for our stock shortly following this offering. In addition, in the past, following periods of volatility in the overall market and the market price of a particular company’s securities, securities class action litigation has often been instituted against these companies. This litigation, if instituted against us, could result in substantial costs and a diversion of our management’s attention and resources.

 

Provisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable.

 

Provisions in our amended and restated certificate of incorporation and amended and restated bylaws, as in effect upon the completion of this offering, may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following:

 

  ·   Our amended and restated certificate of incorporation provides for a dual class common stock structure. As a result of this structure, Ray Dolby and his affiliates will have control for the foreseeable future over virtually all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or its assets. This concentrated control could discourage others from initiating any potential merger, takeover or other change of control transaction that our other stockholders may view as beneficial.

 

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  ·   Our board of directors has the sole right to elect a director to fill a vacancy created by the expansion of the board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors.

 

  ·   After such time as the holders of our Class B common stock hold less than a majority of the combined voting power of our outstanding shares of Class A and Class B common stock, our stockholders may not act by written consent. As a result, a holder or holders controlling a majority of the combined voting power of our outstanding shares of Class A and Class B common stock at such time would not be able to take certain actions without the convening of a stockholders’ meeting.

 

  ·   Our amended and restated certificate of incorporation prohibits cumulative voting in the election of directors. This limits the ability of holders of Class A common stock and minority stockholders to elect director candidates.

 

  ·   Stockholders must provide advance notice to nominate individuals for election to the board of directors or to propose matters to be acted upon at a stockholders’ meeting. These provisions may discourage or deter a potential acquiror from conducting a solicitation of proxies to elect the acquiror’s own slate of directors or otherwise attempting to obtain control of our company.

 

As a Delaware corporation, we are also subject to certain Delaware anti-takeover provisions. Under Delaware law, a corporation may, in general, not engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other things, the board of directors has approved the transaction.

 

Purchasers in this offering will experience immediate and substantial dilution in the book value of their investment.

 

The initial public offering price of our Class A common stock is substantially higher than the net tangible book value per share of our Class A common stock immediately after this offering. Therefore, if you purchase our Class A common stock in this offering, you will incur an immediate dilution of $              in net tangible book value per share from the price you paid, based on an assumed initial public offering price of $              per share. The exercise of outstanding options and warrants will result in further dilution. For a further description of the dilution that you will experience immediately after this offering, see “Dilution.”

 

Future sales of shares by existing stockholders could cause our stock price to decline.

 

If our existing stockholders sell, or indicate an intention to sell, substantial amounts of our Class A common stock, including shares of Class A common stock issuable upon conversion of shares of Class B common stock, in the public market after the lock-up and other legal restrictions on resale discussed in this prospectus lapse, the trading price of our Class A common stock could decline. Based on shares outstanding as of September 24, 2004, upon completion of this offering, we will have outstanding a total of                      shares of Class A and Class B common stock, assuming no exercise of the underwriters’ over-allotment option. Of these shares, only the                      shares of Class A common stock sold in this offering by us and the selling stockholders will be freely tradable, without restriction, in the public market. Our underwriters, however, may, in their sole discretion, permit our officers, directors and other current stockholders who are subject to the contractual lock-up to sell shares prior to the expiration of the lock-up agreements.

 

We expect that the lock-up agreements pertaining to this offering will expire 180 days from the date of this prospectus, although those lock-up agreements may be extended for up to an additional 35 days under certain circumstances. After the lock-up agreements expire, up to an additional                      shares of Class A common stock issuable upon conversion of outstanding shares of our Class B common stock will be eligible for sale in the public market,                      of which shares of Class B common stock are held by directors, executive officers and other affiliates and will be subject to volume limitations under Rule 144 under the Securities Act and various vesting agreements. In addition,                      shares of Class A or Class B common stock that are either subject to outstanding options or reserved for future issuance under our employee benefit plans will become eligible for

 

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sale in the public market to the extent permitted by the provisions of various vesting agreements, the lock-up agreements and Rules 144 and 701 under the Securities Act. If these additional shares are sold, or if it is perceived that they will be sold, in the public market, the trading price of our Class A common stock could decline.

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS AND INDUSTRY DATA

 

This prospectus includes forward-looking statements. All statements other than statements of historical facts contained in this prospectus, including statements regarding our future results of operations and financial position, business strategy and plans and objectives of management for future operations, are forward-looking statements. The words “believe,” “may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “expect” and similar expressions are intended to identify forward-looking statements. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy, short term and long term business operations and objectives, and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in “Risk Factors.” In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this prospectus may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements.

 

This prospectus contains statistical data regarding the consumer electronics product industry that we obtained from industry reports generated by Arbitron, the Consumer Electronics Association and International Data Corporation. These reports generally indicate that their information has been obtained from sources believed to be reliable, but do not guarantee the accuracy and completeness of their information. Although we believe that the reports are reliable, we have not independently verified their data.

 

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USE OF PROCEEDS

 

We estimate that we will receive net proceeds of $             from our sale of the                      shares of Class A common stock offered by us in this offering, based upon an assumed initial public offering price of $             per share, after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us. We will not receive any of the net proceeds from the sale of the shares by the selling stockholders.

 

The principal purposes of this offering are to create a public market for our Class A common stock, to facilitate our future access to the public equity markets and to obtain additional capital. We currently have no specific plans for the use of the net proceeds of this offering. We anticipate that we will use the net proceeds received by us from this offering for general corporate purposes, including working capital. In addition, we may use a portion of the proceeds of this offering for acquisitions of complementary businesses, technologies or other assets. We have no current agreements or commitments with respect to any material acquisitions. Pending such uses, we plan to invest the net proceeds in highly liquid, investment grade securities.

 

 
DIVIDEND POLICY

 

We have never declared or paid any cash dividend on our capital stock. We currently intend to retain any future earnings and do not expect to pay any dividends in the foreseeable future. However, if we are deemed to be a personal holding company for tax purposes, we may elect to pay a dividend to our stockholders in an amount equal to all or a significant part of our undistributed personal holding company income (which could be significant), rather than paying personal holding company tax on such undistributed personal holding company income, if any. See “Risk Factors—We may become subject to a personal holding company tax, which could materially and adversely affect our operating results and financial condition.”

 

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CAPITALIZATION

 

The following table sets forth our cash and cash equivalents and our capitalization as of September 24, 2004, as follows:

 

  ·   On an actual basis;

 

  ·   On an as adjusted basis to give effect to the issuance by us of                      shares of Class A common stock in this offering and the receipt of the net proceeds from our sale of these shares at an assumed initial public offering price of $             per share, after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

You should read this table together with the sections of this prospectus entitled “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited and pro forma consolidated financial statements and the related notes included elsewhere in this prospectus.

 

      
As of September 24, 2004

     Actual

     As Adjusted

     (in thousands, except share data)  

Cash and cash equivalents

   $ 78,711      $             
    


  

Total debt

   $ 14,870      $  

Stockholders’ equity:

               

Class A common stock, $0.001 par value, one vote per share, 500,000,000 shares authorized: no shares issued and outstanding, actual;                      shares issued and outstanding, as adjusted.

             

Class B common stock, $0.001 par value, ten votes per share, 500,000,000 shares authorized: 86,547,910 shares issued and outstanding, actual;                      shares issued and outstanding, as adjusted

     87         

Additional paid-in capital

     73,942         

Deferred stock-based compensation

     (51,594 )       

Retained earnings

     119,860         

Accumulated other comprehensive income

     3,079         
    


  

Total stockholders’ equity

     145,374         
    


  

Total capitalization

   $ 160,244      $             
    


  

 

The table above excludes the following shares:

 

  ·   12,599,820 shares of Class B common stock issuable upon the exercise of options outstanding at September 24, 2004, at a weighted average exercise price of $1.61 per share;

 

  ·   780,750 shares of Class B common stock issuable upon the exercise of options granted after September 24, 2004, at an exercise price of $6.28 per share; and

 

  ·   6,000,000 shares of Class A common stock available for future issuance under our 2005 Stock Plan.

 

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DILUTION

 

If you invest in our Class A common stock, your interest will be diluted to the extent of the difference between the initial public offering price per share of our Class A common stock and the as adjusted net tangible book value per share of our Class A and Class B common stock immediately after this offering. Net tangible book value per share represents the amount of our total tangible assets less total liabilities, divided by the number of shares of Class A and Class B common stock outstanding at September 24, 2004.

 

Our net tangible book value was $116.6 million, computed as total stockholders’ equity less goodwill and other intangible assets, or $1.35 per share of Class A and Class B common stock outstanding, at September 24, 2004. Assuming the sale by us of              shares of Class A common stock offered in this offering at an initial public offering price of $             per share, and after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us, our as adjusted net tangible book value at September 24, 2004 would have been $             million, or $             per share of common stock. This represents an immediate increase in net tangible book value of $             per share to our existing stockholders and an immediate dilution of $             per share to the new investors purchasing shares in this offering. The following table illustrates this per share dilution:

 

Assumed initial public offering price per share of Class A common stock

          $             

Net tangible book value per share of Class A and Class B common stock at September 24, 2004

   $                    

Increase in net tangible book value per share attributable to this offering

             
    

      

As adjusted net tangible book value per share after the offering

             
           

Dilution per share to new investors

          $             
           

 

The following table sets forth on an as adjusted basis, as of September 24, 2004, the number of shares of common stock purchased or to be purchased from us, the total consideration paid or to be paid and the average price per share paid or to be paid by existing holders of common stock and by the new investors, before deducting estimated underwriting discounts and estimated offering expenses payable by us.

 

      
Shares Purchased

  Total Consideration

 

Average

Price Per

Share


     Number

   Percent

  Amount

   Percent

 

Existing stockholders

                %   $                         %   $             

New investors

                          
    
  
 

  
     

Total

                %   $                         %      
    
  
 

  
     

 

The discussion and tables above are based on the number of shares of Class B common stock outstanding at September 24, 2004. The discussion and tables above exclude the following shares:

 

  ·   12,599,820 shares of Class B common stock issuable upon the exercise of options outstanding at September 24, 2004, at a weighted average exercise price of $1.61 per share;

 

  ·   780,750 shares of Class B common stock issuable upon the exercise of options granted after September 24, 2004, at an exercise price of $6.28 per share; and

 

  ·   6,000,000 shares of Class A common stock available for future issuance under our 2005 Stock Plan.

 

To the extent outstanding options are exercised, new investors will experience further dilution.

 

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SELECTED CONSOLIDATED FINANCIAL DATA

 

The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and the accompanying notes included elsewhere in this prospectus. The consolidated statements of operations data for the fiscal years ended September 27, 2002, September 26, 2003 and September 24, 2004 and balance sheet data as of such dates were derived from our audited consolidated financial statements that are included elsewhere in this prospectus. The consolidated statements of operations for the fiscal years ended September 29, 2000 and September 28, 2001 and balance sheet data as of such dates were derived from our unaudited consolidated financial statements. The unaudited consolidated financial statements were prepared on a basis consistent with our audited consolidated financial statements contained in this prospectus and include, in the opinion of management, all adjustments necessary for the fair presentation of the financial information contained in those statements. The historical results presented below are not necessarily indicative of financial results to be achieved in future periods.

 

 
     
Fiscal Year Ended

 
    September 29,
2000


    September 28,
2001


    September 27,
2002


    September 26,
2003


    September 24,
2004


 
    (unaudited)     (unaudited)                    
    (in thousands, except per share data)  

Consolidated Statements of Operations Data:

                                       

Revenue:

                                       

Licensing

  $ 49,489     $ 73,277     $ 106,640     $ 157,922     $ 211,395  

Product sales

    50,538       39,300       41,377       44,403       57,981  

Production services

    11,088       12,076       13,851       15,147       19,665  
   


 


 


 


 


Total revenue

    111,115       124,653       161,868       217,472       289,041  
   


 


 


 


 


Cost of revenue:

                                       

Cost of licensing

    10,520       19,644       25,063       40,001       53,838  

Cost of product sales (includes $0.2 million in stock-based compensation for fiscal 2004) (1)

    30,219       25,754       26,694       26,684       30,096  

Cost of production services (includes $0.1 million in stock-based compensation for fiscal 2004) (1)

    4,604       5,044       5,960       6,958       7,643  
   


 


 


 


 


Total cost of revenue

    45,343       50,442       57,717       73,643       91,577  
   


 


 


 


 


Gross margin

    65,772       74,211       104,151       143,829       197,464  

Operating expenses:

                                       

Selling, general and administrative (includes $12.7 million in stock-based compensation for fiscal 2004) (1)

    44,714       48,244       64,269       76,590       113,477  

Research and development (includes $1.2 million in stock-based compensation for fiscal 2004) (1)

    16,744       16,106       15,128       18,262       23,884  

Settlements

                24,205             (2,000 )

In-process research and development

                      1,310       1,738  
   


 


 


 


 


Total operating expenses

    61,458       64,350       103,602       96,162       137,099  
   


 


 


 


 


Operating income

    4,314       9,861       549       47,667       60,365  

Other income (expenses), net

    (356 )     (3,369 )     (747 )     (57 )     229  
   


 


 


 


 


Income (loss) before provision for income taxes and controlling interest

    3,958       6,492       (198 )     47,610       60,594  

Provision for income taxes

    621       1,230       11       16,079       25,039  
   


 


 


 


 


Income (loss) before controlling interest

    3,337       5,262       (209 )     31,531       35,555  

Controlling interest in net (income) loss

    (371 )     389       104       (562 )     (929 )
   


 


 


 


 


Net income (loss)

  $ 2,966     $ 5,651     $ (105 )   $ 30,969     $ 34,626  
   


 


 


 


 


Basic net income (loss) per common share

  $ 0.03     $ 0.07     $ 0.00     $ 0.36     $ 0.40  

Diluted net income (loss) per common share

  $ 0.03     $ 0.07     $ 0.00     $ 0.36     $ 0.36  

Shares used in the calculation of basic net income (loss) per share

    85,000       85,000       85,008       85,009       85,556  

Shares used in the calculation of diluted net income (loss) per share

    85,000       85,000       85,008       85,983       96,525  

(1)    Stock-based compensation recorded in fiscal 2004 was classified as follows:

      

                       

Cost of product sales

                                  $ 157  

Cost of production services

                                    55  

Selling, general and administrative

                                    12,711  

Research and development

                                    1,215  
                                   


Total stock-based compensation

                                  $ 14,138  
                                   


 

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Fiscal Year Ended

     September 29,
2000


   September 28,
2001


   September 27,
2002


   September 26,
2003


   September 24,
2004


     (unaudited)    (unaudited)               
     (in thousands)

Summary Consolidated Balance Sheet Data:

                                  

Cash and cash equivalents

   $ 13,675    $ 22,602    $ 37,394    $ 61,922    $ 78,711

Working capital

     17,918      23,484      35,854      54,213      82,450

Total assets

     115,030      125,635      157,313      202,707      261,897

Total debt

     21,461      19,510      16,775      15,598      14,870

Total stockholders’ equity

     54,508      60,645      61,742      93,775      145,374

 

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PRO FORMA UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS DATA

 

The following selected pro forma unaudited consolidated statements of operations data give effect to the asset contribution to be made by Ray Dolby, which will occur prior to this offering, as well as the effects of a previous change in certain licensing arrangements with Ray Dolby in June 2002, as though such transactions had been completed prior to the beginning of fiscal 2002. Ray Dolby has licensed certain intellectual property rights to us in exchange for royalty payments. All of our licensing arrangements with, and royalty obligations to, Ray Dolby will terminate at the time the asset contribution is completed. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Pro Forma Presentation.” The selected pro forma unaudited consolidated statements of operations data should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and the related notes included elsewhere in this prospectus. There will be no material change to our balance sheet as a result of the asset contribution. The pro forma results presented below are not necessarily indicative of financial results to be achieved in future periods.

 

      
Pro Forma

 
     Fiscal Year Ended

 
     September 27,
2002


    September 26,
2003


    September 24,
2004


 
     (in thousands, except per share data)  

Consolidated Statements of Operations Data:

                        

Revenue:

                        

Licensing

   $ 113,361     $ 157,922     $ 211,395  

Product sales

     41,377       44,403       57,981  

Production services

     13,851       15,147       19,665  
    


 


 


Total revenue

     168,589       217,472       289,041  
    


 


 


Cost of revenue:

                        

Cost of licensing

     8,685       14,875       20,070  

Cost of product sales (includes $0.2 million in stock-based compensation for fiscal 2004) (1)

     24,281       24,190       27,007  

Cost of production services (includes $0.1 million in stock-based compensation for fiscal 2004) (1)

     5,960       6,958       7,643  
    


 


 


Total cost of revenue

     38,926       46,023       54,720  
    


 


 


Gross margin

     129,663       171,449       234,321  

Operating expenses:

                        

Selling, general and administrative (includes $12.7 million in stock-based compensation for fiscal 2004) (1)

     70,297       76,590       113,477  

Research and development (includes $1.2 million in stock-based compensation for fiscal 2004) (1)

     15,128       18,262       23,884  

Settlements

     24,205             (2,000 )

In-process research and development

           1,310       1,738  
    


 


 


Total operating expenses

     109,630       96,162       137,099  
    


 


 


Operating income

     20,033       75,287       97,222  

Other income (expenses), net

     (747 )     (57 )     229  
    


 


 


Income before provision for income taxes and controlling interest

     19,286       75,230       97,451  

Provision for income taxes

     7,884       26,714       39,267  
    


 


 


Income before controlling interest

     11,402       48,516       58,184  

Controlling interest in net (income) loss

     104       (562 )     (929 )
    


 


 


Net income

   $ 11,506     $ 47,954     $ 57,255  
    


 


 


Basic net income per common share

   $ 0.14     $ 0.56     $ 0.67  

Diluted net income per common share

   $ 0.14     $ 0.56     $ 0.59  

Shares used in the calculation of basic net income per share

     85,008       85,009       85,556  

Shares used in the calculation of diluted net income per share

     85,010       85,983       96,525  

(1)    Stock-based compensation recorded in fiscal 2004 was classified as follows:

                        

Cost of product sales

                   $ 157  

Cost of production services

                     55  

Selling, general and administrative

                     12,711  

Research and development

                     1,215  
                    


Total stock-based compensation

                   $ 14,138  
                    


 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion and analysis should be read in conjunction with our audited consolidated financial statements and the related notes that appear elsewhere in this prospectus. This discussion contains forward-looking statements reflecting our current expectations that involve risks and uncertainties. Actual results may differ materially from those discussed in these forward-looking statements due to a number of factors, including those set forth in the section entitled “Risk Factors” and elsewhere in this prospectus. Our fiscal year is a 52- or 53-week period ending on the last Friday in September. The fiscal years presented herein include the 52-week periods ended September 27, 2002, September 26, 2003 and September 24, 2004.

 

Overview

 

Dolby Laboratories develops and delivers innovative products and technologies that enrich the entertainment experience in theatres, homes, cars and elsewhere. Ray Dolby founded Dolby Laboratories in 1965 to develop noise reduction technologies. Today, we deliver a broad range of sound technologies for use in both professional and consumer applications. In addition, in recent years we have expanded our focus to include other technologies that facilitate the delivery of digital entertainment.

 

We conduct our business in two segments: our products and services segment and our technology licensing segment.

 

In our products and services segment, we sell professional products and related production services to filmmakers, broadcasters, music producers, video game designers, cinema operators and DVD producers. These products are used in sound recording, distribution and playback to improve sound quality, provide surround sound and increase the efficiency of sound storage and distribution. Our production services engineers work alongside artists and content producers throughout the world to help them record and reproduce the high quality sound they envision. Our engineers also work with cinema operators to help ensure that movie soundtracks are replayed with consistent high quality sound in their theatres.

 

In our technology licensing segment, we work with manufacturers of integrated circuits, or ICs, to help them incorporate our technologies into their ICs. These manufacturers then sell ICs to consumer electronics product manufacturers that license our technologies for incorporation in products such as DVD players, DVD recorders, audio/video receivers, television sets, set-top boxes, video game consoles, portable audio and video players, personal computers and in-car entertainment systems. We also license our technologies to software developers who implement our technologies for use in personal computer software DVD players. Our licensing arrangements typically entitle us to receive a royalty for every product that incorporates our technology shipped by our manufacturer and software developer licensees. We do not receive royalties from IC manufacturers.

 

We are a global organization. We sell our professional products and production services in over 50 countries. In fiscal 2002, 2003 and 2004, revenue from sales outside the United States represented 64%, 60% and 59% of our professional products sales and production services revenue, respectively. We have licensed our technologies to manufacturers of consumer electronics products in nearly 30 countries, including countries in North America, Europe and Asia. In fiscal 2002, 2003 and 2004, revenue from licensees outside the United States represented 76%, 80% and 80% of our licensing revenue, respectively. Our licensees distribute consumer electronics products incorporating our technologies throughout the world. Nearly all of our revenue is derived from transactions denominated in United States dollars.

 

Pro Forma Presentation

 

Throughout our history, Ray Dolby has retained ownership of the intellectual property rights he created relating to our business. We have licensed these intellectual property rights from him and paid him royalties in return. Prior to June 2002, we also administered the licensing of certain intellectual property rights for Ray Dolby, remitting to him the revenue derived from licensing these rights, net of the related administrative

 

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costs we incurred. As a result, prior to June 2002 these revenues were not recorded in our consolidated financial statements and Ray Dolby’s reimbursement to us of the administrative costs was reported as a reduction in selling, general and administrative expense in our consolidated statements of operations. In June 2002, we terminated this licensing administration arrangement and amended our licensing agreements with Ray Dolby to license from him the intellectual property rights we had previously administered on his behalf. In exchange, we agreed to pay him royalties in an amount that was intended to approximate the net revenue he would have received under our prior licensing administration arrangement.

 

Prior to the completion of this offering, Ray Dolby will contribute all intellectual property rights he holds related to our business so that Dolby Laboratories will have full ownership rights in this intellectual property once we are a public company. Upon completion of this asset contribution, all of our licensing arrangements with, and royalty obligations to, Ray Dolby will terminate.

 

The pro forma unaudited consolidated statements of operations and other pro forma data contained in this prospectus were prepared on the basis that both the June 2002 amendment to our licensing agreements with Ray Dolby and his asset contribution occurred prior to the beginning of fiscal 2002. The results of giving effect to the June 2002 amendment as though that amendment had occurred prior to the beginning of fiscal 2002 are a $6.7 million increase in our pro forma licensing revenue, representing the payment to us rather than to Ray Dolby of the royalties described above, and a $6.0 million increase in our selling, general and administrative expense in fiscal 2002, reflecting the absence of the reimbursement of administrative costs by Ray Dolby described above, in each case as compared to our actual results. In the absence of the asset contribution, the pro forma effect of the June 2002 amendment would also have resulted in an increase in our cost of licensing, representing the royalties we would have paid Ray Dolby under the amended licensing agreements. This increase, however, is not reflected in the pro forma unaudited consolidated statement of operations for fiscal 2002 because the pro forma effect of the asset contribution extinguishes all royalty payments to Ray Dolby.

 

The results of giving effect to the asset contribution as though that transaction had occurred prior to the beginning of fiscal 2002 was to adjust our pro forma consolidated results of operations to reverse the effects of $18.8 million, $27.6 million and $36.9 million in royalties payable to Ray Dolby that we recorded in fiscal 2002, 2003 and 2004, respectively. There will be no material change to our balance sheet as a result of the asset contribution.

 

Management Discussion Regarding Opportunities, Challenges and Risks

 

Our Technology Licensing Segment

 

Revenue from our technology licensing segment constitutes the majority of our total revenue, representing 66%, 73% and 73% of total revenue in fiscal 2002, 2003 and 2004, respectively. Our licensing revenue has grown from $49.5 million in fiscal 2000 to $211.4 million in fiscal 2004, principally as a result of the increase in sales of DVD players and in-home theatre systems that incorporate our surround sound technologies. Our licensing revenue is primarily dependent upon our licensees’ sales of DVD players, audio/video receivers and home theatre systems. We anticipate that the DVD player, recordable DVD player and home theatre system markets will continue to grow in fiscal 2005 and 2006. However, we do not expect our licensing revenue growth rates attributable to DVD player sales to remain as high as they have been in recent years, as the markets for DVD players mature. Because our technology is so widely adopted in DVD players, audio/video receivers and other home theatre consumer electronics products, our licensing revenue is subject to fluctuations based on consumer demand for these products. We are continuing to actively promote the incorporation of our surround sound technologies for use in other consumer products such as video game consoles, personal audio and video players, personal computers and in-car entertainment systems.

 

We license our sound technologies to consumer electronics product manufacturers throughout the world. Under our revenue recognition policy, we generally book licensing revenue upon receipt of our licensees’ royalty statements. As a result, our recognition of licensing revenue is dependent upon our receipt of royalty reports from our licensees, and our operating results can fluctuate based on the timing of our receipt of those reports. Moreover, our licensees are required to report to us within 30 to 60 days following the end of the quarter in

 

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which they ship the product incorporating our technologies, resulting in a time lag between when our licensees ship their products and when they report those shipments to us. Sometimes this time lag can be significant. In the past we have experienced lags of greater than one year. In addition, it is not uncommon for royalty reports to include corrective or retroactive royalties that cover extended periods of time. Also, there have been times in the past when we have recognized an unusually large amount of licensing revenue from a licensee in a given quarter because not all of our revenue recognition criteria were met in prior periods. This can result in a large amount of licensing revenue from a licensee being recorded in a given quarter that is not necessarily indicative of the amounts of licensing revenue to be received from that licensee in future quarters, thus causing fluctuations in our operating results.

 

We expect that sales of consumer electronics products incorporating our technologies in China and India will increase in the future, as consumers in these markets have more disposable income and are increasingly purchasing entertainment products with surround sound capabilities for use in homes, cars and elsewhere, although there can be no assurance that this will in fact occur. The percentage of our revenue derived from licenses to consumer electronics product manufacturers located in China has increased from 11% in fiscal 2002 to 16% in fiscal 2004. We expect that the percentage of our licensing revenue from Chinese consumer electronics product manufacturers will increase in fiscal 2005 as a result of the increased percentage of consumer electronics products being produced in China due to the lower manufacturing cost structure there as compared to other industrial countries. Doing business in China involves unique risks that have and will continue to affect our operating results. For example, we have experienced problems in the past with Chinese consumer electronics product manufacturers failing to report or underreporting shipments of their products that incorporate our technologies, and we expect to continue to experience such problems in the future. In addition, we may experience similar problems in other countries where intellectual property rights are not as respected as they are in the United States, Europe and Japan. We actively attempt to enforce our intellectual property rights and also focus on strengthening existing relationships and developing new ones with entertainment industry participants in these countries to increase our ability to enforce our intellectual property and contractual rights without relying solely on the legal systems in such countries. We do not recognize revenue until royalties are reported and are deemed collectible. See “Critical Accounting Policies—Revenue Recognition.”

 

We must continue to develop and deliver enduring, innovative entertainment technologies for use in consumer electronics products. As technologies for DVD players and other consumer electronics products with surround sound capabilities evolve, we must continue to design and deliver sound technologies that are sought by manufacturers and consumers alike. In addition, the widespread adoption of alternative formats to DVDs, or our inability to develop sound technology for these new formats successfully, could adversely affect our licensing revenue. We must also continue to strive to have our entertainment technologies adopted either as explicit or de facto industry standards for use in consumer electronics products. Increasingly, standards-setting organizations are adopting or establishing technology standards for use in a wide range of consumer electronics products. As a result, it is more difficult for individual companies to have their technologies adopted wholesale as an informal industry standard. We call this type of standard a “de facto” industry standard, meaning that the standard is not explicitly mandated by any industry standards-setting body but is nonetheless widely adopted. In addition, increasingly there are a large number of companies, including ones that typically compete against one another, involved in the development of new technologies for use in consumer entertainment products. As a result, these companies often end up licensing their collective intellectual property rights as a group, making it more difficult for any single company to have its technologies adopted widely as a de facto industry standard or to have its technologies adopted as an exclusive, explicit industry standard for consumer electronic products. Generally, in order for a technology to be chosen as an industry standard, the royalty rates that can be charged for that technology will be limited, either explicitly or implicitly, because industry standards will be adopted only if they are not excessively costly as compared to other potential alternatives. As a result, the royalty rates we can charge for our technologies that have been adopted as industry standards or that are adopted as industry standards in the future will likely be lower than the royalty rates received for technologies not adopted as industry standards, and our ability to raise these rates will likewise be limited. However, having technologies adopted as explicit industry standards may help increase the volume of products sold that incorporate these technologies. Furthermore, as we continue to expand our focus to include entertainment technologies that are not solely related to sound, such as

 

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technologies that process digital moving images and that protect content from piracy, we will be competing with many companies with longer experience and greater expertise in these areas, and there is a risk that we will not be able to develop technology innovations that are widely adopted in these markets.

 

Our Products and Services Segment

 

Revenue from our products and services segment represented 34%, 27% and 27% of total revenue in fiscal 2002, 2003 and 2004, respectively. We remain committed to developing technologies for use by professionals in the entertainment industry. We believe that filmmakers, broadcasters, music producers and video game designers will continue to push for technology solutions to help create, distribute and play back rich, high quality sounds and images. As a result, we believe that major advances in sound, imaging and other technologies for the recording, delivery and playback of entertainment will likely first be introduced in products designed for use by professionals.

 

Sales of our professional products and production services tend to fluctuate based on the underlying trends in the motion picture industry. In part, this is because our products have been so widely adopted in this industry. When box office receipts for the motion picture industry increase, we have typically seen sales of our professional products increase as well, as cinema owners are more likely to build new theatres and upgrade existing theatres with our more advanced cinema products when they are doing well financially. Our professional product sales are also subject to fluctuations based on events and conditions in the theatre industry generally that may or may not be tied to box office receipts in particular periods. For example, in the late 1990s cinema operators in the United States built a large number of new cinema megaplexes. This initially resulted in increased sales of our cinema processors, but also resulted in an oversupply of screens in some markets. This oversupply led to significant declines in new theatre construction in the United States in the early 2000s, resulting in a corresponding decline in sales of our cinema processors. Our production services revenue, both in the United States and internationally, is also tied to the strength of the motion picture production industry and, in particular, to the number of films being made by studios and independent filmmakers. The number of films that are produced can be affected by a number of factors, including strikes and work-stoppages within the motion picture industry as well as by the tax incentive arrangements that many foreign governments provide filmmakers to promote local filmmaking.

 

We are committed to helping the motion picture industry develop system solutions for digital cinema; this is our major initiative in our products and services segment. We believe that our experience and expertise developing and delivering technology solutions for both the motion picture and broadcast industries position us well to deliver technologies for digital cinema. Digital cinema offers the motion picture industry possible means to achieve substantial cost savings in printing and distributing movies, to combat piracy, and to enable movies to be played repeatedly without degradation in image quality. It also provides additional revenue opportunities for cinema operators, as concerts and sporting events already in digital format could be broadcast live via satellite to digitally equipped theatres. However, digital cinema may require a significant investment per screen by cinema operators. If the market for digital cinema develops more slowly than we anticipate, or if our technologies, products and services for this market are not widely adopted, our significant investment in developing digital cinema technology may not yield the returns we anticipate. In addition, if a large number of cinema owners decide to convert their theatres to digital cinema over a relatively short period of time and our products are selected for these conversions, we may see an initial increase in professional product sales that will not likely be sustained over time.

 

In recent years, our products and services segment has grown more slowly than our technology licensing segment. From fiscal 2002 to fiscal 2004, our annual revenue from professional product sales and production services grew at a compound annual growth rate of 19%, compared to a compound annual growth rate of 41% for our licensing revenue over that period. In addition, the profit margin for our products and services segment has been lower than our technology licensing segment. Our gross margin for our products and services segment was 41%, 44% and 51% in fiscal 2002, 2003 and 2004, respectively, compared to a gross margin of 76%, 75% and 75% for our technology licensing segment in those periods. On a pro forma basis, our gross margin for our products and services segment was 45%, 48% and 55% in fiscal 2002, 2003 and 2004, respectively, compared to a gross margin of 92%, 91% and 91% for our technology licensing segment in those periods.

 

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Transition to Being a Public Company

 

Since Ray Dolby founded Dolby Laboratories in 1965, we have been a privately held company and Ray Dolby has owned nearly all of our outstanding capital stock. As a privately held company with a highly concentrated ownership base, we have always run Dolby Laboratories with a view to the long term, consistent with the goals of our founder. We intend to keep our focus on long-term results.

 

We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, teamwork and a focus both on developing and strengthening long-term relationships with entertainment industry participants and on developing practical, enduring technology solutions for the entertainment industry. As we grow and change in response to the requirements of being a public company, we may find it difficult to maintain important aspects of our corporate culture, which could negatively affect our future success. We intend to continue to focus on developing technologies for entertainment industries that provide long-term benefits.

 

Our management team will also have to adapt to the requirements of being a public company, as none of our senior executive officers has significant experience in the public company environment. In addition, as part of our transition to being a public company, we expect our general and administrative expenses to increase, as we respond to the requirements of being a public company, including increased expenses associated with comprehensively documenting and analyzing our system of internal controls and maintaining our disclosure controls and procedures as a result of the requirements of the Sarbanes-Oxley Act. Furthermore, we are converting all of our systems to a new enterprise resource planning platform over a three-year period, and we expect to incur increased general and administrative expenses during this transition.

 

Critical Accounting Policies

 

The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, or U.S. GAAP. The preparation of these financial statements in accordance with U.S. GAAP requires us to utilize accounting policies and make certain estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingencies as of the date of the financial statements and the reported amounts of revenue and expenses during a fiscal period. The SEC considers an accounting policy to be critical if it is important to a company’s financial condition and results of operations, and if it requires significant judgment and estimates on the part of management in its application. We have discussed the selection and development of the critical accounting policies with the audit committee of our board of directors, and the audit committee has reviewed our related disclosures in this prospectus. Although we believe that our judgments and estimates are appropriate and correct, actual results may differ from those estimates.

 

We believe the following to be our critical accounting policies because they are both important to the portrayal of our financial condition and results of operations and they require critical management judgments and estimates about matters that are uncertain. If actual results or events differ materially from those contemplated by us in making these estimates, our reported financial condition and results of operation for future periods could be materially affected. See “Risk Factors” for certain matters bearing risks on our future results of operations.

 

Revenue Recognition

 

We evaluate revenue recognition for transactions to sell products and services and to license technology, trademarks and know-how using the criteria set forth by the SEC in Staff Accounting Bulletin 104, “Revenue Recognition,” or SAB 104. SAB 104 states that revenue is recognized when each of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price to the buyer is fixed and determinable, and collectibility is reasonably assured.

 

Licensing.     Our licensing revenue is primarily derived from royalties paid to us by licensees of our intellectual property rights, including patents, trademarks and know-how . Royalties are recorded at their gross

 

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amounts, prior to the deduction of foreign withholding taxes. We make judgments as to whether collectibility can be reasonably assured based on the licensee’s recent payment history or the existence of a standby letter-of-credit between the licensee’s financial institution and our financial institution. In the absence of a favorable collection history or a letter-of-credit, we recognize revenue upon receipt of cash, provided that all other revenue recognition criteria have been met.

 

Product Sales and Production Services.     Our revenue from the sale of products is recognized when the risk of ownership has transferred to our customer as provided under the terms of the governing purchase agreement, typically the invoice we deliver to the customer, and all the other revenue recognition criteria have been met. Generally, these purchase agreements provide that the risk of ownership is transferred to the customer when the product is shipped. Production services revenue is recognized as the services related to a given project are performed and all the other revenue recognition criteria have been met.

 

Allowance for Doubtful Accounts

 

We continually monitor customer payments and maintain a reserve for estimated losses resulting from our customers’ inability to make required payments. In determining the reserve, we evaluate the collectibility of our accounts receivable based upon a variety of factors. In cases where we are aware of circumstances that may impair a specific customer’s ability to meet its financial obligations, we record a specific allowance against amounts due, and thereby reduce the net recognized receivable to the amount reasonably believed to be collectible. For all other customers, we recognize allowances for doubtful accounts based on our actual historical write-off experience in conjunction with the length of time the receivables are past due, customer creditworthiness, geographic risk and the current business environment. Actual future losses from uncollectible accounts may differ from our estimates and may have a material effect on our consolidated statements of operations and our financial condition. Our allowance for doubtful accounts totaled $2.1 million at September 24, 2004. An incremental change of 1% in our allowance for doubtful accounts as a percentage of accounts receivable would have a $0.2 million increase or decrease in our operating results.

 

Goodwill

 

In September 2002, we adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” or SFAS 142, which, among other things, establishes new standards for goodwill acquired in a business combination, eliminates the amortization of goodwill and requires the carrying value of goodwill and certain non-amortizing intangibles to be evaluated for impairment on an annual basis. As required by SFAS 142, we perform an impairment test on recorded goodwill by comparing the estimated fair value of each of our reporting units to the carrying value of the assets and liabilities of each unit, including goodwill. We determine the fair value of the reporting units principally based upon the valuation analysis of Dolby Laboratories as a whole. This analysis is prepared by an independent third party each year and in consideration of a number of other factors, including our historical and projected financial results, risks facing us and the liquidity of our common stock. If the carrying value of the assets and liabilities, including goodwill, exceeded our estimation of the fair value of the reporting units, we would record an impairment charge in an amount equal to the excess of the carrying value of goodwill over its estimated fair value. Our fiscal 2004 impairment test of goodwill, which was performed in the third fiscal quarter, resulted in no impairment charge. Fluctuations in our fair value, which may result from changes in economic conditions, our results of operations and other factors, relative to the carrying value, could result in impairment charges in future periods. As of the last test for impairment, our estimated fair value would need to have decreased by approximately 65% in order for goodwill impairment to have been recognized.

 

Accounting for Income Taxes

 

In preparing our consolidated financial statements, we are required to make estimates and judgments that affect our accounting for income taxes. This process includes estimating actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes.

 

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These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheets. We also assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent that we believe that recovery is not likely, we have established a valuation allowance.

 

Significant judgment is required in determining the provision for income taxes, personal holding company tax, deferred tax assets and liabilities and any valuation allowance against our deferred tax assets. Our financial position and results of operations may be materially impacted if actual results significantly differ from these estimates or the estimates are adjusted in future periods.

 

Stock-Based Compensation

 

We have granted options to purchase Class B common stock to our employees with exercise prices equal to the value of the underlying stock, as determined by our board of directors on the date the equity award was granted. Our board of directors determined this value principally based upon valuation analyses prepared by an independent third party valuation firm each year and in consideration of a number of factors, including our historical and projected financial results, risks facing us and the liquidity of our common stock. In connection with the preparation of the financial statements for our initial public offering and solely for purposes of accounting for employee stock-based compensation, we have applied hindsight to reassess the fair value of our common stock for the equity awards granted during fiscal 2004. These reassessed values were determined based on a number of factors and methodologies, including an evaluation of our updated historical and projected financial results and a re-evaluation of our fair value based upon more recent valuation analyses provided by an independent third party valuation firm.

 

Based upon this reassessment of the fair value of our Class B common stock, we have recorded deferred stock-based compensation to the extent that the reassessed value of our Class B common stock at the date of grant exceeded the exercise price of the equity awards. Reassessed values are inherently uncertain and highly subjective. If we had made different assumptions, the amount of our deferred stock-based compensation, stock-based compensation expense, gross margin, net income and net income per share amounts could have been significantly different. We recorded deferred compensation of $58.8 million during fiscal 2004. The deferred stock-based compensation expense is being amortized on a straight-line basis over the stock option vesting period of four years. In fiscal 2004, we recognized $7.2 million in stock-based compensation expense related to Class B common stock options granted to employees based upon the reassessed values of the Class B common stock underlying the stock option awards. We also issued shares of fully vested Class B common stock to an executive officer in fiscal 2004. We recorded stock-based compensation expense in connection with the award calculated based on the reassessed value of our Class B common stock at the date the shares were issued, which resulted in $6.9 million expense recorded in selling, general and administrative expense in fiscal 2004.

 

In October 2004, subsequent to our 2004 fiscal year end, we granted additional options to purchase Class B common stock to our employees at exercise prices that were below the reassessed fair value at the date of grant. We expect to record deferred compensation of $7.3 million related to these equity awards, which will be amortized on a straight-line basis over the vesting schedule of the awards.

 

The amount of stock-based compensation expense expected to be recorded in future periods related to the October 2004 awards and awards previously issued to employees is as follows (in thousands):

 

      
Expense by Fiscal Year

     2005

   2006

   2007

   2008

   2009

Stock-based compensation expense related to stock options granted to employees

   $ 16,366    $ 16,517    $ 16,517    $ 9,315    $ 152
    

  

  

  

  

 

Note 1 of the Notes to Consolidated Financial Statements included as part of this prospectus describes what the effect would have been had we accounted for stock-based awards under the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation.”

 

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Results of Operations

 

Fiscal Years Ended September 27, 2002, September 26, 2003 and September 24, 2004

 

The following table presents our audited actual and pro forma unaudited operating results as a percentage of total revenue for the periods indicated:

 

     Actual

    Pro Forma

 
     Fiscal Year Ended

    Fiscal Year Ended

 
     Sep 27,
2002


    Sep 26,
2003


    Sep 24,
2004


    Sep 27,
2002


    Sep 26,
2003


    Sep 24,
2004


 

Consolidated Statements of Operations Data:

                                    

Revenue:

                                    

Licensing

   66 %   73 %   73 %   67 %   73 %   73 %

Product sales

   25     20     20     25     20     20  

Production services

   9     7     7     8     7     7  
    

 

 

 

 

 

Total revenue

   100     100     100     100     100     100  
    

 

 

 

 

 

Cost of revenue:

                                    

Cost of licensing

   16     19     19     5     7     7  

Cost of product sales (1)

   16     12     10     14     11     9  

Cost of production services (1)

   4     3     3     4     3     3  
    

 

 

 

 

 

Total cost of revenue

   36     34     32     23     21     19  
    

 

 

 

 

 

Gross margin

   64     66     68     77     79     81  

Operating expenses:

                                    

Selling, general and administrative (includes 4% in stock-based compensation for fiscal 2004) (1)

   40     35     39     42     35     39  

Research and development (includes 1% in stock-based compensation for fiscal 2004) (1)

   9     8     8     9     8     8  

Settlements

   15         (1 )   14         (1 )

In-process research and development

       1     1         1     1  
    

 

 

 

 

 

Total operating expenses

   64     44     47     65     44     47  
    

 

 

 

 

 

Operating income

   0     22     21     12     35     34  

Other income (expenses), net

   0     0     0     0     0     0  
    

 

 

 

 

 

Income (loss) before provision for income taxes and controlling interest

   0     22     21     12     35     34  

Provision for income taxes

   0     8     9     5     13     14  
    

 

 

 

 

 

Income (loss) before controlling interest

   0     14     12     7     22     20  

Controlling interest in net (income) loss

   0     0     0     0     0     0  
    

 

 

 

 

 

Net income (loss)

   0 %   14 %   12 %   7 %   22 %   20 %
    

 

 

 

 

 


(1)    Stock-based compensation recorded in fiscal 2004 was classified as follows:

      

Cost of product sales

               0 %               0 %

Cost of production services

               0                 0  

Selling, general and administrative

               4                 4  

Research and development

               1                 1  
                

             

Total stock-based compensation

               5 %               5 %
                

             

 

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Table of Contents  

Fiscal Years Ended September 26, 2003 and September 24, 2004

 

Revenue

 

     Fiscal Year Ended

    Change

 
     September 26,
2003


    September 24,
2004


    In Dollars

   Percentage

 
     ($ in thousands)  

Revenue:

                             

Licensing

   $ 157,922     $ 211,395     $ 53,473    34 %

Percentage of total revenue

     73 %     73 %             

Product sales

     44,403       57,981       13,578    31 %

Percentage of total revenue

     20 %     20 %             

Production services

     15,147       19,665       4,518    30 %

Percentage of total revenue

     7 %     7 %             
    


 


 

  

Total revenue

   $ 217,472     $ 289,041     $ 71,569    33 %
    


 


 

  

 

Licensing .    The $53.5 million, or 34%, increase in licensing revenue from fiscal 2003 to fiscal 2004 resulted from increased sales by our licensees of their consumer electronics products that incorporate our technologies, principally attributable to the growth in sales of DVD players worldwide. Virtually all DVD players incorporate our Dolby Digital technologies. Aside from the growth in sales of DVD players, the increase in our licensing revenue was also attributable to growth in sales of personal computer software DVD players and, to a lesser extent, home theatre systems, set-top boxes and recordable DVD players. Sales of products such as home- theatre-in-a-box and audio/video receivers that incorporate multiple Dolby technologies also helped increase our licensing revenue, as we typically receive royalties for each of our technologies incorporated into a licensee’s product. We do not expect our licensees’ sales of DVD players, and thus our licensing revenue related to these products, to grow as rapidly in future periods as they have in the past.

 

Product Sales .    The $13.6 million, or 31%, increase in our revenue from product sales from fiscal 2003 to fiscal 2004 was principally attributable to a $10.0 million increase in sales of our cinema products, primarily related to new theatre construction and the decisions by cinema operators to retrofit their existing theatres to include our cinema processors. To a lesser extent, the increase in product sales revenue was also attributable to $2.0 million in sales of sound reinforcement products by one of our consolidated subsidiaries, which was acquired in fiscal 2004 and was therefore not included in prior periods, and a $1.6 million increase in sales of our broadcast products to local television stations, cable networks and European satellite broadcasters. We believe that the growth in sales of our broadcast products to terrestrial, or over-the-air, broadcasters in the United States was principally attributable to their efforts to comply with the requirement of the FCC that such stations broadcast digital signals. We also believe that sales of our broadcast products have increased throughout the world as terrestrial, cable and satellite broadcasters seek to deliver programming that can utilize the capabilities of viewers’ home theatre systems.

 

Production Services .    The $4.5 million, or 30%, increase in production services revenue from fiscal 2003 to fiscal 2004 was primarily attributable to an increase in the number of films made using our technologies, particularly in Korea, Scandinavia and Spain, as well as an increase in additional services such as print checking and screening services. To a lesser extent, our technical support services for digital cinema screenings have also contributed to the increase in production services revenue, as we did not offer these services previously.

 

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Table of Contents  

Gross Margin

 

     Actual

    Pro Forma

 
     Fiscal Year Ended

    Fiscal Year Ended

 
    

September 26,

2003


   

September 24,

2004


   

September 26,

2003


   

September 24,

2004


 
     ($ in thousands)  

Gross margin:

                                

Licensing gross margin

   $ 117,921     $ 157,557     $ 143,047     $ 191,325  

Licensing gross margin percentage

     75 %     75 %     91 %     91 %

Product sales gross margin (includes $0.2 million in stock-based compensation expense in fiscal 2004)

     17,719       27,885       20,213       30,974  

Product sales gross margin percentage

     40 %     48 %     46 %     53 %

Production services gross margin (includes $0.1 million in stock-based compensation expense in fiscal 2004)

     8,189       12,022       8,189       12,022  

Production services gross margin percentage

     54 %     61 %     54 %     61 %
    


 


 


 


Total gross margin

   $ 143,829     $ 197,464     $ 171,449     $ 234,321  

Total gross margin percentage

     66 %     68 %     79 %     81 %
    


 


 


 


 

Licensing Gross Margin .    We license intellectual property rights that may be internally developed, acquired by us or licensed from other parties. Our cost of licensing consists principally of royalty payments we make to Ray Dolby and to other third parties for the licensing of intellectual property rights that we sublicense as part of our licensing arrangements with our customers. Our cost of licensing also includes amortization expenses associated with purchased intangibles. Our pro forma licensing gross margin for fiscal 2003 and 2004 excludes $25.1 million and $33.8 million, respectively, of expenses we recorded for sublicensing royalty payments we made to Ray Dolby.

 

Product Sales Gross Margin.     Cost of product sales primarily consists of material costs related to the products sold, applied labor and manufacturing overhead and, to a lesser extent, royalty obligations for technologies we license from Ray Dolby. The increase in our product sales gross margin in fiscal 2004 was the result of increased production levels, but was partially offset by a $0.2 million stock-based compensation expense recorded in fiscal 2004. The increased production levels led to increased gross margins, as the higher production volumes were able to absorb greater amounts of relatively fixed labor and overhead costs due to the high level of automation in our manufacturing processes. Pro forma product sales gross margin excludes $2.5 million and $3.1 million for fiscal 2003 and 2004, respectively, in expenses we recorded for royalty payments we made to Ray Dolby.

 

Production Services Gross Margin .    Cost of production services consists of the payroll and benefit costs of employees performing our professional services, the cost of outside consultants and reimbursable expenses incurred on behalf of the customer. The increase in production services gross margin in fiscal 2004 resulted primarily from an increase in the amount of engineering services provided by our professional services organization during the fiscal year, which was partially offset by a $0.1 million charge in stock-based compensation recorded in fiscal 2004.

 

47


Table of Contents  

Operating Expenses

 

      
Fiscal Year Ended

    Change

 
    

September 26,

2003


   

September 24,

2004


    In Dollars

    Percentage

 
     ($ in thousands)  

Operating expenses:

                              

Selling, general and administrative (includes $12.7 million in stock-based compensation expense in fiscal 2004)

   $ 76,590     $ 113,477     $ 36,887     48 %

Percentage of total revenue

     35 %     39 %              

Research and development (includes $1.2 million in stock-based compensation expense in fiscal 2004)

     18,262       23,884       5,622     31 %

Percentage of total revenue

     8 %     8 %              

Settlements

           (2,000 )     (2,000 )    

Percentage of total revenue

           (1 )%              

In-process research and development

     1,310       1,738       428     33 %

Percentage of total revenue

     1 %     1 %              
    


 


 


 

Total operating expenses

   $ 96,162     $ 137,099     $ 40,937     43 %
    


 


 


 

 

Selling, General and Administrative .    Selling, general and administrative expense consists primarily of personnel and personnel related expenses, facility costs and professional service fees for our sales, marketing and administrative functions. The $36.9 million, or 48%, increase in selling, general and administrative expense from fiscal 2003 to 2004 was primarily due to a $13.8 million increase in payroll and benefits costs as a result of increased headcount and performance-based awards and a $12.7 million increase in stock-based compensation expense. To a lesser extent, our selling, general and administrative expense also increased in fiscal 2004 as compared to fiscal 2003 due to an increase of $7.1 million of expenses incurred in connection with professional and consulting fees related primarily to our preparations for being a public company. These professional and consulting fees included costs incurred in connection with the implementation of a new enterprise resource planning, or ERP, system, the augmentation of our internal controls related to the Sarbanes-Oxley Act, a reengineering project related to our royalty reporting processes, and additional tax and audit services. We expect that our selling, general and administrative expense will increase in absolute dollars in fiscal 2005, as we continue to build our infrastructure in order to accommodate growth and to meet the requirements of being a public company. We expect to continue to incur additional costs associated with Sarbanes-Oxley Act compliance efforts, royalty reporting reengineering projects and ancillary ERP implementations.

 

Research and Development .    Research and development expense consists primarily of salary and related costs for personnel responsible for the research and development of new technologies. The $5.6 million, or 31%, increase in research and development expense from fiscal 2003 to 2004 was primarily due to a $3.3 million increase in payroll and benefit costs as a result of increased headcount and, to a lesser extent, to a $1.2 million charge related to stock-based compensation expense incurred in fiscal 2004. We anticipate that research and development expense will increase in absolute dollars in fiscal 2005, as we expect to hire additional personnel to support the development of new technologies.

 

Settlements .    Settlements include interest and penalties related to the collection of royalties and resolution of disputes in our favor or against us. Settlements of royalty disputes from licensees that specifically represent unpaid royalties are recorded as licensing revenue in the period payment is received, if all other revenue recognition criteria have been met. Settlements of other disputes, such as disputes with implementation licensees from which we typically do not receive royalties, are recorded in settlements. In fiscal 2004, we received a $2.0 million payment in connection with the settlement of a dispute with one of our semiconductor manufacturing implementation licensees regarding violation of the terms of their implementation licensing agreement with us.

 

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Table of Contents

In-process Research and Development .    In fiscal 2004, we recorded a $1.7 million charge related to purchased in-process research and development that had no alternative uses and had not reached technological feasibility. See Note 3 of the Notes to Consolidated Financial Statements included as part of this prospectus for information on in-process research and development we acquired in connection with our acquisition transactions.

 

Other Income (Expenses), Net

 

Other income (expenses), net primarily consists of gains and losses on interest rate swap agreements and interest expense on outstanding balances on our facility debt obligations, offset by interest income earned on cash and cash equivalent balances. Other income, net was $0.2 million in fiscal 2004 compared to $0.1 million in other expenses, net in fiscal 2003. The fluctuation from fiscal 2003 was due to an increase in interest income as a result of higher average cash and cash equivalent balances for fiscal 2004.

   

Income Taxes

 

     Actual

    Pro Forma

 
     Fiscal Year Ended

    Fiscal Year Ended

 
     September 26, 2003

    September 24, 2004

    September 26, 2003

    September 24, 2004

 
     ($ in thousands)  

Income taxes:

                                

Provision for income taxes

   $ 16,079     $ 25,039     $ 26,714     $ 39,267  

Effective tax rate

     34 %     42 %     36 %     41 %

 

Our fiscal 2004 effective tax rate was higher than in fiscal 2003 primarily due to the impact of incentive stock-based compensation expense, which is nondeductible, and losses from our foreign subsidiaries that we incurred in fiscal 2004. Excluding the effect of incentive stock-based compensation expense, our effective tax rate for fiscal 2004 would have been 39%. For fiscal 2003, the effective tax rate was below the statutory tax rate of 35% primarily due to the impact of extraterritorial income exclusion and research and experimentation credits. Our pro forma provision for income taxes and effective tax rate for fiscal 2003 and 2004 reflect the increase in operating income due to the exclusion of $27.6 million and $36.9 million, respectively, in royalty expense payable to Ray Dolby.

 

 

Fiscal Years Ended September 27, 2002 and September 26, 2003

 

Revenue

 

     Actual

    Pro Forma

 
     Fiscal Year Ended

    Fiscal Year Ended

 
     September 27,
2002


    September 26,
2003


    September 27,
2002


    September 26,
2003


 
     ($ in thousands)  

Revenue:

                                

Licensing

   $ 106,640     $ 157,922     $ 113,361     $ 157,922  

Percentage of total revenue

     66 %     73 %     67 %     73 %

Product sales

     41,377       44,403       41,377       44,403  

Percentage of total revenue

     25 %     20 %     25 %     20 %

Production services

     13,851       15,147       13,851       15,147  

Percentage of total revenue

     9 %     7 %     8 %     7 %
    


 


 


 


Total revenue

   $ 161,868     $ 217,472     $ 168,589     $ 217,472  
    


 


 


 


 

Licensing .    Licensing revenue increased $51.3 million, or 48%, from fiscal 2002 to fiscal 2003 principally due to increased sales by our licensees of their consumer electronics products that incorporate our technologies, reflecting the growth in sales of DVD players worldwide. Aside from the growth in sales of DVD players, the

 

49


Table of Contents

increase in our licensing revenue was also attributable to growth in sales of personal computer software DVD players and, to a lesser extent, home theatre systems and set-top boxes. Sales of products such as home-theatre-in-a-box and audio/video receivers that incorporate multiple Dolby technologies also helped increase our licensing revenue. In addition, a portion of the increase in licensing revenue was due to an amendment to our licensing agreements with Ray Dolby in the fourth quarter of 2002. Prior to June 2002, we administered the licensing of certain intellectual property rights for Ray Dolby, remitting to him the revenue derived from licensing these rights, net of the related administrative costs we incurred. These revenues were not recorded in our consolidated financial statements. In June 2002, we terminated this licensing administration arrangement and amended our licensing agreements with Ray Dolby to license from him the intellectual property rights we had previously administered on his behalf. In exchange, we agreed to pay him royalties in an amount that was intended to approximate the net revenue he would have received under our prior licensing administration arrangement. As a result, our fiscal 2003 licensing revenue reflects a full year of royalty revenue resulting from the June 2002 amendment of our licensing agreements, whereas our licensing revenue in fiscal 2002 reflects only one quarter of this additional royalty revenue stream. On a pro forma basis, our licensing revenue in fiscal 2002 increased by $6.7 million as compared to our actual results due to the amendments to our licensing agreements with Ray Dolby described above.

 

Product Sales .    The $3.0 million, or 7%, increase in our revenue from product sales in absolute dollars from fiscal 2002 to fiscal 2003 was principally attributable to a $2.5 million increase in sales of our broadcast products to local television stations, cable networks and European satellite broadcasters. We believe this is principally attributable to the efforts of terrestrial broadcasters in the United States to comply with the requirement of the FCC that those stations broadcast digital signals and the desire of terrestrial, cable and satellite broadcasters throughout the world to deliver programming that can utilize the capabilities of viewers’ home theatre systems. To a lesser extent, the increase in product sales revenue was also attributable to a $0.5 million increase in sales of our cinema products. The decrease in product sales revenue as a percentage of revenue was attributable to increases in licensing revenue both in absolute dollars and as a percentage of total revenue.

 

Production Services .    The $1.3 million, or 9%, increase in production services revenue in absolute dollars from fiscal 2002 to fiscal 2003 was primarily attributable to an increase in the number of billable service calls made as a result of an increase in the number of films released during this period. To a lesser extent, the increase in production services revenue was also attributable to an increase in the number of billable service calls made related to foreign language  
versions of films and commercial and trailer services. The decrease in production services revenue as a percentage of revenue was attributable to increases in licensing revenue both in absolute dollars and as a percentage of total revenue.

 

Gross Margin

 

     Actual

    Pro Forma

 
     Fiscal Year Ended

    Fiscal Year Ended

 
    

September 27,

2002


   

September 26,

2003


   

September 27,

2002


   

September 26,

2003


 
     ($ in thousands)  

Gross margin:

                                

Licensing gross margin

   $ 81,577     $ 117,921     $ 104,676     $ 143,047  

Licensing gross margin percentage

     76 %     75 %     92 %     91 %

Product sales gross margin

     14,683       17,719       17,096       20,213  

Product sales gross margin percentage

     35 %     40 %     41 %     46 %

Production services gross margin

     7,891       8,189       7,891       8,189  

Production services gross margin percentage

     57 %     54 %     57 %     54 %
    


 


 


 


Total gross margin

   $ 104,151     $ 143,829     $ 129,663     $ 171,449  

Total gross margin percentage

     64 %     66 %     77 %     79 %
    


 


 


 


 

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Table of Contents

Licensing Gross Margin.     The decrease in licensing gross margin from fiscal 2002 to fiscal 2003 was due to the increase in licensing revenue derived from royalties from product sales that incorporate technologies we license from third parties. Our pro forma licensing gross margin for fiscal 2002 and 2003 excludes $16.4 million and $25.1 million, respectively, in expenses we recorded for sublicensing royalty payments we made to Ray Dolby. Our fiscal 2002 pro forma licensing gross margin was also affected by the $6.7 million increase in our fiscal 2002 pro forma licensing revenue described above due to the June 2002 amendments to our licensing agreements with Ray Dolby.

 

Product Sales Gross Margin.     The increase in product sales gross margin from fiscal 2002 to fiscal 2003 was the result of higher production levels as compared to fiscal 2002, as the higher production volumes were able to absorb greater amounts of relatively fixed labor and overhead costs. Pro forma product sales gross margin excludes expenses for royalties payable to Ray Dolby of $2.4 million and $2.5 million for fiscal 2002 and 2003, respectively.

 

Production Services Gross Margin  
.    The decrease in production services gross margin was principally attributable to a $0.9 million increase in costs associated with higher staff and related expenses.

 

Operating Expenses

 

     Actual

    Pro Forma

 
     Fiscal Year Ended

    Fiscal Year Ended

 
     September 27,
2002


    September 26,
2003


    September 27,
2002


    September 26,
2003


 
     ($ in thousands)  

Operating expenses:

                                

Selling, general and administrative

   $ 64,269     $ 76,590     $ 70,297     $ 76,590  

Percentage of total revenue

     40 %     35 %     42 %     35 %

Research and development

     15,128       18,262       15,128       18,262  

Percentage of total revenue

     9 %     8 %     9 %     8 %

Settlements

     24,205             24,205        

Percentage of total revenue

     15 %           14 %      

In-process research and development

           1,310             1,310  

Percentage of total revenue

           1 %           1 %
    


 


 


 


Total operating expenses

   $ 103,602     $ 96,162     $ 109,630     $ 96,162  
    


 


 


 


 

Selling, General and Administrative .    Selling, general and administrative expense increased $12.3 million, or 19%, from fiscal 2002 to fiscal 2003, primarily due to a change in our licensing agreements with Ray Dolby. Prior to June 2002, Ray Dolby reimbursed us for expenses we incurred in connection with administering licenses covering certain of his intellectual property rights. Ray Dolby reimbursed us $6.0 million in fiscal 2002 for these administrative services, which we recorded as a reduction in selling, general and administrative expense. In July 2002, we terminated this licensing administration arrangement and amended our licensing agreements with Ray Dolby to license from him the intellectual property rights we had previously administered on his behalf. As a result, selling, general and administrative expense for fiscal 2003 did not include any reimbursements by Ray Dolby. The increase in selling, general and administrative expense was also due to a $1.7 million increase in legal expenses incurred to address intellectual property and licensing revenue collection issues and to a $1.7 million increase in bad debt expense based on a reassessment of our allowance for doubtful accounts. To a lesser extent, selling, general and administrative expense was also affected by a $1.2 million increase in payroll and benefits costs resulting from an increase in headcount and $0.8 million in expenses related to our senior executive supplemental retirement plan in fiscal 2003. The decrease in selling, general and administrative expense as a percentage of total revenue was due primarily to our total revenue growing at a higher rate than our selling, general and administrative expense during such period. On a pro forma basis, our selling, general and administrative expense in fiscal 2002 increased $6.0 million as compared to our actual results due to the June 2002 amendments to our licensing agreements with Ray Dolby described above.

 

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Table of Contents

Research and Development .    Research and development expense increased $3.1 million, or 21%, from fiscal 2002 to fiscal 2003, primarily attributable to a $2.4 million increase in payroll and benefits costs due to increased headcount. The decrease in research and development expense as a percentage of total revenue was due primarily to our total revenue growing at a higher rate than our research and development expenses during such period.

 

Settlements .    In fiscal 2002, we entered into a settlement agreement with a third party regarding an intellectual property dispute and agreed to pay a total of $30.0 million in ten equal annual installments of $3.0 million beginning in June 2002. We recorded this settlement liability in fiscal 2002 at its net present value of $24.2 million with a corresponding charge to our results of operations.

 

In-process Research and Development .    In fiscal 2003, we recorded a $1.3 million charge related to purchased in-process research and development that had no alternative uses and had not reached technological feasibility. See Note 3 of the Notes to Consolidated Financial Statements included as part of this prospectus for information on in-process research and development we acquired in connection with our acquisition transactions.

 

Other Income (Expenses), Net

 

Other expenses, net decreased to $0.1 million in fiscal 2003 compared to  
$0.7 million in fiscal 2002, primarily due to a gain in the market value of our interest rate swap agreements, offset by an increase in interest expense as a result of the imputed interest on the intellectual property dispute settlement payment made in June 2003.

 

Income Taxes

 

     Actual

    Pro Forma

 
     Fiscal Year Ended

    Fiscal Year Ended

 
     September 27, 2002

    September 26, 2003

    September 27, 2002

    September 26, 2003

 
     ($ in thousands)  

Income taxes:

                                

Provision for income taxes

   $ 11     $ 16,079     $ 7,884     $ 26,714  

Effective tax rate

     6 %     34 %     39 %     36 %

 

The fiscal 2003 increase to the effective tax rate was attributable to lower taxable income in fiscal 2002 due to the charge associated with the settlement of the intellectual property dispute. For fiscal 2003, the effective tax rate was below the statutory tax rate of 35% primarily due to the impact of extraterritorial income exclusion and research and experimentation tax credits. Our pro forma provision for income taxes and effective tax rate for fiscal 2002 and 2003 reflect the increase in operating income due to the exclusion of the $18.8 million and $27.6 million, respectively, in royalty expense payable to Ray Dolby.

 

Quarterly Consolidated Results of Operations

 

Actual

 

The following tables present our unaudited quarterly consolidated results of operations and our unaudited quarterly consolidated results of operations as a percentage of revenue for the eight quarters ended September 24, 2004. The unaudited quarterly consolidated information has been prepared on the same basis as our audited consolidated financial statements for our full fiscal years. You should read the following tables presenting our quarterly consolidated results of operations in conjunction with our audited consolidated financial statements for our full fiscal years and the related notes included elsewhere in this prospectus. This table includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for the fair presentation of our consolidated financial position and operating results for the quarters presented. The operating results for any quarter are not necessarily indicative of the operating results for any future period.

 

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Table of Contents
     
Actual

 
    Fiscal Quarter Ended

 
   

Dec 27,

2002


   

Mar 28,

2003


   

Jun 27,

2003


   

Sep 26,

2003


   

Dec 26,

2003


   

Mar 26,

2004


   

Jun 25,

2004


   

Sep 24,

2004


 
    (in thousands, except per share data)  

Consolidated Statements of Operations Data:

                                                               

Revenue:

                                                               

Licensing

  $ 35,670     $ 40,580     $ 40,032     $ 41,640     $ 47,799     $ 58,948     $ 55,487     $ 49,161  

Product sales

    11,111       11,344       9,593       12,355       13,392       14,386       15,355       14,848  

Production services

    3,493       3,871       3,670       4,113       4,232       5,357       5,208       4,868  
   


 


 


 


 


 


 


 


Total revenue

    50,274       55,795       53,295       58,108       65,423       78,691       76,050       68,877  
   


 


 


 


 


 


 


 


Cost of revenue (includes stock-based compensation for periods beginning in fiscal 2004; see table below):

                                                               

Cost of licensing

    9,659       9,864       9,980       10,498       12,781       15,105       13,441       12,511  

Cost of product sales (1)

    6,401       7,035       6,173       7,075       6,896       7,717       7,848       7,635  

Cost of production services (1)

    1,466       1,532       1,632       2,328       1,587       1,931       1,945       2,180  
   


 


 


 


 


 


 


 


Total cost of revenue

    17,526       18,431       17,785       19,901       21,264       24,753       23,234       22,326  
   


 


 


 


 


 


 


 


Gross margin

    32,748       37,364       35,510       38,207       44,159       53,938       52,816       46,551  

Operating expenses (includes stock-based compensation for periods beginning in fiscal 2004; see table below):

                                                               

Selling, general and administrative (1)

    17,662       19,043       19,462       20,423       20,303       31,075       29,167       32,932  

Research and development (1)

    3,952       4,535       4,835       4,940       4,934       5,700       6,388       6,862  

Settlements

                                        (2,000 )      

In-process research and development

                      1,310             1,540             198  
   


 


 


 


 


 


 


 


Total operating expenses

    21,614       23,578       24,297       26,673       25,237       38,315       33,555       39,992  
   


 


 


 


 


 


 


 


Operating income

    11,134       13,786       11,213       11,534       18,922       15,623       19,261       6,559  

Other income (expenses), net

    (130 )     (351 )     46       378       224       156       370       (521 )
   


 


 


 


 


 


 


 


Income before provision for income taxes and controlling interest

    11,004       13,435       11,259       11,912       19,146       15,779       19,631       6,038  

Provision for income taxes

    3,973       4,899       3,443       3,764       6,840       5,877       8,633       3,689  
   


 


 


 


 


 


 


 


Income before controlling interest

    7,031       8,536       7,816       8,148       12,306       9,902       10,998       2,349  

Controlling interest in net income

    (89 )     (102 )     (24 )     (347 )     (286 )     (70 )     (494 )     (79 )
   


 


 


 


 


 


 


 


Net income

  $ 6,942     $ 8,434     $ 7,792     $ 7,801     $ 12,020     $ 9,832     $ 10,504     $ 2,270  
   


 


 


 


 


 


 


 


Basic net income per common share

  $ 0.08     $ 0.10     $ 0.09     $ 0.09     $ 0.14     $ 0.12     $ 0.12     $ 0.03  

Diluted net income per common share

  $ 0.08     $ 0.10     $ 0.09     $ 0.09     $ 0.13     $ 0.11     $ 0.11     $ 0.02  

Shares used in the calculation of basic net income per share

    85,014       85,008       85,006       85,006       85,010       85,432       85,707       86,072  

Shares used in the calculation of diluted net income per share

    85,017       85,010       85,009       87,899       92,531       92,928       97,371       97,236  

(1)    Stock-based compensation recorded in fiscal 2004 was classified as follows:

      

                               

Cost of product sales

 

  $     $     $ 78     $ 79  

Cost of production services

 

                28       27  

Selling, general and administrative

 

    23       7,005       2,772       2,911  

Research and development

 

                607       608  
                                   


 


 


 


Total stock-based compensation

 

  $ 23     $ 7,005     $ 3,485     $ 3,625  
                                   


 


 


 


 

53


Table of Contents
     
Actual

 
    Fiscal Quarter Ended

 
    Dec 27,
2002


    Mar 28,
2003


    Jun 27,
2003


    Sep 26,
2003


    Dec 26,
2003


    Mar 26,
2004


    Jun 25,
2004


    Sep 24,
2004


 

As a percentage of revenue:

                                               

Revenue:

                                               

Licensing

  71 %   73 %   75 %   72 %   73 %   75 %   73 %   71 %

Product sales

  22     20     18     21     20     18     20     22  

Production services

  7     7     7     7     7     7     7     7  
   

 

 

 

 

 

 

 

Total revenue

  100     100     100     100     100     100     100     100  
   

 

 

 

 

 

 

 

Cost of revenue (includes stock-based compensation for periods beginning in fiscal 2004; see table below):

                                               

Cost of licensing

  19     18     18     18     20     19     18     18  

Cost of product sales (1)

  13     13     12     12     11     10     10     11  

Cost of production services (1)

  3     3     3     4     2     2     3     3  
   

 

 

 

 

 

 

 

Total cost of revenue

  35     34     33     34     33     31     31     32  
   

 

 

 

 

 

 

 

Gross margin

  65     66     67     66     67     69     69     68  

Operating expenses (includes stock-based compensation for periods beginning in fiscal 2004; see table below):

                                               

Selling, general and administrative (1)

  35     34     37     35     31     40     38     48  

Research and development (1)

  8     8     9     9     8     7     8     10  

Settlements

                          (2 )    

In-process research and development

              2         2         0