Published: April 16, 2010

"Everything is better in 3-D" seems to be the mantra of media these days. It's not hard to see why. James Cameron's Academy Award-nominated movie Avatar may have shattered box office records, but it hasn't been the only 3-D box office success.

It's hard not to geek-out over 3-D if you're a technophile: the visuals are stunning, the experience immersive. And if the movie is halfway decent, why, that's just a bonus. Not bad for $15 a ticket. These kinds of box office receipts have breathed new life into the major cinema chains and sent shares soaring. Now that 3-D technology has finally made a lasting mark on the silver screen, "everything is better in 3-D" should be words to live by for investors, too.

One company that seems especially primed to benefit from this sea change is Dolby Labs (NYSE: DLB). Dolby entered the 3-D projection business in 2007, and currently holds about 12% of market share. RealD, a privately held company, holds about 83% of market share. It may seem like RealD has a lock on the market, but there are several factors to consider.

Demand for 3-D screens is surging. At the end of 2009, there were slightly more than 3,000 3-D screens in the United States -- 388 of them using Dolby projectors. But the company shipped more than 800 units alone in the first quarter of 2010 ending in January. The pie is also getting bigger: industry experts predict there could be as many as 15,000 3-D screens worldwide by the end of the year (roughly double the current number) and Dolby already has a significant share of the global market.

There's only one problem: Outfitting a single screen to show 3-D movies can turn into a $100,000 affair. The upfront cost for Dolby's projectors is slightly more expensive than RealD's (about $26,000 vs. about $20,000), but Dolby's projection technology allows theater operators to show both traditional 2-D and 3-D movies without having to spend money on a special silver screen for 3-D.

And you can't have a 3-D movie without the glasses. Dolby faces a challenge in this area. RealD uses disposable glasses that cost about a dollar. Dolby's glasses aren't disposable and cost about $17.50. The company claims its 3-D glasses can be cleaned in-house and reused hundreds of times, thus lowering the cost. But it presents a marketing challenge nonetheless. Dolby must convince theater operators that its 3-D projection kits are cheaper in the long-run in order to gain business and continue growing. Given Dolby's sterling reputation for innovation and technical savvy, that shouldn't be a problem.

Revenue from 3-D projectors is already propelling growth at Dolby. The majority of revenue comes from licensing Dolby's patented audio and home theater technologies, but about $47.7 million, or 21%, of $221 million in total revenue came from "product sales" in the first quarter of fiscal 2010, compared with just $17.9 million, or 9%, a year earlier. Most of these product sales are 3-D projectors. Revenue from this segment has more than doubled in a year and could be in the beginning stages of a long-term growth phase. More than 40 movies are expected to release in 3-D within the next three years compared to just a handful in 2008, so demand isn't going to dry up soon.

Movie studios and theater chains may be gearing up for 3-D, but this is just the tip of the iceberg for Dolby. Companies like Panasonic (NYSE: PC) and Sony (NYSE: SNE) are making forays into 3-D televisions as well. The cable networks are getting involved too: ESPN is planning to showcase up to 25 World Cup soccer matches on a special 3-D channel along with a total of 85 sporting events in 2010 and a coalition of Discovery Communications (Nasdaq: DISCA), Imax (Nasdaq: IMAX) and Sony also have plans to launch an as-yet unnamed 3-D network in 2011.

This is the real wild card for Dolby. A 3-D television (with 3-D programming) becoming the next "necessity" for every home theater could mean tremendous upside for the company. Not only could Dolby use its experience in 3-D technology in this space, but the home theater market get a boost as a whole.

The 3-D TV transition is still several years away, however. For one thing, 3-D TVs are expensive (north of $2,000, to be exact). It will also take cable providers and networks some time to roll out 3-D networks (they haven't even finished rolling out high-definition channels yet).

At 29 times earnings, Dolby's shares appear expensive, but are actually in line with their long-term average. The company has few direct competitors, and has a unique business model of licensing, which makes for an almost-unheard-of operating margin of 47%. Given these factors, it's understandable why investors would place a premium on the shares. Dolby's stock is up +68% year-to-date, but appears to be on a long-term winning streak. As the 3-D revolution takes form, expect Dolby to create an irreplaceable and highly profitable niche for itself.

-- Brad Briggs
Staff Writer
Street Authority