2012 Q2 10-Q
Table of Contents

 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
FORM 10-Q
 
 

ý
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended March 30, 2012
OR
¨
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Transition Period From              To             
Commission File Number: 001-32431
DOLBY LABORATORIES, INC.
(Exact name of registrant as specified in its charter)
 
Delaware
 
90-0199783
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
100 Potrero Avenue
San Francisco, CA
 
94103-4813
(Address of principal executive offices)
 
(Zip Code)
(415) 558-0200
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ý Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No ý
On April 19, 2012 the registrant had 49,694,379 shares of Class A common stock, par value $0.001 per share, and 57,183,964 shares of Class B common stock, par value $0.001 per share, outstanding.
 
 
 
 
 


Table of Contents

DOLBY LABORATORIES, INC.
FORM 10-Q
TABLE OF CONTENTS

 
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
 
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 6.
 
 

2

Table of Contents

PART I – FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DOLBY LABORATORIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
 
September 30,
2011
March 30,
2012
ASSETS
(unaudited)
Current assets:
 
 
Cash and cash equivalents
$
551,512

$
747,988

Short-term investments
391,281

350,735

Accounts receivable, net of allowance of $2,466 at September 30, 2011 and $2,098 at March 30, 2012
61,815

57,762

Inventories
26,244

16,562

Deferred taxes
90,869

94,859

Prepaid expenses and other current assets
36,877

26,099

Total current assets
1,158,598

1,294,005

Long-term investments
272,797

209,804

Property, plant and equipment, net
117,107

135,517

Intangible assets, net
51,573

44,816

Goodwill
263,260

264,750

Deferred taxes
14,779

20,337

Other non-current assets
6,273

16,171

Total assets
$
1,884,387

$
1,985,400

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
Current liabilities:
 
 
Accounts payable
$
10,887

$
5,444

Accrued liabilities
117,035

108,245

Income taxes payable
4,762

9,391

Deferred revenue
26,701

26,718

Total current liabilities
159,385

149,798

Long-term deferred revenue
15,526

16,332

Deferred taxes
671

658

Other non-current liabilities
23,455

31,445

Total liabilities
199,037

198,233

Stockholders’ equity:
 
 
Class A common stock, $0.001 par value, one vote per share, 500,000,000 shares authorized: 51,860,546 shares issued and outstanding at September 30, 2011 and 50,284,419 at March 30, 2012
52

50

Class B common stock, $0.001 par value, ten votes per share, 500,000,000 shares authorized: 57,559,554 shares issued and outstanding at September 30, 2011 and 57,183,964 at March 30, 2012
58

57

Additional paid-in capital
210,681

149,082

Retained earnings
1,445,189

1,606,468

Accumulated other comprehensive income
7,533

9,130

Total stockholders’ equity – Dolby Laboratories, Inc.
1,663,513

1,764,787

Controlling interest
21,837

22,380

Total stockholders’ equity
1,685,350

1,787,167

Total liabilities and stockholders’ equity
$
1,884,387

$
1,985,400

See accompanying notes to unaudited condensed consolidated financial statements

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Table of Contents

DOLBY LABORATORIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
 
Fiscal Quarter Ended
Fiscal Year-to-Date Ended
 
April 1,
2011
March 30,
2012
April 1,
2011
March 30,
2012
Revenue:
(unaudited)    
Licensing
$
214,627

$
225,349

$
402,803

$
424,973

Products
26,347

27,228

72,374

53,628

Services
9,052

7,682

17,561

15,036

Total revenue
250,026

260,259

492,738

493,637

Cost of revenue:
 
 
 
 
Cost of licensing
5,771

3,303

9,732

6,631

Cost of products
20,031

17,635

42,229

31,523

Cost of services
2,655

2,654

5,635

5,848

Total cost of revenue
28,457

23,592

57,596

44,002

Gross margin
221,569

236,667

435,142

449,635

Operating expenses:
 
 
 
 
Research and development
28,399

34,236

56,726

67,062

Sales and marketing
37,545

43,194

75,762

86,210

General and administrative
35,155

37,281

72,197

72,746

Restructuring charges, net

910

785

1,278

Total operating expenses
101,099

115,621

205,470

227,296

Operating income
120,470

121,046

229,672

222,339

Interest income
1,953

1,414

3,567

3,151

Interest expense
(85
)
(5
)
(368
)
(31
)
Other income, net
156

60

689

260

Income before provision for income taxes
122,494

122,515

233,560

225,719

Provision for income taxes
(40,012
)
(34,198
)
(64,313
)
(64,036
)
Net income including controlling interest
82,482

88,317

169,247

161,683

Less: net income attributable to controlling interest
(421
)
(197
)
(799
)
(404
)
Net income attributable to Dolby Laboratories, Inc.
$
82,061

$
88,120

$
168,448

$
161,279

Earnings per share attributable to Dolby Laboratories, Inc.:
 
 
 
 
Basic
$
0.73

$
0.81

$
1.50

$
1.48

Diluted
$
0.72

$
0.81

$
1.48

$
1.48

Weighted-average shares outstanding:
 
 
 
 
Basic
112,140

108,415

112,086

108,650

Diluted
113,346

109,170

113,535

109,242

Related party rent expense included in general and administrative expenses
$
343

$
343

$
686

$
686

See accompanying notes to unaudited condensed consolidated financial statements

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Table of Contents

DOLBY LABORATORIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
Fiscal Year-to-Date Ended
 
April 1,
2011
March 30,
2012
Operating activities:
(unaudited)
Net income including controlling interest
$
169,247

$
161,683

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
Depreciation and amortization
21,045

20,103

Stock-based compensation
22,000

23,502

Amortization of premium on investments
7,805

9,306

Excess tax benefit from exercise of stock options
(11,305
)
(425
)
Provision for doubtful accounts
856

132

Deferred income taxes
(472
)
(10,030
)
Other non-cash items affecting net income
157

2,237

Changes in operating assets and liabilities:
 
 
Accounts receivable
(20,218
)
4,103

Inventories
(3,038
)
876

Prepaid expenses and other assets
(3,715
)
(1,128
)
Accounts payable and other liabilities
(13,379
)
(10,634
)
Income taxes, net
620

14,108

Deferred revenue
1,988

836

Net cash provided by operating activities
171,591

214,669

Investing activities:
 
 
Purchases of available-for-sale securities
(368,007
)
(122,249
)
Proceeds from sales of available-for-sale securities
115,462

105,454

Proceeds from maturities of available-for-sale securities
122,914

111,515

Purchases of property, plant and equipment
(19,551
)
(30,450
)
Acquisitions, net of cash acquired
(3,350
)
(575
)
Proceeds from sales of property, plant and equipment and assets held for sale
2,797

715

Net cash provided by/(used in) investing activities
(149,735
)
64,410

Financing activities:
 
 
Proceeds from issuance of common stock, net of shares withheld for taxes
15,215

3,524

Repurchase of common stock
(75,124
)
(86,149
)
Excess tax benefit from exercise of stock options
11,305

425

Net cash used in financing activities
(48,604
)
(82,200
)
Effect of foreign exchange rate changes on cash and cash equivalents
1,155

(403
)
Net increase/(decrease) in cash and cash equivalents
(25,593
)
196,476

Cash and cash equivalents at beginning of period
545,861

551,512

Cash and cash equivalents at end of period
$
520,268

$
747,988

Supplemental disclosure:
 
 
Cash paid for income taxes
$
64,019

$
59,997

Cash paid for interest
205

4

See accompanying notes to unaudited condensed consolidated financial statements

5

Table of Contents

DOLBY LABORATORIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1.  Basis of Presentation
Unaudited Interim Financial Statements
We have prepared the accompanying unaudited condensed consolidated financial statements in accordance with accounting principles generally accepted in the U.S. (“GAAP”), and with Securities and Exchange Commission (“SEC”) rules and regulations, which allow for certain information and footnote disclosures that are normally included in annual financial statements prepared in accordance with GAAP to be condensed or omitted. In our opinion, these condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements for the fiscal year ended September 30, 2011 and include all adjustments necessary for fair presentation. The accompanying condensed consolidated financial statements should be read in conjunction with our consolidated financial statements for the fiscal year ended September 30, 2011, which are included in our Annual Report on Form 10-K, as amended, filed with the SEC.
The results for the fiscal quarter and fiscal year-to-date period ended March 30, 2012 are not necessarily indicative of the results to be expected for any subsequent quarterly or annual financial period, including the fiscal year ending September 28, 2012.
Principles of Consolidation
The condensed consolidated financial statements include the accounts of Dolby Laboratories and our wholly owned subsidiaries. In addition, we have consolidated the financial results of jointly owned affiliated companies in which our principal stockholder has a controlling interest. We report these controlling interests as a separate line item in our condensed consolidated statements of operations as net income attributable to controlling interest and in our condensed consolidated balance sheets as controlling interest. We eliminate all intercompany accounts and transactions upon consolidation.
Use of Estimates
The preparation of the consolidated financial statements in accordance with GAAP requires management to make certain estimates and assumptions that affect the amounts reported and disclosed in our consolidated financial statements and accompanying notes. Significant items subject to such estimates and assumptions include estimated selling prices for elements sold in multiple-element revenue arrangements, valuation allowances for accounts receivable, carrying values of inventories and certain property, plant and equipment, goodwill, intangible assets, stock-based compensation, fair values of investments, accrued expenses, including liabilities for unrecognized tax benefits, and deferred income tax assets. Actual results could differ from our estimates.
Fiscal Year
Our fiscal year is a 52 or 53 week period ending on the last Friday in September. The fiscal periods presented herein include the 13 week periods ended April 1, 2011 and March 30, 2012, and the 27 week period ended April 1, 2011 and the 26 week period ended March 30, 2012. Our fiscal year ended September 30, 2011 (fiscal 2011) consisted of 53 weeks, while our fiscal year ending September 28, 2012 (fiscal 2012) consists of 52 weeks.
Reclassifications
We have reclassified certain prior period amounts within our condensed consolidated financial statements and accompanying notes to conform to our current period presentation. These reclassifications did not affect total revenue, operating income, or net income.

2.  Summary of Significant Accounting Policies
Recently Issued Accounting Standards
In June 2011 the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, (“ASU 2011-05”). This new accounting standard: (1) eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity, (2) requires the consecutive presentation of the statement of net income and other comprehensive income, and (3) requires an entity to present reclassification adjustments on the face of the financial statements from other comprehensive income to net income. This new standard does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income, nor does it affect

6

Table of Contents

how earnings per share is calculated or presented. ASU 2011-05 is required to be applied retrospectively and is effective for fiscal years and interim periods within those years beginning after December 15, 2011, with early adoption permitted. In December 2011 the FASB issued ASU No. 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. This update temporarily defers the effective date of the requirement for presentation of reclassification adjustments, as described above. ASU 2011-05 is expected to be effective for our fiscal year beginning September 29, 2012. As this new standard only requires enhanced disclosure, the adoption of ASU 2011-05 will not impact our financial position or results of operations.
In September 2011 the FASB issued ASU No. 2011-08, Goodwill and Other (Topic 350): Testing Goodwill for Impairment, (“ASU 2011-08”). This new accounting standard simplifies goodwill impairment tests and states that a qualitative assessment may be performed to determine whether further impairment testing is necessary. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. We intend to adopt the provisions of this accounting standard for the goodwill impairment test that will be performed in third quarter of fiscal 2012. We do not expect the adoption of ASU 2011-08 to have a material impact on our consolidated financial statements.
There have been no material changes to our significant accounting policies as compared to those described in our Annual Report on Form 10-K, as amended, for the fiscal year ended September 30, 2011.

3.  Composition of Certain Financial Statement Captions
Cash, Cash Equivalents, and Investments
Cash, cash equivalents, and investments consist of the following:
 
September 30,
2011
March 30,
2012
 
(in thousands)
Cash and cash equivalents:
 
 
    Cash
$
394,474

$
483,622

    Cash equivalents:
 
 
        Money market funds
142,038

264,366

        U.S. agency securities
15,000


            Total cash and cash equivalents
551,512

747,988

Short-term investments:
 
 
     Commercial paper

20,984

     Corporate bonds
52,645

49,885

     Municipal debt securities
330,562

274,853

     U.S. agency securities
8,074

5,013

            Total short-term investments
391,281

350,735

Long-term investments:
 
 
     Corporate bonds
124,313

75,207

     Municipal debt securities
141,639

114,518

     U.S. agency securities
6,845

20,079

            Total long-term investments
272,797

209,804

Total cash, cash equivalents, and investments
$
1,215,590

$
1,308,527

Our investment portfolio, which is recorded as cash equivalents, short-term investments, and long-term investments, consists of the following:
 
September 30, 2011
 
Amortized Cost
Unrealized
Gains
Unrealized
Losses
Estimated Fair
Value
 
(in thousands)
Money market funds
$
142,038

$

$

$
142,038

U.S. agency securities
29,858

65

(4
)
29,919

Corporate bonds
177,129

316

(487
)
176,958

Municipal debt securities
471,005

1,251

(55
)
472,201

Cash equivalents and investments
$
820,030

$
1,632

$
(546
)
$
821,116


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Table of Contents

 
 
March 30, 2012
 
Amortized Cost
Unrealized
Gains
Unrealized
Losses
Estimated Fair
Value
 
(in thousands)
Money market funds
$
264,366

$

$

$
264,366

U.S. agency securities
25,054

38


25,092

Commercial paper
20,984



20,984

Corporate bonds
124,540

565

(13
)
125,092

Municipal debt securities
388,574

840

(43
)
389,371

Cash equivalents and investments
$
823,518

$
1,443

$
(56
)
$
824,905

We have classified all of our investments listed in the tables above as available-for-sale securities recorded at fair market value in our condensed consolidated balance sheets, with unrealized gains and losses reported as a component of accumulated other comprehensive income. Upon sale, amounts of gains and losses reclassified into earnings are determined based on specific identification of the securities sold.
The following tables show the gross unrealized losses and the fair value for those available-for-sale securities that were in an unrealized loss position:
 
 
September 30, 2011
 
Less than 12 months
12 months or greater
Total
 
Fair Value
Gross Unrealized Losses
Fair Value
Gross Unrealized Losses
Fair Value
Gross Unrealized Losses
 
(in thousands)
U.S. agency securities
$
3,997

$
(4
)
$

$

$
3,997

$
(4
)
Corporate bonds
87,613

(487
)


87,613

(487
)
Municipal debt securities
79,466

(52
)
2,081

(3
)
81,547

(55
)
      Total
$
171,076

$
(543
)
$
2,081

$
(3
)
$
173,157

$
(546
)

 
March 30, 2012
 
Less than 12 months
12 months or greater
Total
 
Fair Value
Gross Unrealized
Losses
Fair Value
Gross Unrealized
Losses
Fair Value
Gross Unrealized
Losses
 
(in thousands)
Corporate bonds
$
15,642

$
(13
)
$

$

$
15,642

$
(13
)
Municipal debt securities
57,054

(43
)


57,054

(43
)
      Total
$
72,696

$
(56
)
$

$

$
72,696

$
(56
)
The unrealized losses on our available-for-sale securities were primarily a result of unfavorable changes in interest rates subsequent to the initial purchase of these securities. As of March 30, 2012, we owned 29 securities that were in an unrealized loss position. We do not intend to sell, nor do we believe we will need to sell, these securities before we recover the associated unrealized losses. We do not consider any portion of the unrealized losses at September 30, 2011 or March 30, 2012 to be an other-than-temporary impairment, nor do we consider any of the unrealized losses to be credit losses.
The following table summarizes the amortized cost and estimated fair value of short-term and long-term available-for-sale investments based on stated maturities:


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Table of Contents

 
 
March 30, 2012
 
Amortized Cost
Fair Value
 
(in thousands)
Due within 1 year
$
350,250

$
350,735

Due in 1 to 2 years
193,322

194,147

Due in 2 to 3 years
15,580

15,657

Total
$
559,152

$
560,539


Inventories
Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following:
 
 
September 30,
2011
March 30,
2012
 
(in thousands)
Raw materials
$
10,821

$
5,535

Work in process
2,942


Finished goods
12,481

11,027

Inventories
$
26,244

$
16,562


The primary driver of the decrease in inventories from September 30, 2011 to March 30, 2012 is an effort to reduce overall inventory levels in connection with the restructuring of our manufacturing operations and to match anticipated demand for products.

Additionally, $8.8 million of raw materials inventory is included within other non-current assets in our condensed consolidated balance sheet as of March 30, 2012. This inventory was purchased in bulk in fiscal 2012 to obtain a significant volume discount, and is expected to be consumed over a period that exceeds 12 months. We have reviewed anticipated consumption rates of this inventory and do not believe there to be material risk of obsolescence prior to the ultimate sale of the inventory. As a result no reserve has been recorded as of March 30, 2012. All inventory was classified as current as of September 30, 2011.


Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consist of the following:
 
 
September 30,
2011
March 30,
2012
 
(in thousands)
Prepaid assets
$
9,365

$
8,373

Other current assets
19,683

15,297

Income tax receivable
7,829

2,429

Prepaid expenses and other current assets
$
36,877

$
26,099


 

Property, Plant and Equipment
Property, plant and equipment are recorded at cost and consist of the following:
 

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September 30,
2011
March 30,
2012
 
(in thousands)
Land
$
12,778

$
12,844

Buildings
26,623

26,804

Leasehold improvements
44,021

59,242

Machinery and equipment
20,845

24,131

Computer systems and software
71,220

80,882

Furniture and fixtures
10,537

12,408

Products provided under operating leases
1,060


 
187,084

216,311

Less: accumulated depreciation
(69,977
)
(80,794
)
Property, plant and equipment, net
$
117,107

$
135,517

Depreciation expense for our property, plant and equipment is included in cost of products, cost of services, research and development expenses, sales and marketing expenses, and general and administrative expenses in our condensed consolidated statements of operations.

Goodwill and Intangible Assets
The following table outlines changes to the carrying amount of goodwill:
 
 
 
 
(in thousands)
Balance at September 30, 2011
$
263,260

Acquired goodwill

Translation adjustments
1,490

Balance at March 30, 2012
$
264,750

Intangible assets consist of the following:
 
 
September 30, 2011
March 30, 2012
 
Cost
Accumulated
Amortization
Net
Cost
Accumulated
Amortization
Net
Intangible assets subject to amortization:
(in thousands)
Acquired patents and technology
$
61,611

$
(32,146
)
$
29,465

$
61,570

$
(36,251
)
$
25,319

Customer relationships
30,748

(12,821
)
17,927

30,748

(14,409
)
16,339

Customer contracts
6,063

(6,063
)




Other intangibles
20,308

(16,127
)
4,181

20,308

(17,150
)
3,158

Total
$
118,730

$
(67,157
)
$
51,573

$
112,626

$
(67,810
)
$
44,816

Amortization expense for our intangible assets is included in cost of licensing, cost of products, research and development expenses, and sales and marketing expenses in our condensed consolidated statements of operations.
As of March 30, 2012, our expected amortization expense in future periods is as follows:
 
Fiscal Year
Amortization
Expense
 
(in thousands)
Remainder of 2012
$
5,968

2013
11,923

2014
10,279

2015
7,823

2016
5,654

Thereafter
3,169

Total
$
44,816


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Accrued Liabilities
Accrued liabilities consist of the following:
 
 
September 30,
2011
March 30,
2012
 
(in thousands)
Amounts payable to joint licensing program partners
$
42,502

$
42,350

Accrued compensation and benefits
41,168

35,796

Accrued customer refunds and deposits
10,849

11,011

Accrued professional fees
5,727

4,324

Other accrued liabilities
16,789

14,764

Accrued liabilities
$
117,035

$
108,245


Other Non-Current Liabilities
Other non-current liabilities consist of the following:
 
 
September 30,
2011
March 30,
2012
 
(in thousands)
Supplemental retirement plan obligations
$
1,811

$
2,039

Non-current tax liabilities
13,070

19,499

Other liabilities
8,574

9,907

Other non-current liabilities
$
23,455

$
31,445


See Note 7 “Income Taxes” for additional information related to tax liabilities.
Revenue from Material Customer
In the fiscal quarters ended April 1, 2011 and March 30, 2012, revenue from one customer was $37.8 million and $37.4 million, respectively, or 15% and 14% of revenue for each quarter, respectively. In the fiscal year-to-date periods ended April 1, 2011 and March 30, 2012, the same customer accounted for $66.3 million and $69.2 million, respectively, or 13% and 14% of total revenue, respectively.

4.  Fair Value Measurements
Fair value is the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants at the measurement date. We minimize the use of unobservable inputs and use observable market data, if available, when determining fair value. We classify our inputs to measure fair value using the following three-level hierarchy:
Level 1:
Quoted prices in active markets at the measurement date for identical assets and liabilities.
Level 2:
Prices may be based upon quoted prices in active markets or inputs not quoted on active markets but are corroborated by market data.
Level 3:
Unobservable inputs are used when little or no market data is available and reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability.
Financial assets and liabilities carried at fair value are classified below:
 

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September 30, 2011
 
Level 1
Level 2
Level 3
Total
 
(in thousands)
Assets:
 
 
 
 
Investments held in supplemental retirement plan (1)
$
1,891

$

$

$
1,891

Money market funds (2)
142,038



142,038

Corporate bonds (3)

176,958


176,958

Municipal debt securities (3)

472,201


472,201

U.S. agency securities (2), (3)
29,919



29,919

Total
$
173,848

$
649,159

$

$
823,007

(1)
These assets are included within prepaid expenses and other current assets and within other non-current assets.
(2)
These assets are included within cash and cash equivalents.
(3)
These assets are included within short-term investments and within long-term investments.
 
September 30, 2011
 
Level 1
Level 2
Level 3
Total
 
(in thousands)
Liabilities:
 
 
 
 
Investments held in supplemental retirement plan (1)
$
1,891

$

$

$
1,891

Total
$
1,891

$

$

$
1,891

(1)
These liabilities are included within accrued compensation and benefits and within other non-current liabilities.
 
 
March 30, 2012
 
Level 1
Level 2
Level 3
Total
 
(in thousands)
Assets:
 
 
 
 
Investments held in supplemental retirement plan (1)
$
2,137

$

$

$
2,137

Money market funds (2)
264,366



264,366

Commercial paper (3)

20,984


20,984

Corporate bonds (4)

125,092


125,092

Municipal debt securities (4)

389,371


389,371

U.S. agency securities (4)
25,092



25,092

Total
$
291,595

$
535,447

$

$
827,042

(1)
These assets are included within prepaid expenses and other current assets and within other non-current assets.
(2)
These assets are included within cash and cash equivalents.
(3)
These assets are included within short-term investments.
(4)
These assets are included within short-term investments and within long-term investments.
 
March 30, 2012
 
Level 1
Level 2
Level 3
Total
 
(in thousands)
Liabilities:
 
 
 
 
Investments held in supplemental retirement plan (1)
$
2,137

$

$

$
2,137

Total
$
2,137

$

$

$
2,137

(1)
These liabilities are included within accrued compensation and benefits and within other non-current liabilities.
We base the fair value of our Level 1 financial instruments, which are traded in active markets, using quoted market prices for identical instruments. Our Level 1 financial instruments include money market funds, U.S. agency securities, U.S. government bonds, and mutual fund investments held in our supplemental retirement plan.
We obtain the fair value of our Level 2 financial instruments from a professional pricing service, which may use quoted market prices for identical or comparable instruments, or model driven valuations using observable market data or inputs corroborated by observable market data.
To validate the fair value determination provided by our primary pricing service, we perform quality controls over values received which include comparing our pricing service provider’s assessment of the fair values of our investment securities against the fair values of our investment securities obtained from another independent source, reviewing the pricing movement in the context of overall market trends, and reviewing trading information from our investment managers. In addition, we

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assess the inputs and methods used in determining the fair value in order to determine the classification of securities in the fair value hierarchy.
We did not own any Level 3 financial assets or liabilities as of September 30, 2011 or March 30, 2012.

5.  Stock-Based Compensation
We have adopted compensation plans that provide for grants of stock-based awards as a form of compensation to employees, officers, and directors. We have issued stock-based awards in the form of stock options, restricted stock units, stock appreciation rights, and shares issued under our employee stock purchase plan (“ESPP”).
We recognize stock-based compensation expense net of estimated forfeitures. Stock-based compensation expense included in our condensed consolidated statements of operations was as follows:
 
 
Fiscal Quarter Ended
Fiscal Year-to-Date Ended
 
April 1,
2011
March 30,
2012
April 1,
2011
March 30,
2012
 
(in thousands)
Stock-based compensation expense:
 
 
 
Stock options
$
6,130

$
5,995

$
13,027

$
12,054

Restricted stock units
4,595

5,880

8,721

11,144

Employee stock purchase plan
184

144

366

225

Stock appreciation rights
(169
)
44

(114
)
79

Total stock-based compensation expense
$
10,740

$
12,063

$
22,000

$
23,502

 
 
Fiscal Quarter Ended
Fiscal Year-to-Date Ended
 
April 1,
2011
March 30,
2012
April 1,
2011
March 30,
2012
 
(in thousands)
Stock-based compensation expense was classified as follows:
 
 
 
Cost of products
$
168

$
179

$
314

$
345

Cost of services
44

61

82

117

Research and development
2,611

2,968

4,934

5,632

Sales and marketing
3,367

4,004

6,363

7,719

General and administrative
4,550

4,851

10,307

9,689

Total stock-based compensation expense
$
10,740

$
12,063

$
22,000

$
23,502

As of March 30, 2012, total unrecognized stock-based compensation expense associated with employee stock options expected to vest was $61.5 million, which is expected to be recognized over a weighted-average period of approximately 2.79 years. As of March 30, 2012, total unrecognized stock-based compensation expense associated with restricted stock units expected to vest was $57.9 million, which is expected to be recognized over a weighted-average period of approximately 3.08 years.
The following table summarizes information about stock options issued to officers, directors, and employees under our 2000 Stock Incentive Plan and 2005 Stock Plan:
 
 
Shares
Weighted Average
Exercise Price
Weighted Average
Remaining
Contractual Life
Aggregate
Intrinsic
Value
 
(in thousands)
 
(in years)
(in thousands)
Stock options outstanding at September 30, 2011
5,801

$
45.19

 
 
Grants
2,086

31.55

 
 
Exercises
(181
)
24.34

 
 
Forfeitures and cancellations
(269
)
51.49

 
 
Stock options outstanding at March 30, 2012
7,437

$
41.64

7.8

$
34,766

Stock options vested at March 30, 2012 and expected to vest
7,143

$
41.61

7.7

$
33,732

Stock options exercisable at March 30, 2012
3,355

$
40.27

6.3

$
19,438


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Aggregate intrinsic value is based on the closing price of our common stock on March 30, 2012 of $38.06 and excludes the impact of stock options that were not in-the-money.

 We use the Black-Scholes option pricing model to determine the fair value of employee stock options at the date of grant. The fair value of our stock-based awards was estimated using the following weighted-average assumptions:
 
 
Fiscal Quarter Ended
Fiscal Year-to-Date Ended
 
April 1,
2011
March 30,
2012
April 1,
2011
March 30,
2012
Expected life (in years)
4.40

4.53

4.40

4.53

Risk-free interest rate
1.6
%
0.7
%
1.5
%
0.7
%
Expected stock price volatility
41.2
%
43.5
%
41.5
%
44.4
%
Dividend yield





The following table summarizes information about restricted stock units issued to officers, directors, and employees under our 2005 Stock Plan:

 
Shares
Weighted Average
Fair Value 
 
(in thousands)
 
Non-vested at September 30, 2011
946

$
53.71

Granted
1,082

32.08

Vested
(336
)
51.44

Forfeitures and cancellations
(47
)
48.00

Non-vested at March 30, 2012
1,645

$
40.11



Employee Stock Purchase Plan.    In January 2005, our board of directors adopted and our stockholders approved our ESPP, which allows eligible employees to have up to 10 percent of their eligible compensation withheld and used to purchase Class A common stock, subject to a maximum of $25,000 worth of stock purchased in a calendar year or no more than 1,000 shares in an offering period, whichever is less. The plan provides for a discount equal to 15 percent of the closing price on the New York Stock Exchange on the last day of the purchase period.
Amended Employee Stock Purchase Plan.    During the first quarter of fiscal 2012, the compensation committee of our board of directors approved an amendment to the ESPP to provide for overlapping one-year offering periods composed of successive six-month purchase periods, with a look back feature to the Company’s stock price at the commencement of a one-year offering period. The amended plan also includes an automatic reset feature that provides for an offering period to be reset and recommenced to a new lower-priced offering if the offering price of a new offering period is less than that of the immediately preceding offering period. The amendment is effective for the ESPP offering period commencing in May 2012. We do not expect adoption of the amendment to the ESPP to have a material impact on our results of operations.

6.  Restructuring
In the fourth quarter of fiscal 2011, we informed approximately 55 employees of our plans to reorganize certain aspects of our business under a strategic restructuring program. As a result we recognized total estimated severance and other associated costs for affected employees of $2.5 million and $0.4 million in fiscal 2011 and the fiscal year-to-date period ended March 30, 2012, respectively. In addition, we recognized $0.4 million in facilities and contract termination costs during the second quarter of fiscal 2012. We also recognized $0.2 million and $0.4 million in fixed asset write-off costs related to this restructuring program in fiscal 2011 and during the second quarter of fiscal 2012, respectively. We expect to recognize an additional $0.2 million in other associated costs during the remainder of fiscal 2012. These expenses are being recognized in restructuring charges, net, in our condensed consolidated statements of operations.
Changes in our restructuring accruals, which are included within accrued liabilities in our condensed consolidated balance sheets, were as follows:
 

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Severance
Facilities and
contract termination costs
Fixed assets
write-off
Other associated
costs
Total
 
(in thousands)
Balance at September 30, 2011
$
2,250

$

$

$
120

$
2,370

Restructuring charges
318

432

424

104

1,278

Cash payments
(2,435
)


(185
)
(2,620
)
Non-cash charges
5

93

(424
)

(326
)
Balance at March 30, 2012
$
138

$
525

$

$
39

$
702


7.  Income Taxes
Our effective tax rate is based on a projection of our annual fiscal year results. Our effective tax rate was 33% and 28% for the fiscal quarters ended April 1, 2011 and March 30, 2012, respectively, and 28% and 28% for the fiscal year-to-date periods ended April 1, 2011 and March 30, 2012, respectively.
Our estimated fiscal year 2012 tax provision reflects additional benefits from our election to indefinitely reinvest a portion of our undistributed earnings in a foreign subsidiary. We also benefited from a change in the State of California apportionment sourcing rules, which became effective in the first quarter of fiscal 2012. These benefits were partially offset by the expiration of the federal research and development tax credits, effective from the first quarter of fiscal 2012, which resulted in an increase to our effective tax rate.
In the fiscal year-to-date period ended April 1, 2011, we completed the restructuring of our international operations, which resulted in the release of a deferred tax liability of $11.0 million related to the amortization of an intangible asset from a prior year acquisition, thereby lowering our effective tax rate for that period.
As of March 30, 2012, the total amount of gross unrecognized tax benefits was $14.4 million, of which $8.1 million, if recognized, would reduce our effective tax rate. Our liability for unrecognized tax benefits is classified within non-current liabilities in our condensed consolidated balance sheets.
Withholding Tax.    We recognize licensing revenue gross of withholding taxes, which our licensees remit directly to their local tax authorities, and for which we receive a related foreign tax credit in our income tax provision. Withholding tax remittances were $7.6 million and $10.2 million in the fiscal quarters ended April 1, 2011 and March 30, 2012, respectively. Withholding tax remittances were $15.9 million and $21.4 million in the fiscal year-to-date periods ended April 1, 2011 and March 30, 2012, respectively.

8.  Legal Proceedings
We are involved in various legal proceedings from time to time arising from the normal course of business activities, including claims of alleged infringement of intellectual property rights, commercial, employment, and other matters. In our opinion, resolution of these proceedings is not expected to have a material adverse effect on our operating results or financial condition. However, it is possible that an unfavorable resolution of one or more such proceedings could materially affect our future operating results or financial condition in a particular period. There has been no material change in the status of legal proceedings since our fiscal year ended September 30, 2011.

9.  Commitments and Contingencies
The following table presents a summary of our contractual obligations and commitments as of March 30, 2012:
 
 
Payments Due By Fiscal Period
 
Remainder of 2012
2013
2014
2015
2016
Thereafter
Total
 
(in thousands)
Operating leases (1)
$
4,378

$
10,321

$
9,279

$
7,084

$
5,912

$
10,097

$
47,071

Purchase obligations (2)
1,695

2,972

361




5,028

Total
$
6,073

$
13,293

$
9,640

$
7,084

$
5,912

$
10,097

$
52,099

(1)
Operating lease payments include future minimum rental commitments, including those payable to our principal stockholder, for non-cancelable operating leases of office space as of March 30, 2012.
(2)
Our purchase obligations consist of agreements to purchase goods and services, entered into in the ordinary course of business. These represent non-cancelable commitments for which a penalty would be imposed if the agreement was cancelled for any reason other than an event of default as

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described by the agreement.
We are party to certain contractual agreements under which we have agreed to provide indemnifications of varying scope and duration to the other party relating to our licensed intellectual property. Historically, we have made no payments for these indemnification obligations and no amounts have been accrued in our condensed consolidated financial statements with respect to these obligations. Due to their varying terms and conditions, we are unable to make a reasonable estimate of the maximum potential amount we could be required to pay.

10.  Stockholders’ Equity
Common Stock Repurchase Program
In November 2009 we announced a stock repurchase program, providing for the repurchase of up to $250.0 million of our Class A common stock. Our board of directors approved an additional $300.0 million for our stock repurchase program in July 2010, $250.0 million in July 2011, and $100.0 million in February 2012, for a total authorization of up to $900.0 million in stock repurchases. Stock repurchases under this program may be made through open market transactions, negotiated purchases, or otherwise, at times and in amounts that we consider appropriate. The timing of repurchases and the number of shares repurchased depend upon a variety of factors including price, regulatory requirements, the rate of dilution from our equity compensation programs, and other market conditions. We may limit, suspend, or terminate the stock repurchase program at any time without prior notice. This program does not have a specified expiration date. Shares repurchased under the program will be returned to the status of authorized but unissued shares of Class A common stock. As of March 30, 2012, the remaining authorization to purchase additional shares is $380.2 million.
Stock repurchase activity under the stock repurchase program during the fiscal year-to-date period ended March 30, 2012 is summarized as follows:
 
Shares
Repurchased
Cost
(in thousands)
(1)
Average
Price Paid
per Share (2)
Repurchase activity for the fiscal quarter ended December 30, 2011
885,969

$
26,068

$
29.41

Repurchase activity for the fiscal quarter ended March 30, 2012
1,575,891

$
60,081

$
38.11

Total
2,461,860

$
86,149

 
(1)
Cost of share repurchases includes the price paid per share and applicable commissions.
(2)
Excludes commission costs.
Comprehensive Income
The components of comprehensive income were as follows:
 
 
Fiscal Quarter Ended
Fiscal Year-to-Date Ended
 
April 1,
2011
March 30,
2012
April 1,
2011
March 30,
2012
 
(in thousands)
Net income including controlling interest
$
82,482

$
88,317

$
169,247

$
161,683

Other comprehensive income:
 
 
 
 
Foreign currency translation adjustment, net of tax
2,237

1,934

3,344

1,557

Unrealized losses on available-for-sale securities, net of tax
220

306

(656
)
192

Comprehensive income
84,939

90,557

171,935

163,432

Less: comprehensive income attributable to controlling interest
(555
)
(415
)
(933
)
(556
)
Comprehensive income attributable to Dolby Laboratories, Inc.
$
84,384

$
90,142

$
171,002

$
162,876

Accumulated Other Comprehensive Income
Accumulated other comprehensive income consists of the following:
 
 
September 30,
2011
March 30,
2012
 
(in thousands)
Accumulated foreign currency translation gains, net of tax of ($2,653) at September 30, 2011 and ($3,026) at March 30, 2012
$
6,834

8,239

Accumulated unrealized gains on available-for-sale securities, net of tax of ($387) at September 30, 2011 and ($496) at March 30, 2012
699

891

Total accumulated other comprehensive income
$
7,533

9,130


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Stockholders' Equity and Controlling Interest
The following tables present the changes in total stockholders’ equity attributable to Dolby Laboratories, Inc. and the controlling interest:
 
 
Dolby
Laboratories, Inc.
Controlling
Interest
Total
 
(in thousands)
Balance at September 24, 2010
$
1,473,737

$
20,942

$
1,494,679

Net income
168,448

799

169,247

Translation adjustments, net of taxes of ($301)
3,210

134

3,344

Unrealized losses on available-for-sale securities, net of taxes of $406
(656
)

(656
)
Stock-based compensation expense
22,111


22,111

Repurchase of common stock
(75,124
)

(75,124
)
Tax benefit from the exercise of stock options and vesting of restricted stock units
11,320


11,320

Common stock issued under employee stock plans, net of shares withheld for taxes
15,215


15,215

Balance at April 1, 2011
$
1,618,261

$
21,875

$
1,640,136

 
Dolby
Laboratories, Inc.
Controlling
Interest
Total
 
(in thousands)
Balance at September 30, 2011
$
1,663,513

$
21,837

$
1,685,350

Net income
161,279

404

161,683

Distributions to controlling interest

(13
)
(13
)
Translation adjustments, net of taxes of ($373)
1,405

152

1,557

Unrealized losses on available-for-sale securities, net of taxes of ($109)
192


192

Stock-based compensation expense
23,536


23,536

Repurchase of common stock
(86,149
)

(86,149
)
Tax benefit from the exercise of stock options and vesting of restricted stock units
(2,513
)

(2,513
)
Common stock issued under employee stock plans, net of shares withheld for taxes
3,524


3,524

Balance at March 30, 2012
$
1,764,787

$
22,380

$
1,787,167


11.  Earnings Per Share
We compute basic earnings per share by dividing net income attributable to Dolby Laboratories, Inc. by the weighted-average number of shares of Class A and Class B common stock outstanding during the period. For diluted earnings per share, we divide net income attributable to Dolby Laboratories, Inc. by the sum of the weighted-average number of shares of Class A and Class B common stock outstanding and the potential number of dilutive shares of Class A and Class B common stock outstanding during the period.
The following table sets forth the computation of basic and diluted earnings per share attributable to Dolby Laboratories, Inc.:
 

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Fiscal Quarter Ended
Fiscal Year-to-Date Ended
 
April 1,
2011
March 30,
2012
April 1,
2011
March 30,
2012
 
(in thousands, except per share amounts)
Numerator:
 
 
 
 
Net income attributable to Dolby Laboratories, Inc.
$
82,061

$
88,120

$
168,448

$
161,279

Denominator:
 
 
 
 
Weighted-average shares outstanding - basic
112,140

108,415

112,086

108,650

Potential common shares from options to purchase Class A and Class B common stock
1,015

521

1,206

445

Potential common shares from restricted stock units
191

234

243

147

Weighted-average shares outstanding - diluted
113,346

109,170

113,535

109,242

Net income per share attributable to Dolby Laboratories, Inc. - basic
$
0.73

$
0.81

$
1.50

$
1.48

Net income per share attributable to Dolby Laboratories, Inc. - diluted
$
0.72

$
0.81

$
1.48

$
1.48

Anti-dilutive options excluded from calculation
2,836

5,830

2,855

6,250

Anti-dilutive restricted stock units excluded from calculation
426

439

431

1,592



18

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with our interim condensed consolidated financial statements and the related notes that appear elsewhere in this Quarterly Report on Form 10-Q. These discussions contain forward-looking statements reflecting our current expectations, which involve risks and uncertainties. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue,” or the negative of these terms or other comparable terminology. Forward-looking statements include, but are not limited to: statements regarding the extent and timing of future licensing, products, and services revenue levels and mix, expenses, margins, net income per diluted share, income taxes, tax benefits, acquisition costs and related amortization, and other elements of results of operations; our expectations regarding demand and acceptance for our technologies; growth opportunities and trends in the markets in which we operate; our plans, strategies, and expected opportunities; the deployment of and demand for our products and for products incorporating our technologies; and future competition. Actual results may differ materially from those discussed in these forward-looking statements due to a number of factors, including the risks set forth in Part II, Item 1A, “Risk Factors,” of this Quarterly Report on Form 10-Q and elsewhere in this filing. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of these forward-looking statements. We are under no duty to update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform our prior statements to new developments or actual results.

Overview
Dolby Laboratories has participated in the entertainment industry for more than 45 years. We provide products, services, and technologies to capture, distribute, and play back entertainment content that gives consumers a premium entertainment experience, regardless of how or where they choose to enjoy it. Our core strengths range from our expertise in digital signal processing and compression technology to our long history of providing products, tools, and technologies to participants in the entertainment industry at each stage in the content creation, distribution, and playback process. We provide products and services that enable content creators and distributors to produce, encode, and transmit content with our premium audio technologies, and we license decoding technologies to the manufacturers of entertainment devices to ensure that content is ultimately experienced as the creator and distributor intended.
Throughout our history, we have introduced numerous innovations that have significantly improved the quality of audio entertainment, such as noise reduction for the recording and cinema industries and surround sound for cinema and home entertainment. Today, we continue to derive the vast majority of our revenue from our audio technologies.
Looking forward, we see a number of industry trends that create opportunities for the continued growth of our audio business, including the ongoing global transition from analog to digital television and consumers’ increasing use of portable electronic devices, such as tablets and smartphones, to play back digital content. Our portfolio of technologies and solutions optimize the audio experience for portable devices to provide consumers with a rich, clear, and immersive sound, despite the bandwidth limitations of online and cellular networks.
We also see opportunities to apply our core strengths in areas beyond audio. For example, we believe that significant improvements can be made in the technology currently used to deliver and play back premium video, and we have identified solutions that may substantially improve the video experience. Similarly, we believe we can apply our existing audio technologies to improve the clarity and quality of voice communications in areas such as multi-party teleconferencing.

Business Model
We generate the majority of our revenue by licensing technologies to original equipment manufacturers (“OEM”) of consumer entertainment (“CE”) products and to software vendors. We also generate revenue by selling products and related services to creators and distributors of entertainment content.
We participate in the global entertainment industry in three principal ways:

We offer products, services, and technologies to creators and distributors of entertainment content, such as motion picture, television, and music recording studios, television broadcasters, satellite and cable operators, and increasingly, Internet content streaming and download service providers. These content creators and distributors use our products,

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Table of Contents

services, and technologies to encode and transmit content, creating rich, clear, and immersive audio experiences for consumers upon playback.
We license technologies, such as Dolby Digital, Dolby Digital Plus, and Dolby Pulse, to OEMs and software vendors for incorporation into their CE and other products, so that consumers can play back audio content with our technologies in the rich, clear, and immersive manner the creators intended.
We work directly with standards-setting organizations in the entertainment and technology industries, as well as governments and other regulatory bodies, to promote adoption of our technologies in their standards. As a result our technologies are included in virtually all DVD players, Blu-ray Disc players, audio/video receivers, and personal computer (“PC”) DVD software players.
We license our technologies to OEMs and software vendors in 46 countries, and our licensees distribute products incorporating our technologies throughout the world. We sell our products and provide services in approximately 80 countries. In fiscal 2010, 2011, and the fiscal year-to-date period ended March 30, 2012, revenue from outside of the U.S. was 66%, 68%, and 68% of our total revenue, respectively. Geographic data for our licensing revenue is based on the location of our licensees’ headquarters. Products revenue is based on the destination to which we ship our products, while services revenue is based on the location where services are performed.
Opportunities, Challenges, and Risks
Our licensing and products markets are characterized by rapid technological changes, new and improved product introductions, changing customer demands, evolving industry standards, changing licensee needs, and product obsolescence. As described below, our licensing revenue is subject to uncertainties and trends relating to technology and market growth, as well as the mix of CE products sold that incorporate our technologies. Our licensing business also could be affected by adverse general economic conditions, because many of the products in which our technologies are incorporated are discretionary goods. Furthermore, our products business is subject to intense competition and uncertainties relating to the transition to 3D cinema and purchasing decisions by our cinema customers. Our product revenue is likely to continue to be materially affected if demand for our 3D products does not improve.
Licensing
Licensing revenue constitutes the majority of our total revenue, representing 77%, 83%, and 86% of total revenue in fiscal 2010, 2011, and the fiscal year-to-date period ended March 30, 2012, respectively.
As consumers are presented with more options for receiving content, competition across delivery channels has intensified. We see this reflected in the composition of our licensing revenue, as driven by a shift away from optical disc based products. Optical disc based revenue is generated from the sale of technology solutions that enable DVD or Blu-ray Disc playback functionality. Optical disc based revenue includes the Windows 7 operating system, independent PC DVD software players, DVD, and Blu-ray Disc technologies included in consumer products. However, most of these products can receive content over mobile or online networks, as well as from optical discs, and we have increased our technology penetration into these other distribution channels. Non-optical disc based revenue is generated from the sale of technology solutions other than those used to enable DVD or Blu-ray Disc playback functionality. Non-optical disc based revenue includes licensing revenue derived from products such as TVs, set-top boxes, and mobile phones, as well as our post processing technologies on a range of devices. We remain focused on delivering the products, tools, and technologies needed to ensure a high quality audio experience from any device.
Looking forward, we expect continued growth in the proportion of our licensing revenue we derive from non-optical disc sources. This will be driven partly by the maturity of optical disc as a method for delivering content, but also by the significant opportunities presented by digital broadcast and online distribution, as well as the inclusion of our technologies in the Windows 8 operating system to enable the playback of online content. We also see significant opportunities to offer encode/decode solutions in video and voice that leverage our expertise in signal processing, compression, and the capture and playback of content.
Our licensing revenue comes from the following markets and primarily from the inclusion of our technologies in the products indicated for each market:

Broadcast market: primarily televisions and set-top boxes
PC market: primarily DVD software players and Microsoft Windows operating systems
CE market: primarily DVD and Blu-ray Disc players and recorders, audio/video receivers, and home-theater-in-a-box systems
Other markets:
Mobile – primarily cell phones and other mobile devices

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Gaming – primarily video game consoles
Licensing services – primarily administration of joint licensing programs
Automotive – primarily in-car DVD players
The entertainment industry is in transition. The growth of the Internet, and the related shift by consumers toward online entertainment content, has resulted in a global trend toward an array of online content streaming and download services. Today content is captured, delivered, and played back in more ways than ever before. Content creators and distributors are increasingly focused on delivering content across a multitude of media and devices with varying bandwidth and performance requirements, including PCs, connected TVs, set-top boxes, gaming consoles, connected Blu-ray Disc players, and a variety of mobile devices. Many of these mobile devices are increasingly designed to capture and distribute content through improved camera and WiFi technologies, as well as to play back rich entertainment experiences. This increasingly complex array of devices, with capability for both creating and playing back content, presents a challenge for content creators and device manufacturers seeking consistent audio quality. We believe this challenge provides an opportunity similar to that of digital broadcast, whereby we can provide solutions to optimize the audio experience across the online and portable device ecosystem.
In the area of content creation and delivery, our technologies are included in DVD, Blu-ray Disc, and certain broadcast standards, and we are working to extend our technologies to online delivery services. Online content aggregators, including Netflix, Amazon, VUDU, Apple, HBO GO, Samsung’s Acetrax, and the Roxio Now platform, use our technologies to encode video and audio content. Leading music services such as Rhapsody and Omnifone use our audio encoding tools to deliver a rich music experience to their subscribers. In the second quarter of fiscal 2012, HBO adopted Dolby Digital Plus in its HBO GO service, for content delivered to select connected TVs. HBO will also offer Dolby Digital Plus in its HBO GO service, for content delivered to Blu-ray Disc players. In addition, Samsung is expected to offer Dolby Digital Plus surround sound audio through their Acetrax Video on Demand application during fiscal 2012.
Our broadcast market is driven by demand for our technologies in televisions and set-top boxes and represented approximately 27%, 31%, and 33% of our licensing revenue in fiscal 2010, 2011, and the fiscal year-to-date period ended March 30, 2012, respectively. Higher attach rates in the first half of fiscal 2012 drove increased revenue from both televisions and set-top boxes, relative to the same period in the prior year. We view the broadcast market as an area for potential continued growth, primarily in geographic markets outside of the U.S. We also view broadcast services, such as terrestrial broadcast or IPTV services, which operate under bandwidth constraints, as another area of opportunity for Dolby Digital Plus, HE AAC, and Dolby Pulse. These technologies enable the delivery of high quality audio content at reduced bit rates, thereby conserving bandwidth. We may not, however, be able to extend our current success in the broadcast market to these new opportunities.
Our PC market represented approximately 36%, 30%, and 28% of our licensing revenue in fiscal 2010, 2011, and the fiscal year-to-date period ended March 30, 2012, respectively. Our technologies are incorporated in the majority of PCs sold today, primarily because of the inclusion of DVD and Blu-ray Disc playback in the majority of PCs and the inclusion of Dolby technologies in the DVD and Blu-ray Disc standards.
Historically, we have licensed our technologies to a range of PC licensees, including independent software vendors (“ISV”), PC OEMs, and operating system providers, and the release of new versions of major PC operating systems has often resulted in changes in the mix of our PC licensees. In 2007, Microsoft introduced its Windows Vista operating system, which included our technologies to enable DVD audio playback in two of its editions. In fiscal 2009, Microsoft released its current operating system, Windows 7, which includes our technologies within four editions. As a result, since 2007 the mix of our PC licensing revenue from operating systems has increased relative to that from OEMs and ISVs. We currently license our audio codec technologies directly to OEMs such as Apple, Toshiba, and Sony to support optical disc playback on PCs, and we license our PC Entertainment Experience (“PCEE”) technologies to multiple PC OEMs through our PCEE licensing program.

In May 2012, we entered into an agreement with Microsoft under which Dolby Digital Plus 5.1 channel decoding and Dolby Digital two-channel encoding will be included in all PCs and tablets licensed to run the Windows 8 operating system. Under the arrangement, OEMs generally will be required to directly license and pay us a base royalty rate for the right to use the Dolby technologies included in Windows 8 installed on PCs and tablets for online and file-based content. OEMs will pay a higher per-unit royalty for Windows 8 PCs that also include optical disc playback functionality, which will be implemented by ISV applications. This higher rate is consistent with historical rates paid for the inclusion of Dolby disc playback software. We expect the majority of PCs to continue to ship with optical disc drives when Windows 8 is released and to include optical disc playback functionality.

We believe the Microsoft Windows 8 arrangement provides an easier way for OEMs to enable playback with our technologies of content delivered by online services and video in local files on the device. Given the anticipated release date of Windows 8, we do not expect any such change to have a material financial impact in fiscal 2012, as we expect that Microsoft will continue to license its Windows 7 operating systems with our technologies at least until the release of Windows 8. The

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ultimate financial impact of these licensing arrangements for Windows 8 on our licensing revenue is uncertain and will depend on several factors, including:
The extent and rate at which Windows 8 is adopted in the marketplace;
The extent to which OEMs include optical disc playback in Windows 8 devices;
The extent to which earlier versions of Microsoft operating systems, including Windows 7, continue to be licensed after the release of Windows 8;
Our ability to establish and extend licensing relationships directly with PC OEMs and ISVs;
The rate at which entertainment content shifts from optical disc media to online media, thus reducing the need for PCs to have optical disc drives and DVD and Blu-ray Disc software players; and
Our ability to extend the adoption of our technologies to online and mobile platforms.
In the short term, revenue from our PC market remains dependent on several factors, including underlying PC unit shipment growth and the extent to which our technologies are included in operating systems and ISV media applications. We continue to face risks relating to:
Purchasing trends away from traditional PCs and toward computing devices without optical disc, such as subnotebooks and tablets, which may not include our technologies;
The availability and market attractiveness of PC software that includes our technologies on an unauthorized and infringing basis, for which we receive no royalty payments; and
Continued decreasing inclusion of ISV media applications by PC OEMs in their Windows 7-based PCs, as Windows 7 already incorporates DVD playback software.
Our CE market is driven primarily by revenue attributable to sales of DVD and Blu-ray Disc players and recorders and represented approximately 22%, 21%, and 20% of licensing revenue in fiscal 2010, 2011, and the fiscal year-to-date period ended March 30, 2012, respectively. Blu-ray Disc players continue to represent an important source of revenue within our CE market, as these players are required to include Dolby Digital technology for primary audio content and our Dolby Digital Plus technology for secondary audio content. In addition, our Dolby TrueHD technology is an optional audio standard for Blu-ray Disc. Sales of DVD players are declining, as a result of the maturity of the DVD platform and a shift to Blu-ray Disc players; however, our revenue from sales of Blu-ray Disc players in recent quarters has not offset this decline. In the first half of fiscal 2012, we continued to see reductions in reported units of DVD players incorporating our technologies, as well as a slowing growth rate in the market for Blu-ray Disc players.
Revenue generated from our other markets includes revenue attributable to mobile, gaming, licensing services, and automotive, and represented approximately 15%, 18%, and 19% of licensing revenue in fiscal 2010, 2011, and the fiscal year-to-date period ended March 30, 2012, respectively. Mobile revenue is primarily driven by demand for the Dolby Digital Plus, AAC, Dolby Mobile, and Dolby Digital. We view the mobile device market as an area of opportunity for us to increase revenue; however, actual results may differ from our expectations. Revenue attributable to gaming and automotive is primarily driven by sales of video game consoles and in-car entertainment systems, respectively, that incorporate our Dolby Digital, Dolby Digital Plus, AAC, Dolby TrueHD, and ATRAC technologies. Licensing services revenue, from administration of joint licensing programs, is primarily driven by demand for standards-based audio compression technologies for broadcast, PC, CE, and mobile products.
Consumer entertainment products throughout the world incorporate our technologies. We expect that sales of such products incorporating our technologies in emerging economies such as Brazil, China, India, and Russia, will increase in the future as consumers in these markets acquire more disposable income with which to purchase entertainment products. However, events in these economies or in the world economy in general may contradict these expectations. Moreover, we expect that OEMs in lower-cost manufacturing countries, including China, will increase production in response to this demand and that traditional OEMs will continue to shift their manufacturing operations to these lower-cost manufacturing countries. There are substantial risks associated with doing business in such countries, including OEMs failing to report or underreporting shipments of products incorporating our technologies, that have affected and will continue to affect our operating results.
Revenue from Microsoft represented approximately 14% of our total revenue in the second quarter of fiscal 2012 and the fiscal year-to-date period ended March 30, 2012, and included licensing revenue from our PC, CE, and other markets.
We continue to monitor the effects of the 2011 flooding and recent earthquake in Thailand to determine any potential risks of disruption that would adversely affect our operating results. While we do not expect the catastrophe to have a material adverse effect on our financial position or results of operations, the impact on our licensees’ global supply chains remains uncertain.

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Products
Products revenue is driven primarily by sales of equipment to cinema operators and broadcasters and represented 20%, 14%, and 11% of our total revenue in fiscal 2010, 2011, and the fiscal year-to-date period ended March 30, 2012, respectively.
Our cinema products represented approximately 90%, 87%, and 86% of total products revenue in fiscal 2010, 2011, and the fiscal year-to-date period ended March 30, 2012, respectively. Sales of our cinema products tend to fluctuate based on underlying trends in the cinema industry, including the popularity of individual movies, as cinema owners often purchase equipment to meet expected box office demand.
The cinema industry is in the midst of a transition from traditional film to digital cinema, and we estimate that the industry is more than halfway through this transition. Digital cinema offers motion picture studios a means to save costs in printing and distributing movies, combat piracy, and enable repeated movie playback without degradation in image and audio quality. Our cinema products include our Dolby Digital Cinema screen server and central library server, for the storage and playback of digital content, and our digital audio processor, which provides audio control for our digital cinema servers. We expect that most cinema owners who are either constructing new theaters or upgrading existing theaters will choose digital cinema products over traditional film cinema products. However, our competitive position in the digital cinema market is not as strong as our position in the traditional film cinema market. For example, digital cinema specifications are based on open standards which, unlike traditional cinema standards, do not include our proprietary audio technologies. Furthermore, we are facing more pricing and other competitive pressures for our digital cinema products than we experience for our traditional film cinema products.
Digital cinema standards are defined by the Digital Cinema Initiative (“DCI”) specifications, and we have developed software for our currently available digital cinema server that is DCI compliant. This software was made commercially available during fiscal 2012. We do not have significant contractual provisions arising from the sale of products relating to DCI compliance that would require additional performance from us other than making the software update available to our customers.
Several of our competitors have introduced digital cinema products that support the playback of high frame rate content and also support presentation of movies with higher resolution “4K” digital cinema projectors. We are developing a 4K and high frame rate solution and expect to make it available in fiscal 2012. If we are unable to provide such a solution with a market competitive feature set and price, our results of operations could be adversely affected.
Our digital 3D products provide 3D image capabilities when combined with a digital cinema projector and server. Our cinema products revenue has been negatively impacted by declines in unit shipments for 3D products, as the market for 3D cinema equipment has become increasingly competitive. We also believe the decrease in revenue from our 3D products reflects the increasing saturation of 3D enabled screens within the cinema industry.
Our traditional film cinema products are used primarily to read, decode, and play back film soundtracks, to calibrate cinema sound systems, and to enable soundtracks encoded in digital audio formats to be played back on analog cinema audio systems. As investment by the cinema industry in digital cinema has increased, revenue from our traditional film cinema products has declined, and we expect this decline to continue.
Our broadcast products represented approximately 9%, 10%, and 11% of products revenue in fiscal 2010, 2011, and the fiscal year-to-date period ended March 30, 2012, respectively. Our broadcast products are used to encode, transmit, and decode multiple channels of high quality audio content for DTV and HDTV program production and broadcast distribution and to measure the subjective loudness of audio content within broadcast programming.
In fiscal 2011, we began selling our Professional Reference Monitor product, a flat-panel video reference display for video professionals. These video professionals use the monitor for color critical tasks, such as calibrating color accuracy to professional reference standards. Our Professional Reference Monitor uses our dynamic range imaging technologies, which enhance contrast and extend brightness and dynamic range, while reducing power consumption in LED backlit LCD televisions. We do not anticipate generating significant revenue from this product in fiscal 2012.
Services
Services revenue represented approximately 3% of total revenue in each of fiscal 2010, 2011, and the fiscal year-to-date period ended March 30, 2012. The level of our services revenue is primarily tied to activity in the cinema industry, and in particular, to the number of movies being produced and distributed by studios and independent filmmakers. Several factors influence the number of movies produced in a given fiscal period, including strikes and work stoppages within the cinema industry, as well as tax incentive arrangements provided by many governments to promote local filmmaking.

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Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. (“GAAP”), and pursuant to Securities and Exchange Commission (“SEC”) rules and regulations. GAAP and SEC rules and regulations require us to use 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 or estimate to be critical if it is both important to a company’s financial condition and/or results of operations and requires significant judgment on the part of management in its application. On a regular basis, we evaluate our assumptions, judgment, and estimates. We have discussed the selection and development of the critical accounting policies and estimates with the audit committee of our board of directors. There have been no material changes to our critical accounting policies and estimates from those described in our Annual Report on Form 10-K, as amended, for the fiscal year ended September 30, 2011. Although we believe that our judgments and estimates are appropriate and correct, actual results may differ from these estimates.
We consider the following to be critical accounting policies and estimates because we believe they are both important to the portrayal of our financial condition and results of operations and require management judgments about matters that are uncertain. If actual results or events differ materially, our reported financial condition and results of operation for future periods could be materially affected. See Part II, Item 1A “Risk Factors” for further information on the potential risks to our future results of operations.
Revenue Recognition
We enter into revenue arrangements with our customers to license technologies, trademarks, and know-how and to sell products and services. We recognize revenue when all 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 or determinable, and collectibility is probable. Judgment is required to assess whether collectibility is probable. We determine collectibility based on an evaluation of our customer’s recent payment history, the existence of a standby letter of credit between the customer’s financial institution and our financial institution, and other factors. Some of our revenue arrangements include multiple elements, such as hardware, software, maintenance, and other services.
We evaluate each element in a multiple element (“ME”) arrangement to determine whether it represents a separate unit of accounting. An element constitutes a separate unit of accounting when it has standalone value and delivery of an undelivered element is both probable and within our control. When these criteria are not met, the delivered and undelivered elements are combined and the arrangement fees are allocated to this combined single unit.
If the unit separation criteria are met, we account for each element within a ME arrangement (such as hardware, software, maintenance, and other services) separately, and we allocate fees from the arrangement based on the relative selling price of each element. For some arrangements, customers receive certain elements over a period of time, after delivery of the initial product. These elements may include support and maintenance and/or the right to receive upgrades. Revenue allocated to the undelivered element is recognized either over its estimated service period or when the upgrade is delivered. We do not recognize revenue that is contingent upon the future delivery of products or services or upon future performance obligations. We recognize revenue for delivered elements only when we have completed all contractual obligations.
We determine our best estimate of the selling price for an individual element within a ME revenue arrangement using the same methods used to determine the selling price of an element sold on a standalone basis. If we sell the element on a standalone basis, we estimate the selling price by considering actual sales prices. Otherwise, we estimate the selling price by considering internal factors such as pricing practices and margin objectives. Consideration is also given to market conditions such as competitor pricing strategies, customer demands, and industry technology lifecycles. Management applies judgment to establish margin objectives, pricing strategies, and technology lifecycles.
Revenue recognition for transactions which involve software, such as fees we earn from integrated software vendors, requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor specific objective evidence (“VSOE”) of fair value exists for those elements. For some of our ME arrangements, customers receive certain elements of the arrangement over a period of time or after delivery of the initial software. These elements may include support and maintenance. The fair values of these elements are recognized over the estimated period for which these elements will be delivered, which is sometimes the estimated life of the software. If we do not have VSOE of fair value for any undelivered element included in these ME arrangements for software, we defer revenue until all elements are delivered and/or services have been performed, or until we have VSOE of fair value for all remaining undelivered elements. If the undelivered

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element is support and we do not have fair value for the support element, revenue for the entire arrangement is bundled and recognized ratably over the support period.
For ME arrangements containing both software and hardware, we allocate the arrangement fees to each element based on its relative selling price, which we establish using a selling price hierarchy. We determine the selling price of each element based on its VSOE, if available, third-party evidence (“TPE”), if VSOE is not available, or estimated selling price (“ESP”), if neither VSOE nor TPE is available.
We account for the majority of our digital cinema server sales as ME arrangements that may include up to three separate units, or elements, of accounting. The first element consists of our digital cinema server hardware and the accompanying software, which is essential to the functionality of the hardware. This element is typically delivered at the time of sale. The second element is the right to receive support and maintenance, which is included with the purchase of the hardware element and is typically delivered over a service period subsequent to the initial sale. The third element is the right to receive specified upgrades, which is included with the purchase of the hardware element and is typically delivered when a specified upgrade is available, subsequent to the initial sale. The application of the revenue accounting standards to our digital cinema server sales typically results in the allocation of a substantial majority of the arrangement fees to the delivered hardware element based on its ESP, relative to the VSOE or ESP of the other elements, which we recognize as revenue at the time of sale. A small portion of the arrangement fees is allocated to the undelivered support and maintenance element, and in some cases to the undelivered specified upgrade element, based on the VSOE or ESP of each element. The portion of the arrangement fees allocated to the support and maintenance element is recognized as revenue ratably over the estimated service period and the portion of the arrangement fees allocated to specified upgrades is recognized as revenue upon delivery of the upgrade.
Goodwill, Intangible Assets, and Long-Lived Assets
We evaluate and test our goodwill for impairment at a reporting-unit level. A reporting unit is an operating segment or one level below. Our operating segments are aligned with the management principles of our business. The goodwill impairment test is a two-step process. In the first step, we compare the carrying value of the net assets of a reporting unit, including goodwill, to the fair value. If we determine that the fair value of the reporting unit is less than its carrying value, we move to the second step to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, we would record an impairment loss equal to the difference. We test goodwill for impairment annually during our third fiscal quarter and if an event occurs or circumstances change such that there is an indication of a reduction in the fair value of a reporting unit below its carrying value.
We use the income approach to determine the fair value of our reporting units, which is based on the present value of estimated future cash flows for each reporting unit. Fair value reflects the price a market participant would be willing to pay in a potential sale of the reporting unit. At the time of our annual goodwill impairment test for fiscal 2011, we had two reporting units: Via, which corresponds to our wholly owned subsidiary and has no assigned goodwill, and Dolby Entertainment Technology (“DET”), with goodwill of $268.0 million. The cash flow model was based on our best estimate of future revenue and operating costs. We estimated our future revenue by applying growth rates, consistent with those used in our internal forecasts, to our current revenue forecasts. The revenue and cost estimates were based on several sources, including our historical information, third-party industry data, and review of our internal operations. The cash flow forecasts were adjusted by a discount rate of approximately 13.5%, based on our weighted-average cost of capital derived by using the capital asset pricing model. The primary components of this model include weighting our total asset structure between our equity and debt, the risk-free rate of return on U.S. Treasury bonds, market risk premium based on a range of historical returns and forward-looking estimates, and the beta of our common stock. Our model used an effective tax rate of approximately 30%.
Based on the methodology described above, the fair value of our DET reporting unit exceeds its carrying value. Our market capitalization at the time of our fiscal 2011 goodwill impairment test was approximately $4.8 billion, which exceeded the aggregate carrying value of our reporting units by approximately 190%. There have been no events or changes in circumstances to indicate a reduction in the fair value of a reporting unit below its carrying value since our last annual goodwill impairment test.
Prior to our annual goodwill impairment test in the third quarter of fiscal 2012, we will early adopt the provisions of ASU 2011-08, as described in Note 2 “Summary of Significant Accounting Policies” to our condensed consolidated financial statements. We do not expect the adoption of ASU 2011-08 to have a material impact on our consolidated financial statements.
Intangible assets with definite lives are amortized over their estimated useful lives. Our intangible assets principally consist of acquired technology, patents, trademarks, customer relationships, and contracts, which are amortized on a straight-line basis over their useful lives ranging from two to fifteen years.
We review long-lived assets, including intangible assets, for impairment whenever events or a change in circumstances

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indicate an asset’s carrying value may not be recoverable. Recoverability of an asset is measured by comparing its carrying value to the total future undiscounted cash flows that the asset is expected to generate. If we determine that the carrying value of an asset is not recoverable, an impairment loss is recorded in the amount by which the carrying value of the asset exceeds its estimated fair value.
Accounting for Income Taxes
We make estimates and judgments that affect our accounting for income taxes, including estimates of actual tax exposure and assessment of temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences, including the timing of the recognition of stock-based compensation expense, result in deferred tax assets and liabilities, which are included in our condensed consolidated balance sheets. We assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent that we believe recovery is not likely, we establish a valuation allowance.
Our policy is to recognize a tax benefit from an uncertain tax position only if it is more likely than not that the tax position is sustainable upon examination by tax authorities. We include interest and penalties related to gross unrecognized tax benefits within our provision for income taxes. When accrued interest and penalties do not ultimately become payable, amounts accrued are reduced in the period that such determination is made and are reflected as a reduction of the overall income tax provision.
Significant judgment is required in determining the provision for income taxes, the deferred tax asset and liability balances, the valuation allowance against our deferred tax assets, and the reserve resulting from uncertain tax positions. Our financial position and results of operations may be materially affected if actual results differ significantly from these estimates or if the estimates are adjusted in future periods.
Valuation and Classification of Investments
Fair value is the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants at the measurement date.
We classify our financial assets and liabilities measured at fair value using a three-level hierarchy that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are those that reflect the assumptions market participants would use in pricing the investment that are based on market data obtained from sources independent of the reporting entity, such as market quoted prices. GAAP establishes a three-level hierarchy prioritizing the inputs used in measuring fair value as follows: the fair value hierarchy gives the highest priority to quoted prices in active markets that are accessible by us at the measurement date for identical investments, described as Level 1, and the lowest priority to valuation techniques using unobservable inputs, described as Level 3. We obtain the fair value of our Level 2 financial instruments from a professional pricing service, which may use quoted market prices for identical or comparable instruments. Fair value from this professional pricing source can also be based on pricing models whereby all significant inputs, including maturity dates, issue dates, settlement dates, benchmark yields, reported trades, broker-dealer quotes, issuer spreads, benchmark securities, bids, offers, and other market related data, are observable or can be derived from or corroborated by observable market data for substantially the full term of the asset.
The degree to which estimates and judgment are used in determining fair value, is generally dependent upon the market pricing information available for the investments, the availability of observable inputs, the frequency of trading in the investments and the investment’s complexity. If different judgments regarding inputs were made, we could potentially reach different conclusions regarding the fair value of our investments.
Stock-Based Compensation
We determine the expense for all stock-based compensation awards by estimating their fair value and recognizing that value as an expense, on a ratable basis, in our consolidated financial statements over the requisite service period in which the awards are earned. We use the Black-Scholes option pricing model to determine the fair value of employee stock options at the date of the grant. To determine the fair value of a stock-based award using the Black-Scholes option pricing model, we make assumptions regarding the expected term of the award, the expected future volatility of our stock price over the expected term of the award, and the risk-free interest rate over the expected term of the award. We estimate the expected term of our stock-based awards by evaluating historical exercise patterns of our employees. We use a blend of the historical volatility of our common stock and the implied volatility of our traded options as an estimate of the expected volatility of our stock price over the expected term of the awards. We use an average interest rate based on U.S. Treasury instruments with terms consistent with the expected term of our awards to estimate the risk-free interest rate. We reduce the stock-based compensation expense for estimated forfeitures based on our historical experience. We are required to estimate forfeitures at the time of the grant and

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revise our estimate, if necessary, in subsequent periods if actual forfeitures differ from our estimate.
Recently Issued Accounting Standards
There have been no new accounting pronouncements not yet effective that have significance, or potential significance, to our consolidated financial statements.
Results of Operations
Revenue
 
 
Fiscal Quarter Ended
Change
 
Fiscal Year-to-Date Ended
Change
 
 
April 1,
2011
March 30,
2012
$
%
April 1,
2011
March 30,
2012
$
%
 
($ in thousands)
Licensing
$
214,627

$
225,349

$
10,722

5
 %
$
402,803

$
424,973

$
22,170

6
 %
Percentage of total revenue
86
%
87
%
 
 
82
%
86
%
 
 
Products
26,347

27,228

881

3
 %
72,374

53,628

(18,746
)
(26
)%
Percentage of total revenue
11
%
10
%
 
 
15
%
11
%
 
 
Services
9,052

7,682

(1,370
)
(15
)%
17,561

15,036

(2,525
)
(14
)%
Percentage of total revenue
3
%
3
%
 
 
3
%
3
%
 
 
Total revenue
$
250,026

$
260,259

$
10,233

4
 %
$
492,738

$
493,637

$
899

0
 %
Licensing. The 5% increase in licensing revenue from the second quarter of fiscal 2011 to the second quarter of fiscal 2012 was primarily driven by increases in revenue from our broadcast and other markets, partially offset by a decrease in our PC market. The increase in revenue from our broadcast market was primarily driven by higher shipments in the second quarter of fiscal 2012 of televisions and digital set-top boxes that incorporate our technologies. The increase in revenue from our other markets was primarily driven by increased sales of mobile devices incorporating our Dolby Digital Plus and Dolby Digital technologies. The decrease in revenue from our PC market was primarily driven by lower reported units of Windows 7-based PCs and ISV decoders.
The 6% increase in licensing revenue from the fiscal year-to-date period ended April 1, 2011 to the fiscal year-to-date period ended March 30, 2012 was primarily driven by increases in revenue from our broadcast and other markets, partially offset by decreases in our CE and PC markets. The increases in revenue from broadcast and other markets are due to the same reasons described above. The decrease in our CE market was primarily driven by lower reported units of standard DVD players, while the decrease in revenue from our PC market was due to the same reasons described above.
Products. The 3% increase in products revenue from the second quarter of fiscal 2011 to the second quarter of fiscal 2012 was primarily driven by an increase in revenue from our digital cinema video and audio products, partially offset by decreases in revenue from our traditional cinema products and 3D products. Increases in our digital cinema products revenue in the second quarter of fiscal 2012 resulted primarily from a release of deferred revenue related to DCI compliance for digital cinema video products, as well as increased unit shipments of our digital cinema audio and video products. Decreases in our 3D products and traditional cinema are primarily due to lower unit shipments and reduced pricing.
The 26% decrease in products revenue from the fiscal year-to-date period ended April 1, 2011 to the fiscal year-to-date period ended March 30, 2012 was primarily driven by a decrease in revenue from our 3D products, and to a lesser extent, by a decrease in revenue from our traditional cinema products, as described above.
Services. The 15% decrease in services revenue from the second quarter of fiscal 2011 to the second quarter of fiscal 2012 was primarily attributable to decreases in production services revenue and virtual print fees, which were generated from certain leased digital cinema assets, as we discontinued this program in fiscal 2011. These decreases were partially offset by an increase in maintenance and support services.
The 14% decrease in services revenue from the fiscal year-to-date period ended April 1, 2011 to the fiscal year-to-date period ended March 30, 2012 was due to the same reasons discussed above.
Gross Margin
 

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Fiscal Quarter Ended
Fiscal Year-to-Date Ended
 
April 1,
2011
March 30,
2012
April 1,
2011
March 30,
2012
 
($ in thousands)
Cost of licensing
$
5,771

$
3,303

$
9,732

$
6,631

Licensing gross margin percentage
97
%
99
%
98
%
98
%
Cost of products
20,031

17,635

42,229

31,523

Products gross margin percentage
24
%
35
%
42
%
41
%
Cost of services
2,655

2,654

5,635

5,848

Services gross margin percentage
71
%
65
%
68
%
61
%
Total gross margin percentage
89
%
91
%
88
%
91
%
Licensing Gross Margin. We license intellectual property to our customers that may be internally developed, acquired by us, or licensed from third parties. Our cost of licensing consists principally of amortization expenses associated with purchased intangible assets and intangible assets acquired in business combinations. Our cost of licensing also includes third-party royalty obligations paid to license intellectual property that we then sublicense to our customers. Licensing gross margin increased two points from the second quarter of fiscal 2011 to the second quarter of fiscal 2012, as a previously acquired intangible asset was fully amortized in fiscal 2011. Licensing gross margin remained flat from the fiscal year-to-date period ended April 1, 2011 to the fiscal year-to-date period ended March 30, 2012.
Products Gross Margin. Cost of products primarily consists of the cost of materials related to the products sold, applied labor, manufacturing overhead and, to a lesser extent, amortization of certain intangible assets. Our cost of products also includes third-party royalty obligations paid to license intellectual property that we then include in our products. Products gross margin increased 11 points from the second quarter of fiscal 2011 to the second quarter of fiscal 2012. This increase is primarily due to the recognition of previously deferred product sales related to DCI compliance and 3D kit sales, as well as lower discrete charges recorded in the second quarter of fiscal 2012 compared to the same quarter of fiscal 2011. These increases were partially offset by price reductions on our 3D and digital cinema audio products.

Products gross margin decreased one point from the fiscal year-to-date period ended April 1, 2011 to the fiscal year-to-date period ended March 30, 2012. This decrease was primarily due to decreased unit sales of 3D products and price reductions in digital cinema audio and video products. This decrease was partially offset by the recognition of previously deferred product sales related to DCI compliance and 3D kit sales and lower discrete charges in the fiscal year-to-date period ended March 30, 2012, as discussed above.
Services Gross Margin. Cost of services primarily consists of compensation and benefits expenses for employees performing our professional services and the cost of outside consultants. Services gross margin decreased six points from the second quarter of fiscal 2011 to the second quarter of fiscal 2012 due to decreased revenues which were not fully offset by decreased costs, as well as a decrease in virtual print fees, which had relatively higher gross margins.
Services gross margin decreased seven points from the fiscal year-to-date period ended April 1, 2011 to the fiscal year-to-date period ended March 30, 2012 due to the same reasons discussed above.

Operating Expenses
 
 
Fiscal Quarter Ended
Change
Fiscal Year-to-Date ended
Change
 
April 1,
2011
March 30,
2012
$
%
April 1,
2011
March 30,
2012
$
%
 
($ in thousands)
Research and development
$
28,399

$
34,236

$
5,837

21
%
$
56,726

$
67,062

$
10,336

18
%
Percentage of total revenue
11
%
13
%
 
 
12
%
13
%
 
 
Sales and marketing
37,545

43,194

5,649

15
%
75,762

86,210

10,448

14
%
Percentage of total revenue
15
%
17
%
 
 
15
%
17
%
 
 
General and administrative
35,155

37,281

2,126

6
%
72,197

72,746

549

1
%
Percentage of total revenue
14
%
14
%
 
 
15
%
14
%
 
 
Restructuring charges, net

910

910

100
%
785

1,278

493

63
%
Percentage of total revenue
n/a

n/a

 
 
n/a

n/a

 
 
 
$
101,099

$
115,621

$
14,522

14
%
$
205,470

$
227,296

$
21,826

11
%

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The fiscal periods presented herein include the 13 week periods ended April 1, 2011 and March 30, 2012, and the 27 week period ended April 1, 2011 and the 26 week period ended March 30, 2012.
Research and Development. Research and development expenses consist primarily of employee compensation and benefits expenses, including stock-based compensation, consulting and contract labor costs, depreciation and amortization expenses, facilities costs, and information technology expenses. The 21% increase in research and development expenses from the second quarter of fiscal 2011 to the second quarter of fiscal 2012 was primarily driven by increases in compensation and benefits expenses related to increased headcount, as well as higher facilities and related costs resulting from worldwide expansion.

The 18% increase in research and development expenses from the fiscal year-to-date period ended April 1, 2011 to the fiscal year-to-date period ended March 30, 2012 was due to the same reasons discussed above.
Sales and Marketing. Sales and marketing expenses consist primarily of employee compensation and benefits expenses, including stock-based compensation, marketing and promotional expenses, travel-related expenses for our sales and marketing functions, facilities costs, depreciation and amortization expenses, and information technology expenses. Sales and marketing expenses increased 15% from the second quarter of fiscal 2011 to the second quarter of fiscal 2012, primarily driven by increases in compensation and benefits expenses related to increased headcount, as well as higher consulting costs, and facilities costs resulting from worldwide expansion. These increases were partially offset by increased settlements from implementation licensees in the second quarter of fiscal 2012, which are recorded as an offset to sales and marketing expenses.

The 14% increase in sales and marketing expenses from the fiscal year-to-date period ended April 1, 2011 to the fiscal year-to-date period ended March 30, 2012 was primarily driven by increases in compensation and benefits expenses related to increased headcount, stock-based compensation, and increased facilities costs resulting from worldwide expansion. Additionally, increased settlements from implementation licensees in fiscal 2012 partially offset the increases noted above, which are recorded as an offset to sales and marketing expenses.
General and Administrative. General and administrative expenses consist primarily of employee compensation and benefits expenses, including stock-based compensation, depreciation, information technology expenses, and facilities costs. The 6% increase in general and administrative expenses from the second quarter of fiscal 2011 to the second quarter of fiscal 2012 was primarily due to increases in compensation and benefits expenses related to increased headcount and increases in professional services, partially offset by decreases in consulting and contract labor costs.

The 1% increase in general and administrative expenses from the fiscal year-to-date period ended April 1, 2011 to the fiscal year-to-date period ended March 30, 2012 was due to the same reasons discussed above. In addition, stock-based compensation expenses decreased in the first quarter of fiscal 2012, due to recognition in the first quarter of fiscal 2011 of expense upon the accelerated vesting of equity awards granted to a former employee under a separation agreement.
Restructuring Charges, net. Restructuring charges for the second quarter of fiscal 2012 and the fiscal year-to-date period ended March 30, 2012 include severance and other associated costs attributable to the strategic restructuring program we initiated in the fourth quarter of fiscal 2011. For additional details, see Note 6 “Restructuring” to our condensed consolidated financial statements.
Other Income, Net
 
 
Fiscal Quarter Ended
Change
Fiscal Year-to-Date ended
Change
 
April 1,
2011
March 30,
2012
$
%
April 1,
2011
March 30,
2012
$
%
 
($ in thousands)
Interest income
$
1,953

$
1,414

$
(539
)
(28
)%
$
3,567

$
3,151

$
(416
)
(12
)%
Interest expense
(85
)
(5
)
80

94
 %
(368
)
(31
)
337

92
 %
Other income, net
156

60

(96
)
(62
)%
689

260

(429
)
(62
)%
Total other income, net
$
2,024

$
1,469

$
(555
)
(27
)%
$
3,888

$
3,380

$
(508
)
(13
)%
Other income, net, primarily consists of interest income earned on cash, cash equivalents, and investments, as well as net gains/losses from foreign currency transactions.
Income Taxes
 

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Fiscal Quarter Ended
Fiscal Year-to-Date ended
 
April 1,
2011
March 30,
2012
April 1,
2011
March 30,
2012
 
($ in thousands)
Provision for income taxes
$
40,012

$
34,198

$
64,313

$
64,036

Effective tax rate
33
%
28
%
28
%
28
%
Our effective tax rate is based on a projection of our annual fiscal year results. Our effective tax rate was 33% and 28% for the second quarters of fiscal 2011 and fiscal 2012, respectively, and 28% and 28% for the fiscal year-to-date periods ended April 1, 2011 and March 30, 2012, respectively.
Our estimated fiscal year 2012 tax provision reflects additional benefits from our election to indefinitely reinvest a portion of our undistributed earnings in a foreign subsidiary. We also benefited from a change in the State of California apportionment sourcing rules, which became effective in the first quarter of fiscal 2012. These benefits were partially offset by the expiration of the federal research and development tax credits, effective from the first quarter of fiscal 2012, which resulted in an increase to our effective tax rate.
In the fiscal year-to-date period ended April 1, 2011, we completed the restructuring of our international operations, which resulted in the release of a deferred tax liability of $11.0 million related to the amortization of an intangible asset from a prior year acquisition, thereby lowering our effective tax rate for that period. 

Liquidity, Capital Resources, and Financial Condition
 
 
September 30,
2011
March 30,
2012
 
(in thousands)
Cash and cash equivalents
$
551,512

$
747,988

Short-term investments
391,281

350,735

Long-term investments
272,797

209,804

Accounts receivable, net
61,815

57,762

Accounts payable and accrued liabilities
127,922

113,689

Working capital(a)
999,213

1,144,207

 
 
 
 
April 1,
2011
March 30,
2012
 
(in thousands)
Net cash provided by operating activities
$
171,591

$
214,669

Capital expenditures (b)
(19,551
)
(30,450
)
Repurchase of common stock
(75,124
)
(86,149
)
Net cash provided by/(used in) investing activities
(149,735
)
64,410

Net cash used in financing activities
(48,604
)
(82,200
)
(a) Working capital consists of total current assets less total current liabilities.
(b) Capital expenditures consist of purchases of office equipment, building fixtures, computer hardware and software, leasehold improvements, production and test equipment.
Our principal sources of liquidity are our cash, cash equivalents, and investments, as well as cash flows from operations. We believe that our cash, cash equivalents, and potential cash flows from operations will be sufficient to satisfy our currently anticipated cash requirements through at least the next 12 months.
We have historically generated significant cash from our operations; however, there can be no assurance that our operations will continue to generate significant cash flows in the future. We retain sufficient cash holdings to support our operations and we also purchase investment grade securities diversified among security types, industries, and issuers. We have used cash generated from our operations to fund a variety of activities related to our business in addition to our ongoing operations, including business expansion and growth, acquisitions, and repurchases of our common stock. Cash provided by operations and the value of our investment portfolio could also be affected by various risks and uncertainties, as described in Part II, Item 1A “Risk Factors.”
Net cash provided by operating activities increased $43.1 million from the fiscal year-to-date period ended April 1, 2011

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to the fiscal year-to-date period ended March 30, 2012, primarily due to the following:
An increase in the cash flows from collections of accounts receivable from the fiscal year-to-date period ended April 1, 2011 to the fiscal year-to-date period ended March 30, 2012; and
Increases in cash flows from other changes in operating assets and liabilities; partially offset by
A decrease in net income.
Net cash provided by investing activities increased $214.1 million from the fiscal year-to-date period ended April 1, 2011 to the fiscal year-to-date period ended March 30, 2012, primarily due to the following:
A decrease in purchases of available-for-sale securities; offset by
A decrease in proceeds from the sales and maturities of available-for-sale securities; and
A decrease in capital expenditures due to significant worldwide expansion in the first half of fiscal 2011.
Net cash used in financing activities increased $33.6 million from the fiscal year-to-date period ended April 1, 2011 to the fiscal year-to-date period ended March 30, 2012, primarily due to the following:
A decrease in net proceeds from the exercise of stock options and the related tax benefit; and
An increase in share repurchases of our Class A common stock.

Off-Balance-Sheet and Contractual Obligations
Our liquidity is not dependent on the use of off-balance sheet financing arrangements.
There has been no material change in our contractual obligations other than in the ordinary course of business since our fiscal year ended September 30, 2011. For additional details regarding our contractual obligations, see Note 9 “Commitments and Contingencies” to our condensed consolidated financial statements.


ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Sensitivity
We had cash, cash equivalents, and marketable securities totaling approximately $1.3 billion at March 30, 2012. This amount was invested primarily in money market funds, corporate notes and bonds, municipal debt securities, and U.S. agency securities. Our investment policy and strategy are focused on the preservation of capital and on supporting our liquidity requirements. We do not enter into investments for trading or speculative purposes, nor do we use leveraged financial instruments. Our holdings of cash and cash equivalents and marketable securities, the majority of which are managed by external managers, meet the guidelines of our investment policy. We invest in highly rated securities with a minimum credit rating of A- and our policy limits the amount of credit exposure to any one issuer other than the U.S. government. At March 30, 2012, our weighted-average portfolio credit quality was AA and the weighted-average duration of our investment portfolio was less than one year.
Our fixed-income portfolio is subject to fluctuations in interest rates, which could affect our financial position, and to a lesser extent, results of operations. Based on our investment portfolio balance as of March 30, 2012, a hypothetical change in interest rates of 1% would have approximately a $4.0 million impact, and a change of 0.5% would have approximately a $2.0 million impact on the carrying value of our portfolio.
Foreign Currency Exchange Risk
We maintain sales, marketing, and business operations in foreign countries, most significantly in the United Kingdom, Australia, China, the Netherlands, and Germany. We also conduct a growing portion of our business outside of the U.S. through subsidiaries with functional currencies other than the U.S. dollar (primarily British Pound, Australian Dollar, Chinese Yuan Renminbi, and Euro). As a result, we face exposure to adverse movements in currency exchange rates as the financial results of our international operations are translated from local currency into U.S. dollars upon consolidation. Most of our revenue from international markets is denominated in U.S. dollars, while the operating expenses of our international subsidiaries are predominantly denominated in local currency. Therefore, if the U.S. dollar weakens against the local currency, we will have increased operating expenses, which will only be partially offset by net revenue. Conversely, if the U.S. dollar strengthens against the local currency, operating expenses will decrease, which will only be partially offset by net revenue. Additionally, foreign exchange rate fluctuations on transactions denominated in currencies other than the functional currency result in gains or losses that are reflected in our condensed consolidated statements of operations. Our international operations are subject to risks typical of international business, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and foreign exchange rate volatility.

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We enter into foreign currency forward contracts to hedge against assets and liabilities for which we have foreign currency exchange rate exposure, in an effort to reduce the risk that our earnings will be adversely affected by foreign currency exchange rate fluctuations. These derivative instruments are carried at fair value with changes in the fair value recorded to other income, net, in our condensed consolidated statements of operations. Our foreign currency forward contracts which are not designated as hedging instruments are used to reduce the exchange rate risk associated primarily with intercompany receivables and payables. These contracts do not subject us to material balance sheet risk due to exchange rate movements because gains and losses on these derivatives are intended to offset gains and losses on the related receivables and payables for which we have foreign currency exchange rate exposure. As of September 30, 2011 and March 30, 2012, the outstanding derivative instruments had maturities of 30 days or less and the total notional amounts of outstanding contracts were $4.7 million and $10.1 million, respectively. The fair values of these contracts were nominal as of September 30, 2011 and March 30, 2012, and were included in prepaids and other current assets and other accrued liabilities on our consolidated balance sheets.
A sensitivity analysis was performed on all of our foreign currency forward contracts as of March 30, 2012. This sensitivity analysis was based on a modeling technique that measures the hypothetical market value resulting from a 10% shift in the value of exchange rates relative to the U.S. dollar. For these forward contracts, duration modeling was used where hypothetical changes are made to the spot rates of the currency. A 10% increase in the value of the U.S. dollar would lead to an increase in the fair value of our financial instruments by $1.0 million. Conversely, a 10% decrease in the value of the U.S. dollar would result in a decrease in the fair value of these financial instruments by $1.0 million.


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ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
We maintain “disclosure controls and procedures,” as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
Subject to the limitations noted above, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the fiscal period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective to meet the objective for which they were designed and operate at the reasonable assurance level.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting during the fiscal quarter ended March 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


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PART II – OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are involved in various legal proceedings from time to time arising from the normal course of business activities, including claims of alleged infringement of intellectual property rights, commercial, employment, and other matters. In our opinion, resolution of these proceedings is not expected to have a material adverse effect on our operating results or financial condition. However, it is possible that an unfavorable resolution of one or more such proceedings could materially affect our future operating results or financial condition in a particular period.

ITEM 1A. RISK FACTORS
The following risk factors and other information included in this Quarterly Report on Form 10-Q should be carefully considered. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we presently deem less significant may also impair our business operations. If any of the following risks actually occur, our business, operating results, and financial condition could be materially adversely affected.
We depend on the sale by our licensees of products that incorporate our technologies and any reduction in those sales would adversely affect our licensing revenue.
Licensing revenue constitutes the majority of our total revenue, representing 77%, 83%, and 86% in fiscal 2010, 2011, and the fiscal year-to-date period ended March 30, 2012, respectively. We do not manufacture consumer entertainment products ourselves and we depend on licensees and customers, including software vendors and original equipment manufacturers (“OEM”), to incorporate our technologies into their products.
Although we have license agreements with many of these companies, these agreements do not have minimum purchase commitments, are non-exclusive, and do not generally require incorporation or use of our technologies. Accordingly, our revenue will decline if our licensees choose not to incorporate our technologies in their products, or if they sell fewer products incorporating our technologies, or if they otherwise face significant economic difficulties. Changes in consumer tastes or trends, rapidly evolving technology, competing products, changes in industry standards or adverse changes in business and economic conditions, among other things, may result in lower sales of products incorporating our technologies which would adversely affect our licensing revenue.
We also face the risk that our licensees retain product channel inventory levels that exceed future anticipated sales. If such product sales do not occur in the time frame anticipated by our licensees for any reason, these licensees may substantially decrease the number of technologies they license from us in subsequent periods.
We continue to monitor the effects of the 2011 flooding and recent earthquake in Thailand to determine any potential risks of disruption that would adversely affect our operating results. While we do not expect the catastrophes to have a material adverse effect on our financial position or results of operations, the impact on our licensees’ global supply chains remains uncertain.
To the extent that sales of PCs with Dolby technologies decline, our licensing revenue will be adversely affected.
Revenue from our PC market depends on several factors, including underlying PC unit shipment growth, the extent to which our technologies are included on computers, through operating systems, independent software vendors (“ISV”) media applications, or otherwise, and the terms of any royalties or other payments we receive from licensors of such software. In the short term, we face many risks in the PC market that may affect our ability to successfully participate in that market, including, but not limited to the following:
 
Purchasing trends away from traditional PCs and toward computing devices without optical disc, such as subnotebooks and tablets, which may not include our technologies;
The availability and market attractiveness of PC software that includes our technologies on an unauthorized and infringing basis, for which we receive no royalty payments; and
Continued decreasing inclusion of ISV media applications by PC OEMs in their Windows 7- based PCs, as Windows 7 already incorporates DVD playback software.

In May 2012, we entered into an agreement with Microsoft relating to the inclusion of Dolby Digital Plus decoding and Dolby Digital Consumer Encoder in the Windows 8 operating system. There are no assurances that we will derive as much licensing revenue under this model as we did under our prior licensing arrangements with Microsoft. The ultimate financial impact of these licensing arrangements for Windows 8 on our licensing revenue is subject to various risks, including:

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The extent and rate at which Windows 8 is adopted in the marketplace;
The extent to which OEMs include optical disc playback in Windows 8 devices;
The extent to which earlier versions of Microsoft operating systems, including Windows 7, continue to be licensed after the release of Windows 8;
Our ability to establish and extend licensing relationships directly with PC OEMs and ISVs;
The rate at which entertainment content shifts from optical disc media to online media, thus reducing the need for PCs to have optical disc drives and DVD and Blu-ray Disc software players; and
Our ability to extend the adoption of our technologies to online and mobile platforms and devices.

Any of these risks could adversely affect our licensing revenue.
General economic conditions may reduce our revenue and harm our business.
We continue to be cautious regarding future general economic conditions and their potential for suppressed consumer demand in the markets in which we license our technologies and sell our products. Our business could be affected by adverse changes in general economic conditions, because many of the products in which our technologies are incorporated are discretionary goods, such as PCs, digital televisions, set-top boxes, DVD players and recorders, Blu-ray Disc players, video game consoles, audio/video receivers, mobile devices, in-car entertainment systems, home-theater-in-a-box systems, camcorders, and portable media devices. The global economic environment has adversely affected consumer confidence, disposable income, and spending. While we cannot predict future general economic conditions, these conditions may persist or worsen.
Furthermore, continued weakness in general economic conditions may result in a greater likelihood that more of our licensees and customers will become delinquent on their obligations to us or be unable to pay, which in turn could result in a higher level of write-offs. Additionally, such economic conditions may result in increased underreporting and non-reporting of royalty-bearing revenue by our licensees as well as increased unauthorized use of our technologies, all of which would adversely affect our revenues.
Our future success depends upon the growth of new and existing markets for our technologies and our ability to develop and adapt our technologies for those markets.
The future growth of our licensing revenue will depend, in part, upon the growth of, and our successful participation in, new and existing markets for our technologies, such as digital broadcast, online and mobile media distribution, consumer video and voice. For example, growth of our broadcast revenue is dependent upon continued global growth of digital television broadcasting and the adoption of our technologies into emerging digital broadcast standards. In addition, our revenue is dependent upon the growth of the PC market and the continued adoption of our technologies into PCs as well as the adoption of our technologies into connected portable devices such as tablets and smartphones. Furthermore, our ability to drive OEM demand for our technologies depends in part on whether or not we are able to successfully participate in the online and mobile content delivery markets.
Our ability to penetrate new and existing markets for our technologies depends on increased consumer demand for products that contain our technologies, which may not occur. Some of these markets are ones in which we have not previously participated or have limited experience, such as voice and consumer video, and we may not adequately adapt our business and our technologies to consumer demand.
If new and existing markets for our technologies do not develop or consumer demand for products that contain our technologies does not grow, our business and prospects would be materially adversely affected.
If we do not continue to develop and deliver innovative technologies in response to industry and technology changes, our business could decline.
The markets for our technologies and products are defined by:
 
Rapid technological change;
New and improved technology and product introductions;
Changing consumer and licensee demands;
Evolving industry standards; and
Technology and product obsolescence.
Our future success depends on our ability to enhance our existing technologies and products and to develop acceptable

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new technologies and products that address the needs of the market in a timely manner. The development of enhanced and new technologies and products is a complex and uncertain process requiring high levels of innovation, highly-skilled engineering and development personnel, and the accurate anticipation of technological and market trends. We may not be able to identify, develop, acquire, market, or support new or enhanced technologies or products on a timely basis, if at all. For example, while we view the continued advancements in online and mobile media content delivery as an area of opportunity, if we are not able to competitively address the needs of the changing online and mobile markets, our ability to generate revenue from those markets would be limited. 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.
We face many risks related to the emerging 3D cinema market.
We face many risks in the 3D cinema market which may affect our ability to successfully participate in that market, including, but not limited to the following:
 
We face risks that our customers maintain excess product inventory levels which could reduce future anticipated sales;
At least one of our competitors has exclusive licensing arrangements for 3D products with theater exhibitors, which has in the past and we expect will in the future restrict our ability to compete in the 3D market;
The 3D market has become increasingly competitive and we may lose further market share;
As the industry transition to 3D enabled screens becomes substantially complete, demand for new 3D enabled screens will drop significantly and the industry will enter into a replacement cycle;
Industry participants may perceive our up-front 3D equipment costs and reusable glasses business model or our 3D products as less attractive;
Our participation in the 3D cinema market will be limited to the extent theaters do not convert from analog to digital cinema;
Demand for our 3D cinema products is driven by the number of 3D cinema releases and the commercial success of those releases;
Our 3D glasses could become subject to regulation in the U.S. and other countries in the future, which could restrict how our 3D glasses are manufactured, used, or marketed; and
There has been increased public scrutiny of potential health risks relating to viewing 3D movies. If these potential health risks are substantiated, the popularity of 3D movies could decline. In addition, if health risks associated with our 3D products materialize, we may become subject to government regulation or product liability claims, including personal injury claims.
If we are unable to manage these risks effectively, our ability to compete profitably in the 3D cinema market may be adversely affected.
Events and conditions in the cinema and broadcast industries may affect sales of our cinema products and other services.
Sales of our cinema products and services tend to fluctuate based on the underlying trends in the cinema industry. For example, when box office receipts for the cinema industry increase, we have typically seen a corresponding increase in sales of our cinema products, as cinema owners will be more likely to build new theaters and upgrade existing theaters with our more advanced products. Conversely, when box office receipts are down, cinema owners tend to scale back on plans to expand or upgrade their systems.
Our cinema product sales are also subject to fluctuations based on events and conditions in the cinema industry generally that may or may not be tied to box office receipts in particular time periods. For example, the growth in piracy of motion pictures adversely affects the construction of new screens, the renovation of existing theaters, and the continued production of new motion pictures.
Our services revenue, both in the U.S. and internationally, is tied to the number of movies being produced and distributed by studios and independent filmmakers. A number of factors can affect the number of movies that are produced, including strikes and work stoppages within the cinema industry, as well as tax incentive arrangements provided by many governments to promote local filmmaking.
The demand for our cinema products and services could decline as the cinema industry adopts digital cinema.
As cinema exhibitors have constructed new theaters or upgraded existing theaters, they have generally chosen digital cinema over traditional film cinema and we expect this trend to continue. Digital cinema, which is based on open standards, does not include our proprietary audio technologies. As the cinema industry continues to adopt digital cinema, the demand for our traditional film cinema products and services has declined significantly and we anticipate that the demand for film based products will decline in future periods. Furthermore, exhibitors adopting digital cinema can choose from multiple digital cinema playback servers and audio processors, many of which may not contain our technologies, and our competitive position

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in the digital cinema market is not as strong as our position in the traditional film cinema market. Decreases in demand for our traditional film cinema products and services accompanied by decreases in revenue from digital cinema products and services would adversely affect our revenue stream from the cinema industry.
A decrease in demand for our cinema products and services could adversely affect our consumer products licensing business.
A decrease in the demand for our cinema products and services could adversely affect licensing of our consumer technologies, because the strength of our brand and our ability to use professional product developments to introduce new technologies, which can later be licensed to OEMs and service providers, would be impaired. If, in such circumstances, we are unable to adapt our products and services or introduce new products for the digital cinema market successfully, our business could be materially adversely affected.
We face risks relating to the online and mobile content delivery markets and declines in optical disc media.
For nearly 20 years, movies have been distributed, purchased, and consumed through optical disc media, such as DVD and more recently Blu-ray Disc. However, the growth of the Internet and home computer usage, connected televisions, set-top boxes, tablets, smartphones, and other devices accompanied by the rapid advancement of online and mobile content delivery has resulted in the recent trend to movie download and streaming services in various parts of the world. We expect a further shift away from optical disc media to online and mobile media content consumption, which will result in declines in revenue from DVD and Blu-ray Disc players. Such declines would adversely affect our licensing revenue.
In addition, online and mobile media content services that compete with or replace DVD and Blu-ray Disc players as dominant media for consumer video entertainment may choose not to encode their content with our proprietary technologies, which could affect OEM and software vendor demand for our decoding technologies. Furthermore, our participation in online media content playback may be less profitable for us than DVD and Blu-ray Disc players. The online and mobile markets are characterized by intense competition, evolving industry standards and business and distribution models, disruptive software and hardware technology developments, frequent new product and service introductions, short product and service life cycles, and price sensitivity on the part of consumers, all of which may result in downward pressure on pricing. Any of the foregoing could adversely affect our business and operating results.
Our operating results may fluctuate depending upon the timing of when we receive royalty reports from our licensees, royalty report adjustments, and the satisfaction of our revenue recognition criteria.
Our quarterly operating results fluctuate based on the risks set forth in this section, as well as on:

The timing of when we receive royalty reports from our licensees and when we have met all revenue recognition criteria;
Royalty reports including positive or negative corrective adjustments;
Retroactive royalties that cover extended periods of time;
The recognition of unusually large amounts of licensing revenue from licensees in any given quarter because not all of our revenue recognition criteria were met in prior periods; and
The recognition of large amounts of products and services revenue in any given quarter because not all of our revenue recognition criteria were met in prior periods.
This can result in the recognition of a large amount of revenue in a given quarter that is not necessarily indicative of the amounts of revenue to be received in future quarters, thus causing fluctuations in our operating results.
Inaccurate licensee royalty reporting could materially adversely affect our operating results.
We generate licensing revenue primarily from OEMs and software vendors who license our technologies and incorporate those technologies in their products. Our license agreements generally obligate our licensees to pay us a specified royalty for every product they ship that incorporates our technologies, and we rely on our licensees to accurately report their shipments. However, we have difficulty independently determining whether or not our licensees are reporting shipments accurately, particularly with respect to software incorporating our technologies because unauthorized copies of such software can be made relatively easily. Most of our license agreements permit us to audit our licensees’ records, but audits are generally expensive, time consuming, and potentially detrimental to our ongoing business relationships with our licensees.
In the past, licensees, particularly in emerging economies, such as China, have understated or failed to report the number of products incorporating our technologies that they shipped, and we have not been able to collect and recognize revenue to which we were entitled. We expect that we will continue to experience understatement and non-reporting of royalties by our

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licensees, which could adversely affect our operating results. Conversely, to the extent that our licensees overstate the number of products incorporating our technologies, or report the products under the wrong categories, corrections of prior reports could result in reductions of royalty revenue in subsequent periods, which could also adversely affect our operating results.
Third parties from whom we license technologies may challenge our calculation of the royalties we owe them for inclusion of their technologies in our products and licensed technologies, which could adversely affect our operating results, business, and prospects.
In some cases, the products we sell and the technologies we license to our customers include intellectual property that we have licensed from third parties. Our agreements with these third parties generally require us to pay them royalties for that use, and give the third parties the right to audit our calculation of those royalties. A third party may disagree with our interpretation of the terms of a license agreement or, as a result of an audit, a third party could challenge the accuracy of our calculation. We have in the past been, and may in the future be, involved in disputes with third-party technology licensors regarding license terms.
A successful challenge by a third party could result in the termination of a license agreement or increase the amount of royalties we have to pay to the third party, which would decrease our gross margin and adversely affect our operating results.
Unauthorized use of our intellectual property could materially adversely affect our operating results.
We have often experienced, and expect to continue to experience, problems with non-licensee OEMs and software vendors, particularly in emerging economies, such as China, incorporating our technologies and trademarks into their products without our authorization and without paying us any licensing fees. Manufacturers of integrated circuits, or ICs, containing our technologies occasionally sell these ICs to third parties who are not our system licensees. These sales, and the failure of such manufacturers to report the sales, facilitate the unauthorized use of our intellectual property. As emerging economies transition from analog to digital content, such as the transition from analog to digital broadcast, we expect to experience increased problems with this form of piracy, which would adversely affect our operating results.
We have limited experience in non-sound technology markets which could limit our future growth.
Our future growth will depend, in part, upon our expansion into areas beyond sound technologies. For example, in addition to our digital cinema and 3D digital cinema initiatives, we are exploring other areas that facilitate delivery of digital entertainment, such as video solutions for the consumer market. We will need to spend considerable resources in the future on research and development or acquisitions in order to deliver innovative non-sound products and technologies. However, we have limited experience in non-sound technology markets and, despite our efforts, non-sound products, technologies, and services we expect to develop or acquire and market may not achieve or sustain market acceptance, may not meet industry needs, and may not be accepted as industry standards. If we are unsuccessful in selling non-sound products, technologies, and services, the future growth of our business may be limited.
If our products and technologies are not 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 compatibility across delivery platforms and a wide variety of consumer entertainment products. Accordingly, we make significant efforts to design our products and technologies to address capability, quality, and cost considerations so that they 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. To have our products and technologies adopted as industry standards, we must convince a broad spectrum of standards-setting organizations throughout the world, as well as our major customers and licensees who are members of such organizations, to adopt them as such and to ensure that other industry standards are consistent with our products and technologies. 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.
Additionally, the market for broadcast technologies has traditionally been heavily based on industry standards, often set by governments or other standards-setting organizations, and we expect this to be the case in the future. If our technologies are not chosen as industry standards for broadcasting in particular geographic areas, this could adversely affect our ability to compete in these markets.
It may be more difficult for us, in the future, to have our technologies adopted as individual industry standards to the extent that entertainment industry participants collaborate on the development of industry standard technologies.
Standards-setting organizations are increasingly adopting or establishing technology standards for use in a wide range of consumer entertainment products. As a result, it is more difficult for individual companies to have their technologies adopted

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wholesale as an informal industry standard. We call this type of standard a “de facto” industry standard, meaning that the industry has widely adopted the technology, although no industry standards-setting organization has explicitly mandated such standard. Increasingly there are multiple companies, including ones that typically compete against one another, involved in the development of new technologies for use in entertainment-oriented 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 entertainment products.
Even if our technologies are adopted as an explicit industry standard for a particular market, market participants may not widely adopt our technologies.
Even when a standards-setting organization mandates our technologies for a particular market, which we call an “explicit” industry standard, our technologies may not be the sole technologies adopted for that market as an explicit 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. For example, the continued growth of our revenue from the broadcast market will depend upon both the continued global adoption of digital television generally and the choice to use our technologies where it is one of several accepted industry standards.
If we do not obtain new patents or proprietary technologies as our existing patents expire, our licensing revenue could decline.
We hold patents covering much of the technologies that we license to system licensees, and our licensing revenue is tied in large part t