Description

After going through years of disappointment (about 10), Nuance may be showing signs of growth as demonstrated by recent results.  It is trading at below historical multiples with a few secular tailwinds behind it.

Investment Summary

Nuance is a technology company with recurring revenues of over 70% that is currently trading at a cheap multiple of cash flow (10x) due to various reasons.  However, it appears that the company is near an inflexion point where it can show bookings and sales growth on a sustainable basis.  There are end markets which show strength namely Artificial Intelligence and Automobile.  If Nuance can show continued progress this year, the shares could re-rate to an appropriate multiple bringing the stock to $24/share, a 50% return.

Brief Business Description

Nuance Communications is the leader in speech recognition, dictation and imaging software and services.  It is a leading company in medical transcription services.  It’s products utilize speech recognition to interact with other products and services including autos, telecom, medical, office and home entertainment.  Please take a look at the 10-k for a further elaborate business description.

The Negatives on Nuance

There are many negatives on Nuance, and I will mention some of the bigger ones here.  They have been contributing to the stock performing so badly.  Some things the company can put behind them and some things they won’t.

1. Nuance is made up of many acquisitions over the years, and clearly they haven’t paid off with earnings stagnant and sales growing at mid single digits.  

2. CEO not well liked.

3. Carl Icahn threw in the towel due to mis-execution.

4. There are a lot of moving parts to its business that are unrelated.  They serve different customers with different products, and this is detrimental to Nuance being viewed as a takeover candidate.

5. Not clean financials.  There are a lot of adjustments to get to a non-GAAP earnings number, including stock comp, amortization of intangibles, non-cash interest, non cash taxes etc.

6. Declining legacy business in healthcare.

Brief Description of Business End Markets

Healthcare represents about ½ of the company’s total revenues.  Of that, approximately $350mm of revenue represent Transcription services which is undergoing a continued decline in business.  It is declining about 8-10% per year due to its displacement to other technologies that Nuance such as Dragon Cloud.  Net Net this is causing the largest segment of Nuance’s business to be stagnant.  However, it appears that we are in the beginning of an inflexion point where revenue declines from transcription are offset by faster growing products in Healthcare.

The Mobile business segments include products and services to automobile manufacturers, mobile telecommunications customers, and device manufacturers.  Nuance has been seeing solid growth in this category recently in the automobile vertical as car manufacturers seek to make their cars more safe using hands free technology.

The Enterprise Segment represents the second largest business segment, and probably the most annoying to customers worldwide.  Nuance’s technology enables Articficial Intelligence offering using its voice recognition and speech capabilities.  Its technology is used in call centers, as well as voicemail.

The imaging business sells technology that enables the scanning and organization of paper documents into digital format.  Their customers include the largest printer and copier manufacturers including HP, Samsung etc.

Earnings Model

There is a couple of things to note with NUAN’s earnings model.  First off, there is a lot of pro-forma to GAAP reported earnings.  Stock Comp, Amortization of Intangibles, etc.  While not ideal due to the non-precise nature of this, I do believe that the company needs to be analyzed on a pro-forma number.  

The other thing to note is that the company has been undergoing a shift from offering perpetual licenses to a recurring revenue model.  3 years ago, over 25% of the business was perpetual product and licenses, while today it is only about 14%, with recurring revenue representing nearly 75% of total revenue.

Balance Sheet

The company has been taking on leverage to repurchase stock.  Currently the company is leveraged at about 3x.  Recently it issued a convertible bond to retire existing convertible debt and repurchase additional stock.

Valuation

Currently NUAN is trading at about a 10X multiple of earnings and free cash flow.  If the company can start to show steady mid single digit growth in sales, and double digit in earnings, NUAN’s multiple will rerate to about 15X or $24-25/share.

Why Invest Now??????

It appears that the stock is not responding to pretty strong bookings growth in the last two quarters.  This is probably due to skepticism given the company’s history.  But it’s end markets are showing strength in artificial intelligence and automotive.  The health care business is finally showing signs of stabilization.  The company believes that the segment will actually show growth this year as new products outstrip the decline in transcription services.  While last quarter revenues declined in all segments besides Enterprise,  bookings for the entire company was up 23%.  This compares to annual bookings guidance of 3-6%.  While bookings can be inconsistent, It would appear that the company is set up for beating earnings this year.  

Risks

Continued decline in transcription business.

A return to mis-execution by management.  

Leverage.

Catalysts

Execution on recent bookings growth.  

New CEO in March of 2008.

Catalyst

Execution on recent srong bookings.