by Hilary Kramer | February 18, 2014 3:58 pm
At first glance, Nuance Communications (NUAN) has a few factors working against it. The company is in the midst of a long-term transition to a new business model, has posted a string of earnings disappointments, and saw shares flounder last year as the overall market soared.
But dig deeper and you’ll see that this speech recognition software company stands out as a game changer thanks to its impressive technology, large-cap ally, and a big-name activist shareholder with a large stake in its future. And with evidence the company’s results are turning a corner, the stock is an attractive buy at current prices ahead of strong potential growth.
Even if you’re not familiar with Nuance, you’re likely on friendly terms with one of its most famous software personas. NUAN powers Siri, the ubiquitous personal assistant that so many iPhone users look to for directions, where to eat or just some disembodied conversation. NUAN earns revenue from Apple (AAPL) via flat fees, which are not determined by how many phones it sells. So the tech juggernaut’s recent low iPhone sales number, while disappointing, does not necessarily mean any problems for NUAN. And while NUAN is a bit of an indirect play on AAPL, no customer accounts for 10% or more of sales, which adds further downside protection.
The company also makes Dragon NaturallySpeaking software, which converts speech into text for PCs, and recently announced that it will work with Intel to introduce new voice recognition into Atom and core chips powering notebooks. Another key product is Nuance’s Swype technology, which has been making inroads into Android-powered devices.
All told, Nuance operates in several segments, including healthcare (49% of revenues), mobile and consumer (25% of revenues), enterprise (17%) and imaging. Given the size of the company’s revenue presence in healthcare, Nuance stands to benefit nicely from the continued push via government legislation for IT advancement in this sector, including better record keeping (transcribing doctor’s voice recordings) and more efficient treatment. In fact, management has said this segment should see double-digit growth going forward.
As I mentioned earlier, Nuance is in the midst of a long-term business model transition, moving to a software-as-a-service (SaaS) model to sell subscriptions to its products that are then delivered via the cloud. This is a departure from its traditional licensing (and installed on premise) model. While the transition has not been a smooth one, the new set up will ultimately help the company improve efficiency. This is similar to what we’ve seen from HomeAway (AWAY), which was pressured by investor concerns over its business model change but rose on evidence of a beneficial and smooth transition.
Looking at the revenue trajectory, growth rates have dropped from double digits to mid-single digits in the last year, and guidance and earnings reports disappointed over several quarters. As license sales drop and are only partly compensated by recurring revenue/maintenance sales, margins get hit. While overall revenue growth has been impressive on a non-GAAP basis (which includes the accounting impact of the revenue recognition timing changes tied to the shift), much of that growth has been driven by dozens of acquisitions over the past several years.
Revenue growth may also be limited as the company pushes out some technology deals with phone makers in order to gain some pricing leverage. With investors concerned over the impact the transition was having, NUAN dropped from $23 a year ago to current prices around $15.
But recent evidence suggests that Nuance may be turning a corner. Last week, management pre-announced positive results for the fiscal first quarter (ended in December) that trumped analyst expectations and beat previous company guidance. The company expects to see revenues of $487-$491 million, up from previous guidance of $477-$487 million. Projected earnings of 23 cents to 24 cents a share were also higher than initial estimates of 18 cents to 21 cents per share.
Of course, one quarter does not make a trend, but the raised guidance was an encouraging sign. Given the current valuation of 12X forward estimates of $1.22 in earnings, which is roughly in line with projected growth and a bit below market multiples, the Street was looking for “show me” story when Nuance announced its first-quarter revenue.
NUAN stock slid a bit after the announcement, despite the company posting better than expected results and moving its guidance numbers higher.
But the pullback gives us a chance to get in now, while the company has multiple new revenue streams in place that are just starting to materialize, from voice biometrics (which could be a boon to financial institutions and others looking to protect sensitive data) to new avenues like voice ads.
Let’s not forget about that big-name shareholder I mentioned. Nuance has come under fire in the past for its corporate payment structure, when the CEO’s salary famously accounted for 50% of operating income. But now, activist investor Carl Icahn owns about 18% of NUAN – up from the low-single digits a year ago. He’s also managed to get two of the 12 board seats.
Some investors have speculated that he will push for a breakup of the company or at least a substantial change in management. And given his recent famed forays into Apple, where he owns about $4 billion in shares, other industry watchers think he’ll push for AAPL to buy NUAN.
For now, Icahn has said he would not do that, but his presence certainly brings a level of attention to NUAN. Whatever course of action Icahn takes (and given his level of persuasion, other large shareholders may be inclined to join him), it’s likely that major changes are in the offing for this company, and that could send the stock soaring.
In the meantime, with a little cost discipline as new software revenues materialize, $1.22 in EPS and a mid-single digit growth rate may prove to be conservative. If the company can get to $1.30 in near-term annual earnings, multiple expansion to the high teens gives us a target of $23.
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