Nothing Subtle About Nuance Communications

by Will Ashworth | September 21, 2011 9:00 am

Making a living writing about stocks is a fantastic privilege. However, for me, the downside is that I’m a notoriously slow typist. What takes someone who is faster two hours to complete takes me almost twice the time. To improve my productivity and life balance, I’ve been investigating solutions. The best one I’ve come up with — although I’ve yet to test it out — is Dragon Dictate, a voice recognition software program from Nuance Communications (NASDAQ:NUAN[1]). While the program seems a winner, I can’t say the same about its stock. Here’s why.

Warburg Pincus

The private equity firm first bought into Nuance back in March 2004, when it acquired Xerox’s (NYSE:XRX[2]) entire stake of 15.6 million shares for $80 million. Known as Scan Soft at the time, the company changed its name to Nuance a year later as part of its focus on speech recognition software. Nuance’s most recent DEF 14A indicates Warburg Pincus owns 73 million shares, or 23.6%, of the company. It is by far the largest shareholder and has the most to gain from a higher stock.

My guess is that Warburg Pincus has paid an average price per share of about $9 since 2004. Based on the Sept. 16 closing price of $19.60, its return on investment on an annual basis is 10.5%. That’s not bad for retail investors, but it’s certainly not the expected return for private equity. Whatever influence Warburg Pincus’s two board seats can bring to bear on management to increase the value of its investment will, I’m sure, factor significantly in Nuance’s strategy. This suggests Nuance might choose to pursue short-term gains at the expense of its long-term future.


Probably the least tasteful aspect of Nuance is its ongoing court battle with Vlingo, which, like Nuance, also is based in the Boston area. Vlingo provides voice-recognition technology for mobile devices like Research In Motion’s (NASDAQ:RIMM[3]) BlackBerry and Apple’s (NASDAQ:AAPL[4]) iPhone.

A recent article in the Boston Business Journal said Vlingo, after winning its most recent patent infringement case brought by Nuance, is itself suing Nuance for attempting to bribe three of its top executives in 2009, when the two companies were in merger discussions. Vlingo claims Nuance CEO Paul Ricci allegedly offered the trio a total of $15 million on top of what they would have received if Nuance acquired Vlingo.

While I’m certain Nuance will fight these latest accusations, it’s clear both sides don’t like each other. To date, Vlingo has spent $20 million to defend itself against Nuance’s patent infringement claims. If any of Vlingo’s complaint is remotely accurate, Nuance’s business practices seem highly combative at best, improper and unethical at worst. For this reason alone, I’d likely pass on its stock.


Analysts estimate Nuance’s September 2011 non-GAAP earnings will be $425 million, or $1.35 a share. At its current price of $19.60, that’s a P/E of 14.5. Earnings in the next five years should grow 13% annually. From this perspective, its share price in five years should be over $30. However, that’s only if everything goes off without a hitch.

Besides, with notable differences between its GAAP and non-GAAP statements, there are better ways to evaluate Nuance, including free cash flow and return on invested capital. For the first nine months of its fiscal year, its free cash flow increased 39%, to $235 million, which is approximately 25% of its $952 million in revenue. That’s an excellent return on free cash. Unfortunately, free cash flow returns are deceptive in this instance because Nuance also makes capital improvements through acquisitions, which aren’t subtracted from cash flow. If you add in acquisitions, its free cash flow is actually -$876 million, paid for through the issue of stock and the addition of $900 million in long-term debt in 2006 and 2007. It’s not something that will kill the business, but it indicates that it’s not growing earnings organically.

As for return on invested capital, once more it’s a case of GAAP versus non-GAAP. Its GAAP ROIC is 1.43%. That’s not a business I want to own. However, its non-GAAP ROIC in fiscal 2010 is 11.2%, which is good. In this case, it all comes down to your comfort level with non-GAAP financial statements. I personally don’t have a problem with them, but many do. If I didn’t know of the legal troubles following the company, I’d be fine with Nuance.

Bottom Line

I want to own companies that I’m proud of and, quite simply, Nuance has too much baggage for my taste.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.

  1. NUAN:
  2. XRX:
  3. RIMM:
  4. AAPL:

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