Nuance Communications
January 2006 Issue
Hidden Gem by Bill Mann
Motley Fool
Risk-Level Rating: High
Fueled by shrewd acquisitions, it boasts the leading technology in the explosive speech recognition industry.
Its strong management team moved from document imaging to speech by buying Lernout & Hauspie's assets in 2002.
In 2008, 50% of automobiles will have speech recognition capabilities.
Nasdaq: NUAN
1 Wayside Road
Burlington, MA 01803
Ph: 781-565-5000
www.nuance.com
Recent Share Price: $6.57
Market Cap: $737
Cash/Debt: $95.8/$0
Owner Earnings Run Rate: $4
Buy-Around Price: $6.90
Does your car call your mom when you tell it to? If so, you may already be using technology by Nuance Communications (Nasdaq: NUAN). Among others, the company offers speech recognition technologies used in voice-activated services over telephone, automated voice dictation, and spoken-word device and application control.
But I'm getting ahead of myself. This company's story is one worth telling, so here it is.
Months ago, I used a conference call transcript service through Thomson (NYSE: TOC) that I noticed used software by a familiar name, Dragon Systems. Once a subsidiary of Lernout & Hauspie, Dragon was one of the wunderkinder of the late 1990s bull market. The Belgian company's market cap exceeded $10 billion at its height in March 2000.
All was not right with L&H, however. Its management loved the spotlight and embellished demand for its products by lying about sales figures by about $277 million. Lawsuits and bankruptcy followed. Two months before, the brilliant husband-and-wife team of Jim and Janet Baker had agreed to sell Dragon to L&H for $600 million in stock. Now, both their company and wealth were gone. The supremacy of Dragon's product was never in doubt, however. But unlike desks or buildings, computer code is a very difficult asset to sell in bankruptcy, because it may be unusable without the people who created it.
The Business
Let's go back to Nuance. Founded in 1992 as an independent spin-off from Xerox (NYSE: XRX), Visioneer, as it was then named, provided services that converted paper documents to electronic formats using optical character recognition (OCR). In 1999, it changed its name to ScanSoft. Two years later, it entered into the speech recognition business, buying L&H's assets for $59.5 million. At the time, ScanSoft considered speech to be a complement to its imaging business since they shared similar markets. The move eventually became a redefining one.
Since then, ScanSoft has made a dozen other acquisitions in the speech arena. Most importantly, in 2002 it added telecommunications capabilities by buying Speechworks, which once traded at a market cap of more than $2 billion. In addition, it purchased MedRemote, a medical dictation specialist, and, of course, Nuance, which also at one point sported a $2 billion market cap. After taking over Nuance in September of this year, ScanSoft formally shifted its corporate identity by changing its name.
The company is now made up of four segments: imaging, network speech, embedded speech, and dictation. Imaging, a slow growing but highly profitable business, will account for about $70 million of an anticipated revenue range of $315 million to $325 million in 2006. While this business is unexciting, the Nuance solutions for OCR are essentially the standard in the industry. As such, the company has built a sturdy moat around a business that's expected to keep growing at about 8% a year. Network speech includes speech recognition for call center applications for clients such as Blue Cross/Blue Shield and Wal-Mart (NYSE: WMT), as well as telecommunications network providers including Cox and Verizon Wireless (NYSE: VZ).
Embedded speech has two rapidly growing markets: wireless handsets and automotive. Nuance has deals with Nokia (NYSE: NOK), Kyocera (NYSE: KYO), and others to provide voice-activated dialing and other operations for mobile handsets. Meanwhile, automotive speech control is a rapidly growing segment. Industry analysts anticipate that as many as 50% of cars sold in the United States will include voice-command capabilities, up from less than 5% today.
Finally, dictation is a $10 billion business in the U.S. health-care segment alone. Nuance predicts massive growth there, up 70% in the most recent quarter. The company's superior technology differentiates itself here, harkening back to the Bakers' programming roots when they owned Dragon. With the addition of other related segments, such as the conference call transcription application used by Thomson, Nuance faces an enormous opportunity. The Justice Ministry in the German state of Hesse, for example, recently announced the installation of Dragon's Naturally Speaking software in 1,300 workstations in government offices.
The Financials
As a condition of its Nuance agreement, ScanSoft this year launched a secondary offering to sell shares, raising its cash stake to $95 million as of September. The company has a $750 million market cap and generated $8 million in operating cash flow in its most recent quarter. Because it has been so acquisitive, Nuance possesses a massive goodwill account, which currently exceeds $459 million. It carries almost no debt, though when I spoke with CEO Paul Ricci, he suggested that the company would consider taking on debt under certain conditions, such as paying cash for an acquisition. A key concern is a substantially longer cash conversion cycle in the most recent quarter, which CFO Jamie Arnold acknowledged in a recent conference call as a failure on their part to execute well in that area.
The Valuation
At first glance, this may not seem like a company that a value-oriented investor like me should recommend. After all, it lost $7 million in the most recent quarter, and before stock option expenses, it expects to earn between $0.14 and $0.16 in 2006, or $0.29 to $0.31 with non-GAAP adjustments, giving it a forward price-to-earnings ratio (P/E) of 20 to 22. Through the first nine months of fiscal 2005, then-ScanSoft generated $4.7 million in free cash flow, and more than likely doubled that amount in the last quarter. Nuance's revenues have risen 36% year over year, and it is counting on increasing operating leverage as revenues grow.
Though the smooth integration of Nuance has created a company that dominates its many markets, expenses associated with the merger may cause some indigestion in the upcoming quarter.
The Risks
It is risky that we're assuming a large slug of future revenues in the current price. But because Nuance has put itself into a strong position in many of its markets, we'll likely find that it was awfully cheap at prices less than $7 per share.
In addition, some of the company's segments may make for what Ricci describes a "complex agenda." Small caps tend not to have the breadth of management that larger organizations do to handle a variety of divisions, so there is a danger that Nuance will stumble. There's also a chance that speech technology won't be adopted as quickly as we hope.
Conclusion
In 2008, more automobiles, handsets, and computers will carry voice-recognition technology. Large corporations are slowly starting to warm to the idea of adding a voice-recognition component to their customer service. To be sure, the technology saves companies a lot of money. As such, further automation is inevitable.
If Nuance continues to experience rapid organic growth, it could reward shareholders with a market cap approaching any one of its component divisions when they were stand-alone entities. And this time, the company will justify every pe
Q&A: Nuance Communications
Tom: Tell me more about CEO Paul Ricci.
Bill: He has made several bets now that have completely changed the firm's focus from imaging to voice recognition and conversion. When I spoke with him, he came across as a no-nonsense guy.
The company is extremely conservative in its presentations and seems to have learned the lesson of the downside of overpromotion from the failure of Lernout & Hauspie and the struggles of other companies in this space. I believe we'll enjoy this relationship. He was extremely complimentary of the intelligence of Nuance's outside investors, and it was clear that he valued their input.
Tom: Warburg Pincus owns more than 15% of the company, giving it a powerful seat on the board of directors. Any concerns that its powerful interest as a financial investor might hinder Nuance's drive to reach full, fair value, à la Transkaryotic?
Bill: Warburg bought the remainder of Xerox's stake earlier this year ScanSoft's move away from imaging and into voice meant that it had less in common with its former corporate parent.
As a spin-off of a widely held company, ScanSoft has a fairly broad ownership base. Though it's possible for Warburg to look for a liquidity event, unlike Transkaryotic, this is a newer position for Warburg. It does not have the baggage of a near-collapse and an investigation by the Securities and Exchange Commission.
Tom: The stock traded at $22 in 1995 and goes for $7 today. What was the problem? Are you worried about recommending a company with a long history of losing shareholder money?
Bill: I wouldn't sweat it. Remember that in 2002 this became a vastly different company with the purchase of L&H's assets. Since Ricci and his team have come in, they've delivered market-beating returns and delivered a floundering company to what could well be massive success.
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