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Nuance Communications Inc. (NASDAQ:NUAN)

F1Q13 Earnings Call

February 7, 2013 5:00 pm ET

Executives

Kevin Faulkner – Vice President-Investor Relations

Paul A. Ricci – Chairman and Chief Executive Officer

Analysts

Richard Davis – Canaccord Genuity

James R. Moore – FBR Capital Markets

Shyam V. Patil – Raymond James & Associates

Gray Powell – Wells Fargo

Jeff Van Rhee – Craig-Hallum

John F. Bright – Avondale Partners

Scott Zeller – Needham & Company

Operator

Ladies and gentlemen good afternoon, thank you for standing by and welcome to Nuance's First Quarter Fiscal 2013 Conference Call. At this time all lines are in a listen-only mode. Later there will be an opportunity for your questions, and instructions will be given at that time. (Operator Instructions) As a reminder, today's call will be recorded.

With us today are the Chairman and Chief Executive Officer of Nuance, Mr. Paul Ricci; CFO, Mr. Tom Beaudoin; and Vice President of Investor Relations, Mr. Kevin Faulkner. At this time, I'd like to turn the call over to Mr. Faulkner. Please go ahead sir.

Kevin Faulkner

Thank you, Tom. Before we begin, I remind everyone that matters we discuss this afternoon include predictions, estimates, expectations and other forward-looking statements. These statements are subject to risks and uncertainties that could cause actual results to differ materially. You should refer to our recent SEC filings for a detailed list of risk factors.

As noted in our press release, we also issued a set of prepared remarks in advance of this call, which are available on our website. Those remarks are intended to serve in place of extended formal comments and we will not repeat them here.

Now, let me turn the call over to Paul Ricci.

Paul A. Ricci

Good afternoon. Before taking your questions, I would like to underscore a few key points. In the first quarter, we delivered revenue and EPS at the midpoint of our guidance range. We delivered 29% revenue growth and 37% cash flow growth. In addition to these strong financial results we continue to make significant strategic and operational progress across our businesses.

In our mobile and consumer business, we expanded our privileged position as a premier provider of voice and natural language solutions for the leading Smartphone platform providers worldwide including the two market share leaders, Apple and Samsung.

We delivered a particularly strong quarter in the automotive market, continuing our unrivaled leadership in achieving additional design wins in the emerging market for connected car solutions. Q1 marked the initial shipments of Dragon Assistant in the PCs, laptop and hybrid markets under our Intel contract.

In our healthcare business, we saw early success in our end-to-end clinical quality, compliance and revenue cycle solutions combining clinical documentation, clinical language understanding and computer-aided coding to implement a clinically oriented end-to-end solution that will once again revolutionize the industry’s approach to healthcare documentation.

We improved growth in our enterprise business. We began several pilots for Nina, our platform for delivering customized virtual assistance for customer self service. These pilots engage us with leading companies and targeted vertical markets, airline, banking, insurance, retail and telecommunications.

There were three factors though that laid upon our first quarter results and that will affect our fiscal 2013 outlook. First, as referenced in our prepared remarks, we saw faster than expected erosion of our healthcare on-demand transcription volumes within existing customers due to the implementation of EMR systems and to the installation of Dragon medical software, both of which reduce on an average, the amount of hosted transcribed lines generated.

Second, although we had strong EMEA results in our handset and automotive business, the environment in EMEA was weaker than expected across our other businesses. We expect this weakness to continue in Q2 and throughout fiscal 2013.

Finally, we observed a slowdown in Windows based software sales, especially in our direct consumer business in conjunction with the Windows 8 replacement cycle, the emergence of tablets is an alternative to PCs and through some channel disruption.

Also as referenced in our prepared remarks we did make significant investments in R&D and sales in the first quarter and continuing into the second quarter. We expect these investments to slow as we enter the second half of the year. Furthermore we will realize significant savings from the consolidation of acquisitions as we progress through this year. These savings will improve operating margins as we move through the remainder of the year.

To close on a point that we have made in previous investor communications, we believe that our markets are transitioning to a new paradigm of virtual agents and intelligence systems, which seamlessly combine voice recognition, natural language processing, advanced dialog capabilities, and reasoning systems to better interpret and anticipate user intent. We’ve made important investments in sales, technology, and across an unprecedented level of customer engagements to best position ourselves to capitalize on this opportunity through the balance of fiscal '13 and into the next fiscal year.

And we will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question today comes from the line of Richard Davis, representing Canaccord. Please go ahead.

Richard Davis – Canaccord Genuity

Thanks. With regard to EMEA, do you view this as – I mean I know you did say that weakness will continue, macro, I mean obviously it's sales execution in the sense that always sales execution but can you kind of allocate the level of challenge there? And then just finally on healthcare, is this a business that you feel that would continue to face these headwinds with regard to the on-demand – I know you talked about it in guidance, but is there something more kind of a systemic thing or is it more temporary for at least – by temporary I mean just a few quarters. Thanks.

Paul A. Ricci

With respect to EMEA I don't believe that our issues are primarily sales execution. I believe that the issues are primarily macro and we have had challenges in Europe for some time, but they did seem more pressing both in the consumer environment and in enterprise capital purchases in the last quarter. So I think that we will continue for the foreseeable future.

In healthcare, we have experienced and anticipated a erosion of existing customer volumes as EMRs were implemented and importantly as we implemented our own Dragon installations in those same customers. The pace of that erosion was a little bit higher in the previous quarter than we anticipated. And we did have some delays in bringing new customers online, that the antidote to the problem is sales of two new customers and new volumes as we bring those new customers online and of course new revenues through the other products in healthcare.

I remain quite bullish about our healthcare business and about its growth rate over time, but the EMR erosion will weigh somewhat on healthcare growth for the next few quarters, particularly until we see revenues associated with our newly acquired products in computer-aided coding and clinical documentation, improvement until we see those revenues begin to take hold. There has been some delay in those revenues because of the revenue accounting associated with those acquisitions and we will see the benefits, more benefits from those revenue streams as we go in later in the year.

Richard Davis – Canaccord Genuity

Okay thanks. I'll let other people ask questions.

Operator

We will go to the line of Daniel Ives with FBR Capital Markets. Please go ahead.

James R. Moore – FBR Capital Markets

Hey guys, this is James Moore for Dan. Just a follow-up to the healthcare question; is your previous target of $1 billion for FY'13 is still in the plans or kind of get pushed?

Paul A. Ricci

It is in the plans. I will tell you it’s a tougher goal, but we as I mentioned in the previous quarter’s call and alluded to in these, and our prepared remarks here, we have been increasing our sales staffing throughout the first quarter and somewhat into this quarter and we will begin to see the benefits of that sales staffing as we go through the balance of the year, and as I mentioned, we expect to see additional growth from the newly acquired businesses that we completed at the very beginning of this year.

James R. Moore – FBR Capital Markets

Okay, great. And then may be can you just talk about uses of cash, employee you guys are seeing on the acquisition front for this year?

Paul A. Ricci

Well, as I signaled in recent conversations, our main line plan is to do fewer acquisitions or at least acquisitions of smaller assets of the kind that we have done now and then, but it’s difficult to predict. That is our expectation, but we have to be opportunistic as the market presents itself.

James R. Moore – FBR Capital Markets

Thanks very much.

Operator

Our next question today come from the line of Brent Thill with UBS. Please go ahead.

Unidentified Analyst

Hi, this is Jonathan for Brent, thank you. And you mentioned Europe, I want to ask you what you are seeing in some of the outer geographies, any weakness or strengths, and then secondarily in healthcare, could you talk a little bit about how the sales cycles and/or dealer pipeline is progressing along the ICD-10 initiative? Thank you.

Paul A. Ricci

With respect to your first question could I ask you to restate it, I am not sure I understood it.

Unidentified Analyst

Yeah, you mentioned there was weakness in the EMEA region, I am wondering what you are seeing in some of the other region, Asia-Pac and Americas.

Paul A. Ricci

For example we had a very strong quarter in enterprise in North America, so it doesn't seem that the enterprise spending issue I raised in EMEA is also here. And Asia which is heavily weighted towards our mobile business did quite well. I don't think it's a general statement about the other geographies. And with respect to health care, I think you were asking about the state of momentum and the ICD-9, the ICD-10 and the computer-aided coding, the CDI and CAC acquisitions that I mentioned earlier. As our prepared remarks mention we've seen real strength there, we saw a very strong bookings in our Quantum business and J.A. Thomas, so we think we are off to an excellent start in those businesses, and in fact I think we are more bullish on the CDI business than we even were previously, and we are seeking to leverage and expand that opportunity. I did note though in a comment a few moments ago that the recognition of revenue from that is more elongated than anticipated because of the accounting of those revenues. But we will still see the benefit of those revenues this year.

Unidentified Analyst

Thank you.

Operator

Question comes from the line of Shyam Patil with Raymond James.

Shyam V. Patil – Raymond James & Associates

Thanks, thank you. Just to go back to Europe, can you talk a little bit about just when you started to see the weakness that’s gotten worse since the end of December quarter and is there any particular verticals where it’s more pronounced?

Paul A. Ricci

I can’t say that it’s deteriorated since the end of December, that’s a relatively brief period of time, but it has been less worse than we expected and we planned in the first quarter, with respect to verticals, the businesses that are, that have been most affected by that have been the imaging business, and the enterprise business, which rely on capital spending, but we have seen certainly the effect as well in our dragon consumer business there, I think consumer purchasing sentiments in Europe have been quite weak for sometime, but we did see that effect, and we didn’t see the benefit of the holiday quarter that we might have anticipated as a result in Europe.

Shyam V. Patil – Raymond James & Associates

Okay. And then switching to healthcare business, how do you feel about the $1 billion target, you have given earlier, is that still something that’s achievable or is there a new target that we should be thinking about for the year?

Paul A. Ricci

No, we’re not changing that target as I mentioned to the earlier question, the target is more challenged than it was three months ago, but we’ve committed a lot of resources to the business, and we continue to try and push on leveraging those resources and we expect to see benefit of those as we move into the back half of the year.

Shyam V. Patil – Raymond James & Associates

And then at the Analyst Day, you’ve talked a lot about Wintermute, what are your expectations around that, is that something, there’s sort of the numbers this year or is that more of a longer-term opportunity?

Paul A. Ricci

Wintermute is an expression really of the sequential vision that we’ve articulated around the hybrid solution we are building in conjunction with Intel across series of platforms and so I think realistically the revenues from that are going to be in fiscal ‘14, but remember we are enjoying revenues already from that product line, and those revenues will continue as we move throughout this year, and with additional releases that are coming later this year, we will see real benefits in early ‘14?

Shyam V. Patil – Raymond James & Associates

Okay thank you.

Operator

Next question today comes from the line of Gray Powell. Please go ahead.

Gray Powell – Wells Fargo

Great thanks for taking my questions. And looking at the EPS guidance range for next year, it seems pretty wide at $0.09 given the full year range, it’s about $0.11, what are the factors that are going to lead you to such a wide range, and then how do you get to the top end of the range or the bottom end of the range, thanks.

Paul A. Ricci

The reason to range this quarter is relatively large with respect to the full year range is that we have confidence on a number of deals closing over the course of the year, and we have more uncertainty about whether they will in fact close in the coarse of this quarter, so that explains that.

Gray Powell – Wells Fargo

All right, thank you.

Operator

Question comes from the line of Jeff Van Rhee with Craig-Hallum. Please go ahead.

Jeff Van Rhee – Craig-Hallum

Great, thank you. Paul, can you just go back and revisit you gave the three factors that weighed; the first one in terms of the erosion of on-demand volumes, can you talk to just help to give us a sense of scale here, what proportion of the on-demand volumes, do you think are vulnerable to this EMR install and Dragon Medical shift, if you will?

Paul A. Ricci

Well, over time a substantial proportion of them will see some erosion because there will be a high prevalence of EMR Systems throughout the North America and throughout the U.S. hospital systems. And that of course, I think I mentioned previously this afternoon that has some amount has been factored into our plans, but the speed of that erosion was somewhat greater. To some extent driven by the EMR, and some extent driven by Dragon itself. We have been more successful with Dragon in the course of fiscal ‘12 than we expected and we are seeing some of the migration of those volumes into Dragon as a result.

Jeff Van Rhee – Craig-Hallum

Last quarter obviously the trend started to play itself out and you had taken somewhat of a more cautious stance, in between there and here, again somewhat of a similar step. How comfortable are you with the implicit in the guidance, what you have assumed for this sector for the fourth quarter, for the year just sort of redouble the conservatism, I know it's a could question sort of high-level, but how should we think about how you are approaching modeling this or understanding what to expect?.

Paul A. Ricci

Well, I don't think I can offer you anymore guidance about other than what I've said, we’ve put forward our best understanding of the situation, and our guidance of course it assumes that we're going to be successful with the several factors that I have mentioned earlier, and I can just repeat those for you. First of all, we put a number of additional sales resources in place and they have to become productive, and we have some history. So we think that's a reasonable estimate. We have to see a resumption, some acceleration of the hint of the implementation of customers that we have booked for on-demand, who not yet implemented, we have been somewhat behind in that, and those reasons have mostly to do with customer priorities not with operational issues, within our company, and we're assuming that we can in fact bring those accounts online as we go through the balance of the year. We have to get into success with our Dragon Medical products and importantly we have to realize the benefits of the new product line initiatives in CDI and CAC that I mentioned earlier in the call, and have talked about previously.

Jeff Van Rhee – Craig-Hallum

Okay, on two last real quick ones then, in terms of the organic growth. I mean obviously you're accounting on the back-end loaded year, having put our focus on organic growth in 2012, is that still a reasonable bogie, it’s hard to tell what's implicit in the guide, I know you don't like to back-end that, but how should we think about organic growth from the vantage point we are sitting at now in terms of '13 versus '12, does it feel flattish, is that what’s embedded here, do you feel like there is a short of the acceleration, how do you broadly think about that?

Paul A. Ricci

Well I don't want to forecast organic growth and I apologize that we've been fairly steadfast about that, but I will say the new guidance range for the full year is clearly a bit over lower than the previous guidance range, and so you should factor in that our expectations about organic growth are somewhat slower.

Jeff Van Rhee – Craig-Hallum

Okay, and last one on the JATA surprise on Revtrak, you said that things are good there but there has been some surprise in terms of the deferral or inability to recognize maybe I missed, can you just sum that up real quick for me what that refers to.

Paul A. Ricci

I think that with our CDI and CAC products, the revenue recognition just is more drawn-out than we expected, because of the various complex things that you have to certain accounting requirements in our direct measure revenue and that’s way too implicated to go into in this call, but it’s not an unfamiliar problem and it has some modest effect over the course of this year.

Jeff Van Rhee – Craig-Hallum

Okay, okay. Thanks Paul.

Operator

Our next question comes from the line of John Bright with Avondale Partners. Go ahead.

John F. Bright – Avondale Partners

Thanks. Paul, I’ll stay with the accounting treatment on the Rev Rec, I’m not familiar with it, are we talking about software recognition, maybe a little bit more clarity on that topic?

Paul A. Ricci

When you have services in software together, there are a variety of things that have to occur in order to recognize revenue and the set of assumptions that were made during the process of diligence just turned out to be a bit too optimistic with respect to the timing of when those milestones will be met. It’s really that simple.

John F. Bright – Avondale Partners

I want to make sure I understand this correctly, so I think early December when the Analyst Day was, we’re talking early February now and you list three factors, if I assume that the erosion in on-demand – on healthcare component is probably the majority of that change over that period of time, is that fair?

Paul A. Ricci

Sorry, say that again.

John F. Bright – Avondale Partners

The first factor you gave for the change in guidance regarding the arrosion of on-demand?

Paul A. Ricci

Yeah, what’s your question about it?

John F. Bright – Avondale Partners

That’s going to be the majority of the reason for the lowering of the guidance.

Paul A. Ricci

No, I didn’t say that, I said all the three contributed and I didn’t try and quantify them.

John F. Bright – Avondale Partners

But, if I was asking you to quantify them, would do you say that’s the majority?

Paul A. Ricci

No, I would simply say they all three contributed and I can’t offer anymore details on that.

John F. Bright – Avondale Partners

And you mentioned in the same comments that customer delays were part of the reason that didn’t offset that. Maybe you have any color on what the reason for the customer delay is?

Paul A. Ricci

We’ve been doing this a long time and there are some periods of time when some of these contracts are of significant size and there are some periods of time in which the customers have more capacity to implement than other times. And for reasons that are particular to each customer, there the ability to achieve the implementations over the last few months has been somewhat slower than we expected.

John F. Bright – Avondale Partners

Final question on this; the erosion then is happening because of the new product offering that you are putting in place as well as some substitution from the dragon products, is that fair?

Paul A. Ricci

The erosion is occurring because as EMR’s are implemented, transcribe lines declined in some instances and depending on which EMR is being implemented, the decline maybe more or less and because as users adopt dragon, often in conjunction with EMR that is in fact substitution way from the online – on volumes.

John F. Bright – Avondale Partners

Thank you.

Operator

Question today comes from the line of Adam Holt, representing Morgan Stanley. Please go ahead.

Unidentified Analyst

Thank you very much. I am Austin, representing Jim. It’s been low with the your patience. I just have two questions, first is, if you look at the build of the forward guide, it looks like it’s little bit full of a more backend loaded year than we have seen in some years, can you walk through what gave you some comfort that you are going to see things sort of improve as you get into the second half.

And then secondly, could you walk us through what the assumptions are around that Windows piece, obviously the PC market has been weak, are you assuming stability there and to growth in the PC market or are you continuing to assume that the Windows business will remain weak? Thanks very much.

Paul A. Ricci

We are assuming that the Windows business will remain somewhat weaker than expected throughout the course of the year. But we are expecting some improvements just through shifts in various marketing programs essentially operational things we're doing in response. We are also assuming some benefits from the alternative channel for that software that's been opened up through our work with PC OEMs and Intel. And I think that's it.

Unidentified Analyst

And if you could just touch on the PC, the backend loading of the year?

Paul A. Ricci

I'm sorry, what was your question again on that.

Unidentified Analyst

It just looks like two years a little bit more backend loaded than some of the years you have seen previously. You are pretty comfortable that that we are conservative enough here or if what things are comfortable with that kind of the acceleration.

Paul A. Ricci

You're right. It is a bit more backend loaded and it does assume that we are going to be successful and as I mentioned in some detail, a few minutes ago in the variety of programs that we have implemented in healthcare that are going to in the backend of the year, we anticipate providing additional growth there. It also assumes some additional expansion in the mobile business due to opportunities that we see is being available to us through the course of this fiscal year. And it assumes some success in the imaging business where we have launched and are going to launch additional products and have a number of investments as well.

Unidentified Analyst

Okay, thank you.

Operator

We have time for one final question today, and that will come from the line of Scott Zeller representing Needham & Company. Please go ahead.

Scott Zeller – Needham & Company

Thank you. Another follow-up question on the Windows impact. As you look at the consumer business overall, and you look at the impact from the slowdown due to Windows, how do you view the consumer business overall for the year versus where you were at Analyst Day?

Paul A. Ricci

I think I have just mentioned somewhat qualitatively that it’s a bit weaker than we expected. And I should add that we are seeing a gradual transition of that business from the traditional Windows package software to a business in which we are working directly with the OEMs integrating this next generation of virtual agent on their hybrid devices, and their tablets and laptops, and I think that is the future growth, and opportunity of that business. What I might say is that we are seeing the transition of that occur more quickly than we expected. The good news about that is that the level of engagements we are seeing with OEMs on systems that they want to deploy is quite attractive, and I think it will provide long-term value for shareholders. The challenge about it is that it is substitutional as the transition is going on, and those revenues are going to occur in the future as we see some weakness in the packaged software business today.

Scott Zeller – Needham & Company

And a question on margins, Paul or Tom, could you just give us your latest thoughts again on stabilization of gross margin as more of your business shift through on-demand and cloud?

Paul A. Ricci

I think we just underestimated the speed of that shift and so in our prepared comments, I think we referenced that perhaps 200 to 250 basis points differential year-over-year was the right target, and I think that’s up a bit from 100 basis points to 200 basis points, which we suggested to you back in our previous call.

Scott Zeller – Needham & Company

Thank you.

Operator

Gentlemen, do you have any concluding remarks?

Paul A. Ricci

Well, thank you very much for joining us and we look forward to talking to you again next quarter.

Operator

Ladies and gentlemen, this conference will be available for replay starting at 6:00 p.m. Eastern this evening and running through February 21 at midnight. You may access the AT&T Executive playback service at anytime by dialing 1800-475-6701 and entering the access code of 279312. International participants may dial 320-365-3844, once again, those numbers are 800-475-6701, international participants dial 320-365-3844, please enter the access code of 279312. And that does conclude our conference for today. We thank you for your participation and using the AT&T Executive Teleconference. You may now disconnect.

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