Nuance Communications CEO Discusses F1Q 2014 Results - Earnings Call Transcript

| About: Nuance Communications, (NUAN)

Nuance Communications (NASDAQ:NUAN)

F1Q 2014 Earnings Conference Call

February 10, 2014, 5:00 p.m. ET

Executives

Kevin Faulkner - President, IR

Paul Ricci - Chairman & CEO

Tom Beaudoin - EVP & CFO

Analysts

Richard Davis - Canaccord

Brent Thill - UBS

Shyam Patil - Wedbush Securities

Jennifer Lowe - Morgan Stanley

Jeff Van Rhee - Craig-Hallum

Tavis McCourt - Raymond James

Scott Zeller - Needham & Company

Daniel Ives - FBR

Operator

Ladies and gentlemen, thank you for standing by, and welcome to Nuance's first quarter fiscal 2014 conference call. [Operator instructions.]

With us today are the Chairman and Chief Executive Officer of Nuance, Mr. Paul Ricci; the Chief Financial Officer, Mr. Tom Beaudoin; the Executive Vice President of Corporate Strategy and Development, Mr. Bruce Bowden; and Vice President of Investor Relations Mr. Kevin Faulkner.

At this time, I would like to turn the call over to Mr. Faulkner. Please go ahead sir.

Kevin Faulkner

Thanks. Before we begin, I'd 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 Ricci

Good afternoon. Before taking your questions, I’d like to highlight some key points about our strategic and financial progress during the first quarter. In Q1 ’14, we had strong bookings across our key growth businesses, and we outperformed our targets for revenue and EPS. We drove 26% bookings growth over Q1 ’13, led by strong performance across our healthcare portfolio and from our automotive business in several large enterprise deals.

Based on this strong start, we are confident that we will achieve our targeted 15% bookings growth for the year. These bookings are the basis for our return to improved growth and profitability later in 2014 and in fiscal ’15.

I’m also pleased that we exceeded our targets for Q1 revenue and EPS. Our revenue performance was enabled by growth in our on-demand businesses, Dragon Medical, healthcare diagnostics, and by contributions from our expanded enterprise outbound business.

With respect to EPS, we benefited from discipline in our investments in R&D, sales and marketing, and focusing our support on key growth businesses while also finding cost and productivity improvements in areas of our business that are more mature.

Overall, our Q1 results and current pipeline give us increased confidence that we are on track to achieve our full year revenue projections. Additionally, we now believe we will somewhat outperform our previous projections for full year EPS.

Equally importantly, we continue to make strong progress bringing our innovative solutions to attractive adjacent growth markets. In our healthcare business, we won key customers for our Clintegrity Solutions. We are pleased with the success of our computer-assisted coding and other CLU-based solutions in this area, and we believe that we are the innovation leader in this market.

For example, and as noted in our prepared remarks, we had a number of important competitive wins in our Clintegrity Solutions. In our mobile business, one of the most important developments has been the success of our connected car offering.

Building on the strength of our automotive market presence, we’ve secured numerous design wins for our connected platform with auto OEMs in North America, Europe, and Asia, and as many of you are aware, it was difficult to walk the floor at this year’s Consumer Electronic Show without seeing the ubiquity and prominence of next-generation natural language and personal assistant technologies, demand for which continues to create enhanced interest in our solutions.

In order to drive our growth and innovation agenda, we continue to make significant investments, most especially in sales and R&D. We remain focused on leadership in natural language understanding, reasoning, and virtual assistant technologies and on delivering sophisticated implementations of these technologies. We also continue to invest in scalable cloud-based platforms to deliver these solutions.

While these investments are pressuring margins in the near term, we are balancing them with efficiencies in other areas and believe that overall we are positioning the company for strong medium-term growth and increased profitability.

In addition to our focus on limiting expense growth, we’ve made some additional improvements in operations of the business. We’ve undertaken a comprehensive initiative to improve the efficiency of our corporate cloud infrastructure, and of course we recently announced the hiring of Bill Robbins as our new worldwide sales leader, which is an important step in improving our selling productivity.

Finally, we continue to evolve our business towards connected solutions and therefore recurring revenues. In Q1, this shift continued, as on demand revenue rose from 31% of revenue last year to 35%. Even within our licensing business, an increased proportion of our revenue came from term and other recurring licensing models.

We continue to embrace this transition and its effect on near term revenues, because of the high customer demand for on-demand solutions and because we value the recurring nature, predictability, and longevity of these revenue streams.

So overall, fiscal ’14 is off to a good start, and our year is progressing as we anticipated. Our performance reinforces our confidence in the strategy we have articulated, and we believe we’re putting the company on solid ground for the future.

And with that, we would be happy to take your questions.

Question-and-Answer Session

Operator

[Operator instructions.] Our first question today comes from the line of Richard Davis of Canaccord.

Richard Davis - Canaccord

The mobile continues to kind of decline year over year. I just assume, from reading the text and things, this is kind of a trend that’s continuing. At what point does that turn? And two, how does that fit into your new head of sales with regard to different strategies and/or tactics?

Paul Ricci

There’s a number of factors that are involved, of course, in the decline in mobile, the most important of which is the migration from largely embedded solutions to connected solutions, the revenue for which will be recognized over time. There are some other dynamics that we’ve mentioned previously, including the consolidation of the smartphone business, which has hurt royalties from some of the previous participants in that industry.

And we should also include, of course, that we had a disappointing quarter in Dragon consumer, and we are seeing, as well, there, a migration from a conventional model to a model in which we have connected versions of dragon, which are sold primarily with OEM partners.

So that’s a transition we’re going to have to continue to go through. It’s going to take a couple of years. We should see a resumption in growth in our mobile business next year, a modest resumption in growth next year, and better growth the year after, as some of the medium-term effects of the connected solutions take effect. I should say that within all of that, the automotive business continues to be a very strong performer, and should yield strong growth next year.

Richard Davis - Canaccord

That’s more just execution. And then the second question was, just in terms of your new head of sales, is there any strategy changes? Or is it just better execution, kind of up and down the ladder?

Paul Ricci

Well, the things I’ve mentioned so far are not primarily execution issues. They have to do with the transition of the market, and I think that is the most important effect in our mobile business to focus on, which is we are going through a market transition. There undoubtedly are execution opportunities in our selling and marketing, and Bill will contribute to those, but I think the primary issue in mobile is one of transition.

Operator

The next question, from the line of Brent Thill with UBS, please go ahead.

Brent Thill - UBS

One on bookings. Could you go into a little bit more detail as to where some of the strength was by major segment, and which one was maybe better than others? And then in terms of your new head of sales, any changes contemplated, either in the sales organization or in your go-to-market approach at a high level?

Paul Ricci

With respect to strength in bookings, as we noted in the prepared remarks, and perhaps the press release and alluded to in my opening comments, there were numerous areas in which we had strength in bookings. Enterprise on demand was particularly strong. Automotive was quite strong. Several places within our healthcare were strong. Diagnostics, our radiology business, was especially strong. And Dragon medical bookings were also robust.

With respect to the head of sales, again, Bill will make operational adjustments, and there will undoubtedly be some go-to-market adjustments as part of that, some geographical shifts, some other operational adjustments. But I think it’s probably too early for me to speak to that.

Operator

And the next question comes from the line of Shyam Patil of Wedbush Securities.

Shyam Patil - Wedbush Securities

Paul, in the prepared remarks, you made a comment about Dragon medical seeing success with term license pricing. I think that’s the first time I’ve seen you guys talk about that. Do you think that you could convert the majority of your base to that over time? And do you think that would help more than offset the on demand subscription erosion that you’ve been seeing over the past couple of years?

Paul Ricci

As we’ve discussed in previous conference calls, the transition from conventional perpetual solutions to cloud-based solutions is one that’s going to occur in our healthcare, our enterprise, and in our mobile business. And we, as we noted in our comments, are continuing to evolve in that direction and in fact embracing it where there’s customer demand, and as our solutions themselves are evolving technologically.

We should not of course that the healthcare on demand business is already a cloud-based solution, and what I think will offset the erosion there is partly the evolution of our other product lines, our Clintegrity product line, the growth of our Dragon medical product line, diagnostics, but also the expansion of our healthcare on demand into adjacent markets.

We particularly mentioned the middle markets and specialty clinics and other areas, and there’s a lot of untilled ground in those markets, where people are still not using automated solutions for their transcription, and we have made go-to-market adjustments over the last year to focus on that, and we’re seeing some early success in that.

And I think some of that is evidenced by the performance of the healthcare business in the first quarter, which as we noted in our comments, we were pleased with, and the outlook for that business this year appears to us to be quite strong.

Shyam Patil - Wedbush Securities

On the mobile margins, you talked about deployment of large deals potentially impacting the mobile margins in the quarter. Should we be thinking of this as kind of a trough level, and expansion from here? Or just how should we think about the mobile margins going forward?

Paul Ricci

We have a lot of focus right now on improving our mobile margins, and those include reductions in expense growth in lower growth areas, other productivity initiatives, particularly in reducing the growth in cost in our cloud-based infrastructure, which has been very expensive as we’ve ramped up that part of the mobile business, and I mentioned an initiative within the company to limit those expenses.

I think we’re also probably at the peak moment of implementation costs on some of our very large implementations in that business, which have been running for some period of time. So I would anticipate margins improving in that business as we look ahead, yes.

Operator

And the next question comes from the line of Jennifer Lowe of Morgan Stanley.

Jennifer Lowe - Morgan Stanley

I wanted to drill a little bit on the bookings strength in the quarter and just contextualizing it versus the guidance for the year. And I know in the prepared remarks there’s some commentary around some things that were renewals that happened sooner than expected, and so it sounds like some of the 26% growth came out of future periods. But if you did 26% Q1, it really only means you need to do 10% growth over the next nine months to hit the target for the year.

As we think about it, is this the new metric for all of this, and we don’t have the historical context, necessarily? Is there anything we should be thinking about in terms of particularly difficult compares over the next three quarters, or something along those lines, that might cause that growth to maybe be less? Or is it more conservatism? How should we sort of think about the strength in Q1 versus the increased confidence, but not the actual increase in numbers for the full year guide?

Paul Ricci

As we built our model initially this year, we were pleased that our sales plans allowed us to target a 15% growth, that that was a reasonable target. And we’re still happy with that level of growth for the full year.

You’re right, we did have a very strong start to the year, and as the comments noted, and as you noted just now, there were some influences on the first quarter that I think suggest that it was a particularly strong quarter, and it certainly drew some from the second quarter. The seasonality of bookings in the first quarter, holiday bookings in the consumer business, and year-end buying by corporations and large healthcare institutions both contributed, as well as partner channels, where some of the partners of course are on calendar year end, so they were motivated.

So all of that I think contributed to the first quarter. And as we mentioned in the documents, we expect slower growth in the second quarter. We’ll see, as we get through the second quarter, whether we have a foundation for improving our outlook on bookings, but we felt right now that being able to reiterate our confidence in a 15% year over year growth was a good sign, and that we ought to stop there.

Unidentified Speaker

Strong bookings growth in the quarter seems to be a good thing. The organic growth seemed to be in line. Maybe answer when should investors expect overall bookings growth to reaccelerate, I guess, if you will, organic growth, or connect the dots, if you can, between the bookings growth and the non-GAAP financials that we’re going to see, and maybe, if you have an idea on the timeline.

Paul Ricci

Sure, I think we can offer some qualitative statements on that. First, in the document, I believe we noted that about a third of our revenues this year come from bookings this year, so the bookings growth in excess of revenues will contribute some revenue growth as we look into the back half of the year, and I think that’s when you should anticipate it.

Unidentified Speaker

Second question is around the weakness in the mobile segment, specifically the Dragon consumer business, weak because of the PC market being weak. Is there a way that you can give us a sense of the size of that business within mobile and consumer so that we might quantify the headwind risk there?

Paul Ricci

I think we’ve previously indicated that that business is somewhere in the $75 million to $100 million range. And I should say that I think there are two issues going on in the Dragon consumer business. One is a real migration to a new generation of solutions, and we’ve talked a lot about those solutions, and we’re very excited about the progress of selling connected versions of Dragon, particularly the work we’ve been doing with Intel in the marketplace, but other work as well.

And secondly, I think there have been some execution issues. We did make a management change in that area recently, and I think with time we will see some better execution in that area.

Unidentified Speaker

Third question. Staying with the mobile piece of the business, particularly the connected solutions, could you talk to us about how you’re monetizing those connected solutions and the value to the OEMs? There are some terrific statistics in your prepared text about the transactions being up 76%, but is that translating into monetization with those OEMs?

Paul Ricci

Yes, our monetization with OEMs is typically a payment for the technology and the connected service to the OEM and we have seen real rises in the OEM volumes using the connected service. But as you know, the connected service revenues are recognized over a period of time, so that will take some time to be realized. And that’s increasingly true in our automotive business as well.

Unidentified Speaker

I guess the follow up to that one would be as we get through this transition, how do you think this is going to make your offering stickier, for those OEMs, in differentiated versus a competitive alternative?

Paul Ricci

Well, in both the smartphone segment as well as the automotive segment, the solutions we create with the OEMs are done over a significant period of time based on very intensive engagement, and we’ve discussed this in previous calls. Some of these projects have many tens of engineers and researchers working on them, bringing out the initial solution and then refining that solution over a period of years.

And that solution, when it’s presented in the marketplace by the OEM, represents a user experience that that OEM is making part of its brand and its offering, and it’s a complex engineering engagement. And it’s not trivial to switch that solution, so in order to displace us, someone will have to come along with technology that is comparable or superior to our core technology. That’s difficult to do, and able to build a better experience, a better capability, while preserving the continuity of the existing experience. That’s a very hard task to do.

So we don’t take our large OEM customers for granted, we pour an extraordinary amount of money and time into serving their very demanding schedules and we’ve developed a very good reputation for doing that, a stellar reputation, in the automotive industry, which is the reason why we’ve really become a de facto standard for providing voice enabled solutions in the automotive industry, and a very strong reputation in the smartphone business as well, which is reflected in our market share for voice-enabled solutions there. I don’t think those will be easily displaced.

Operator

And the next question is from the line of Jeff Van Rhee of Craig-Hallum.

Jeff Van Rhee - Craig-Hallum

First, would you just, from a high level, as you look at the transcription business and the EMR erosion, if you will, of the transcription market as it used to be, now that you’re a little further into that transition, are you better able to quantify the impact and what it means on an apples to apples basis for a customer, namely spend was X, and in the EMR paradigm, if you will, it’s going to be X% of the original number? Have you been able to dial that in any better?

Paul Ricci

There are a lot of factors at work in the dynamics in the healthcare on demand business, but the actual EMR erosion itself does seem to have stabilized, and it’s in the low to mid-single digits annually, would appear to be the number we are seeing right now.

Jeff Van Rhee - Craig-Hallum

As it relates to the bookings guidance, could you narrow it at all to whatever degree you’re comfortable in terms of what you think the mix will be within that bookings number, [unintelligible] versus cloud, or probably just in that respect?

Paul Ricci

I think I can give you some indication of where we’re expecting strength over the balance of the year. We’re looking for continued performance in bookings in our automotive business, particularly the connected solutions. We expect an acceleration of bookings in the later part of this year in certain parts of our healthcare business. We should note that the migration from perpetual to term in certain parts of our healthcare is of course having a positive influence on our bookings, as I think we noted in the prepared remarks.

We had a very strong first quarter in the enterprise on demand, so we may not see a growth in performance throughout the next couple of quarters in that, but there are other parts of the business, particularly professional services and licensing there, where we’re expecting better performance for the remainder of the year.

And I think those are probably the main areas. Oh, some improved performance, I’m sorry, in the other parts of mobile as well.

Jeff Van Rhee - Craig-Hallum

And then third, just back to the mobile profitability. The segment contribution had been running somewhere in the mid $30 million per quarter. This quarter, it dipped down to $13 million. I heard you touch on it a few times, but I couldn’t pick out what in there would have accounted for the step function move there. Could you just revisit that for me?

Paul Ricci

Part of your question got garbled. The question was specifically about the mobile profit margin?

Jeff Van Rhee - Craig-Hallum

Yeah, the absolute dollars of profit had been running in the mid-$30 million per quarter, and then dipped to $13 million this quarter. And I heard some of the explanations, but I’m looking for something that maybe explains a little more of the step function drop, if you could just sort of tease out what was the really important part of the impact to the margins for mobile?

Paul Ricci

In addition to the migration from license revenues to connected revenues that I mentioned earlier, there are three big expense items in that business. One is the cost of the cloud-based infrastructure. Those costs have gone up substantially. We are working on trying to ameliorate those costs and reduce the growth in expenses there, as I referenced earlier.

The second is the implementation costs around some of these large [questioners]. One of your colleagues asked environment about the stickiness of our business, and I responded that part of the stickiness of our business has to do with complexity of the integration of our solutions and the amount of focus work we do with OEMs in developing these next generation solutions. Those are very expensive services, and a good part of them, a substantial part of them, are hitting in period. And we have to meet our commitments and therefore there’s been expense growth related to that.

And third, there’s been substantial growth in R&D related to just building out this next-generation virtual assistant solutions.

As I said, those have weighted, as you noted, on the mobile margin, and we did bring, beginning in this quarter, I think, a better focus on how we can limit some of the expense growth and economize in some of the slower growth areas. And I think as we look out over the remainder of fiscal ’14, we’ll see some improvements in the mobile business as we bring those productivity initiatives to bear there.

Operator

And the next question comes from the line of Tavis McCourt of Raymond James.

Tavis McCourt - Raymond James

If we take the Q1 revenues and the Q2 revenue guidance, obviously you’re calling for a pretty decent acceleration in the back two quarters of the year. And I was wondering if you could talk about should we think about that being broad-based across all the segments? Or is there a specific segment or two where you have visibility for year over year growth organically improving meaningfully in the back half of the year?

And my second question was you mentioned Intel in your mobile commentary, and Intel’s talked a lot about offline speech recognition now, baking it onto chips. And I was wondering if you could talk about your thoughts on that. Is that an area where Nuance’s technology would have value? Would you see potentially a time down the road where this trend toward the cloud and mobile reverses and goes back to the devices? Or is this kind of a one-off type solution?

Paul Ricci

I think there are two pretty separate questions, so we’ll try and take them in turn. On the first one, there is a section in the prepared remarks that talks about where we anticipate some of the growth in the second half of the year. The bookings in the first half of the year will, the conversion of bookings to revenue, will provide us some growth in the second half of the year.

Also in the prepared remarks there’s reference to a number of product launches mentioned, and those product launches are assumed to yield results in the second half of the year. We do have a belief that our enterprise licensing business will show stronger performance in the back half of the year. We should also mention that there are some modest acquisitions, primarily in healthcare, that are in flight, that will make some contribution in the back half of the year.

To your second question, on the Intel matter, with Intel, we have been building both a solution that is embedded and sold in the device with Intel’s chip, as well as a cloud-based solution. I think it is correct, what you say. I don’t want to speak for Intel, but I believe it is correct that they anticipate the hybrid of those two solutions’ impact will be important as computing power at the device continues to grow, and we agree with that.

That hybrid solution has been important in other markets for us, particularly in the automotive market, where there’s interest in having both local speech processing and cloud-based solutions. So I think that is correct.

Operator

[Operator instructions.] You have a question from the line of Scott Zeller of Needham & Company.

Scott Zeller - Needham & Company

Another question on mobile and consumer. Could you tell us in broad terms what the largest driver of revenues and bookings is in that group? Could it be auto at this point? Have they moved ahead of mobile?

Paul Ricci

I think within the mobile business, it’s reasonable for you to think of the automotive segment and the smartphone segment as being roughly comparable in size at this point.

Operator

And the final question is from the line of Daniel Ives of FBR.

Daniel Ives - FBR

Just more of a high level question. Just talk to me about how conversations have changed with customers maybe over the last three to six months. Maybe just compare internally how things feel going into this calendar ’14 versus even a year ago. That would be helpful just from a high level.

Paul Ricci

If you could just clarify when you say conversations with customers, you mean the interest in our solutions in particular?

Daniel Ives - FBR

Exactly. Just interest, maybe going from kicking the tires phase to actually signing deals, more along those lines.

Paul Ricci

Well, let me make a few comments. Within mobile, of course, I mentioned the intense interest that was manifest at CES, and that over the last year, and certainly over the last couple of quarters, has resulted in a number of important bookings for us. I’ve referenced the automotive segment, which continues to perform unabated in the strength of its bookings in particular.

In healthcare, we struck out on a reasonably ambitious agenda for an adjacent market related to our Clintegrity solutions, and we’ve begun citing numbers for a number of sales and bookings in Clintegrity. And at the same time, we’ve also mentioned the ongoing interest around Dragon medical, which has been extremely active in the healthcare segment. There’s a great deal of intensity in the healthcare industry around the Dragon product line, and somewhat smaller but still quite strong for us has been the diagnostics business.

In enterprise, we’ve seen renewed interest in our on demand business, in the last couple of quarters, and that’s been gratifying for us. And the pipeline in some of our newer products, particularly our voice biometrics product, appears quite promising, and we’ll see how that plays out over the balance of this year.

Operator

Thank you, and back to you, gentlemen, for closing remarks.

Paul Ricci

Well, we want to thank you all again for joining us this quarter, and we look forward to speaking to you again next quarter. Take care.

Operator

Okay, thank you. And lag, this conference will be made available for replay after 7 o’clock p.m. today, through March 3, at midnight. You may access the AT&T executive replay system at any time by dialing 1-800-475-6701, entering the access code 316887. International participants dial 320-365-3844. And again, that access is 316887.

And that does conclude our conference for today. Thank you for your participation.

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