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Summary

  • Nuance Communications is up strongly this year, but its financials tell another story.
  • High executive compensation and threat from Apple can take Nuance down in the future.
  • Nuance has a weak balance sheet, and its bottom line isn't expected to improve at a solid rate either, making the stock unattractive.

Voice and language solutions provider Nuance Communications (NASDAQ:NUAN), which provides technology for Apple's (NASDAQ:AAPL) Siri, was soaring recently, after The Wall Street Journal reported that the company is exploring a possible sale of the company. WSJ cited "people familiar with the matter" as its source for the news, and this sent Nuance shares close to 52-week highs. However, I think that investors shouldn't buy into Nuance on the basis of this speculation, as not all is going well for Nuance. As such, if the rumor doesn't turn into reality, Nuance might give up its gains.

Weak financials

Nuance's results are the first red flag that an investor should watch out for. When the company announced second-quarter results, it reported non-GAAP revenue of $490 million, compared to $484 million in the year-ago period. However, despite an increase in revenue, its non-GAAP net income declined to $88.3 million, or $0.28 per diluted share, compared to non-GAAP net income of $110.4 million, or $0.34 per diluted share, in the prior-year period.

The reason behind this drop in earnings can be attributed to high executive compensation that Nuance executives generally take home. As pointed out by Seeking Alpha writer Andrew Lim in his Pro article back in March, Nuance execs take home a whopping 90% of its operating income. As such, it is not surprising to see why Nuance is still not profitable on a GAAP basis, and even its non-GAAP net income is now declining, due to a drop in operating margins. In fact, in the last quarter, Nuance's operating margin was 23.9%, down from 29.1% in the year-ago quarter.

Apple's threat

On the other hand, Nuance is in danger of facing competition from Apple, which is its customer right now. Nuance supplies the technology for Siri to Apple, but it has been reported that Apple is developing an in-house solution. As reported by The Next Web:

"We may now know why Apple quietly set up shop in Boston earlier this year, if a report from Xconomy is to be believed. According to the site, Apple is developing a team of top speech technologists in Boston to eventually eliminate its dependence on Nuance for Siri.

The likelihood of this is actually extremely high - we've illustrated why below.

As a reminder, Nuance is the Boston-based multinational software maker which powers Apple's voice recognition feature in Siri. Nuance has recently seen at least two of its speech scientists leave the company and join Apple. In other words, Apple is pulling talent from Nuance and putting them to work in its own backyard.

Currently, as Xconomy details, Apple's Boston team publicly includes former Nuance employee Gunnar Evermann, who has a history of developing speech recognition technology; Larry Gillick, whose title is "Chief Speech Scientist, Siri at Apple;" and Don McAllaster, another ex-Nuance employee whose title at Apple is simply "Senior Research Scientist." There are also a handful of other former Nuance employees currently at Apple, but not based in Boston, including Caroline Labrecque and Rongqing Huang."

So, it looks like Nuance is in danger of losing a client such as Apple going forward. So, in case the rumors regarding a sale of the company do not materialize, Nuance will be a risky bet.

Some positives

However, there are some positives for Nuance bulls. The company increased its bookings by 43% from the same quarter last year to $638 million in Q2, and exceeded its 15% annual bookings growth guidance in Q1. However, the caveat is that these bookings in the second quarter were a result of several deals that happened earlier in the year than originally anticipated, including one large connected service deal in the automotive market.

In addition, Oracle (NYSE:ORCL) has chosen Nuance's voice and language solutions for its portfolio of mobile apps. Through this agreement, Oracle will use Nuance Cloud Services to add speech recognition and synthesis to certain mobile apps that support Oracle applications.

Weak fundamentals

But, the positives are brief in nature. A closer look at Nuance's fundamentals and earnings growth projections will give investors a reason to worry. Nuance has a weak balance sheet, with cash of $809 million and a massive debt of $2.37 billion. The company's current ratio is also weak, at 1.67. Also, for the next five years, analysts expect Nuance's earnings to grow at a CAGR of just 0.76%. Considering that the company's bottom line got worse in the previous quarter, Nuance doesn't look like a good buy.

Conclusion

Nuance shares have done well this year, but the performance might not be sustainable. Moreover, investors shouldn't buy the stock on the basis of speculation. Nuance is trading at its 52-week high and has weak fundamentals, while its financial performance isn't up to the mark as well. So, it would be a wise idea for investors to stay clear of this stock.

Source: Apple's Threat And High Executive Compensation Make Nuance A Bad Buy