Looking Beyond Nuance's Transition Pains

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 |  About: Nuance Communications, Inc. (NUAN)
by: Anup Singh

Summary

Nuance Communications is struggling, as the company is going for a change of the business model.

However, Nuance should see more predictable revenue streams in the future as a result of its business model change.

Nuance's latest innovations are clicking well, allowing the company to pen new deals.

Nuance's bottom line is expected to grow at a faster rate in the coming five years than the last five.

Speech recognition specialist Nuance Communications (NASDAQ:NUAN) started the year brightly, but the stock seems to have hit a speed bump after reporting its third-quarter results. Nuance reported weak numbers for the third quarter on account of rising costs and a transition in its business model.

A weak performance

The numbers were not only below Street expectations, but also down on a year-over-year basis. In addition, management gave a weak outlook. Consequently, its stock has declined around 5% since its results were released on August 11.

Nuance's adjusted revenue for the quarter came in at $486.81 million, which is marginally less than $490.8 million in the year-ago period. Its non-GAAP net income also fell to $87.6 million from $109.5 million last year. On a GAAP basis, its net loss widened to $54.2 million from $35 million last year. In addition, its operating margin declined to 23.5% from 28.1% in the same period last year.

Hence, Nuance struggled last quarter. But now, the question is, will Nuance get better in the future?

Transition pains

The numbers in the previous quarter were, no doubt, not up to the mark. Nuance, however, is undergoing a transition from traditional software license sales to a subscription-based business model. In the former model, the company used to get instant revenue when the product was sold. However, in a subscription based model, the payment from customers is spread over the entire period of its use. In the long run, this model might be more beneficial, as it ensures more predictable and recurring source of revenue.

But, the problem is that management has not clearly revealed the entire proceedings of the model shift and there are a lot of grey areas, which the investors are not fully aware of. According to Canaccord Genuity's Richard Davis, "Nuance seems to be a riddle wrapped in a mystery inside an enigma."

Positive indicators

But apart from these headwinds, Nuance has certain deals that could fuel its growth in the coming days. China Mobile (NYSE:CHL) has leveraged Nuance's speech technology to provide better support and service to its callers, who previously had to listen to a series of phone menus, which were quite confusing. According to a Nuance release:

Together with partner Huawei, Nuance has created a more natural and intuitive customer experience for China Mobile Jiangsu Branch, replacing their phone menu trees with a conversational speech interface that saves customers time and increases call routing accuracy. Whatever their request, Jiangsu Mobile customers can simply speak naturally to receive fast and convenient assistance.
The newly-launched NLU interactive voice response (IVR) Call Steering system - the first of its kind in China - offers people the opportunity to get what they need quickly and easily when they contact China Mobile Jiangsu Branch over the phone.

This customer win is a testament to Nuance's strong product development, and since it is being used by China Mobile, which is among the world's biggest telecom companies, it can be expected that the company might land more such deals going forward

In addition, Nuance has also launched its new Dragon software that will allow PC users to convert voice messages into written text.

According to a report:

There are few areas in which Dragon 13 can't be used to good effect to speed the entry of text, but you don't have to be sitting in front of a PC to take advantage of its benefits. Dragon 13 Premium can also transcribe speech from audio files. These can be created on a personal recorder and there is a version of the product with a digital recorder in the box.
It's also possible to create a suitable file on just about any device that can make quality sound recordings. Applications available on Android devices and iPhones can be used to create speech files, which can then be copied onto a PC back at base and transcribed by Dragon 13 Premium.

Also, Nuance has incorporated various measures to reduce its expenses that enabled the company to reach the mid point of its earnings guidance during the third quarter. Management said:

We will sustain these expense initiatives in Q4 and into FY15 with the objective of delivering improved margins while also ensuring future growth in our key markets.

Yet, it will be too early to call this as a turnaround since management is not very optimistic about the near-term, and it consequently lowered its outlook. According to research firm FBR Capital Markets:

While the company posted healthy growth on the all-important bookings number, management lowered FY14 top-line guidance, as well as bottom-line guidance, despite an ongoing focus on cost controls.

Conclusion

Currently, Nuance does not have any signs of a trailing P/E because it is incurring losses. However, its forward P/E seems attractive at 14.33, which shows that its bottom line will improve in the future. Moreover, its business is undergoing a transition period, because of which it facing various challenges. But once the transition is complete, investors can expect a steady flow of revenue in accordance with its new business model.

Because of a poor set of numbers during the previous quarter, Nuance's share price has declined. But, over the next five years, its earnings are expected to improve at a CAGR of almost 10%, which is way better than the last five year's average of just 3.75%. So, investors should consider capitalizing on Nuance's recent drop as the company's performance is expected to improve in the future.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.