Nuance Communications Deserves a Spot on Your Watch List

 |  Includes: NUAN, SSNLF
by: Ted Stamas

Nuance Communications (NASDAQ:NUAN) had an agenda the past seven years. That agenda was to spearhead its push to be, by far, the leader in speech recognition technology. Nuance was successful, but not without some sacrifices. Because of the many costs incurred by making acquisitions of smaller companies to help solidify its position as market leader, the company hasn’t been able to quite put it together in regards to profits. This year Nuance is going from the red into the black and I want to take a look at it because its kind of disruptive technology puts it in the category of a sexy security. Given human nature, this could catapult the company to a much higher valuation level.

To the consumer, Nuance's technology is stealthily ubiquitous. Make a telephone call to Bank of America (NYSE:BAC), Citibank (NYSE:C), Disney (NYSE:DIS), FedEx (NYSE:FDX), United Airlines (NYSE:UAL) or Wells Fargo (NYSE:WFC) and you are interacting with Nuance voice-enabled technology. Dictate directions to a GPS device like a TomTom
(OTCPK:TMOAF) or a Garmin (NASDAQ:GRMN) and you are working with Nuance know how. Have a Bluetooth set-up in your automobile from the likes of Audi, BMW (BAMXY.PK), Ford (NYSE:F) or Mercedes Benz and again, those voice commands you utter are successful because of Nuance. Apple (NASDAQ:AAPL), HTC, LG Electronics, Nokia (NYSE:NOK), Samsung (OTC:SSNLF) and T-Mobile smartphones and, some tablets like the iPad, can use Nuance engineering for verbal prompts and speech to text solutions.

Besides its Consumer and Enterprise divisions, Nuance has also established beachheads in Imaging and HealthCare. In fact, the Healthcare segment constitutes 40% of revenues, while Consumer and Enterprise make up 26% each and Imaging is a distant 4th with 8%. ValueLine seems to feel that the Consumer and Mobile division will probably make or break the company in the next few years. I disagree. I believe the Healthcare unit will be a big boon to both the top and bottom lines and I'm going to explore this division in greater depth because it will be boosted by the HITECH Act and could sway investor psychology.

I've written about the HITECH Act in other postings and in order to not be redundant, will give you the condensed version. The HITECH Act is part of the US Government Stimulus Plan where almost $30 billion has been slotted to reimburse physicians and hospitals for adopting electronic health records (EHR) in their practices. With a current minuscule market penetration of 10%, the US Government's goal is to equip 90% of doctors with electronic health records by 2019. This digital divide with physicians is not from a lack of technical expertise, but from a belief that electronic health records, "slow them down and don't achieve a measurable financial impact.", according to a recent Wall Street Journal article. That's where Nuance comes in.

Nuance's speech recognition products dovetail with most, if not all, of the main players in the EHR space. Companies such as Cerner (NASDAQ:CERN), Allscripts Healthcare (NASDAQ:MDRX) and Epic utilize Nuance technologies that are currently in use at The Cleveland Clinic, Department of Veterans Affairs, The Mayo Clinic and the US Army. In addition, Nuance and Athenahealth (NASDAQ:ATHN) have recently partnered with a new platform to enable speech to text capabilities in the cloud computing space.

According to a 3/1/2011 article on PhysiciansMoneyDigest.Com, the Fallon Clinic in Worchester, MA, phased in Nuance's speech recognition products to interface with its EHR's and saved more than $7,000 annually per physician in transcription costs. With HMO's and medical insurance companies' iron grip on the Healthcare Industry, I would not be surprised if they insist on the adoption of voice enabling technologies to reduce costs and speed up patient processing. Adapting to Nuance's products will eventually be inevitable, like going from the telegraph to the telephone. Those who do not assimilate will be fighting the last war and be left behind.

With such a commanding lead in its industry, what could short-circuit Nuance's rise to prominence and make it hit the wall? The war chests of two of its rivals, Microsoft (NASDAQ:MSFT) and Google (NASDAQ:GOOG). Nuance may have a fight on its hands in regards to a turf battle, but I believe that because of its dominating position in the space, it would most likely be an acquisition target with the deep pockets of its two lagging, but, larger competitors, which covet its technology. After all, we're talking about going forward, not going back, and that's what speech recognition is all about.

The analyst circus in tow seems to be enamored with Nuance even though its shares have gained 300% in the last two years. Out of the 19 firms that cover the stock, 15 have a buy or strong buy recommendation on Nuance according to Yahoo Finance. It's a difficult stock to evaluate because it lacks an earnings history, which always makes my knees buckle a bit, but, there is a work around for that. That alternative solution is a free cash flow analysis as opposed to your more traditional P/E, PEG or Price/Sales Ratios.

From the research that I've done on security metrics, a good rule of thumb when looking for an inexpensive equity based on a Price/Cash Flow Ratio is to find one with a P/CF Ratio under 10. According to ValueLine, the Cash Flow/Share on Nuance is $.80 and with its shares trading at roughly $18, you get a P/CF ratio of 22.5. That's way out of my league. I'm not implying I would wait for the P/CF ratio to get down to 10, but at more than double that, it looks very expensive to me despite the great story behind it.

I know I'm on a tightrope with the message that I believe we are due for a serious market correction, which is why I'm hesitant to put money to work at this juncture. I am certainly keeping an eye on stocks like Nuance and including them on my watch list for investment opportunities under much more favorable conditions. If you are in the Bull's camp, then by all means knock yourself out and maybe make a wager on something with a very bright future like Nuance. Personally, I'm going to sit this one out and wait.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am short the market with inverse ETF's.