Introduction/Financial Highlights of the quarter
February 9th as it happens is the anniversary of the lowest temperature ever seen in Boston, Nuance's (NASDAQ:NUAN) hometown - it was -18F on February 9th, 1934. It was quite a bit warmer for Nuance and its shareholders in the wake of another quarterly beat and another raise in earnings guidance. In terms of the overall highlights of the quarter, operating margins continued their long-term improvement and were 660 bps higher than in the year earlier period. Bookings rose 7% in constant currency, deferred revenues were up by 18% and operating cash flow was $141 million, up 48% from the year earlier period and 125% of non-GAAP net income. The strength in operating cash flow was partially a function of a slightly better than anticipated level of perpetual licenses. In addition, the company continued to enjoy a continued reduction in DSO as revenues coming from multi-year agreements that are collected more or less automatically on a monthly basis continue to rise. It is not, I believe, really feasible for Nuance to continue to realize such a favorable ratio of cash flow to non-GAAP net income over an extended period.
I had suggested in an article published on the Seeking Alpha site earlier this year that Nuance was on the cusp of a breakout in both its operating performance and concomitantly its share price. The results published by the company this afternoon validate the thesis that the company is making steady progress in terms of restoring a highly profitable business model, in developing a consistent revenue growth environment for its solutions and for migrating the company's business model such that revenues are more predictable and recurring than in the past. The share price - well the best one can suggest that it is still a work in progress.
One factor that has continued to weigh on the company's booking performance is the continued decline in the company's medical transcription business. Many people don't realize just how big a transition that has been for the company to go through. At one time, the company was getting close to 40% of its revenues from medical transcription which is not now and is unlikely to be a growth business over the long term. At this point, the company's medical software solutions are now equal to its transcription business and are growing faster than transcription revenues are shrinking. If there was one surprise in the details of this call it was that the CEO suggested that there were growth opportunities he saw in medical transcription and he expected that these opportunities would surface in the balance of the year. From my own understanding of the numbers, if medical transcription revenues actually grow, or even if they stop declining for a while, Nuance will significantly overachieve the guidance it gave which is for just over $2 billion of revenues and non-GAAP EPS of $1.46 at the mid-point of the guidance range.
In listening to the course of many calls from many different management teams over the years, one imagines developing a skill set in understanding the commentary of different executive groups. If I were to attempt to analyze the most surprising macro-comment made by CEO Paul Ricci it was his reasonably direct assertion that macro-trends in the global economy had not hurt the current performance for this company and were not expected to hurt performance for the balance of the current fiscal year. He called out two wins this past quarter in the financial services vertical - at Citi and at Banamex - as examples of users signing up for new initiatives - in these cases in voice biometrics - regardless of their own operating performance. He went on to suggest that the revenue model of the company, with such a large mix of recurring revenues, was somewhat immune to cyclical perturbation and that healthcare IT was more or less not correlated to trends in the broader economy.
In my recollection, Paul Ricci is not in the habit of going out of his way to reassure investors - the contrary is more true most of the time. I was quite surprised by just how assertive Mr. Ricci chose to be regarding his confidence in the presented outlook and reading between his lines, one would reasonably conclude that he is looking for significantly stronger percentage bookings growth at some point during the balance of this fiscal year. Despite his enthusiasm, I would point out that it is more or less impossible that the company will be able to substantially grow its fiscal 2016 bookings metric when compared against the prior year which included an extraordinary level of bookings in the automotive sector that will be recognized as revenue over the next several years.
Nuance shares seem to be in a netherworld where they command little to no respect on the part of investors. Although the shares are up by 24% over the past year, they peaked in early December and are down more than 20% since that time. Lots of that is a function of the very weak market for tech stocks over the past couple of months. But I believe that part of that is doubtless, the general lack of effort on the part of the CEO to propitiate investors. For a company of its size, this business does as little as possible to try to communicate its message - giving analysts 30 minutes to ask questions four times a year is probably not a tactic designed to encourage much in the way of recommendations. The low point in that regard was Mr. Ricci's answer to a question about competition - he averred that it hadn't changed much - case closed, next case.
For the record and using after-hours prices, Nuance shares are now selling at a bit less than 12X earnings. In the past 12 months the company generated total cash flow of $525 million and free cash flow of about $460 million. As I have written, the current ratio of cash flow to net income is not likely sustainable indefinitely at the moment, the shares sell for 15.2X free cash flow. Again, based on after-hours prices, the company has an EV/S of about 3.5X. About 30% of the operating cash flow is a product of stock-based compensation. That is down from almost 50% in the year earlier quarter.
Because of the company's transition and its steady but uneven trend to cloud and subscription revenues, it is somewhat difficult to compare valuation metrics for Nuance to many other companies. It is almost impossible to try to reconcile all of the financial metrics that are provided to some objective standard of growth. As I pointed out in my initial report, a significant amount of growth is masked in the first couple of years after bookings, when the bookings primarily result in revenues that are recognized ratably either in a SaaS or subscription model. That being said, using the least controversial of the various growth metrics, constant currency booking, and adding to that some of the specific comments on this evening conference call and looking at the P/E and the relationship of market cap to free cash flow suggests that the shares, particularly in the wake of their 12% pullback since the start of this year, have significant upside. For what it is worth, the average price target of the nine analysts who cover the shares is $23-33% greater than the after-hours quote. It is conceivable in the wake of the company's performance, its guidance and its commentary that estimates will float up a bit and that price targets will tend to be revised upward, of course depending on the performance in the rest of the market.
Specific Growth Drivers
One of the particularly important demand drivers for Nuance at this point is something called voice biometrics. Currently, market research suggests most mobile users feel the need to reset their passwords every month. In addition, market research suggests that 85% of users, including this writer, are frustrated with existing authentication technology - I think the word frustrated is in lieu of something a fair bit stronger. In total, 90% of users prefer voice biometrics over the status quo and allegedly corporations can save $15,000 per user over a three-year span by switching to the new technology. I think that if anyone has ever lost their PIN or forgotten the answers to backup security questions, the advantages of voice are obvious.
It appears that 2016 is going to be a year in which voice biometric solutions become standard and most corporations and government agencies are going to have to adopt the technology or face trying to work with a degraded user experience. I'm not sure, because management doesn't break out results with this kind of granularity, but it seems conceivable that some of the voice biometric contracts can be as large in dollars as the automotive contracts that have recently animated enterprise bookings growth. While Nuance obviously charges much more per car for its voice solutions than it can possibly charge for user authentication products, banks and other institutions have many times the number of authentications to process than there are cars to equip with voice. Indeed, at some point, voice biometrics will come to cars, I'm told, where voice is used in lieu of keys to open and start cars. (That hasn't happened yet but I believe it is supposed to be one of the on-deck innovations in the near future.)
One of the other products that is propelling bookings growth is called Clintegrity 360 which is perhaps the core offering of Nuance Medical. For some years there have been standard codes that are used to document elements of patient care. The codes are necessary for patient billing, of course, and in the long run the use of these codes is supposed to improve patient care and lead to better results for patients. The writer is dubious about that later point - but not dubious at all about how Clintegrity is going to improve the accuracy and timeliness of patient billing and reimbursement to healthcare providers. It is hard to believe, but apparently the latest ICD-10 medical coding standards have 8 times the number of codes compared to the current ICD-9 standard. Simply put, what was awkward and cumbersome heretofore will now be completely infeasible for hospitals and doctors unless they use automated software solutions to read and translate electronic clinical documentation into these new codes. Nuance has something that is called a Clinical Understanding (CLU) engine that is intelligent enough to dramatically reduce errors and of course speed up the manual processes that are swamping hospital administration. Replacing hand coding with an automated process is often a long-term sell, but according to Nuance management, the tipping point has been reached here and the growth in absolute dollars of the Clintegrity solution is starting to overcome the revenue decline in the company's medical transcription business. It would be helpful, to be sure, if management chose to provide observers with just a little quantification beyond what I just wrote, my impression from anecdotal sources is that Clintegrity deals are starting to become very large and very pervasive and users are accepting the Nuance CLU as a standard.
It probably sounds very dull and mundane to read about Clintegrity and how it is automating hospital coding and speeding up billing when compared to the far sexier medical diagnostics that IBM (NYSE:IBM) sells using Watson. On the other hand, hospitals these days are all about billing and getting reimbursed and this is one of the better ways to achieve that goal.
Overall, management has guided to bookings growth for the current fiscal year of 2-5% at current exchange rates and a bit higher in terms of constant currency. I think it is likely that Nuance might have a breakthrough year in bookings based on the strength it appears to be experiencing with both its Clintegrity and its voice biometric solutions and the intriguing comment of Mr. Ricci about opportunities to sell more medical transcription services.
Nuance reported another quarter of upside encompassing both revenues, earnings and operating cash flow. Deferred revenues, up 18% year over year, suggested that the company is building greater visibility than has heretofore been the case. The company has achieved another quarter of strong margin growth and margins may well have another leg of expansion beyond those forecast by management based on its current $125 million cost transformation program.
Of particular interest to this observer were management comments regarding visibility and immunity from cyclical perturbations that have roiled shareholders in many sectors and particularly in tech in recent months. Needless to say the company CEO is not an oracle whose vision on macro correlation to company performance can be accepted without a bit of skepticism, but it was interesting to hear this executive avoid the excuse taken by many peers in other companies when reporting the current quarter and providing his outlook for the balance of the year.
The combination of share price declines and improving operating performance has I believe led to a very favorable entry point for investors. Nuance shares have not been deep value since the days of the company's perceived liquidity crisis back during the Great Recession. But nowadays, the company's improving financials coupled with growth that has been masked from investors by the company's transition to a recurring model presents a very favorable and underappreciated combination of risk and rewards for investors.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.