Nuance Communications' (NUAN) Paul Ricci on Q4 2016 Results - Earnings Call Transcript

| About: Nuance Communications, (NUAN)

Nuance Communications Inc. (NASDAQ:NUAN)

Q4 2016 Earnings Conference Call

November 17, 2016 05:00 PM ET

Executives

Paul Ricci - Chairman and CEO

Dan Tempesta - CFO

Bruce Bowden - EVP of Corporate Strategy and Development

Richard Mack - VP of Corporate Marketing and Communications

Analysts

Brent Thill - UBS

Saket Kalia - Barclays Capital

Tavis McCourt - Raymond James

Nandan Amladi - Deutsche Bank

Jeff Van Rhee - Craig Hallum

David Hynes - Canaccord

Josh Baer - Morgan Stanley

Parker Lane - Stifel Nicolaus

Operator

Ladies and gentlemen, thank you for standing by. And welcome to the Nuance's Fourth Quarter and Full Year Fiscal 2016 Conference Call. As a reminder, this conference is being recorded.

With us today from Nuance are Chairman and CEO, Paul Ricci; CFO, Dan Tempesta; EVP of Corporate Strategy and Development, Bruce Bowden; and Vice President of Corporate Marketing and Communications, Richard Mack.

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

Richard Mack

Thank you, Greg. Before we begin, I remind everyone our discussion this afternoon includes predictions, estimates, expectations and other forward-looking statements. These statements are subject to risks and uncertainties that could cause material difference in our actual results. Please refer to our recent SEC filings for a discussion of these risks.

All references to income statement results are non-GAAP unless otherwise stated. And as noted in our press release, we issued a set of prepared remarks in advance of this call, which are available on our Web site. Those remarks are intended to serve in place of extended formal comments, and we will not repeat them here.

I will now turn the call over to Paul.

Paul Ricci

Good afternoon, everyone. Before taking your questions, I'd like to discuss three key highlights from our earnings report, and a couple of updates that we announced today.

First, we delivered a strong fourth quarter and end to our fiscal year with excellent performance and momentum. We delivered record net new bookings for the quarter and year, up 45% compared to Q4 '15, and up 4% year-over-year compared to fiscal year '15. We reported quarterly revenue of $512.4 million with solid contributions from each of our business segments. Recurring revenue increased to 70%, up 400 basis-points from fiscal year '15. Q4 non-GAAP operating margin improved by 50 basis points and non-GAAP EPS met the high end of our guidance range at $0.41. And we delivered full year record cash flows from our operations, up 16% from the prior year and at 125% of non-GAAP net income.

Second, we continued to strengthen our competitive position as we secure the significant wins across our business, advanced our offerings with new innovations, demonstrated benchmark superiority in our core technologies and won several industry awards. In Healthcare, we achieved our highest net new bookings in the quarter, had notable wins with marquee accounts and introduced Dragon Medical Advisor, a new AI-assisted offering for physicians.

In Mobile, we delivered significant wins in automotive and Dragon TV and also won a prestigious BMW Supplier Innovation award that recognizes the impact we have on innovation in this business segment. In Enterprise, we also achieved record net new bookings in revenue, delivering our best year yet with notable growth in our voice biometrics business line and improved performance in our contact center solutions. And in Imaging, we continued to advance our product portfolio, strengthened our service capabilities, and further positioned the business to benefit from the transition in the MFP industry.

Overall, we delivered impressive performance, which leads to me to our third point that we expect to return to organic revenue growth in fiscal year 2017. To start, we recognized this as an important milestone for the investment community and we're pleased with the trends we've discussed in recent years; namely, bookings growth; the compounding effect of recurring revenue; and general market strength, have come to fruition and will serve as growth catalyst for 2017.

We expect our growth businesses such as automotive, voice biometrics, omni-channel customer care, unified print and scan solutions, Dragon Medical, CDI and diagnostics, to outpace our few declining businesses and lead to approximately 1% organic growth in fiscal 2017. Recurring revenues will approach 73%. In addition, continuing our prior year momentum, we expect net new bookings to grow in the range of 2% to 6% led most notably by our Enterprise and Healthcare divisions. But the partners of those bookings will be for hosted and other recurring revenue solutions, and will drive improving growth in FY17, and FY18.

And finally, we continue our transformation program with further cost initiatives that will enable investments in key growth businesses, yet still maintain gross margins and operating margins similar to FY16 levels. You will note that in our prepared remarks we also provided some preliminary guidance for FY18. Given the increasing consistency of our business trends, we're able to speak more confidently about our expectations for the following year. Our growing license revenue streams will offset any further decline in our handset license business. At the same time, we will see even more substantial growth in our hosted revenue lines, and particularly our Dragon Medical, enterprise cloud, mobile cloud and connected car offerings. As a result, we expect even stronger bookings, revenue and profit growth in FY18 as indicated in our prepared remarks.

Now, as we begin the new fiscal year, we also made two other announcements today. First, we announced that Bill Robbins, who's led our global sales organization for the last three years, will be leaving the Company. Bill and I have discussed for sometime the eventual evolution of our sales organization as part of our transformation to a divisional structure. This change will further strengthen the responsibility and accountability of our four business divisions.

Supporting that, last year we aligned our global sales leaders with each of the four businesses. Bill and I agreed the final stage of this evolution was to integrate the sales team directly into their respective divisions. Bill has done a tremendous job leading our sales organization and preparing us for this transition by driving close collaboration across our sales and divisional teams. I want to thank him most sincerely for his many contributions.

The second announcement we made today was that the Board of Directors has extended my contract through March 2018. And then I’ve advised the Board that at the end of that period, I intend to retire. I've had the privilege of leading this Company for more than 16 years. But having turned 60 recently, I concluded that it was time to plan more concretely for the next generation of leadership. By March of 2018, we will substantially be through our Nuance next transformation, which will provide a solid foundation for my successor. The Board will select, by the end of my term, a candidate who will continue our momentum driving innovation and delivering value for shareholders, customers and our employees in this fast paced market.

For the next 16 months though, I intend to stay focused and to commit all my energy to accelerating the agenda we've articulated in recent quarters, which is; first, enhancing customer engagements through additional investments in sales, services and vertical market expertise; elevating our growth by intensifying focus on our most promising business lines; expanding our solutions with new innovations based on AI and cognitive computing technologies; accelerating our transition to recurring revenue models; and maintaining our discipline in cost and investment.

We’ve made substantial progress in these areas to-date. I'm confident in our ability to achieve these objectives and to position Nuance for a future of growth, value, innovation and customer success. And we are now happy to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Brent Thill with UBS. Please go ahead, your line is open.

Brent Thill

I had a question regarding the organic growth. Last year, you had aspirations to be organically positive in terms of the growth. I think this year, you were negative too. Can you just walk though some of the headwinds that you saw this year that you may think that turn to tailwinds as we going to next fiscal year?

Paul Ricci

So just to be clear, I think you're asking about the headwinds we faced in '16 that will be newly rated in '17.

Brent Thill

Correct.

Paul Ricci

I think the most important thing to remember is that our growing revenue streams, which were growing throughout '16, are now becoming powerful enough to offset our decline in revenue streams, which themselves are diminishing as they've gotten smaller. So, the impact of our transcription revenue losses in '17, for example, are less than they were in '16; the impact of our handset revenue declines in '17 are less than they were in '16.

Meanwhile, we have contributions from the streams that I talked about previously, including the Dragon Medical cloud, CDI, our Enterprise business, which is perform in robustly across the board and contribution, of course, from our Mobile automotive business, which has been a stellar performer for us.

Brent Thill

And when you look at this year, it was a really back-end loaded year in terms your contract value-add. What do you think drove such a back-end loaded year? And do you believe that as we go into next year that that may be slightly more linear than it was this year?

Paul Ricci

I think we have to acknowledge that because of our fiscal year ending September 30th, we have more unnatural summer season, the high seasonality, than perhaps we projected. There are lots of factors that contribute into that. But of course it includes performance incentives and in our filed organization. On top of that, I do think we saw increased momentum in a couple of key areas as we completed the year. First, our Dragon cloud business had a remarkable bookings performance in the last quarter, may be even a bit more than just the last quarter of the year, remarkable performance.

Our Enterprise business had very strong bookings. And our automotive business, which we've been talking about all-year long, finished the year much more robustly that we expected and what we anticipated was already a good year. So I think the investments we’ve made in the business over the course of '15 to '16, we talked repeatedly to you all about focusing our investments on our growth businesses. I think, we saw some performed -- we saw some results from that and particularly in the bookings line as we completed FY16.

Operator

Next we turn to the line of Saket Kalia with Barclays Capital. Please go ahead.

Saket Kalia

May be just to start first on the Healthcare business. Can you just talk about how much of a bookings driver or contributor, the Dragon Medical, plus transcription bundle was? And to the extent that it was an important driver. Can you just talk about rev rec behind that as well?

Paul Ricci

So, I can't quantify for you, because we just don't break out bookings with that level of granularity. I can say, indicatively, that Dragon Medical cloud was a significant bookings contributor. And the combined bundled solution that we've been offering in FY'16 was also a material contributor to the Healthcare bookings performance, and the Company's bookings performance. I think for the question of revenue recognition, I'm going to ask my colleague, Dan Tempesta, to comment.

Dan Tempesta

Sure. The Dragon Medical cloud is a SaaS based offering, service SaaS offering, and therefore comes in rateable on the hosted line over the term of service.

Saket Kalia

And that includes any sort of transcription volume, might which -- maybe before would be recognized based on lines, but now would be recognized as a subscription similar to Dragon Medical. Is that right, Dan?

Dan Tempesta

That's one way to do it. We still have Dragon Medical cloud by itself coming in over some period of time; we still have transcription coming in on a line basis; and then we do have combined offerings that might come-in in a fee-based approach, but all rateable over the service term.

Saket Kalia

And then for my follow-up, if I may. Can you just talk about how much TouchCommerce contributed this quarter, and revenue and net new bookings? And relatedly, the 100 bps of contribution in 2017, seems a little lower than the $70 million run rate that we originally expected. So what am I doing wrong there?

Paul Ricci

Two different questions, so let me see if I can take them in term. We don't break out acquisition revenues. It wasn't the material part of the overall revenue story for the fourth quarter of fiscal '16, either on a revenue line or bookings line. With respect to '17, what we've said previously in two closely linked announcements was that we expected in fiscal '17 to provide a couple of 100 basis-points of organic growth improvement. And then we commented separately that TouchCommerce acquisition would add about another 100 basis-points to that. And that in fact is what we're projecting for fiscal '17.

Saket Kalia

Right, but then the 100 bps on the revenue base would indicate slightly less of a TouchCommerce run rate than what we originally expected. Am I reading that right? Has something changed to the business? Or is there an accounting impact? Any color you can offer there would be helpful?

Dan Tempesta

I think you need to recall what our definition of organic growth is. And our definition of organic growth is that we had TouchCommerce for the previous year. So we say it in there their estimated previous revenues to calculate that100 basis-point improvement. Does that make sense?

Operator

And next we turn to line of Tavis McCourt with Raymond James. Please go ahead.

Tavis McCourt

I've got two or three. First, in the prepared comments within the auto bookings, you referred to time Daimler, Ford and BMW. I think you had announced BMW earlier in the year. Were Ford and Daimler new deals this quarter, or were they booked earlier in the year?

Paul Ricci

We had Daimler and Ford bookings in the fourth quarter. I'm not sure if we had BMW bookings in the fourth quarter or not, I don't recall precisely what the prepared remarks said.

Tavis McCourt

And then a competitive question on two fronts. First, with Amazon and Query, I don't know if Google has or not, kind of opening up APIs for their speech engine. Do you see any competition from start-ups that are using that as a beach back in to compete with you in some of your verticals? Or do you expect to see that in the future? I guess why or why not. And then there's a lot of -- IBM is obviously talking a lot about Watson these days, and specifically in relation to healthcare. Can you review your IBM relationship at this point? I know there were some transactions a few years back. Or is that a competitor, a friend, a little bit of both. A view on IBM as it relates to your business would be helpful. Thanks.

Paul Ricci

Well, with respect to the first question, I think the question you asked was do we anticipate seeing competition from start-ups based on publically available APIs for speech engines. And the answer to that will undoubtedly be yes. But, you have to remember the Nuance's business is in selling, providing solutions to large corporations, and global brands and healthcare institutions. We do that in very specific vertical markets with a great deal of domain expertise. And we do that as a trusted advisor to those companies with all the apparatus and infrastructure, and obligations that they insist upon to be that kind of advisor.

And it's just not easy for start-ups to compete in that respect. So I don't see that as a significant peril to us. We certainly have competition but we're just not seeing that kind of competition from start-ups based on these horizontal platforms. Your second question was related to Watson. I think, specifically Watson healthcare, I don't think that what IBM and Watson in healthcare is focused on is particularly relevant to the markets that Nuance is serving. Healthcare is a very large space. And I do think they're trying to solve other problems. I can't say too much about our current relationship really.

Operator

And next we turn to the line of Nandan Amladi with Deutsche Bank. Please go ahead.

Nandan Amladi

So Paul you've had quite a bit of executive turnover this past year. We have Head of the Healthcare business leave and now Bill Robbins. Are we done with the changes that you intend to make at least for the next six quarters, while you're still there?

Paul Ricci

I can't comment on future changes. I can -- I think I've discussed both of the changes so far. They were really driven by very different causes. But I can say we have an excellent management team. It's a highly engaged management team. And while I am not anticipating making changes in the near-term, I can speculate about what's six quarters would hold.

Nandan Amladi

Then a quick one on the realignment of the sales function within each division. Does that increase your overhead, or the complexity and the rate of the business around relative to where in the past perhaps it was more of a centralized function?

Paul Ricci

No, it hasn't been our experience that the centralizing response to an accountability increases overhead. In fact, it has been our experience that it drives efficiencies. And perhaps, more importantly, it drives speed and alignment and in the business that I just described in an answer to a previous question, speed of response and alignment in these deep customer engagements is really very important. And it's been an important enabling factor for success for Nuance. So I think this will simply increase the capabilities we have that have been driving that success.

Operator

Next we turn to the line of Jeff Van Rhee with Craig Hallum. Please go ahead.

Jeff Van Rhee

Just a follow-up on that one Paul, just to be clear with the change in sales leadership as the sales roles move down to sort of divisional responsibilities. Have all those changes essentially been communicated and are already in play, whether it's quarters territories, or any other meaningful changes? Or should we expect some fairly meaningful changes over the next quarter or two? And then secondly with respect to leverage, Paul, I believe I heard you say there is no leverage in terms of operating margin changes in '17. Just kind of some color I guess on how you think about leverage over the next few years. Should we start as a base line that its' going to be flat margins, or just how to think about that? Thank you.

Paul Ricci

Let's see, on your first question. I understand your question, and I am confident that this change really was a completion of sub transformations that Bill Robbins and I engineered together, and that he led. And I think there will be -- its clearly quite seamless transition in sales. It doesn’t represent refactoring the quarters or territories or anything like that. It really represents an alignment of his global sales leaders that were previously organized in to correspond with each of the four divisions. And more close alignment of those four global sales leaders with each of the respective divisions. So, the need that there is really no changes at all. And as I said, Bill has done terrific job of creating that alignment over the last year. Your second question about leverage, I think you're asking about operating margin leverage in ’16 and '17 and beyond. Is that right?

Jeff Van Rhee

Yes, that's correct.

Paul Ricci

So, I think we indicated in the various notes and comments that we were anticipating a flat to slight improvement in operating margins this year, perhaps 50 basis- points. And I think that we indicated that we would have similar, or slightly better, margins in '18 and that would provide leverage on a growing revenue base.

But we're trying to -- let me be clear. We're trying to be clear with you that we're, while we're taking cost out of the Company, we are putting them back in to key investment areas, so as to drive additional growth. And as we’ve what talked about in previous quarter or two, we believe that growth is the most -- is the best way to create additional shareholder value. And while we're taking costs out, we are making investments to correspond to those. And that's the reason for relatively limited margin expansion as we look into '17 and in '18.

Jeff Van Rhee

And then just one quick follow-up or actually two. Obviously, the organic growth is going to accelerate a bit here, that's the expectation. Sounds like some of the drags are lessening. But I guess I'm still a little unclear. If you look at the fundamental demand environment, is there anything you could call out that's notably improving in the end-market fundamental demand? And then just one brief one, you talked about one of your key objectives accelerating the transition to recurring. Just curious, if you flush that out a little bit. How far do we go in terms of recurring and how do you do that?

Paul Ricci

With respect to the question of fundamental demand, I think there are some markets where our demand is accelerating. A good example of that is automotive where there's clear enthusiasm for our solutions in a connected car world and in a world that is increasingly concerned about safety, and in the increasingly digital environment that the car presents. And there are also markets where our expanded product portfolio is simply allowing us to expand our business; a good example of that is the new product offerings that we have in our enterprise business; and for example in our contact center solutions business, in Enterprise. So I think there's a combination of those two. I’ve articulated previously what the drivers are for '17. But I think the combination of product investments that are paying off and in increased demand in some of the markets.

Jeff Van Rhee

And then just that last one in terms of you talked about one of your key objectives being accelerating the transition to recurring over the next -- until the end year [multiple speakers]?

Paul Ricci

So, I think we indicated that we will approach '17 3% this year. So I think that's about 3 percentage point improvement over '16. And you should expect further improvement in '18. We've indicated previously that in the current state of the business with the current mixture of businesses we have that we probably start to grow out some product in the upper 70s. So I think that gives you some indication of where we are in that journey.

And remember that when I commented previously on this, I said that over a longer period of time that asymptote may move up as technology evolves and market demand evolves. But I think given the current market situation and the current state of technological needs of our customers that as we approach the upper 70s, we're growing out some product to what we think is relatively more stable state.

Operator

And next we turn to the line of David Hynes with Canaccord. Please go ahead.

David Hynes

So Paul, last quarter you’ve alluded to several kind of $50 million bookings opportunities in the pipeline. Just with the strong bookings results. Was this an example, was this kind of a -- and everything broke right quarter, draining of the pipeline? Or do some of those large opportunities remain to be had?

Paul Ricci

Some of them do remain to be had. I don’t think it would be fair to say everything broke, but it would be reasonable to say we had an excellent quarter driven by year-end momentum. And we realized bookings that were not planned for the quarter based on the early interest of customers and the effectiveness of our sales organization of driving those bookings to completion.

But we enter '18 with an attractive pipeline for looking at bookings performance this year. And I’ll just remind you that we always caution that we think the market should look at bookings on an annual basis, not on a quarterly basis, remembering that we do have large bookings and they -- as they create regularities in any particular quarter. And so we encourage you to think about our bookings performance over a full-year.

David Hynes

And then a follow-up, with all the buzz around AI, as you think about the opportunity with artificial intelligence. How much of that opportunity we can capitalize on by internally developing vertical specific apps versus -- how much could come from third parties leveraging your SDK? Is that an important part of your AI strategy?

Paul Ricci

We will see some of both. I think that our primary emphasis is on the former, and that is expanding the envelope of our current solutions in specific vertical markets to be smarter, more anticipatory, capabilities that I articulated previously. And one that I mentioned today was our Dragon AI -- Dragon Assistant, which is a good example of our focus on building out solutions beyond speech and even beyond language to have other predictive capabilities that help add greater value to the users solution.

Operator

And next we turn to the line of Sanjit Singh with Morgan Stanley. Please go ahead.

Josh Baer

This is Josh Baer on for Sanjit. Congrats on a really strong quarter. But digging a little deeper into Healthcare, organic revenue declines accelerated a bit in the quarter. So I'm wondering when does growth in the transcription business reach a floor, or reach a bottom? And looking ahead FY17 Healthcare revenues are still expected to be down. So wondering when growth in Dragon Medical cloud, Dragon Medical Advisor starts offsetting the declines in transcription? When do you see a return to organic growth in Healthcare? Thanks.

Paul Ricci

Well, we've indicated previously that the basic transcription business will undergo continual erosion for the foreseeable future, driven by the combination of EMRs and Dragon Medical Solutions, which is replacing some amount of volume of transcription each year. What I indicated in the previous comments was the magnitude of that erosion in fiscal '17 is less than it was in fiscal '16. And our model suggests that it will be less yet in fiscal '18. So, we're seeing it diminishing contribution, we’re seeing a diminishing absolute contribution, negative contribution, to revenues from that. But it will be ongoing for the foreseeable future.

To the question of your overall point about the decline in revenues in Dragon Medical -- I mean, in Healthcare. Remember there is two contributory factors in '16 they continue into '17. And those are we have the transcription erosion, which as I said, lessens in '17. And we have the movement from Dragon perpetual licenses to Dragon cloud, which while creating terrific bookings is a negative contribution to revenue in '16, and in '17.

Having said that, as we go out of the back-half of '17 that reverses to be a positive contribution and the positive contribution is really quite historic in '18, because of the compiling volumes of subscriptions to the -- in the SaaS based Dragon cloud model. So we will see -- we should see as we’re trying to grow within Healthcare as we look at fiscal '18.

Operator

And our final question comes from the line of Tom Roderick with Stifel. Please go ahead, sir.

Parker Lane

Hi, it's actually Parker Lane in for Tom Roderick. Thanks for taking my question. I was just wondering as part of your continued transformation program, what segment or segments of your business you anticipate the greatest headcount turnover in '17? And whether or not the transformation program is isolated to '17, or do you expect that in '18 as well?

Paul Ricci

Well, I can’t comment on headcounts turnover by any specific business. I will say that, as I’ve talked about previously, there are many ways of reducing costs in the business, and many -- and most of them don't involve headcount, or that many of them don’t involve headcounts. So, we have a number of cost initiatives underway, which include consolidation of data centers, improve purchasing practices, and other things, that I've enumerated previously. But I can't really comment about specific headcount in any particular business.

Parker Lane

All right, thanks.

Paul Ricci

Okay. Then I think that is our last question and that brings us to the conclusion of this call. So, thank you very much. And we look forward to speaking to you again next quarter.

Operator

And ladies and gentlemen, the call is now complete. You may now disconnect.

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