Nuance - Blue Skies Or Stormy Weather?

| About: Nuance Communications, (NUAN)


Nuance reported the results of its fiscal 2016 last Thursday.

Results included a beat on EPS, a beat on revenue, and very strong performance on bookings.

The company raised guidance a bit, and introduced some elements of fiscal 2018 guidance.

The CEO announced he would retire in the middle of 2018.

NUAN's shares are modestly valued, and it is reasonable to believe that the company could finally unlock shareholder value through dismemberment.

Just how blue are the skies for Nuance?

Nuance (NASDAQ:NUAN) reported the results of its quarter and fiscal 2016 year-end last Thursday. Talk about saving the best for last, the company's results marked the end of the calendar Q3 reporting season, and based on the way I keep score, the results were the best relative to prior expectations of all of the companies that I track. Not on the headline numbers, although they were a modest beat, but on bookings, which were by far the best performance relative to expectations in the IT space last quarter. 45% growth in bookings is not something I expected, and I am still scratching my head at how it happened (Just kidding - the bookings result was because the company closed several major transactions that it had deliberately excluded from its forecast at the end of Q3 - it was year-end and closing large deals is a rite of passage for most software companies at the end of the year). The bookings overattainment was approximately $60 million or 13% above the company's forecast from August. The number of companies that beat revenue/bookings expectations by 13% at this scale are about equal to the number of times I have passed up a glass of a Chateau d'Yquem.

I do think I should mention that while the 45% growth in bookings was an exceptional number, bookings for the year wound up growing by about 4%. Investors do look at quarters, but sometimes seasonality is not fixed, and it would be a mistake to think that Nuance is going to reprise its bookings performance, at least in percentage terms, in the near future. It has provided a conservative set of expectations for the current year that could readily be exceeded,-but I think double-digit bookings growth is at least a year or two away; I imagine that the company's operating margins will continue to expand, but not at the rates seen in the recent past.

While Nuance's shares gratified holders for a change on Friday, appreciating almost 9%, this has been a very disappointing year for investors in this company. Indeed, while Friday saw positive share price action, the shares seem to have already run into resistance. Given the enormous overattainment in bookings, which are far more relevant than reported revenues in judging the company's long-term business health, the shares might have appreciated further…but then again, Nuance as a company has seen more false dawns than most other software vendors.

That being said, the conference call featured comments from the CEO which are worth quoting directly. Mr. Ricci has not been much of a cheerleader over the years, and so I think that the foregoing is quite relevant in marking out the likely progress for the company.

"You will note that in our prepared remarks we also provided some preliminary guidance for FY'18 (this is just the start of FY'17). Given the increasing consistency of our business trends, we are able to speak more confidently about our expectations for the following year.

Our growing license revenue streams (subscription revenues) 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 FY '18, as indicated in our prepared remarks."

I should remark that being confident about 3% growth is nothing to write home about; that said, this is Paul Ricci and Nuance, and one takes what one gets. I would suggest that the comments about stronger bookings, revenue and profit growth are a bit inconsistent with the specifics of the prepared call remarks and are more in tune with a greater expectation than the company was willing to publish.

Obviously, at this point, the preponderance of opinion does not believe that forecast, or anything like that forecast. I think I can fairly characterize the tenor of the conference call queries as dubious and tendentious. The shares of this company are priced at levels that belie expectations for any sustained growth. I myself, having waited to see a transition completed quarters ago, have a certain skepticism that the millennium has finally arrived. It really should have arrived long ago. And oh, yes, having had my patience tested to beyond the breaking point, I sold the shares a couple of months ago. Not the way one is supposed to invest.

What should investors do? I see many more positives than negatives. The company is having demonstrable competitive success with its newer technologies and the sins of the past are abating.

But the fact is, if the transition is winding down, as suggested both by the massive bookings overattainment and the comments the management has been willing to make, this is a very cheap name with plenty of upside. Given the current valuation discussed below, I think the shares are worthy of inclusion in a growth/risk portfolio, although I would be very price sensitive and buy a position over weeks and months. Most investors, institutional as well as retail, have had their patience sorely tested and are not sure Nuance is going to be a "show-me" investment for years to come, or at least until a new management is installed and evaluated.

The company's forecast despite the results in the past quarter is not greatly changed from the forecast it made in August. Organic growth of 1%, inorganic growth of 1% and operating margins that are flat year on year, including the acquisition of TouchCommerce. None of that is going to precipitate any additional changes in estimates or ratings, I believe. Investors buying the shares today are going to have to rely on the company continuing to out-execute or on the company selling a piece of itself. It is easier for me to see the later, but then hope springs eternal with regards to the former.

In the wake of the results and the guidance, Raymond James upped its rating on the shares from "outperform" to "strong buy" with a price target of $24. The average price target is just $20/share, and the average rating is between buy and hold. There is plenty of room for analysts to reverse their opinion.

Company guidance basically suggests that revenues will grow by 2% in the current year, one-third of which is organic and that operating margins will rise another 50 basis points. The revenue forecast incorporates the assumption that an additional 3% of revenues will transition from perpetual streams to subscription models (70% to 73%). In other words, the company's basic organic growth rate is expected to be 4% this coming year net of all of the puts and the takes. The new sales forecast at its mid-point is about 2.5% above the prior analyst consensus. Presumably the new revenue estimate reflects the latest dollar strength, which is going to necessarily be some kind a headwind on reported revenues.

The shares still have a painful loss of 15% YTD despite a 25% rally from a low set earlier this month. As a sometime shareholder in the name, and as a positive commentator on this site, this has not been a fun experience for me. Nuance is one of those companies that always should've, would've, could've, and never has done. Honestly. What I would describe as a blowout in Q4 is one of the few pieces of blue sky investors have seen in more than a couple of years. For the most part, it has all been about clouds, showers and dealing with transitions from dying product areas to new opportunities, but never managing to achieve the traction that the new areas seemed capable of generating.

A lot of the share price history relates to the disposition by Carl Icahn of more than half of his position in Nuance's shares back in March and the concomitant loss of faith in NUAN's management and the dissipation of expectations regarding the potential for the company to get consolidated.

As readers may recollect, Nuance would end up buying back the preponderance of Mr. Icahn's share sale and wound up taking on a considerable amount of debt in the process and ruling out any further share repurchase opportunities in the near term. The fact that long-time CEO Paul Ricci has announced his intention of retiring at the end of March 2018 is likely to renew takeover speculation.

In addition, there are many who feel that Mr. Ricci has proven to be ineffectual in steering the company through multiple transitions, and there is obviously something that might be said for that argument. The fact is that while Nuance was first in terms of the development of natural language capabilities and of a form of AI, the company has not really been able to capitalize effectively on its first-mover advantages, and revenues have been stalled at or near current levels for several years now.

In addition to Mr. Ricci's retirement, and the departure of the company's head of sales, Bill Robbins, I would pay careful attention to the announcement that NUAN is moving toward a sales structure that is totally divisional. Given the lack of almost any synergies between the various components of the company, it may be that a divisionalized structure will allow acquirers to bid on the pieces of the business they want and to avoid saddling themselves with other businesses that they find to be unstrategic. In particular, it becomes far more possible to conceive of Nuance accepting a bid either in a typical fashion or in some form of spin-merger for its healthcare operations from a Cerner (NASDAQ:CERN) or even an athena (NASDAQ:ATHN) if they didn't have to buy the rest of the businesses.

Just to put the bookings attainment in context, the sequential growth in that metric was 44%, and according to the company, some of the larger deals that it had withdrawn from the Q4 forecast because of their size did not close and remain in the Q1 pipeline. In the prior fiscal year, bookings actually declined sequentially between Q3 and Q4. It would seem reasonable to assume, given that nugget, that the outlook as provided for Q1 bookings, and perhaps revenues as well, is on the conservative side.

Quarterly bookings were an all-time record, surpassing a quarter a couple of years past that had seen exceptional bookings in the automotive sector. As a result of the exceptional level of bookings, another metric which is worth tracking, the three-year value of recurring revenues, increased by 12% sequentially to another record.

The bookings result was just enough to bring that metric to positive territory for the full year, and the company was able to report positive revenue growth for the full year as well. Quarterly revenues of $512 million were consistent with the top end of the company's forecasted range, were a bit more than 1% above the previous analyst consensus, and were flat compared to year earlier results.

Non-GAAP EPS of $.41 for the quarter was also at the top end of the forecasted range and beat the analyst consensus expectations by $.02. Operating cash flow (CFFO) dropped by 8% year on year although the internals were strong. CFFO was 117% of non-GAAP net income, and DSO was unchanged despite the large deals that drove the revenue results. Overall, the decline in CFFO was driven by both the drop in stock-based comp and because of the recognition of a tax benefit, which really is not a function of operations in the September quarter.

For the full year, CFFO grew by 16%. Free cash flow showed similar trends. Capex was up marginally for the year, but is just $13 million out of CFFO of $138 million. Overall, quarterly free cash flow was $125 million, and yearly free cash flow was $511 million. The increase in CFFO was despite a noticeable decline in stock-based comp, which dropped 8% for the year and which actually fell almost 30% in Q4. All of the opex categories continued to fall in Q4 versus a year ago by between 5% and 10%.

The company continues to have a significant level of net debt. Much of the net debt has resulted from prior acquisitions, but the net debt increased meaningfully in the wake of buying back shares from major shareholder Icahn earlier this year. Gross cash on the balance sheet was about $580 million, and long-term debt is $2.4 billion. As the company completed the acquisition of TouchCommerce this quarter, it did not see any improvement in its net cash position.

The title for this article, Blue Skies, was composed by Irving Berlin and was #1 on the hit parade in 1927. It ranked #1 again in 1978 based on a recording by Johnny Cash. Most lately, it has been sung by Sharon Van Etten in a Corona Beer commercial. For me, the most iconic recording was that of Ella Fitzgerald, and I can't say I have ever seen the beer commercial.

The question for long suffering Nuance shareholders is whether these are to be long-term blue skies or just a break in the clouds. My inclination is more blue than cloudy - but challenges still abound.

What are the possible clouds if the sky is now blue?

One of the legacies of Mr. Ricci's tenure is that Nuance is a far more complex company to look at than many software vendors with annual revenues of $2 billion. Investors simply have not been willing to pay up for the shares in a roll-up, and the company has different strategies for different components of its business. The success of Dragon Medical, for example, really does nothing to enhance the value of the company's enterprise or mobility solutions, and there are few synergies between the solution offerings of Nuance either in terms of revenues or costs.

About the only exception to that comment is the Viecore unit, a company specializing in implementing the kind of complex implementations that are inherent in deploying natural language projects for large enterprises. Even nine years after the acquisition of Viecore, Nuance has a differentiated set of implementation capabilities that allow it to compete successfully against many rivals that simply cannot address the customization capabilities provided by Nuance.

Overall, however, I imagine that it is this rather crazy quilt of solutions, all having to do with voice, that has been a major deterrent to the ability of larger vendors to make an acceptable offer to consolidate the company. As mentioned earlier in this article, the fact that NUAN is moving to a more divisionalized structure may change that calculus in terms of making pieces of the company more attractive to potential acquirers.

I imagine that most observers are concerned that a company of this scale is having to compete with vendors such as Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) (NASDAQ:GOOGL) or IBM (NYSE:IBM). Many investors feel that Nuance goes head to head with these competitors and must need to have better technology or better pricing to succeed. And the hypothesis has been reinforced over the years by the fact that as more vendors talk about voice and as Nuance's revenues haven't grown, it must be competition with these behemoths that is the problem. Makes sense - it just happens not to be the case.

Paul Ricci is many things, but being a fool is not amongst his character flaws. I will let his answer regarding the question stand on its own. Some readers will disagree. My own anecdotal checks suggest that Nuance's issues over the years have more to do with execution and the company's reliance on its older business lines such as transcription, far more than it has had to do with competition. But here is what Mr. Ricci said during this past conference call, and I think it is really far closer to the facts than anything else one is likely to see written on the subject by third-party analysts:

You have to remember the Nuance business is in selling, providing solutions to large corporations and global brands and health care institutions. We do that in very specific vertical markets with a great deal of domain expertise. We do that as a trusted advisor to those companies with all of the apparatus and infrastructure and obligations that they insist upon to be that kind of advisor. It's just not easy for a start-up to compete in that respect…Your second question was related to Watson. I think-specifically, Watson in health care. I don't think what IBM and Watson in health care is focused on is particularly relevant to the markets that Nuance is serving. Health care is a very large space. I do think they're trying to solve other problems. I can't say too much about our current relationship. (Some years ago Nuance acquired all of IBM's technology in speech and in return, IBM signed, what in essence is a non-compete. So, it is relevant, at this point to understand the relationship but Mr. Ricci chose, or is mandated from making an attempt to provide enlightenment).

As in any transition, the biggest pitfalls are those concerning the decline in legacy revenue streams. Once a business becomes legacy, it simply loses the attention of management, it obviously loses resources and potential customers have to be concerned by the level of support that is going to be provided for a dying product area.

One of the nicer things about a transition like this as pointed out by the CEO during the course of the conference call is that as the declining businesses decrease in size, the impact of their decline necessarily diminishes. That is now happening at Nuance, and more than anything else is the single most substantial factor in forecasting that the company should return to positive organic growth and that the organic growth percentages ought to accelerate going forward.

It may be hard to believe at this point, but Nuance at one point was built on the back of a business that aggregated dictated patient notes, shopped them to India, and delivered the transcriptions back to the physicians. This business grew consistently and noticeably for many years, and it was highly profitable and seemed almost to be on auto-pilot. If anyone wonders why the company reports "lines" in its prepared remarks, it is because of the importance of its transcription results in the past. The transcription business will decline for the foreseeable future. Ricci said that

"The magnitude of that erosion in FY '17 (will be) less than it was in FY'16. Our models suggest it will be less yet in FY'18. We're seeing a diminishing contribution-seeing a diminishing absolute contribution-negative contribution to revenue from that, but it will be ongoing for the foreseeable future."

The company's reported healthcare revenues are also burdened by an additional transition from perpetual licenses to the cloud, which is one of the factors that creates terrific bookings, but has been and will remain a negative contributor to reported revenues. Management has forecast that the effect of that transition specifically will reverse in the second half of the current fiscal year which will significantly alter the trajectory of reported revenue performance, particularly for the 50% of the business that is healthcare and which may make that segment even more attractive to potential acquirers.

It is a key predicate in terms of how this business will perform going forward and eventually how the stock will or will not work for the decline in transcription revenues to diminish. If it does, then many other financial metrics from headline revenue numbers and gross margins will all start to respond to a significant tailwind whose magnitude is certainly neither specifically forecast nor appreciated at the current share valuation.

The other major area of secular decline has been the company's handset business. The number of handsets being deployed is not growing, the applications such as voice mail have become commodities and the service providers have to constrain their costs to deal with their own cutthroat pricing environment. It is obvious by now that the declines in the Nuance handset business are going to continue indefinitely.

But again, as in medical transcription, there is no solution to the woes of the Nuance cell-phone business within its control. The company is forecasting, that at least in dollar terms, the revenue decline from the handset business will abate during the course of the current fiscal year and that will be sufficient to turn revenues from that division to positive growth.

Nuance has a host of other solutions that it is selling within what is described as it mobile solutions group. For reasons buried in the history of the company, Nuance includes its automotive, IoT and other embedded solutions in its mobile business unit. While handset volumes are declining, the company is starting to see decent revenues from its royalties paid by its automotive clients, and it won deals with Daimler (OTCPK:DDAIY) and Ford (NYSE:F) this past quarter.

Valuation in the midst of many moving parts

How much are Nuance shares really worth? There are easier questions to tackle - I would prefer for the Jesuits to take on this question. The biggest problem to address is what might the company's real long-term growth rate be? Might it reach double digits? Such a case might be made if one starts to think about sawing off the negative growth boat anchors. Management is basically talking about fiscal 2018 as being a happy year, but the company is still looking for organic growth of just 2-4% with bookings growth of 2-6%, although as mentioned earlier, in an answer to a query Mr. Ricci seemingly belied the numbers presented in the scrip. How does anyone handicap something like that, and is it worth doing so? I can answer that question - if the best that this company can do is to see bookings growth of 2-6%, and it isn't dismembered, most stakeholders will not experience any kind of joyous epiphany. I think the possibility of dismemberment is not insubstantial, and I think the possibility of double-digit bookings growth is greater than 50%. That is the way it should happen, but for most mere mortals, anything to do with this company is a bit of a guess.

I think that investors would do well to look at the 10% year-on-year decline in "lines" in the company's healthcare transcription business and look as well at the growth to a record of the three-year value of on-demand committed revenues. Looking at the sequence of those two trends suggests to me that the potential for double-digit organic growth is on the table at some time in fiscal 2018. Basically, as the impact of the decline in transcription lines abates and as the impact of more long-term subscription arrangements compound, the company should have a chance to reach the empyrean of double-digit growth.

The company has an enterprise value of $6.6 billion and it has forecast sales to be $2.050 billion. That is an EV/s of 3.2. The current consensus EPS is at $1.63, and the new forecast is basically at the same level. So, call the P/E about 10X, a rather compressed level, although one that is a function of the inability of the company to grow reported EPS for some years now.

The company generated CFFO last year of $566 million and capex was $54 million. The company is forecasting that CFFO for the current year will be 110% of non-GAAP net income, which would in turn be $531 million.

I do not have a crystal ball, but I would be surprised if both earnings and cash flow were not above the forecast. I am going to use $525 million as an estimated free cash flow estimate for this current year. That would provide a free cash flow yield of just short of 8%, a very reasonable valuation for this company, and one that would provide investors with 25-50% positive returns - returns which have been a very long time in coming. I do think that Nuance's shares offer positive alpha, and I think the potential for dismemberment needs to be actively considered at this point.

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.