Nuance Communications: The Good, the Bad and the Ugly (NUAN)

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 |  About: Nuance Communications, Inc. (NUAN)
by: Ashish Kelkar

I have a preference for value investing based on fundamentals. But value is never just a DCF calculation: there is value in undiscovered markets and new technologies, and that makes small cap companies in emerging areas interesting. Information on these is often hard to find and sometimes they stay undiscovered until it's too late. Note also that they are quite volatile. With that, here's my pick:

Speech recognition is a technology that has always overpromised and underdelivered, the technology spawned several start-ups but failure to deliver has resulted in consolidation. Nuance Communications, Inc. (NUAN) ($11.20) seems to have emerged the winner. (Although I have been following this area, and Nuance out of my interest in linguistics - the company was recommended I believe in Jan 2005 by Motley Fool in one of their newsletters).

Scansoft was a spin-off from Xerox (XRX). It was an optical character recognition (NYSE:OCR) company to convert paper documents to electronic formats. In 2001 however the company decided to add speech technology to its OCR business by buying Lernout & Hauspie's assets out of bankruptcy for $59.5 million. L&H was the wunderkid of the go-go 90's tech bull market, it once had a valuation of $10B, the company imploded in accounting scandals and management malfeasense. Since then, ScanSoft has shrewdly made a dozen other acquisitions in the speech arena. In 2002 it added telecommunications capabilities by buying a once hot MIT startup Speechworks. In addition, it purchased MedRemote, a medical dictation specialist,
and, of course, Nuance, which was the leader in speech recognition technology. After the merger the Scansoft took on the name Nuance Communications.

The company is now made up of four segments: imaging, network speech, embedded speech, and dictation.

Imaging, a slow growing but highly profitable business, will account for about $70 million of an anticipated revenue range of $315 million to $325 million in 2006. While this business is unexciting, the Nuance solutions for OCR are essentially the standard in the industry. This is a steady cash cow that's expected to keep growing at about 8% a year. Network speech includes speech recognition for call center applications for clients such as Blue Cross/Blue Shield and Wal-Mart (WMT), as well as telecommunications network providers including Verizon Wireless (VZ). Embedded speech has two rapidly growing markets: wireless handsets and automotive. Nuance has deals with Nokia (NOK), Kyocera (KYO), and others to provide voice-activated dialing and other operations for mobile handsets. Meanwhile, automotive speech control is a rapidly growing segment.

Finally, dictation and transcription is a $10 billion business in the U.S. health-care segment alone. Nuance predicts massive growth there, up 70% in the most recent quarter.

The Good

- Carries no debt
-According to a former linguistics professor from MIT, the company has far superior technology and IP assets than anyone in the industry.
-Revenues rose 35% year over year
- Embedded speech and dictation are expected to deliver 50% growth (source: Morgan Stanley - seems high to me!!)
- Imaging and Network speech are steady cash cows

The Bad
- Because it has been so acquisitive, Nuance possesses a massive goodwill account,
which currently exceeds $459 million.
- The company is losing money $7M in the last quarter.
- The company boasts a high forward P/E of 22 (BTW I do not believe in P/E ratios and even more so in forward P/E ratios)

The Ugly
- Talent is key in this business, Yahoo recently poached some folks from them.
- New start-ups like Tell-Me, Be Vocal, Nice Systems are nipping at their heels

Having said all of the above, the speculator in me sees value in this company, they are shrewd when it comes to acquisitions and as voice-recognition gets more into the main stream - cars, cellphones etc this company can deliver the goods. On a personal note I would love not to type this blog but speak out my thoughts and let Nuance do the rest!!!

(Disclaimer : I have a small position in this stock, thinking of adding more next week)