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Executives

Paul Ricci – Chairman and CEO

Jamie Arnold – CFO

Analysts

Brent Thill – Citigroup

Daniel Ives – FBR

Richard Davis – Needham & Company

Jeff Van Rhee – Craig-Hallum

Shyam Patil – Raymond James

Tom Roderick – Thomas Weisel Partners

Derek Bingham – Goldman Sachs

John Bright – Avondale Partners

Mark Murphy – Piper Jaffray

Craig Nankervis – First Analysis

Nuance Communications Inc. (NUAN) F3Q08 (Qtr End 06/30/08) Earnings Call Transcript August 11, 2008 4:30 PM ET

Operator

Ladies and gentlemen, thank you for standing by and welcome to Nuance's third quarter 2008 conference call, for the conference all the participants lines are in a listen-only mode. However, there will be an opportunities for your questions. Instructions will be given at that time. (Operator instructions) As a reminder, today's conference call is being recorded. With us today are the Nuance, Chairman and Chief Executive Officer of Nuance’s Mr. Paul Ricci, CFO, Jamie Arnold and Tom Beaudoin who will be assuming the CFO roll at Nuance’s this week.

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

Paul Ricci

Good afternoon, everyone. Thank you for joining us today. Before we begin, I remind everyone that matters we discuss this morning include predictions, estimates, expectations and other forward-looking statements. These statements are subject to risks and uncertainties that could cause actual results to differ materially. You should refer to our recent SEC filings for a detailed list of risk factors.

The strength of Nuance results today including recorded revenues, pro forma earnings, cash flows and operating margins reflect a balance performance across a diverse speech market of mobility, healthcare and enterprise. Revenues were especially strong in mobility and among are on demand offering in all three of our speech markets. Revenues also benefited from improve growth in our enterprise market and from another strong quarter in the Asia-pacific region.

Conversely revenue growth in the third quarter was offset somewhat by a street decline in Dragon revenues as to prepare the channels for the fourth quarter launch that commenced last week. As noted we once again experienced strength in our on demand and subscription based revenues across our business. In total on demand and subscription revenues reached $49.9 million in the quarter, up 86% from a year ago owing to strong demand for software’s and services offerings among hospitals, carriers and enterprises.

Pro forma, as if we had owned all acquired businesses year ago organic growth for on-demand revenues was 42%. Our mobile and embedded solutions reached $45.3 million. Organically mobile revenues grew about 34% in the quarter, our performance owes to the growing adoption among partners and design wins and contributions from companies such as Howdy, LG, Nokia and Samsung as well as an important additional customers to be announced in subsequent quarters.

In addition, our mobile surge and connected services team brought new initiatives and offers as well as expanding relationships with voice serge customers. We launched our new carrier based voicemail to text and have secured two important customer wins. We also demonstrated in an earlier version of Nuance open voice service to allow voice powered web search on mobile phones.

In our healthcare business we achieved revenues of $74.6 million in the quarter, up 23% versus the same period in the prior year. Notably the team signed significant long term contracts that contribute to the rapid growth of our hosted services revenue, which was up 68% over last year for healthcare.

In addition we introduced the newest release of our flagship radiology solutions PowerScribe 5.0. Implementation cycles for PowerScribe typically run about six months though, so we saw very limited revenues from the new release during the quarter, and in the third quarter we acquired eScription to expand and complement our on-demand healthcare transaction offerings.

The momentum of this business, which was evident in the public filings of their financials, has continued in the short time since the transaction closed. Cost synergies from the transaction are running ahead of plan and will positively contribute to margins in the fourth quarter. Organically, total healthcare revenues in the third quarter were up 15% over the same period last year.

Turning to our enterprise network speech business, revenues were $79.7 million up 53% as reported from the same period last year. The Nuance on-demand business for enterprise again performed above expectations, as new customer deployments that were expanded were bought online. On-demand revenue in enterprise was up more than a 100% in the quarter over the same quarter last year.

We saw an improvement as well in our solution sales led by our Viecore unit in which we provide core technologies, applications and services directly to large enterprise customers such as City and Dell. We continue however, to see weak royalty reports from most of our traditional IVR partners, who contributed more than one half of our license revenues in these segments historically.

Organic growth for total enterprise revenues was 11% up from the last quarter’s growth at about 7%.

Turning to the Dragon product line, where revenues were about 10.5 million in the quarter down 23% from the same quarter last year. As mentioned previously our expectations for Dragon in the period were modest as we prepared for the new version which we announced last week.

Early reactions from customers that channel impressed point to an exceptional product and favorable outlook for exceeding launch expectations over this quarter and quarters to come, and finally total imaging revenues were $19.2 million up 16% from a year ago, owing largely to the continues strength and success of our imaging OEM arrangement and PDF product line.

During our last earnings call, we discussed efforts to reduce cost and realize synergies from recent acquisitions. These efforts did contribute to operating margins as 27% in the quarter and put us on course to achieve our full-year operating margin objective.

Finally, cash flow from operations were quite strong, a record $48 million in the third quarter, and now before I discuss our second half outlook, I want to turn the call over the Jamie who will take you though additional operating highlights.

Jamie Arnold

Thank you, Paul. Good afternoon everyone. As you saw on the press release, Nuance’s GAAP revenues in the quarter were $216.7 million, up 38% over the same period in fiscal 2007. GAAP revenues exclude approximately $12.5 million of revenues that were lost to purchase accounting in conjunction with the eScription, Tegic, Viecore and Voice Signal acquisitions. After including these revenues, non-GAAP revenues were $229.2 million for the quarter, up 46% over the last year.

On a GAAP basis Nuance recognized a net loss of $9.9 million or $0.05 per basic share in the quarter, compared with net loss of $7.6 million or $0.04 a year ago. Using a non-GAAP measure, net income was $51.4 million or $0.22 per diluted share in the quarter, compared with $27.8 million or $0.14 a year ago.

Our non-GAAP measure of net income or loss excludes acquisition related transaction and integration cost and as applicable non-cash taxes interest in stock-based compensation, amortization and impairment of intangible assets and restructuring and other charges. Non-GAAP speech revenue was $210.1 million, which included $74.6 million for healthcare revenue, $79.7 million in enterprise revenue, $45.3 million in embedded revenue and $10.5 million in Dragon revenue, imaging revenue was $19.2 million.

GAAP product revenue was $96.4 million; non-GAAP product revenue was a $106.4 million up $31.3 million or 42% from $75.1 million a year ago. GAAP professional services revenue including subscription at hosted applications was $82.3 million. Non-GAAP professional services revenue was $84.1 million up $34.4 million or 69% compare to $49 million last year.

GAAP maintenance and support revenue was $38 million; non-GAAP maintenance support revenue was $38.7 million up $6.6 million or 21% compared to $32.2 million a year ago. North American revenue accounted for approximately 78% of total revenue compared with 81% in the same period year ago. The changes are attributable to a strong performance in our European and Asia-Pacific operations mentioned earlier.

For you connivance let me recap the organic growth rate you heard earlier, mobile embedded revenues grew organically at 34%, healthcare revenues grew organically at 15%, enterprises revenues grew at 11% up from 7% last quarter. Total on demand revenues across all three business lines grew 42%, dragon revenues decline 23%, and imaging revenues grew 16%. Total company revenues grew organically 14%.

Cost of revenues in the quarter was approximately 31% of revenue for a gross margin 69% reflecting a sequential two point improvement from last quarter a 1% decrease from last year. Our gross margins improved in three areas including cost containment and efficiencies ongoing revenues, higher revenues from professional services on a fixed expenses base and the inclusion of the eScription with favorable margins.

Please note that in discussing cost of goods we exclude certain cost, including transition cost, acquisition related amortization and stock based compensation expenses. Product gross margins were 90% in this quarter as compared to 87% a year ago, owing to a greater mix of speech license revenue particularly embedded speech revenues that have lower cost of goods.

Gross margins for professional services were 35.8% in the quarter as compared to 36.6% in the same period of last year. Maintenance margins were 80% in the quarter as compared to 79.2% in the same period last year. Turning to operating expenses, I remind you that the cost excludes certain items including non-cash stock based compensation, amortization of intangibles, and transition and integration cost. For more information please see the reconciliation on our website.

R&D was approximately $24.3 million or 10% revenue versus $17.7 million or an 11.2% of revenue a year ago. The increase in absolute dollars is primarily attributed to additional headcount to our speech product lines from recent acquisitions. Sales and marketing spending was $49 million or 21.4% of revenue as compared to $40.9 million or 26.1% of revenue a year ago.

This absolute dollar increased for the year-over-year comparison corresponds to an increase headcount in our sales organization and additional sales headcount from our acquisitions. The decreases as the percentage of revenue relates to the growing recurring revenue streams in on-demand and hosted solutions and maintenance and support that do not carry additional significant variable selling expenses.

G&A expenses were $20.9 million or 9.1% of revenue as compared to $15.2 million or 9.7% of revenue in the same quarter of last year. The increase in absolute dollars is due to additional employee supporting larger business as well as additional professional fees in finance and legal. Net interest expense was inline with our expectations at $10.3 million as the rate we earn on our deposit, declined inline with reduction in the Feb funds rates. We anticipate net interest expense for the fourth quarter between $10 million and $10.5 million.

Turning to the balance sheet, the company generated record cash flows from operations this quarter of approximately $48.1 million, up 59% over the last year. DSO’s net of deferred maintenance revenues were 37 days versus 44 days last quarter, owing to strong collections as well as strong sales and maintenance contracts. Depreciation was $3.9 million and capital expenditures were approximately $6.9 million. We existed the quarter with unrestricted cash and marketable securities of $265.8 million, and now I’ll turn the call back over to Paul

Paul Ricci

Thanks Jamie. Nuance’s performance in the third quarter reflects the benefits of our leadership market position across the diverse speech markets and the increased synergies and efficiencies we achieved from share, technologies and operations among these markets. We expect continuation of these benefits as we look toward the completion of this fiscal year. Additionally, we expect that the following factors will influence our fourth quarter results.

First, the launch in Dragon NaturallySpeaking 10 will contribute materially to revenue growth in the fourth quarter and should continue to do so well into fiscal year 2009. The earlier days of the launch have been very promising as customer and press reactions appear stronger even than those we experienced in the launch of DNS 9.

Second, we expect continued strength in our on-demand solutions across all business lines. The addition of eScription bolsters our healthcare portfolio and our Nuance’s on-demand enterprise continues its expansion into targeted vertical segments. I should also note another important solution Nuance’s Mobile Care announce last week benefits from the confluence of our mobile and enterprise capabilities, and already has one carrier agreement in place. On-demand solutions in total should comprise more than 20% of revenues in the fourth quarter and should grow to nearly 30% in fiscal year 2009.

Second, we anticipate the continuation of strong performance in our mobile business. Our extensive solutions portfolio both embedded and connected branded relationships with carriers and major phone, auto and PMD manufacturers have never been stronger.

Mobile revenues, which were about 13% of revenue in fiscal year of 2007, will constitute about 20% of revenues in this full fiscal year. Healthcare revenues will be up sharply in the quarter, as we realized the full quarter benefit of eScription, the continuing performance of our iChart hosted solution and revenue growth in our PowerScribe and Dragon Medical product lines. Please note from earlier comments that revenues from PowerScribe five, would be substantially differed to first quarter fiscal year 2009, as we complete the initial implementation and acceptance cycles.

We also call attention again to the speed in which our healthcare business is moving toward on demand hosted solutions and subscription pricing in our on-premise solutions. While this trend does moderate nearer-term growth as we look out over fiscal year 2009, we believe nonetheless at the increasing recurring nature of these revenue streams and the attended lower cost of selling that the accompanies then will be attractive to investors.

Within our enterprise segment, investors should anticipate a continuation of the recent trends we outlined earlier. We anticipate that enterprise revenues will be up again sequentially in the quarter, based upon continued strength in our on-demand and solutions offering, but the growth will limited by continued sluggishness among several of our IVR, OEM partners.

As we looked towards fiscal year ’09, we expect the affects of these partners to diminish as enterprise growth is increasingly driven by our on-demand offerings, solution sold directly to large enterprises and new speech based applications that are coming to market.

Gross margins in the quarter should be up sequentially by one point reflecting the contributions of mix and cost efficiencies. Operating margins in the fourth quarter should also be up over Q3. We do anticipate 27% operating margins for the full-year, thereby achieving the two point gain we establish as a target for fiscal 2008.

Investors may also note that we expect second half fiscal 2008 margins to be approximately 28%, positioning us well for additional margin expansion in fiscal year 2009. With these factors in mind, we expect non-GAAP revenues in the fourth quarter to be in the range of $255 million to $262 million, including approximately $10 million of the acquisition related revenues that will be lost to purchase accounting. We expect GAAP revenues to be in the range of $245 million to $252 million. We expect non-GAAP EPS between $0.24 and $0.25, GAAP EPS should be a loss between $0.02 and $0.03.

For the fiscal year we expect non-GAAP revenues between $9.13 and $9.20 million consistent with the range we’ve given previously including approximately $53 million of acquisition related revenues lost purchase accounting. We expect GAAP revenues between $860 million and $867 million.

We are though increasing our full-year non-GAAP EPS guidance, which we now anticipate being between $0.82 and $0.83, reflecting the strength in our gross margins and operating margins as discussed earlier. GAAP EPS should be a loss between $0.27 and $0.28. Before we take your questions I would like to extend to Jamie Arnold the sincere thanks on behalf of the board and the management team.

Jamie’s played an instrumental all the company having seen us through numerous acquisitions and helping the executive team reach this natural transition. Jamie will continue to support the finance organization and will help expedite Tom Beaudoin’s transition into the company. Later this week Tom, will officially become Nuance’s CFO. He comes to Nuance with a wealth of experience, most recently having served as President, CFO and COO of Polaroid. We’re pleased to have Tom on the team and look forward to as many contributions.

This concludes our formal comments and we are now happy to take your questions.

Question-and-Answer-Session

Operator

(Operator instructions) And first question we will go to line of Brent Thill with Citi. Please go ahead.

Brent Thill – Citigroup

Thanks, Paul, can you just talk a little bit about the enterprise business. You mentioned a slight recovery from Q2, just what you’re seeing in terms of sales cycles and the ability to start to penetrate some of these accounts overseas as well?

Paul Ricci

Well overall I must say that our assessment of the enterprise business remains positive. We think the fundamentals are improving. We think that our on-demand business continues unabated. We’re seeing terrific bookings and a pipeline in our solutions activities led by our Viecore team. The one real area of weakness in our enterprise business are revenues associated with our partners and I think our view about that is that there is no reason to think that’s going to abate soon, but as I mentioned in my formal comments it has become and we’ll continue to become a less and less factor in our revenue stream and that reflects the growing proportion of direct enterprise sales people we have both here and internationally; you referenced international and it is the case at our European and Asian performance over the last couple of quarters, has continued to outpace North America and although we did have in the segments I mentioned just now a better quarter in North America.

Brent Thill – Citigroup

Thanks

Operator

And next question from the line of Daniel Ives with FBR. Please go ahead.

Daniel Ives – FBR

Yes, thanks solid quarter, solid guidance first off Jamie it’s been great working with you. I guess on the healthcare side are you seeing specific stuff in regards to deal sized. It seems like deals are getting larger; what is the dynamics around that?

Paul Ricci

Now it’s a little difficult to talk of that deal size, because there are very different elements to the business. The on-demand, the hosted solutions are very large deals. We are targeting the largest hospitals and healthcare networks in the country and the license contracts range from, one to three years and so those are very large deals indeed. On the other hand the on-premise deals for PowerScribe and or other on-premise products are considerably smaller. I don’t think there is a particular pattern in deal size though other than that mix change I just referenced to on hosted that I would call out to you.

Operator

And next from the line of Richard Davis with Needham and Company please go ahead.

Richard Davis – Needham & Company

Okay, thanks. It’s kind of a tactical question, but with regard to the gross margin that’s softer I think or just around 89%; are there things in their that you must be purchasing with some one else or something embedding, is there are way to get that number higher and also how should we think about as you go to more of an on-demand model, a lot of those companies kind of embed services and software’s so the numbers kind of get pushed around; there’s a way that you think about directionally how that’s going I know you did talk about rising and stuff, but kind of longer-term?

Paul Ricci

With respect to the gross margins on software; the constituent elements within the company have margins at very different places our OEM and mobile licensing for example very, very high gross margins, our windows application software somewhat lower gross margins because of the cost of manufacturing and so forth.

We do have a small amount of embedded growth, but it’s not an overwhelming factor. I think that we can improve the gross margins particularly in the Dragon and imaging product lines I’m not sure we’ve been intelligent about that as we should be. With respect to your second question, which had to do with I think demand margins?

Richard Davis – Needham & Company

Right now, how would that affect us as a play though? I guess overtime it would, you probably look at the operating margins, probably the more relevant issue.

Paul Ricci

The operating margins across our on-demand businesses, I think will be quite good as we look at fiscal ’09. Stronger in healthcare than an enterprise, but in trending upward considerably in both, the net effect of the combination of our healthcare of our eScription and iChart businesses; there’ll be significant improvement in both gross margins and operating margins in that business in fiscal ’09, in particular dramatic improvement. So, I think that the overall trending in our on-demand business should be for improving margins in ’09.

Operator

And next go line of Jeff Van Rhee, with Craig-Hallum. Please go ahead.

Jeff Van Rhee – Craig-Hallum

Thanks. A couple of questions Paul, could you just talk on the enterprise of the network side, as you bought Viecore you’ve enhanced your internal service capabilities and you’re going more direct. Just talk about the transition and the avoidance of channel conflict and potentially to the extent that that weighed on your IVR partners is lower royalties in the quarter?

Paul Ricci

I don’t believe that channel conflict is the issue at hand. There has been a lot of disruption in several of our IVR partners and I don’t want to go into the specifics of that, but its I think well-known in the industry and that has resulted in I think some disruption in business flow to us, but I don’t think its because of frustrations in channel conflict.

We have good relationship for the channel partners. There is some overlaps in services, but I think we’ve been managing that for many years now and a Viecore represented a continuation of that trend not rather than anything else. I should emphasize that the nature of the growth of the business right now is towards larger deals that have longer recurring revenues, but which do have both longer time to early revenues for example, we signed a very large on-demand deal with a large commercial bank in the last quarter that will result in recurring revenues of several million dollars per year, but we won’t see those revenues begin until well into fiscal year ’09.

We also signed a very large deal with one of our large customers in North America, but again won’t see significant revenues until fiscal year of ’09 as well because of the way revenues recognized, but I nonetheless believe that by continuing to focus that business on the primary message of relieving cost in large services enterprises while maintaining customer satisfaction through speech automation that it’s a compelling ROI and that we will see steady improvement in the growth by businesses we look through fiscal year ’09.

Jeff Van Rhee – Craig-Hallum

Just in terms of the quarter and the progression through the quarter and even subsequent to the end of the quarter, you just talk about the general tone of business, general economic conditions, headwind or decreasing accelerating headwinds that type of thing?

Paul Ricci

I don’t really have any strong messages to deliver on that point. Jeff, clearly there is some anxiety being reported in capital purchasing and enterprises or cognizant of that, but I don’t want overstate that and I don’t want to make that a primary effect in talking about as we look out over the next several quarters because I’m just not seeing that.

Jeff Van Rhee – Craig-Hallum

Okay I guess and then just lastly sale cycles any material variance this quarter outside of your internal expectations, the bigger deals often tend to take longer, even more difficult, any material variances on sales cycles?

Paul Ricci

If you look over at the pattern of Nuance during the last 12 months, there are some recurring themes; one is a growth in on-demand hosted solutions and the other is a growth in larger complete solutions delivered on-premise in which services and licenses are bundled together. Both of those forms of transactions require a more contemplated selling, which certainly involves a longer sales cycle. So, I think we look at across those businesses excluding mobile for the moment, I think we would say that sales cycles have gone longer in favor of larger deals; mobiles at very different situation with the whole different set of sales cycles.

Operator

And next from line of Shyam Patil with Raymond James. Please go ahead.

Shyam Patil – Raymond James

Paul, you talked about disruption being an issue in the IVR but, and typically disruption tends to be a near-term thing but it sounds like you aren’t expect is to improve there. I guess it seems like longer term, is that conservative to the one year part or can you reconcile those two?

Paul Ricci

Well, I’m sure you follow the IVR business and I think as you are aware the disruption among several participants in that business has not been short term. It’s been sustained over the course of the last six months and I don’t have visibility into their businesses, but I think it would be imprudent for us to plan on that reversing anytime soon. We have a couple of partners for whom that’s not true incidentally and they are becoming a more important part of that OEM revenue stream for us, but they don’t make up for the shortfalls and the other partners and I’m not in a position to provide a prognosis on their business, but as I said in any case I think it’s the diminishing part of our model.

Shyam Patil – Raymond James

Got it and then for ’09, about on-demand being a driver for the enterprise business, but you also talked about in solutions that you will be selling, can you talk about what new solution your are most optimistic about heading into ’09?

Paul Ricci

I’m sorry, this phone just – I got it about half of your questions, if you repeat it, I will answer it.

Shyam Patil – Raymond James

Okay, you talked about for the enterprise business for 2009 that on-demand is going to be a driver for that, but she also talked about new solutions which are going come on board, can you talk about what solutions you’re most optimistic about for ’09 for the enterprise business?

Paul Ricci

Well, I can’t only because I don’t want pre-announce things that are in the works but haven’t yet been announced, but our enterprise team has been working to expand our application footprint and those include both internal developments and license agreements with partners and I just can’t pre- announce them.

Shyam Patil – Raymond James

Got it, okay and then who are the large (inaudible) outsourcer this quarter we’ve talked about in declining call volumes in their call centers and specifically relating to your on-demand enterprise this, how would such a trend effect that business and are you seeing anything indicative of this trend being widespread?

Paul Ricci

Our hosted business and enterprise has enjoyed significant volume increases in our existing customers in additions to new and in addition to the volume that we’ve gotten from new customers. So, now we happen to be in some segments for I think call volumes are simply increasing most notably the wireless segment. So, we might simply not be the experienced in the segments we’re in. I don’t have a view about other segments, so we’ve really haven’t seen that.

Shyam Patil – Raymond James

Okay and then the large deals, which you mentioned won’t be seen for a while, can you talk about if that’s reflected in deferred revenue right now or they are up balance sheet?

Paul Ricci

I don’t know the answer to that question. I think that one of them probably is and one of them probably is not, but Jamie Arnold will answer.

Jamie Arnold

Well most of it is all balance sheet at this point.

Operator

And our next question is from line of Tom Roderick with Thomas Weisel Partners. Please go ahead.

Tom Roderick – Thomas Weisel Partners

Hi, good afternoon and thank you. Paul you spoke quite frequently on call about the on-demand business and within the Enterprise segment you hinted at getting into some new verticals there. You also mentioned a nice large commercial banking win which I believe you said was on-demand. Can you detail how of vertical financial services vertical could become within the enterprise on-demand segment? Are there or is there a pretty long pipeline of opportunities there and should we look for some more deals of this nature?

Paul Ricci

Well, that the primary verticals in our enterprise business generally as I mentioned previously are telecommunications, financial services, travel hospitality, retail and utilities and that will be true both for hosted and that has been true for on premise solutions and it will also true for hosted solutions. I think one interesting factor, we've recently has been an increased interest in some financial services customers for a hosted solution perhaps in part to avoid a large upfront at a capital acquisition costs. So, I think it’s lightly to be a growing part of financial services, but our on-demand business will support other accounts in those vertical adjustment changes as well.

Tom Roderick – Thomas Weisel Partners

Last question from me here; just on the point of Dragon, which fell down to I believe you said $10.5 million. On the call I guess, we saw this a couple of years ago, when the prior release version was getting a little longer than the tune it’s in now; you’ve launched Dragon 10; should we look for similar jump here? If we go back to Q3 of ’06 it almost doubled quarter-over-quarter. Should we look for a similar jump as we’re modeling out our own assumptions for next quarter that Dragon could see a similar big, the high single-digit million or even double-digital million growth on overall tax.

Paul Ricci

We certainly, our expectations are to achieve similar success for Dragon 10 in the first quarter and second quarter that we did last year and its difficult to know customer acceptance will be in this environment, but the early indications are quite positive and as I referenced the reviews are actually stronger than the reviews of Dragon 9 and the time Dragon 9 came out, we were ecstatic about the review. So, I’m quite positive about the opportunities for Dragon 10 and I do think that the level of effort and the breath of the effort in terms of international markets for the marketing we’re doing around the product is stronger than it was last time.

Operator

And next was Derek Bingham with Goldman Sachs. Please go ahead.

Derek Bingham – Goldman Sachs

I had a follow-up on gross margins, the margins on your professional services rebound to I think you said 36%; do you view that as the new base line and could you give us some color on kind of what your targets are for that professional services margins going forward?

Paul Ricci

Our objective is to modestly increase services margins continuously over the next several quarters. We did have somewhat of a weak period in gross margins professional services subsequent to the Viecore acquisition mostly having to do with diminished utilization as we integrated the two services teams, but the management of our global enterprise services organization is really very strong and they’ve been making progress and I think we’ll see further progress this quarter and into fiscal year ’09 and I also as I referenced a couple of times earlier, the demand for that particular element of our business is quite robust. So, I think that two will drive utilization and improve margins as well.

Derek Bingham – Goldman Sachs

And then on the embedded business, there has obviously been tough headlines for auto sales and probably a little bit softer for handset sales. Could you talk about any changes to your assumptions in terms of just unit shipments in the embedded segment and any just any changes to your assumptions and how that would flow through to your revenues?

Paul Ricci

Sure, well we model our revenues for those sub-segments based on some compositive or publicly available shipment data and as you reference the aggregate shipment data worldwide for both handsets and cars is off modestly from what it was a year ago, but that really isn’t the primary variable that drives our revenues. The primary variable driving our revenues is the increased adoption rate by our OEM partners and incorporating speech as a new capability.

So, if automobile sales go from being a 3% growth next year to a 3% decline, that factor is washed aside by the much more important factor that there is considerable intensity for automotive customers to incorporate speech as one element of dealing with the challenges of driver distraction and other capabilities they are trying to incorporate into the car and also remember that in automotive design wins revenues lag design wins by a couple of years for the most part so we’re really looking at royalties from cars for which the design win occurred well in the past; so I don’t think it’s much of a factor in automotive.

Even in cell phones again where the macro economic climate may reduce the overall shipment in cell phones, far more important to us is the pace at which the major cell phone companies adopt our technologies as part of their product lines.

Derek Bingham – Goldman Sachs

I understand and then one more follow up if I could on the embedded; just with another three months behind you anything new in terms of what is shifting by mix in terms of one of those major segments handsets, autos, connected services really, kind of outshining one of the others?

Paul Ricci

There hasn’t been a dramatic change in the last three months I think the order of revenue magnitude of each of those segment has remained fairly stable. The connected services as I mentioned previously is going more rapidly, but from the much smaller base and that will probably continue a pace into ’09, when some of these large contracts begin to contribute more revenue.

Operator

Our next question is from John Bright with Avondale Partners. Please go ahead.

John Bright – Avondale Partners

Thank you, good afternoon. Paul I will stay embedded and mobility. It seems to be a strong driver for you and it has been a solid organic performer. Paul do you anticipate when you look out beyond the next six months or so; is that about the visibility you have for the contracts in place now and design you have in place now or do you have a better visibility in that segment going forward on the embedded and mobility segment?

Paul Ricci

Well, in the embedded world we’re dealing with contracts that range from six month to six years. It’s useful to remember for example in the automotive market that design wins today are being focused on the model years 2011 and once your in the design wins typically it runs for a number of years; so those are very long term contracts.

In the cellular market it is clearly a much shorter term both to time of deployment which can be as little as six month and the lifecycle of that product line or that product architectural family, but even there it’s typically a couple of years from start up to ramp down. So, when one aggregates the summary of our contracts across all of those embedded segments we have fairly in-depth revenue models that show revenues over the next one, two, three, four years and as you would expect the position of those models declines as time goes forward because we know less and less about the likely penetration of any particular model, likely success of any model, but for a given fiscal year it’s a fairly high visibility.

John Bright – Avondale Partners

To follows ups for that Paul then; one characterize the break up of embedded mobile between auto, PND and hand sets if you would mind and the two, if consumers unlikely enterprise or the healthcare side of the business, if consumers are using the speech recognition capability and don’t experience the high nines of performance associated with it and maybe frustration; did that affect your value proposition in the embedded mobility segment near term or are these contracts negotiated for that entire one to four year period?

Paul Ricci

The first question we don’t give specific revenues, but I can tell you that in order of magnitude handsets, automotive and navigation devices would be the ranking of revenues contributions.

To the second question, there is no doubt that the overall quality of the experienced we’re delivering to our customers typically, the ultimate consumer greatly affects the success of our business. Sometimes more directly than other times, but we’re keenly focused on the quality of experience people are having whether they’re using voice destination and channel navigation device or voice dialing in a cell phone and there is perhaps what you’re eluding to a quite a variable experience in that and that’s the nature of this technology and the nature of the technology that continuous to matures. We’ve made real strides in that and every time we make an improvement we see an expanded market.

I’ve referenced this point with respect to Dragon many times in the past. Dragon 9 in its total lifecycle had revenues that exceeded Dragon 8 by something in the range of 30% to 40% and we would describe that to more than anything to the improved quality of the experience of using the product and we aspire to the same kind of market expansion from Dragon 10, but quite similarly by analogy we think that future versions of our products in the mobile space are going to expand the market. A very good example is the reception we’re getting for the Natural Language Capabilities in our mobile solutions for automotive which have achieved enormous reception among the automotive manufacturers and I think will increase the acceptance and penetration rate in automotive.

John Bright – Avondale Partners

Final question, thank you. The organic growth of 14% in the quarter, Paul would you characterize based on the assets you have now like the time period, what should we be thinking about as an organic growth rate for new ones?

Paul Ricci

We’ve said for quite sometime that our objective is to achieve 20% organic growth with 2% operating margin improvement per year. I think, we’re going to achieve the 2% operating margin improvement this year and I think we’re going to fall short of the 20% growth. I think nonetheless that those are if not easy targets, they are targets we remain focused on. I think that realistic looking at 2009 as we sit here today that something more like 17% or 18% growth is probably a more reasonable target, but we’re not there yet and we aren’t done working on how we can improve that to 20%.

John Bright – Avondale Partners

Thank you very much.

Operator

And we’ll go to Mark Murphy, with Piper Jaffray. Please go ahead.

Mark Murphy – Piper Jaffray

Yes thank you Paul. A question on Dragon version 10; could you describe some of the key enhancement and specifically, is it the recognition accuracy, the speed or some other feature set that is driving the excitement here?

Paul Ricci

No, recognition accuracy has got an attention, speed has gotten a lot of attention, the improvements in latency, access to web search and some of the ease of use of voice commands in the system have also gotten a lot of attention, and I refer you to any number a recent reviews that have come out in the last week, which have just been terrific about those capabilities.

Mark Murphy – Piper Jaffray

Okay, also Paul which recognition engine is eScription currently using; is that still a proprietary engine or has there been a change made there?

Paul Ricci

eScription is using an engine that eScription developed and no, we haven’t made any shift in technology integration between eScription and Nuance’s Healthcare business. It’s something that will take the better part of a year.

Mark Murphy – Piper Jaffray

And then finally; when you look at it, there is a very small delta between revenue guidance for Q3 and then the reported result; is the principal driver of that delta from your perspective, is it the Dragon decline or are you seeing an accelerated mix shift toward the on-demand business which is deferring revenue into the future or is it some other effect?

Paul Ricci

No, I think our revenue guidance for Q3 was 229 to 234, so you maybe talking about a difference between revenues and something else, I’m not sure.

Mark Murphy – Piper Jaffray

I’m sorry; I thought the guidance was at 230 to 234 of the 229?

Paul Ricci

Well maybe you’re right. I thought it was 229, but anyway your question is what factor influenced revenues?

Mark Murphy – Piper Jaffray

Yes, I guess Paul then if you look at it and say what was is that would have prohibited you from maybe achieving the upper part of that range, which you have done in some past quarters versus whereas things came in or where anything might have varied from the internal plan, how would you kind of allocate the differences?

Paul Ricci

There were several positives and several negatives in the quarter and I think I mentioned all those clearly. We did anticipate Dragon revenues declining a bit sharper than our anticipation, but I don’t worry very much about that because it’s a very transitory factor. We had hoped for somewhat some recovery among our enterprise partners and we didn’t really see that, but we did on the other hand see strength in our own efforts. Healthcare was more or less as we expected it to be and mobility was about as we expected it to be.

Jamie Arnold

Mark this Jamie; just to confirm Paul’s comment our guidance last quarter was 229 to 234.

Mark Murphy – Piper Jaffray

Okay, thank you.

Operator

Our final question from line of Craig Nankervis with First Analysis. Please go ahead.

Craig Nankervis – First Analysis

A couple quick ones on the enterprise side. I’m not sure if I heard it or not, but are you sticking to your second half enterprise organic growth target of 15%?

Paul Ricci

Probably not. We probably aren’t going to get the 15% in the second half, but I do once again reinforce that we are going to see steady improvement in that business as we look out over fiscal ‘09. I think probably 15% for the full second half is not going to happen.

Craig Nankervis – First Analysis

Okay, thank you and then just secondly maybe just to clarify a little more about BeVocal and what’s driving the nice performance there; to what extent are enterprises looking at using the platform or is the growth you’re seeing today really just mainly good growth from this service provider demand.

Paul Ricci

Well, it’s both. As we look over the last 12 months or so, we’ve won a number of new enterprise accounts in the business and we’ve seen increased demand among the carriers for the solutions regarding deploy.

Craig Nankervis – First Analysis

Lastly on healthcare; can you discuss operating margin progress? I understood there is a lot you felt you could do out there and are you still on your earlier innings or just what’s an update there?

Paul Ricci

Operating margins in the third quarter for healthcare were I believe a point of two above our internal plan; I don’t have that in front of me, but that is my recollection and we are going to see a continuation of that trend in the fourth quarter as eScription contribution and the synergies come into place and in fact, the synergy has already provided some benefit in the third quarter and we will see sustaining of that trend throughout ’09. So, over the course of the five or six quarters after post eScription, we will have seen operating margin improvement in the healthcare business. I think on the order of 8 or 10 points. It’s quite a strong improvement because of the combination of mix of the business and synergies between the integration.

Craig Nankervis – First Analysis

That would be great. Thanks very much.

Operator

And Mr. Ricci I will turn it back to you for any closing comments.

Paul Ricci

Okay. Well that ends our discussion today and we look forward again to speaking with you again next quarter. Thank you.

Operator

Ladies and gentlemen that does conclude your conference for today. Thank you for your participation. You may now disconnect.

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Source: Nuance Communications Inc. F3Q08 (Qtr End 06/30/08) Earnings Call Transcript
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