This Takeover Candidate Has Low Forward Multiples

| About: Nuance Communications, (NUAN)
This article is now exclusive for PRO subscribers.

By Steven Edwards

What is language worth? Think about the difference between a chimpanzee and a person - only about 2%, DNA-wise. Physically, the chimp is stronger and has prehensile feet. He can certainly climb trees better, to gather the high-hanging fruit, but nevertheless, the chimp is an endangered species while humans rule the earth.

Language is what allows us to cooperate one with another. Language is what allows our minds to conceptualize. Language is what allows us to gather information.

Machines are much better than us, when it comes to manipulating information, but despite their awesome speed at computing, they haven't been awfully smart. Until recently. By now, unless you're stranded on an asteroid somewhere, you have come into contact with Siri (Speech Interpretation and Recognition Interface), the voicebot in Apple's iPhone 4S. You may have also caught the act of Watson, the Jeopardy-playing computer.

Probably neither Siri nor Watson could pass a Turing test, wherein a judge tries to distinguish a computer from a human. But they are getting close, and they will only get better with time. Already, Siri was the subject of a Big Bang Theory episode where one of the nerds fell in love with her. Think about how many proposals of marriage that Siri handles every day. Does she understand what is really contemplated in that proposal? Does she get the joke? Philosophers can argue about what a machine understands. But as long as the machine is interacting with us in a way that we understand, what difference does it make?

Though Apple (NASDAQ:AAPL) will not officially acknowledge it, the speech recognition software underlying Siri comes from Nuance Communications (NASDAQ:NUAN). Siri isn't all that Nuance does. It sells the Dragon voice dictation systems that turn voice into text. The company has applied this technology to medical dictation, so that doctors can make comments on their patients' charts without having to resort to the keyboard or expensive medical transcriptions services. The company also supplies text into voice services for mobile phones. Its automated voice turns up in GPS devices and services and of course, on call routing services.

Nuance is also collaborating with IBM (NYSE:IBM) to team Watson analytical capabilities to Nuance's voice and clinical language features in the healthcare industry.

Of course Nuance isn't the only business that is involved in voice recognition. Microsoft's (NASDAQ:MSFT) System Seven operating system can be set up to respond to voice commands. Google (NASDAQ:GOOG) is involved with voice search and text/voice conversions. But these are still pretty primitive compared to Siri.

Once upon a time, there was a whole host of small companies working on natural language processing. Nuance has achieved its dominance in the field the old fashioned way; they bought out the competition. Nuance, in its present form, was created when ScanSoft, a firm originally dedicated to optical character recognition, bought out Nuance in 2005, and kept the name for the surviving firm. Prior to that, it had acquired the Speech and Language division of Lernout and Hauspie (which brought the Dragon dictation software) and in 2001, and Nuance's primary competitor, SpeechWorks in 2003.

Since then, they have taken over Dictaphone Corp., Mobile Voice Control, Inc., Voice Signal Technologies, Phillips Speech Recognition Systems GmBH, Jott Networks, Spinvox, MacSpeech, PerSay, SVOX, Loquendo, Vlingo, and most recently, Transcend Services, among others. Most of these transactions have been small by Silicon Valley standards, but have resulted in Nuance controlling much of the intellectual property surrounding speech recognition and processing.

So what is it all worth? Until recently, Nuance had only rung up a stream of losses. Consequently, its current price-to-earnings ratio of about 160 seems a little rich. It missed earnings expectations in its latest quarter, but going forward, analysts see the company earning $1.60 per share in 2012 and $1.82 in 2013. Its current price of 24 doesn't seem all that out of line for this techy stock tied to the Apple phenomenon, at about 13 times 2013 earnings. The price-to-book ratio is about 3.0, but the book value is stacked with intangibles, given the history of acquisitions. How do you value all the speech recognition patents? Nobody really knows.

But science fiction aficionados will appreciate that Siri and her clones will inhabit all machines going forward. You will talk to your house and your car and maybe your coffee machine and they will talk back to you. The technology is now at hand for a C3PO type robot, complete with fussy English accent if you want it.

Of 19 analysts covering Nuance, 15 rate it as a buy or outperform, while only one rates it a sell. I think it is a screaming buy, mainly because Google, Apple and Microsoft are sitting on mountains of cash. The market cap of Nuance is over $7 billion, but that is not out of reach for any of these three. I can't think of a better acquisition than Nuance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.