A speech recognition stock for the future

Nuance Communications' weak share price is ratcheting up the pressure for bolder action. Here's what investors should look for.

By StreetAuthority Sep 25, 2013 4:41PM
Image: Businessman checking watch © Gerard Launet, PhotoAlto Agency RF, Getty ImagesBy David Sterman

Over the past year, as we've grown more accustomed to simply speaking requests into our smartphones, we've started typing less and less.

It's a subtle shift right now, but in coming years, futurists predict we'll be dictating our emails, tweets, text messages and documents, as punching letters into a keyboard becomes a slowly dying art.

Yet the company that is leading this revolution, Nuance Communications (NUAN), has had little to cheer about lately. Its shares have been flat for the past two years, even as the Standard & Poor's 500 Index ($INX) has risen 50%. The fact that activist investor Carl Icahn has bought more than 30 million shares this year and currently owns 16.9% of the company still wasn't enough to boost the stock meaningfully higher.

Yet in the quarters ahead, there are several catalysts in place that could push this stock back toward the $30 mark. First, a quick recap of Nuance's current woes.

Signs of a slowdown
Nuance posted very impressive annual results for the fiscal year ended September 2012. Sales, earnings per share (EPS), net income and cash flow all grew more than 25%, indicating that the company's speech recognition technology was seeing strong demand. Yet it was also apparent that key end markets were slowing, when fiscal fourth-quarter results were released last November.

Sales in the health care segment, for example, came in at $190 million in the quarter, which slightly trailed consensus forecasts. Government sales also began to slow ahead of the sequester, and in the consumer dictation segment, revenues were hurt by a shift away from upfront software purchases and toward monthly licensing fees.

Those trends have continued to play out, and fiscal 2013 sales are expected to grow just 12% to 13% to about $1.96 billion. That's quite a letdown for a company that had a 32% annual growth rate going back to fiscal 2005 (though some of that growth was juiced by acquisitions). Worse still, analysts expect sales to grow just 6% in the fiscal year that begins in October.

Icahn's presence -- and plans?
News that Icahn began building a big stake in the company may not have been seen as a welcome sign from management. After all, he's known for ratcheting up a severe amount of pressure on underperforming management teams, compelling them to make short-term, shareholder-friendly moves at the expense of long-term value creation.

Management has already identified a long-term plan, which was articulated at the annual analysts' day last December. The plan was to boost the sales force from 675 to 775 and to devote more resources toward new product development. Those spending efforts partially explain why per-share profits are on track to fall more than 20% in fiscal 2013 (to around $1.30) and rise less than 10% in fiscal 2014.

Thus far, Icahn has not publicly disclosed any tangible steps he thinks management should be taking, but we can get a pretty good sense of what he will suggest when he starts to bang the drums more loudly. (In years past, Icahn has tended to take a big stake, remain quiet for a stretch, and then become vocal.)

Back in 2008, Icahn owned a large stake in Motorola, and eventually pressured that firm to split itself up. Motorola had a pair of key assets: a growing presence in mobile communications and a vast trove of patents. Nuance, too, has a strong mobile presence -- it runs the technology behind Apple's (AAPL) Siri -- and also owns more than 2,800 patents.

Staying the course?

In the absence of any value-unlocking moves being pushed by Icahn or others, what's the outlook for Nuance and speech recognition? The company's recent sales slowdown has led some to conclude that the technology is not a true game-changer and has already made its deepest inroads into technology. They suggest that touch-screens may be enough to satisfy most data input requirements. And there have also been some concerns about speech recognition accuracy, which is obviously a key consideration for health care IT buyers.

Yet that's an incredibly myopic view, reflecting only what is taking place in the company's business divisions right now in 2013. It's as if investors have chosen to ignore the powerful long-term trends that have been in place for a decade and are using recent tepid quarterly results as a sign that speech recognition has a limited future.

Yet it's hard to fathom how speech recognition won't become a larger part of our lives. Here's an example: The next generation of refrigerators will already know what's inside, as consumers can scan each item before it goes in or out. Using speech recognition, time-stressed parents will simply ask the fridge, "What can I cook for dinner based on the ingredients inside?" I could cite other examples, but I'll point you toward this article in MIT Technology Review instead.

The road ahead

Here's what to look for over the next six months.
  • After Icahn boosted his stake in late August, he is likely talking with the company about getting a seat on the board. That allows him to argue his case from the inside. (Nuance subsequently adopted a poison pill, so a hostile takeover is unlikely.)
  • Look for Nuance to give Icahn a board seat on or before the company's mid-November earnings release. At that time, expect another set of tepid quarterly results.
  • In December, during the annual meeting with analysts, look for a discussion of the new products that have resulted from the recent big push in R&D. Analysts will also more hear about the rising traction of the new sales force hires, who typically need nine to 12 months to become productive (which is how long it has been since the sales force was expanded).
  • Later in the winter, if shares still haven't budged from current levels, look for Nuance to extend its current $500 million share buyback program (initiated last April) and to become more receptive to selling one of its divisions.
Risks to consider: This is clearly a company in transition, so don't look for a sudden uptick in quarterly results any time soon.

Action to take:
Carl Icahn's timing is perfect. Nuance is a proven industry leader with a technology focus suitable to the decade ahead, yet its shares are currently deeply out of favor. You'd be wise to follow Icahn's lead, despite the obvious challenges the company is facing right now.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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