Nuance Communications, Inc.
Q2 2018 Earnings Call Transcript

Published: 10 May 2018

[Operator:]

Ladies and gentlemen, thank you for standing by and welcome to Nuance's Second Quarter Fiscal 2018 Earnings Call. At this time, all lines are in a listen-only mode. And later, we will conduct a question-and-answer session with instructions being given at that time. And, as a reminder, today's call is being recorded. With us today from Nuance are Chief Executive Officer, Mark Benjamin; Chief Financial Officer, Dan Tempesta; and Senior Vice President of Corporate Marketing and Communications, Richard Mack. Mr. Mack, please go ahead.

[Richard Mack:]

Great. Thank you and good afternoon, everyone. Before we begin, I want to remind you that our discussion this afternoon includes predictions, estimates, expectations, and other forward-looking statements. These statements are subject to risk and uncertainty that can cause material differences in our actual results. I would ask that you please refer to our SEC filings for a discussion of these risks. On the call, all references to income statement results are non-GAAP unless otherwise stated. And as noted in our press release, we issued prepared remarks in advance of this call. Those can be found on the IR portion of our website. Those are intended to supplement the remarks on this call today and will not be repeated here. Today, we will use a slightly different format for the call. Mark Benjamin, who joined as CEO a few weeks ago, will offer introductory comments. And then, Dan Tempesta will talk briefly about our results and outlook before we open the call to Q&A. With that, I'll turn the call over to Mark.

[Mark D. Benjamin:]

Okay. Thank you, Rick, and good afternoon, everyone. I'm excited to be here. Before we dive into the quarter's results, as Rick mentioned, I'll take a few minutes to introduce myself, share my first impressions and talk to my initial priorities at the company. As an outsider, I was attracted to Nuance for its reputation, foresight innovation and because I believe the company is at a pivotal point in its evolution. In just three weeks inside the company, my optimism for the business has been confirmed and my conviction for our future has been strengthened. For everyone following this business, you know firsthand that we have real strengths in our technology, customers, channels and markets, all backed by fundamental excellence in conversational AI. Over the long-term, I believe that this expertise and leadership will position the company to deliver compelling value for our stakeholders. So who am I and what can you expect from me as we look to enter this next phase? I've had the good fortune to learn from some truly outstanding business leaders over the course of my career. And my leadership principles have evolved with experience across virtually every aspect of a large multinational, multidimensional company. I'm a firm believer that empowered and purpose-driven teams lead to superior business results. I also believe in transparent communication and open dialog. And that's true regardless of audience, be it an investor audience, employees or customers. I believe successful leaders must have integrity and they and their teams must be accountable for execution, for the results they drive, and for the culture they create. It's vitally important to me that we create a culture at Nuance that is focused on delivering business-driven solutions for our customers that in turn power innovation in our markets, growth in our businesses and value for our shareholders. These are just a few of my core leadership principles and they should help you understand what to expect from me and the team here at Nuance going forward. I have been impressed with the leadership team who are motivated to really dig deep into these businesses. I'm looking forward to working with them as we accelerate momentum in our core businesses and put this company on a clear path to drive consistent organic growth and deliver returns for our shareholders. To do so, I intend to focus on several key priorities in my early days with the company. First and foremost is delivering on our commitments and doing what we say. Second is detailed conversations with Nuance's associates. Third is customer immersion. And fourth is shareholder introductions and, more importantly, doing a fair bit of listening. Regarding delivering on our commitments, this almost goes without saying but I'll say it anyway, execution comes first. This includes commitments to our customers, our associates and our shareholders. This priority doesn't change or go away while the team and I are working on everything else. Second on the business immersion and my work to really understand the business. I've asked for a comprehensive business and portfolio review and prioritization exercise to enable us to position the company optimally and maximize long-term shareholder value. I've already participated in detailed business reviews starting at the core and asking fundamental questions, so we can sharpen our strategy and approach to the market. What is the outlook? What are the competitive dynamics? What do customers expect? Where should we invest and where should we cut? What kind of margins, cash generation and growth can we achieve? As you know, we have a mix of businesses at Nuance, so this effort is important and will take our time to do it right. Third, on customers. Throughout my career, I have found that customers are one of my most valuable sources of information. So I'm scheduled to spend a lot of time with them in my first months at Nuance. I want to better understand in detail why they do business with Nuance and how they see their needs shifting over time. Their feedback will be instrumental as we evaluate our strategy and portfolio investments and how we prioritize. And, finally, I'll continue my dialog with shareholders. I've already had a number of conversations with shareholders, and my goal has been twofold. First is to introduce myself and offer a sense of what you can expect from me, but, more importantly, my goal is to listen to your perspectives and your concerns to help guide how we run Nuance and drive shareholder value. You can rest assure that my executive team and I will be looking at each of our actions through a TSR lens. As noted earlier, I'm excited to be here at Nuance and about the many opportunities ahead. I look forward to working with the team and to speaking with all of you to help realize those opportunities. I will now turn the call over to Dan to provide more details on our performance. Dan?

[Daniel David Tempesta:]

Thank you, Mark, and welcome to Nuance. As Rick noted, I'll start with a brief review of the quarter, certain changes in the business and our outlook. In my comments, I want to highlight three key areas. First, we're pleased with our performance in the second quarter with overall results largely in line with expectations. Second, we've taken additional steps to streamline and simplify the business, which includes several changes in our business segment reporting and organization. And, third, we have confidence in the fundamentals of the business, especially in Healthcare, Automotive and Enterprise, despite a handful of headwinds which I will discuss. Let me begin with a review of the quarter. As you saw in our press release and prepared remarks, we delivered a solid second quarter. We delivered non-GAAP revenue of $518.3 million, up 1% organically, and non-GAAP EPS of $0.27, both meeting our midpoint guidance. We also delivered strong cash flows from operations of $109.3 million which equates to 138% of non-GAAP net income. Our investment in growth businesses are producing measurable results, driving organic revenue growth for the second sequential quarter in the first half of fiscal year 2018. Healthcare and Automotive continued as prominent growth drivers in the quarter, with Healthcare delivering 8% organic revenue growth and Automotive providing 12% organic revenue growth. Enterprise did underperform for the quarter, with lower services and some license deals shifting into Q3. Net new bookings in the quarter were down 8% compared to the prior year. We've said previously that net new bookings will vary quarter-to-quarter, driven by the timing of large multi-year arrangements and we urge shareholders to look at our performance on an annual basis. Bookings in the first half of 2018 were up 1% year-over-year. And based on the strength of our sales pipeline, we are reiterating our fiscal 2018 net new bookings guidance of 5% to 7% growth. Turning to operations for a moment, we've talked recently with you about ongoing actions to simplify and streamline the business to more efficiently address our best market opportunities and improve transparency. As discussed last quarter, we made several changes to our reporting segments and we've provided new segment information for the periods presented to reflect this reporting. First, we established Automotive as a separate reporting segment. Second, we merged the Dragon TV product line into the Enterprise segment. And, third, our Subscriber Revenue Services business, known as SRS, and our Devices business now comprise a segment called Other, which represents about 5% of our revenues. As a result, we have five reporting segments now

[Mark D. Benjamin:]

Thanks, Dan. I want to again reiterate that the team and I remain confident in our fundamentals and prospects of the business. As we continue through this period of transition, we are going to be prudent with providing our longer-term outlook. Given everything we have underway and the ongoing transformation of the business, we will provide 2019 guidance when we announce fourth quarter results in November. I look forward to working with our management team to do what's right for the business and the long-term value for our shareholders. We now would be happy to take your questions.

[Operator:]

Thank you. And our first question comes from Saket Kalia from Barclays. Please go ahead.

[Saket Kalia:]

Hi, guys. Thanks for taking my questions here and welcome, Mark.

[Mark D. Benjamin:]

Thank you.

[Saket Kalia:]

Hey. Maybe for my first question for you, Dan. I think the SRS segment is what we've called mobile operator in the past and correct me there if I'm wrong. I think you mentioned in the prepared remarks that customers maybe change some pricing plans which will lower demand for Nuance solutions. Can you just go one level deeper through the detail of those changes and how it affects the SRS business?

[Daniel David Tempesta:]

Sure. Hi, Saket. Yes. Thank you. And you are correct. It is our mobile operator business that we referred to in the past. So if I was to do a double-click, this is the business where we provide value-added services such as top-up for upsell services or other value-added services to the prepaid marketplace. And there's a lot of prepaid market, of course, in Brazil, India and other emerging markets. So we monetize that platform of activity and we revenue share with the carrier when those activities occur. So, in India and Brazil, there has been a dramatic shift towards bundled offerings. Those offerings are still prepaid but because they're bundled all of the services whether it'd be voice, text, data, and a whole host of other activities, there's less opportunity to top off and upsell. So since there's less opportunity, the volume and demand goes down and that shift is having a real impact on our outlook. And we just don't think that outlook is going to – that trend is going to return. So at this time, it's prudent to take the adjustment.

[Saket Kalia:]

That makes sense. Maybe for my second question for you, Mark. So, first of all, thanks a lot for the intro. I think all of us have read your bio about your time at ADP, but maybe could you just go one level deeper into some of the accomplishments that you're most proud of your time at ADP or NCR for that matter? Thank you.

[Mark D. Benjamin:]

Sure. Yeah. Thank you for the welcome. I'm happy to be here. And I think, as you mentioned, I did have the privilege of really having some great tenure at ADP. So, it may be difficult for me to pinpoint any one specific item that stands out from many others. So maybe at a high level, Saket, I would suggest that I think after 20 plus years of delivering just great business performance at ADP with great colleagues and teammates I mean that's really how I look back on many of the proud accomplishments I was part of. With my tenure, I had the opportunity there to really do many different roles across many different aspects of the business, so from running large businesses and operations to being part of sales and sales leadership and driving strategy and products. And ADP is incredibly focused on customer experience. So those were some of the experiences I had perhaps more functionally. And then I was really able to run many different types of business. So from entrepreneurial start-up type of businesses that were adjacent to ADP that ultimately became multi-billion parts of the core company today to running and being part of more mature businesses within the U.S. that needed to find new growth and new expansion. As well as I also look back on my international experience there with geographic expansion, market expansion, margin expansion opportunities that I was part of. So many fond memories and many of my colleagues that are still there running major parts of the company. So really I'm excited really to reflect that experience here at Nuance.

[Saket Kalia:]

Super helpful. Thanks very much, again, Mark, and welcome.

[Mark D. Benjamin:]

Thanks, Saket.

[Operator:]

Thank you. And now to the line of Jeff Van Rhee from Craig-Hallum. Please go ahead.

[Jeff Van Rhee:]

Great. Thank you. I'll add my welcome, Sir Mark. Look forward to spending some time with you and the team. A handful of questions for me, guys. I guess just working – starting I guess with the segment overview, Enterprise, weak performance in the quarter, sounds like you're expecting it again in the next. Is this a function of more of the legacy what I call (19

[Daniel David Tempesta:]

Yeah. This is Dan. I think we just had an underperforming quarter. We just didn't execute. There wasn't one part of the business where we saw an issue. It was really across the business. We were light on our licenses and some of them pushed out to Q3. That was unfortunate that we didn't execute there. Our professional services, just given the timing of some of the large service arrangements we were working on, we didn't achieve our full professional services objective. And then we did have some of the activity that run through our on-demand and cloud networks. We had some weather seasonality where the weather wasn't that bad, so our outbound offerings were lower than expected from a volume standpoint. And there was some program adjustments with some of our customers. So, really was across the board. We don't see any longer-term issues. We expect growth going into the second half and we expect enterprise to end as a growth division for the year.

[Jeff Van Rhee:]

Okay. The bookings, understanding they're lumpy if you roll them in and take a look at – I mean, you crushed it in Q1 if you roll these together. As the first half it's just okay and you're certainly looking for strong second half. But specifically this quarter again, understanding the lumpiness, which areas in particular did you see the most lumpiness?

[Daniel David Tempesta:]

Well, as we've talked about in the past we have in the Auto space – the Auto space can have very large deals and then it can have – and then you can have – you don't see a deal because they come in large chunks. So Q1 was a good strong Auto quarter. We didn't have some of the large deals that we had recur in the second quarter. But, of course, as you look forward, we feel very confident with our 5% to 7%. So that gives us – we have a lot of large deals across the business whether it'd be Dragon Medical, Enterprise and Auto, so we still feel good about that guide.

[Jeff Van Rhee:]

Okay. Obviously you're seeing pretty good momentum on the Healthcare side. What about with respect to Digital Imaging? I know maybe a year back there was a false start on some sales and then Paul put in I think with the team some sales realignment, but it looks like results there are also weak this quarter. Expect them to stay around this level, any thoughts about what's going on in Digital Imaging?

[Daniel David Tempesta:]

Imaging is still dealing with – it's dealing with two things that we're very focused on. Well, first of all, we've had Al Monserrat start with the company. He started in January. He's had a busy 100 days. He's been focused in two areas. Number one is continuing to adjust the go-to-market strategy that we've been talking about over the last 12 months and that's a heavy focus on realigning the sales organization to best connect with the highest prospect OEMs and our end users. So that continues and then other distribution channels as well. The second thing that Al is now very focused on is our products and our product offerings and what our roadmap is. We have a tremendous market share in this space and we believe by adjusting go-to-market with some investment in product which we've been making, we can get this division back to growth. Right now it's a flat division. But those are the two areas we're focused in.

[Jeff Van Rhee:]

Okay. And then just numbers-wise, you gave a fairly wide range but I guess at the midpoint there was $32 million spent in the quarter and the description was a little unclear to me. That was for – can you fill in a few of the gaps there?

[Daniel David Tempesta:]

You're talking about...

[Jeff Van Rhee:]

This was under the Other/strategic review. It's backed up from GAAP to non-GAAP.

[Daniel David Tempesta:]

Yeah. I think we mentioned it was about $28 million. The second quarter for us was a very busy and the first quarter as well. Occasionally, as you know, we undertake strategic assessments for the business in different parts of the business. And the second quarter was, number one, very busy from that perspective working with consultants and advisors. And as well as, there was a very large effort for the separation of the Automotive business. As we talked about, we've now created a segment. There was a lot of financial separation, system separation, as well as organizational items there. So, it's the combination of all those items in the second quarter.

[Jeff Van Rhee:]

Got it. Okay. Last one and I'll let somebody else jump on. But obviously understand with Mark coming in, you don't necessarily want to rubberstamp the forward 2019 guide. And obviously given the SRS weakness, that would explain some of the caution, although it's a relatively small piece of the overall business. Offsetting that is obviously a percent of revenues, that's recurring here, has gone up substantially. So visibility should have been pretty good going into that out-year. Does anything else in the business underpin the decision to pull the 2019 other than the SRS?

[Mark D. Benjamin:]

Yeah. No, this is Mark. So I'll let Dan, of course, comment, but I think you've captured it. I think the SRS impacts that certainly I think came quickly and that's why you see essentially the adjustment in 2018 is really essentially all driven by that. I think on the 2019 guidance, as I mentioned, as I get involved with the business and perhaps a little bit of pressure to see how SRS, I would say, performs over these next couple of quarters. We just thought and really I drove the prudence here as far as reassessing 2019 guidance at the right time, which would for me be on that fourth quarter call. And that'll likely be how we approach forward-looking guidance in future years during that timeline.

[Jeff Van Rhee:]

Okay. All right. Great. Thanks. Welcome again.

[Mark D. Benjamin:]

Thank you.

[Operator:]

Thank you. And now to the line of Sanjit Singh from Morgan Stanley. Please go ahead.

[Sanjit K. Singh:]

Hi. Thank you for taking the questions and welcome, Mark, and congrats on the role.

[Mark D. Benjamin:]

Thank you.

[Sanjit K. Singh:]

Looking forward to working with you.

[Mark D. Benjamin:]

Thank you.

[Sanjit K. Singh:]

So I had so just some higher level questions. I think you sort of addressed this in your script. But if you can sort of just lay out for the shareholder base what your timeline is in terms of you mentioned you wanted to – you're going – could be talking to a bunch of customers. But what should we expect from a communication standpoint over the next six months, whether it's a strategic plan that you want to detail later on the year? Can you just give a sense of the timeline of what shareholders should expect?

[Mark D. Benjamin:]

Yeah. It's a very fair question and I think you probably peg the timeline. My plans – I'm in my third week here, so I have been able to get involved with the businesses very quickly. But my plan over, call it, this next 100, 120 days is to do exactly as I described in my opening comments, a very deep review of the portfolio here internally and business reviews which have already begun, customer and shareholder meetings and conversations. While I'm doing that with the management team here, we are ultimately embarking on some strategic visioning and opportunities for the future of the company. So, Sanjit, I would anticipate some time certainly before the end of the fourth quarter you would have already or you'd be beginning to hear from the management team, including me, on some strategic directions and the future look of Nuance.

[Sanjit K. Singh:]

That's super helpful. And I wanted to also revisit I think a question that Saket asked on the top. And it sort of relates to your background and then also the dynamics of the business. So I think what this quarter highlights is sort of the extreme volatility that we see in the business. Enterprise, this time last year was growing in the teens. This quarter was down 8% organically. Last quarter Imaging was up 7% organically. This quarter it's down, right. So just a lot of volatility in the results. So I guess my question is to what extent have you experienced similar challenges in your previous roles whether at ADT or otherwise and any sort of high level thoughts on what the levers that could be pooled to maybe tighten up the execution or still (29

[Mark D. Benjamin:]

Yeah. So I think it's a great question. And, again, there is a very good recurring revenue base here that fluctuates quarter-by-quarter. And the team here has done a good job, I think, moving that into the low 70% to mid-70% range from as far back as 2014. So I do think we have a lot of goodness there. I think the variability and a bit of the lumpiness is that we do have some legacy business models where we can have quarter-to-quarter licenses and large transactions that come in and create that. So I think as my priorities and the team's priorities start to take hold, call it, over this next six months, we're going to be focused on the cloud businesses that we're in and how to grow that recurring base. I think we'll take a careful look at moderating some of the businesses that don't necessarily fit into the way we'll grow the business and create recurring revenue streams. And that could include our go-to-market. That could include the way we sell certain parts of our solutions. I think one thing that Dan could specifically comment is that in really in our Healthcare, Enterprise and Automotive solutions, those cloud solutions and a large part of their recurring revenue solutions are really taking hold and really showing some nice growth. So my goal is to really move that recurring revenue percentage up and improve the predictability quarter-to-quarter because like you I prefer to have more consistency. And I think that's certainly a prominent part of the challenge for this team to solve for.

[Sanjit K. Singh:]

Got it. And then my last question maybe is for Dan and it goes back to the margin. I think the context here – I think this is the third quarter in a row where the margin guidance has ticked down. And I think most of the shareholder base would certainly appreciate delivering growth in the business versus managing to a specific margin. But given that it's three quarters in a row of a margin downtick, is there any sort of levers that you can pull to ensure that you guys hit your margin guidance? I understand that we need to invest and that's certainly important for top line growth, but how do we know that as we continue in the course ahead that we're just not going to continue to get margin surprises?

[Daniel David Tempesta:]

It's a good question. At this point, we're not very, as a management team, pleased with the margin adjustments that we've had. Some of them – if you just reflect on where we came from, at the beginning of the year, we reduced margins 100 basis points for security initiatives and 100 basis points for investments that we wanted to make into conversational AI. That was the plan going into the year and those are going well. Last quarter, we took it down 50 basis points because of the significant market shift we saw in professional services. And, of course, this quarter, we're taking it down a little because of SRS. So we're going to look very hard as part of the work that Mark mentioned around portfolio review. Included in that is really going to be cost initiatives as well. We always have been very protective of our margins. We worked really hard to get them up to the upper 20s and now they're coming down a little bit. And I think that cost work that we're about to undertake with Mark now here and looking at both portfolio and business is how we're going to try and get it back.

[Sanjit K. Singh:]

Thank you very much.

[Operator:]

Thank you. And now to the line of Tom Roderick from Stifel Communications. Please go ahead.

[Thomas Michael Roderick:]

Hi, gentlemen. Thanks for the chance to ask a question here. First question for me just looking at the professional services line in a little bit more detail. Mark, I think you had mentioned it was perhaps a little bit disappointing relative to your expectations. But as we look at it, it looks like it's growing pretty nicely, particularly last couple of quarters. Is there something going on there that we should be aware of? Can you help us understand why that had a big jump and perhaps where it is falling short of your expectations? Thanks.

[Daniel David Tempesta:]

Sure, this is Dan. The professional services that I mentioned falling short was just part of Enterprise and the quarter didn't achieve what we expected from Enterprise in PS. It's usually a really strong PS organization. But, in general, you're right. Our professional services have been growing. They've had strong growth in Q1 and Q2. And we talk about it in the call remarks. That's really due – in our Healthcare business we have a growing what we call EHR optimization and implementation business. So this is where we go into an EH hospital system that has Epic primarily. And we work on optimizing the EHR environment whether it'd be making the workflow better and easier for the physician to capture its documentation, whether we make the speech work more effectively, whether we connect it to our back-end cloud more efficiently. So this has some spike to it. We had some large implementations that happened both in Q1 and Q2. So it's good work. It's very strategic because it gets us connected to the hospital systems early. And then we have this optimization set of services going forward. But it can be spiky and so that's what we saw in the first couple quarters. That will come down in the third quarter. We don't see large implementations in the third quarter at this time. And so that's what we're referring to.

[Thomas Michael Roderick:]

Okay. Good. And then, Dan, this is probably a follow-up question for you as well but would love to hear a little bit more detail. Looks like you're moving the Dragon TV line into Enterprise. Can you just remind us what is in that? Obviously it would seem like all of the solutions embedded within TV like your Panasonic relationship fall into that. Curious if some of the operator relationships like the Comcast relationship on the remote control would be something that falls into that bucket. And what is the magnitude of that, just so that we can start thinking about what the apples-to-apples is on Enterprise going forward? Thanks.

[Daniel David Tempesta:]

Sure. That is exactly what it is. It's the activity like the Comcast activity and some of the other bookings that we've been doing. If you go deep into the call remarks you can see that's a very small business right now that will be growing. You can see some of the growth. But in the call remarks we've given a reconciliation of old Enterprise to new Enterprise. In this quarter it was around a $3.5 million business but that will grow given some of the bookings that we've seen recently and as we stand up those offerings.

[Operator:]

All right. Thank you. And now to the line of Shaul Eyal from Oppenheimer. Please go ahead.

[Shaul Eyal:]

Thank you. Good afternoon. And, Mark, welcome onboard from my end as well.

[Mark D. Benjamin:]

Thank you, Shaul.

[Shaul Eyal:]

So I want to go back to Saket's and Sanjit's questions with respect to your back on coming out of ADP. So clearly ADP was a very steady Eddie business, some would even say boring but boring in a good sense of stability and predictability. Nuance structurally appears to be slightly more complex, three, four, right now five different divisions. How do you think strategically of the business? How – or maybe in other words, do you think there's a room to import some of the ADP DNA into Nuance?

[Mark D. Benjamin:]

Yes. Shaul, it's a very good question. And this call certainly is about Nuance. But I would say that ADP is – it may be referred to as a boring company but it has its complexities. I would tell you that our goal would – we'd, of course, love to be a boring 90% recurring revenue business, but I can assure you even if we achieve that, we'd have its complexity. So, I would tell you that some of my experience at ADP, some of my experience at NCR, which I'll bring here and hopefully drive culturally would be portfolio rationalization and simplification. And I think it's too early for me to comment on which product lines or lines of business that could fit that simplification and rationalization here. I could tell you that that will be something that this team pursues aggressively. And I think that not only will help our investments in the business. We'll be able to isolate greater investments in core growth opportunities, but also just simplify the business going forward and achieve some greater predictability. So boring would be great. I think we have those opportunities. But even at boring ADP, we had complexities in the business and it didn't seem – trust me, it was never as easy as it may appear. And we'll work hard here to also drive a similar type of simplification.

[Shaul Eyal:]

Got it. Thank you so much and good luck going forward.

[Mark D. Benjamin:]

Thank you.

[Daniel David Tempesta:]

Thanks, Shaul.

[Operator:]

Thank you. We have no one else in queue. Please continue.

[Daniel David Tempesta:]

Okay. Well, thank you very much for joining this call. And we look forward to speaking to you all next quarter. Thank you.

[Mark D. Benjamin:]

Yeah. Thank you very much.

[Operator:]

Thank you. And, ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T Executive TeleConference Service. You may now disconnect.