Nuance Communications, Inc.
Q3 2018 Earnings Call Transcript

Published: 9 Aug 2018

[Operator:]

Ladies and gentlemen, thank you for standing by and welcome to Nuance's third quarter fiscal 2018 conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. As a reminder, this call is being recorded. With us today from Nuance are Chief Executive Officer, Mark Benjamin; Chief Financial Officer, Dan Tempesta; Senior Vice President, Corporate Marketing and Communications, Richard Mack. At this time I would like to turn the call over to Mr. Mack. Please go ahead.

[Richard Mack:]

Thank you and good afternoon everyone. Before we begin, I want to remind you our discussion here includes predictions, estimates, expectations, and other forward-looking statements. These statements are subject to risks and uncertainties that could cause material differences in our actual results. Please refer to our SEC filings for a discussion of these risks. All references to income statement results are non-GAAP unless otherwise stated. And as we noted in our press release, we issued prepared remarks in advance of this call which are available on the IR portion of our website. These remarks are intended to supplement our comments on this call today. Today, Mark will cover the quarter's highlights, initial observations and our ongoing portfolio and business review. Dan will recap our outlook for 2018, and then we'll take your questions. Mark?

[Mark D. Benjamin:]

All right. Thank you, Rick, and good afternoon everyone. I'm pleased to be here with you after a fast furious first 100 days at Nuance. After more than 100 investor discussions, multiple customer visits, several board meetings, deep dives on each of our businesses, two sets of quarterly operating reviews, and many touch points with our energized and motivated associates, I know we're much closer to the strategic and operational thesis of where we need to be for lasting success and value creation. As I've noted with many of you in our discussions, I remain impressed by our strengths of our business, the loyalty of our customers, the capabilities of our technologies, and the value we can unlock. And that begins with the quarter we just posted, delivering on what we said we'd do. As you saw in our press release and prepared remarks, Nuance delivered a solid Q3 across the company. Non-GAAP revenue of $506 million was above the high end of our guidance, reflecting 1% organic growth and keeping pace with our full year targets. Net new bookings grew 7% over the prior year with strength in Healthcare and Enterprise and we're confidently on track to achieve our full year guidance. Non-GAAP diluted EPS of $0.27 was slightly above the midpoint of our guidance. In the quarter, we generated approximately $100 million in cash flow from operations. Non-GAAP gross margin was 62.1%, an improvement of 60 basis points from last year and toward the lower end of our expectations due to better than expected EHR professional services which come with lower gross margins. And, non-GAAP operating margin was 24.7%, down 230 basis points from last year, reflecting planned investments in security and conversational AI as well as higher legal expense related to IP protection plus the revenue mix that I just mentioned. As I've reflected on the quarter, stepping (00

[Daniel David Tempesta:]

Thanks, Mark, and good afternoon. As you heard, we've got significant work ongoing to reshape the future of Nuance. In the meantime, we remain focused on our customer commitments and our financial performance. As you can see, we posted a strong third quarter, one that puts us on track to achieve our full year targets. We expect many of the same favorable trends to continue in the fourth quarter, namely, the continued performance across our cloud solutions, in particular Dragon Medical One, better execution in our Enterprise business, and continued growth in Automotive. Building on the first three quarters and based on these trends, we expect to be within previously provided guidance ranges for fiscal year 2018. Specifically, for the year, we expect organic non-GAAP revenue growth of approximately 3%. Net new bookings are expected to grow between 5% and 7% and cash flow from operations is expected to be between $410 million and $430 million. Our gross and operating margins for the year, while within our prior guidance, are expected to be on the lower end of our range. We expect that gross margins for the year will be around 62% and operating margins will end the year around 25.5%. Throughout 2018, higher professional services revenue mix and the performance issues in our SRS business have weighed on gross margins and operating margins for the year include our planned security and research and development investments, as well as the additional IP related expenses Mark mentioned earlier. Regarding Q4, we are guiding non-GAAP revenue between $517 million and $532 million, a non-GAAP EPS between $0.30 and $0.34 per diluted share. Please note that complete details on our Q4 and fiscal 2018 guidance are provided in our prepared remarks. And as communicated on our May call, we will discuss fiscal year 2019 guidance when we announce earnings in November. Before turning it back to Mark, let me reiterate the progress and plans for our capital allocation strategy. In addition to the 8.1 million shares we repurchased in Q3, we expect to leverage our share repurchase program as opportunities present themselves. With our incremental share repurchase program, we currently have approximately $565 million available for share repurchases. In addition to the share repurchases, we intend to pay down $150 million of our 2020 5.375% high-yield bonds which will be callable at par after August 15, 2018. We expect to complete this transaction in mid-September and as a result we'll reduce our debt maturity value to $2.44 billion and our annual cash interest expense will also be reduced by approximately $8.1 million. I'm pleased with the progress we've made in this area, doing what we believe is right for the business and being responsive to the feedback we've heard from our investors And now I'll turn the call back to Mark.

[Mark D. Benjamin:]

Thanks, Dan. After a solid Q3 and with attractive opportunities we see ahead, I want to reiterate that the team and I remain confident in our fundamentals and prospects for the business. We have tremendous leadership, technology, and experience to build on, and in fact, I'm more excited today than I was when I joined in late April. I look forward to talking with greater clarity about the future of Nuance when we report of our fourth quarter results in November. We're now happy to take your questions.

[Operator:]

Our first question comes from the line of Saket Kalia of Barclays. Please go ahead. Your line is open.

[Saket Kalia:]

Hi, guys. Thanks for taking my questions here, and, Mark, congrats on your first 100 days.

[Mark D. Benjamin:]

Thanks, Saket, I appreciate that.

[Saket Kalia:]

Mark, maybe just to start with you kind of more strategically. I don't want you to pre-announce anything on the portfolio strategic review, but perhaps higher level, what are going to be some of the qualitative and maybe quantitative items that you're going to look at when deciding which businesses Nuance is going to compete in down the road?

[Mark D. Benjamin:]

Okay. Sure. So let me start with really how we're looking at the initiatives. We're really taking two core areas. We're looking at the portfolios of the business and, really, the organizational structure of the business. So, let me start with the portfolio, Saket, and I'll kind of walk you through, somewhat qualitatively, how we're looking and analyzing this. At the business unit level, we're looking at, truly, all the portfolios and products, first with a growth lens – and we're examining the growth opportunities – followed by a margin lens, if you will. We're favoring in all of our analysis growth for the future of the business for greater value creation. And then, we're assessing, really, the underlying markets of the solutions and the drivers of those markets and really pressure-testing our right to win, whether it's currently very strong or we see future opportunities. And then we lay that against, really, the closeness to the core of the business. So is it something that really leverages the strength of Nuance and our technology? Is it more of an adjacency? And really, will it return higher-value sustainable results? So then, we really step back and look at the investments required for really making these solutions more successful and accelerating growth. We look at the portfolio around deprioritizing other assets or investments within the portfolio, Saket. So we know we have somewhat a fungible investment base to work with and, really, to double down on opportunities. So we're doing that at a business unit. The management teams are working really hard at that. We take all of that really what all the findings, if you will, and then we lay that against, really, our corporate lens around growth and margins. We analyze if there's any potential combinations of the solutions, synergies, or maybe a lack thereof, dis-synergies or perhaps something that doesn't necessarily fit within the corporate long-term view of the business and our capabilities. So we're really doing that with all the business units, with the solutions and the portfolio underneath each business unit. Again, we're asking ourselves, do we have a durable competitive advantage? Is it something that we see growth accelerating from? And does it give us, obviously, the financial profile for the future of Nuance? So that's, really, how I'm looking and how we're looking at the portfolio review, and it's happening across the company. The second part, Saket, is really around the organizational review or said another way, our organizational effectiveness. And that's really where we look at the business units, and we establish baselines. We essentially lay out how they're organized, how they're designed, and how they spend, and then we introduce external data and benchmark data to make sure that – are we properly structured, are we competitively structured, and is this really the current, if you will, landscape for tech companies like Nuance? And we're asking ourselves questions along the way. So we're saying, are we best-organized to serve our customers? To partner in channels? And are our associates closest to the customer today? Are we too complex in the structure that we have at the business-unit level or the entire broader enterprise level? Are we innovating fast enough? Is it organic innovation? Or is it mostly M&A? So we're asking, obviously, a number of those questions, again, all focused with, are there efficiencies and better ways to organize ourselves to be more effective and more competitive for the future of the business? So those are really the two categories that are part of this review process. We've been quite busy at it, as you can imagine. And they'll continually evolve. So while we're focused on really reaching this fall timeline for showing some – not just tangible results, but obviously some strategic decisions that we'll make. They will always evolve. They'll become part of the DNA of the business and how we always analyze ourselves and keep ourselves competitive. The good news, also, is that much of the organization is involved with these reviews. So there is an excitement around the opportunity to change and not just within my management team, but really when I talk to associates in the cafeteria, getting coffee in the morning, I think people really are feeling the excitement around making Nuance a different, more competitive and growth oriented company.

[Saket Kalia:]

Got it. That's super helpful, Mark. Dan, maybe for you on the business, really nice to see Enterprise sort of bounce back to levels that we're used to seeing in the quarter. Maybe in your postmortem, after looking at last quarter's results, what do you think happened last quarter? And looking forward, how do you feel about the pipeline and execution going into the fourth quarter here?

[Daniel David Tempesta:]

Sure, thanks, Saket. Good question. We did see a softer Q2 for Enterprise. We talked about that at length last quarter and it really was across the board, whether it be in the license business or the PS business or the hosting volume transactions, they were all down in Q2. And we were disappointed, but we weren't overly alarmed. We knew that was a good business. We said it would come back and rebound next quarter and it did. In Q3 we saw a strong licensing, both in on-premise and in voice biometrics, so pleased with that. And PS and hosting both performed as we had planned. So good quarter overall, I think it was 5% growth. For Q4, based on the pipeline, I'd expect another strong quarter. So we're looking good in the fourth quarter for Enterprise.

[Saket Kalia:]

Go it, very helpful. Thanks, guys.

[Mark D. Benjamin:]

Thanks, Saket.

[Daniel David Tempesta:]

Thanks, Saket.

[Operator:]

Your next question comes from the line of Jeff Van Rhee of Craig-Hallum. Please go ahead. Your line is open.

[Jeff Van Rhee:]

Great. Thanks. Thanks for taking my question. Couple for you. Mark, just to follow on to that, in terms of the pipeline, so you commented on Enterprise, just maybe a little more color about what you're seeing in pipe, what's changing, where you're seeing acceleration, deceleration. I realize we're not getting a 2019 guide but as we start to think about 2019, I mean, certainly it takes bookings now and pipeline now to drive things. So can you just sort of anecdotally comment on what you're seeing in the pipeline and particularly if you're seeing areas of acceleration or deceleration?

[Mark D. Benjamin:]

Yeah, sure. Thanks, Jeff, for the question. So I mean, I – I'd say obviously we still feel very good about the year in bookings. So, as you know, we're just coming off a good quarter and we feel still confident very much in the full year guide. So our pipelines are very strong right now, really across the portfolio, certainly we're seeing some good strength in Enterprise, as Dan mentioned. Our Healthcare and Automotive business is also I think a very healthy pipeline and Imaging as well. So it's really somewhat across the board, probably particular strength in Healthcare, Auto and Enterprise right now. We run the models against the pipeline and our conversion rates and we apply obviously levels of risk tolerance and historical levels. So we feel very good and, again, we're really pleased with the performance of the sales force. I mean, just remember, the sales force is 1,200 people. It's a global sales force and we're really thrilled with what they're doing kind of in this back half of the year.

[Daniel David Tempesta:]

Hey, Jeff. This is Dan. Let me just add on to that. We had a 7% bookings growth in the third quarter, 3% for the year and we're maintaining our 5% to 7% for the year. So obviously, we're planning on having a very good quarter in the fourth quarter and that is, of course, due to the strong pipeline that Mark just mentioned.

[Jeff Van Rhee:]

Yeah, yeah. Got it. And on Health, I guess two questions. One, I think you alluded to it in the prepared remarks that there's some increased bundling with respect to some of the transcription and we might need to change how we think about the rate of decline there in terms of the lines. So I guess two questions related to Health, one, just if you want to expand on what's going on there with the lines and the bundling and how to better think about that. And then two, I think you commented that you're seeing a substantial increase in professional services, particularly related to EHR. Maybe you can just touch on how that might be exceeding your expectations of what it's indicative of.

[Daniel David Tempesta:]

Sure. So let me see if I can take both of those. This is Dan. As it relates to – we did make a comment that HIM erosion for the standalone contracts continues to execute as we planned around 10% erosion. But when you put the bundles together, which we've been talking about all year, when you bundle up HIM transcription with the DMO cloud, we're seeing the beginnings of faster erosion from the HIM revenues. But, of course, that's moving towards the benefit of the DMO cloud. So, while the rates may be slightly higher, and we'll talk more about that next quarter, the fundamental economics are sort of accretive to us in the longer term as we move things to the DMO cloud. As it relates to EHR-implementation and optimization services, that was a big grower in the first half of the year. Both Q1 and Q2 were very high levels of services. We talked a lot about that last quarter. Those have come down to more historic levels, still a little bit high, still outperformed what we expected this quarter, but much more rational levels than what we've seen in the first two quarters.

[Jeff Van Rhee:]

Okay. Great. And just one last then, and it's along those lines. I think you commented in terms of the operating margin pressures, you pointed to the professional services shift. Just sort of bundle that up, if you would, as to where those particular surprises have come over the last few quarters in professional services that's driving that operating margin guidance shift.

[Daniel David Tempesta:]

I think it's primarily the overperformance in the EHR, so we performed each quarter better than we thought and that put margin pressure on us. We did talk last quarter about some of the reduced professional services that we're seeing in the Auto space. But we are seeing some margin pressures in the Auto space, just the way the OEMs want to buy. They're paying less for the professional services and they're putting more in the per-unit pricing. That's causing a little bit of PS pressure as well. I think the bigger impact in the overall operating margin, though, really is the SRS business. That certainly surprised us last quarter. We talked about it quite a bit. That is having a bigger impact than the professional services mix.

[Jeff Van Rhee:]

Great. Okay.

[Daniel David Tempesta:]

And, of course, that's noncore to our business and really doesn't impact the three larger businesses.

[Jeff Van Rhee:]

Got it. Okay. Great. Thank you.

[Operator:]

Your next question comes from the line of Sanjit Singh of Morgan Stanley. Please go ahead. Your line is open.

[Sanjit K. Singh:]

Thank you for taking the questions, and congrats on a solid Q3. I think, Mark, maybe my question is going back to sort of the strategic review. Can you give us a sense of to what extent you've looked at the competitive environment, particularly around the major cloud web scale providers? Because I think there's a view that some of these markets you're evolving faster than others. And so as you incorporate some of that analysis into the strategic plan, can you give us any sort of insights into how you're thinking about the competitive environment as it relates to your core markets?

[Mark D. Benjamin:]

Yeah, sure. So, I mean, it's certainly a major part of the filter, if you will, of all the reviews is the competitive landscape, our position against not just our competitors but really the embedded nature of our solutions. So, as you know, the core technology of Nuance, which started many years ago around speech, whether it's ASR or TTS and really has evolved into NLU and CLU, the Clinical Language Understanding, that's very strong in our Healthcare business. And as we move up around conversational AI, cognitive AI with our solutions, taking the richness of those core technologies at Nuance and how embedded those are into our customer use cases and where (00

[Sanjit K. Singh:]

That's very helpful. And maybe as a follow-up, in terms of – again not to preview anything too much, but in terms of the range of options you are looking at when it comes to portfolio, is the right way think about the range being maybe de-emphasizing certain product lines versus exiting, versus potential asset sales? Is that the sort of options on the table? How would you sort of describe the ranges that you're considering with respect to the strategic review?

[Mark D. Benjamin:]

Yeah, I mean, I think you're doing a good job answering for me. I mean, I think there's – as I've said, really since day one, we're going to consider all options and keep all options available to us. That will really, I think, have a full range of opportunities. I mean, certainly we have assets or products or solutions that are in our markets today that are going to be considered to be de-emphasized or de-prioritized that could be worth more to someone else than certainly the board and the management team here. We'll consider those as we do the review. And certainly, we want to start to be more focused. We want to simplify the business. We want to reduce the complexity. And we want to make, I think, more prominent bets in places that we have the highest confidence in around our customer base, around our core technology and capabilities. So, yes, so again, not to over-answer your question, the spectrum is wide and we'll consider all options.

[Sanjit K. Singh:]

Wonderful. Looking forward to next quarter.

[Mark D. Benjamin:]

Thank you.

[Operator:]

Your next question comes from the line of Tom Roderick of Stifel. Please go ahead. Your line is open.

[Thomas Michael Roderick:]

Hey, gentlemen. Good afternoon. Thanks for taking my question. Looking at the cash flow statement this quarter, this may be aimed at you Dan, but Mark jump in on the strategy side of this, if you don't mind. It looks like there's under $100 million this quarter for acquisitions made. And I noted during the quarter you guys made an acquisition in the auto space of VoiceBox. I was hoping if you could kind of talk a little about what VoiceBox brings to the table to you strategically. What didn't you have that you're getting from that? And what they bring to the table? And then beyond that acquisition, was there anything else in the quarter that we should be aware of in other segments that would stand out? Or is that pretty much all of the $96 million number on that free cash flow statement?

[Daniel David Tempesta:]

Yeah, it's a good question. We did two acquisitions. We did the VoiceBox acquisition and we did a very small health care acquisition that got us distribution and sales capabilities in the UK and in some of the European countries. So, that was the remaining balance of the acquisitions. And that second acquisition is important, because the Healthcare team sees real opportunity for international expansion and of course expanding the sales org. As it relates to VoiceBox, it gave us two things. It gave us – it did have some technology that was complementary to our current connected technology. So that was number one. But, more importantly, it gave us a terrific relationship. We had a relationship with one large OEM. They had a relationship with the same OEM. And that provided further expansion of that relationship.

[Mark D. Benjamin:]

Yeah, and Tom, this is Mark. So, just following up more strategically, because we've been consistently speaking around our capital allocation strategy. So, the VoiceBox acquisition was I think very early in the quarter, that was, I would say, had been underway for many, many months that ultimately closed at the beginning of the quarter. The small acquisition that Dan referenced in the UK was relative to our Healthcare business where we have a business, where we have international aspirations of growth, was, I would put it as a very small tuck-in type acquisition that gave us something specific to the UK market. So I just don't want any confusion. Our allocation or our capital allocation strategy will continue to be focused on everything we've been talking about now for the second quarter around more balanced approach and a de-emphasizing M&A spend.

[Thomas Michael Roderick:]

Outstanding. That's helpful. And on that topic, let me just follow up with a secondary question. A bit philosophical here for you, Mark. But in thinking about the way that you guys have guided EPS this year, so if I take the high end of the range, EPS will grow sort of loosely 10% over last year's number at the high end of the range. Were that to continue – and obviously you're not guiding out to 2019 or beyond at this point, but were you to try and to continue to grow EPS at, let's just call it 10% to 15%, how do you think about what the appropriate mix of levers are when you think about revenue growth, sort of cost containments to expand margins, and then utilizing your capital to buy back stock? What's the right mix in that? Is that kind of one-third, one-third, one-third? Would you rather see more revenue growth and leave margins sort of steady? Just talk about how you philosophically think about trying to drive that double digit EPS growth in the future with those three levers.

[Mark D. Benjamin:]

Sure. So listen, I think it's a great question. It's I think we're – part of the answer is we're pursuing in some of the reviews around the portfolio, around the efficiency or effectiveness analysis we're doing at the company. I will tell you, my bias will be to growth. The growth lens for Nuance is an important – not just for the future of the company, but really how we'll ultimately create value or unlock value. Certainly, growth will have to be followed on by the right margin profile for the business and for the growth. So not just for growth's sake. So I would say it leans to growth. From a cost containment aspect, we're examining our cost footprint and really the expenses that we have in the business and that is really in my second part of the effectiveness of the company analysis. We'll be balanced. We're going to be making the right long-term decisions with a real focus on growth for the future that ultimately is scalable and that will obviously provide future margin for the company and its future.

[Thomas Michael Roderick:]

Wonderful. That's great perspective. Thank you very much.

[Mark D. Benjamin:]

All right. Thank you.

[Operator:]

There are no further questions at this time. I would like to turn the call back over to Mark Benjamin for closing remarks.

[Mark D. Benjamin:]

Okay. Well, thank you for joining us, everyone. We appreciate the time and I look forward to our continued discussions in the coming weeks and months. Thank you very much.

[Operator:]

This concludes today's conference call. You may now disconnect.