Nuance Communications, Inc.
Q3 2017 Earnings Call Transcript

Published: 8 Aug 2017

[Operator:]

Ladies and gentlemen, thank you for standing by and welcome to Nuance's third quarter fiscal 2017 conference call. As a reminder, this conference is being recorded. With us today from Nuance are Chairman and CEO Paul Ricci, CFO Dan Tempestan, and head of Investor Relations Christine Marchuska. I'd now like to turn the call over to Ms. Marchuska. Please go ahead.

[Christine Marchuska:]

Thank you. Before we begin, I remind everyone our discussion this afternoon 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 recent SEC filings for a discussion of these risks. All references to income statement results are non-GAAP unless otherwise stated. And, as noted in our press release, we issued a set of prepared remarks in advance of this call, which are available on our website. Those remarks are intended to serve in place of extended formal comments, and we will not repeat them here. I will now turn the call over to Paul.

[Paul A. Ricci:]

Good afternoon, everyone. I want to take a few minutes to discuss today's results and our expectations for the remainder of the year. Our fiscal 2017 has been a year of strong performance, enabled by opportunities in our most attractive markets, focused investments in support of the business, and productivity initiatives in our transformation program, which have enhanced our earnings and cash flows. Our performance has been demonstrated by sustained bookings growth that has exceeded our expectations throughout FY 2017 and underscores broad-based momentum in our businesses. Within Healthcare, we've capitalized on the adoption of our Dragon Medical cloud solutions and continue to see strong pipeline development. In Enterprise, we've seen strength from our omni-channel cloud offerings and voice biometric solutions. For Imaging, although we faced some challenges, we've seen recently strengthening of our pipeline and bookings. And in Mobile, we returned to organic revenue growth for the first time in almost two years due to the strength of our automotive business and expanded geographical footprint of our telecommunications and mobile operator business. Our third quarter in particular was set to be an excellent quarter by nearly all measures prior to the onset of the June 27 global malware incident that disrupted our business operations as well as thousands of other companies globally. As noted, the incident had an effect on our third quarter, primarily in our healthcare transcription and imaging businesses, although the impact was limited since it occurred just four days before the end of the quarter. Despite the incident, we delivered solid results in key financial metrics, including bookings, recurring revenues, and cash flow from operations. On an as-reported basis, net new bookings were strong, up 21% year over year. Recurring revenue was at 73%, up 200 basis points from a year ago, and cash flows were robust at $132 million. Furthermore, on a pro forma basis, had the incident not occurred, we would have generated organic revenue growth for the second consecutive quarter, a trend we have not seen for several years. Of note, our primary growth business lines, Dragon Medical cloud, omni-channel solutions, automotive, and biometrics, continue to fuel our performance with key bookings wins. As previously forecasted, Q3 would have marked the milestone in which Dragon Medical Cloud growth outpaced the HIM transcription decline. We also note that absent the incident, gross margins and operating margins would have improved further from a year ago. Overall, we remain confident in our business fundamentals and the continuation of recent trends. Without the malware incident, Q4 and the fiscal year would have landed well within the previous revenue and EPS guidance ranges we provided. However, the effects of the incident in the fourth quarter will be extensive, with an impact of approximately $65 million to $75 million in Healthcare and Imaging revenue, bringing our Q4 non-GAAP revenue guidance range to $442 million and $472 million. To help you understand the core performance of the business absent this impact, we estimate that Q4 revenue on a pro forma basis would have been between $517 million and $537 million had the incident not occurred. Our prepared remarks outline the company's revised guidance in detail. As we exit the fiscal year, the remediation of our systems will be largely behind us. In Healthcare, we have steadily brought hospitals back online, and as of today have met our goal of enabling functionality for substantially all our clients for our flagship transcription platform. Furthermore, we've made rapid progress in restoring our systems safely and with enhanced security. As we look ahead to fiscal 2018, we anticipate continued growth from our AI, cloud, and virtual assistant offerings, sustained performance in our core domains, and additional expansion in international markets. Similarly, we expect a continuation of trends in our most promising lines of business, including strong growth for Dragon Medical cloud, which will accelerate as we increasingly transition transcription clients, ongoing competitive advantage in Automotive, led by our cognitive and voice capabilities within Dragon Drive, momentum for our Enterprise omni-channel and virtual assistant solutions, solid demand for our biometrics, one of our fastest growing product lines, and expansion and building volume of our mobile operator services. Overall, our pipeline remains strong, and we are confident in delivering bookings growth in fiscal 2018, but we expect some remaining effects of the incident in the next fiscal year. We believe the incident will reduce FY 2018 revenue by approximately $65 million to $75 million, primarily within our HIM transcription business, and to a much lesser extent within our Imaging business. In previous earnings calls, we have provided organic revenue growth guidance for FY 2018 of between 2% to 4%. After adjusting for the impact of the incident on revenue and evaluating the other trends in our business, we reaffirm our estimate of organic revenue growth in the range of 2% to 4%. In addition, we previously provided guidance for FY 2017 operating margins between 28% and 29%, with an additional 50 basis point improvement for fiscal 2018. Prior to the incident, we were on track to achieve our FY 2017 target. We expect that the reduced FY 2018 HIM revenue will carry with it though a loss of $25 million in FY 2018 operating profit, and that we expect some ongoing remediation expenses in FY 2018 as well. While we will offset some of these effects through accelerated transformation initiatives, investors should preliminarily anticipate operating margins in FY 2018 in the range of 27% to 28%. We'll provide more definitive guidance on FY 2018 in November as part of our customary annual guidance briefing. In closing, I'd like to return to where I began. Fiscal 2017 has operationally been an excellent year for Nuance, led by growth opportunities and bookings in our most attractive markets, focused investments in the business, and productivity initiatives that have enhanced earnings and cash flows. Despite the malware incident, these trends remain intact and will propel us ahead as we move forward into FY 2018. And with that, we're pleased to take your questions.

[Operator:]

And our first question will come from the line of Saket Kalia with Barclays. Please go ahead.

[Saket Kalia:]

Hi, guys. Thanks for taking my questions here and for the detail in the prepared remarks. First question maybe for you, Dan, can you just talk about how much of the dollar impact from the malware incident in Q3 and Q4 are from customer credits, and when would those customer credits stop?

[Daniel David Tempesta:]

So there is a fair amount of customer credits, although we haven't given that number. The majority of the number is related to the production, but I think you should think of it as maybe 70% of the number from production and credits and then 30% from other items.

[Saket Kalia:]

Okay, got it. And then for my follow-up, again for you, Dan, so thanks for reiterating the fiscal 2018 guide. Just mechanically, should we be adding back the $90 million in fiscal 2017 related to the incident, and then growing 2018 by that 2% to 4% and then reducing by $65 million to $75 million in fiscal 2018 to get where you're generally thinking about revenue for next year? I know that was a little bit of math in there, but does that make sense in terms of the approach?

[Daniel David Tempesta:]

I think the best approach would be, we had told you we're going to grow to 2% to 4% on our run rate in 2017, so I would start there. I would then reduce the ending balance, so the ending plan, by the $70 million, and then assume a 2% to 4% growth rate from there.

[Saket Kalia:]

Got it, that's helpful. Thanks very much.

[Operator:]

Next, we'll go the line of Tavis McCourt. Please go ahead.

[Tavis C. McCourt:]

I have a couple more follow-ups on the impact specifically within HIM transcription. So in the prepared remarks, you indicate 2018 you expect to be impacted by $65 million to $75 million in transcription, so that's above and beyond the typical decline of call it $30 million to $40 million that you would normally expect in that business, correct?

[Daniel David Tempesta:]

I think what we said is $65 million to $75 million in total revenue impact in FY 2018, of which the preponderance is in Healthcare, but not quite all of it. And I think your question is, is that independent of the erosion factor?

[Tavis C. McCourt:]

Correct, and does it – and is that also taking into account – some of that transitioned revenue I assume will end up with Dragon Medical. In other words, is that a net number?

[Daniel David Tempesta:]

It is true that some of that revenue will transfer to Dragon Medical. We haven't estimated that number. And it is also true that that's in effect above and beyond the erosion.

[Tavis C. McCourt:]

Got it. So I guess although I can probably appreciate you want to be a little conservative at this point, you're baking in, in effect, some significant market share losses in transcription.

[Daniel David Tempesta:]

We're baking in some market share losses and some transfer to front end Dragon cloud solutions as well.

[Tavis C. McCourt:]

Got it. And then on the Imaging business, although I guess slightly better if you pro forma it this quarter, the third consecutive weak quarter. You did mention that perhaps the pipeline looks a little better. Do you expect that to get back to stability either in Q4 or 2018?

[Paul A. Ricci:]

We did expect – first, we have seen strengthening of the pipeline in the third quarter, and we were projecting a strong finish to bookings in the year. I think we'll still have a reasonable finish to bookings in the year for Imaging. It has been affected, and the delay in bringing back the operational systems in Imaging have had an impact in Q4, will have some impact in Q1, but I do think the business will stabilize in FY 2018, yes.

[Tavis C. McCourt:]

Got you. And then final question, a big picture thought with the – although I guess not completely behind us, at least the worst part of the impact of the malware behind us, does it change your opinion on how you run the technology platforms throughout your businesses? Historically, I think it's been reasonably decentralized. Will you do more work to centralize technology platforms going forward, and is that baked into the expense guidance if so?

[Paul A. Ricci:]

I think what I can say, I'm not sure about your comment about decentralization. We have some centralized platforms in the company and we have some divisionalized platforms, and that's a function of the specific technologies. What is true is that we have implemented additional security measures to prevent this kind of attack in the future.

[Tavis C. McCourt:]

Got it, fair enough. Thanks very much.

[Daniel David Tempesta:]

Operator, is there another question. Operator?

[Operator:]

And next we will go to line of Jeff Van Rhee. Please go ahead.

[Jeff Van Rhee:]

Thanks. Hi, guys, so a couple for me. First, I guess, Dan, with respect to margins for 2018, just to be clear because there are a lot of adjustments to work through here, the 50 basis point improvement that you had referenced as the initial target for 2018 ex the impact here is reiterated, you were on track and nothing has changed outside of the impact of the malware?

[Daniel David Tempesta:]

We were tracking to our previous guidance, the modest 50 basis points that we had been talking about for the year. But in the call remarks and as Paul discussed, as you think about 2018 with the impact of the malware, you should plan the 27% to 28% operating margin. But absent the malware, yes, we were tracking fine.

[Jeff Van Rhee:]

Okay, that's what I was looking for. And then with respect to the net new, help us understand seasonality. You certainly put up some good quarters thus far through the year. How do you envision typical seasonality in a year, and how might this year's Q4 vary from that?

[Paul A. Ricci:]

We've been I think consistent throughout the year of saying that although we were significantly outperforming our guidance range for bookings, that Q4 would be a difficult year-over-year comparison because of a very large bookings quarter in fiscal 2016, and that remains our expectation. Having said that, the fourth quarter is typically a robust bookings quarter because of end-of-year incentives within the sales organization and other factors, and we expect it to be a good quarter. And as you note, in our formal comments, we raised somewhat – we narrowed the range and raised the midpoint of our guidance in net new bookings from last quarter.

[Jeff Van Rhee:]

So maybe I could just follow up on that a little bit. As I look at 2015, you had exceptional bookings in Q3 that made some compares difficult. You had Q4 difficulties in the September 2016 year. So rather than year over year, I guess what I'm looking for is the sequentials through the year, in particular because of the incentives and other reasons. All else the same, you would typically look for a Q4 that would exceed a Q3?

[Paul A. Ricci:]

On average, over any number of years, that would be true. But I want to remind you of something else that we've always accentuated, and that is we have some very large bookings, seven and eight-figure bookings that occur in our business, and it's very difficult to know what period they're going to occur in. We enjoyed a couple of really prominent bookings in Q3, and we can't know whether some of the bookings in our pipeline that are of that magnitude will close in Q4, and they would be significantly determinative of whether we saw that uplift in seasonality in the fourth quarter. So we've been I think consistent with investors that we want them to – we encourage them to think of bookings on an annual basis and avoid focusing on the lumpiness of quarter-to-quarter performance.

[Jeff Van Rhee:]

Okay. And I guess last for me, understanding the guidance for 2018 is limited at this point, you narrowed the net new bookings to 8% to 10% for this year. Would you speak to 2018 and things that would potentially be accelerants to that level of net new bookings, things that would potentially be decelerants to the ability to hit that range, again without – I understand you're probably not going to be willing to give us a narrow range. But give us some crude sense of is that a basic reasonable run rate for bookings growth, or are there some obvious things that will accelerate it or decelerate it?

[Paul A. Ricci:]

I really appreciate the question. But we're not in a position today to provide any more specificity on the FY 2018 bookings forecast. I will say though in response to your question that we had an outstanding year in bookings performance this year. And so as we head into next year, the year-over-year comparisons will be more significant than they were – more difficult than they were this year.

[Jeff Van Rhee:]

Got it. Okay, thank you.

[Operator:]

Next, we'll go to the line of Nandan Amladi. Please go ahead.

[Nandan G. Amladi:]

Hi, good afternoon. Thanks for taking my question. So on this malware attack, can you characterize any potential reputational damage to your business from which you might have lost some customers or any maybe change in the way competitors are reacting to it?

[Paul A. Ricci:]

From the first hours of the incident, we've had an extremely proactive program focused on our customers of getting them back online, getting our systems up and running, and ensuring that we had the highest level of security protection that we could. We did that. I think we've been very transparent with our customers about the incident, which as you know, affected thousands of companies globally. And we've been very transparent with them about the security measures we have in place and the additional security measures that we're putting in place. I think that we've always enjoyed a great deal of trust from our customers, and I think we've managed to get through this with that trust intact based on our transparency and the steps we've taken.

[Nandan G. Amladi:]

And a quick follow-up on the financial model, over the last three or four quarters, you talked about maybe still doing a little bit of OpEx improvements, but generally speaking, skewing more towards a shift to a revenue growth mindset, more of an investment mindset. Has this malware attack changed any of that thought process?

[Paul A. Ricci:]

No, I don't believe it has, and I appreciate the question. You'll note in our prepared remarks, we referenced the fact that we were balancing margin expansion with growth. We've been signaling that over the last year. We continue to do that. And we believe the fundamental opportunities in our market, automotive, voice biometrics, enterprise, omni-channel, our healthcare clinical documentation business, we believe the fundamental opportunities remain large. We believe we're well positioned to serve them, and we think it's important to continue to manage that balance between margin expansion and growth investments in order to do that.

[Nandan G. Amladi:]

Thank you, that's all for me.

[Operator:]

The next question comes from the line of Sanjit Singh. Please go ahead.

[Sanjit K. Singh:]

Hi, thank you for taking the questions. I had a question on the net new bookings. As we think about the composition of net new bookings, it seems like it's been a little more weighted to enterprise versus maybe automotive compared to prior years. So my question is in terms of the conversion of bookings to revenue, when enterprise accounts for a greater amount of the mix, does that imply a faster conversion to revenue versus bookings that would be otherwise weighted more towards automotive?

[Paul A. Ricci:]

First, it is true that the enterprise business is having an excellent bookings year, but the automotive business is also having an excellent bookings year. And I think that the commentary we provided may have suggested some shift in this quarter, some proportional shift in this quarter towards enterprise. They did have a really outstanding set of bookings, in particular in voice biometrics. But I don't think that the composition change this year would materially change our revenue recognition, the aggregate revenue recognition for the company.

[Sanjit K. Singh:]

Understood. And then in terms of just – I'm sorry, I missed that.

[Paul A. Ricci:]

I should have said revenue realization, not revenue recognition.

[Sanjit K. Singh:]

Understood. And then on the mobile segment, it did seem like there was a big uplift in margins, and I wanted to get understanding of some of the factors that drove the uplift in margins and how sustainable we should think about that as the level of segment margins in mobile that we should be continuing to expect going forward.

[Paul A. Ricci:]

I think the mobile business has benefited first of all from expanding revenues, particularly in its automotive business, and that has created operating leverage in the model. It also benefited from productivity and transformation initiatives through the business over the last 18 months, and that's also benefited the margins. What is true for the entire business is true for the mobile business, and that is that we have to balance margin expansion with growth. And in particular the growth opportunities in the automotive business are considerable, and so we are leaning more towards an investment posture there than margin expansion at the moment.

[Sanjit K. Singh:]

Got it. And one last one if I may, and this goes back to the impact on fiscal year 2018 guidance from the malware incident. When we think about the $65 million to $75 million range, if we think about some of the factors that could cause you to underperform that range, what might those factors be? If fiscal 2018 were to play out and we saw a greater than expected impact, what would be some of the sources for that?

[Paul A. Ricci:]

For fiscal 2018?

[Sanjit K. Singh:]

That's right.

[Paul A. Ricci:]

I think that's unlikely. But if it were to happen, it would be possibly because we suffered market share loss. I think we have a good sense about that at this point, and it might also be because there is a faster transition to alternative solutions, in particular the Dragon cloud solution, which is of course the long-term direction of that business.

[Sanjit K. Singh:]

I appreciate the color. Thanks, Paul.

[Operator:]

Next, we will go to line of David Hynes. Please go ahead.

[David E. Hynes:]

Great, thanks. Paul, I just want to get some color on the record biometrics deal in the quarter. I guess I'm curious. Was that part of a broader systems upgrade? How long had this deal been in the pipe? Just give us some context of what needs to break right for these big biometrics deals to push across the finish line.

[Paul A. Ricci:]

The interest around voice biometrics in the financial services industry in particular has been quite keen, and we've seen a great deal of success over the last 18 to 24 months in focusing on that vertical as part of the overall solution – security solution that the financial services industry is trying to implement. I don't know precisely how long that sales cycle was. It's a complex sale, so it was undoubtedly lengthy, but I don't know precisely.

[David E. Hynes:]

Okay, and then maybe one for Dan. Obviously, bookings growth has been really strong on a trailing 12-month basis, I'm getting like 30%. My worry is that bookings without duration can at times be misleading. So help us think about what this net new growth might approximate to if we considered it on an ACV basis.

[Daniel David Tempesta:]

That's a challenging way to look at it. Because we have so many different business models, we really just don't equate it to that type of a metric. We have said historically that about 30% of the bookings convert within a 12-month period, and then another 30% in the second year, and it ratchets itself up to around 90% within five years. And there's a tail at the end because of some of those long auto bookings. That's still a pretty good model to go by.

[David E. Hynes:]

Okay, that makes sense, and then one last quick one. Just as we think about modeling out the impact of the malware incident, is it fair to think that any healthcare impact runs through the services and hosting line and any imaging impact runs through the product and licensing line?

[Daniel David Tempesta:]

Yes, that's actually a very good way to think about it for the most part.

[David E. Hynes:]

Okay, got it. All right, thanks, guys.

[Operator:]

And our last question will come from the line of Tom Roderick. Please go ahead.

[Jeffrey Parker Lane:]

Hi, it's actually Parker Lane in for Tom. Thanks for taking my question. You guys highlighted a clinical documentation win with a French-based organization during the quarter that was driven by a partner. I was wondering if you could comment on some of the best opportunities for growth in international regions in Healthcare, what your penetration rates looks like there today, and what the relative growth is of international versus domestic for Healthcare? Thank you.

[Paul A. Ricci:]

I don't know the answer to the penetration question. I do know that the international business in Healthcare has enjoyed a good year. It's a much smaller business than our North American business, but it's been growing well this year. It's, as you know, not a single market, our European market in particular, which is where our growth, our international business is focused. It has to be looked at country by country. And the UK, Germany in particular are strong countries for us in that market.

[Operator:]

And at this time, there are no further questions in queue.

[Paul A. Ricci:]

Okay then. We thank you all for joining us and we look forward to speaking with you again in November. Take care.

[Operator:]

Ladies and gentlemen, it does conclude our conference for today. Thank you for your participation and for using AT&T Teleconference. You may now disconnect.