Nuance Communications, Inc.
Q4 2017 Earnings Call Transcript

Published: 29 Nov 2017

[Operator:]

Ladies and gentlemen, thank you for standing by. And welcome to Nuance’s Fourth Quarter and Full Year 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 Tempesta; and Head of Investor Relations, Christine Marchuska. At this time, I would 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 Ricci:]

Thank you, Christine, and good afternoon, everyone. Before taking your questions, I would like to highlight few key points regarding our FY17 results, outline our expectations for FY18 and provide preliminary thoughts on FY19. I want to begin by noting that I am pleased with how Nuance completed its fiscal 2017. As you know, in June, we were the victim of a cyberattack which had a significant impact on our performance in Q4. Absent the incident we completed an excellent year operationally, strategically and financially. Notwithstanding the malware incident, we have performed well against several key metrics. We delivered net new bookings at the high end of our guidance range of 10% for fiscal ‘17. Additionally, our Healthcare business delivered its best net new bookings quarter in history in Q4, despite the challenges this segment faced as it recovered from the malware. We outperformed our post-incident expectations, notably, we had favorable outcomes for our Q4 and FY17 revenue and EPS incident impacts as compared to the malware impact guidance we have provided in Q3 and we met our recurring revenue target of 73% as we saw continued momentum across our growth businesses. Our fiscal year ‘17 performance provides further evidence that our strategic focus on evolving our business to conversational AI and predictive analytics-based solutions is generating demand in our key vertical markets. Worth noting is that our total pipeline metric grew by $900 million or an increase of about 30% during fiscal year ‘17. Throughout the year we accelerated important product initiatives in each of our segments. For example, in Healthcare, we continued our shift to the cloud with Dragon Medical, launched new virtual assistant capabilities, enhanced our offering in analytics, critical result management and workflow optimization and diagnostics, and just yesterday, introduced within video, the world’s first open marketplace for AI algorithms in radiology. In Enterprise, we continued the rapid expansion to omni-channel engagement powered by AI and analytics, and added new facial and behavioral capabilities to our voice biometrics portfolio. And in Mobile, we accelerated our automotive 2020 product initiative and delivered outstanding customer deployments to make the connected car a reality for leading automakers, again making automotive an excellent growth business for Nuance. We expect to build on our momentum, capitalize on the new AI-based solutions and benefit from favorable market trends as we enter our new fiscal year. As you saw in our earnings material, we reiterated our growth expectation for 2018 of organic revenue growth between 2% and 4%. We have confidence in our revenue projection, based on the growing volume of our pipeline, our bookings performance of 2017, the compounding effect of our recurring revenue streams, and importantly, a turning point whereby our growing revenue streams are now outpacing our declining streams. For several years we have managed a shift in our revenue streams and address several declining businesses while investing in longer term growth opportunities. For example, we have managed the erosion of our HIM solutions in Healthcare as we concurrently build our Dragon Medical clinical documentation improvement and diagnostics business lines. By the end of 2018, Dragon Medical will eclipse transcription as the largest revenue contributor in Healthcare where its growth will more than offset the erosion expected in HIM. Similarly in Mobile, automotive now comprises the lion shares of the segment’s revenue approximately 63% with a double-digit growth rate. In addition to these effects, we anticipate revenue growth from our CDI offerings, our Mobile Services business and new releases for our imaging solutions. Our Imaging business is worth noting, has slated for fiscal ‘18 the most robust set of new product offerings in the division’s history. Along with our strong revenue projections, we expect continued favorable trends in our booking performance and forecast net new bookings growth between 5% to 7% in FY18, which you will note is somewhat above the initial guidance range for our FY17 net bookings growth which we have provided at this time last year. Bookings will be led by an expansion of our -- Enterprise omni-channel and voice biometrics solutions, the continued growth of our automotive business and the adoption of our Dragon Medical cloud solution. We expect that margins will increase from FY17 levels, but we note that in FY18 they would be flat or slightly down from our pre-incident levels, as we accommodate additional investments in our enhanced security posture and infrastructure following the incident. As you saw in our prepared remarks, we’ve embarked upon a multiyear organizational and productivity initiatives focused on increasing investments in our growth businesses, building on our previously successful efficiency programs. We will use these efficiencies to fund our increasing investments in AI and our expansion of our go-to-market resources in our key vertical markets and to deliver steady year-over-year margin improvements. This initiative along with our enhanced pipeline, our booking trajectory, the relative strength of our growth businesses and the diminishing effect of our declining businesses has encouraged us to provide initial thoughts about fiscal year ‘19. In particular, we expect our growth businesses to further outpace our declining businesses, which should improve organic growth rates to between 3% and 5% in fiscal year ‘19, with each segment contributing to overall growth. We expect similar performance in FY18 for net new bookings, with strong contributions from automotive, Dragon Medical cloud and Enterprise omni-channel solutions. And as we put the incident farther behind us, we expect operating margin expansion of approximately 50 basis points, while gross margins will remain at similar levels to FY18. Overall, our efforts to set us on the path for steadily increasing growth while balancing the use of productivity gains between funding growth and enabling operating margin expansion. Finally, I wish to comment briefly on the topic of CEO succession. As I mentioned previously, the Board and the search committee have in recent quarters initiated a process to evaluate both internal and external candidates. The committee has made progress in that process and expects to complete its work prior to the end of March. You can expect a further update after the first of the year. In closing, I’d like to reiterate that fiscal 2017 was remarkable year for Nuance, one that borne witness to numerous milestones amidst our recovery from a devastating malware attack. I’m confident we exited fiscal ‘17 as a stronger organization owing both to our success and the challenge we endured. Now as we begin the New Year the combination of our investment in new solutions, our position in key vertical markets, the strength of our growth businesses and our deep customer relationships will allow us to recognize our potential for fiscal ‘18 and the years ahead. And we are now pleased to take your questions.

[Operator:]

[Operator Instructions] And the first question comes from Saket Kalia from Barclays Capital. Your line is open. Please go ahead.

[Saket Kalia:]

Hi, guys. Thanks for taking my questions here. Dan, maybe just to start with you and it looks like the impact of the malware incident this quarter was much better than expected and luckily that’s carrying forward to next year. Just to level set, can you just talk about what sort of dollar impact you are assuming from the malware impact -- from malware incident in FY18?

[Dan Tempesta:]

Sure. Hi, Saket. Thanks. Yes. First of all, the incident impact in Q4 was better than expected. In ‘18 we originally expected an impact to revenue around $70 million. I would say because of the better performance we would expect an estimated impact of around $60 million to $65 million in 2018.

[Saket Kalia:]

That’s great. That’s great. Maybe for my follow-up for you Paul, more of a segment question on the Healthcare business. It felt like the critical data improvement or CDI solutions had a particularly good bookings quarter. Can you just talk about if that is something that’s coming from just continued optimization that hospitals are constantly doing or is there may something industry-wide or regulatory driven that is perhaps driving strength in CDI?

[Paul Ricci:]

Yes. We did have a good year in CDI and bookings were particularly strong. It is driven in fact by both of those trends within hospitals. There is regulatory pressure on hospitals to improve the quality of documentation and to reduce errors. Those errors affect the patient outcomes and as you know that’s a central focus in Healthcare right now. There’s also of course enormous pressure on hospitals business models to further optimize and CDI improves the efficiency of the entire clinical documentation and chain, and so benefits in that way as well.

[Saket Kalia:]

Got it. That’s it for me. Thanks very much guys. Nice quarter.

[Operator:]

Thank you. The next question comes from Sanjit Singh from Morgan Stanley. Your line is open. Please go ahead -- one moment, now it’s open. Please go ahead.

[Sanjit Singh:]

Thank you for taking the questions. Dan a quick question on margin so I think relative to the Q3 update, margins are little bit down, I think was sort of in that originally 27% and 27.5% range and now it’s down like 50 basis points. Can you just give us an insight on where those incremental investments are going or what drove the slight downtick in margins?

[Dan Tempesta:]

Sure. You are right. We are guiding for the year 26.5% to 27% operating margins. I would say from the trajectory that we’re on in 2017 to that landing point you can think about it as about 100 basis points are impacted by malware and updating the environment -- the security environment and other 100 basis points are for a number of investment areas particularly in auto R&D, as well as in Enterprise. Those are the two main drivers of the adjustment.

[Sanjit Singh:]

Got it. And I do appreciate your initial sort of commentary on fiscal year ‘19 and also sort of breaking out the automotive contribution for fiscal year ‘17. So we think about durable growth, obviously, automotive is going to be one of these -- one of the major components of that. So in terms of thinking about the durability of your automotive business, as we think about 2020 and 2021 sort of design wins, what gives you the confidence that you are going to be able to continue to secure those wins, you see Alexa making some in roads within some OEMs, what sort of the stickiness or the value proposition that you guys are working on to secure those wins going forward? Thanks.

[Paul Ricci:]

I should note that 2020 and ‘21 design wins are the wins that we have been doing of late, so it is a business where one signs contracts well in advance of the shipment of the cars, so we are already having success with design wins in that time period. But more generally to your question, our business model in automotive has been driven by our close alignment with the automotive manufacturers and helping them present the digital experience that they seek inside the car consistent with the overall design parameters and experiences that that they are trying to evoke with their brand. We’ve said in the past and continue to believe that the automotive manufacturers will accommodate the digital lives that that drivers bring into the car from other platforms, but that doesn’t mean that they’re going to abandon their own investments and their own initiatives in building a complete solution and that seems to be the strong message we get from the cars, it seems to -- from the automotive manufactures. It seems to be consistent with the success rate we are having in winning designs.

[Sanjit Singh:]

Got it. Very helpful. Thank you, Paul.

[Operator:]

Thank you. The next question comes from Jeff Van Rhee from Craig-Hallum. Your line is open. Please go ahead.

[Jeff Van Rhee:]

Great. Thank you. Paul, with respect to AI machine learning, just take that a few steps further, would you. I mean I know you’re deploying and it is central to a lot of things within a lot of -- a product sets. But in terms of its ability to drive the revenue line, sort of narrow our focus a little bit here, what are the solutions and the actual use cases of AI that that you think are going to be most impactful the next 12 months, 24 months?

[Paul Ricci:]

I want to start by noting that machine learning has been a central focal point of the -- at the frontier of the evolution of speech technology itself, so we’ve been using deep learning in improving the capabilities of our speech technology for some number of years, equally importantly in the expansion to natural language processing, which of course, has been the extension that we’ve -- of that technology that we have been focused on for the last several years and as we move to a more conversational AI that includes interactions and dialogue that will continue to be the case. But there are other use cases such as CDI, the radiology use cases we talked about, the application of machine learning to the virtual assistant solutions in Enterprise customer management, customer service, and of course, in automotive as well. So our solutions is, my comments in recent quarters and this quarter have suggested are increasingly focused on specializing for the vertical markets we are solving and taking advantage of the rich data sets that are in those markets and providing analytics and more complete solutions around that data.

[Jeff Van Rhee:]

Okay. And I guess, just shifting gears, the new role, EVP Business Transformation with Tom Beaudoin’s return. Can you take the few steps further, he talks about, you talk about rationalization of business portfolio and a few of the other kind of core things that you are going to be focusing on there, just why now and why those particular areas are focused?

[Paul Ricci:]

Well, this initiative is really an attempt to build upon the initiatives that we undertook a couple of years ago and had considerable success with and that initiative was designed to improve margins and to free investments to produce growth and as you’ve seen in our forecast today we’ve had some success in that. We are seeking to redouble our efforts in that regard to free more funds from existing expenditures that we can use to drive further investments in the conversational AI agenda that I just mentioned, as well as further investments in the vertical markets such as the financial services market where we’ve done so well in our Enterprise business, the telecommunications market that spans initiatives in both our Enterprise and Mobile business and the automotive and healthcare markets, of course. So we want to fund investments in those two areas, because we believe that will drive further growth and we want to create the opportunity for margin expansion and to do that there is a lot of optimization has to go on, not just cost-cutting, but realignment to take advantage of synergies within the company and to bring accentuation to certain areas such as for example our automotive business which we think has such durability that we want to pursue greater growth there.

[Jeff Van Rhee:]

Okay. And then I guess just last then for me, it looks like you are pointing to roughly $400 million-ish in free cash flow, just thoughts if there’s any shifts in terms of how that free cash is likely to be deployed as you go through fiscal ‘18?

[Dan Tempesta:]

I think the previous plan around capital allocation in the balanced manner is still the plan between attractive stock repurchase prices, repurchasing the debt and then some cash for M&A.

[Jeff Van Rhee:]

All right. Got it. Great. Thanks for taking my questions.

[Dan Tempesta:]

Thanks, Jeff.

[Operator:]

Thank you. The next question comes from the line of Nandan Amladi. Your line is, I am sorry, Deutsche Bank. And your line is open. Please go ahead.

[Nandan Amladi:]

Hi. Good afternoon. Thanks for taking my question. So, Paul, building a little bit on your -- the previous question around the transformation, would it be fair to say that the previous $125 million OpEx program was really more cost focused and now you’re also focusing a little bit more on growth opportunities?

[Paul Ricci:]

Well, when we started -- it’s a good question. When we started that initiative it was primarily cost focused, as we migrated through it, about a year into it, we began to talk about channeling some of that into growth opportunities. We pointed to our bookings growth and the -- and some of the expansions that we funded last year that we’ve outlined previously. It is the case in this instance that we want to try to accelerate the growth potential for the business while defending and expanding our margins steadily -- gradually and steadily over the next couple of years.

[Nandan Amladi:]

Then on the AI marketplace that you announced yesterday, how many developers are there in these specialized fields like Healthcare, clearly, your announcement yesterday was on the Healthcare front, but I would imagine that’s it’s a broader initiative. Historically, you have built most of these applications yourselves, what was the impetus to open it up?

[Paul Ricci:]

Well, this initiative that we announced yesterday is exclusively focused on Healthcare today and it is and in particular it is focused on the diagnostics and radiology market within Healthcare. The advent of machine learning has as many people pointed out and as we pointed out yesterday, democratized the ability to create new solutions from data sets, there are lot of resources available in deep learning resources available and using in this case the NVIDIA platform and the reach that Nuance has in its radiology reporting platform in PowerScribe and its image sharing platform in PowerShare, we can enable a broad set of radiologists who want to innovate algorithms based on deep learning technologies and their data sets, and provide an infrastructure where they can get visibility for those algorithms, get validations for those algorithms and establish a marketplace for those algorithms. So we think that there’s going to be a lot of work within the radiology industry to develop those algorithms based on insights that individuals and groups of radiologists have based on their data.

[Nandan Amladi:]

Thank you.

[Operator:]

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

[Tom Roderick:]

Hi, guys. Thanks for the question. Paul, can you just take a few minutes here to talk a little bit more about the mechanics of how the malware outage actually impacted the revenue stream and how it’s impacting the way you guys think about it. So certainly there was the period of time where you couldn’t offer services so I think we all get that. But as it relates to certain customers, perhaps moving transactional volumes to other systems or reputational risk and some share loss? Can you just kind of talk through the impact of the different ways that the revenue streams have been impacted and how you are thinking about any customer churn that’s come out of this? Thanks.

[Paul Ricci:]

Yes. Well, we reported, I think, an expectation through Q3 and Q4 of about $85 million, I am looking to Dan for confirmation of revenue loss in those two quarters due to the outage itself, due to customer credits…

[Dan Tempesta:]

And the final number -- that was originally what we were guiding to, but the final number was $68 million.

[Paul Ricci:]

Yeah. So we have -- we reported -- we forecasted $85 million, the final number was just below $70 million and that was due to customer credits and the outage and some volume loss to both to early migration to Dragon Medical and to competitive offerings. And I think, what Dan said earlier was that, the effect that we had expected in ‘18 was about $70 million, but now look closer to $60 million to $65 million.

[Tom Roderick:]

Okay. Okay. That’s helpful. So, Dan, following up on that as it impacts the gross margins and the way we should see that play out. You guys have laid out an expectation for gross margins expand, I think, about 120 basis points for the year. If I look at the EPS guide for Q1, it would seem to suggest that there is either a drop in gross margins in Q1 or some OpEx that we have to be aware of, can you kind of take us through the progression of gross margins and OpEx as we go through the year and how you are thinking about layering those in?

[Dan Tempesta:]

Yeah. I think the first thing I would say is gross margins we are projecting for the year to be around 63%, which is consistent. Of course, last year we had the effects of malware pulling those -- that margin down, but we think we get back to 63%. When you think about gross margins we are still seeing a shift to away from licensing and towards hosting a Professional Services, but we are able to maintain that 63%, because regaining leverage in those hosted offerings and the margins are improving there, so that that trend continues. As far as operating margins in general, they will ramp through the year. Q1 has historically and in this quarter in particular is a lower operating margin, but that will get back to the higher levels as we progress through the year.

[Tom Roderick:]

Okay. Thank you.

[Operator:]

Thank you. The next question comes from the line of David Hynes with Canaccord. Your line is open. Please go ahead.

[David Hynes:]

Hey. Thanks, guys. Maybe one more follow-up on the malware incident, Dan, any more color you can give that helps us reconcile the difference between the cash flow impact and the revenue impact, I -- the gap was a little wider than I was expecting?

[Dan Tempesta:]

Yeah. I think when you think about cash flows, we certainly saw significant shortfalls in collections. Number one that was due to the lost production that we saw in June, July and early August, those -- that level of cash would have otherwise been collected. Two, as Paul alluded to, we gave credits and we had to work through credits with our customers and some of those credits happened in the quarter, of course, the majority happened in the quarter. But that caused our customers to defer payments until the credit process was resolved. So, I think, the combination of those three had a significant impact on our collections. In addition, as we noted, last quarter there were significant costs we had to incur, one-time costs in the quarter to remediate and restore, and we paid a fair amount of those expenses in the quarter as well. So the combination of those -- all those items make up the predominance of the shortfall.

[David Hynes:]

So should we expect any different linearity in terms of the way cash comes in fiscal ‘18?

[Dan Tempesta:]

So in Q1, yes, the answer is, yes, we are going to have a little bit of a shortfall carryover in Q1, but then in Q2, 3 and 4 we would expected to be more aligned with the percentage averages that we have provided in the call remarks.

[David Hynes:]

Okay.

[Dan Tempesta:]

But in Q1 we still have some expenses to pay that happened in Q4.

[David Hynes:]

Yeah. Got it. And then, Paul, the 30% pipeline metric growth, I don’t recall you sharing that in the past. That’s helpful. Can you maybe help kind of frame that growth across your segments, I mean, where do you -- where does it feel like the most incremental opportunity has been created?

[Paul Ricci:]

Well, without quantifying it, I can say that the major contributors included notably automotive, voice biometrics, Dragon Medical, a cloud, our CDI and generally our Enterprise pipeline was very strong.

[David Hynes:]

Yeah. Okay. So spread across the growth businesses. And then, last, maybe the M*Modal litigation that was announced recently, can you kind of speak to the claims there? And then maybe more broadly, as the strategy on patent enforcement going forward, I mean, is this an area where we still expecting Nuance to be more aggressive or how you are thinking about it?

[Paul Ricci:]

I don’t want to talk in any detail about the specific litigation with M*Modal. I will say generally that it is our interest and our intent to enforce respect for our intellectual property. We’ve talked about that previously. There has been a lot of investor questions about that and you should see this in that broader light.

[David Hynes:]

Okay. I will pass it on. Thanks, guys.

[Operator:]

The next question comes from the line of Tavis McCourt with Raymond James. Your line is open. Please go ahead.

[Tavis McCourt:]

Hey. Thanks for taking my questions. I have got a few of them. First on the Enterprise business growth has been a pretty good all year, but the margins are down to 30% or so, and I think, in the prepared remarks you talk about kind of transition to cloud there. I guess, what is -- is there margin run rate that you think that bottoms out or do you think that segment is in kind of a growth phase where we should expect margins to continue to trend down as long as it’s growing?

[Paul Ricci:]

Well, it’s still a business delivering attractive margins in comparison to benchmarks in that market. That -- it -- the margins have declined for two reasons. One has been the transition to digital cloud revenues, which are -- which do have a lower gross margin, and secondly, the increased investments to fund the growth that we’ve been talking about this afternoon. It’s possible that there are some additional modest margin decline but it’s probably in the realm of where it should be.

[Tavis McCourt:]

Okay. Cool. The -- and then back on the commentary around 30% pipeline growth, you’ve got a lot of businesses where you are bidding reasonably complex Professional Services latent contracts and it appears demand is reasonably high across a lot of segments. So, I guess, how do you incent your business level managers to have the right economics on these deals and is there any sign of customers getting less price sensitive as demand for some of these AI applications increases?

[Paul Ricci:]

Well, with respect to the first question, we have plenty of focus inside the company on incentives and discipline around Professional Services margins. We aren’t perfect there and there are areas of the business that for which the performance is better than other areas, but the trend has generally been quite good and I think we have a lot of experience that allow us to remediate the areas where which not as good. With respect to the pricing question, it really depends on the market, there are some segments in which there is more pricing freedom and some in which there is less and it’s difficult given the breadth of the market we are in to generalize about that.

[Tavis McCourt:]

Fair enough. And a housekeeping one for Dan, Dan, I think, you’re implementing 606 revenue rec in 2019. Any update on the likely impact of that given kind of the broad nature of your business?

[Dan Tempesta:]

I think the answer continues to be the same. We certainly are going to be impacted quite significantly. The revenue stream that’s going to be most impacted is going to be the term licenses. So we have a number of different offerings that have term licenses and that will -- if you are familiar with 606 you will -- that will accelerate, so that will be the largest area. There will be smaller areas across the rest of the portfolio, but that’s the largest.

[Tavis McCourt:]

Fair enough. And the guidance for recurring revenue of about 73% for next year pretty similar to this year, should we read into that about this transition nearing its end or is that just kind of a rounding error?

[Paul Ricci:]

Well, there are number things contributing to that being somewhat flat this year. One, of course, is the loss of recurring revenues in the HIM segment, so that’s a significant offset. The second is the growth in our On-Premise Voice Biometrics business, which of course, is very attractive business to us, but it’s not recurring in revenues. And the second and the final is the growth in Professional Services related to your earlier question.

[Tavis McCourt:]

Okay. Thanks a lot.

[Operator:]

There are no further questions in queue at this time. Please continue.

[Paul Ricci:]

Okay. Well, we thank you for joining us this quarter and we look forward to speaking to you again next quarter. Take care.

[Operator:]

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