Nuance Communications, Inc.
Q2 2016 Earnings Call Transcript

Published: 11 May 2016

[Operator:]

Ladies and gentlemen, thank you for standing by and welcome to the Nuance's Second Quarter Fiscal 2016 Conference Call. At this time, all lines are in a listen-only mode. Later, we'll conduct a question-and-answer session. And, as a reminder, this conference is being recorded. With us today from Nuance are Chairman and CEO, Paul Ricci; CFO, Dan Tempesta; EVP of Corporate Strategy and Development, Bruce Bowden; and Vice President of Corporate Marketing and Communications, Richard Mack. At this time, I would like to turn the conference over to Mr. Mack. Please go ahead.

[Richard Mack:]

Great, thank you. Before we begin, I'll remind everyone our discussion today 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. You should refer to our SEC filings for a list of risk factors. All references to income statement results are non-GAAP unless otherwise stated. It is 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. Before taking your questions, I'd like to highlight several key points from today's earnings announcement. First, we continued our strong start to FY 2016 delivering a solid quarter across nearly all of our financial metrics. With these latest results, in the second quarter, we had now delivered seven consecutive quarters of year-over-year improvement in non-GAAP operating margin, non-GAAP EPS and operating cash flow. Compared to Q2 last year, non-GAAP operating margin improved by 250 basis points, non-GAAP EPS improved by $0.08, gross margin improved by 50 basis points, net new bookings grew 3% and deferred revenue grew by 17%. Perhaps most notably, operating cash flow grew 33% to $159.9 million, bringing our trailing 12-month cash flow to $573 million, a strong testament to the underlying strength of our business. Second, our transformation program continues to deliver results. We continued our focus on this program that to-date has generated $128 million in annualized savings, exceeding the $125 million target we set for Q1 2017. We have reduced expenditures broadly in cost of goods sold and operating expenses, which contributed handsomely to our improved year-over-year performance in Q2 2016. We intend to continue our transformation program, as we complete FY 2016 and head into FY 2017, maintaining our cost discipline and prioritizing investments for stronger bookings and revenue growth. The transition of our business towards recurring revenue models also continued during the quarter with non-GAAP recurring revenue representing 71% of non-GAAP total revenue compared to 65% a year ago. Our latest bookings point to a continuation of this trend in recurring revenue streams, most notably the transition of our Dragon Medical and Diagnostics Solutions towards term license continues to accelerate. More broadly, strong new net bookings, so far this year point towards improving future revenue growth. In our second quarter, net new bookings were $313.7 million, up 3% compared to Q2 2015, increasing our confidence that we'll be comfortable in the target range of 2% to 5%, we set for new bookings for the full fiscal year. We have, though, slightly reduced our expectations for full year revenue growth, by about $15 million on approximately a $2 billion revenue base. As referenced in our prepared remarks, we are seeing sustained growth in our automotive business, mobile operator services, CDI solutions in Healthcare, MFP solutions and especially in our Enterprise business. But the acceleration of the transition of Dragon Medical and Diagnostics Solutions to a cloud and recurring model which will drive enhanced bookings and improved revenue growth in FY 2017 is weighing on revenue growth in the second half of FY 2016. We're also seeing the cumulative effects of the penetration of Dragon Medical which when implemented in conjunction with electronic medical records increase erosion in our base of on-demand HIM transcription revenues. We expect our strong profit performance during fiscal 2016 to continue for the balance of the year. As we noted in our prepared remarks, we are increasing the midpoint of our fiscal 2016 non-GAAP EPS guidance from $1.48 to $1.56. The positive trends in our financial performance provide us with even greater conviction in reaffirming the longer term views that we had shared previously with investors. So, as we look ahead, we expect the net new bookings growth in fiscal 2017 will show additional improvements over fiscal 2016 based on the investments we're making in our best growth businesses. We anticipate the revenue growth will show an increase of 100 basis points to 200 basis points over fiscal 2016 drawing upon the benefits of our recurring revenues and our new bookings growth this year. And our operating margin in 2017 should improve at least 100 basis points driven by the continuation of the transformation and cost initiatives that have benefited this year for us. Overall, our performance provides us with confidence and is further evidence of continued improvement across our financial metrics as we execute on our transformation, evolve toward greater recurring revenues, deliver increasing profitability and cash flows and establish the foundation for increased future revenue growth. We're now happy to take your questions.

[Operator:]

Our first question comes from the line of Brent Thill with UBS. Please go ahead.

[Brent Thill:]

Good afternoon. Paul, can you maybe provide a little more color about the comment around Healthcare and the strong net new bookings. I know you don't give it out in terms of the booking number or by segment, but realize that there is the legacy component weighing, but the new component sounds like it may be going a little bit better than we all think, but it's hard to see from the finances we look at. Can you just give us a little more color on that segment that would be helpful.

[Paul A. Ricci:]

You're talking about Healthcare, just to be clear?

[Brent Thill:]

Yes.

[Paul A. Ricci:]

Yeah, so we are seeing strong performance across this year in our – the new growing areas of Healthcare in particular our recurring models for Dragon Medical as I mentioned and Diagnostics Solutions that I mentioned, also our CDI solutions where bookings have been up sharply this year. We are of course seeing an offset to that in our revenues as I mentioned in the call and related primarily to our transcription revenues.

[Brent Thill:]

Okay. And on mobile, you mentioned the weakness in more mature markets, how do you think of an offset to that slowdown which is going to continue. Is there another component of the mobile playbook that you're putting more emphasis on to help offset that, if you could talk through that, that'd be great?

[Paul A. Ricci:]

Sure. So in mobile, we have two primary growth segments that are active and large today, and those include our automotive business, which is now the largest segment of mobile, and our mobile operator services business. Our third segment, smartphones and other devices is suffering erosion from the erosion of our handsets and smartphone revenues. That's beginning to be offset by the license, the bookings and revenues associated with new devices, in the confederation of IoT devices, and that will pick-up as we go into next year. But as you know, we've talked for sometime about the erosion of the smartphone and handset, and we continue to believe that particular line is going to erode.

[Brent Thill:]

Thank you, Paul.

[Operator:]

Our next question comes from the line of Sanjit Singh with Morgan Stanley. Please go ahead.

[Sanjit K. Singh:]

Thank you for taking my questions. I wanted to follow up on the mobile part of the business, and specifically the handset and devices. Looking at the mobile overall organic growth, falling 16% year-over-year this quarter, and that seems like if there was a noticeable acceleration in terms of the rate of decline. So I wanted to see if there was – what changed this quarter in terms of what you are seeing from your end customers?

[Paul A. Ricci:]

Sorry, just say the question one more time. I want to make sure, I answer the question properly.

[Sanjit K. Singh:]

Yeah. So, I guess, I'm pointing to the 16% organic growth decline in the overall Mobile segment, and I'm trying to understand first taking that deceleration versus the flat growth we saw last quarter, what changed this quarter, in terms of the Mobile business?

[Paul A. Ricci:]

Okay. Thank you. First of all, I would encourage you to average the growth rates in any particular segment over several quarters, because in any particular segment, there can be the realization of revenues based on the timing of royalty payments, the receipt of royalty reports. And so, I think it's more valuable to look at the trends than any specific point. Having said that, the erosion that we're seeing in mobile is entirely related to, as I mentioned, devices, primarily handsets, smartphones, other consumer electronics devices, other than automobiles and of course, separate from our mobile operator services, which is growing. So, what's growing in mobile is our population of automobiles and revenues associated with automotive, as well as mobile operator services. What has been declining have been revenues associated with mobile phones and other consumer electronic devices. As we look into next year, we believe based on early activity we have from our IoT offerings, that we will see some relief from that shrinkage and some growth from IoT revenues, but we won't see that until next year.

[Sanjit K. Singh:]

Great. Fair enough. And I want to ask you a sort of a medium- to longer-term strategic question if I may. In terms of the competitive environment, there have been some announcements from Microsoft and Google, in terms of their natural language strategy. I wanted to see if we could get your take on the competitive environment and how you guys are positioned to go up against the larger platform vendors over the next year or two?

[Paul A. Ricci:]

So, we're not primarily trying to compete with those platform vendors. We're serving the automotive market with a set of very differentiated offerings that includes a highly tuned hybrid system of embedded in cloud along with a set of engineering services that are able to customize and serve the world's largest automotive manufacturers on a global basis in dozens of languages. And we're serving the mobile operator services market which is I think relatively distinct from what you're talking about. There may be some overlap in the IoT market, but there too, we've targeted specific verticals where we think our engineering services and professional services team can work in conjunction with our largest OEM customers in these specific verticals and we think we have an offer there that will be distinct.

[Sanjit K. Singh:]

Thank you.

[Operator:]

Our next question comes from the line of Saket Kalia with Barclays Capital. Please go ahead.

[Saket Kalia:]

Hey, guys. Thanks for taking my questions here, and thanks for having me on the call. First for Dan, on the cost cuts, can you just maybe talk about what areas you are able to find the incremental cost efficiencies maybe by business and then ultimately where can that $128 million go as you sort of balance the investments that you're making in the business as well?

[Daniel David Tempesta:]

I think that – first I would say it's across all functions and across all divisions, and it's both in OpEx and in COGS as well. So, there isn't one particular area. And then going forward, we're going to keep on looking for additional cuts to find that right balance with operating margin and growing the top line.

[Saket Kalia:]

Got it. And then just to dig – and my follow-up, just to dig into specific business being Enterprise, you had nice acceleration in revenue, but also in profitability. So, how much of that uptick in profitability is maybe coming from the efficiencies that Dan just talked about, versus maybe some product mix, maybe IVR versus the voice biometrics and other?

[Paul A. Ricci:]

Well, the profitability in Enterprise was driven in part by the very large revenue increase in that quarter. Again, my encouragement would be for you to look at the rolling average profitability over several quarters and to look at the trend there. I think Enterprise has shown real profitability improvement. And I think that's where you should focus on, but it's primarily driven by increased revenues. They have had ongoing efficiencies that Dan has alluded to, and including in their cost of goods.

[Saket Kalia:]

Got it. Very helpful. Thanks.

[Operator:]

Our next question comes from the line of Jeff Van Rhee with Craig-Hallum. Please go ahead.

[Jeff Van Rhee:]

Great, thanks. Just a couple for you, probably, as it relates to the quarter, I just want to read this back to make sure I got it, so the bookings obviously, net new is in the range, you reiterated the range; you're tweaking down. Is it entirely coming to faster than expected shift to the recurring side? And then you point out the Dragon Medical and related businesses impacting HIM. Is that a fair read back of the guide, I just want to make sure, I'm capturing it?

[Paul A. Ricci:]

When you say the guide down, you mean the $15 million employee revenues?

[Jeff Van Rhee:]

Yeah. Yes.

[Paul A. Ricci:]

I think, that the number one element is, first element is as I mentioned the migration, the transition from Dragon Medical and Diagnostics to cloud and recurring models. The second is the erosion of HIM revenues associated with penetration of Dragon Medical and EMRs. And the third factor would be the reduction in the erosion of smartphone handset revenue.

[Jeff Van Rhee:]

Okay. With respect to the shift to the recurring 71%, I mean big jump and that number's come a long way. It had – the pace of transition had started to decelerate and then, took a substantial jump this quarter, when you look at sort of a percent of the overall revenue mix, are we any closer, in terms of your thinking to being able to outline or put some benchmarks around what the full transition looks like? Maybe like what percent of revenue can or should go recurring once you're fully transitioned?

[Paul A. Ricci:]

We've spoken to that question previously and what we said is, we think that growth in recurring revenues, again, as a trend rather than any quarter, the growth in recurring revenue is slowing. We see our way forward (16

[Jeff Van Rhee:]

Okay. And just two real quick ones here then, one, do you see all segments showing top line growth in 2017? And then, one numbers question on the sales capacity, I know you're reallocating some of the cost savings strategically to sales capacity. Can you just talk to a, or quantify the number of reps, where we're now, where we were to get a sense of sales capacity? Thanks.

[Paul A. Ricci:]

First off all the answer to the first question is, yes, we do expect to see top-line growth in all four businesses. We've added – to your second question we've added about 40 people this year in our sales organization and we'll have added about 60 or a bit more as we complete the year.

[Jeff Van Rhee:]

Okay, great. Thank you.

[Operator:]

Our next question comes from the line of Tom Roderick with Stifel. Please go ahead.

[J. Parker Lane:]

Yes, it's actually Parker Lane in for Tom Roderick. I was wondering, if you comment on the demand environment and market opportunity you're seeing for customer service applications like your voice biometric solution? Thanks.

[Paul A. Ricci:]

The demand for voice biometrics in particular is extremely strong right now, based on the desire for enhanced security, particularly in certain verticals, government and financial services are at the top of that list. And so bookings in the voice biometrics segment of the Enterprise business were up very sharply year-over-year, one of the highest bookings growth rates across all of Nuance's product lines. We're also seeing growth in the Enterprise segment owing to the interest in digital multi-channel, we talked about this at length in previous calls, but large corporations are interested in handling their customers in an integrated way across diverse channels and our offerings are increasingly capable of handling that, and that has been very well received among large enterprises.

[J. Parker Lane:]

Thank you.

[Operator:]

Our next question comes from the line of Steven Wardell with Leerink Partners. Please go ahead.

[Steven Wardell:]

Hi. Thanks for taking my question. Can you give us a little more color on the decline of the Healthcare transcription business, how fast has that been eroding and do you expect it to increase its pace of erosion, or decrease its pace of erosion? Thanks.

[Paul A. Ricci:]

Yes. So, I think the right way to think about that is that erosion was roughly in mid-single digits as we entered this year, and as we're looking now, it seems to us to be more at the upper single digits. And we would expect that to be, we'll expect that to continue, we don't expect a significant depreciation of that, but we do see a higher erosion rate.

[Steven Wardell:]

Great. Thank you.

[Operator:]

And the last question in queue comes from the line of Shaul Eyal with Oppenheimer. Please go ahead.

[Shaul Eyal:]

Thank you. Hi. Good afternoon guys. I know you guys don't have the sizeable foreign exchange or international exposure, but was there any foreign exchange headwinds this quarter?

[Paul A. Ricci:]

It was a very modest. We don't have a large exposure. From a P&L standpoint, we have a balance between our revenues and our costs, so it generally nets out. And we didn't have a large FX impact at the top-line.

[Shaul Eyal:]

Fair enough, fair enough. Now, aside from voice biometrics, is there anything else which is driving the solid performance on the Enterprise front, over the course of the past few quarters?

[Paul A. Ricci:]

As I mentioned just a moment ago, the voice biometrics business is performing – product line is performing well for us, as is the digital multi-channel product line, which is a new growth segment of Enterprise as well.

[Shaul Eyal:]

Got it. Fair enough. Thank you.

[Paul A. Ricci:]

Okay. Before we close, I simply want to correct something I made in my opening comments, where I misspoke. I said that the midpoint of our full-year EPS guidance had moved from $1.48 to $1.56, but that was wrong. I meant to say, it moved from a $1.48 to $1.52. I apologize for that error. So, with that, I want to thank you all for joining, and we look forward to speaking to you again next quarter. Thank you.

[Operator:]

Ladies and gentlemen, this does conclude today's conference. We want to thank you for your participation. You may now disconnect.