Nuance Communications, Inc.
Q2 2013 Earnings Call Transcript

Published: 30 Apr 2013

[Operator:]

Ladies and gentlemen, thank you for standing by, and welcome to Nuance's Second Quarter Fiscal 2013 Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. With us today are the Chairman and Chief Executive Officer of Nuance, Mr. Paul Ricci; CFO, Mr. Tom Beaudoin; Vice President of Investor Relations, Mr. Kevin Faulkner; EVP of Corporate Strategy and Development, Bruce Bowden; and VP of Business Financial Planning and Analysis, Rick Booth. At this time, I'd like to turn the call over to Mr. Faulkner. Please go ahead.

[Kevin Faulkner:]

Thanks, Brad, and before we begin, I'll remind everyone that matters we discuss this morning include, predictions, estimates, expectations and other forward-looking statements. These statements are subject to risks and uncertainties that could cause actual results to differ materially. You should refer to our recent SEC filings for a detailed list of risk factors. As noted in our press release, we also 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. Now let me turn the call over to Paul Ricci.

[Paul A. Ricci:]

Good morning, and thank you for joining us on short notice. Before we take your questions, I'd like to highlight some key points from the second quarter, speak to the factors that affected our results and discuss how we are responding. At the outset, let me say I'm disappointed with our Q2 performance and we have already begun to take corrective actions. But despite the challenges we faced in the first half of FY '13, I remain confident in our market opportunity and convinced that we have the right technology, solutions and customer relationships to drive improved long-term results. The share buyback program that we announced today underscores our confidence in the business and our commitment to improving shareholder value. There were some encouraging results in the quarter that bolster our confidence. Several businesses performed quite well, especially automotive, where we have expanded into the domestic Chinese market, extended our relationships with key Japanese automakers and delivered significant growth in Dragon Drive!, our connective car initiative. We continue to see strength in our Dragon Medical products, with strong sales into the customer base of our EMR partners, including especially Cerner and Epic. We also had encouraging bookings in newer product areas, including Nina, our new Mobile customer care solution, and in our health care coding and revenue cycle management solutions. In addition, we advanced new products that will fuel future organic growth such as Clintegrity 360, our integrated end-to-end clinical information management solution, and Nina Web for customer care. But now let me return to our assessment of what drove our Q2 results, which includes a combination of internal factors and external factors in our markets. Foremost, we suffered from sales execution issues, including poor account management and deal strategies. As a result, we had weak license revenues in the quarter. We had particularly poor results in EMEA, where weak execution was compounded by a difficult market environment. Second, we are continuing to shift toward royalty, on-demand and term license models, especially in our new solutions and our mobile solutions. In particular, this trend has accelerated our mobile solutions increasingly using -- increasingly -- includes usage-based pricing, and as we offer our health care coding and revenue cycle management solutions under a term license model. Although these recurring streams are building a stronger, more predictable business in the long term, new bookings did not build revenues fast enough to offset our license shortfall. Third, we experienced delayed revenues in our Mobile business due to several factors. We saw delays from smaller handset OEMs as they experience pressure from market consolidation. Additionally, some deals were delayed by our efforts to enforce better pricing discipline in this segment. While this had a negative impact on Q2, it will ultimately benefit Nuance as we realize long-term economic improvements in these relationships. And we experienced delayed royalty reporting for some of our OEM customers that push revenues to future periods. Fourth, declining PC sales and structural changes in the Windows software distribution channel negatively affected our desktop software businesses. We have strategies in place to mitigate this issue, including the addition of an OEM distribution model and new subscription-based licensing models for our Dragon and imaging products. Now let me turn to the changes we're making in response to our Q2 shortfall. As referenced in our prepared remarks, we have revised our FY '13 outlook. The revised outlook takes an updated view of our market conditions and operational issues. The guidance in our prepared remarks shows that we now expect FY '13 revenue performance that is more or less flat organically compared to FY '12. The outlook assumes that license revenues represent a smaller proportion of our revenue mix with an increasing proportion of On Demand and term license revenue streams, which are recurring but building more slowly. In fact, the second half outlook reflects a concerted effort on our part to favor and accentuate those revenues as we seek to build a larger recurring revenue base going into FY '14. We're committed to improving our results and enhancing our profitability and have taken several remedial actions towards that. We've reduced our cost structure for the balance of FY '13 and for FY '14 through a combination of personnel reductions, non-personnel cost reduction measures and a slowing of our planned hiring. We're actively addressing sales management and operational issues, which include some management changes, and we've slowed the pace and reduced the size of acquisitions consistent with our recent trend to focus resources on driving organic growth. Due to the extent of the changes in our revised FY '13 plan, we've completed an extensive evaluation of FY '14 earlier than usual, as reflected in our prepared remarks. In fiscal year '14, we expect to return to solid revenue growth and slightly improving margins. The adjustments we have made to the business, combined with strong bookings performance into fiscal year '13, will deliver benefits in fiscal year '14. Additionally, we expect to see greater revenue contributions from new product lines, including our integrated health care solutions, additional functionality in the Mobile & Consumer business, including natural language understanding and biometrics, our expanded Enterprise product family, including Nina Web and biometrics and new MFP and desktop product releases in the imaging division. We will see growth from our health care market expansion as we bring more of our product family online in Europe and address newer segments, including the midmarkets. We also expect significant growth in Dragon consumer business associated with our new OEM business model, and as we expect to achieve growth in our voicemail-to-text business as we ramp up subscribers and new and existing carriers. Finally, we expect continued strong performance for our Automotive business as we see our embedded and connected solutions deployed in more and more models. In closing, I want to reiterate that while we're disappointed with our Q2 performance, I remain confident that we have the plans in place to improve the financial performance of the business. I'm enthusiastic about our long-term prospects as we focus on our mission of reinventing the relationship between people and technology. We'll now take your questions.

[Operator:]

[Operator Instructions] And our first question will come from Richard Davis with Canaccord.

[Richard H. Davis:]

You talked about focus on pricing discipline. To what degree have you seen pricing pressure? And what is the source of the pricing pressure on the Mobile & Consumer side?

[Paul A. Ricci:]

Our Mobile business, in particular, our mobile handset business, where we sell to the large consumer electronics manufacturers who build smartphones, has always been a business that has faced pricing pressures. We talked about that in previous quarters. That pricing pressure has intensified as the competitive situation -- the competitive dynamic of that industry has evolved. Our largest partners are very demanding in terms of pricing. And even the smaller firms, because they're suffering such margin erosion, have been very difficult in renegotiation for new product lines or new deals. And we have talked before how those firms have tried to use smaller competitors to -- as price leverage against us. We simply concluded over the last first half of this year that we had to be more disciplined about maintaining our price levels and therefore, we had to be prepared that there would be protracted negotiations in concluding deals around that. We saw a good deal of that in the second quarter -- we're going to see more of it as we go through the balance of the year. We believe that by doing that and given the strength of our intellectual property position and given the leadership and our technology and products, that this discipline will favor the business as we look into '14 and into '15. But it is causing real disruptions in our revenue stream in the short term.

[Operator:]

And our next question will come from Brent Thill with UBS.

[Brent Thill:]

Paul, you mentioned emphasis on recurring versus perpetual. I'm curious if you can just give us a sense in the second half of the year what you're seeing in terms of new business coming in. Is there an easy split for us to understand what's going towards recurring versus perpetual? And I had a quick follow-up.

[Paul A. Ricci:]

I don't -- I think I can speak to that qualitatively, and Tom may add some comments here. I think if we look across each of our business lines, there is an increasing proportion of revenue that is moving away from traditional licensing towards some form of a recurring revenue. In the Mobile, we talked about the increasing preponderance of the connected revenue streams. In health care, we discussed the term licensing model that's prevailing in our newer solution. In Enterprise, we, of course, have an Enterprise on-premise licensing business, but we are favoring new products that are hosted and therefore, are recurring in their revenues. And even in our Windows-based products, we're seeing a migration towards alternative pricing, including subscription and term licensing, that has the effect of elongating revenues.

[Thomas L. Beaudoin:]

Yes, I think one way to think about it is that over the last year, our product and license revenues have gone from about 48% of revenues to about 41% in the latest quarter. And at the same time, as we've talked about it and we talked about it in Analyst Day, the hosting revenues have continued to grow quite rapidly, and we've gone from about 27% a year ago to 34%. And I think that's a trend that we see going out, as Paul talked about the growth in those segments, and plus some of the disciplined processes around our licensing revenues.

[Operator:]

And our next question will come from Shaul Eyal with Oppenheimer & Co.

[Shaul Eyal:]

Two quick questions on my end. Paul, in the prepared remarks, you also indicated some of the weakness being driven by some prior acquisitions. Can you kind of discuss kind of like more provide us -- was that kind of the health care in that perspective? I know health care numbers were absolutely solid. Was it Enterprise? Was it kind of Mobile-related acquisitions? Any color would be like greatly appreciated.

[Paul A. Ricci:]

Well, in the previous quarter's remarks, I referenced the fact that the revenue models for the recent health care acquisitions were more protracted than what we assumed at that time we bought the businesses, and that was simply a mistake on our part. That continues to be true, and that creates a drag on revenues throughout fiscal '13. It does, as we've referenced previously, build a recurring revenue base as we look out into '14. Some of the other acquisitions that we've done, which are smaller, in the last 12 to 18 months have been somewhat disappointing in their revenue contributions. I don't want to overstate that, and I don't think the acquisitions were a mistake. Our execution in sales integration in some of them perhaps has not been as good as it should have been.

[Shaul Eyal:]

Got it. And one kind of quick follow-up. You did indicate some management changes. Without kind of being too kind specific about it, is that sales, marketing, R&D, operations, all of the above or any kind of specific category?

[Paul A. Ricci:]

I apologize that I can't say more about the management changes now than I have said. We have made one senior sales management change already. There are other changes that we're going to be making in the coming weeks and I simply can't say more about them right now.

[Operator:]

Your next question will come from John Bright with Avondale Partners.

[John F. Bright:]

On Enterprise, I think you mentioned the -- you underperformed for on-premise license business. How large is the on-premise license business within Enterprise, and does it have a disproportionate EMEA mix in it?

[Paul A. Ricci:]

The adverse quarter we had in the Enterprise business this quarter is at least partly situated in the context of a very strong quarter this quarter last year, which itself driven by revenues associated with the acquisition of Loquendo some couple of years ago now and the realization of some very strong European revenues in that quarter. So the comparison year-over-year is somewhat unfavorable and I think probably should be normalized. Even in that context, licensing was weak in Enterprise, and that weakness was especially driven by poor performance in EMEA. We referenced that poor performance in EMEA in the first quarter. It was as bad or worse in the second quarter. We had very solid performance in Europe in Enterprise licensing in the first quarter. It was not as good in the second quarter. There were some delayed deals. I don't think those deals are lost, but they were delayed and I think they'll be realized over the course of this fiscal year. That's been disappointing. I think that is, to some extent, a sales execution problem. We're -- and you'd asked one more question. What was that?

[John F. Bright:]

I was asking how large the on-premise license business is within Enterprise and if you -- if it had a disproportionate amount of business in EMEA?

[Paul A. Ricci:]

We don't have a disproportionate amount of business in EMEA, but EMEA was always a pretty big disappointment, and we don't break out segment license revenues separately.

[John F. Bright:]

A follow-up question goes back to the Mobile discussion. If I look at your prepared text and I note the consolidation in the smartphone market, should I interpret that to mean Samsung and Apple gained a disproportionate market share? And then if I see the increased focus on pricing discipline as well as comments, I think, previously that you're going to be increasing your legal efforts to defend your IP, can I interpret that to mean they're getting more share and you're just going to -- that you need to hold the line in pricing now to try to realize more of that IP value?

[Paul A. Ricci:]

Well, we have strong and long-term relationships with the leaders in the smartphone market as you know. But there remain a number of other firms who are participating in that market. To some extent, our revenues have been frustrated by the decline of those firms who previously have contributed more revenues and to some extent, we have held -- we have protracted negotiations with some of those firms because we were unwilling to meet their price demands. And associated with that, I have referenced in my comments and I think in the prepared remarks and in previous quarters that we have a strong IP position and that we are investing in that and we intend to support our -- the value of our intellectual property through those investments. I think there are comments in the prepared remarks about the increased legal investments we're making in IP associated with that.

[Operator:]

And our next question is going to come from Tom Roderick with Stifel.

[Tom M. Roderick:]

So Paul, last quarter, you referenced some changes happening in the health care segment where, in particular the EMR mandate, where hospitals are bringing EMR systems in-house that's actually benefiting Dragon Medical. And it seems like this is something that have perhaps gone on for a while. So I guess the question is can you give us an update on that trend and what Dragon Medical, well, perhaps on the on-premise segment, looked like for you this quarter? And also can you offer some more details as to how much prior periods, particular fiscal year '12, benefited from that shift as you recognized more on-premise perpetually licensed revenues?

[Paul A. Ricci:]

Yes. Last quarter, I think I referenced 2 issues that our On Demand business and health care for existing customers was seeing some volume erosion, and that volume erosion was being driven by 2 factors. One was the electronic medical records implementations. And I think there may have, at that time, been, to some extent, an over -- my communications about that may have been somewhat muddled, and there may have been an overreaction and suspicion about the magnitude of that. That erosion is in the low single digits, just to give you a sense of proportion. But we are also seeing the effect of our Dragon Medical licensing, which cumulatively has been building up and now addresses a material proportion of clinical professionals in North America. That has a flip side, as you pointed out in your question, and the flip side is that the Dragon Medical license revenues are growing. We don't break out Dragon Medical license revenues, but I can say that it is among the fastest-growing product lines we have in the company and that has been true for several years. It remains a very fast-growing product line. I think that, to give you a single data point, I believe the growth in the first half of this year will remain probably above 30%, for example. But the business, it will slow. The growth of that will slow as the numbers of that business increase, but it is a rapidly growing business for us.

[Tom M. Roderick:]

Okay, great. Let me -- one quick follow-up on the Mobile business. When we look at your -- the construction of your guidance for the rest of the year, does that guidance contemplate any changes to the nature of the relationship with Samsung and Apple or to the pricing of those relationships? And the reason I call those specifically is, of course, given the magnitude of their -- and importance of their relationship on the Mobile side.

[Paul A. Ricci:]

I can't speak -- as you know from previous quarters, I can't speak to specifics about the relationship of either of those 2 firms really.

[Operator:]

Our next question is going to come from Scott Zeller with Needham & Company.

[Scott Zeller:]

So getting back to the points earlier from Tom about the mix and evolution of revenues, could you tell us where you think gross, blended gross margins may actually stabilize over the next few quarters?

[Paul A. Ricci:]

In the prepared remarks and in my opening comments, I reiterated those. As we look into fiscal '14, we expect gross margins to improve slightly in fiscal '14, and that will be, I believe, a combination of 2 effects

[Thomas L. Beaudoin:]

I think that comment that Paul made is pretty consistent with the back half of the year and then going into FY '14. Some of the cost savings -- we've had programs in place for the last few quarters and we're achieving some of those benefits. But I think gross margins will be kind of flat to slightly up. There will be some adjustment quarter-to-quarter depending on the mix in the license, but I think and really feel it's consistent.

[Scott Zeller:]

Okay. And then to follow-up, regarding some of the Mobile & Consumer projects, Paul, that you've talked about that are growing in scope and complexity, could you tell us how the progression has gone with those? And as far as meeting milestones and being able to recognize revenue for those larger projects, have they gone as planned with the company being able to meet milestones on these larger engagements?

[Paul A. Ricci:]

We have a number of large projects. You correctly cite in your question and I referenced in previous calls, those projects include expansive projects with our smartphone partners, automotive partners and now within the Dragon OEM channel and large systems and chip manufacturers. And on balance, those projects are going very well. They are, as I've discussed in some detail, large complex projects that run -- that have development spans of a year, in some cases, more. But by and large, they're going very well. We have some issues, but you would expect that given the breadth of products -- breadth of projects we have underway. There may be some delays in revenues associated with those, but I don't think that they're appreciable. In the case of our OEM business for -- related to that, that I've referenced, the OEM business for the new Dragon variance that we're bringing to market, I think there has been some revenue delay in the second half of this year, but I think we'll see that pick up in fiscal '14.

[Operator:]

And our next question is going to come from Jeffrey Van Rhee with Craig-Hallum.

[Jeffrey Van Rhee:]

Paul, just 2 questions for you. First, on the gross margins, obviously, some revenue underperformance and some mixed shifts going on. But outside of that sort of open ended, if you will, where else might there be gross margin pressures that you're seeing now you weren't seeing 3, 6 months ago?

[Thomas L. Beaudoin:]

Yes, sure. Our gross margins by line of business, by category have been quite consistent and have actually improved, particularly in some of the services areas. So the vast majority -- the preponderance of the decrease in gross margins kind of year-over-year or even between Q1 and Q2 are predominantly mixed shifts.

[Jeffrey Van Rhee:]

Okay. And then Paul, but just back to the other comment you had made about the health care side in terms of the pace of the hosted decline, you mentioned single digit. Just wanted to understand that a little more. What -- in terms of the growth, when you say single digit, can you just expand on what you mean there? And if you can at least give us a ballpark on health care, as what percent of health care is, in fact, for the hosted transcription side?

[Paul A. Ricci:]

I think my -- the comment I made earlier, Jeff, was that the erosion of our existing volumes was in the low single digits this year. And the second question you asked was, what?

[Jeffrey Van Rhee:]

Just -- before we jump onto that, just erosion of existing -- you're talking about the existing On Demand customers apples-to-apples, you're looking at low single digit declines. That's what you're saying?

[Paul A. Ricci:]

Yes, that's right.

[Jeffrey Van Rhee:]

Okay. And then second part was health care was from transcript -- hosted transcription?

[Paul A. Ricci:]

I think it's about 40%.

[Operator:]

And our next question is going to come from Daniel Ives with FBR Capital Markets.

[Daniel H. Ives:]

Paul, with all due respect, just given the last few quarters the performance even in the last year, what should give investors confidence that we have the right management team operating the company right now?

[Paul A. Ricci:]

Well, the performance, if we're looking back over the last year, has had its strengths and some challenges. It's a big and complex business, and we actually delivered a -- record results in FY '12 in almost every element. So I think the company feels very good about the fiscal performance and the operational performance through the fiscal '12 calendar year. This half, this first half of this year has been difficult and we are making some management changes. And nonetheless, it's a very talented management group. I have a great deal of confidence in them. And as I look back over building long-term shareholder value, this management team has done a lot of extraordinary things, so I remain confident in them.

[Daniel H. Ives:]

Okay. And then just as a follow-up, can you confirm if you've hired a financial advisor in terms of working your strategic alternatives?

[Paul A. Ricci:]

I can say that Nuance is very well advised and we work with many firms.

[Operator:]

And our next question will come from Mike Latimore with Northland Capital.

[Michael Latimore:]

On the health care acquisitions, you talked about a revenue model for traction there. What about just the bookings on those acquisitions? Have the bookings met kind of your internal expectations?

[Paul A. Ricci:]

The bookings on the recent health care acquisitions, I believe, are slightly above plan, and that has been an indication of comfort for us, so yes.

[Michael Latimore:]

And then with some of the discussions around pricing with the smartphone manufacturers, are they basically saying they are looking at using small company alternatives to you or using kind of resources that are out there?

[Paul A. Ricci:]

I think, primarily, they're trying to position small regional firms against us in specific markets.

[Michael Latimore:]

And then just last on the delayed royalty report. Can you just elaborate on that a little bit, if that they've used the product but haven't reported how much they've used or they haven't used the product as expected?

[Paul A. Ricci:]

Some of the royalty parts are sizable and in one case, it was simply delayed beyond the point at which we could include it in this quarter's results. In another case, we have a dispute over the royalty report.

[Operator:]

And our next question will come from Mark Murphy with Piper Jaffray.

[Mark R. Murphy:]

Your referenced the potential for some sales personnel changes. Do you expect any impact to the top few or maybe the top handful of sales positions in the company?

[Paul A. Ricci:]

I think my reference was to management personnel in general. I don't think I was more specific. We have made one senior sales management change in our EMEA operations, and I can't be more specific than that really.

[Mark R. Murphy:]

Okay. And then Paul, in terms of the shift to On Demand or recurring revenue streams and the ability for that shift to cause you to miss your revenue forecast, it feels like we've been talking about this for quite a long time, perhaps 4 or 5 years. So I'm curious do you think we're approaching a point where you fully and accurately accounted for that shift so that we're not falling into the same pit here year after year?

[Paul A. Ricci:]

It's a good question. We have been talking about it for a number of years, and it is, in fact, a transition that's been going on for a number of years. And I think you're aware that, that's the transition that situated in a much broader industry transition of the way software is delivered, and we are experiencing that transition. I -- there are 2 comments I'd make about it. One, I think with the revised numbers we've provided you, we've indicated that we are embracing that transition and therefore, looking to accentuate it where we can to build a stronger recurring revenue base as we look into fiscal '14 and even more so into fiscal '15. And secondly, we do think that the numbers we have provided you reflect some caution on our part about that transition, about that -- the effects of that transition on nearer-term revenues and therefore, a view that we have to be -- that we will see -- that we are seeing the impact as we look into the balance of fiscal '13 of that transition on revenues over the next second half of the year.

[Operator:]

Our last question is going to come from Dan Cummins with B. Riley.

[Daniel T. Cummins:]

I wonder, Paul, if you could characterize the growth in revenues that you're seeing from all sources of voice-enabled mobile search? And with respect to your comment about intellectual property, are you -- 2 things really, are you completely satisfied that all of your partners are currently in complete compliance with all terms of -- and conditions with respect to your intellectual property right now? And B, do you still feel that your position is -- has been underleveraged with respect to the carriers in particular and how they cope with sort of being on the outside looking in on the Mobile gravy train, if you will?

[Paul A. Ricci:]

Well, there are a couple of topics in the questions you've asked, and let me see if I can address them. I think I should begin by saying that our view is that the management and cultivation of our intellectual property assets, like the cultivation of any asset, should be seen in the long term. That is, we look at the actions we take legally and the posture we take with respect to our intellectual property is one intended to optimize the value of that asset over a longer period of time. And while that might result in a more cautious approach to the enforcement of that IP, I think it's our view that, that's the appropriate approach and also mindful of the fact that, that business is dependent upon the quality of our long-term partnerships with our customers and that we have to be mindful of that as we balance the maximization of our intellectual property with the realization of the fruits of those long-term relationships. With respect to the carriers, I do think there's additional opportunity with the carriers. We did make a management change in our Mobile services business about 6 months ago because we were not happy with the pace at which we were progressing those Mobile services, and the new manager in that business I think is doing a very good job of focusing on a global basis for where there are -- the opportunities that can be developed now and where the opportunity opportunities that will have to wait. It's very geographically particular because of practices and specific geographies and regulations and other factors.

[Daniel T. Cummins:]

Okay. Can I just ask one follow-on? I was curious if YP or yellowpages.com is a partner currently or a customer?

[Paul A. Ricci:]

I apologize. I just don't know.

[Operator:]

And no further questions at this time.

[Paul A. Ricci:]

All right then. I thank you all for joining us and look forward to speaking to you again next quarter.

[Operator:]

And ladies and gentlemen, this conference will be made available for replay after 7