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How Should Investors Play Nuance Communications in 2013?

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The market hasn't been too kind to mobile growth play Nuance Communications (Nasdaq: NUAN) so far this year. Heading into the end of 2012, the company finds its shares down nearly 11%. However, investors have hung with it, in no small part thanks to its close ties to the tech investing storyline of the decade -- the rise of mobile devices such as smartphones and tablets.

Looking beyond its slumping share price, though, the company still managed a relatively strong set of financial performances this year, growing its top line by more than 20% each quarter. Translating those results to the bottom line, however, did prove somewhat problematic. Regardless, no one disputes the immense growth potential the company holds, and the potentially massive payouts it could generate for shareholders as a result.

The real question when it comes to sizing up Nuance, and whether to buy in or sit on the sidelines, is how likely shareholders are to see this outcome, The Fool recently enlisted one of our star tech writers to create a premium research report on Nuance. To acquaint our readers, we decided to include a brief excerpt from the report here for you today, free of charge. If you want to learn more about Nuance, you can access the report in its entirety by just clicking here. Enjoy!

Understanding the layers
Long ago, most of the voice recognition industry transitioned from local speech recognition engines housed in physical devices to a server-based approach that taps into the power of the cloud. The primary benefit was that far more computational horsepower is available in servers than what's available in a local device, especially if the device is to be small and portable. The biggest disadvantage to this approach is the need for constant connectivity, although this downside continues to become less prominent thanks to advances in cellular data technology like 3G and 4G.

Voice interactions primarily involve two layers to function: the speech recognition engine and the application software. The speech engine serves as the ears, translating sounds into input data, and is typically located in the server. The application software is like the brain, processing and interpreting that data into meaning, and is typically processed locally.

When consumers have poor interactions with voice recognition, like calling the bank or cable company, it's typically weaknesses in the application software layer (frequently built in-house by said bank or cable company) that leads to a poor experience. Many of these companies tap Nuance for the speech engine since it has the best third-party speech engine available to license, working in over 60 languages, but that's little good if the application software doesn't recognize all the different ways that a speaker can say "yes."

Buying the way to the top
Nuance is a serial acquirer, and scoops up companies at a breathtaking pace. The company has purchased over 50 companies since Paul Ricci became CEO in 2000. It's even been known to pummel rivals with intense competition and patent infringement lawsuits only to turn around and make an outlandish acquisition offer.

This presents some unique challenges when assessing Nuance's fundamentals, because in the pursuit of its highly acquisitive strategy, the company's ballooning goodwill and intangible asset carrying values represent impairment risks should acquisitions fail to generate revenue growth or cost-saving synergies. For example, goodwill and intangible assets totaled $3.65 billion last quarter, or 76% of total assets.

At the same time, Nuance has accumulated quite a bit of debt to finance these acquisitions over the years. Total long-term debt and capital leases (including the current portion due within the next 12 months) now stands at $1.41 billion. That's well above the $860 million it owed a year ago, and quarterly net interest expense has likewise increased from $8 million to $19.9 million since then. Nuance also recently announced that it plans on selling an additional $600 million in senior notes due 2020, further increasing its debt burden, to pursue more acquisitions.

Additionally, Nuance is continuously amortizing intangible assets, which puts a drag on reported net income and inflates traditional valuation multiples like price-to-earnings, making it appear more expensive relative to GAAP earnings. This is why investors should also factor in other metrics like enterprise value-to-EBITDA or enterprise value-to-free cash flow when evaluating Nuance.

These multiples have decreased since the beginning of the year, offering investors looking for an entry point a more attractive valuation.

Speaking clearly
That concludes the sneak peek at our Nuance report. If you'd like to keep reading about what investors interested in Nuance absolutely have to understand before investing, click here now to grab your copy today.

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