Why You Should Be Worried About Nuance Communications

Nuance Communications' (NASDAQ: NUAN  ) recent earnings results likely left investors worried about its ability to successfully navigate a difficult revenue transition. The company's fiscal 2014 full-year earnings guidance fell significantly short of analyst expectations, which prompted the stock to sell off to multiyear lows. Unfortunately, there are plenty of reasons why Nuance may have a difficult future ahead.

Getting up to speed
Nuance has been dealing with a shift in the way it's being compensated by its customers, which has accelerated in recent years. Instead of licensing out its voice recognition technology for a predetermined period and being paid up-front, a growing base of customers are opting for on-demand (or usage-based) terms in which Nuance is only compensated when its cloud-based services are actually being used by the customer. This transition has put near-term pressure on Nuance's revenue streams, but the hope is that it will ultimately improve revenue predictability. Despite these headwinds, Nuance still expects its fiscal 2014 revenue will increase by 6% to 10% over fiscal 2013 results.

A double-edged sword
On one hand, transitioning to a usage-based service model invites the possibility of significant revenue upside for Nuance, assuming its products become more in demand with each passing year. On the other, an on-demand service model assumes that its services will increase in the future, which isn't even close to guaranteed.

Currently, it remains unclear whether this shift will actually benefit Nuance's business over the long-term because Nuance's estimated three year on-demand total contract value has fallen over the last two quarters. You would think that with more customers transitioning to an on-demand service model that Nuance's total on-demand contract value would be steadily rising.

Fiscal Quarter

Estimated 3-Year Total Value of On-Demand Contracts (millions)

Q4 2012

$1,906.4

Q1 2013

$2,083.8

Q2 2013

$2,103.4

Q3 2013

$2,091.2

Q4 2013

$2,084.1

 Source: Nuance Communications.

Part of the problem
Given the current trajectory of worldwide smartphone adoption, it's surprising to learn that Nuance isn't expecting to organically grow its mobile phone revenue over the next year. After all, one of Nuance's biggest claims to fame is that it powers the voice recognition technology behind Apple's Siri and many other mobile voice-recognition engines. Considering Nuance's entire mobile and consumer segment, which includes smartphones, accounted for about 25% of Nuance's adjusted revenue last quarter, it's possible this lack of growth could be dragging down the total future on-demand contract value.

The other problem
Nuance has acknowledged that the shift to from up-front revenue to on-demand revenue has put a drag on operating profits. Last quarter, Nuance's on-demand revenue increased by about 9% year over year, growing to represent 32% of the company's total revenue. At the same time, its operating profit margin declined by 11% year over year to 32%, which was partially driven by the increase in on-demand revenue. At the end of the day, if the company wants to maintain a stable level of profitability as it goes through this potentially long-winded revenue transition, it will have to make up for the profitability shortfall with increases in usage from its on-demand customers.

What's more, with only 32% of Nuance's revenue coming from on-demand sources, it's quite possible that this revenue transition is only in its early stages, and investors may have to brace themselves for more profitability headwinds in the future.

Well, that was depressing
Theoretically, Nuance is one of those companies that offers tremendous promise in the future. It sits at the intersection of the next great leap in human productivity where we interact with our machines by using natural language. Unfortunately, the reality of the situation is that there are underlying issues with Nuance's business that's stopping it from realizing its full potential.

Perhaps Nuance will be able to work through these issues over the long-term, but it will certainly be a tall order and likely take a number of years. Realistically, if you're not willing to see this through at least two or three years, investing in Nuance's turnaround efforts isn't for you. This is going to require a high degree of patience and there's no guarantee the company will be able to escape the threat of shrinking margins and revenue headwinds.

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