Is Nuance Communications Inc. Destined for Greatness?

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does Nuance Communications (NASDAQ: NUAN  ) fit the bill? Let's look at what its recent results tell us about its potential for future gains.

What we're looking for
The graphs you're about to see tell Nuance's story, and we'll be grading the quality of that story in several ways:

  • Growth: Are profits, margins, and free cash flow all increasing?
  • Valuation: Is share price growing in line with earnings per share?
  • Opportunities: Is return on equity increasing while debt to equity declines?
  • Dividends: Are dividends consistently growing in a sustainable way?

What the numbers tell you
Now, let's look at Nuance's key statistics:

NUAN Total Return Price Chart

NUAN Total Return Price data by YCharts

Passing Criteria

3-Year* Change

Grade

Revenue growth > 30%

60.6%

Pass

Improving profit margin

(522.7%)

Fail

Free cash flow growth > Net income growth

19.6% vs. (901.8%)

Pass

Improving EPS

(840%)

Fail

Stock growth (+ 15%) < EPS growth

(7.2%) vs. (840%)

Fail

Source: YCharts.
*Period begins at end of Q4 (Dec.) 2010.

NUAN Return on Equity (TTM) Chart

NUAN Return on Equity (TTM) data by YCharts

Passing Criteria

3-Year* Change

Grade

Improving return on equity

(725.4%)

Fail

Declining debt to equity

143.9%

Fail

Source: YCharts.
*Period begins at end of Q4 (December) 2010.

How we got here and where we're going
Things do not look good for Nuance in its second assessment -- the speech-recognition software leader picked up only two out of seven passing grades, compared to the five of seven it earned in its prior assessment in 2013. Over the past few quarters, Nuance's profit margins have collapsed despite solid top-line growth, the latter of which has been primarily driven by a couple of recent acquisitions. However, those acquisitions also resulted in drastic increase in debt, earning Nuance a failing grade. Can the company turn these sliding metrics around in 2014, or will investors in this former high-tech highflier find their gains lost in translation? Let's delve a little deeper to find out.

Nuance did post better-than-expected revenue and earnings per share in its fiscal first-quarter results, thanks to a 26% increase in total bookings year-over-year, driven by strong growth from its health care and automotive segments. The company also issued favorable guidance for the upcoming quarter, which will be driven by a strong pipeline of new products and (hopefully) improved strategies in its health care segment.

Fool contributor Mukesh Baghel notes that Nuance's partnership with Hyland Software has resulted in new product eCopy ShareScan gaining significant traction in the domestic health care industry. Nuance's $80 million acquisition of Tweddle Connect also helped the company integrate its Dragon Drive software with the latter's in-car infotainment system, and that should help Nuance tap into other automotive-support growth markets. Nuance also launched a simpler biometric voice-identification suite for law enforcement agencies. This new product should be able to identify individuals based on audio files with a level of accuracy approaching traditional biometric analysis -- fingerprints or possibly DNA.

Fool contributor Hunter Hillman also notes that Intel (NASDAQ: INTC  ) has partnered with Nuance to hardwire voice-recognition capabilities (using Nuance's Dragon Assistant algorithms) into Intel Core- or Atom-powered Ultrabooks and other laptops. This might not move the needle much for Intel, but it could be a major coup for Nuance to get its technology into more consumer hands. The company also plans to ramp up its investments in cloud-based platforms to maintain its leadership in natural-language processing and virtual-assistant technologies. All told, these positive moves have been well-received by the market, as Nuance's shares have bounced strongly off of recent lows.

Activist investor Carl Icahn has acquired almost a fifth of all Nuance shares over the past few months, which has been one reason why the voice-recognition specialist has been up as much as 11% since the start of the year. However, Nuance's transition from a license-based revenue model to subscription- and term-based pricing models has resulted in a serious short-term decline in sales and earnings (as you can see in the graphs above) despite demanding higher upfront development costs.

However, Google's (NASDAQ: GOOG  ) (NASDAQ: GOOGL  ) acquisition of London-based artificial intelligence specialist DeepMind Technologies could further augment its already-potent Google Now voice-search application on Android, threatening Nuance's efforts to remain relevant in a world where its greatest strengths appear to lie in declining platforms Apple (NASDAQ: AAPL  ) has also rumored to be developing its own speech-recognition technology to drive its virtual-assistant Siri software, which would end its reliance on Nuance's solutions and further restrict the company's opportunities in the mobile arena. Nuance has fired back with a cloud-based artificial intelligence app, Project Wintermute, which would work on smartphones, televisions, and other Internet-connected devices, but unless this service vastly outclasses existing technology from the mobile industry's market leaders, it may not do much to turn Nuance around.

Putting the pieces together
Today, Nuance Communications has few of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 29, 2014, at 12:01 AM, Sunrise250 wrote:

    When Nuance wakes up to *exactly* what they are sitting on then it will be a huge company.

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