Disruptive Yet Stable: A Growth Stock Oxymoron

Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Nuance Communications (NASDAQ: NUAN) is a voice and language solutions provider. Essentially the company uses proprietary voice recognition technology to solve problems for customers in health care, mobile and enterprise areas. The nature of each of Nuance’s business segments is dramatically different, making Nuance one of the more unique growth stocks I’ve ever seen.

Mobile and others: Nuance’s disruptive growth businesses

The mobile and health care businesses essentially make up Nuance Communications’s identity. The mobile business is Nuance’s disruptive growth area. Nuance has strong relationships with all sides of the smart phone equation, providing voice recognition solutions across the breadth of the market.

The smart phone market is currently a warzone with a huge battle by the top three players for market share. Apple (NASDAQ: AAPL) controls much of the luxury smartphone market with the iPhone 5 and 4S devices, and many investors worry that Apple, having saturated its wealthier markets will have a hard time growing in the future due to inability to grow in the low-end smartphone arena. Meanwhile, Samsung, and Google's (NASDAQ: GOOG) Android by extension, are achieving high growth in the low-end smartphone markets, having grown market-share from 23% to 29% in the last quarter.

While the smartphone industry seems cut-throat, Nuance has been able to enter the market from both sides through relationships with Apple and their Siri voice recognition assistant and a partnership with Samsung, which uses Nuance technology in its Samsung Galaxy S III and should profit no matter what side wins. Moreover, the segment is bolstered by innovation and growth in other areas. Nuance started providing voice solutions for TV’s, and their Dragon TV product, partnering with LG Display, has already been sold through 750,000 TVs.

Nuance’s Dragon Drive solution is another disruptive growth area as they’ve developed partnerships with Ford (NYSE: F), GM, BMW, and Audi among others. Ford is targeting 13 million of its customers alone to use its voice activated systems by 2015, 3.5 million of which will be European customers. Thus far, 20 million voice enabled cars use Nuance’s technology. Nuance has also added Hyundai and Chrysler as new customers this year.  In terms of innovation and disruption, Nuance has a wide breadth of market opportunities it still has to tap. They’ve begun a voicemail to text service that has already transcribed 1 billion voicemails and have many other doors like this to open for money to potentially be made.

Healthcare: Nuance’s main asset isn’t fully appreciated

Nuance’s health care business uses the same trademark voice recognition product to make health care services more efficient. Nuance is trying to revolutionize the transcription of doctor’s notes by making an automated voice recognition-based process, and they’re even trying to get involved in hospital document processing as they provide coding solutions for hospitals. The ultimate goal seems to be involvement in all phases of the process: the creation of the document by the doctor and the coding and storage of the document.   

While the mobile business gets a lot more attention for its disruptive potential, the health care business is Nuance’s bread and butter. Much of the health care revenue is based upon volume of lines transcribed making it a recurring revenue source for Nuance. The barrier of entry into this business is growing with Nuance’s revenue. 

Annualized line run rate in Nuance's healthcare business

<img src="/media/images/user_51/screen-shot-2013-01-31-at-120754-am_large.png" />

As you can see, the annualized line run rate is quickly increasing, and with it Nuance’s health care position is becoming ever more entrenched. According to their financial analyst day transcript from December 2012, Nuance has surpassed 450,000 physicians that directly use Nuance products. It’s important to note that according to this source, there are slightly over 830,000 active professional physicians in the US, meaning that Nuance has directly engaged over 53% of its market. Nuance has shown clear market dominance and a clear need in the marketplace for its product.

Customers clearly believe in the quality of the service being provided. In the health care business, the gold standard for performance ratings is KLAS performance ratings. Nuance has 6 products that are #1 in their category and one product that has been #1 in its category for 8 years running. Even with Nuance’s large share of physicians, there is still a lot of room for growth. Nuance can leverage its current market by increasing the number of Nuance products that each physician uses, and it has a lot of room to grow in expanding its access to the remaining 47% of physicians who don’t yet use Nuance’s health care products.

Management concluded the quarter by guiding towards $1 billion in revenue for the health care business in the next year and is clearly expecting the health care business to accelerate in 2013. I don’t think management is being too aggressive with this estimate given how stable and dominant Nuance is and has been in the health care business. Ultimately, if Nuance is to be a winning stock, it will be the health care segment that carries it to high returns.

3 reasons to buy Nuance

1) Dual threat: stable and disruptive

On one side you have the health care business with a huge share of the market, becoming ever more entrenched in its market through a strong recurring revenue model. On the other hand you have a disruptive mobile business with a potentially gigantic market and limitless opportunities to expand the technology(cars, voicemail, and TVs are only the beginning). Nuance is clearly ramping up for growth as we see a 64% increase in employees in 2012, and this dual threat combined with scale increases to accommodate growth will be guide Nuance to a market beating performance.

2) Innovation:

Of course you have a disruptive business with the Mobile segment and the applications of the technology already in place, but there is a lot more to Nuance Communications than that. Nuance prides itself in its innovation, and they have two new technologies on hand that are ready to produce. Nina, a disruptive virtual assistant, is one of these products. To quote management:“We note in particular that early bookings and the breadth of our pipeline for our enterprise virtual assistant, Nina, indicate a reception well beyond our expectations.” Nuance has also been developing voice biometrics technology that could help in many areas of the business including customer service, where Nuance could allow companies to recognize repeat customers and provide more effective services.

3) Catalysts:

Finally, there are a few catalysts that could bump up Nuance’s stock in the future. First, Nuance took on a lot of debt recently to finance its growth. If that growth comes to fruition, Nuance will pay off its debt and pressure will be reduced on the stock. There is also a lot of goodwill on Nuance’s balance sheet. Management’s promises that acquisitions will be reducing as a portion of Nuance’s growth strategy over time should allow for organic growth which would strengthen Nuance’s balance sheet as well. However, apart from financial statement catalysts, there are material aspects of the business that could help Nuance. In hospitals, medical practitioners must all use a uniform code as prescribed by the government. Currently, most hospitals use ICD9, but by Oct. 1st 2014, all hospitals are required to change to ICD10. Nuance sees a large productivity loss in this switch to ICD10 unless hospitals begin to use Nuance products, a possible growth catalyst in 2013 and 2014.

3 reasons to sell Nuance

1) Is the growth fake?

The biggest concern with Nuance is with the level of Nuance’s acquisitions. Nuance had 10% organic growth in revenue in 2012 compared to its 25% total revenue growth. If organic growth can’t grow as a portion of total revenue, Nuance may run into problems as M&A activities aren’t known to be very value accretive for shareholders.

2) Financial statement and valuation questions

Goodwill makes up 50% of total assets, a level that is quite big enough to worry shareholders. Moreover, GAAP earnings per share is still only $.67, so Nuance isn’t at all cheap at 35x earnings.

3) Competition is fierce

Nuance isn’t quite as special as it thinks it is. At its core, all of Nuance’s business is based upon its voice recognition technology. However, Nuance isn’t the only company that has voice recognition technology of its own. Google, among other companies, has voice recognition with error rates only single percentage points behind Nuance’s. With recognition rates so similar among companies, it is hard to justify giving any company pricing power, and it is very likely that margins will be compressed in low barrier to entry segments like Mobile.

The threat here is the same as the threat to OpenTable (NASDAQ: OPEN). OpenTable is a growth business making money from online restaurant reservations. While it is a major market leader and has strong growth, the core of OpenTable’s business is easily replicable by businesses such as Google or restaurants themselves which have the infrastructure already set up through their own websites to provide OpenTable’s services. Even while at the forefront of a revolution, OpenTable is very vulnerable to competition, and this type of scenario may apply to Nuance’s mobile business as well.

At today’s prices I’m not confident that Nuance is a buy. Nuance’s healthcare business might justify most of the high price, but ultimately an investment today in Nuance implies your belief that Nuance’s mobile business will gain traction over competitors. If you’re comfortable with all the risks I’ve mentioned, Nuance is a great business with a lot of potential over the next few years.

shamapant owns shares of Apple. The Motley Fool recommends Apple, Google, Nuance Communications, and OpenTable. The Motley Fool owns shares of Apple, Google, and Nuance Communications. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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