This is the iPhone 5 Supplier to Buy

By Steven Heller - September 26, 2012 | Tickers: AAPL, GOOG, INTC, MSFT, NUAN | 0 Comments

• Email
• Print

Apple’s (NASDAQ: AAPL) iPhone 5 is shaping up to be a blockbuster.  More than five million were sold in the first weekend, which should bode well for component companies.  However, owning these suppliers hasn’t necessarily been as fruitful as the all mighty King.  Is it possible they’ve been blinded from Apple’s halo? 

For the strategic investor, this could be an untapped opportunity Mr. Market has overlooked.  Let’s use the iPhone 5 release to remind ourselves which supplier is in best position to benefit.  It’s not chipsets I’m thinking about – those will likely change with each new generation.  It’s a company that will benefit because Apple’s installed base continues to grow, regardless of what chip went inside.

That company is Nuance Communications (NASDAQ: NUAN), the ears of Siri.  And this business isn’t just about Apple.  It serves multiple industries and aims to increase productivity worldwide with their industry leading voice recognition technology.  Consider it the biggest input enhancement to happen to the computer since the keyboard.  Best of all, this growth story is still within the first act and reaches far beyond personal computing. 

The Business
Here’s the breakdown of business performance last quarter:

This is what I call the definition of a growth company.  Across the board revenue growth helps justify the near triple-digit PE ratio shares are fetching.  But this should change in the next year.  If all goes to plan and earnings estimates are accurate, shares should begin trading around 14 times earnings.  That’s when things will start getting interesting because shares will likely trade at a discount to historical growth rates.    

In this scenario, shares will trade at a discount until Nuance “proves” to investors that their earnings growth rate is higher than shares are pricing.  When the market becomes convinced, Nuance’s shares will experience PE multiple expansion, rewarding patient shareholders along for the ride.        

The Competition
Microsoft (NASDAQ: MSFT) and Google (NASDAQ: GOOG) are Nuance’s most threatening competitors.  They have more resources, greater reach, and can potentially respond more quickly to changing market demands.  Even with greater perceived power, they lack specialization and technological superiority.  Nuance is the best-of-breed when it comes to voice recognition technology.  They have many design wins to attest to this.  It has allowed them to specialize in fields that Microsoft or Google can’t effectively compete in. 

Nuance’s technology is available in 60 languages and dialects.  Between this and carving out niches, they are – for the time being – well insulated from the threat of others.  

Growth Prospects
More businesses are beginning to understand the value proposition of utilizing voice recognition technology. On average, talking is three times faster than typing, which is great news for the bottom line.  Businesses who integrate this technology are poised to increase productivity and save on costs. 

Nuance has three major growth opportunities directly ahead of itself.  Thinking alphabetically, they are: automotive, healthcare, and mobile.

In automotive, Nuance wants a piece of your dashboard with its Dragon Drive offering.  It’s a piece of software already installed in 70 million cars and 50 million portable navigation systems.  The main features include speech recognition and text-to-speech dictation.  And both increase the chances the driver is keeping a hand on the wheel.               

In healthcare, it is common practice for doctors to voice record reports, which are later transcribed into text format.  What used to be done by an employee can now be done with Nuance’s medical software suite.  The medical transcription industry is estimated to be worth up to $25 billion annually, and is growing at 15% per year.  Nuance is gaining market share here because their revenue growth rate is doubling the industry. 

In Mobile, it’s all about virtual assistance, where users can benefit from having a Siri-like assistant onboard.  The client list that leverages this technology is impressive.  Big-name customers include Apple, Nokia, Motorola, and Samsung.  If the industry leaders are using it, it must be good. 

Also on the mobile front, they’ve introduced Nina, a developer tool to integrate voice commands into mobile applications.  For example, with a Nina enabled banking application, a user could potentially be able to transfer money with their voice.  In another example, your voice becomes your password.  It’s up to the developer community to carry this innovation further.      

Nuance is also pushing tie-ins.  They recently announced a partnership with Intel (NASDAQ: INTC), which brings their Dragon Assistant software to Ultrabooks.  With this program, users will be able to surf, shop, type, and dictate commands without touching a key.  In theory, this should make interaction more natural.  But in reality, it will likely be a bit quirky at first, and then refined down the road.      

Risks & When to Sell

1. The big boys get more involved.  Watch what Google, Microsoft, and others are doing in the voice recognition space.  It will offer clues about the competitive landscape.   
2. Growth by dilution.  Nuance has had a bad history of making acquisitions by issuing common shares, a practice not welcomed by existing shareholders. 
3. Debt repayment hurts growth.  In the coming years, a significant amount of their debt is going to be repaid, which means Nuance needs future cash flow.  If they can’t remain profitable, it’s a major problem.  It may put a damper on earnings growth, leading to stagnant shares.       
4. The largest shareholder controls 23% of the vote.  Watch the activity of Warburg Pincus for any clues to how business is faring.    
5. Apple drops Nuance.  Losing Apple is a bad sign.    

Bottom Line
Nuance’s shares are expensive on a trailing PE basis.  A big near-term risk is how they treat loyal shareholders in relation to future acquisitions.  At a forward multiple of about 14, shares are downright cheap compared to its 5-year historical revenue growth rate of 27%.  Ideally, I’d be comparing historical earnings growth rates to PE multiples, but earnings didn’t exist over this term.      

As Peter Lynch once said, “invest in what you know.”  And I know the iPhone 5 is going to be Apple’s most popular phone yet.  This will create greater understanding of what Nuance’s products are all about, paving the road for future growth.  They are in the business of helping others be more productive, which is a great business to be in.  There is a lot of ground to cover and growth to be had.  For Nuance, staying number one in this industry is crucial.          

In the end, if Nuance has it their way, the keyboard will become a thing of the past.   

• Email
• Print
• Feedback