This Speech Recognition Company Faces Headwind

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

Did you ever dream of talking to your PC? Just imagine: you relax on your chair, say what you have to say, and everything is typed for you.

Well, speech recognition systems do exist in the market. Of course, they are not yet faultless, so you would have to edit your recordings. However, the technology gets better every day.

Sadly, technological advances are not always supported by stock price advances. After all, business is about your ability to generate profits, and it’s the bottom line that counts.

Nuance Communications (NASDAQ: NUAN), a speech recognition company, has under-performed this year. Its shares are down 16% year-to-date. The stock got hammered after its quarterly report and was not able to recover. Nuance Communications trades at 12.20 forward P/E. This is typically an attractive value for a technology company, but investors do not seem to be attracted. Do they miss something?

Recognizing your words

Nuance Communications operates in four segments: healthcare, mobile and consumer, enterprise and imaging. The healthcare segment was the sole segment that demonstrated meaningful growth over the last year. According to Nuance’s quarterly report, healthcare segment revenues grew 53% year-over-year and accounted for 51% of total revenues.

Nuance's solutions for healthcare seem to meet the needs of the market. Doctors need an easy way to record the patient stories and their own thoughts and prescriptions and do not have time to type all that.

The environment is tougher for the remaining segments. Nuance Communications crosses paths with giants like Microsoft (NASDAQ: MSFT) and Google (NASDAQ: GOOG). Google’s voice search enables the customer to perform a search without actually typing it. With the help of massive financial power, Google’s speech recognition technologies are rapidly evolving.

Google is yet to become a serious competitor in this field, because it is concentrating on enriching its search. Meanwhile, Microsoft is already taking its piece of the pie. Speech recognition comes with Windows. You can say commands to the computer and you can dictate text to the computer. This is a threat to both the customer and enterprise segments of Nuance. Most customers prefer to take the path of least resistance and use the features of the product they already have, instead of paying for something else. As the result of that, Nuance saw its mobile and consumer segment revenue rise only 0.9% year-over-year. The enterprise segment revenue declined 18.5%.

Activist investor Carl Icahn has recently disclosed a 9.3% stake in Nuance. Icahn is known for his ability to build shareholder value, so this fact has reinforced takeover rumors. There were always rumors about Nuance taken over by Microsoft, Google or Apple. Apple has Siri, which is an application that uses language commands. The fact that Apple did not already buy Nuance, although it had the necessary cash to do this, can mean the company is not really interested in such a purchase.  Microsoft has a long history of work on speech recognition. This function was available for installation on Windows XP and Office 2002. As of now, it does not seem as though Microsoft is concentrating a lot on speech recongnition technologies, so it's doubtful it would seek purchases in this domain. Google's voice search is performing well. The company seems in no need of external technology, as things are going the right way organically. 

Worrying signs

The problems do not end on direct competition with Microsoft and possible threats from Google.

Nuance has $2.34 billion of long-term debt, and $2.77 billion in shareholders’ equity. This means that 84% of equity attributable to shareholders is covered with debt. Shareholders’ equity is calculated by subtracting liabilities from assets. If we look at Nuance’s balance sheet, we would see that goodwill accounts for 53% of total assets. In comparison, Google’s goodwill is 11.2% of its total assets, while Microsoft’s goodwill is 11% of its total assets. Why is this important? Every year companies reassess their goodwill. Sometimes, it leads to goodwill impairment when large sums are written off the balance sheet. This is always bad news for the stock. When the goodwill accounts for a large proportion of total assets, it presents risks. In combination with a substantial debt level this draws a scary picture.

Bottom line

Nuance Communications is trading at an attractive forward P/E, but you must be aware that estimates often change. Earnings estimates for the next quarter have dropped 35% during the last 90 days. If the company fails to catch momentum, the estimates would fall further, and shares would be punished. On the other hand, the healthcare segment seems to perform well. The company has announced a $500 million stock repurchase plan. Still, the competitors’ stocks look more attractive. Microsoft trades at an 11.63 forward P/E and pays a 2.58% dividend yield. Google trades at a 16.32 forward P/E and is positioned to turn into an information monopoly. Normally, you would expect smaller companies to offer better growth prospects to justify bigger investment risks.

Currently, Nuance does not present such an opportunity.

Speech recognition is yet another nascent technology set to explode with the rise of tablets and smartphones, and no company is better poised to benefit from this coming boom than Nuance Communications. However, this growth story doesn't come without risks, too. The Motley Fool recently published a premium research report to break down what investors interested in Nuance absolutely have to understand before investing, so click here now to grab your copy today.

Vladimir Zernov has no position in any stocks mentioned. The Motley Fool recommends Google and Nuance Communications. The Motley Fool owns shares of Google, Microsoft, 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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