Nuance Communications, Inc. (NUAN)

[chmcnfunds]

Nuance Communications: A Dive Into The Valuation Divulges Significant Upside
Dec. 16, 2014 3:22 PM ET | About: Nuance Communications, Inc. (NUAN)

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)

Summary

Voice recognition technologies are likely to witness growth during the next five years. Nuance is a prominent player in this space.
The stock under performed during 2014, thanks to the net loss during the year.
Consequently, the stock is trading quite cheaply, presenting investors with an opportunity to buy.
FCF, EVA and PE based valuations reveal significant upside.
Sometimes beaten down stocks provide great value for prospective investors. This report is dedicated to one such stock that is Nuance Communications, Inc. (NASDAQ:NUAN). The stock was an underperformer during 2014 as it lost 25% of its value during the last six months. Negative net income might be the reason Nuance underperformed during the last few quarters. However, with income expected to bounce back going forward, the stock seems quite underpriced. This report will discuss the valuation of Nuance in detail using the PE, EVA and FCF approach. Let's start with a brief introduction.

Nuance Communications is a technology company that belongs to the application software industry. The company is involved in the provision of voice recognition and natural language solutions for consumers and enterprises. Nuance's primary solutions include customer service virtual assistants, speech recognition for consumers, professionals and businesses, and transcription and clinical documentation software and services for the healthcare industry. The company basically markets its speech-to-text solutions for different industries.

Popular products

Some popular products of the company include Clintegrity 360, Nina Virtual Assistant, Copitrak and Dragon. Brief details are as follows:

Clintegrity 360 is a clinical documentation solution that includes hands-free documentation, coding, documentation improvement and quality management services for the healthcare industry.

Nina Virtual Assistant, as the name indicates, is a virtual assistant that automates customer services. The company claims that the virtual assistant delivers customer service through a human-like conversational interface.

Copitrak is a cost management and cost recovery solution for law firms. The software offers features like recovering client-billable expenses, recording client information and allocating expenses to a particular client.

Dragon, a speech recognition software, converts speech into text. Nuance offers separate solutions for consumers, professionals and businesses.

Revenue classification

The company generates its revenue from licensing its products or obtaining royalties from OEMs. Licenses are offered on a perpetual basis or term basis. Revenue for hosted services is based on volume of usage, number of seats or number of devices. Anyhow, the company serves four segments, including healthcare, mobile and consumer, enterprise and imaging. See the chart below:

(click to enlarge) (clink link below for charts/tables)


Source: Nuance earnings press release

The chart depicts that the company generates most of its revenue from healthcare, thanks to popular solutions like Clintegrity 360. During fiscal 2014, the company posted nominal revenue growth of 3.7% supported by 10.4% and 3.3% growth in enterprise and healthcare segment, respectively. However, the consumer segment and imaging segment offset this growth by 5.9% and 3%, respectively.

Some other significant facts about the company include the following:

Two-third of the Fortune 100 companies uses Nuance products. Eight largest smartphone OEMs and ten large automakers are Nuance customers.
Some prominent customers include Avera Health, Cleveland Clinic, Acer (OTC:ACEIY), Advanced Micro Devices (NYSE:AMD), Motorola (NYSE:MSI) and Samsung (OTC:SSNLF).
Vantage Point - Valuation

In this section, the valuation of Nuance is explored in detail. Valuation metrics like PE, FCF and EVA are used to analyze whether the equity is cheap in the current scenario.

Cash-flow approach

Nuance generates healthy cash flows. The company generated average operating cash flow of $408 million p.a. for the last three years. As net income is negative for the past two years, cash flow to revenue relation is analyzed to build a cash flow projection for the company. See below:

(click to enlarge) (clink link below for charts/tables)



Source: Yahoo Finance and author's calculations.

Now, average OCF/revenue ratio is around 22.6%. This will be used as a starting point to project future cash flows. It can be argued that the ratio is declining year over year. The counter argument is that earnings are expected to witness double-digit growth going forward. OCF/Revenue ratio also will improve. Anyhow, to be prudent, a ratio of 20% will be used for calculation purposes. Average capital expenditures, as calculated above, will be used as a starting point, which also is assumed to remain constant going forward.

Projection of revenue growth is a difficult task. Industry growth projections and recent revenue growth trends for the company are explored to select the growth figure. 7% growth for the next five years is assumed for calculations. This is a very cautious estimate. Industry experts are projecting double-digit growth. TechNavio projected a CAGR of 22% during 2012-2016 for the global voice recognition market.



Source: TechNavio, BCC Research and ReportsnReports

Analysts are expecting growth of 5.5% p.a. for the next two years. 7% seems to be a viable growth figure for the company given the combination of analysts' forecasts and double-digit industry growth.

Miscellaneous assumptions:

CAPM is used to calculate the cost of equity. Ten-year cumulative annual return on NASDAQ is used as a proxy for market return in CAPM calculation.
0% growth is assumed in perpetuity.
Long-term treasury yield is assumed as a proxy for risk-free rate.
(click to enlarge)


Source: Focus Equity estimates

So, FCF-based valuation reveals an upside on around 23% relative to the current stock price of Nuance. Let's explore the EVA approach. For those of you not familiar with EVA, read this.

EVA approach

As earnings are expected to grow at a much higher rate than revenue during the next five years, EVA may be the best approach to analyze Nuance. Sticking to the analysts' consensus for this one might be a good idea as well. Assumptions are as follows:

Consensus earnings projections are used for FY2015 and FY2016. 13% growth is assumed during 2016-2019. No growth is assumed in perpetuity.
Balance sheet value of shareholders' equity is used for the calculation of total cost of capital. 0% share dilution is assumed going forward.
CAPM assumptions as above.
(click to enlarge)


Source: Focus Equity estimates

EVA-based valuation reveals a potential upside of 26%. Note that the assumptions are quite cautious. Analysts are expecting earnings growth of 20% p.a. for the next five years. Growth rate used in the above projection equates to CAGR of 11.5% during 2015-2019.

PE approach

Nuance seems pretty cheap on a PE basis. The company is trading around 11.50 times forward earnings while earnings are expected to grow at CAGR of 20% p.a. during the next five years. The application software industry attracts a PE of 40.5, according to Yahoo Finance. Industry average mentioned by Reuters is 25.85. Thereby, Nuance is very cheap on a PE basis. A multiple of 15 is very reasonable, rather prudent for Nuance. PEG ratio of 0.62 also indicates that the stock is undervalued. Anything below 1 is considered cheap from a PEG perspective. PE-based valuation reveals an upside of 30% based on a justifiable multiple of 15.



Source: Focus Equity estimates

Final thoughts

Technologies like voice recognition and speech-to-text are being adopted at a decent rate. Industry experts are forecasting double-digit growth. Nuance is a prominent player in the industry. Therefore, it is highly likely that the company will capitalize on the growth prospects in the industry.

Now, from a valuation perspective, the stock seems a buy. FCF, EVA and PE based valuations project upside of 23%, 26% and 29%, respectively. This translates to an average equal weight price target of $17.8, or 27% upside. Neither of the valuations provides any downside evidence. All in all, I am inclined to rate the stock as a buy amid cheap valuations.
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