Monopolist Review – Nuance Communications

NASDAQ:    NUAN  –  19.05

What makes this a good business?

Designing and delivering intuitive technologies that help people live and work more intelligently, Nuance Communications is the leading provider of speech and imaging solutions around the world.  Headquartered in Burlington, MA, Nuance holds more than 4,000 patents and patent applications, and maintains one of the world’s largest libraries of speech data.  The cost, performance, and ease of use for the new paradigm of speech interactions in the mobile solutions is radically improving, and experts are predicting substantial future growth opportunities within the mobile voice recognition market even when many other facets of growth in the modern world have stalled.  After closely reviewing its business model and recent financial statements, we believe this is an excellent business that has delivered robust revenue growth in a time period when growth is hard to achieve.

Nuance’s leadership advantage in sales, industry partnerships, and innovation are a significant deterrent for new competitors attempting to gain a foothold.  However, the growth prospects for this niche industry are so appealing that the aura of green emanating from the horizon of profitability has many industry heavyweights diligently looking into this high growth market.  Nuance’s many patents and innovative expertise make it very desirable as a partner for larger, more established companies looking for solutions in this area, and nearly two-thirds of Fortune 100 companies currently rely on Nuance solutions.  Consequently, Nuance has the odds on advantage for providing the de facto standard for many parts if this field and we see it having great potential for monopolistic domination.

Nuance delivered strong 29% revenue growth and a 37% increase in cash flow, which stand alone as very impressive numbers. However, this was disappointing to Nuance and the analysts that follow it and this resulted in a decline in the stock price to where it now trades at about 10 times analysts expected earnings for 2013 based on forecasts.  After Nuance’s stock price came down, the market’s punishment for coming in a penny shy of estimates and an over hyped relationship with Apple (AAPL) after Nuance was revealed as the engine behind Siri, what came to mind was one of Warren Buffett’s rules, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”  After a little consideration of its monopolistic potential, our opinion is that Nuance more than qualifies as a “wonderful company.”

The Industry

According to TechNavio, the voice recognition industry is forecast to grow at a constant annual growth rate of 22.07% through 2016.  Analysts further explain that the next major wave for the fast growth in this market is the growing demand for voice biometrics. The global voice recognition market growth also depends on the increased demand for speech recognition in mobile devices and the new paradigm of virtual agents and intelligence systems, which seamlessly combine voice recognition, natural language processing, advanced dialog capabilities, and reasoning systems to better interpret and anticipate user intent.

Nuance has pioneered the highest functioning speech software in the world, ceaselessly perfecting the ability for machines to recognize and emulate the human voice.  Providing valuable insight into the industry at large, as well as what trends users and investors should be on the lookout for, Jim Greenwell (CEO of Datria, a small voice-recognition software company) declared that “Nuance clearly has the best [speech] engine out there” and noted that it worked in more than 60 languages and had underlying linguistic algorithms able to recognize small phonetic sound bites, which vary greatly between languages.  Datria, which has been reselling Nuance’s engine for 14 years, has been acquired by Intelligrated (a North American based automated material handling solutions provider) and is now known as Knighted.

While Nuance’s speech technology is able to identify about 60 languages and synthesize 39 languages by “Speech to Text,” its imaging technology supports over 100 languages.  By designing and delivering technologies that intuitively link man, machine and the global storehouse of knowledge to help companies and consumers work seamlessly and intelligently with the world, Nuance has won awards for its solutions in every major product family.

The launch of the Ecosystem

Nuance seems to be developing a robust ecosystem with more than 10,000 developers that have joined the NDEV Mobile developer program since it first launched in 2011. This many voice based storefronts provide tremendous leverage for Nuance’s prominent expansion into this powerful new arena.  Some of the featured websites utilizing Nuance’s technologies are:

The Mobile Market

In the mobility market, we are starting to see the second major wave of growth that will have  a mushrooming of applications.  The 8 largest handset and 10 largest automakers use Nuance solutions, and Nuance solutions have shipped in more than 5 billion mobile phones and 70 million cars.  Millions more mobile consumers have downloaded Nuance’s Dragon Mobile Apps.  With the world excited about Apple’s launch, we are excited about the many thousands of developers working with large websites developers for many applications, in many languages, of the recognition technologies that will strengthen and enhance Nuance’s vital position and value within this explosive ecosystem.

Voice Biometrics

It appears voice biometrics breakthroughs are making this a far easier, more efficient and eventually lower cost way to establish higher levels of personal security.  Furthermore, these biometric programs will easily “plug and play” in the major speech recognition call centers, giving major companies another way to enhance and lower their fixed cost structure.  There are more than 22 million registered users of Nuance desktop solutions, and Nuance has been recognized by Opus Research as the world’s leading provider of voice biometrics solutions.  A strong validation of Nuance’s voice biometrics solution portfolio is its over 23 million enrolled voiceprints, which is more than the rest of the industry combined.  Having 23 million voice prints out of a total 28 million voice prints worldwide gives them an over 80% market share.  Dan Miller, senior analyst of Opus Research, recently stated,

“The breadth of Nuance’s product line enables them to provide a secure user interface that includes voice biometric authentication, speech recognition, synthesized speech, natural language understanding, artificial intelligence, and mobile user interfaces.”

The Cloud

Cloud use, the next generation of voice recognition, enables usage on any device at any time. This will be a critical element of Nuance establishment as the de facto standard.  As leaders for voice biometrics and text recognition in the medical industry, desktop solutions, and mobile apps, Nuance appears to have the advantage in achieving an integrated solution and in becoming the interface of choice for next generation products.  If or when this can be realized, Nuance stock could become a manifold gain from its current valuation.

Our previous studies have recognized that companies achieving monopoly positions have more of a “gutter approach” versus the individual roof shingle, which only sees the rain that falls on it.  While the gutters often remain unseen, they typically receive the same amount of rain (or in business terms, profit) as all of the singles combined.  Nuance is endeavoring to be the stand alone leader and the de facto standard for the entire new voice recognition industry.  There are outstanding barriers to competition, and Nuance has been able to achieve excellent margins and economics of scale as a result of its strong products, in essentially every voice recognition category, and its very strong strategic partnerships.

Further evidence of Nuance’s success

More than 3,000 hospitals in the U.S. use Nuance healthcare solutions, and more than 150,000 doctors and caregivers use Dragon Medical.  Ford SYNC voice activated technology attempts to integrate the car’s GPS navigation, entertainment options (including iPod and satellite radio), climate controls, and hands-free voice calling into a single, unified in-dash interface. Buy PC magazine’s top editor’s choice says,

“If you’ve never used dictation and voice command software before, Dragon Naturally Speaking seems almost futuristic. It translates accurately. The speed is incredible. Intelligent features allow the software to become smarter the more you use it, by looking for words in context…I’ve found my workflow completely changed, in particular when writing scripts.”

Some of Nuances partners are:

• Apple

• Audi

• BMW

• Hyundai

• Ford

• Chrysler

• ZTE Corporation

• Cerner

• Granger mobile app

• Mac

• Intel

• Linux

• Samsung

• Siemens

• Sharp

• T-mobile

The Risks

Google is very competitive in the mobile environment, and it’s this risk of competition that is the largest that we could identify. Considering Forbes’ widely publicized advances that Google has made in voice recognition, it is almost surprising that Apple has trumped Google with Siri.  Apple has taken more of an almost Microsoft operating system kind of approach, using Nuance as the underlying engine and adding it’s own application layer on top.  Google has used more of an Apple operating system kind of approach, providing more of a cradle to grave complete solution.  Siri’s approach allows Apple (and others) to implement a dynamic solution while committing far less resources to it.  Google has not noticeably altered the market share in Nuance’s largest market, voice recognition for the medical industry.

Microsoft appears to be more focused on the personal computer (PC), and has been quietly attempting to take things a few steps further by building a system around technologies that not only recognize human speech, but also translate it into text (including that of foreign languages) and then play back the words in a language using a synthesized voice intended to sound like the speaker.  Apple, Microsoft and Google all have far more resources and much greater capital than Nuance, but these behemoths all seem to be focused on recognition technologies designed to enhance and supplement future generations of what they consider their core products or services.  Nuance, whether in partnership or in competition with anyone, is focused on its recognition technologies as the prime driver for organic growth.

In general, there is a gradual transition of the recognition business away from the traditional Windows package software to a business which involves working directly with the OEMs integrating the next generation of a virtual agent on their hybrid devices, including tablets and laptops.  This is where we expect to find real opportunity and the future growth in this business. However, this transition appears to happening much more quickly than we first thought. The challenge in this is that as this transition is substitutional, with its revenues occurring more in the future, we will likely see some weakness in today’s packaged software business.  The good news in this is that the level of engagements we are seeing with OEMs on systems intending to deploy this technology is quite attractive, and we think it will provide long-term value for Nuance shareholders.

In Summary and Conclusion

The potential market for recognition technology is enormous.  Nuance already has the early advantage, and has experienced significant growth.  It has already established certain scale and technical advantages that appear to have it in the pole position in a race to monetize this massive industry’s latent potential.  Considering how few players may even remain in contention for second place, we think Nuance Communications, its products and its intellectual properties, has monopolistic potential and represents an extremely attractive longer term investment opportunity.  Therefore, we are adding it to our collection of equities tending towards a Monopolistic advantage.

Disclosure:  Durig Capital and certain of its clients may currently hold positions in
Nuance.

Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security.  We are not a broker/dealer, and reports are intended for distribution to our clients.  As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports.  If you intend to use our research efforts to make an investment decision, we kindly ask that you respect our fiduciary business model and allow us the opportunity to assist in your equity acquisition.  We sincerely appreciate your courtesy and understanding.

Disclosure: Durig Capital and certain of its clients may currently hold positions in Telit.

Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. If you intend to use our research efforts to make an investment decision, we kindly ask that you respect our fiduciary business model and allow us the opportunity to assist in your equity acquisition. We sincerely appreciate your courtesy and understanding.

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