Nuance Communications Transitions From Perpetual Licenses To Cloud-Based Delivery

Before I discuss Nuance Communication's (NUAN) Q3, I would be remiss not to mention that corporate raider Carl Icahn recently increased his stake in the company to 16%. According to Investopedia, the definition of a Corporate Raider is:

An investor who buys a large number of shares in a corporation whose assets appear to be undervalued. The large share purchase would give the corporate raider significant voting rights, which could then be used to push changes in the company's leadership and management. This would increase share value and thus generate a massive return for the raider.

I can't speak for Mr. Icahn's intentions as to why he is taking such a large position in Nuance. For all I know it may be a passive investment like his stake in Netflix (NFLX), but one thing I can tell you is that he probably sees opportunity here. News just broke that Icahn is taking a stake in Apple (AAPL), and Nuance is the engine behind Apple's Siri technology. Perhaps there will be a shotgun wedding for the two companies somewhere down the line. In any event, I would think it would be positive for Nuance in maintaining a large and influential client like Apple.

Nevertheless, Nuance is going through some growing pains from the transition from perpetual licenses to cloud-based delivery. According to the company's prepared statements (.pdf file) for Q3:

We are transitioning to a higher concentration of recurring revenues associated with on-demand, transactional, term-based or subscription pricing models. This benefits the business in the medium and long term by increasing recurring revenues and predictability. However, it has a negative effect on near-term revenue and margins.

Negative effect indeed. Nuance projects Q4 sales of $470 million to $500 million. That's below consensus of $520 million. Blended gross margins for fiscal 2013 will decline by between 450 and 500 basis points. As CFO Tom Beaudoin states in the Q&A session: "I think you should model margin improvement as being modest next year."

If you examine the chart below carefully, you can see where all of the organic revenue growth came to a standstill in 2013.

click to enlarge

This is a direct correlation from two phenomena - the shift away from desktops to mobile, and the move to the cloud. The company isn't giving guidance for 2014 yet, but Yahoo Finance shows a consensus sales growth of low single digits, $1.96 billion for this year to $2.09 billion for 2014. It's putting a lot of pressure on shares.

Earnings are another story. Nuance expects Q4 earnings per share to be in the range of $.24-$.32. They predict Fiscal Year 2013 earnings to be in the range of $1.27-$1.35. They had previously forecast earnings of $1.33-$1.45. Some of this decrease could be from litigation expenses. CEO Paul Ricci explains:

Throughout this year, fiscal ’13 we’ve had a larger amount of litigation and patented related expenses than anticipated, and that’s been accentuated and particularly true in the second half of this year as specific litigations have moved to more critical phases.

Another reason for the decline in revenue and earnings for Q4 is that some of their mobile customers are delaying contracts. Clients want lower prices, and Nuance is not giving discounts to their superior technology. Mr. Ricci believes in delaying deals for the sake of price discipline. Sales from their mobile segment constitutes roughly 30% of revenues. Revenue from that division dropped 14% in Q3.

The company has an aggressive buyback plan. As of July 31, 2013, they have spent $174.6 million out of their authorized $500 repurchase plan, repurchasing 9.283 million shares. They expect to continue to execute their repurchase plan tactically. Their plans incorporate a full-year, weighted share count of 322.5 million diluted shares.

In a bull market, the equity trades at $19.50, near the low point of their 52 week $18-$26 range. In my opinion, the stock would have traded lower after poor guidance for Q4, but the anticipation of Mr. Icahn's potential fiscal actions have buoyed the stock. Nuance is primarily a domestic company with 72% of their revenue coming from the United States. There's a big opportunity for overseas expansion. However, the company has a history of being unprofitable, although the last few years have been in the black.

I'm long the stock because I use Nuance products, and believe they will remain the leader in voice-recognition technology for the foreseeable future. Although earnings are under pressure, the going rate of $19.50 seems reasonable of you utilize a price/sales metric of 3.38. Price/book is 2.2. Those are low figures for a technology company. Although I didn't buy the stock because of Icahn's stake, he's there nonetheless. I expect him to raise some dust at the next shareholder meeting. After all, he's an "activist shareholder".

Fusion-io: No Longer The Belle Of The Ball, But New Management Might Right The Ship

Sometimes the hot money on Wall Street gets a little too hot. Case in point data facilitator and accelerator Fusion-io (FIO). Last October, the stock had an outstanding quarter and went ballistic. It reached $32/share based on impressive revenue streams from hyperscale clients Apple (AAPL) and Facebook (FB). These large information sharing platforms where Fusion-io excels, propelled them to international prominence. It now trades at $11.25, and despite the drop in value, still remains an industry leader with disruptive technology.

Fusion-io gets little love on trading floors right now. I'm making an investment in the company not only based on superior technology, but because of a new management team that has the experience to turn things around. Valuation is still steep if you go by a P/E metric, but adding more hypersacle clients can raise those earnings figures (or lack thereof) in a heartbeat. Pandora (P), Alibaba, Salesforce.com (CRM), Spotify, LinkedIn (LNKD) and China Mobile are current customers that are building data centers, and Fusion-io will have an opportunity to deploy there, but not for the next year or two.

I believe it's a management change that is the key for the company to succeed. Back in early May, Fusion-io founder David Flynn resigned as CEO to pursue entrepreneurial investing activities. Mr. Flynn did a great job of guiding Fusion-io through its early stages, but perhaps wasn't the right person to lead a larger entity. This happens a lot in business. Not everybody is equipped to be a Bill Gates or Steve Jobs. In steps Shane Robison, an old pro who was formerly at Hewlett-Packard (HP) in the position of Chief Strategy and Technology Officer from 2002 to 2011.

This past quarter, 2013 Q4, was light, but since Mr. Robison has been at the helm only three months, I am giving him the benefit of the doubt. There were channel conflicts with the OEM's in Q4, and although those conflicts may have begun under Mr. Flynn's tenure, it is Mr. Robison who is now responsible for the mishaps. He discusses this at various points in the Q&A session during the conference call:

• "The kinds of channel conflict challenges that we've been having have to do with first, pricing. We've been inconsistent in how we priced our direct products relative to our OEM products. And we have to have very clear discipline about how we price our direct sales products, and how we price relative to what we're doing with the OEMs. So obviously, that's an easy thing for us to fix, and we will fix it."
• "Our ioControl product, which is the new name for NexGen, is now mature enough that it's really starting to get traction in the mid-market, and it will be exclusively sold through the value-added reseller channel. There's been a lot of question about channel conflict with our enterprise customers, and we're determined to eliminate that. So as we go into the second half of this year, we'll rebuild our OEM relationships."
• "When we talk to our OEMs about qualifying products, their qualification cycles sometimes take several months. And we'll go have a good discussion with the OEMs, get them to agree to qualify our products, they're working away on qualifying the products. And then all of a sudden, we pop up with an announcement in the market and pre-announce that product, which is very disruptive for them. And it's the kind of channel conflict that destroys relationships. We will fix that."

That's no way to run a railroad, especially when the OEM's in question may be Cisco (CSCO) and NetApp (NTAP). However, the new CEO is taking steps to correct the issues.

According to the conference call, IDC predicts that by 2016, the enterprise segment, which is what the OEM's are targeting, will be $78 billion. This is also referred to as the optimized server segment. The hyperscale market, where Fusion-io's direct sales team concentrates on, is purportedly going to grow to $43 billion by 2017. Although these lofty projections by data research companies often fall short of forecast, it is still a significant opportunity.

It wasn't just the weak quarter that hammered the stock. It was lowered guidance for fiscal 2014. Previously, Fusion-io expected 30% sales growth for next year, but has since calibrated that number to 20%. It came out of the blue, and put a black mark on their record. However, they are still selling products, albeit with concerns about slumping margins and pricing pressure. They did $432.8 million in sales last year. Tack on 20% for next year, and you've got over half a billion in revenues going forward.

They are also losing money, $.03/share for Q4, and aren't projected to earn much for 2014. The number I looked at from Credit Suisse is an estimate of $.09 from July 2013 to July 2014, with a loss of ten cents a share for the current quarter, Q1 2014. Credit Suisse maintains an outperform rating on the equity, so take that nine cent gain with a grain of salt. They could keep losing money for the next year, but with $238.4 million in cash and cash equivalents, they won't be going bust.

I've written two previous articles on Fusion-io cautioning investors about the overvaluation of the equity, one last August, the other in November. On a P/E Basis, I still feel the same way, but this a young growth company and other econometrics can be applied: Price/Sales is 2.57, Price/Book is 2.24, Cash/Share is $3.61. Not very expensive despite the lack of earnings. That's my train of thought, and may also be on the same wavelength of possible suitors.

Mergers and acquisitions are on the rise in the bull market. There's a lot of fat cat companies looking for canaries, and Fusion-io would be a nice quarry for one of those slow tech growers like IBM (IBM), Intel (INTC), EMC (EMC), or, Oracle (ORCL). Charity begins at home, so let's not forget that besides Apple and Facebook, Hewlett-Packard is also a hyperscale client of Fusion-io. They could be a possible suitor. So could OEM partners Cisco and NetApp.

I don't know what the downside is for this stock, but I do know that at my purchase price of $11.36, I may make a 20% gain in the next twelve months. That's not insignificant when you compare it to what a certificate of deposit is getting you at the bank. A 20% gain would equate to roughly $13.50/share by August of next year. I think that's manageable. However, we are near market highs in an incredible year, September is historically a bad month, and the company could come up short on that 20% revenue growth in the near term, so you may find a better entry point.

Ruckus Wireless: First Mover Advantage In Carrier Wi-Fi

With the proliferation of smartphones and tablets congesting cellular spectrum, off-loading end-users to Wi-Fi hotspots is a technique of choice for a majority of Tier 1 telecom carriers and MSO's (Multi-System Cable Operators). Ruckus Wireless (RKUS) has a first mover advantage over competitors Cisco (CSCO) and Aruba Networks (ARUN), and continues to occupy a leading competitive position in the carrier Wi-Fi market. They make the base stations that make off-loading happen.

If you aren't familiar with Ruckus, they were a hot IPO this past year. The company's coronation came shortly after launch when they bolted from approximately $14/share, to $25/share. It was a headliner. After a lackluster Q1, the equity crashed to $10. A bad quarter, but perhaps an anomaly. My belief is that the security just got too far ahead of itself from Wall Street's exuberance. It trades now at $14. Back to square one if you bought at the outset.

In the Q2 conference call, Ruckus had revenue of $63.9 million, an increase of 31% year-over-year, and at the top-end of their sales guidance. As CEO Selina Lo explained:

In Q2, our service provider business regained momentum. We had a record number of new customer wins, and expanded deployments by existing customers. Our enterprise business also continued to perform well. Q2 was a quarter of recovery and improved visibility for us.

My impression of Ruckus Wireless is that it's important to separate the enterprise market from the carrier market. As the CEO emphasized in the conference call, the enterprise business is very predictable, and they will have limited problems projecting numbers for this niche. It's with the telecom carriers and MSO's that the metrics become lumpy. Ruckus won't break out numbers on these two separate market segments on a quarterly basis, just annually, so it's hard to get a grip on things if you invest quarter to quarter.

Nevertheless, it's the business from the telecom carriers that may propel shares higher, so let's take a look at some of the initiatives the company is taking as stated by CEO Lo:

• "An important catalyst for the carrier Wi-Fi market is Hotspot 2.0 also known as Passpoint. Hotspot 2.0 enables the mobile device to automatically connect to any Wi-Fi access point belonging to the device users, service provider, or, the providers roaming partners. Apple (AAPL) recently announced support of Hotspot 2.0 in iOS 7, and a number of Android (GOOG) devices are already supported. Ruckus has been a strong sponsor of this technology."

  Ruckus is working with a number of partners in integrating their Wi-Fi technology into their smartphones.

• "Wi-Fi is the predominant method of connectivity for tablets. We believe that tablets are becoming a key driver for high capacity, reliable Wi-Fi in many of our market segments such as education, hospitality and mid-tier enterprise. Wi-Fi access is also becoming a customer service differentiator for public venue."

  Many service providers are offering managed wireless line service for public venues as a way to capture the tablet population and improve their hotspot footprint.

• "We acquired YFind, a pioneer in indoor positioning and real-time location analytics technology. The YFind team has developed capabilities that we intend to integrate with our Smart Wi-Fi to create a new class of location intelligence, high performance wireless infrastructure."

  ABI Research released a report that forecasts by 2017, this will be a $5 billion market.

On a continual basis, every quarter Ruckus adds new service providers to the roster. In Q2 it was fifteen, bringing the total to 90. They also won four MSO's, and are seeing that accelerate. Although there was momentum in the quarter, it can take multiple quarters before service provider design wins come to fruition. As CEO Lo cautioned: "I think from a pipeline perspective, we have always been very, very careful about forecasting service provider and there is always chances for surprises."

One happy accident that could be brewing is China. Visibility in their China business has improved, but sales in China have not caught up to historical levels. Ruckus management is taking a very cautious view on the country. However, a recent win with China Telecom may be a catalyst for future business. They work with additional operators in China in the build-out of "wireless cities". This is the concept of turning an entire city into a Wireless Access Zone. Everybody gets free Wi-Fi courtesy of the government.

If we examine the Yahoo Finance earnings projections, we can see that Ruckus is slated to earn $.04/share in Q3. Full year 2013 earnings estimates are for $.18/share, and $.27/share for 2014. For the current year, that's a P/E of 75, an expensive stock. Going out 16 months, we get a P/E of 50, still paying top dollar even though many analysts will begin crunching next year's numbers sometime in early Fall. Sales and earnings are expected to be in the mid 20% region for the next two years. This gives you a PEG (Price/Earnings/Growth) Ratio on the steep side for both this year and next.

I'm long the stock, and believe that there is a three to four year window of opportunity in the buildup of Wi-Fi hotspots on an international basis. With a lofty P/E Ratio, I may be courting disaster, but the potential opportunities for Ruckus in mind-boggling. They've got a lot on the drawing board, and have set the standard for Tier 1 telecom operators to make your wireless experience much more efficient and cost effective. I may be in for a rude awakening, but once a year has passed, a 25% profit could very well be in the cards.

After Goldman's Kiss Of Death, Synchronoss Technologies Bounces Back

On July 9th, Goldman Sachs (GS) put the kibosh on Synchronoss Technologies (SNCR) by downgrading the stock from neutral to sell, sending shares into a tailspin. Synchonoss, which activates data-enabled mobile devices, and offers cloud storage to end-users via Tier 1 telecom operators, fell over 10% on that call, dropping the equity to $26.50. Investors ran for the exits.

After last week's blowout Q2 conference call, shares now trade at $35, and may be heading higher for the foreseeable future. The quarter was encouraging, with revenue of $85.2 million, an increase of 24% year over year. Earnings per share of $.31 was higher that Wall Street's expectation of $.29. Guidance for 2013 was raised, too, which probably accounts for the upward trajectory of the stock price in just a week.

With the Goldman downgrade, the analyst believed there was lack of visibility in the adoption of the personal cloud service for the next two quarters. Synchronoss CEO Stephen Waldis and his associate, CFO Lawrence Irving, rebutted this claim by implying that Q2 may just be an appetizer. The best is yet to come. This can be exemplified by the implementations of their Personal Cloud Platform with major Tier 1 mobile operators Verizon Wireless (VZ), Telefonica, Vodafone (VOD), and AT&T (T).

Here are some quotes from CEO Waldis about the early adoption of the Synchronoss Personal Cloud Platform:

• "The investments we have made over the past several years, building out the world's most comprehensive Personal Cloud Platform, and signing up multiple Tier 1 mobile operators, is in the early stages of paying off. And we believe that we are well positioned to drive meaningful growth in this business over the long-term."
• "We have now successfully deployed our Personal Cloud Platform with each of our major mobile operators. We are encouraged with the results to date, including how our Personal Cloud Platform had scaled at each of our mobile operator customers."
• "We have successfully completed the launch of our Personal Cloud Platform in 11 of the 14 Vodafone markets, slightly ahead of schedule."
• "Our Telefonica cloud deployment began scaling in the second quarter, and they are set to begin more significant promotions around their cloud during the second half of 2013."

It should be noted that Verizon was first to market with their deployment in April, and that AT&T is the laggard, not anticipating to launch until the second half of the year. Nevertheless, as the CFO stated:

We are in the early stages of a dynamic, high-growth market opportunity, and we are committed to making the investments necessary to ensure our long-term success...We anticipate revenue growth to accelerate in the second half of the year, as our mobile operator customers begin to more heavily promote their cloud services.

So what's the big deal about these remote digital storage systems? It's about to become a land office business. With the increased connectivity of smartphones and tablets, the telecom carriers are getting into the business of what previously was solely in the domain of handset manufacturers like Apple (AAPL) with the iCloud offering. Throw in the connected home with smart-TV's and appliances, and the connected car, you've got a gold mine on your hands.

Gartner predicts the worldwide need for total consumer digital storage will increase nearly twelve fold by 2016, at least according to CEO Waldis in the conference call. This is a sector that is ready to ignite, like a smoldering cigarette in a munitions factory. Waldis believes that as mobile operators roll out more devices, with more upgrades, and promote family sharing plans, the central glue for the telecom carriers will be the personal cloud, or, personal content locker.

For example, you will be able to share all of your favorite songs on your smartphone, car stereo system, or on an application enabled television. Have a favorite movie? All family members will be able to access the same video packets on a variety of devices if they are plugged into the cloud platform. This is high-tech wizardry at its finest. Synchronoss had the financial wherewithal to do the nitty-gritty, heavy lifting behind the scenes before competition stepped in.

Personally, I use Apple products, and fully understand the convenience of the Apple "ecosystem", and there is an argument to be made that only the non-Apple ecosystem is addressable. But Mr. Waldis informed the analysts that the company hasn't seen one particular operating system versus another that has significantly outperformed in terms of adoption of the personal cloud. Also, let's not forget that it's Android (GOOG) that has significant market share now.

The company is primarily spearheading its expansion into North America and Europe, but India and the Asia-Pacific region may be in the cards in the not too distant future. Synchronoss is moving into trials with an unnamed Indian mobile operator in the later part of this year. Developments in the Asia-Pacific region are encouraging, but nothing has been green-lighted as of this date.

To enable the continued thrust into new geographic and technical areas, the company allocated $14.5 million, or 17% of revenues into research and development in Q2. Another highlight of Q2 was cash flow from operations of $18.1 million which exceeded Wall Street's estimate of $11.6 million. The quarter's gross margin of 60% was in-line with guidance.

Examining the full year 2013 guidance given by the CFO, we can see that buying Synchronoss Technologies at this level may not be an open and shut case, but it sure is compelling if you like GARP (growth at a reasonable price).

• Sales guidance was increased to be in a range of $345 million - $352 million versus the previous guidance of $335 - $350 million. This represents growth of 26% to 28% on a year-over-year basis.
• Continue to target gross margins in the 60% to 62% range. Operating margins are expected to the in the 23% to 24% range.
• Earnings per share will be in the range of $1.31 to $1.36.

Although this is the beginning of August, we are almost halfway through Q3, and analysts will be looking at 2014 numbers to calculate Price/Earnings valuations sometime in the next month or two. If we divide the current price of $35 by the lower end of 2013 earnings per share guidance of $1.31, we get a P/E Ratio of 27. That's not a dirt cheap price, but with the equity growing at close to 25%, I believe it has room to run during the next twelve months.