Nuance (NUAN): Invest in speech recognition

"For investors with a more aggressive bent, one stock on our radar is Nuance Communications (NASDAQ: NUAN)," says trading and investing expert Bill Martin.

In BullMarket.com, he explains, "The firm's core niche is producing speech-based voice-recognition and synthesis software for use in corporate customer-care operations, mobile applications including the new iPhone and to automate health records."

"Nuance creates those automated voices you have to listen to when what you really need is a human being to tell you why your cable modem isn't delivering the Internet.

"While at times annoying, we acknowledge the cost-benefit for companies to use the technology to manage and screen routine customer calls.

"Its mobile speech solutions add voice-control capabilities to mobile devices and services; it's a necessity for 'hands free' cell phone operations that certainly make it safer to use a cell phone while operating a car.

"The company is also in the medical records sector. It provides dictation and transcription solutions and services that enhance the way patient data is captured, processed, and used, as well as automate the input and management of medical information used by hospitals in the U.S. 

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"What makes Nuance's business model particularly appealing is that 70% of its revenue is from a recurring, predictable revenue stream that offers good visibility.

"Nuance also has multi-year royalty contracts, largely through its offerings to mobile devices. For example, the new iPhone 3G S from Apple includes such features as voice-activated dialing and iPod-like control features.

"With it, the iPhone can announce such details as what song is playing. Another feature is called VoiceOver, which enables the iPhone to read aloud what the user touches on the keypad. Apple did not disclose the vendor, but as the market leader, Nuance is widely believed to be a principal supplier.

"Considering that Nuance earns approximately 25 cents per device for every mobile phone shipped with its speech generation and voice recognition software, and the fact the new iPhone is likely to be another big seller for Apple, the additional revenue is potentially substantial.

"In the enterprise market, Nuance serves customers in a broad swath of industries ranging from telecommunications, financial services, travel, entertainment, and government, with the telco and financial services market the biggest customers.

"What has given us pause about Nuance in the past is that the company is something of a serial acquirer, which can lead to choppy earnings and integration risks. Nuance itself was acquired and merged with ScanSoft Inc. in 2005 and kept the Nuance name.

"Since then Nuance has purchased 11 companies, starting with Dictaphone in 2006. It's most-recent deal was to buy Zi Corp. in April of this year. The company provides solutions for mobile search, text input, and advertising. 

"Surprisingly, though, its balance sheet is in good shape. Tight cost controls helped Nuance to post a better-than-expected fiscal second-quarter profit. Management said it will maintain the cost discipline throughout the year.

"There is a lot to like about Nuance. It is a market leader for providing what is clearly a very useful technology, converting speech into text and vice-versa. We especially like the growth potential in the mobile and healthcare fields. 

"The fact the company offers products in the healthcare IT arena that don't have to be capitalized could be a real growth driver.

"The difficult thing is breaking out how much of the company's growth is organic and what amounts are coming from acquisitions, especially for a company with less than $1 billion in annual revenue. Still, it is an interesting niche. 

"The apparent iPhone win, however, is what really excites us. If Nuance's technologies can become ubiquitous in the smartphone world, then the opportunity is tremendous.

"We would be looking at a $20-$24 target on Nuance, which at the mid-point would put it at about a 20x P/E based on 2010 adjusted earnings and a PEG of 1.1x. Interested investors should look to average into the stock."