4. TABLE OF CONTENTS
INVESTMENT CONCLUSION AND SUMMARY ........................................................................................... 6
OUTLOOK ........................................................................................................................................................... 6
Nuance Communications.................................................................................................................................. 7
SpeechWorks International............................................................................................................................... 7
Speech Recognition and VoiceXML................................................................................................................ 7
Technologies .................................................................................................................................................. 10
Sales Strategies............................................................................................................................................... 12
Staying Power................................................................................................................................................. 14
Capitalization ................................................................................................................................................. 14
Customer and Geographic Diversity.......................................................................................................... 14
Management/Employees............................................................................................................................ 16
Product Development ................................................................................................................................ 16
VALUATION ..................................................................................................................................................... 17
Cash Flow....................................................................................................................................................... 18
Catalysts ......................................................................................................................................................... 19
Risks............................................................................................................................................................... 20
CONCLUSION ................................................................................................................................................... 20
NUANCE COMPANY DESCRIPTION ............................................................................................................ 21
Software Products........................................................................................................................................... 23
Nuance 7.0................................................................................................................................................. 23
Nuance Verifier ......................................................................................................................................... 24
Nuance Vocalizer ...................................................................................................................................... 24
Nuance Voyager ........................................................................................................................................ 25
Nuance Voice Web Server ........................................................................................................................ 25
SpeechObjects ........................................................................................................................................... 25
Nuance Developer’s Toolkit...................................................................................................................... 25
Professional Services...................................................................................................................................... 25
Management ................................................................................................................................................... 26
SPEECHWORKS COMPANY DESCRIPTION................................................................................................ 26
SpeechWorks Relationships with AT&T, AOL and Net2Phone.................................................................... 28
Software Products........................................................................................................................................... 29
SpeechWorks 6.5....................................................................................................................................... 30
SpeechSite ................................................................................................................................................. 31
Speechify................................................................................................................................................... 31
ETI-Eloquence........................................................................................................................................... 32
SpeechSecure ............................................................................................................................................ 32
Professional Services...................................................................................................................................... 33
Management ................................................................................................................................................... 33
Stephens Inc. 4
5. FIGURES
Figure 1 SPEECH RECOGNITION INDUSTRY Flow Diagram of a Voice-Enabled Customer Care
Application................................................................................................................................................................. 8
Figure 2 SPEECH RECOGNITION INDUSTRY Product Comparison............................................................ 11
Figure 3 SPEECH RECOGNITION INDUSTRY Key End-Users .................................................................... 13
Figure 4 SPEECH RECOGNITION INDUSTRY Margin Comparison for 2000.............................................. 13
Figure 5 SPEECH RECOGNITION INDUSTRY Capitalization Comparison.................................................. 15
Figure 6 SPEECH RECOGNITION INDUSTRY Customer Concentration Comparison ................................. 15
Figure 7 SPEECH RECOGNITION INDUSTRY Geographic Concentration Comparison .............................. 15
Figure 8 SPEECH RECOGNITION INDUSTRY Insider Ownership Comparison........................................... 16
Figure 9 WIRELESS APPLICATIONS INDUSTRY Valuation Comparison................................................... 17
Figure 10 NUANCE COMMUNICATIONS Discounted Cash Flow Analysis .................................................. 18
Figure 11 SPEECHWORKS INTERNATIONAL Discounted Cash Flow Analysis ......................................... 19
Figure 12 NUANCE COMMUNICATIONS Revenue Composition, 1Q01....................................................... 21
Figure 13 NUANCE COMMUNICATIONS Selected Customers...................................................................... 22
Figure 14 NUANCE COMMUNICATIONS Nuance 7.0................................................................................... 23
Figure 15 SPEECHWORKS INTERNATIONAL Revenue Composition, 1Q01............................................. 27
Figure 16 SPEECHWORKS INTERNATIONAL Selected Customers............................................................. 28
Figure 17 SPEECHWORKS INTERNATIONAL Examples of Speech-Activated Services............................. 29
Figure 18 SPEECHWORKS INTERNATIONAL SpeechWorks Platform ....................................................... 30
Figure 19 SPEECHWORKS INTERNATIONAL SpeechWorks 6.5 Platform ................................................. 32
Figure 20 NUANCE COMMUNICATIONS Earnings Model, FY2000A-FY2002E......................................... 38
Figure 21 NUANCE COMMUNICATIONS — Financial Data FY2000A-FY2002E............................................ 39
Figure 22 SPEECHWORKS INTERNATIONAL Earnings Model, FY2000A-FY2002E................................. 40
Figure 23 SPEECHWORKS INTERNATIONAL Financial Data, FY2000A-FY2002E ................................... 41
Stephens Inc. 5
6. INVESTMENT CONCLUSION AND SUMMARY
We are initiating We are initiating research coverage of Nuance Communications and SpeechWorks
research coverage of International with identical OUTPERFORM ratings. We are genuinely excited about
NUAN and SPWX the potential of speech recognition software to transform the way in which we interact
with OUTPERFORM with Internet content and corporate data. We believe that the success of both Nuance and
ratings. SpeechWorks will be driven primarily by the market’s rapid growth over the next several
years and doubt that either of the companies will succeed at the expense of the other.
At present, speech Currently, speech recognition technology is used primarily to deflect calls from live
recognition customer service representatives. The economic benefit is reduced headcount. In
technology is used organizations without a touchtone system, the savings is substantial. Whereas live agent
mostly to deflect calls service could easily cost an organization several dollars per call, a self-service system
from live customer powered by speech recognition may cost less than $0.50. In most cases, a well-designed
service voice recognition system will also result in lower overall costs than a touchtone system by
representatives. improving the customer experience and reducing the caller’s propensity to seek live agent
help.
Speech recognition Longer term, speech recognition software could fundamentally change how consumers
technology may access Internet content via either independent or wireless carrier-controlled voice portals.
eventually be part of Perhaps more interestingly, mobile professionals will eventually have a truly ubiquitous
a multi-modal means of accessing corporate data from the road. Speech recognition technology may
platform in which eventually be part of a multi-modal platform in which voice input is married to graphic
voice input is married output. For example, a field service technician might query a corporate database by
to graphic output. speaking into a handheld device the question, “Where is my next appointment?” and
receive a vocal response with the customer’s name and problem along with a map
viewable on the device.
In the short run, we In the short run, we favor SpeechWorks’ greater revenue visibility and focus on customer
favor SPWX’s solutions. At this stage in the market’s development, there is still a great deal of
solutions model with customer education required, which makes it more challenging to sell software primarily
its greater revenue through channel partners, as does Nuance. We are also impressed with SpeechWorks
visibility. In the long alliances with AT&T, AOL and Net2Phone and see these relationships as key
run, we like NUAN’s differentiators (see page 30 for more details). Longer term, though, we foresee a large
pure software model. group of skilled developers and systems integrators emerging that will be able to
implement complex speech recognition solutions. So in the long run, we favor Nuance’s
pure software model, which has positive implications in terms of margins and sustainable
growth.
In the first quarter 2001, Nuance experienced a 40% sequential decline in revenue to
$11.0 million, as the technology spending slowdown had a profound impact on its
business. SpeechWorks, on the other hand, grew revenue by 8% sequentially to a nearly
identical $11.1 million. SpeechWorks’ focus on providing comprehensive customer
solutions seems to be translating into exceptional results, at least in the current
environment.
OUTLOOK
In no uncertain terms,
we believe that speech We emphatically believe that most speech recognition initiatives are on hold until
recognition initiatives economic conditions improve. We do not expect that either Nuance or SpeechWorks will
are on hold until grow revenue significantly until at least 2002. However, our longer-term view is much
economic conditions more sanguine. We believe that 2001 will ultimately be considered a pivotal year in the
improve. evolution of the speech recognition industry, mostly in terms of developer and customer
Stephens Inc. 6
7. education. Speech recognition is one of the keys to true anytime, anywhere Internet
access and should eventually be viewed as a core enabler of enterprise mobility.
Nuance Communications
For NUAN, we We forecast total Company revenue of $9.9 million in 2Q01 (ending June 30), a 10%
forecast total revenue sequential decline, and $42.5 million for the full year 2001, an 18% decline from the
of $9.9 million in previous year. We expect a cash loss of ($1.29) in 2001. Clearly the Company is
2Q01. suffering from the slowdown in technology spending this year.
In 2002 we forecast total revenue to grow by 65%, slightly surpassing $70 million, with
license revenue more than doubling. We expect a cash loss of ($0.53), as margins should
continue to improve. We anticipate that the Company will use over $100 million of its
cash in 2001 and 2002 before turning cash flow positive in 2003 as it leverages its cost
structure over a rapidly expanding revenue base.
SpeechWorks International
For SPWX, we
forecast total revenue We forecast total Company revenue of $11.6 million in 2Q01 (ending June 30), a 5%
of $11.6 million in sequential increase, and $49.1 million for the full year 2001, an impressive 63% increase
2Q01. from 2000. We expect a cash loss of ($0.82) in 2001. SpeechWorks is faring remarkably
well in the current environment, in marked contrast to Nuance.
In 2002 we forecast total revenue to grow by 52% to slightly under $75 million, with
license revenue growing slightly faster at a 58% clip. We expect a cash loss of ($0.28),
as margins should continue to improve. We anticipate that the Company will use over
$80 million of its cash in 2001 and 2002 before turning cash flow positive in 2003 as it
too leverages its cost structure over a rapidly expanding revenue base.
We anticipate rapid In general, we foresee rapid growth for both SpeechWorks and Nuance over the next
growth for both several years, as speech recognition software is deployed to improve productivity, lower
SPWX and NUAN costs, enhance customer service and even generate revenue.
over the next several
years. When considering an investment in Nuance or SpeechWorks, there are four key issues to
examine:
• The outlook for the speech recognition industry;
• Nuance’s and SpeechWorks’ underlying technologies;
• Their sales strategies; and
• Their ability to weather an economic downturn.
Speech Recognition and VoiceXML
Effective and useful speech recognition, the process of converting audible signals into
digital symbols, has been one of the holy grails of technology for the past 20 years.
Speech recognition has the power to transform the way we interact with machines.
Speech is a natural, efficient and flexible interface with computers.
Lack of processing The barrier to usable technology has been as much a lack of raw processing speed as a
speed has been a lack of modeling knowledge. However, with the rapid advances in computing power
barrier to usable over the past decade, the technology is beginning to turn up in our everyday life. In fact,
speech recognition a portion of this report was authored without the use of a keyboard using IBM’s Via
technology. Voice dictation software and an iMac. From a user’s perspective, the product is
marginally useful but frustratingly far from perfection. Neither Nuance nor
SpeechWorks offers dictation software.
Stephens Inc. 7
8. Both Nuance and SpeechWorks focus on telephony solutions in which the speech
recognition software understands, rather than just transcribes, natural human language.
Current systems are able to understand elements of a full sentence by using either 1) a
finite “grammar,” or vocabulary, that will include all variations in the way a particular
request can be voiced, 2) a multi-word probabilistic model (N-Grams), or 3) a keyword
spotting algorithm. New statistical models, such Nuance’s Say Anything or
SpeechWorks’ How May I Help You, are helping build better natural language
recognition by dynamically learning from user behavior.
This natural language understanding, along with other software components, makes it
possible to create user-friendly customer service solutions (see Figure 1). The brokerage
and airline industries have been early adopters of speech-driven self-help systems for
retrieving quotes and flight information, respectively. These proprietary solutions are
generally built on Interactive Voice Response (IVR) platforms from vendors such as
InterVoice-Brite or Avaya. The return on investment is generally quite high, as the
software helps reduce calls to live customer service agents.
Figure 1 SPEECH RECOGNITION INDUSTRY Flow Diagram of a Voice-
Enabled Customer-Care Application
Source: VoiceXML Forum
Stephens Inc. 8
9. VoiceXML might The recent emergence of the VoiceXML standard is likely to accelerate the deployment
prove to be a catalyst of speech recognition technology. Compared to proprietary IVR solutions, VoiceXML
for the deployment of leverages existing corporate investments in Web infrastructure, simplifies the
speech recognition development effort by creating an open standard, and supports more deployment options
technology. (e.g., hosted applications). Both Nuance and SpeechWorks are proponents of
VoiceXML, though Nuance seems to be more vocal regarding the importance of the
standard to the industry.
VoiceXML is a Web- VoiceXML is a Web-based markup language like HTML (hypertext markup language).
based markup Unlike the graphical HTML, VoiceXML uses a voice browser with audio output
language that uses a (computer-synthesized and/or recorded) and audio input (voice and/or keypad tones).
voice browser with The goal is to enable voice access and interactive voice response (e.g., by telephone,
audio output and PDA, or desktop) to Web-based content and applications. Among the potential speech
input. recognition solutions utilizing VoiceXML are the following:
• Customer service. This is the most typical speech recognition solution and is really
just a much more robust version of simple touchtone self-service. With VoiceXML,
a caller could be routed from one VoiceWeb site to another. For example, a retail
store’s voice site might transfer a caller to a specific vendor’s site if the customer
wants product information.
• Content. This might include the ability to retrieve personalized information such as
address books, calendars, weather reports, travel information and stock quotes.
Portals such as TellMe, BeVocal and HeyAnita offer voice content.
• Unified messaging (UM). UM allows users to access e-mail, voice mail, instant
messaging (IM), short messaging service (SMS) and faxes in one place, either in text
or spoken format.
• Intranets. For instance, users could order supplies or access human resources
information. More interestingly, field sales personnel might place orders by phone or
access a CRM (customer relationship management) system.
• E-Commerce. Usage in this area probably makes sense only in specific applications
such as stock trading or ticket purchases, though Office Depot already successfully
processes orders from business customers via a speech recognition system.
Our due diligence This may not be the breakthrough year for VoiceXML applications, however. The
leads us to believe decrease in technology spending is having a profound impact on emerging technologies
that there is such as speech recognition. Corporations are now generally reluctant to deploy new
substantial interest in technology even in light of clear evidence of substantial ROI. However, the education
speech recognition. process has not stopped. Our due diligence leads us to believe that, while most
companies are reluctant to acquire the technology this year, there is substantial interest in
speech recognition. We believe that this interest will translate into accelerated sales in
2002.
Although the potential market for speech recognition software is difficult to quantify, we
have no doubt that it is big. Cahners In-Stat Group expects the market for speech
recognition software to grow from $200 million today to $2.7 billion by 2005. This
strikes us as an ambitious forecast but still indicative of the market’s potential.
Just in streamlining In the streamlining of customer service operations alone, we would expect a significant
customer service market opportunity. We can quantify this specific market opportunity in terms of overall
operations, we would call center headcount reduction. We estimate that there are over 4 million call center
expect a market seats throughout the world. Assuming just $25,000 per seat, the total labor costs are
opportunity of $1 approximately $100 billion. We believe that at least 20% of the seats could be displaced
billion. by speech recognition systems for a total cost reduction of $20 billion. If annual software
Stephens Inc. 9
10. expenditures are just 5% of the cost reduction, this segment of the market is still a $1
billion opportunity.
Consumer demand for broader VoiceXML applications is still unproven. While we
cannot envision surfing the Voice Web anytime soon, we believe that consumers will
ultimately embrace numerous specific services, such as voice dialing and unified
messaging. Speech recognition technology should help overcome the input constraints of
small handheld devices, especially with the introduction of 2.5G and 3G networks that
will allow simultaneous voice and data connections. Perhaps the key to winning
consumer acceptance, though, is designing intelligent and friendly user interfaces.
Simple things like the rhythm or tone of speech output can have a profound impact on
user acceptance.
The biggest threats to The biggest threats to the speech recognition software market are commoditization of the
the market are core technology and increased competition. Both Nuance and SpeechWorks purchased
commoditization of most of their core technology from third parties, including speech recognition technology
the core technology from SRI International and MIT, respectively. While their current products are much
and increased more advanced than the technology the companies purchased, there is still the threat,
competition. albeit a weak one, of a movement towards open source code for the core speech
recognition technology as VoiceXML is developed.
Nuance’s and SpeechWorks’ competition includes the embattled Lernout&Hauspie,
InfoSpace (Locus Dialogue), and Philips Electronics as well as the original VoiceXML
sponsors—AT&T, IBM, Lucent and Motorola. We are most concerned about IBM,
which has developed high-quality speech recognition software but is not currently
marketing products to the enterprise market. However, if Nuance and SpeechWorks
prove that there is a viable market, IBM may devote more resources to this area.
Technologies
On the surface, At first glance, and even at second glance, Nuance and SpeechWorks appear to be very
NUAN and SPWX similar organizations. Both market speech recognition software to telecommunications
appear to be very carriers, enterprises and portals that enables access to Internet content and corporate data
similar organizations. via telephones. Both posted approximately $11 million in revenue in the latest quarter,
and both have market capitalizations near $450 million. Certainly their product lines
bear a striking similarity (see Figure 2).
Overall, we do not believe that either firm can claim technical superiority. Still, there is a
bit of an “East Coast/West Coast” feud between the two Companies that deserves closer
examination.
Nuance can trace its roots back to SRI International, an independent R&D and consulting
shop based in Menlo Park. Nuance was founded as a vehicle to commercialize SRI’s
voice interface software. Nuance’s speech recognition technology uses the Hidden
Markov Model (HMM), a statistical process model used in speech recognition since the
early 1970s, combined with Gaussian-mixture processing, which divides digitized speech
into short segments for faster processing.
By and large, we do Similarly, the SpeechWorks technology, developed at MIT, relies on segmental systems
not believe that either rather than the frame-based HMM to account for the entire phonetic segment, which
firm can claim again allows for faster processing and increases accuracy. So, the core technologies are
technical superiority. not a significant point of differentiation.
Stephens Inc. 10
11. Figure 2 SPEECH RECOGNITION INDUSTRY Product Comparison
Product NUAN SPWX
Speech Recognition Engine Nuance 7.0 SpeechWorks 6.5
Text-To-Speech Vocalizer Speechify/Eloquence
Authentication Verifier SpeechSecure
Browser Voyager Speech Browser
VoiceXML Tools VoiceXML Interpreter OpenVXI
Developer Tools SpeechObjects DialogModules
Statistical Language Models Say Anything How May I Help You
Turnkey Auto-Attendant na SpeechSite
Source: Company documents and Stephens Inc.
Nuance claims that its software handles noisy environments better than SpeechWorks’ as
a result of its extensive work with General Motors. SpeechWorks disputes the claim, and
we have not found any independent verification.
What is indisputable is that Nuance’s speech recognition software supports 25 languages,
while SpeechWorks, supports just 18. However, we cannot imagine that support for the
additional seven languages is a significant driver of revenue. Likewise, Nuance’s
verification software, instant messaging product and its voice browser are points of
differentiation but are not significant revenue contributors.
System architecture is Perhaps the biggest difference between the two technologies is the system architecture.
the biggest difference Nuance uses a distributed client/server architecture, while SpeechWorks favors an “N+1
between the sparing” approach. We find the Nuance approach more impressive, but our due diligence
technologies offered leads us to believe that buyers of IVR systems are as likely to favor SpeechWorks’ single
by SPWX and NUAN.
server “in the skins” approach. Key points regarding each architecture are listed on the
next page.
Stephens Inc. 11
12. Nuance’s Distributed Architecture
O Balances load across multiple servers.
O High fault tolerance.
O More efficient use of hardware.
O More accuracy by leveraging multiple CPUs.
SpeechWorks’ N+1 Sparing
O Relies on a single server with a backup.
O Seamless integration with IVR platforms.
Source: Company Documents
Although text-to-speech (TTS) is not yet a meaningful contributor to earnings for either
We believe that the Company at this time, the product has a bright future, and it is worth noting the
TTS software offered differences between the Nuance and SpeechWorks offerings. While Nuance’s offering
by both NUAN and has yet to ship, we doubt that its U.S. English version will be technically superior to the
SPWX has bright Speechify product SPWX licensed from AT&T. On the other hand, SpeechWorks’ other
prospects. TTS offering, Eloquence, supports multiple languages but is based on a less natural
sounding formant technology. Nuance may have an edge selling its new product to
multinational customers. We summarize the key points regarding TTS below.
Nuance’s Vocalizer
O Has not shipped.
O Cobbled together from multiple vendors, including Lucent and Fonix.
O Will support nine languages with state-of-the-art concatenated technology.
SpeechWorks’ Speechify/Eloquence
O Speechify technology licensed from AT&T.
O Speechify may be best on the market—licensed by Microsoft, AOL and Yahoo!
O Eloquence product supports 13 languages but uses outdated formant technology,
which produces a less life-like voice.
Source: Company Documents
Net-net, we are not convinced that either Company’s product line is wildly superior to the
other, and our feedback from systems integrators indicates that neither is substantively
better. Still, based mostly on anecdotal evidence and our own perception, we view
Nuance as slightly more forward thinking than its speech recognition software peers.
Sales Strategies
NUAN and SPWX offer Not only are Nuance’s and SpeechWorks’ technologies similar, but also the customers
their products to that use their products are comparable (see Figure 3). It almost appears that customers in
similar customers. each key market segment are evenly divided between the two competitors.
In 2000, NUAN derived However, there is a very clear difference in the way in which Nuance and SpeechWorks
72% of its revenue market their products. In 2000, 72% of Nuance’s revenue was achieved through
through resellers versus resellers, including 22% of sales through Nortel. In contrast, SpeechWorks derived just
SPWX's 38%. 38% of its 2000 revenue from resellers, OEMs and ASPs, including 16% from call
automation vendor InterVoice-Brite. SpeechWorks has a more significant professional
services organization and even resells hardware as part of its end-to-end solutions.
Stephens Inc. 12
13. Figure 3 SPEECH RECOGNITION INDUSTRY Key End-Users
Industry NUAN SPWX
Financial Services Fidelity Investments Ameritrade
Charles Schwab CSFBdirect
TD Waterhouse E*TRADE
Airlines American Airlines United Airlines
British Airways Continental Airlines
Telecommunications Sprint PCS BellSouth
Telespree WorldCom
Portals BeVocal AOLbyPhone
Tellme HeyAnita
Source: Company reports and Stephens Inc.
We believe that the The bottom line, in our opinion, is that Nuance sells products, while SpeechWorks sells
bottom line is that solutions. As we mentioned earlier in the report, at this early stage in the market’s
Nuance sells growth, it may be necessary to hold the customers’ hands through the design and
products, while implementation phases. Thus, SpeechWorks’ direct sales approach appears to be more
SpeechWorks sells successful in the current environment, as witnessed by its 8% sequential sales growth in
solutions. the 1Q01 compared to Naunce’s 40% sequential decline. In recognition of this, Nuance
recently introduced a comprehensive set of design and production services aimed at
helping businesses build voice applications. To be clear, though, we do not expect that
Nuance will build a large systems integration organization.
As this market matures and more qualified integrators emerge, the need for direct
customer contact may decrease. Therefore, Nuance’s pure software model may
ultimately prove to have positive implications for both sustainable growth and attractive
margins.
NUAN should In terms of margins, Nuance’s numbers are closer to what we expect from a software firm
generally have higher (see Figure 4). In 2000, the Company’s revenue from software licenses was roughly 72%
gross margins than of total revenue, and its gross margin was close to 80%. On the other hand,
SPWX. SpeechWorks derives just 54% of total revenue from product licenses, and its gross
margin in 2000 was closer to 60%. In addition, Nuance’s R&D expense as a percent of
revenue was higher than SpeechWorks’, while SpeechWorks’ administration costs were
much higher than those of Nuance (though this is somewhat misleading due to expense
allocation). Interestingly, sales and marketing expenses for the two competitors were an
identical 66% of sales.
Figure 4 SPEECH RECOGNITION INDUSTRY Margin Comparison for 2000
FY2000 NUAN SPWX
Gross Margin 79% 63%
S&M % of Rev. 66% 66%
R&D % of Rev. 39% 29%
G&A % of Rev. 19% 58%
Note: Comparisons ot G&A expenses are generally a challenge due to different allocation methods.
Source: Company reports and Stephens Inc.
Stephens Inc. 13
14. Another difference is in revenue recognition. For Nuance, the revenue clock starts at
zero each quarter and, thus, there is little visibility. SpeechWorks, on the other hand,
often recognizes revenue over the approximate six months that it takes to implement the
software or solution. The upshot is that SpeechWorks’ management enjoys 50%
visibility into the next quarter’s results, which is obviously a comfort in this uncertain
market.
Staying Power
The fundamental The issue of the moment is how well any given software vendor can hold up in a difficult
question is, How well macroeconomic environment and an overall tech spending slowdown. We have little
can software vendors doubt that speech recognition systems have a substantial quantifiable ROI, especially in
hold up in a difficult customer service and auto-attendant applications. However, there is still a great deal of
macroeconomic skepticism from potential customers, and therefore, we are pessimistic about the near-
environment? term prospects for both Companies’ products.
In 2001, we may be more likely to see limited-scope test projects (e.g., an internal voice
directory) to evaluate the potential for speech recognition rather than sweeping business
process changes to truly take advantage of the technology. Again, we believe that
SpeechWorks’ direct customer interaction will help it outpace Nuance in the short run.
In any case, we are Regardless of the specifics, we are not assuming that either firm will grow rapidly in
not assuming that 2001. We do, however, foresee a bright long-term future for speech recognition and for
either Company will the two Companies. So we will examine the Companies’ staying power, or their ability
grow rapidly in 2001. to emerge from what may be a challenging 2001 as strong, if not stronger, businesses—
capitalization, customer and geographic diversity, management and employee
commitment, and product development.
Capitalization
First, we must consider the two Companies’ cash positions and their capital requirements
over the next year or two, as it may be a challenge to raise additional funds in the current
environment. Both companies completed an IPO in 2000 and are well capitalized. We
estimate that neither one will require additional capital over the next three years (see
Figure 5).
Customer and Geographic Diversity
Next, we consider the Companies’ customer and geographic diversification. We tend to
We tend to place a
premium on place a premium on firms with a broadly diversified customer base in terms of geography
companies with a and vertical industry groups. Both service roughly the same customer base, and neither
broadly diversified appears over-exposed to any customer or group of customers. The top five customers for
customer base in each of them make up roughly half of revenue (see Figure 6). However, Nuance is much
terms of geography farther along in terms of international expansion, with almost half of its revenue derived
and vertical industry from overseas compared to less than 10% at SpeechWorks (see Figure 7). Clearly, this
groups. has not necessarily helped in 2001, but its broad geographic reach should serve it well in
the future.
Stephens Inc. 14
15. Figure 5 SPEECH RECOGNITION INDUSTRY Capitalization Comparison,
1Q01
($ in millions) NUAN SPWX
Cash and Short-term Inv. $206.07 $98.09
Total Assets 275.49 147.88
Debt 0.00 0.67
Total Liabilities 33.07 10.38
Total Liab. and Equity 275.49 147.88
EBITDA Loss in 1Q ($14.42) ($8.29)
Cash in Years 3.6 3.0
Source: Company reports and Stephens Inc.
Figure 6 SPEECH RECOGNITION INDUSTRY Customer Concentration
Comparison, 1Q01
NUAN SPWX
Top 5
Other Top 5 47%
49% 51% Other
53%
Source: Company reports and Stephens Inc.
Figure 7 SPEECH RECOGNITION INDUSTRY Geographic Concentration
Comparison, 1Q01
NUAN SPWX
International
9%
International
47%
U.S.
53%
U.S.
91%
Source: Company reports and Stephens Inc.
Stephens Inc. 15
16. Management/Employees
Third, we evaluate management’s and employees’ commitment to building a world-class
organization. Anecdotally, we can vouch for enthusiasm throughout the Nuance
organization after spending three days at its V-World conference and were impressed by
Nuance’s shared culture. While we have not had the same broad exposure to
SpeechWorks’ employees, our feedback from customers indicates that its people have a
strong commitment to service.
We generally believe
We generally believe that the SpeechWorks/Nuance competition has a positive impact on
that the SPWX/NUAN employee morale and generates pride at both organizations. The common pursuit of the
competition has a two firms, though, is more usable speech recognition technology and, thus, an improved
positive impact on man/machine interface. This quest tends to attract some of the brightest minds in the
employee morale at world.
both organizations.
More substantively, neither one’s management has a particularly impressive level of
insider ownership, which might suggest an obvious incentive to build value for the long
run (see Figure 8). Clearly, though, the insider stake at SpeechWorks is substantively
greater.
Figure 8 SPEECH RECOGNITION INDUSTRY Insider Ownership
Comparison
NUAN Shares SPWX Shares
Total Insider Ownership 1,175,561 or 4% 3,460,016 or 11%
Float 30,780,439 27,947,984
Total Shares Outstanding 31,956,000 31,408,000
Source: Company reports and Stephens Inc.
Product Development
Currently NUAN Finally, we believe it is important to consider the ability of each Company to develop or
holds one U.S. patent acquire technology that will keep it at the vanguard of the sector. One clue might come
versus SPWX’s five. from their patent portfolios. Nuance holds one U.S. patent and has multiple patents
pending. SpeechWorks has 5 U.S. patents and has filed for another 12 in the U.S. and
several others overseas. While software patents should not be viewed as protection from
competition, they at least provide some legal grounds to defend core technologies.
Neither company Neither Company appears to have any defensible intellectual property, and both have
appears to have any licensed nonexclusive core technology. That said, improvements in speech recognition
defensible intellectual software are made through trial and error. Both NUAN and SPWX are distancing
property, and both themselves from potential competitors by learning at the speed of their market share and
have licensed constantly improving their products. So a new market entrant could license SRI or MIT
nonexclusive core technology, but it would be five years behind the times.
technology.
Nuance currently employs approximately 120 engineers, and its cash R&D expenses of
$5.24 million equaled 48% of revenue in the first quarter. SpeechWorks has over 100
engineers on its payroll, and cash R&D expenses of $3.35 million were roughly 30% of
first quarter revenue. Our point here is that both Companies possess experience and
R&D commitment that, should translate into a growing portfolio of valuable intellectual
property, which we view favorably.
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17. VALUATION
Based on a price to revenue analysis, neither the shares of Nuance nor SpeechWorks
could be considered inexpensive (see Figure 9). However, their leadership positions in
an attractive but nascent market may warrant premium multiples.
Figure 9 WIRELESS APPLICATIONS INDUSTRY Valuation Comparison (dollars in millions except per
share amounts)
Stephens 6/5/01 Shares Market Revenue P/Revenue
Company Ticker Rating Price Out Cap CY00A CY01E 2000 2001
724 Solutions SVNX $8.76 53.6 $469.4 $21.2 $72.3 22.1 6.5
Aether Systems AETH N 11.58 40.5 468.4 58.2 149.3 8.1 3.1
At Road ARDI 1.90 42.9 81.5 10.6 29.9 7.7 2.7
AvantGo AVGO 2.28 31.3 71.5 16.3 34.5 4.4 2.1
Comverse Technology* CMVT 67.52 187.5 12,660.0 1,225.1 1,461.4 10.3 8.7
Extended Systems XTND B 7.77 10.7 83.4 39.1 28.4 2.1 2.9
GoAmerica GOAM 2.40 52.3 125.6 13.9 91.2 9.1 1.4
InfoSpace INSP 3.83 323.1 1,237.6 214.6 214.8 5.8 5.8
Nuance Comm. NUAN O 17.56 32.0 561.1 51.8 42.5 10.8 13.2
Omnisky OMNY 2.30 60.1 138.1 11.1 38.3 12.5 3.6
Openwave Systems OPWV N 42.99 177.8 7,642.5 286.6 551.0 26.7 13.9
Portal Software PRSF 5.31 168.2 893.1 268.3 350.2 3.3 2.6
Pumatech* PUMA O 3.81 44.2 168.5 38.3 43.7 4.4 3.9
SignalSoft SGSF 8.75 23.6 206.5 13.6 32.6 15.1 6.3
SpeechWorks Int'l SPWX O 14.50 31.4 455.3 30.0 49.1 15.2 9.3
TeleComm. Systems TSYS O 4.00 27.4 109.6 66.9 81.2 1.6 1.3
Average 9.9 5.5
* Revenue for the 12-month periods ending in January; all others are calendar year.
Note: Companies in bold are Stephens Inc. estimates.
Source: IBES and Stephens Inc.
Our 12-month price Our 12-month price targets are based on a price to revenue multiple applied to our second
targets are based on a 12-month revenue estimate for each firm. Our 12-month target for Nuance is $20.00, or
price to revenue 14% above the current price, based on a price to revenue multiple of 8 applied to our
multiple applied to second 12-month revenue estimate of just over $80 million.
our second 12-month
revenue estimate for Our 12-month price target for SpeechWorks is $19.00, or 31% above the current price,
each firm.
based on a price to revenue multiple of 7 applied to our second 12-month revenue
estimate of $83.4 million. We afford Nuance a slightly higher multiple than
SpeechWorks based on the slightly higher gross margins that should be possible with its
indirect sales model.
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18. Cash Flow
We believe that an assessment of a stock’s value should include a discounted cash flow
analysis as a means to verify the plausibility of a valuation if not to pinpoint a price
Our DCF analyses
target.
suggest that both
NUAN’s and SPWX’s
current valuations Our DCF analyses suggest that both Nuance’s and SpeechWorks’ current valuations are
may be slightly low. basically fair, given our reasonable assumptions of slowly declining revenue growth
beginning in 2005 and peak net margins in 2007 of roughly 20% for Nuance and 17% for
SpeechWorks (see Figures 10 and 11). Importantly, we believe that Nuance’s $200
million in cash and SpeechWorks’ $100 million in cash should provide more than
adequate capital for growth until both are expected to turn cash flow positive in FY2003.
Figure 10 NUANCE COMMUNICATIONS Discounted Cash Flow Analysis
(dollars in millions except per share)
2000A 2001E 2002E 2003E 2004E 2005E 2010E
Revenue $51.8 $42.5 $70.0 $107.0 $160.5 $232.7 $557.2
Year-to-Year Change (18%) 65% 53% 50% 45% 8%
Net Margin NM NM NM 5% 10% 15% 20%
Earnings ($23.5) ($49.0) ($21.5) $5.1 $16.0 $34.9 $111.4
Depreciation & Amortization 2.7 6.0 6.0 6.0 6.0 6.0 6.0
Non-Cash Compensation 4.9 5.3 1.9 1.9 1.9 1.9 1.9
Other (0.3) (2.4) (2.8) (3.4) (3.4) (3.4) (3.4)
Cash from Operations ($21.1) ($45.4) ($18.3) $9.6 $20.5 $39.4 $115.9
Net Investments (9.1) (32.0) (6.0) (6.0) (6.0) (6.0) (6.0)
Free Cash Flow ($30.2) ($77.4) ($24.3) $3.6 $14.5 $33.4 $109.9
Year-to-Year Change 306% 130% 8%
Free Cash Flow Per Share (0.95) (2.42) (0.76) 0.11 0.46 1.05 3.44
Terminal Value $41.64
Shares Outstanding 32.0
2001-2010 Cash Flows Per Share $3
Terminal Value Per Share $10
Total Discounted Value Per
Share $13
Excess Cash Per Share $1
Implied Market Price $14 per share
Note: Our DCF analysis assumes a 15% discount rate, revenue growth accelerating to 65% in 2002 before
declining to 8% in 2010, net margins improving to 20% by 2007 and a terminal value of roughly 12 times
earnings.
Source: Stephens Inc. and Company reports.
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19. Figure 11 SPEECHWORKS INTERNATIONAL Discounted Cash Flow
Analysis (dollars in millions except per share amounts)
2000A 2001E 2002E 2003E 2004E 2005E 2010E
Revenue $30.0 $49.1 $74.6 $112.9 $169.3 $245.5 $588.0
Year-to-Year Change 63% 52% 51% 50% 45% 8%
Net Margin NM NM NM 3% 8% 12% 17%
Earnings ($29.6) ($39.1) ($22.0) $3.9 $13.5 $29.5 $100.0
Depreciation & Amortization 1.9 10.0 10.0 10.0 10.0 10.0 10.0
Non-Cash Compensation 4.5 7.4 7.4 7.4 7.4 7.4 7.4
Other 4.1 (2.4) (2.7) (3.6) (3.6) (3.6) (3.6)
Cash from Operations ($23.6) ($31.5) ($14.8) $17.7 $27.3 $43.3 $113.8
Net Investments (17.6) (11.4) (6.0) (6.0) (7.5) (9.0) (10.0)
Free Cash Flow ($41.2) ($42.9) ($20.8) $11.7 $19.8 $34.3 $103.8
Year-to-Year Change 69% 73% 7%
Free Cash Flow Per Share (1.31) (1.37) (0.66) 0.37 0.63 1.09 3.30
Terminal Value $40.52
2001-2010 Cash Flows Per Share $4
Terminal Value Per Share $10
Total Discounted Value Per Share $14
Excess Cash Per Share $0
Implied Market Price $14 per share
Note: Our DCF analysis assumes a 15% discount rate, revenue growth slowly declining to 5% in 2010, net
margins improving to 17% by 2007 and a terminal value of roughly 12 times earnings.
Source: Stephens Inc. and Company reports
Catalysts
For better or worse, the futures of Nuance and SpeechWorks are dependent on the same
sector trends. While we recognize the distinct capabilities of each Company, we tend to
believe that their stocks will be driven by similar catalysts and will face comparable risks.
New Customers: To a certain extent, both Nuance and SpeechWorks are “show me”
stocks in the sense that the shares may not appreciate significantly until the Companies
prove that a viable market exists by adding new high-profile customers.
Product Developments: Both Companies continue to bring new products to the market,
which should eventually translate into revenue.
Acquisition Announcements: Somewhat related to the preceding point, we expect that
Nuance and SpeechWorks may make small acquisitions to add to their product and
service portfolios.
New Alliances and Partnerships: Although this is quickly changing, there is a lack of
qualified integrators and developers in the speech recognition sector. We look for
SpeechWorks and especially Nuance to benefit from the addition of high-quality resellers
and integration partners. Resellers would generally include hardware vendors such as
InterVoice-Brite, which is a key SpeechWorks partner and a developing Nuance
relationship. Systems integrators would include specialists such as Gold Systems as well
as the bigger name consultants such as Accenture.
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20. Risks
Competition: As we mentioned earlier in the report, we believe that IBM could pose a
real threat, as it has both quality technology which could be and strong relationships with
enterprise customers.
Commoditization: There is at least a modest threat of commoditization of the core
speech recognition technology. Both Companies licensed technology from third parties
at their inception, and though their products have evolved, the core source code could
conceivably be utilized by any potential competitor.
Service Failures: The biggest barrier to growing the market is getting potential
customers comfortable with the technology. Any integration or deployment problems
could generate long-term ill will to the detriment of future revenues. It is interesting to
note that most failures are more a function of faulty user interface design rather than a
failure of the core recognition software.
Growing Pains: Both Companies could potentially face a period of hyper-growth over
the next couple of years. While we believe that both management teams are solid, it may
be a challenge to grow the businesses at the pace of the market’s growth.
CONCLUSION
We recommend both Again, we recommend both Nuance and SpeechWorks with OUTPERFORM ratings
NUAN and SPWX based on our optimistic outlook for the speech recognition software market. We view
with OUTPERFORM both as leaders in an important but nascent market. While we do not expect spectacular
ratings. results in 2001, we believe that customers are continuing to evaluate the technology and
will likely begin to deploy speech recognition solutions more aggressively in 2002.
In the short run, we favor SpeechWorks, because it has greater revenue visibility and
emphasizes comprehensive solutions and customer service. Longer term, we tend to
favor Nuance’s indirect sales strategy and forward-thinking technology mindset. Still, we
believe that both Companies will benefit from positive market dynamics and that both
will prove to be wise investments for those who can tolerate the risk.
Our 12-month price Our 12-month price target for Nuance is $20.00, or 14% below its current price, and our
targets for NUAN and target price for SpeechWorks is $19.00, or 31% above its current price.
SPWX are $20 and
$19, respectively.
We will become even more bullish when we see one or more of the following:
• An increase in overall corporate technology spending.
• Increased demand for speech recognition in various vertical industry solutions.
• Signs that Nuance and SpeechWorks will remain leaders in the industry, evidenced
by continued Fortune 500 customer wins.
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21. NUANCE COMPANY DESCRIPTION
NUAN is a provider Nuance, based in Menlo Park, California, is a provider of software and services that
of software and enable the content and services of the Internet and telephone networks to be accessible
services that enable from any telephone. The Company’s software platform consists of software servers that
the content and perform speech recognition, natural language understanding, text-to-speech (TTS)
services of the synthesis and voice authentication. Nuance also provides professional services to
Internet and facilitate the development, implementation and support of applications operating on its
telephone networks to software platform.
be accessible from
any telephone.
Nuance software products are based on research originally conducted by SRI
International. Upon its inception, Nuance received a license from SRI International to a
number of patents and other proprietary rights, including a right to software relating to
voice interface technologies. Since then, the Company has invested significantly in
developing and improving this core technology. The license was exclusive until
December 1999; subsequent to that the Company allowed the exclusivity to lapse.
Nuance’s software offerings include Nuance 7.0, the Company’s core voice recognition
software; Speechify, a speech synthesis software; Nuance Vocalizer, a text-to-speech
(TTS) engine; Application Development Tools; Nuance Verifier, a speaker verification
software; and Nuance Voyager, a voice browser. The Company licenses its products to
software and service providers as well as enterprises. In the first quarter 2001, about half
of it’s revenue was derived from services, though this was unusually low due to a sharp
decline in software license revenue (see Figure 12).
In May 2001, Nuance In May 2001, Nuance introduced a new speech recognition technology “Say Anything.”
introduced a new Say Anything allows people to say whatever they want to speech systems to conduct
speech recognition transactions or obtain information. Until now, developers have built applications by
technology “Say predefining lists of what callers can say. Say Anything combines this capability with
Anything.” statistical models that recognize free-style speech and extract key concepts to determine
the meaning of user input. Say Anything is not yet generating revenue.
Figure 12 NUANCE COMMUNICATIONS Revenue Composition, 1Q01—
ended 3/31/01 (In millions)
Total Revenue = $11.01
Licenses
Services
$5.3
49%
$5.7
51%
Source: Company reports and Stephens Inc.
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22. Nuance’s core Nuance’s core technology consists of speech recognition, natural language
technology consists of understanding, TTS synthesis and voice authentication. The Company uses the Hidden
speech recognition, Markov model for voice recognition. Under this approach, digitized speech is divided
natural language into numerous short segments and statistical processes are used to analyze and interpret
understanding, text- these segments.
to-speech (TTS)
synthesis and voice Natural language understanding is the ability of the software to extract relevant parts of
authentication. the speech using rules established by the developer of the voice interface. The text-to-
speech engine synthesizes text into speech, providing a natural sounding voice interface.
Last but not least, voice authentication software provides security for applications using
biometric speaker verification.
Nuance sells its software and services across a variety of industries and market segments
in the United States and internationally. Among the list of notable customers are
American Airlines, Banco Bradesco, Charles Schwab, Fidelity Investments, OnStar,
Sears, Siebel Systems and SprintPCS (see Figure 13).
For instance, OnStar has integrated NUAN ‘s software into its virtual advisor platform
that will deliver in-vehicle, hands-free access to a collection of Internet-based content.
Cisco also announced a multi-year agreement with Nuance that will allow it to
incorporate the Company’s speech recognition and voice authentication software into its
Architecture for Voice, Video and Integrated Data (AVVID) products. More recently,
Japan’s largest carrier, Japan Telecom, has licensed NUAN’s software to power its voice
portal.
Figure 13 NUANCE COMMUNICATIONS Selected Customers
Communications Travel
Bell Atlantic (now Verizon) American Airlines
British Telecommunications plc Delta Airlines
CTBC Telecom (Brazil) Other
Deutsche Telekom (Germany) Avon
Sprint PCS Commonwealth of Virginia
Southwestern Bell CTC Create (Japan)
Telenor (Norway) Dreyfus Corporation
Telia (Australia) Entergy Corporation
Z-Tel Technologies Home Shopping Network
Technology/Manufacturing National Car Rental Systems, Inc.
Dell Japan Odeon Cinemas (United Kingdom)
Ford Motor Company OnStar
General Electric Co. Sears, Roebuck and Co.
Sony Japan Siebel Systems
Finance/Brokerage/Banking United Parcel Service
American Century Voice Portals/Enhanced Service Providers
American Express Financial Advisors BeVocal
Banco Itau (Brazil) General Magic
Banco Mercantil (Venezuela) GoSolo Technologies
Charles Schwab & Co. GTG Technologies
Fidelity Investments ShopTalk
Merrill Lynch Tellme Networks
Dot.coms Webversant
Cheap Tickets
Fingerhut
Source: Company reports and Stephens Inc.
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23. Software Products
Nuance’s primary software products are Nuance 7.0, Nuance Vocalizer, Nuance
Voyager, Nuance Web Server, SpeechObjects and the Nuance Developer’s Toolkit.
Nuance 7.0
Nuance 7.0 is the Nuance 7.0 is the Company’s flagship software that provides speech recognition and
Company’s flagship natural language understanding capabilities. The software has a unique distributed
software that provides architecture that supports concurrent load balancing of speech recognition, natural
speech recognition language understanding, voice authentication and text-to-speech synthesis. The
and natural language architecture utilizes three primary components: the Recognition Server, Recognition
understanding
Client and Resource Manager (see Figure 14).
capabilities.
Figure 14 NUANCE COMMUNICATIONS Nuance 7.0
Speech-Enabled Application
Nuance Clients
Resource Manager
Nuance Nuance Nuance Nuance
Server Server Server Server
Source: Company documents and Stephens Inc.
The Recognition Server performs speech recognition and verification. The Resource
Manager balances the load across all the recognition servers. The Recognition Client
interacts with the speech-enabled application. The unique architecture enables the
separation of light client processing from volume CPU-intensive server processing. For a
small system or a prototype, both the client and server can run on the same machine.
The speech recognition and natural language understanding technology of the software is
available for 25 languages and dialects.
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24. Speech Recognition Software Customer Case Study (UPS)
UPS, the world's largest package distribution company, needed a solution to enable its
customers to schedule pickups and track packages using voice-only input. Touch-tone
phones couldn't handle the 11- to 18-digit tracking numbers, and using customer service
agents was too expensive. UPS utilized Nuance’s speech recognition software to develop
an automatic speech recognition (ASR) application. Now, UPS customers can schedule
pickups and track packages using voice.
Source: Company reports and Stephens Inc.
Nuance Verifier
Nuance Verifier is a Nuance Verifier is a verification software that authenticates the identity of callers based
verification software on their unique voiceprint. The software captures and stores the caller’s voiceprint
that authenticates the during a short one-time enrollment process. Subsequently, callers who wish to enter the
identity of callers system just speak, and their voice is compared by the software against their previously
based on their unique enrolled voiceprint. If there is a match, the caller is accepted into the system.
voiceprint.
Speech Verification Customer Case Study (The Home Shopping Network)
Operators at the Home Shopping Network (HSN) were handling roughly 48,000 calls per
day from customers who had forgotten their HSN ID number. The company needed a
solution that would automate the process to reduce costs. HSN utilized Nuance’s
verification software to develop an ASR application. Today, customers calling HSN
simply speak their phone numbers and are securely identified. The software provides a
95% automated rate in identifying and authenticating callers, so only 5% of callers are
forwarded to an operator for assistance.
Source: Company reports and Stephens Inc.
Nuance Vocalizer
Nuance Vocalizer is a Nuance Vocalizer is a text-to-speech software engine that converts text-based information
text-to-speech into an audio format for access over the telephone. The software retrieves the waveforms
software engine that from a database of prerecorded human speech. The output sounds natural because the
converts text-based resulting speech is actually made up of concatenated units of human recordings. TTS
information into an should prove to be especially important in unified messaging, as it will allow e-mails to
audio format for be “read” over the phone.
access over the
telephone.
Pricing is based on the number of TTS ports licensed. The list price per port is $600, but
volume discounts are available. The software is currently available in developer’s release
only, with general availability expected in first half of 2001.
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