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Adding defensive measures as earnings season brings back volatility

Adding defensive measures as earnings season brings back volatility

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The full content of Tematica Investing is below; however downloading the full issue provides detailed performance tables and charts.Click here to download.

Our Thoughts on Connected Society Company
Apple’s “Record” Earnings

We wish we could say it’s been a quiet week since our last issue of Tematica Investing, a smooth sailing one in fact, but thanks to the growing political drama coming out of the new White House and a pick up in the velocity of earnings reports this week, the only word we can use to describe it is “frenetic.”

Last night I was a guest on CGTN America to discuss Apple’s (AAPL) quarterly results. The long and short of it is that while Apple CEO Tim Cook called it a record quarter, the reality is the iPhone still accounts for 70 percent of Apple’s overall business. While Cook boasted of strong Apple Watch growth, iPhone shipments were up 5 percent year over year, hardly the robust growth levels we’ve seen in the past.

Meanwhile, the Mac business — the next largest business line next to the iPhone — saw volumes rise 1 percent year over year, while iPad units fell 19 percent compared to the year-ago quarter. If Apple didn’t flex its cash position, which now sits at $246 billion, to buy back stock during the quarter, reported earnings would have been flat year over year.

To us here at Tematica this means until Apple can bring to market a new product, or reenergize an existing one that can jumpstart growth, the company will be tied to the iPhone upgrade cycle. Expectations for the next iteration, the presumed iPhone 8, call for a new body, new display — hence our position in Disruptive Technology company Universal Display (OLED) — and a greater use of capacitive touch that should eliminate the current home button. But we’ll have to see if this new model on the 10thanniversary of the transformative device’s launch will capture the hearts of customers, as the last couple of models have only had a meh response.

Despite Apple’s current reliance on the iPhone, there are hopeful signs in other areas, such as the new AirPods that echo past design glory, an Apple TV business that has 150 million active subscriptions and a growing services business. We’ll continue to keep tabs on this poster child company for our Connected Society company, but with no evident catalyst over the coming months, we’re inclined to sit patiently on the sidelines and pick off the AAPL shares at better prices.

In the meantime, our position in Universal Display (OLED), up 24 percent since initiating the position in October, gives us exposure to any Apple upside as the rumors persist it will integrate the OLED technology into the iPhone 8. As we often like to say — even though it’s somewhat politically incorrect in today’s hyper-sensitive world — “it’s better to buy the bullets, not the gun.”

  • Until there is more confirmation of the integation of OLED’s into the next iPhone, or another thematic tailwind reveals itself, we are maintaining a Hold rating on Universal Display (OLED) as the current price of $66 per share is close to our $68 per share target. 

 

Confirming Thematic Data Points From Earnings Reports and Other Sources

While we are not buyers of Apple shares just quite yet, there was a number of confirming thematic data points shared during the company’s earnings conference call last night:

  • Rise & Fall of the Middle Class — “The middle class is growing in places like China, India, Brazil, but certainly, the strong dollar doesn’t help us.”
  • Cashless Consumption — “Transaction volume was up over 500% year over year as we expanded to four new countries, including Japan, Russia, New Zealand, and Spain, bringing us into a total of 13 markets. Apple Pay on the Web is delivering our partners great results. Nearly 2 million small businesses are accepting invoice payments with Apply Pay through Intuit QuickBooks Online, FreshBooks, and other billing partners. And beginning this quarter, Comcast customers can pay their monthly bill in a single touch with Apple Pay.”
  • Content is King — “In terms of original content, we have put our toe in the water with doing some original content for Apple Music, and that will be rolling out through the year. We are learning from that, and we’ll go from there. The way that we participate in the changes that are going on in the media industry that I fully expect to accelerate from the cable bundle beginning to break down is, one, we started the new Apple TV a year ago, and we’re pleased with how that platform has come along. We have more things planned for it but it’s come a long way in a year, and it gives us a clear platform to build off of… with our toe in the water, we’re learning a lot about the original content business and thinking about ways that we could play at that.”
  • Connected Society — “every major automaker is committed to supporting CarPlay with over 200 different models announced, including five of the top 10 selling models in the United States. “

Aside from Apple, there has been no shortage of thematic data points buried in earnings reports over the last few days. Even though we cut Under Armour (UAA) from the Tematica Select List yesterday, we’d note its Direct to Consumer business, which reflects its online and mobile shopping efforts, rose 26 percent year over year in the December quarter. H&M Stores has announced it will slow its physical store openings and instead focus more of its efforts online.  Both confirming data points for our Connected Society investment theme.

Shifting gears somewhat, a new study from the Food Marketing Institute and Nielsen projects online grocery sales in the U.S. could grow tremendously in the next decade. By 2025, the report suggests that American consumers could be spending upwards of $100 billion on online grocery purchases, comprising some 20 percent of the total market share. Currently, 23% of US consumers purchase groceries through digital channels.

Confirming the accelerating shift toward digital shopping that is a hallmark of our Connected Society investing theme, during the December quarter United Parcel Service (UPS) saw its domestic average daily volumes rose 5% year over year with International domestic growth up more than 20% in Asia and 10% across the Eurozone. Noting the strong growth in Asia, we’d say it likely reflects the Rise aspects of our Rise & Fall of the Middle-Class thematic.

We expect to hear much more on the accelerating shift toward digital shopping when Amazon (AMZN) reports its quarterly earnings tomorrow (Feb. 2).

Getting back to Cashless Consumption, Juniper Research now expects $1.35 trillion to be spent worldwide through mobile wallets by the end of 2017. The nearly 30 percent increase over 2016 spending will be due to users in the Far East and China through Alipay and WeChat while Westerners continue to embrace mobile wallets from Apple Pay, MasterCard (MA) and PayPal.
Turning to our Fattening of the Population theme: 

  • McDonald’s (MCD) is deploying Big Mac vending machines… yes, we know what you’re thinking and there is no way we could make something like that up.
  • Civil servants in the UK have been warned that bringing cake into work for birthdays and celebrations could be a “public health hazard”. The Faculty of Dental Surgery at the Royal College of Surgeons (RCS) warned that in large offices, sweets and cakes have become a daily occurrence and the growing trend is contributing to poor oral health and the obesity epidemic. (There is a “bad teeth” joke somewhere in there, but for once we’ll take a pass on that one) On a serious note, sadly it seems that yes, despite what we may like to think, too much a good thing may not be good for us.

 

 
Hey Alexa, Order My Starbucks

Our most recent addition to the Tematica Select List was Disruptive Technologycompany Nuance Communications (NUAN) given the explosive growth that is expected in voice digital assistants over the coming years. We know that Starbucks (SBUX) has been an early adopter of technology that allows customers to pay and order ahead online with the Starbucks app. Starbucks Mobile Order & Pay currently accounts for more than 7 percent of transactions in US company-operated stores. Building on that, Starbucks has launched My Starbucks Barista, a voice-activated “barista” baked into the company’s existing iOS mobile app that uses artificial intelligence. Currently in beta testing, My Starbucks Barista will be available to 1,000 select US customers initially, with a planned rollout through summer 2017 and an Android version to follow.

As we pointed out when we added NUAN shares to the Tematica Select List, Amazon’s Echo technology is leading the way, and the same holds with Starbucks. Select customers can now use Amazon’s Alexa to order “on command”  and the ability to recall and repeat past favorite drinks is also included. Customers simply need to say “Alexa, order my Starbucks” from wherever they have an Alexa device.

As with My Starbucks Barista, we expect Starbucks will deploy this across more Echo devices in the coming months. What it means is more people adopting the use of voice technology, and we find that very bullish for our NUAN shares.

  • We continue to rate NUAN shares a Buy with a $21 price target, as well as Guilty Pleasure company Starbucks (SBUX) with a price target of $74.

 

 

Beholden to the All-Mighty Buck

Finally, one recurring standout this earnings season is the impact of currency given the dollar’s strength during 4Q 2016. We’ve heard it from Buy-rated McCormick & Co. (MKC), United Parcel Service (UPS) and others, but it was Apple that really hammered the point home. In the earnings call last night, Apple said, “we expect foreign exchange to be a major negative as we move from the December to the March quarter.” Not exactly a surprise, given that 60 percent of its revenue is from outside the US.

 

 

Housekeeping at the House of Mouse

While The Walt Disney Company (DIS) will not report its December quarter results until February 7, we’re boosting our protective stop loss on the shares to $101.50 from $87. Currently, we’re up 10 percent% on a blended basis with the shares and while we are enjoying that nice return, after languishing in the red for a while on the positions we are aware of how volatile earnings season can be. This move in the stop loss should prevent any losses in the Disney position on the Tematica Select List.

Why $101.50? Because our blended buy-in price is $101.50.

Even as we reset this stop loss level, we remain bullish on Disney shares given the slate of Marvel, Pixar and Star Wars films that will hit theaters in coming quarters. We are also encouraged by Disney’s other moves to spread the content wealth across its licensing and parks businesses as well as its exploration of streaming alternatives for ESPN.

  • As we boost our protective stop-loss on DIS to $101.50, our price target for the shares remains $125

 

 

Setting a Stop Loss on Facebook (FB) Shares

We’ve come to appreciate the volatile nature of corporate earnings season and we’re starting to see that once again these last few days. While we continue to see Facebook (FB) benefitting from its monetization efforts across its various social media platforms as advertisers embrace digital over radio, print and broadcast, we’ve noticed a something that could be a near-term issue. Over the last several weeks, we’ve noticed a shift toward people curbing their Facebook usage due to a growing sense of political outrage complete with over the top comments. This has prompted some to start referring to Facebook as “Hatebook”.

Our concern is all of this could lead to a softer short-term outlook than most might be expecting for the current quarter.

  • As such, we’re going to install a protective stop loss at $112 for our FB shares. Better to be prudent ahead of time, than sorry later is our thinking. 

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The full content of Tematica Investing is above; however downloading the full issue provides detailed performance tables and charts. Click here to download.

As the market scales new heights, we review our current holdings

As the market scales new heights, we review our current holdings

DOWNLOAD THIS WEEK’S ISSUE
The full content of Tematica Investing is below; however downloading the full issue provides detailed performance tables and charts.Click here to download.

Over the last few days, we’ve been attending the Inside ETF conference in warm and sunny Hollywood, FL. While we were focused on the latest developments in the ETF space, we’ve kept one eye on the markets and the renewed climb in the stock market, with the DOW tipping over the 20,000 mark for the first time in history just this morning.

With yesterday’s close both the tech-heavy Nasdaq composite index and the S&P 500 powered to new all-time highs amid news that President Trump is already getting down to business, the domestic manufacturing economy perked up further in January and the continued mixed bag of December quarter earnings.

As we shared in this week’s Monday Morning Kickoff, this is the first full week of the year that teems with both data and earnings, with the latter escalating as the week goes on and on into next week. Toward the end of the week, we get the first print on 4Q 2016 GDP and we close it out with the start of Chinese New Year. As that holiday begins, we’ll be looking for confirming points for our Affordable Luxury, as well as Rise & Fall of the Middle-Class themes.

This week we have four positions on the Tematica Select List reporting – Cash-strapped Consumer company McCormick & Co. (MKC), Connected Society player AT&T (T), Guilty Pleasure company Starbucks (SBUX) and Alphabet (GOOGL), which resides in our Asset-lite Business Model investing theme. This morning McCormick reported is 4Q 2016 results, and despite the impact of currency, which was expected given the company’s geographic mix, we found the results rather favorable and the same can be said for the outlook over the next year – more on that below.

After today’s market close, AT&T will share its full results for the December quarter. Last week the company pre-announced several metrics for its December quarter, but yesterday Verizon’s (VZ) results fell short of Wall Street expectations. As part of our monthly position review below, we’ve laid out some of those metrics as well as shared reporting dates for those companies that have made their reporting dates known. That’s right, today is the last Wednesday in January and it’s time to take stock (pun intended) of the positions on the Tematica Select List.

This week’s issue is jammed packed, with updates on the 15 of the holdings in the Tematica Select List along with our current ratings and guidance on each position. Given the length, we recommend you download the full issue by either clicking on the download button below or simply clicking here.

DOWNLOAD THIS WEEK’S ISSUE
The full content of Tematica Investing is above; however downloading the full issue provides detailed performance tables and charts. Click here to download.

A Wait-and-See Approach as Trump Inauguration and Earnings Cocktail Unfolds

A Wait-and-See Approach as Trump Inauguration and Earnings Cocktail Unfolds

DOWNLOAD THIS WEEK’S ISSUE
The full content of Tematica Investing is below; however downloading the full issue provides detailed performance tables and charts.Click here to download.

As you sit down and digest this latest issue of Tematica Investing, you’ll notice it’s a tad shorter than the usual 6-10 pages that we fill to the brim. On the one hand, we’re inclined to say “you’re welcome,” but the reality is with the market rangebound over the last 20 plus days, the presidential inauguration about to take-over the news cycle, the velocity of earnings reports about to pick up, and Eurozone drama likely to re-emerge in the coming days, we’ve opted to see how things unfold over the next several days before making any new moves with the Tematica Select List.

That said, the thematic tailwinds are still blowing for a number of our positions with a “Buy” rating, including: Facebook (FB), Nuance Technologies (NUAN), McCormick & Co. (MKC), Dycom Industries (DY), Universal Display (OLED), CalAmp Corp. (CAMP), United Natural Foods (UNFI), Starbucks (SBUX) and International Flavors & Fragrances (IFF).

With the market move over the last several weeks, we’d recommend subscribers continue to hold their positions in AT&T (T), Costco Wholesale (COST), Disney (DIS), Alphabet (GOOGL) and Amazon (AMZN), but wait for a pullback before adding any more capital to those positions. For new subscribers that means we’d recommend you watch from the sidelines for now on those positions.

 

Is the Trump Rally Over as Investors Keep the Markets Range Bound Since the New Year?

Since last week’s Tematica Investing, we’ve seen the overall stock market little changed, with the Dow Jones Industrial Average down slightly, the S&P 500 essentially flat and the Nasdaq Composite Index up a tick.

range-bound index

We’ve had a number of favorable moves on the Tematica Select List, with Facebook (FB) climbing more than 2 percent and Amazon (AMZN) up more than 1.5 percent with favorable moves in International Flavors & Fragrances (IFF), AT&T (T), Costco Wholesale (COST) and Universal Display (OLED) were had. Several Tematica Select List positions moved relative sideways during the week, like Alphabet (GOOGL) and Nuance Communications (NUAN), but we see that as treading water ahead of the earnings report deluge.

As the market braces for the deluge of fourth quarter earnings announcements, we continue to find confirming data for our active positions. Case in point, reports that smartphone vendors are concerned Apple (AAPL) could “monopolize OLED supply capacity for this year’s iPhone 8,” and are looking to secure organic light emitting diode capacity fits with our thesis and bodes well for our Universal Display (OLED) shares.

Another, even though we just added Disruptive Technology theme company Nuance Communications (NUAN) to the Tematica Select List last week, we continue to hear about new voice-enabled applications like the one from Adobe Systems (ADBE) called “intelligent digital assistant photo editing” that is more simply put a voice-controlled photo editor. We have to admit, we are rather excited for that one assuming it helps reduce the trial and error effort to touch up photos and get rid of all those red eyes.

As we mentioned above, we are preparing to drink from a firehose-like deluge of earnings announcements this week and the next few. As evidenced by what we’ve seen thus far from JPMorgan Chase (JPM), Bank of America (BAC), PNC Bank (PNC), United Continental (UAL), WD40 (WDFC), CSX (CSX) and Gigamon (GIMO) it’s going to be a rather mixed bag of reports over the coming weeks. Once again we’re seeing earnings misses relative to expectations lead to falling stock prices. Not a bad thing considering how far and how fast the stock market has jumped since early November, especially if you’ve been a prudent investor like we have been these past several weeks. During that time we added Rise & Fall of the Middle Class McCormick & Co. (MKC), Facebook (FB) as our latest Connected Society play and last week Nuance Communications (NUAN) given its disruptive voice technology.

While we could point out that all three have moved nicely higher, especially Facebook, which certainly has us feeling pretty good, it’s the opportunity to circle back to the ones that got away that has us rather excited this earnings season. It’s not that we want bad news, but rather the opportunity to buy well positioned, thematically driven businesses at better prices. That’s how we added Facebook shares to the Tematica Select List — we knew the company was a key player in our Connected Society investing theme, but we waited until we had a compelling risk-to-reward tradeoff in the share price.

This reminds us of one of “Uncle” Warren Buffet’s most used sayings, “Price is what you pay. Value is what you get.”

We suspect there will be far more value to be had in the stock market over the next few weeks compared to the last several as December quarter earnings kicks into gear. As we’ve shared in the last several issues of The Monday Morning Kickoff, expectations have been running high, but recently more investors have been scratching their heads as they put the economic reality puzzle pieces together and reassess what is “expected.” Making this even more challenging is we have the Volatility Index near its lowest levels in over a year. Looking at the chart below, the words “reversion to the mean” ring in our head.

What this tells us is should the news turn to something less than expected, we are bound to see a far more bumpy time in the market than the smooth sailing we’ve seen since early November.

 

President-elect Trump’s Tweets and Interviews Suggest a Bumpy Ride 

Unless you live under a rock or are stuck under a very large piece of furniture with no access to a TV or the internet (yes, the internet has become so ubiquitous that it now lowercase), you know this week also marks the presidential inauguration, which will dominate headlines over the next few days. While we will watch the events of the week and listen to the speeches and confirmation hearings for clues as to what’s to come from the new Trump administration, we won’t be shedding a tear as we move past the event and onto the work that needs to be done.

As that happens, we also hope that President Trump rethinks his Twitter (TWTR) usage, but not necessarily for the same reasons as the media. While we like the push to bring jobs back to the US and put a more effective healthcare program in place, as investors we are not fans of the policy-by-bullhorn we have seen.

What makes this even more challenging is we have yet to receive a holistic view on what President-elect Trump’s policies will be, and this “keep them guessing” approach of one-off pronouncements may be good for his intended deal making, it’s added a layer of uncertainty for the stock market, and as we know the market doesn’t like uncertainty.


As we’ve seen from president-elect Trump’s tweets and interviews, his words have the potential to be very disruptive to the investment playing field:

  • Earlier this month, close to $25 billion was shaved off the value of the S&P 500’s top nine pharmaceutical companies in a matter of minutes, following President-elect accusing them of “getting away with murder.”
  • Last week following a newspaper interview with President-elect Trump in which he warned he would impose a border tax of 35 percent on vehicles imported from abroad to the US market, German carmaker stocks sold off sharply.
  • The US dollar slumped to a seven-week low against Japan’s yen late Tuesday, and continued to trade lower against a slew of currencies early this morning after President-elect Trump said that the buck was “too strong”. In an article in The Wall Street Journal, Mr. Trump said the strength of the US dollar against China’s yuan “is killing us.”

 

Amidst All This Uncertainty, We’re Taking a Wait and See Approach 

We’ve encountered many disruptions in the past and odds are these current events won’t be last. Over the last few years, we’ve seen earnings season become a greater source of stock price volatility — miss EPS expectations by a penny, and we now see share prices fall 10-20 percent, far greater than the single digits selloffs that had been the norm. These tend to be short-term disruptions that give way to market forces, which means that as we continue to focus on thematic fundamentals, we’ll be vigilant for opportunities presented by wide swings in stock prices.

With this in mind, we’re holding off making any moves with the Tematica Select List this week as we instead digest company comments regarding the tone of the economy, impact of the dollar on their business outlook and of course the strength of our thematic tailwinds.

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The full content of Tematica Investing is above; however downloading the full issue provides detailed performance tables and charts. Click here to download.

Making a Nuanced Move With The Tematica Select Investment List

Making a Nuanced Move With The Tematica Select Investment List

DOWNLOAD THIS WEEK’S ISSUE
The full content of Tematica Investing is below; however downloading the full issue provides detailed performance tables and charts.Click here to download.

Over the last week, while many have been watching the Dow Jones Industrial Average flirt with 20,000, the Nasdaq Composite Index continued to climb higher. That led our Connected Society investment theme positions in Facebook (FB), Alphabet (GOOGL) and Amazon (AMZN) higher over the last week.

  • Even so, we still have ample room to our respective price targets for each of those positions and our buy rating on all three remains.

 

Over the last few months, we’ve been talking about the impact of food deflation, which has been confirmed by our Cash-strapped Consumer play that is Costco Wholesale (COST) as well as grocery chain Kroger (KR) and others.

We’ve also called out the inability of restaurants to harness that deflation for their own margins given minimum wage increases and other cost drivers. The latest findings from Fitch Ratings sees restaurant sales slowing this year, and the NPD Group expects traffic will be flat this year, with a 2 percent decline at dine-in restaurants offsetting a 1% increase at quick-service concepts.  We expect confirmation to be had this coming earnings season, and if Kona Grill’s (KONA) 4 percent decline in same-store sales for the December quarter is any indication it’s not going to be pretty.

Still, we know that people need to eat and are continuing to shift toward organic and natural foods and other products, which bodes well for our McCormick & Co. (MKC) and United Natural Foods (UNFI) shares. Recent findings from a new poll conducted by Pew Research Center underscore our bullish position. According to the Pew poll, 55 percent of Americans believe that “organic food, particularly organically grown fruits and vegetables, are healthier than conventional.” The same poll also showed a growing distrust of GMO foods and concern over pesticide use.

A different study conducted by the European Parliament’s Independent Research Service, titled “Human health implications of organic food and organic agriculture,” concluded that eating organic food improves early development, reduces pesticide exposure, strengthens the nutritional value of food, and mitigates disease risks.
We do not see this as a short-term fad and point to a recent report from Research and Markets that forecasts the global market for organic food to grow at “a CAGR of over 14 percent during 2016-2021, on account of high demand for organic food.”

  • Both MKC and UNFI remain Buys at current levels.

 

rogueonecharact-6d3c3120104-originalOn the continued strength of Rouge One at the box office and the news that Content is King investment theme company The Walt Disney Co. (DIS) is firming up plans for a streaming ESPN service, our Disney shares moved higher over the last several days.

The same can be said with our CalAmp (CAMP) shares following management’s presentation at the annual Needham Growth Conference that focused on its expanding market opportunities across fleet management, Connected Car and enterprise asset tracking markets.

Adding Nuance Communications (NUAN)
to the Tematica Select List as Voice Goes Big

Last week was the tech world descended upon Las Vegas for CES 2017. The annual trade show kicks off the new year and introduces a number of new consumer gadgets that we’re likely to see — some this year and others in the coming ones.

Among the sea of announcements, there were a number that focused on one aspect of our Disruptive Technology investing theme and that is the area of voice recognition technology. Over the years we’ve seen various incarnations of this technology, most recently with Siri from Apple (AAPL), Cortana from Microsoft (MSFT), Google Assistant from Alphabet (GOOGL) and Alexa from Amazon (AMZN). Each of these has come to the forefront like in products like Amazon Echo and Google Home that house these virtual digital assistants (VDAs), but for now one of the largest consumer-facing markets for voice interface technology has been the smartphone. Coming in 2016, Parks Associates found that nearly 40 percent of all smartphone owners use some sort of voice recognition software such as Siri or Google Now.

 

 

In 2016, the up and comer was Amazon as sales of its Echo devices were up 9x year over year this past holiday season and “millions of Alexa devices sold worldwide this year.” If you’re a user of Amazon Echo like we are, then you know that each week more capabilities are being added to the Alexa app such as ordering a pizza from Dominos (DPZ), calling for an Uber, checking sports scores and weather to getting holiday cocktail recipes.

As we entered 2017, Amazon announced that Prime members can voice-order their next meal through Amazon Restaurants on their Alexa-enabled devices including the Amazon Echo and Echo Dot. Once an order is placed, Amazon delivery partners deliver the food in one hour or less. Pretty cool so long as you have Amazon Restaurants operating in and around where you live.

 

 

Virtual digital assistants cut across more than just smartphones and devices like Amazon Echo and the recently announced Google Home. According to a new report from Tractica, while smartphone-based consumer VDAs are currently the best-known offerings, virtual assistant technologies are also beginning to penetrate other device types including smart watches, fitness trackers, PCs, smart home systems, and automobiles.

We saw just that at CES 2017 with some landscaping changing announcements for VDAs. Alphabet had several announcements surrounding its Google Home product at CES 2017, including integration into upcoming Hyundai and Chrysler models; and acquiring Limes Audio, which focuses on voice communication systems, and will likely be additive to the company’s Google Home, Hangouts and other products. Microsoft also scored a win for Cortana with Nissan.

While those wins were impressive, the big VDA winner at CES was Amazon as it significantly expanded its Alexa footprint on deals with LG, Dish Network (DISH), Whirlpool (WHR), Huawei and Ford (F). In doing so Amazon has outflanked Alphabet, Microsoft and even Apple in the digital assistant market. To us, that’s another leg to the Amazon stool that offers more support to the share alongside the digital shopping/services, content, and Amazon Web Services businesses. You don’t need to read between the lines to think that we still see big upside to our $975 Amazon price target.

To be fair, Apple originally did not license out its Siri technology and only in June 2016 did it announce that it would open the code behind Siri to third-party developers through an API, giving outside apps the ability to activate from Siri’s voice commands, and potentially endowing Siri with a wide range of new skills and datasets.
Tractica forecasts that unique active consumer VDA users will grow from 390 million in 2015 to 1.8 billion worldwide by the end of 2021.  During the same period, unique active enterprise VDA users will rise from 155 million in 2015 to 843 million by 2021.  The market intelligence firm forecasts that total VDA revenue will grow from $1.6 billion in 2015 to $15.8 billion in 2021.

 

An Overlooked Player in the VDA Segment

Nuance Communications logoThe one drawback when it comes to the VDA market is the players mentioned above have large existing businesses, which means their respective VDA businesses, at least in the next few yeas, will have at best modest influence on their overall financial picture. In keeping with our “buy the bullets not the guns,” coming out of CES 2017 we find ourselves looking at speech technology and voice recognition company Nuance Communications (NUAN).

Nuance’s voice solutions compete in four markets:

  • Healthcare (49 percent of revenue): In this business, Nuance supports clinical documentation workflows and electronic medical record (EMR) adoption through flexible offerings, including transcription services, dictation software for the EMR, diagnostics workflow, and mobile applications. Recently Nuance released Dragon Medical Advisor, an AI Assistant for doctors. More than 500,000 clinicians and 10,000 healthcare facilities worldwide use Nuance’s healthcare solutions, which are sold through customers that include Cerner (CERN), Epic, McKesson (MCK), UPMC, Cleveland Clinic, Siemens, and the Mayo Clinic. Over the last few quarters, Nuance has been transitioning this business from a perpetual license business to a software as a service (SAAS) one, but with that shift expected to be largely completed by the second half of 2017 that revenue drag should be eliminated.
  • Enterprise (20 percent of revenue): This business segment offers automated intelligent self-service solutions that include speech and artificial intelligence (AI) technologies that reduce or replace human contact center agents with conversational systems, across voice, mobile, web and messaging channels. Think of when you call your bank, broker or even consider using the phone to call for a pizza from Dominos (candidly we’re not sure why you would call given the ease of the Domino’s app that can be used on either your smartphone, Apple TV, or Amazon’s Alexa, but hey that’s us). Representative customers include Avaya, BT, Cisco, DiData, Genesys, Huawei, MoshiMoshi, NICE, Telstra, and Verint. Nuance’s customers include: American Airlines, Amtrak, Bank of America, Barclays, Dominos, Delta, Deutsche Telekom, e*trade, ING Bank, Lloyds Banking Group, T-Mobile, Telefonica, Telstra, and Vodafone.
  • Mobile (19 percent of revenue): Here Nuance offers a portfolio of specialized virtual assistants and connected services built on voice recognition, text-to-speech, natural language understanding, dialog, and text input technologies across automotive, device and mobile operator solutions. With regard to automotive in particular, Nuance has announced Daimler, Ford and BMW as customers, and as evidenced at both CES 2017 and the 2017 North American International Auto Show we are nearing the tipping point for the Connected Car, which should bode well for this business segment.
  • Imaging (12 percent of revenue): In this division, segment Nuance provides software solutions and expertise that help professionals and organizations to gain optimal control of their document and information processes. Customers and partners include Ricoh, Xerox, HP, Canon, and Samsung. This business has been bumping along at around 11 to 12 percent of revenue the last few years as Nuance has reorganized itself over the last several quarters.

When we step back from Nuance’s business segments and look at the overall market growth for voice recognition technologies, BCC Research sees it growing to $184.9 billion in 2021, up from $90.3 billion in 2015. Breaking these two markets down into Consumer and Enterprise markets, BCC expects the Consumer market to grow to $95.9 billion in 2021 from $54.4 billion in 2016 and the Enterprise market to reach $79.0 billion by 2021 up from $44.0 billion in 2016. Viewed against that larger market, we see ample room for Nuance to expand beyond the $1.9 billion in revenue it generated in 2016.

Over the last few years, after delivering significant revenue growth during 2010-2014,  the pace of revenue growth, while positive, has dipped. Part of that is due in part to erosion for the transcription business in the company’s Healthcare business, as well as the shift from a contract business model to a Cloud based one that offers integrated solutions. In 2016, roughly 70 percent of the company’s revenue stream was recurring in nature, up from 65 percent or so in 2015.

What this tells us is the bulk of the revenue shift is largely behind the company. Like a turning tanker, these changes take time, but once they catch momentum they tend to pick up speed and Nuance should see its recurring revenue growth to 70-75 percent of overall revenue during 2017. As investors, we like the nature of a recurring revenue model, given that it affords far greater visibility and shares tend to be rewarded with better multiples given that predictability.

We’ve seen the power of this business shift already at Adobe Systems (ADBE), which now has more than 70 percent of its revenue recurring in nature, up from 19 percent in 2011, and its shares that have climbed to just over $108 from $28 at the end of 2011.

Looking Ahead to 2017 for Nuance

The growth businesses at Nuance include its automotive, voice biometrics, omni-channel customer care, unified print and scan solutions, Dragon Medical, CDI and diagnostics. Paving the way is the company’s most recent quarterly bookings, which were up 45 percent year on year. Longer-term we expect more applications across the consumer electronics market to develop. As noted above, Whirlpool is working with Amazon and odds are that means before too long we’ll see VDAs built into various appliances across the kitchen and laundry rooms. In our view, that’s just scratching at the surface.

The big question circling Nuance is the competitive landscape, particularly the move by Amazon, Alphabet and Apple to open up their application programming interface (API) to third-parties. Just like Rackspace (RACK) specializes in Cloud computing, but thus far has remained unharmed by Amazon’s AWS, Nuance specializes in selling to global brands, health care, and large corporations, which are not likely to utilize Google’s free API for its business needs. As you’ve probably notice with Android, one of the issues with a free API is malware and cyber hacking.

It’s also not lost on us that Alphabet recently acquired Limes Audio to improve its voice recognition capabilities. As anyone who has used Apple’s Siri knows, it’s far from perfect in voice recognition and voice to text. In our view, this means Nuance could be an attractive candidate for a larger player that needs to improve its technology positioning.

 

What are NUAN shares worth?

In looking over historic multiples, including P/E and Enterprise Value to Revenue, and applying them to consensus 2017 earnings expectations that call for EPS of $1.59 on revenue of just over $2 billion, we see upside to $21 and downside to just under $15.

At the current share price — $15.45 as of market close on 1/10/17 — NUAN shares are trading at under 10x expected 2017 earnings of $1.59 per share. We certainly like that risk-to-reward trade-off in NUAN shares at a time when voice technology is expanding its market size across the device, automotive and Internet of Things markets.

 

Bottomline on Nuance Communications (NUAN)
  • We’re adding NUAN shares to the Tematica Select list with a price target of $21.
  • Because this is a new position, we are holding off with a stop loss recommendation at this time, preferring to use near-term weakness to scale into the position and improve the cost basis.

 

* We strongly recommend you use the link below to download the full report on Nuance Communications (NUAN), which includes background on our Disruptive Technology thematic as well as financials on NUAN.

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