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International Business Machines Corp. (IBM), Microsoft Corporation (MSFT): Should We Follow Icahn Into Nuance Communications Inc. (NUAN)?

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Billionaire activist investor Carl Icahn has gotten active again by accumulating a 9.3% stake in Nuance Communications Inc. (NASDAQ:NUAN), a voice and language solutions provider to businesses and consumers globally. After Icahn’s stake was publicly disclosed, Nuance Communications Inc. (NASDAQ:NUAN) surged as much as 9%. However, since the beginning of the year, Nuance has experienced a significant decline of around 13.4%. Should investors follow Carl Icahn into Nuance at its current trading price? Let’s find out.

Nuance Communications Inc.

Business snapshot

Nuance Communications Inc. (NASDAQ:NUAN) is considered the leading provider of voice and language solutions for use in the healthcare, mobile, enterprise customer service, consumer, and imaging markets. The company operates in four main business segments: Healthcare, Mobile and Consumer, Enterprise, and Imaging.

Nuance Communications Inc. (NASDAQ:NUAN) derived the majority of its revenue, or 39% of total 2012 revenue, from the Healthcare segment. Mobile and Consumer ranked second, representing 29% of total revenue, while the Enterprise segment and Imaging segment accounted for 19% and 13% of total sales, respectively.

In 2012, professional services and hosting was the biggest revenue source, with $674 million in sales. Product and licensing sales ranked second, contributing $740.7 million in revenue, while the maintenance and support generated nearly $237 million in sales. In terms of geography, Nuance Communications Inc. (NASDAQ:NUAN) derived most of its revenue, nearly $1.2 billion, or 71% of total sales, from the U.S.

A consistent growing business but negative tangible book value

In the past five years, Nuance has demonstrated a consistently improving performance in both its top and bottom lines. Revenue increased from $868 million in 2008 to $1.65 billion in 2012, while net income rose from $(30) million, or a loss of $0.14 a share, to $207 million, or $0.65 per share during the same period.

What makes me excited about Nuance is its ability to generate increasing cash flow. While operating cash flow has risen from $196 million to $473 million since 2008, its free cash flow has also climbed from $142 million to $410 million in the past five years.

Nuance seems to have an overleveraged operation. As of December 2012, it had $2.78 billion in total stockholders’ equity, $961 million in cash, and nearly $2.4 billion in debt. What makes me worried is the high level of goodwill and intangible assets, of as much as $4.2 billion. Thus, the company had a negative tangible book value of $1.42 billion.

It has quite an expensive valuation but the lowest profitability

At around $21 per share, Nuance is worth about $6.7 billion on the market. The market values Nuance quite expensively at 20.4 times EV/EBITDA. Compared to its much bigger peers, including International Business Machines Corp. (NYSE:IBM) and Microsoft Corporation (NASDAQ:MSFT), Nuance is the least profitable company, but has the highest valuation.

International Business Machines Corp. (NYSE:IBM) is trading at around $212 per share, with a total market cap of $235 billion. It is valued at only 9.67 times EV/EBITDA. Microsoft Corporation (NASDAQ:MSFT) is the biggest company of the trio with a total market cap of nearly $240 billion. At around $29 per share, Microsoft is valued the cheapest at 6.44 times EV/EBITDA.

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