Cerence Inc. Fiscal 2019 Form 10-K Summary
Business context and reporting period
Cerence provides embedded and cloud-connected automotive cognitive-assistance software, including speech recognition, natural-language understanding, virtual assistants, multimodal interfaces and connected services. Customers include major automobile manufacturers and tier-one suppliers worldwide. The report covers the fiscal year ended September 30, 2019. Cerence was wholly owned by Nuance Communications during the periods presented and completed its tax-free spin-off on October 1, 2019; its common stock began regular-way Nasdaq trading on October 2, 2019 under “CRNC.”
The historical financial statements are combined carve-out statements, including allocations of Nuance corporate costs and using Nuance’s centralized cash-management structure. They may not represent the results, costs, financing or liquidity Cerence would have had as an independent public company.
Financial performance and position
| Metric | Fiscal 2019 | Fiscal 2018 | Change |
|---|---|---|---|
| Revenue under reported accounting | $303.3 million | $277.0 million | Up 9.5% |
| Gross profit | $204.0 million | $194.0 million | Up 5.1% |
| Gross margin | 67.2% | 70.0% | Down 2.8 points |
| Operating income | $10.9 million | $36.9 million | Down 70.5% |
| Operating margin | 3.6% | 13.3% | Down 9.7 points |
| Net income | $100.3 million | $5.9 million | Up substantially |
| Cash flow from operations | $88.1 million | $115.3 million | Down 23.6% |
Revenue consisted of $172.4 million of license revenue, $78.7 million of connected-services revenue and $52.2 million of professional-services revenue. On a comparable ASC 605 basis, fiscal 2019 revenue was $306.5 million, up 10.7%, and operating income was $14.1 million, producing a 4.6% operating margin. Fiscal 2019 results adopted ASC 606 using the modified retrospective method, limiting direct comparability with prior periods.
Net income was substantially affected by an $89.1 million income-tax benefit, including a net benefit of approximately $91.7 million related to intangible-property transfers, partially offset by uncertain tax positions and $3.9 million of GILTI expense. The effective tax rate was negative 796.5%, compared with 84.0% in fiscal 2018. Pre-tax income was only $11.2 million.
At September 30, 2019, total assets were $1.48 billion, total liabilities were $415.7 million, deferred revenue was $353.3 million, goodwill was $1.12 billion and net deferred tax assets were $150.6 million. Historical balance sheets did not include Cerence debt or cash because of Nuance’s centralized financing arrangements.
Material changes versus the prior comparable period
- Connected-services revenue increased 32.2% under ASC 605 to $79.6 million, reflecting increased adoption of hybrid solutions.
- Professional-services revenue increased 20.2% under ASC 605 to $54.9 million, while its gross profit remained low at $4.4 million.
- Research and development expense increased 15.0% to $93.1 million as Cerence expanded engineering and product-investment personnel.
- Restructuring and other costs increased to $24.4 million from $12.9 million, primarily due to costs of establishing Cerence as a standalone public company.
- Operating cash flow declined primarily because of unfavorable working-capital timing and lower deferred-revenue-related cash generation.
- Fiscal 2018 included $79.8 million of cash acquisition payments for Voicebox; fiscal 2019 investing cash use was only $4.5 million.
- Approximately 52% of vehicles shipped during fiscal 2019 were estimated to include Cerence technology, compared with approximately 48% in fiscal 2018. Hybrid solutions shipped on approximately 7.8 million vehicles, up about 37%.
Liquidity, debt and commitments
Upon the spin-off, Nuance allocated $110.0 million of cash and cash equivalents to Cerence. Management stated that operating cash flow, available cash and revolving-credit availability should meet near-term needs. However, the historical cash-flow statements show no cash balance because of the prior centralized cash-management structure.
On October 1, 2019, Cerence entered into a $270.0 million senior secured term loan and a $75.0 million senior secured revolving facility. The revolving facility was undrawn as of December 19, 2019. The term loan matures five years after issuance; quarterly principal payments begin March 31, 2020. Interest is generally based on LIBOR plus 6.00% or a base rate plus 5.00%. The facilities are secured by substantially all specified assets and contain restrictive covenants, including a maximum net first-lien leverage ratio of 6.00 to 1.00.
Contractual operating and capital lease obligations totaled $26.5 million as of September 30, 2019. Fixed backlog was $408.9 million, including $353.3 million of remaining performance obligations and $55.6 million of uninvoiced contractual commitments. Estimated variable backlog was $955.7 million, producing adjusted backlog of approximately $1.36 billion; management expected approximately 50% to be recognized over the following three years. Backlog estimates depend on vehicle shipments, contract changes, cancellations and foreign-exchange movements.
Outlook, commentary, risks and unusual items
- Management plans continued investment in research and development, cloud-connected functionality, third-party assistant interoperability, China and other geographic markets, and additional functionality for the installed base.
- Management expects R&D to remain the largest operating-expense category. The shift toward cloud-connected services may increase development and delivery costs and could pressure near-term margins.
- Revenue and cash flow are exposed to automotive production cycles, customer vehicle shipments, contract timing, royalty reports, pricing pressure and customer concentration. Toyota represented 21% of fiscal 2019 revenue; two customers represented 33.0% in the detailed revenue disclosure.
- Risks include competition from large technology companies and specialized vendors, loss or delay of major customer programs, cybersecurity and privacy incidents, software defects, intellectual-property claims, foreign-exchange and international operating risks, and dependence on skilled personnel.
- The spin-off creates execution risks, including building independent information-technology, finance, legal, human-resources and other corporate infrastructure, increased public-company costs, and reliance on transition services from Nuance.
- The tax-free status of the spin-off depends on specified representations and covenants. Cerence could owe material indemnification to Nuance if the transaction becomes taxable under applicable circumstances.
- Legal proceedings and intellectual-property claims arise in the ordinary course. Recorded legal reserves were not material, and management did not expect existing matters to have a material adverse effect, although outcomes remain uncertain.
- Goodwill impairment was not recorded in any period presented, but goodwill represented approximately $1.12 billion of assets and remains subject to future impairment risk.
Most important facts for investors to verify
- Reconcile reported ASC 606 results with ASC 605 results before assessing revenue growth, margins and year-over-year trends.
- Separate the $89.1 million tax benefit from recurring operating profitability and verify the sustainability of the company’s future effective tax rate.
- Review post-spin-off cash balances, term-loan amortization, interest expense, covenant compliance and the availability of the revolving facility.
- Assess customer concentration, especially Toyota and the major tier-one suppliers, and verify the conversion of fixed and variable backlog into recognized revenue.
- Evaluate whether connected-services growth can offset pricing pressure, professional-services margin pressure and the company’s elevated R&D and standalone-public-company costs.
- Review the tax matters, intellectual-property, transition-services and employee matters agreements with Nuance for potential obligations or operating restrictions.