Cerence Inc. (CRNC) Earnings Call Transcript & Summary

Thanks, everyone, for joining. Welcome. My name is [indiscernible], and I'm part of the software team at Credit Suisse. Excited to be here and excited to have -- both Mark and Rich with us. Thank you for coming.

Thank you.

Maybe for those less familiar with the story, would really appreciate maybe you sharing your vision for the company and maybe telling us a little bit about how your products create value for your customers.

Sure. Yes. So Cerence actually spun out from Nuance Communications 2 years ago. So even though we're a newly -- fairly new minted public company, the company has been around and the technology has been around for several decades now. And so Nuance made a strategic decision to spin us out, and we became a separate independent company back on October 1, 2019. But basically, what Cerence does is we provide a lot of the voice AI and connected technology that goes into the automobile. And so -- and other mobility spaces as well. But basically, our technology is there to enable a safer, more enjoyable experience for the consumer, for the end driver and other passengers in the automobile. So essentially, that's what we do. The value add, obviously, as the car gets more and more digital, and the car gets more and more connected, our technology is becoming more central to that digitization of that automobile. And so it's becoming far more strategic than it has been over the last 5 to 10 years. And so the auto OEMs are really viewing this sort of technology as a way to differentiate their brand in the future. In the past, it used to be 0 to 60x in horsepower and many other features, but now a lot of consumers are coming into the auto showrooms and talking more about the infotainment and the digital experience. And voice is obviously a very key component of that because you don't want distracted drivers. So it's a safety feature. It's a convenience feature, and it is becoming, like I said, more central to the digital car.

Maybe on that point, could you talk to us a little bit about what your market opportunities like maybe both in terms of where your content per vehicle has been historically and where it's trending and also help us better understand as you're getting more strategic and more important, where you see penetration rates in vehicles going over time?

Yes. Well, that's actually the crux of the story for Cerence, right, is the secular tailwind that's happening. And it hasn't started just now. It's been going on for a number of years, where cars are getting more and more digital, cars are getting more and more connected. And so those trends are not slowing down. If anything, they're accelerating. And so we track that penetration rate with -- by using a lot of IHS information and forecast. And those forecasts have actually gone up, which is good. So we see even more acceleration happening. We sell 2 products. One is the edge AI or embedded technology. And that's what -- that's where our technology gets designed into the infotainment system. And then the other portion is the connected capabilities. And so on the edge or the embedded technology approximately as of last year, approximately 69% of worldwide vehicles had some level of edge AI capability built into it. That penetration is expected to grow to about 82% in 2024. So that's what's allowing us to grow above the auto industry growth rates, right? And that's just on the edge component. On the connected side, it's even stronger growth because the penetration rates are lower. Last year, I think it was around 49% of all vehicles, and that's expected to grow into the high 60s over that same time period, so 2024. So that's a little bit of a steeper curve than the embedded, which has got more penetration today versus in the past. So that's the opportunity for us, is embedding our edge capabilities into the infotainment system. And as more and more cars get connected, we're in a really good position to leverage our large installed base on the embedded side and grow our connected services as well. In addition, there's other market opportunities. We've recently -- over the last 12 to 18 months, we've recently introduced new applications and services. For example, Cerence Pay, which uses voice biometric technology to help consumers pay for transactions like, let's say, the gas pump, for example, to just simply authorize those transactions by using your voice, okay, instead of pulling out a credit. card. We've got also other applications such as tour guide and Car Life to basically add more value to the end consumer. So we're adding more applications beyond just the core hosting capabilities. And so that's another vector for us to grow.

Could investors think of part of your revenue opportunity as a dollar content per vehicle? And maybe help us understand what there is today. And maybe on the 3 different kind of opportunities that you've talked about, how is it different? And how do you see it kind of curbing over time?

Yes. So I kind of think of our vectors for growth as kind of like a layer cake, if you will. So that first layer is going to be our embedded AI technology first. And we typically get around $4 or $5 per car, and that's a onetime perpetual license. And then layered on top of that is as more and more cars get connected, we provide that -- we can provide that connected service as well. And so that would be another vector for our growth that gets added on top of that $4 or $5 per car, for example. And so those connected services is more of a recurring revenue, right, because most of our contracts when the initial subscription period starts, it's for multiple years. It could be 4, 5, 6-plus years. And we're actually seeing those commitment periods trending higher as more and more of our customers, which is the auto OEMs or B2B, by the way. And so as our customers see that the connected car is not going away, they're feeling more comfortable committing to longer periods of time. So we're actually seeing a good trend there. And then layered on top of that would be new applications and services, which I talked about, which is Cerence Pay, Tour Guide, Car Life and then other things as well. And that, I think, as you layer these different revenue streams on top of one another, our goal and our vision, of course, is to get more content per vehicle. And that could, I believe, over time, approach that $20 per car.

So you said a perpetual is 4% to 5%?

Yes.

The subscription...

The subscription -- it depends because a lot of -- it depends on the length of the contract period. It depends on the number of domains that the customer wants us to host. I'd say that could be another $4 or $5 per car, and that could be assuming maybe a 5-year period, so call it about $1 per car per year kind of thing. And then the next layer would be the applications. And those are going to be a different model. Those are going to be more transaction-based, or they could be subscription-based or they could be a combination of the two. And so those are still early on. And so that business model is a little bit more difficult to articulate right now. But we are seeing good demand and good interest from the auto OEMs to adopt some of those new applications and integrate those into the next-generation platforms.

Could you help us understand the relationships you have with auto OEMs? To what degree are you really a strategic partner for them as they're defining what the future will look like for their customers?

Yes. That's actually trended in our favor. If you went back 10-plus years ago, we were probably less strategic to them. It was more, hey, the Tier 1s would make the decision if there is going to be a voice provider or voice technology to get designed into the car. We still obviously work very closely with the Tier 1s, but ultimately, that decision now because the car, like I said before, is getting more digital, those decisions are happening at the auto OEM level now. And so they're the ones making the decision, do we go with Cerence or do we go in another direction? And then once that decision is made, we'll work directly with the auto OEM and/or work with the Tier 1s as well.

What are the implementation time lines like for your technology?

Good question. I'd say on average, it's -- once a decision is made to adopt Cerence, for example, for embedded, we'll start working. That's the first piece of the whole activities. We'll start working directly with Tier 1 as well as the auto OEM with our professional services team. And typically, from when we book something to when start of production occurs, it's around a 2- to 3-year window. So it's a long cycle, right? And so when we get a booking today, for example, you won't necessarily see revenue coming from those cars for the license or for the connected for a few years out. However, you will see the professional services revenue. And so we price for our PS business as well. So you get the booking and then you first start to work with the OEMs on the integration and any sort of customization work that needs to get done. And then after that, after a few years, then you'll start to see the license and the connected.

You got to have a fair bit of visibility in your business model?

It's a pretty good visibility. We just finished our fiscal year, and we have approximately $2 billion in backlog. And so it does give us pretty good visibility with all the different design wins and those commitments. We don't get volume commitments from our customer. We get forecast, of course, but we do get contractual commitments that they said, okay, we're going to design in Cerence for this next generation car platform. And usually, those platforms, as you know, they don't -- it's not just for a single model year, you get designed in for the next platform decision, which is typically like maybe a 3- to 5-year platform. So it's -- you get locked in pretty nicely. And so yes, it does give us pretty good visibility.

Could you help us understand the competitive landscape a little bit? And in particular, maybe in terms of your new product wins. To what degree are they split between, call it, greenfield opportunities technologies that haven't been in the vehicle before and you are now coming in and implementing them versus maybe some sort of competitive displacements?

Yes. So the competitive landscape, I probably put it into 2 buckets, right? One is smaller niche players because we are the global leader for voice AI. And so you do have some smaller niche players. For example, in China, we would compete against companies like Highfly tech, right? And they're a good competitor. They're very focused on the China market. And so we would typically run into them. There's another company you may have heard of SoundHound, who just announced a SPAC that they're trying to do. They're based in California, a much, much smaller company. Actually, as a matter of fact, a lot of their disclosures just came out over the past month, and I was kind of surprised as to how small they actually really are. But they do have technology that would compete with us on the embedded plus on the connected side. And then on the other side is large tech giants, right? There's no surprise that the Googles and the Amazons of the world, they're trying to get into the car because their business model is to try to mine for data and monetize that data, e-commerce. And so we do see them trying to get into the vehicle. But that tends to be more of a coexistence with the large tech giants as opposed to a head-to-head competition. And the auto OEMs, they are also trying to find ways to monetize all this data that gets created inside their vehicles, and they look at that as an opportunity to monetize themself. And so the auto OEMs and the large tech giants, there's some friction there because they both want to monetize some of that e-commerce and that data that is created inside the car. On the other hand, Cerence enables that technology for the auto OEMs. So we're very well aligned with enabling this opportunity for the auto OEMs. Whereas I think the large tech giants, they tend to have more friction with the auto OEMs. And that's one of the key differentiators for us, is that we're the white label provider. And we help the auto OEMs differentiate their brand. And we can easily coexist with the Amazons and the Googles of the world. So it's not necessarily always going to be a decision one way or the other. It could be a coexistence.

Do you have a sense for vehicles that have both, let's call it, bring your own device capabilities of CarPlay or Android Auto and some sort of branded voice AI capability. What percent of the time will end users use one or the other in the vehicle?

Yes, it's a good question. I'll see if Rich wants to...

Yes. So I think it comes down to what is the easiest system to use and for what you're trying to accomplish, right? And the big differentiation between what our technology does versus an Apple CarPlay or Android Auto is that we are embedded inside the head unit, which means we have access to all the sensors, cameras, microphones located anywhere in the car. And we have -- we can leverage that data to create more capabilities in our technology. So we can do things like realize how many people are sitting in the car. And if there's more than 1, when the driver is looking to do a navigation rule, we can look for high occupancy vehicle routing, right? So we can leverage different types of things from being embedded in the car that the Apple CarPlay or the Android auto can't do. The other thing is all the automakers, they want their customers. They're spending a lot of money to develop the systems inside the car because the only opportunity for them, the automakers to make money beyond the sale of the car is by having the drivers use the embedded system. When you use Apple CarPlay or Android auto, all the data that's generated, that's being monetized or potentially being monetized goes through the phone. The automaker has no access to that data. So it's only when that data is flowing through the system that's embedded that the carmaker looks to have the opportunity to monetize it. And therefore, they're spending a lot of time and effort and money to create that system that takes the full digital life from outside the car, seamlessly translates it or transforms it to inside the car, but their own branded system versus one of the other ones, the mobility ones.

As infotainment has become just a general multimedia experience that cars become more important to the OEM, how have you seen their internal capabilities evolve? And are they may be bringing some of this in-house?

Yes. I think the auto OEMs, they understand that in the future, it's going to -- a lot of their differentiation and their livelihood is going to be around the infotainment system or the digital experience. And so they are pumping hundreds and millions of dollars into their own R&D efforts. And they understand that they need to be able to control their own destiny, and that's why I think a lot of them are taking this pretty seriously and investing very heavy amounts. I think when it comes to voice, I don't see that as being a good use of their time to try to develop their own voice capabilities. It takes a very, very long time to get to the point where Cerence is. This didn't happen 2 years ago when we spun out from Nuance. It's taken decades to get to the number of languages that we cover. We provide more language coverage than anybody out there, 70-plus. And our voice is not an AI technology, it's not a general purpose like the large tech giants, they've created general purpose voice technology. Ours is vertically focused for the auto industry. So it's really optimized for that experience. There's a lot of things that are to happen in the car, in-cabin noise and road noise and so forth. And we've developed our technology to optimize that experience under those conditions. And those general purpose solutions, really, I don't think can provide that same experience versus us.

Maybe shifting gears a little bit. Could we talk a little bit more about Connected Services? And maybe help us understand what type of traction you're seeing both in terms of design pipelines from your OEMs. But also as you have content in the vehicle, to what degree does the install base then become monetizable for new products? So maybe remind us how many vehicles you have on the road today and to what degree you could turn on certain features, call it OTA, and monetize those?

Yes. So I'll start, and Rich, you can jump in as well. Today, we are shipping -- our technology at some level is shipping in over 1 out of every 2 vehicles, a little bit. I think last quarter, our KPI was around 53% of all cars shipped worldwide have some level of Cerence technology built into it. Our embedded technology, we have very high market share. I think it's about 80%. So very, very significant share on the embedded portion. The connected, there's other options, right? You don't have to necessarily use the Cerence connected capabilities. Even though we are embedded in most of those vehicles, you have other options. And many auto OEMs have decided to host some of the connected services themselves. So they could be competitors of ours. But do you have other choices as well? So our share -- even though our share is high there, we have about 25% to 30% share, which still probably puts us in the #1 position. There are other options on the connected side. I think as more and more cars get connected, it's our view that it's a natural choice for the auto OEM to just combine the 2 and why separate it, right? Why not have your embedded supplier and partner as well as your connected partner just do the same. And so I think we're in a pretty good competitive position to continue to grow that part of our business. Not to mention the secular part, that's a steeper growth curve because there's fewer connected cars out there, and that's expected to grow. As of last year, IHS upped their forecast on how this technology is going to grow over the next 3, 4, 5 years. So that's a good trend. I think that's going to benefit us as well.

I think from the over-the-air update perspective is that there's still a relatively small percentage of cars today that have that capability. But as that continues to grow as a percentage, you'll find much more -- today, when we develop a new application and so forth, what customers are tending to do is saying, that's great, I'm going to bundle that into my next-generation capability, right? Whereas we've designed a product such that you don't have to wait for the next generation, you can do it from an over-the-air update. So I think as more of that digitalization of the car takes place and OTA becomes more standard, that gives us more opportunities to roll out a lot of our new products on a much faster schedule than we do today.

Do you have a sense of what percent of your -- what percent of the vehicles in which your technology is in today has OTA capabilities?

I don't have. I'd be merely speculating. So I don't have any quantifiable numbers for you. But what I do know is like Rich said, that is a growing trend, where the auto OEMs, historically, they've combined the hardware and the software and they basically create those solutions that are integrated in the future, they're seeing those 2 activities being separated. Hardware design and then the software implementation are now getting decoupled. And so -- as a result of that, there's going to be more OTA opportunities in the future. That's definitely a growing trend.

Great. Maybe looking back over the last 18 months, as you've executed on your strategy, maybe help us understand what will you have done differently?

Gosh. So much has happened over the last 18 months with COVID and then with the semi shortages. I think the company has done a really, really good job of adapting to a lot of unknowns, a lot of unforeseen, the Black Swan event, if you will, with COVID, especially. And so I think we've been -- we're very flexible. We adapt very rapidly to a changing environment. Personally, I don't think there's anything we would have changed. I mean there's always little things here and there. But in terms of like the big decisions, I think we've done a really nice job as a company adapting to a pretty rapidly evolving environment. And so unfortunately, I don't think I can tell you if there's anything in particular that I'd want to change because I really don't think there is anything.

Maybe let's see if there are any questions from the floor. Please go ahead. Would you mind just coming up to the mic. Thank you so much.

Maybe if you could just quickly touch on the margin profile of the business at the gross level and the operating margin?

Yes. Thank you. Gross margins are in the mid- to high 70s. We are a software-only business. So as a result, we do enjoy pretty nice margins. Operating margins or I'll go to EBITDA margins because that's what a lot of people look at, which is similar to the operating margins as well. But we -- last fiscal year, for example, we did 40% adjusted EBITDA margins. And we cautioned investors a year ago, don't get used to these margins because we did adapt the business model because of COVID, right? So we cut back our contractors. We stopped hiring. We've put a hiring freeze in place, and of course, travel budgets went to 0. And so as a result, our margins were very nice. I mean, we -- there were a couple of quarters where we actually north of 40% EBITDA. But for all of last fiscal year, we were 40% and this year, we're forecasting that to be around 37-ish type percent for EBITDA margins because we are going to keep investing in R&D. We're going to keep investing in our Pro services. That's our livelihood. And we want to keep extending our technology lead. And so we're -- we've got the projects, we've got the opportunities in front of us. And we think the best way for us to grow that top line is to keep investing in R&D and keep investing in our professional services team. So even though the margins have come down from last year from 40% to, call it, 37-ish percent, it's very -- still very, very good leverage to the business. And also we do have a 2024 target model out there, which has us at around 37% EBITDA margins as well. So we're already there. And now it's just a question of what else can we do to make it even more efficient. But right now, we feel pretty good about the margin profile and the consistent profitability that we've been able to achieve.

We have time for 1 more question.

Sure.

Maybe I'll kick off the last one. More of a general question. What technology or trends do you think will happen faster than anyone expects over the next few years?

I would say it's going to be the car getting more connected faster than what people think. I was really encouraged when I saw the IHS update last year where they upped their numbers. And I think I sort of look back -- it's probably over 15, almost 20 years ago now when tire pressure sensors first got introduced into the auto industry. And that was really just for the high-end vehicles. But that technology trickled down very, very rapidly into mainstream automobiles to the point where now practically everything has gotten. Now of course, government mandates and regulations help accelerate that. But when it comes to semiconductor technology or software technology, it evolves faster than people think, right, and cost downs for semiconductors and so forth. Performance goes up, cost goes down. It just happens faster than what people think. And so I think for our part of the industry, the connected vehicle is hugely valuable for all consumers. And I think everyone sees that value. And as a result, I think it's going to get adopted quicker than what people think.

What was the key driver behind that, call it, upgrade in penetration rates?

Good question. I'm not really sure why they upgraded it. I would probably just assume that they were just seeing the next-generation vehicles getting designed faster -- getting connectivity designed in faster.

Yes. I mean it comes back to your carmaker. Do you want to monetize just at the point of sale or monetize the life of the car, right? And if it's connected, that gives you opportunity to monetize the life of the car.

Great. Well, Mark. Great, Rich. Thank you for your time.

Yes. Thanks, everybody.

Thank you.