2021 Strategy Series – 2nd Highest Conviction Company for 2021 – Cerence (CRNC)

Vested with initial price at US$53.50 and average price of US$57+.

Cerence used to be my biggest position. It has now gone to 2nd place due to my aggressive adding to Digital Turbine. Regardless, I have as much faith towards Cerence as I have towards Digital Turbine. 

You can refer to my 1st article on Cerence here. There is information below that could be repetitive and if they are repeated it meant that this is VERY IMPORTANT.

I have also stated I have 2 portfolios– 1st one is mixed SG with US companies. 2nd one has 90% US companies. Thus, Cerence and Digital Turbine are in the 2nd portfolio, contributing almost 15% to the portfolio.

Without further ado, let’s get to the 25 Must Know about Cerence and why it remains a high conviction for me.

The Business

1. As per my first article, Cerence is a WHITE LABEL company that is behind the voice recognition/command system in the car such as Mercedes, Audi, BMW, Nio, Xpeng, Toyota and many more. Remember “Hey BMW” or “Hey Mercedes”? 

2. The company is currently providing Cerence Drive 2.0 and Cerence Cloud to their customers. There are many new improvements in this upgrade and you should look through their investor deck to understand more.

3. As of FY20, there is currently 350m+ cars shipped with Cerence and almost 1 in every 2 cars shipped in 2020 has Cerence Tech. Backlog as per FY20 was at US$1.8bn.

4. As per the May 21 investor deck, their customers consist of the major OEM and Tier 1 Suppliers. This is the most complete customer listing I found. (I always wonder if Tesla is a customer. It was not stated till now.)

Cerence Investor Deck

5. Other than cars, it is getting involved into 2-wheeler space, ATV and Elevator Market. This increases their TAM in the future. 

6. In my personal opinion, I see this as a Personal Assistant to the driver when Autonomous Driving becomes the norm in the future.

The Financials and Guidance

7. Fundamental Scorecard Updates: Revenue has continued to grow and the company has turned around. With revenue increasing and profitable with positive FCF, I will say this is special for a tech company that is listed since Oct 2019.

Fundamental Scorecard

8. Forward Guidance improved and shows promised.

9. To understand the business, the revenue flow goes like this - Professional Fees > License > Connected Services. 

Do note that Professional Fees has almost zero gross profit. It is a service where Cerence work with the OEM engineers to incorporate their AI voice commend system into the OEM system. 

Then for License, it is almost 100% gross profit and is charge only once per vehicle sold. 

After which, it is Connected Services where updates for the car maps or new/additional voice command apps are being charged for and this is where it is expected to be recurring.

10. Each award from an OEM will probably takes about 12 months to 24 months before the main bulk of the revenue flows into the company. That is probably also depends on how fast the technology improves to allow the lead time to become shorter.

11. The 2024 Guidance:

Cerence Investor Deck

In the latest transcript, the CEO stated:

12. “…Our total first half bookings were $293 million, approximately flat to the second half of fiscal 2020…We expect that burst to happen in the second half of this fiscal year. In fact, we are off to a very strong start in Q3 with over $100 million bookings already booked… But to summarize pipeline is there and we surely hope that will meet or exceed last year's $800 million number.”

13. “…win rate remains extremely high…we won back an important multinational customer that had chosen a competitor when the business was still part of Nuance…”

14. “…first half booking highlights include strategic customer wins with Hyundai and a prominent Japanese car company.”

15. “…two important decisions in the two-wheeler market with one of the most prestigious and fastest-growing two-wheeler and ATV companies in China and an iconic domestic motorcycle brand that you would all recognize…”

16. “…further progress in the elevator market and expect to share more progress with you on our next earnings call.”

17. “…announced new product capabilities to seamlessly work with Google's Android Automotive OS, allowing Cerence technology to more deeply coexist with all Google applications.”

18. “…Forecast from various firms about the time required to resolve the semiconductor manufacturing issues are changing frequently…and believe we have accounted for the impact on our guidance…only about 35% to 40% of our business is directly impacted by auto production in any given quarter.”

19. “…full year revenue to be in the range of $380 million to $390 million, which is up from our original guidance of $360 million to $380 million…”

20. “…between 60 million to 80 million two-wheelers are shipped slightly about the same size slightly lower than the automotive market…we're focusing globally of course but we are really focused on the Asian market for two-wheelers…Japanese OEMs ship almost 50% of the volume of the world in two-wheelers.”

21. “Our field-of-use agreement with Nuance is for five years from the date of spin. That basically means, we're getting close to ending the second year now. So there are three more years left onto this field of-use agreement. And under this agreement, Cerence has to stay within transportation and mobility with its technology and Nuance has to stay within health care and enterprise and – just so that the two companies don't compete and step on each other for five years…In terms of our understanding of Microsoft acquisition of Nuance, we don't expect any more competition for Cerence because this acquisition is purely driven and was focused around health care.”

22. “…like 75% to 77% range. I think it's going to be a bit of a challenge to get another 10 points, for example. We saw the big improvement last year and it far exceeded all of our expectations…”

Risk

23. Big tech and OEM developing the service themselves.

24. Main competition seems to come from iFlytek:

This company is stated in their investor presentation and latest transcript. As per Wikipedia, it is a partially state-owned Chinese information technology company established in 1999. It creates voice recognition software and 10+ voice-based internet/mobile products covering education, communication, music, intelligent toys industries. It is listed in Shenzhen and has a US$20bn market cap.

Cerence Investor Deck

25. A long term headwind – if Autonomous Driving takes off and there may end up less cars produced and license fees will be affected.

The Conclusion

Cerence continues to be my top 2 highest conviction companies in my portfolio. This should be emphasized by this article having more positives than negatives stated in the article. 

With its rising revenue, profitable earnings, improving FCF, improved guidance, major booking, increasing TAM, penetration of the market in terms of existing end-users and OEM customers, high gross margin of 70+%, non-competition from Nuance for at least another 3 years, and its significant standing in the industry, the negativity seems negligible.

With its target revenue of US$600m in 2024 and a general PS ratio of 8 (medium PS ratio for US Tech Large Cap companies & iFlytek has a PS ratio of 9), the estimated market cap is US$4.8bn. 

This is about just slightly higher than the current market cap and may indicate that the company is at fair value. 

In my opinion, it seems to be a situation of a Great Company at a fair value. 

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