10-Q 1 f74898e10-q.txt FORM 10-Q QUARTERLY PERIOD ENDED JUNE 30, 2001 1 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ________________ TO ________________. COMMISSION FILE NUMBER 333-96217 NUANCE COMMUNICATIONS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 94-3208477 (STATE OF INCORPORATION) (IRS EMPLOYER IDENTIFICATION NUMBER) 1005 HAMILTON AVENUE MENLO PARK, CALIFORNIA 94025 (650) 847-0000 (ADDRESS AND TELEPHONE NUMBER OF PRINCIPAL EXECUTIVE OFFICES) Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] 32,834,221 shares of the registrant's common stock, $0.01 par value, were outstanding as of July 31, 2001. 2 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES FORM 10-Q, JUNE 30, 2001 CONTENTS

ITEM NUMBER PAGE ------ ---- PART I: FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets: June 30, 2001 and December 31, 2000......................... 1 Consolidated Statements of Operations: Three and six months ended June 30, 2001 and 2000........... 2 Consolidated Statements of Cash Flows: Six months ended June 30, 2001 and 2000..................... 3 Notes to Consolidated Financial Statements.................. 4 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 9 Item 3. Quantitative and Qualitative Disclosures about Market Risk........................................................ 23 PART II: OTHER INFORMATION Item 1. Legal Proceedings........................................... 24 Item 6. Exhibits and Reports on Form 8-K............................ 25 SIGNATURES........................................................... 26

3 NUANCE COMMUNICATIONS INC. & SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS) ASSETS

June 30, DECEMBER 31, 2001 2000 ----------- ------------ (UNAUDITED) Current assets: Cash and cash equivalents $ 190,911 $ 219,047 Short-term investments -- 8,728 Accounts receivable, net of allowance for doubtful accounts of $1,301 and $1,823, respectively 8,176 19,106 Prepaid expenses and other current assets 4,918 4,280 --------- --------- Total current assets 204,005 251,161 Property and equipment, net 10,697 9,414 Intangible assets 4,261 5,217 Other assets 20,548 13,546 --------- --------- Total assets $ 239,511 $ 279,338 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current portion of long-term debt -- 12 Accounts payable 1,959 1,649 Accrued liabilities 13,420 12,389 Restructuring accrual 8,365 -- Deferred revenue 12,795 10,745 --------- --------- Total current liabilities 36,539 24,795 Long-term debt, less current portion -- 32 Restructuring accrual 24,548 -- Other liabilities -- 2,520 --------- --------- Total liabilities 61,087 27,347 --------- --------- Commitments (Note 9) Stockholders' Equity: Common stock, $.001 par value, 50,000,000 shares authorized; 32,776,420 shares and 32,158,875 shares issued and outstanding, respectively 33 32 Additional paid-in capital 322,293 316,958 Deferred stock compensation (4,652) (7,636) Accumulated other comprehensive loss (129) (16) Accumulated deficit (139,121) (57,347) --------- --------- Total stockholders' equity 178,424 251,991 --------- --------- Total liabilities and stockholders' equity $ 239,511 $ 279,338 ========= =========

The accompanying notes are an integral part of these consolidated financial statements. 1 4 NUANCE COMMUNICATIONS INC. & SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (in thousands, except per share data)

Three Months Six Months Ended June 30, Ended June 30, ------------------- -------------------- 2001 2000 2001 2000 -------- ------- -------- -------- Revenue: License $ 5,030 $ 8,692 $ 10,692 $ 14,720 Service................................. 4,977 3,311 10,321 5,224 -------- ------- -------- -------- Total revenue......................... 10,007 12,003 21,013 19,944 -------- ------- -------- -------- Cost of revenue: License................................. -- 13 -- 13 Service................................. 4,221 2,120 9,110 3,725 -------- ------- -------- -------- Total cost of revenue................. 4,221 2,133 9,110 3,738 -------- ------- -------- -------- Gross profit............................ 5,786 9,870 11,903 16,206 -------- ------- -------- -------- Operating expenses: Sales and marketing (1) ................ 10,328 8,053 22,112 14,839 Research and development (1) ........... 5,088 4,727 10,327 9,123 General and administrative (1) ......... 3,657 2,627 7,167 4,298 Amortization of intangibles............. 477 -- 955 -- Non-cash compensation expense........... 1,475 1,138 3,066 2,154 Restructuring charge and asset impairment............................ 55,028 -- 55,028 -- -------- ------- -------- -------- Total operating expenses.............. 76,053 16,545 98,655 30,414 -------- ------- -------- -------- Loss from operations...................... (70,267) (6,675) (86,752) (14,208) Interest and other income, net.......... 2,283 1,154 5,281 1,478 -------- ------- -------- -------- Loss before provision for income taxes.. (67,984) (5,521) (81,471) (12,730) Provision for income taxes.............. 153 146 303 146 -------- ------- -------- -------- Net loss.............................. $(68,137) $(5,667) $(81,774) $(12,876) ======== ======= ======== ======== Basic and diluted net loss per share...... $ (2.10) $ (0.22) $ (2.54) $ (0.87) ======== ======= ======== ======== Shares used to compute basic and diluted net loss per share....................... 32,400 25,936 32,178 14,800 ======== ======= ======== ======== (1) Excludes non-cash compensation and other non-cash expenses as follows: Sales and marketing................... $ 522 $ 243 $ 1,113 $ 460 Research and development.............. $ 760 $ 523 $ 1,547 $ 990 General and administrative............ $ 193 $ 372 $ 406 $ 704 -------- ------- -------- -------- $ 1,475 $ 1,138 $ 3,066 $ 2,154

The accompanying notes are an integral part of these consolidated financial statements. 2 5 NUANCE COMMUNICATIONS INC. & SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (IN THOUSANDS)

SIX MONTHS ENDED JUNE 30, ------------------------ 2001 2000 --------- --------- Cash flows from operating activities: Net loss ................................................ $ (81,774) $ (12,876) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Tenant improvement asset impairment .................. 20,898 -- Depreciation and amortization ........................ 2,137 1,060 Amortization of intangibles .......................... 955 -- Non-cash compensation and other expenses ............. 3,066 2,154 Provision for doubtful accounts ...................... 593 212 Changes in operating assets and liabilities: Accounts receivable .................................. 10,337 (5,130) Prepaid expenses and other assets .................... (193) (2,265) Accounts payable ..................................... 310 (249) Restructuring accrual ................................ 32,913 -- Accrued and other liabilities ........................ (1,489) 3,881 Deferred revenue ..................................... 2,050 2,387 --------- --------- Net cash used in operating activities ........... (10,197) (10,826) --------- --------- Cash flows from investing activities: Purchase of marketable securities ....................... -- (11,220) Purchase of long-term investment ........................ -- (10,943) Maturities of marketable securities ..................... 8,728 22,448 Purchases of property and equipment ..................... (24,318) (3,879) Purchased technology .................................... (7,000) -- --------- --------- Net cash used in investing activities ........... (22,590) (3,594) --------- --------- Cash flows from financing activities: Proceeds from issuance of common stock .................. -- 80,341 Repurchase of common stock .............................. (365) -- Proceeds from exercise of stock options ................. 2,825 5,728 Proceeds from ESPP ...................................... 2,349 -- Proceeds from exercise of Series D warrant .............. -- 1,000 Repayment of borrowings ................................. (44) (2,053) --------- --------- Net cash provided by financing activities ....... 4,765 85,016 --------- --------- Effect of exchange rate fluctuations on cash and cash equivalents .......................................... (114) (20) Net increase (decrease) in cash and cash equivalents .... (28,136) 70,576 Cash and cash equivalents, beginning of period .......... 219,047 18,073 --------- --------- Cash and cash equivalents, end of period ................ $ 190,911 $ 88,649 ========= ========= Supplementary disclosures of cash flow information: Cash paid during the period for: Interest............................................... $ 28 $ 78 Income taxes........................................... $ 32 $ -- Supplementary disclosure of non-cash transaction: Issuance of warrant....................................... $ 526 $ --

The accompanying notes are an integral part of these consolidated financial statements. 3 6 NUANCE COMMUNICATIONS INC. & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The unaudited consolidated financial statements have been prepared by Nuance Communications, Inc. (the "Company") in accordance with instructions to Form 10-Q and Article 10 of Regulation S-X. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated. In the opinion of management, all adjustments, consisting only of normal recurring adjustments considered necessary for a fair presentation, have been included. The results of operations for the three and six month periods ended June 30, 2001 are not necessarily indicative of the results to be expected for the full year or for any future periods. The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements contained in the Company's Form 10-K filed with the Securities and Exchange Commission on April 2, 2001. 2. RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 requires certain accounting and reporting standards for derivative financial instruments and hedging activities. In June 1999, the FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities -- Deferral of the Effective Date of FASB Statement No. 133," which amends SFAS No. 133 to be effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. The Statement became effective for the Company on January 1, 2001. Because the Company does not currently hold any derivative instruments and does not engage in hedging activities, the adoption of these statements did not have a material impact on the Company's financial position or results of operations. On June 29, 2001, the FASB approved for issuance SFAS 141, "Business Combinations," and SFAS 142, "Goodwill and Intangible Assets." Major provisions of these Statements are as follows: all business combinations initiated after June 30, 2001 must use the purchase method of accounting; the pooling of interest method of accounting is prohibited except for transactions initiated before July 1, 2001; intangible assets acquired in a business combination must be recorded separately from goodwill if they arise from contractual or other legal rights or are separable from the acquired entity and can be sold, transferred, licensed, rented or exchanged, either individually or as part of a related contract, asset or liability; goodwill and intangible assets with indefinite lives are not amortized but are tested for impairment annually using a fair value approach, except in certain circumstances, and whenever there is an impairment indicator; other intangible assets will continue to be valued and amortized over their estimated lives; in-process research and development will continue to be written off immediately; all acquired goodwill must be assigned to reporting units for purposes of impairment testing and segment reporting; effective January 1, 2002, existing goodwill will no longer be subject to amortization. Goodwill acquired subsequent to June 30, 2001 will not be subject to amortization. Nuance Communications will apply SFAS 141 to business combinations initiated after June 30, 2001. SFAS 142 is effective beginning in the first quarter of 2002 with the exception of goodwill and intangibles assets acquired after June 30, 2001, which will be subject immediately to the non-amortization and amortization provisions. 4 7 Beginning in the first quarter of 2002, the Company will no longer amortize goodwill, thereby eliminating annual goodwill amortization of approximately $1.8 million, based on anticipated amortization for 2002. Amortization for the six months ended June 30, 2001 was $889,000. As of June 30, 2001, unamortized goodwill was approximately $4.1 million. 3. RESTRUCTURING CHARGE AND ASSET IMPAIRMENT In April 2001, the Company's Board of Directors approved a restructuring plan that would align the Company's expenses with revised anticipated demand and create a more efficient organization. In connection with the restructuring plan, the Company recorded a restructuring charge of $34.1 million for the lease loss and severance costs and an asset impairment charge of $20.9 million on tenant improvements. In conjunction with the restructuring plan, the Company decided not to occupy a new leased facility. This decision has resulted in a lease loss of $32.6 million, comprised of a sublease loss, broker commissions and other facility costs, and an asset impairment charge of $20.9 million. To determine the sublease loss, the loss after the Company's cost recovery efforts from subleasing the building, certain assumptions were made related to the (1) time period over which the building will remain vacant (2) sublease terms (3) sublease rates. The lease loss is an estimate under SFAS No. 5 "Accounting for Contingencies" and represents the low end of the range and will be adjusted in the future upon triggering events (change in estimate of time to sublease, actual sublease rates, etc.). The Company has estimated that the high end of the lease loss could be $55 million if operating lease rental rates continue to decrease in these markets or should it take longer than expected to find a suitable tenant to sublease the facility. The Company recorded $1.5 million in costs associated with severance and related benefits. The Company reduced its headcount by approximately 80 employees, with reductions ranging between 10% and 20% across all functional areas and affecting several locations. The Company expects to save an estimated $8.0 million annually of salary and related benefits as a result of this reduction in headcount. In addition, the real estate restructuring plan is expected to lower facilities expenses which would have been incurred had the Company occupied the new leased facility. The restructuring charge as of June 30, 2001 is as follows (in millions):

Severance Lease and Related Total Loss Benefits Restructuring Total charge in second quarter 2001 $32.6 $1.5 $34.1 Amount utilized in second quarter 2001 $ 0 $1.2 $ 1.2 ----- ---- ----- Accrual balance at June 30, 2001 $32.6 $0.3 $32.9

Total cash outlay for the restructuring plan is expected to be $34.1 million, with $32.9 million accrued at June 30, 2001 and $1.2 million paid out in the three months ended June 30, 2001. The Company expects $8.0 million of the lease loss to be paid out over the next twelve months, and the remaining $24.6 million to be paid out over the remaining life of the lease of approximately 11 years. The Company expects the $300,000 of employee severance and related benefits to be paid out by December 31, 2001. 4. NET LOSS PER SHARE Historical net loss per share has been calculated under SFAS No. 128, "Earnings Per Share." Basic net loss per share on a historical basis is computed using the weighted average number of shares of common stock outstanding. Diluted net loss per share is equal to basic net loss per share for all periods presented since potential common shares from conversion of the convertible preferred stock, stock options and warrants are antidilutive. The total number of shares excluded from diluted net loss per share was 6,557,000 for the three months ended June 30, 2001 and 6,816,000 for the six months ended June 30, 2001. The total number of shares excluded from diluted net loss per share was 4,992,000 for the 5 8 three months ended June 30, 2000 and 14,910,000 for the six months ended June 30, 2000. The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share data):

Three Months Ended Six Months Ended June 30, June 30, ---------------------- ---------------------- 2001 2000 2001 2000 -------- -------- -------- -------- Net loss ................................ $(68,137) $ (5,667) $(81,774) $(12,876) ======== ======== ======== ======== Basic: Weighted average shares of common stock outstanding .......................... 32,671 26,841 32,517 15,252 Less: Weighted average shares of common stock subject to repurchase .......... (271) (905) (339) (452) -------- -------- -------- -------- Weighted average shares used in computing basic and diluted net loss per share ... 32,400 25,936 32,178 14,800 ======== ======== ======== ======== Basic and diluted net loss per share .... $ (2.10) $ (0.22) $ (2.54) $ (0.87) ======== ======== ======== ========

5. NON-CASH COMPENSATION AND OTHER NON-CASH EXPENSES In connection with the grant of certain stock options to employees through March 31, 2000, the Company recorded deferred stock compensation within stockholders' equity of $8.7 million, representing the difference between the estimated fair value of the common stock for accounting purposes and the option exercise price of these options at the date of grant. Such amount is presented as a reduction of stockholders' equity and is being amortized over the vesting period of the applicable options using an accelerated method of amortization. Under the accelerated method, each vested tranche of options is accounted for as a separate option grant awarded for past services. Accordingly, the compensation expense is recognized over the period during which the services will be provided; however, the method results in a front-loading of the compensation expense. The Company recorded amortization of deferred compensation of $592,000 and $1.2 million for the three and six months ended June 30, 2001 and $1.1 million and $2.2 million for the three and six months ended June 30, 2000, relating to approximately 3,152,000 options with a weighted average exercise price of $8.58. In connection with the SpeechFront acquisition, the Company recorded deferred compensation of $4.1 million. This amount is part of the purchase agreement and is payable to the founders in common stock, approximately 38,710 shares, and contingent upon their continued employment. Approximately $871,000 and $1.8 million was amortized in the three and six months ended June 30, 2001 related to these deferred compensation amounts. In December 2000, the Company issued to a customer a warrant to purchase 100,000 shares of common stock at an exercise price of $138.50 per share subject to certain anti-dilution adjustments. The warrant is exercisable at the option of the holder, in whole or part, at any time between January 17, 2001 and August 2002. In January 2001, the Company valued the warrant at $526,000, utilizing the Black-Scholes valuation model using the following assumptions; risk-free interest rate of 5.5% expected dividend yields of zero, expected life of 1.5 years, and expected volatility of 80%. The Company amortized $84,000 and $152,000 related to this warrant in the three and six months ended June 30, 2001. In the three months ended June 30, 2001, the Company received an invoice for $72,000 from this customer and reduced the warrant expense for the period by this amount. The Company expects to amortize $5.8 million, $1.8 million and $500,000 of non-cash compensation and other expenses in 2001, 2002 and 2003, respectively. 6. PURCHASED TECHNOLOGY 6 9 The Company entered into an agreement with a third-party that gives the Company non-exclusive Intellectual Property Rights to software code. The Company has paid this third-party a $7.0 million license fee related to this agreement. $2.5 million of this fee was paid in the three months ended March 31, 2001 and $4.5 million was paid in the three months ended June 30, 2001. This license fee is being amortized to research and development expense during the development stage and thereafter as cost of revenue over a period of five years, and $350,000 and $525,000 was amortized in the three and six months ended June 30, 2001, respectively. 7. ACQUISITION On November 10, 2000, in an acquisition accounted for under the purchase method of accounting, the Company acquired all the outstanding shares of SpeechFront Inc. ("SpeechFront") for approximately $7.1 million, including acquisition costs of approximately $129,000. SpeechFront is a developer of voice instant messaging systems. The consideration included approximately 16,590 shares of the Company common stock valued at $1.7 million and cash of approximately $5.3 million. The purchase agreement contained additional payments, of approximately $4.1 million, to be made in common stock, approximately 38,710 shares, contingent upon the continued employment of the founders of SpeechFront. Maximum future payments, contingent solely on continued employment of the founders, is $1.7 million, approximately 16,590 shares, and is payable upon the eighteen month anniversary of the acquisition date. The remaining $2.4 million, approximately 22,120 shares, also relates to the continued employment of the founders, and is payable upon the twelve-month anniversary of the acquisition date, or earlier if certain performance milestones are achieved. The contingent payments will be accounted for as compensation expense over the term of the employment condition and not as part of the purchase price. Upon consummation of the acquisition, the Company established an escrow for these contingent payments. The allocation of the purchase price to the assets acquired and liabilities assumed based on preliminary estimates of fair value, which are subject to final adjustment, are as follows (in thousands): Cash........................................................ $ 136 Other current assets........................................ 7 Property and equipment...................................... 66 Acquired in-process research and development................ 1,500 Goodwill.................................................... 5,336 Workforce................................................... 200 ------ 7,245 Less: Liabilities assumed................................... (95) ------ $7,150 ====== At the time of acquisition, Nuance expensed $1.5 million of purchased in-process research and development. Other purchased intangible assets, including goodwill and workforce of approximately $5.5 million are being amortized a straight-line basis over their estimated useful lives of thirty-six and eighteen months, respectively. Beginning on November 10, 2000, SpeechFront's operating results were included with those of the Company. The value assigned to purchased in-process technology, based on the income method prepared by an independent third-party was determined by identifying research projects in areas for which technological feasibility had not been established. SpeechFront's in-process projects included the research and development associated with the voice instant messaging + Mobile HQ product. The value of in-process research and development was determined by estimating the costs to develop the purchased in-process technology into a commercially viable product, estimating the resulting net cash flows from such project and discounting the net cash flows back to their present value. The discount rate includes a risk-adjusted discount rate to take into account the 7 10 uncertainty surrounding the successful development of the purchased in-process technology. The risk-adjusted discount rate applied to the projects' cash flows was 30% for the in-process technology. The Company believes that the estimated in-process technology amounts represent fair value and do not exceed the amount a third-party would pay for the projects. The valuation includes cash inflows from in-process technology through 2006 with revenues commencing in 2002. Where appropriate, the Company allocated anticipated cash flows from an in-process research and development project to reflect contributions of the core technology. At the time of the acquisition, SpeechFront's remaining tasks were approximately 35 percent complete based on engineering man-month data and technological progress. As of June 30, 2001, these tasks were 75% complete and are expected to be complete by September 30, 2001. If the projects are not successful or completed in a timely manner, management's product pricing and growth rates may not be achieved and Nuance may not realize the financial benefits expected from the projects. The Company is not disclosing pro forma financial information for the quarter ending June 30, 2000 due to the immateriality of differences between actual and pro forma results. 8. SEGMENT REPORTING The Company has two operating segments: licenses and services. Revenue and cost of revenue for the segments are identical to those presented on the accompanying consolidated statements of operations. The Company does not track expenses nor derive profit or loss based on these segments. Sales of licenses and services through June 30, 2001 occurred through resellers and direct sales representatives located in the Company's headquarters in Menlo Park, California, and in other locations. These sales were supported through the Menlo Park location. The Company does not separately report costs by region internally. For the three and six months ended June 30, 2001 no foreign country accounted for more than 10% of the Company's total revenue. 9. COMMITMENTS The Company leases its facilities under non-cancelable operating leases with various expiration dates through July 2012. Future minimum lease payments under these agreements as of December 31, 2000, are as follows (in thousands):

OPERATING FISCAL YEAR LEASE ----------- --------- 2001....................................................... $ 4,274 2002....................................................... 8,308 2003....................................................... 8,583 2004....................................................... 8,570 2005....................................................... 8,263 Thereafter................................................. 61,055 ------- Total minimum lease payments..................... $99,053 =======

In May 2000, the Company entered into a lease for a new headquarters facility. The lease has an eleven-year term, beginning in August 2001, and provides for monthly rent payments starting at approximately $600,000. An $11.0 million certificate of deposit secures a letter of credit required by the landlord for a rent deposit. In conjunction with the restructuring plan (see note 3), the Company decided not to occupy this new leased facility. The facility will be subleased and the sublease income will be used to offset rental payments. 10. LITIGATION 8 11 In March 2001, the first of a number of stockholder complaints was filed in the United States District Court for the Northern District of California against the Company and certain of its officers. The complaints were filed on behalf of a purported class of people who purchased the Company's stock during the period January 31, 2001 through March 15, 2001, alleging insider trading and false and misleading statements in violation of the federal securities laws. The plaintiffs are seeking unspecified damages. The Company believes that the allegations of these lawsuits are without merit and intends to defend the litigation vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Company's business, results of operations, or financial condition. In June and July 2001, putative shareholder derivative actions were filed in California state court alleging breaches of fiduciary duty and insider trading by various of our directors and officers. While we are named as a nominal defendant, the lawsuits do not appear to seek any recovery against us. Proceedings in these actions have been stayed. In August 2001, a complaint styled Atlas v. Nuance Communications, No. 01 CIV. 7344, was filed in federal district court for the Southern District of New York on behalf of a purported class of persons who purchased our stock between April 12, 2000 and December 6, 2000. The complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to our initial public offering of securities. The complaint brings claims for violation of several provisions of the federal securities laws against those underwriters, and also against us and some of our directors and officers. Similar lawsuits concerning more than 100 other companies' initial public offerings have been filed this year. We believe that the allegations against us are without merit and intend to defend the litigation vigorously. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this report. The results shown herein are not necessarily indicative of the results to be expected for the full year or any future periods. This Report on Form 10-Q contains forward-looking statements, within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act, including but not limited to our expectations for results over the balance of the year, regarding expense trends, cash positions, future capital requirements and our outlook for the Company, as well as our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this Report on Form 10-Q are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. These statements involve risks and uncertainties and actual results could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including, but not limited to, those set forth in "Factors that affect future results" and elsewhere in this Report on Form 10-Q. In particular, see "Factors that affect future results - Our ability to accurately forecast our quarterly sales is limited, our costs are relatively fixed in the short term and we expect our business to be affected by seasonality. As a result, our quarterly operating results may fluctuate." OVERVIEW: The Company develops, markets and supports a voice interface software platform that makes the content and services of the Internet, telecommunications networks and enterprises accessible from any telephone. The software platform consists of software servers that run on industry-standard hardware and perform speech recognition, natural language understanding and voice authentication. The Company sells products and services through a combination of value-added resellers, original equipment manufacturers, systems integrators and directly to end users. On March 15, 2001, we announced our revised expectations for our first quarter financial results based upon our then-current outlook, including a 9 12 revenue shortfall and a larger than expected net loss for the quarter due to general economic conditions which have led customers and customer prospects to postpone capital investment in Nuance products and service offerings based on Nuance products. On April 19, 2001, we announced that the trends seen in the first quarter were expected to continue in the second quarter as a result of a continuing weak economic environment. We are not certain when the economic environment will improve. The foregoing was a forward-looking statement within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act; see page 9 of this Report on Form 10-Q. In April 2001, we announced a restructuring plan that reduced our workforce by approximately 80 employees. In connection with that reduction, we recorded a lease loss and a tenant improvement asset impairment (see note 3). These charges are being recorded to align our cost structure with changing market conditions and to create a more efficient organization. They are recorded in the quarter ending June 30, 2001. RESULTS OF OPERATIONS: The following table sets forth, for the period's indicated, the percentage of net revenue represented by certain items in our statements of operations for the three and six months ended June 30, 2001 and 2000.

THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ---------------- ---------------- 2001 2000 2001 2000 ---- ---- ---- ---- Revenue: License............................ 50% 72% 51% 74% Service........................ ... 50 28 49 26 ---- --- ---- --- Total revenue.............. 100 100 100 100 Cost of revenue: License............................ -- -- -- -- Service............................ 42 18 43 19 ---- --- ---- --- Total cost of revenue...... 42 18 43 19 ---- --- ---- --- Gross Margin......................... 58 82 57 81 Operating expenses: Sales and marketing(1).............. 103 67 105 74 Research and development(1)......... 51 39 49 46 General and administrative(1)....... 36 22 34 21 Amortization of intangibles......... 5 -- 5 -- Non-cash compensation expense....... 15 10 15 11 Restructuring charge and asset impairment ....................... 550 -- 262 -- ---- --- ---- --- Total operating expenses.... 760 138 470 152 ---- --- ---- --- Loss from operations.................. (702) (56) (413) (71) Interest and other income, net........ 23 10 25 7 ---- --- ---- --- Loss before provision for income taxes................................ (679) (46) (388) (64) Provision for income taxes............. 2 1 1 1 ---- --- ---- --- Net loss..................... (681)% (47)% (389)% (65)% ==== === ==== ===

-------------- (1) Percentages are net of non-cash compensation and other non-cash expenses 10 13 COMPARISON OF THREE AND SIX MONTHS ENDED JUNE 30, 2001 AND 2000 Revenue Total revenue for the three months ended June 30, 2001 was $10.0 million, compared with $12.0 million in the three months ended June 30, 2000, a decrease of 17%. Total revenue for the six months ended June 30, 2001 was $21.0 million, compared with $19.9 million in the six months ended June 30, 2000, an increase of 5%. License revenue for the three months ended June 30, 2001 was $5.0 million, compared with $8.7 million in the three months ended June 30, 2000, a decrease of 42%. License revenue for the six months ended June 30, 2001 was $10.7 million, compared with $14.7 million in the six months ended June 30, 2000, a decrease of 27%. The decline in license revenue was due to an uncertain economic environment that caused customers to delay purchases in the six months ended June 30, 2001. License revenue represented 50% and 51% of total revenue for the three and six months ended June 30, 2001 and 72% and 74% of total revenue for the three and six months ended June 30, 2000. Service revenue for the three months ended June 30, 2001 was $5.0 million, compared with $3.3 million for the three months ended June 30, 2000, an increase of 50%. Service revenue for the six months ended June 30, 2001 was $10.3 million, compared with $5.2 million for the six months ended June 30, 2000, an increase of 98%. This increase in service revenue was due primarily to growth in professional services headcount, which enabled completion of more professional services projects. Service revenue represented 50% and 49% of total revenue for the three and six months ended June 30, 2001 and 28% and 26% of total revenue for the three and six months ended June 30, 2000. Cost of Revenue Cost of service revenue for the three months ended June 30, 2001 was $4.2 million, compared with $2.1 million in the three months ended June 30, 2000, an increase of 99%. Cost of service revenue for the six months ended June 30, 2001 was $9.1 million, compared with $3.7 million for the six months ended June 30, 2000, an increase of 145%. The increase was due to hiring approximately 46 additional personnel in the professional services, technical support and training groups. The service margin decreased due to lower service revenue than originally anticipated. Cost of service revenue as a percentage of service revenue was 85% and 88% in the three and six months ended June 30, 2001 and 64% and 71% for the three and six months ended June 30, 2000. We anticipate that cost of service revenue will remain relatively constant in absolute dollars, although cost of service revenue will vary as a percentage of service and total revenue from period to period. Operating Expenses Sales and Marketing -- Sales and marketing expenses primarily consist of compensation and related costs for sales and marketing personnel and promotional expenditures, including public relations, advertising, trade shows and marketing collateral materials. Sales and marketing expenses for the three months ended June 30, 2001 were $10.3 million, compared with $8.1 million in the three months ended June 30, 2000, an increase of 28%. Sales and marketing expenses for the six months ended June 30, 2001 were $22.1 million, compared with $14.8 million for the six months ended June 30, 2000, an increase of 49%. This increase was attributable to the addition of approximately 42 sales and marketing personnel, an increase in our allowance for bad debt and increases in marketing costs and external consultants. As a percentage of total revenue, sales and marketing expenses were 103% and 105% in the three and six months ended June 30, 2001, and 67% and 74% in the three and six months ended June 30, 2000. Due to the more challenging economic environment, we anticipate that sales and marketing expenses will remain relatively constant in absolute dollars, but will vary as a percentage of total revenue from period to period. Research and Development -- Research and development expenses primarily consist of compensation and related costs for research and development personnel and contractors. Research and development expenses for the three months ended June 30, 2001 were $5.1 million, compared with $4.7 million in the three months 11 14 ended June 30, 2000, an increase of 8%. Research and development expenses for the six months ended June 30, 2001 were $10.3 million, compared with $9.1 million in the six months ended June 30, 2000, an increase of 13%. This increase was primarily attributable to the amortization expense of a license fee paid to a third party (see note 6). As a percentage of total revenue, research and development expenses were 51% and 49% in the three and six months ended June 30, 2001, and 39% and 46% in the three and six months ended June 30, 2000. Due to the more challenging economic environment, we anticipate that research and development expenses will remain relatively constant in absolute dollars, but will vary as a percentage of total revenue from period to period. General and Administrative -- General and administrative expenses primarily consist of compensation and related costs for administrative personnel, legal services, accounting services and other general corporate expenses. General and administrative expenses for the three months ended June 30, 2001 were $3.7 million, compared with $2.6 million in the three months ended June 30, 2000, an increase of 39%. General and administrative expenses for the six months ended June 30, 2001 were $7.2 million, compared with $4.3 million in the six months ended June 30, 2000, an increase of 67%. The increase was largely due to the addition of approximately 13 administrative personnel and increased legal and professional fees. The additional expenses enhanced the Company's administrative infrastructure to strengthen controls and accommodate growth. As a percentage of total revenue, general and administrative expenses were 37% and 34% in the three and six months ended June 30, 2001 and 22% and 21% in the three and six months ended June 30, 2000. Due to the more challenging economic environment, we expect that general and administrative expenses will remain relatively constant in absolute dollars, however, we expect that these expenses will vary as a percentage of total revenue from period to period. Amortization of Intangibles -- Goodwill and other acquired intangible assets of $5.5 million were recorded in connection with the acquisition of SpeechFront in November 2000 and are being amortized over their useful lives of 18 to 36 months. Amortization of intangibles was $477,000 and $955,000 for the three and six months ended June 30, 2001. There was no amortization of intangibles for the three and six months ended June 30, 2000. Non-Cash Compensation -- In connection with the grant of certain stock options to employees through March 31, 2000, we recorded deferred stock compensation within stockholders' equity of $8.7 million, representing the difference between the estimated fair value of the common stock for accounting purposes and the option exercise price of these options at the date of grant. Such amount is presented as a reduction of stockholders' equity and is being amortized over the vesting period of the applicable options using an accelerated method of amortization. Under the accelerated method, each vested tranche of options is accounted for as a separate option grant awarded for past services. Accordingly, the compensation expense is recognized over the period during which the services will be provided; however, the method results in a front-loading of the compensation expense. We recorded amortization of deferred compensation of $592,000 and $1.2 million for the three and six months ended June 30, 2001 and $1.1 million and $2.2 million for the three and six months ended June 30, 2000, relating to approximately 3,152,000 options with a weighted average exercise price of $8.58. In connection with the SpeechFront acquisition, we recorded deferred compensation of $4.1 million. This amount is part of the purchase agreement and is payable to the founders in common stock, approximately 38,710 shares, and contingent upon their continued employment. Approximately $871,000 and $1.8 million was amortized in the three and six months ended June 30, 2001 related to these deferred compensation amounts. In December 2000, we issued to a customer a warrant to purchase 100,000 shares of common stock at an exercise price of $138.50 per share subject to certain anti-dilution adjustments. The warrant is exercisable at the option of the holder, in whole or part, at any time between January 17, 2001 and August 2002. In January 2001, we valued the warrant at $526,000, utilizing the Black-Scholes valuation model using the following assumptions; risk-free interest rate of 5.5% expected dividend yields of zero, expected life of 1.5 years, and expected volatility of 80%. We amortized $84,000 and $152,000 related to this warrant in the three and six months ended June 30, 2001. In the three months ended June 30, 2001, we received an 12 15 invoice for $72,000 from this customer and reduced the warrant expense for the period by this amount. The Company expects to amortize $5.8 million, $1.8 million and $500,000 of non-cash compensation and other non-cash expenses in 2001, 2002 and 2003, respectively. Restructuring Charge and Asset Impairment - For the three and six months ended June 30, 2001, we recorded a restructuring charge of $34.1 million for the lease loss and severance costs and an asset impairment charge of $20.9 million. In April 2001, our Board of Directors approved a restructuring plan that would align our expenses with revised anticipated demand and create a more efficient organization. In conjunction with the restructuring plan, we decided not to occupy a new leased facility. Our decision has resulted in a lease loss of $32.6 million, comprised of a sublease loss, broker commissions and other facility costs, and an asset impairment charge of $20.9 million. To determine the sublease loss, the loss after our cost recovery efforts from subleasing the building, certain assumptions were made related to the (1) time period over which the building will remain vacant (2) sublease terms (3) sublease rates. The lease loss is an estimate under SFAS No. 5 "Accounting for Contingencies" and represents the low end of the range and will be adjusted in the future upon triggering events (change in estimate of time to sublease, actual sublease rates, etc.). We have estimated that the high end of the lease loss could be $55 million if operating lease rental rates continue to decrease in these markets or should it take longer than expected to find a suitable tenant to sublease the facility. We recorded $1.5 million in costs associated with severance and related benefits. We reduced our headcount by approximately 80 employees, with reductions ranging between 10% and 20% across all functional areas and affecting several locations. We expect to save an estimated $8.0 million annually of salary and related benefits as a result of this reduction in headcount. In addition, the real estate restructuring plan is expected to lower facilities expenses which would have been incurred had we occupied the new leased facility. Total cash outlay for the restructuring plan is expected to be $34.1 million, with $32.9 million accrued at June 30, 2001 and $1.2 million paid out in the three months ended June 30, 2001. We expect $8.0 million of the lease loss to be paid out over the next twelve months, and the remaining $24.6 million to be paid out over the remaining life of the lease of approximately 11 years. We expect the $300,000 of employee severance and related benefits to be paid out by December 31, 2001. Interest and Other Income, Net Interest and other income, net, consists primarily of interest earned on cash and cash equivalents and short-term investments. Interest and other income, net was $2.3 million in the three months ended June 30, 2001 and $1.2 million in the three months ended June 30, 2000, an increase of 98%. Interest and other income, net was $5.3 million in the six months ended June 30, 2001 and $1.5 million in the six months ended June 30, 2000, an increase of 257%. The increase was due to higher interest income, which was earned on the cash received from our initial public offering and follow-on public offering in 2000. Provision for Income Taxes We have incurred operating losses for all periods from inception through June 30, 2001 and therefore have not recorded a provision for federal income taxes for any period through June 30, 2001. We recorded income tax expense relating to foreign taxes of $153,000 and $303,000 for the three and six month periods ended June 30, 2001, respectively, and $146,000 for the three and six months ended June 30, 2000. LIQUIDITY AND CAPITAL RESOURCES From inception to our initial public offering, we financed our operations primarily from private sales of convertible preferred stock totaling $70.0 million through March 31, 2000 and, to a lesser extent, from bank financing. On April 18, 2000, the Company raised approximately $80.3 million through the 13 16 completion of its initial public offering of common stock. On October 2, 2000, the Company raised approximately $144.0 million through the completion of its follow-on public offering. As of June 30, 2001, we had cash and cash equivalents aggregating $190.9 million. Our operating activities used cash of $10.2 million for the six months ended June 30, 2001, and used cash of $10.8 million during the six months ended June 30, 2000. This negative operating cash flow in the six months ended June 30, 2001 resulted principally from our net loss, partially offset by a decrease in accounts receivable and an increase in the restructuring accrual and the tenant improvement asset impairment. The negative operating cash flow in the six months ended June 30, 2000 resulted principally from our net losses and increases in accounts receivable, prepaid expenses and other assets. These factors were partially offset by increases in accrued liabilities and deferred revenue. Investing activities used cash of $22.6 million during the six months ended June 30, 2001, and $3.6 million during the six months ended June 30, 2000. Our use of cash in investing activities for the six months ended June 30, 2001 resulted from additions to property and equipment and purchased technology, partially offset by maturities of short-term securities. The use of cash for the six months ended June 30, 2000 resulted from the net purchases of short-term investments, a long-term investment and additions to property and equipment, partially offset by the maturities of short-term securities. We plan to spend approximately $900,000 in capital expenditures during the rest of 2001. Our financing activities generated cash of $4.8 million during the six months ended June 30, 2001, and $85.0 million for the six months ended June 30, 2000. The generation of cash for the six months ended June 30, 2001 was primarily the result of proceeds from the exercise of employee stock options and employee stock purchase plan contributions from employees. The generation of cash for the six months ended June 30, 2000 was largely the result of proceeds from the completion of our initial public offering. Our capital requirements depend on numerous factors. Through fiscal year 2001, we will be holding headcount relatively constant. We believe that our current cash and cash equivalents and our borrowing capacity will be sufficient to fund our activities for the next 12 months. Thereafter, we may need to raise additional funds in order to fund more rapid expansion, including increases in employees; to develop new or enhance existing products or services; to respond to competitive pressures; to pay litigation costs in excess of our insurance policy, or to acquire or invest in complementary businesses, technologies, services or products. Additional funding may not be available on favorable terms or at all. In addition, we may, from time to time, evaluate potential acquisitions of other businesses, products and technologies. We may also consider additional equity or debt financing, which could be dilutive to existing investors. FACTORS THAT AFFECT FUTURE RESULTS WE HAVE A HISTORY OF LOSSES. WE EXPECT TO CONTINUE TO INCUR LOSSES AND WE MAY NOT ACHIEVE OR MAINTAIN PROFITABILITY. We have incurred losses since our inception, including a loss of approximately $68.1 million in the three months ended June 30, 2001. As of June 30, 2001, we had an accumulated deficit of approximately $139.1 million. We expect to have net losses and negative cash flow for at least the next 12 months. We expect to spend significant amounts to enhance our products and technologies and expand international sales and operations. As a result, we will need to generate significant additional revenue to achieve profitability. Even if we achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. OUR ABILITY TO ACCURATELY FORECAST OUR QUARTERLY SALES IS LIMITED, OUR COSTS ARE RELATIVELY FIXED IN THE SHORT TERM AND WE EXPECT OUR BUSINESS TO BE AFFECTED BY SEASONALITY. AS A RESULT, OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE. Our quarterly operating results have varied significantly in the past and we expect that they will vary significantly from quarter to quarter in the 14 17 future. On March 15, 2001, we announced our revised expectations for our first quarter financial results based upon our then-current outlook, including a revenue shortfall and a larger than expected net loss for the quarter due to general economic conditions which have led customers and customer prospects to postpone capital investment in Nuance products and service offerings based on Nuance products. On April 19, 2001, we announced that the trends seen in the first quarter were expected to continue in the second quarter as a result of a continuing weak economic environment. We are not certain when the economic environment will improve. The foregoing was a forward-looking statement within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act; see page 10 of this Report on Form 10-Q. These quarterly variations are caused by a number of factors, including: - general economic downturn and delays or cancellations in orders by customers who are reducing spending; - delays in customer orders due to the complex nature of large telephony systems and the associated implementation projects; - timing of product deployments and completion of project phases, particularly for large orders; - delays in recognition of software license revenue in accordance with applicable accounting principles; - our ability to develop, introduce, ship and support new and enhanced products, such as our voice browser and new versions of our software platform, that respond to changing technology trends in a timely manner and our ability to manage product transitions; - the amount and timing of increases in expenses associated with our growth; and - the utilization rate of our professional services personnel. Due to these factors, and because the market for our voice interface software platform is new and rapidly evolving, our ability to accurately forecast our quarterly sales is limited. In addition, most of our costs are for personnel and facilities, which are relatively fixed in the short term. If we have a shortfall in revenue in relation to our expenses, we may be unable to reduce our expenses quickly enough to avoid lower quarterly operating results. We do not know whether our business will grow rapidly enough to absorb the costs of these employees and facilities. As a result, our quarterly operating results could fluctuate significantly and unexpectedly from quarter to quarter. In addition, we expect to experience seasonality in the sales of our products. For example, we anticipate that sales may be lower in the first quarter of each year due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers. We also expect that sales may decline during summer months. These seasonal variations in our sales may lead to fluctuations in our quarterly operating results. Because we have limited operating results, it is difficult for us to evaluate the degree to which this seasonality may affect our business. WE ARE CURRENTLY ENGAGED IN A SECURITIES CLASS ACTION LAWSUIT, WHICH, IF IT RESULTS IN AN UNFAVORABLE RESOLUTION, COULD ADVERSELY AFFECT OUR BUSINESS, RESULTS OF OPERATIONS OR FINANCIAL CONDITION. In March 2001, the first of a number of stockholder complaints was filed in the United States District Court for the Northern District of California against us and certain of our officers. The complaints were filed on behalf of a purported class of people who purchased our stock during the period January 31, 2001 through March 15, 2001, alleging insider trading and false and misleading statements in violation of the federal securities laws. The plaintiffs are seeking unspecified damages. We believe that the allegations of these lawsuits are without merit and intend to defend the litigation vigorously. An unfavorable resolution of this litigation could have a material adverse effect on our business, results of operations, or financial condition. 15 18 OUR STOCK PRICE MAY BE VOLATILE DUE TO FACTORS OUTSIDE OF OUR CONTROL. Since our initial public offering on April 13, 2000, our stock price has been extremely volatile. During that time, the stock market in general, and The Nasdaq National Market and the securities of technology companies in particular, has experienced extreme price and trading volume fluctuations. These fluctuations have often been unrelated or disproportionate to the operating performance of individual companies. The following factors, among others, could cause our stock price to fluctuate: - actual or anticipated variations in operating results; - announcements of operating results and business conditions by our customers and suppliers; - announcements by our competitors relating to new customers, technological innovation or new services; - economic developments in our industry as a whole; and - general market conditions. These broad market fluctuations may materially adversely affect our stock price, regardless of our operating results. Our stock price may fluctuate due to variations in our operating results. For example, on March 15, 2001, we announced our revised expectations for our first-quarter revenues based upon our then-current outlook. As a result, the trading price of our common stock declined rapidly and significantly. VOICE INTERFACE SOFTWARE MAY NOT ACHIEVE WIDESPREAD ACCEPTANCE BY BUSINESSES AND TELECOMMUNICATIONS CARRIERS, WHICH COULD LIMIT OUR ABILITY TO GROW OUR BUSINESS. The market for voice interface software is relatively new and rapidly evolving. Our ability to increase revenue in the future depends on the acceptance by both our customers and their end users of voice interface software. The adoption of voice interface software could be hindered by the perceived costs of this new technology, as well as the reluctance of enterprises that have invested substantial resources in existing call centers or touch-tone-based systems to replace their current systems with this new technology. Accordingly, in order to achieve commercial acceptance, we will have to educate prospective customers, including large, established telecommunications companies, about the uses and benefits of voice interface software in general and our products in particular. If these efforts fail, or if voice interface software platforms do not achieve commercial acceptance, our business could be harmed. The continued development of the market for our products also will depend upon the following factors: - widespread deployment of voice interface applications by third parties, which is driven by consumer demand for services having a voice user interface; - demand for new uses and applications of voice interface technology, including adoption of voice user interfaces by companies that operate web sites; - adoption of industry standards for voice interface and related technologies; and - continuing improvements in hardware technology that may reduce the costs of voice interface software solutions. Our products can have a long sales and implementation cycle and, as a result, our quarterly operating results may fluctuate. The sales cycles for our products have typically ranged from three to twelve months, depending on the size and complexity of the order, the amount of 16 19 services to be provided by us and whether the sale is made directly by us or indirectly through a value added reseller, a voice application service provider or a systems integrator. Purchase of our products requires a significant expenditure by a customer. Accordingly, the decision to purchase our products typically requires significant pre-purchase evaluation. We may spend significant time educating and providing information to prospective customers regarding the use and benefits of our products. During this evaluation period, we may expend substantial sales, marketing and management resources. In addition, during any quarter we may receive a number of orders that are large relative to our total revenues for that quarter or subsequent quarters. After purchase, it may take substantial time and resources to implement our software and to integrate it with our customers' existing systems. If we are performing services that are essential to the functionality of the software, in connection with its implementation, we recognize software revenue based on the percentage completed using contract accounting. In cases where the contract specifies milestones or acceptance criteria, we may not be able to recognize either software or service revenue until these conditions are met. We have in the past and may in the future experience unexpected delays in recognizing revenue. Consequently, the length of our sales and implementation cycles and the varying order amounts for our products make it difficult to predict the quarter in which revenue recognition may occur and may cause license and services revenue and operating results to vary significantly from period to period. OUR FAILURE TO RESPOND TO RAPID CHANGE IN THE MARKET FOR VOICE INTERFACE SOFTWARE COULD CAUSE US TO LOSE REVENUE AND HARM OUR BUSINESS. The voice interface software industry is relatively new and rapidly evolving. Our success will depend substantially upon our ability to enhance our existing products and to develop and introduce, on a timely and cost-effective basis, new products and features that meet changing end-user requirements and incorporate technological advancements. If we are unable to develop new products and enhanced functionalities or technologies to adapt to these changes, or if we cannot offset a decline in revenue from existing products with sales of new products, our business would suffer. Commercial acceptance of our products and technologies will depend, among other things, on: - the ability of our products and technologies to meet and adapt to the needs of our target markets; - the performance and price of our products and our competitors' products; and - our ability to deliver customer service directly and through our resellers. WE ARE EXPOSED TO GENERAL ECONOMIC CONDITIONS. As a result of recent unfavorable economic conditions and reduced capital spending, it is possible that our sales will decline. If the economic conditions in the United States worsen or if a wider or global economic slowdown occurs, we may experience a material adverse impact on our business, operating results and financial condition. OUR PRODUCTS ARE NOT 100% ACCURATE AND WE COULD BE SUBJECT TO CLAIMS RELATED TO THE PERFORMANCE OF OUR PRODUCTS. ANY CLAIMS, WHETHER SUCCESSFUL OR UNSUCCESSFUL, COULD RESULT IN SIGNIFICANT COSTS AND COULD DAMAGE OUR REPUTATION. Speech recognition, natural language understanding and authentication technologies, including our own, are not 100% accurate. Our customers, including several financial institutions, use our products to provide important services to their customers, including transferring funds to accounts and buying and selling securities. Any misrecognition of voice commands or incorrect 17 20 authentication of a user's voice in connection with these financial or other transactions could result in claims against us or our customers for losses incurred. Although our contracts typically contain provisions designed to limit our exposure to liability claims, a claim brought against us for misrecognition or incorrect authentication, even if unsuccessful, could be time-consuming, divert management's attention, result in costly litigation and harm our reputation. Moreover, existing or future laws or unfavorable judicial decisions could limit the enforceability of the limitation of liability, disclaimer of warranty or other protective provisions contained in our contracts. ANY SOFTWARE DEFECTS IN OUR PRODUCTS COULD HARM OUR BUSINESS AND RESULT IN LITIGATION. Complex software products such as ours may contain errors, defects and bugs. With the planned release of any product, we may discover these errors, defects and bugs and, as a result, our products may take longer than expected to develop. In addition, we may discover that remedies for errors or bugs may be technologically unfeasible. Delivery of products with undetected production defects or reliability, quality, or compatibility problems could damage our reputation. Errors, defects or bugs could also cause interruptions, delays or a cessation of sales to our customers. We could be required to expend significant capital and other resources to remedy these problems. In addition, customers whose businesses are disrupted by these errors, defects and bugs could bring claims against us which, even if unsuccessful, would likely be time-consuming and could result in costly litigation and payment of damages. OUR CURRENT AND POTENTIAL COMPETITORS, SOME OF WHOM HAVE GREATER RESOURCES AND EXPERIENCE THAN WE DO, MAY DEVELOP PRODUCTS AND TECHNOLOGIES THAT MAY CAUSE DEMAND FOR, AND THE PRICES OF, OUR PRODUCTS TO DECLINE. A number of companies have developed, or are expected to develop, products that compete with our products. Competitors in the voice interface software market include IBM, ITT Industries, Lernout and Hauspie Speech Products, Locus Dialogue, Lucent Technologies, Microsoft, Philips Electronics, SpeechWorks International, T-NETIX, Veritel and Vocalis. We expect additional competition from other companies, our competitors may combine with each other, and other companies may enter our markets by acquiring or entering into strategic relationships with our competitors. Current and potential competitors have established, or may establish, cooperative relationships among themselves or with third parties to increase the abilities of their advanced speech and language technology products to address the needs of our prospective customers. Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, product development and marketing resources, greater name recognition and larger customer bases than we do. Our present or future competitors may be able to develop products comparable or superior to those we offer, adapt more quickly than we do to new technologies, evolving industry trends and standards or customer requirements, or devote greater resources to the development, promotion and sale of their products than we do. Accordingly, we may not be able to compete effectively in our markets, competition may intensify and future competition may harm our business. WE DEPEND ON RESELLERS FOR A SIGNIFICANT PORTION OF OUR SALES. THE LOSS OF A KEY RESELLER, OR THEIR INABILITY TO RESELL OUR PRODUCTS AND SERVICES, WOULD LIMIT OUR ABILITY TO SUSTAIN AND GROW OUR REVENUE. In 1998, 31% of our revenue was achieved by indirect sales through resellers. The percentage of revenue through indirect sales increased to 56% in 1999 and to 72% in both 2000 and the six months ended June 30, 2001. We intend to continue to rely on resellers for a substantial portion of our sales in the future. As a result, we are dependent upon the continued viability and financial stability of our resellers, as well as upon their continued interest and success in selling our products. The loss of a key reseller or our failure to develop new and viable reseller relationships could limit our ability to sustain and grow our revenue. Significant expansion of our internal sales force to replace the loss of a key reseller would require increased management attention and higher expenditures. 18 21 Our contracts with resellers generally do not require a reseller to purchase our products. We cannot guarantee that any of our resellers will continue to market our products or devote significant resources to doing so. In addition, we may, from time to time, terminate some of our relationships with resellers. Any termination could have a negative impact on our business and result in threatened or actual litigation. Finally, these resellers possess confidential information concerning our products, product release schedules and sales, marketing and reseller operations. Although we have nondisclosure agreements with our resellers, we cannot guarantee that any reseller would not use our confidential information in competition with us or otherwise. If our resellers do not successfully market and sell our products for these or any other reasons, our sales could be adversely affected and our revenue could decline. WE DEPEND ON A LIMITED NUMBER OF CUSTOMER ORDERS FOR A SUBSTANTIAL PORTION OF OUR REVENUE DURING ANY GIVEN PERIOD. LOSS OF, OR DELAYS IN, A KEY ORDER COULD SUBSTANTIALLY REDUCE OUR REVENUE IN ANY GIVEN PERIOD AND HARM OUR BUSINESS. We derive a significant portion of our revenue in each period from a limited number of customers. For example, in the three months ending June 30, 2001, five customers made up 40% of our total revenue, and one of those customers, acting as a reseller, accounted for approximately 23% of our total revenue. We expect that a limited number of customers and customer orders will continue to account for a substantial portion of our revenue in a given period. Generally, customers who make large purchases from us are not expected to make subsequent, equally large purchases in the short term. As a result, if we do not acquire a major customer, if a contract is delayed, cancelled or deferred, or if an anticipated sale is not made, our business could be harmed. SALES TO CUSTOMERS OUTSIDE THE UNITED STATES ACCOUNT FOR A SIGNIFICANT PORTION OF OUR REVENUE, WHICH EXPOSES US TO RISKS INHERENT IN INTERNATIONAL OPERATIONS. International sales represented approximately 18% of our revenue in 1998, 21% in 1999, 47% in 2000 and 42% in the six months ended June 30, 2001, and we anticipate that revenue from markets outside the United States will continue to represent a significant portion of our total future revenue. We are subject to a variety of risks associated with conducting business internationally, any of which could harm our business. These risks include: - difficulties and costs of staffing and managing foreign operations; - the difficulty in establishing and maintaining an effective international reseller network; - the burden of complying with a wide variety of foreign laws, particularly with respect to intellectual property and license requirements; - political and economic instability outside the United States; - import or export licensing and product certification requirements; - tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by foreign countries; - potential adverse tax consequences, including higher marginal rates; - unfavorable fluctuations in currency exchange rates; and - limited ability to enforce agreements, intellectual property rights and other rights in some foreign countries. IN ORDER TO INCREASE OUR INTERNATIONAL SALES, WE MUST DEVELOP LOCALIZED VERSIONS OF OUR PRODUCTS. IF WE ARE UNABLE TO DO SO, WE MAY BE UNABLE TO GROW OUR REVENUE AND EXECUTE OUR BUSINESS STRATEGY. 19 22 We intend to expand our international sales, which requires us to invest significant resources to create and refine different language models for each particular language or dialect. These language models are required to create versions of our products that allow end users to speak the local language or dialect and be understood and authenticated. If we fail to develop localized versions of our products, our ability to address international market opportunities and to grow our business will be limited. IF THE STANDARDS WE HAVE SELECTED TO SUPPORT ARE NOT ADOPTED AS THE STANDARDS FOR VOICE INTERFACE SOFTWARE, BUSINESSES MIGHT NOT USE OUR VOICE INTERFACE SOFTWARE PLATFORM FOR DELIVERY OF APPLICATIONS AND SERVICES. The market for voice interface software is new and emerging and industry standards have not been established yet. We may not be competitive unless our products support changing industry standards. The emergence of industry standards, whether through adoption by official standards committees or widespread usage, could require costly and time-consuming redesign of our products. If these standards become widespread and our products do not support them, our customers and potential customers may not purchase our products. Multiple standards in the marketplace could also make it difficult for us to ensure that our products will support all applicable standards, which could in turn result in decreased sales of our products. Our V-Builder applications-building tool, our Voice Web Server software and our Voyager browser application are each designed to work with the recently emerged VoiceXML standard. If VoiceXML is not widely accepted by our target customers, then sales of our products could decline and our business would be harmed. In that case, we may find it necessary to redesign our existing products or design new products that are compatible with standards that replace VoiceXML. This design or redesign could be costly and time-consuming. WE MAY ENCOUNTER DIFFICULTIES IN MANAGING OUR GROWTH, WHICH COULD PREVENT US FROM EXECUTING OUR BUSINESS STRATEGY. Our rapid growth has placed, and continues to place, a significant strain on our resources. To accommodate this growth, we must implement or upgrade a variety of operational and financial systems, procedures and controls, including the improvement of our accounting and other internal management systems. We have had to hire additional employees to accommodate this growth in business and product development activity. This has resulted in increased responsibilities for our management. Our systems, procedures and controls may not be adequate to support our operations. If we fail to improve our operational, financial and management information systems, or to hire, train, motivate or manage our employees, our business could be harmed. ANY INABILITY TO ADEQUATELY PROTECT OUR PROPRIETARY TECHNOLOGY COULD HARM OUR ABILITY TO COMPETE. Our future success and ability to compete depends in part upon our proprietary technology and our trademarks, which we attempt to protect with a combination of patent, copyright, trademark and trade secret laws, as well as with our confidentiality procedures and contractual provisions. These legal protections afford only limited protection and may be time-consuming and expensive to obtain and/or maintain. Further, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our intellectual property. Although we have filed multiple U.S. patent applications, we have currently only been issued a small number of patents. There is no guarantee that more patents will be issued with respect to our current or future patent applications. Any patents that are issued to us could be invalidated, circumvented or challenged. If challenged, our patents might not be upheld or their claims could be narrowed. Our intellectual property may not be adequate to provide us with competitive advantage or to prevent competitors from entering the markets for our products. Additionally, our competitors could independently develop non-infringing technologies that are competitive with, equivalent to, and/or superior to our technology. Monitoring infringement and/or misappropriation of intellectual 20 23 property can be difficult, and there is no guarantee that we would detect any infringement or misappropriation of our proprietary rights. Even if we do detect infringement or misappropriation of our proprietary rights, litigation to enforce these rights could cause us to divert financial and other resources away from our business operations. Further, we license our products internationally, and the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States. THIRD PARTIES COULD OBTAIN LICENSES FROM SRI INTERNATIONAL RELATING TO VOICE INTERFACE TECHNOLOGIES AND DEVELOP TECHNOLOGIES TO COMPETE WITH OUR PRODUCTS, WHICH COULD CAUSE OUR SALES TO DECLINE. Upon our incorporation in 1994, we received a license from SRI International to a number of patents and other proprietary rights, including rights in software, relating to voice interface technologies developed by SRI International. This license was exclusive until December 1999, when we chose to allow the exclusivity to lapse. As a result, SRI International may license these patents and proprietary rights to our competitors. If a license from SRI International were to enable third parties to enter the markets for our products and services or to compete more effectively, we could lose market share and our business could suffer. OUR PRODUCTS MAY INFRINGE THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS, AND RESULTING CLAIMS AGAINST US COULD BE COSTLY AND REQUIRE US TO ENTER INTO DISADVANTAGEOUS LICENSE OR ROYALTY ARRANGEMENTS. The software industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of intellectual property rights. Although we attempt to avoid infringing known proprietary rights of third parties we may be subject to legal proceedings and claims for alleged infringement by us or our licensees of third-party proprietary rights, such as patents, trade secrets, trademarks or copyrights, from time to time in the ordinary course of business. Any claims relating to the infringement of third-party proprietary rights, even if not successful or meritorious, could result in costly litigation, divert resources and management's attention or require us to enter into royalty or license agreements which are not advantageous to us. In addition, parties making these claims may be able to obtain injunctions, which could prevent us from selling our products. Furthermore, former employers of our employees may assert that these employees have improperly disclosed confidential or proprietary information to us. Any of these results could harm our business. We may be increasingly subject to infringement claims as the number of, and number of features of, our products grow. IF WE ARE UNABLE TO HIRE AND RETAIN SELECT PERSONNEL, OUR BUSINESS COULD BE HARMED. We intend to hire select personnel during the remainder of the year. Competition for these individuals can be intense, and we may not be able to attract, assimilate, or retain additional highly qualified personnel in the future. The failure to attract, integrate, motivate and retain these employees could harm our business. The decline in the value of our common stock may also make it more difficult to retain our employees. WE RELY ON THE SERVICES OF OUR KEY PERSONNEL, WHOSE KNOWLEDGE OF OUR BUSINESS AND TECHNICAL EXPERTISE WOULD BE DIFFICULT TO REPLACE. We rely upon the continued service and performance of a relatively small number of key technical and senior management personnel. Our future success depends on our retention of these key employees, such as Ronald Croen, our Chief Executive Officer. None of our key technical or senior management personnel are bound by employment agreements, and, as a result, any of these employees could leave with little or no prior notice. If we lose any of our key technical and senior management personnel, our business could be harmed. We do not have key person life insurance policies covering any of our employees. CERTAIN STOCKHOLDERS MAY DISAGREE WITH HOW NUANCE USES THE PROCEEDS FROM ITS PUBLIC OFFERINGS. 21 24 Management retains broad discretion over the use of proceeds from the Company's April 2000 initial public offering and September 2000 secondary public offering. Stockholders may not deem these uses desirable and our use of the proceeds may not yield a significant return or any return at all. Because of the number and variability of factors that determine our use of the net proceeds from these offerings, we cannot guarantee that these uses will not vary substantially from our currently planned uses. SOME OF OUR EXISTING STOCKHOLDERS CAN EXERT CONTROL OVER NUANCE AND MAY NOT MAKE DECISIONS THAT ARE IN THE BEST INTERESTS OF ALL STOCKHOLDERS. As of July 31, 2001, our executive officers and directors, their affiliates and other current principal stockholders together control approximately 20% of our outstanding common stock. As a result, these stockholders, if they act together, are able to exert a significant degree of influence over our management and affairs and over matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. In addition, this concentration of ownership may delay or prevent a change in control of Nuance, even when a change in control may be in the best interests of other stockholders. Moreover, the interests of this concentration of ownership may not always coincide with our interests or the interests of other stockholders and, accordingly, these controlling stockholders could cause us to enter into transactions or agreements which we would not otherwise consider. OUR CHARTER AND BYLAWS AND DELAWARE LAW CONTAIN PROVISIONS WHICH MAY DELAY OR PREVENT A CHANGE OF CONTROL OF NUANCE. Provisions of our charter and bylaws may make it more difficult for a third party to acquire, or discourage a third party from attempting to acquire, control of Nuance. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions include: - the division of the board of directors into three separate classes; - the elimination of cumulative voting in the election of directors; - prohibitions on our stockholders from acting by written consent and calling special meetings; - procedures for advance notification of stockholder nominations and proposals; and - the ability of the board of directors to alter our bylaws without stockholder approval. In addition, our board of directors has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by the stockholders. The issuance of preferred stock, while providing flexibility in connection with possible financings or acquisitions or other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. Since the completion of our initial public offering on April 13, 2000, we have been subject to the antitakeover provisions of the Delaware General Corporation Law, including Section 203, which may deter potential acquisition bids for our company. Under Delaware law, a corporation may opt out of Section 203. We do not intend to opt out of the provisions of Section 203. WE MAY INCUR A VARIETY OF COSTS TO ENGAGE IN FUTURE ACQUISITIONS OF COMPANIES, PRODUCTS OR TECHNOLOGIES, AND THE ANTICIPATED BENEFITS OF THOSE ACQUISITIONS MAY NEVER BE REALIZED. As a part of our business strategy, we may make acquisitions of, or significant investments in, complementary companies, products or technologies. 22 25 For instance, in November 2000 we acquired SpeechFront, a Canadian company, and in February 2001, we acquired non-exclusive Intellectual Property Rights from a third-party. Any future acquisitions would be accompanied by risks such as: - difficulties in assimilating the operations and personnel of acquired companies; - diversion of our management's attention from ongoing business concerns; - our potential inability to maximize our financial and strategic position through the successful incorporation of acquired technology and rights into our products and services; - additional expense associated with amortization of acquired assets; - maintenance of uniform standards, controls, procedures and policies; and - impairment of existing relationships with employees, suppliers and customers as a result of the integration of new management personnel. We cannot guarantee that we will be able to successfully integrate any business, products, technologies or personnel that we might acquire in the future, and our failure to do so could harm our business. INFORMATION THAT WE MAY PROVIDE TO INVESTORS FROM TIME TO TIME IS ACCURATE ONLY AS OF THE DATE WE DISSEMINATE IT, AND WE UNDERTAKE NO OBLIGATION TO UPDATE THE INFORMATION. From time to time, we may publicly disseminate forward-looking information or guidance in compliance with Regulation FD promulgated by the Securities and Exchange Commission. This information or guidance represents our outlook only as of the date that we disseminated it, and we undertake no obligation to provide updates to this information or guidance in our filings with the Securities and Exchange Commission or otherwise. OUR FACILITIES ARE LOCATED NEAR KNOWN EARTHQUAKE FAULT ZONES, AND THE OCCURRENCE OF AN EARTHQUAKE OR OTHER NATURAL DISASTER COULD CAUSE DAMAGE TO OUR FACILITIES AND EQUIPMENT, WHICH COULD REQUIRE US TO CURTAIL OR CEASE OPERATIONS. Our facilities are located in the San Francisco Bay Area near known earthquake fault zones and are vulnerable to damage from earthquakes. In October 1989, a major earthquake that caused significant property damage and a number of fatalities struck this area. We are also vulnerable to damage from other types of disasters, including fire, floods, power loss, communications failures and similar events. If any disaster were to occur, our ability to operate our business at our facilities could be seriously, or potentially completely, impaired. The insurance we maintain may not be adequate to cover our losses resulting from disasters or other business interruptions. WE RELY ON A CONTINUOUS POWER SUPPLY TO CONDUCT OUR OPERATIONS, AND CALIFORNIA'S CURRENT ENERGY CRISIS COULD DISRUPT OUR OPERATIONS AND INCREASE OUR EXPENSES. California is in the midst of an energy crisis that could disrupt our operations and increase our expenses. In the event of an acute power shortage, that is, when power reserves for the State of California fall below 1.5%, California has on some occasions implemented, and may in the future continue to implement, rolling blackouts throughout California. We currently do not have backup generators or alternate sources of power in the event of a blackout, and our current insurance does not provide coverage for any damages we, or our customers, may suffer as a result of any interruption in our power supply. If blackouts interrupt our power supply, we would be temporarily unable to continue operations at our facilities. Any such interruption in our ability to continue operations at our facilities could damage our reputation, harm our ability to retain existing customers and to obtain new customers, and could result in lost revenue, any of which could substantially harm our business and results of operations. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 23 26 MARKET RISK The following discusses our exposure to market risk related to changes in interest rates, equity prices and foreign currency exchange rates. This discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results could vary materially as a result of a number of factors including those set forth in the risk factors section of this Quarterly Report on Form 10-Q. Foreign Currency Exchange Rate Risk To date, all of our recognized revenues have been denominated in U.S. dollars and primarily from customers in the United States, and our exposure to foreign currency exchange rate changes has been immaterial. We expect, however, that future product license and services revenues may also be derived from international markets and may be denominated in the currency of the applicable market. As a result, our operating results may become subject to significant fluctuations based upon changes in the exchange rates of certain currencies in relation to the U.S. dollar. Furthermore, to the extent that we engage in international sales denominated in U.S. dollars, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in international markets. Although we will continue to monitor our exposure to currency fluctuations, and when appropriate, may use financial hedging techniques to minimize the effect of these fluctuations, we cannot assure you that exchange rate fluctuations will not adversely affect our financial results in the future. Interest Rate Risk As of June 30, 2001, we had cash and cash equivalents of $190.9 million. Any decline in interest rates over time would reduce our interest income from our cash and cash equivalents and short-term investments. Based upon our balance of cash and cash equivalents at June 30, 2001, a decrease in interest rates of 0.5% would cause a corresponding decrease in our annual interest income by approximately $950,000. PART II: OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS: In March 2001, the first of a number of stockholder complaints was filed in the United States District Court for the Northern District of California against us and certain of our officers. The complaints were filed on behalf of a purported class of people who purchased our stock during the period January 31, 2001 through March 15, 2001, alleging insider trading and false and misleading statements in violation of the federal securities laws. The plaintiffs are seeking unspecified damages. We believe that the allegations of these lawsuits are without merit and intend to defend the litigation vigorously. An unfavorable resolution of this litigation could have a material adverse effect on our business, results of operations, or financial condition. In June and July 2001, putative shareholder derivative actions were filed in California state court alleging breaches of fiduciary duty and insider trading by various of our directors and officers. While we are named as a nominal defendant, the lawsuits do not appear to seek any recovery against us. Proceedings in these actions have been stayed. In August 2001, a complaint styled Atlas v. Nuance Communications, No. 01 CIV. 7344, was filed in federal district court for the Southern District of New York on behalf of a purported class of persons who purchased our stock between April 12, 2000 and December 6, 2000. The complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to our initial public offering of securities. The complaint brings claims for violation of several provisions of the federal securities laws against those underwriters, and also against us and some of our directors and officers. Similar lawsuits concerning more than 100 other companies' initial public offerings have been filed this year. We believe that the allegations against us are without merit and intend to defend the litigation vigorously. 24 27 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K: (a) No exhibits were filed during the quarter. (b) No reports on Form 8-K were filed during the quarter. 25 28 SIGNATURES Pursuant to the requirements of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NUANCE COMMUNICATIONS Date: August 14, 2001 By: /s/ GRAHAM SMITH ------------------------------------ Graham Smith Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) 26