NUAN 03-31-2014 10-Q
Table of Contents

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 _____________________________________________
Form 10-Q
 _____________________________________________
(Mark One)
ý    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2014
Or
 ¨    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 001-36056
 _____________________________________________
NUANCE COMMUNICATIONS, INC.
(Exact name of registrant as specified in its charter)
 _____________________________________________
Delaware
 
94-3156479
(State or Other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
1 Wayside Road
Burlington, Massachusetts
 
01803
(Address of principal executive offices)
 
(Zip Code)
Registrant’s telephone number, including area code:
(781) 565-5000
 _____________________________________________
Indicate by check mark whether the 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 (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
ý
 
 
Accelerated filer
 
¨
Non-accelerated filer
¨
 (Do not check if a smaller reporting company)
 
Smaller reporting company
 
¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
The number of shares of the Registrant’s Common Stock, outstanding as of April 30, 2014 was 318,607,119.




NUANCE COMMUNICATIONS, INC.
TABLE OF CONTENTS
 
 
 
Page
Item 1.
Condensed Consolidated Financial Statements (unaudited):
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
Certifications
 






Part I. Financial Information 

Item 1. Condensed Consolidated Financial Statements (unaudited)

NUANCE COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
 
Three months Ended March 31,
 
Six Months Ended March 31,
 
2014
 
2013
 
2014
 
2013
 
(Unaudited)
(In thousands, except per share amounts)
Revenues:
 
 
 
 
 
 
 
Product and licensing
$
174,819

 
$
173,065

 
$
353,256

 
$
369,796

Professional services and hosting
227,526

 
213,264

 
445,661

 
413,569

Maintenance and support
73,308

 
64,670

 
146,716

 
129,902

Total revenues
475,653

 
450,999

 
945,633

 
913,267

Cost of revenues:
 
 
 
 
 
 
 
Product and licensing
25,226

 
22,943

 
50,435

 
49,252

Professional services and hosting
157,437

 
138,534

 
312,017

 
263,690

Maintenance and support
12,359

 
13,098

 
25,196

 
27,895

Amortization of intangible assets
15,342

 
16,610

 
30,536

 
32,920

Total cost of revenues
210,364

 
191,185

 
418,184

 
373,757

Gross profit
265,289

 
259,814

 
527,449

 
539,510

Operating expenses:
 
 
 
 
 
 
 
Research and development
84,581

 
69,681

 
165,051

 
138,402

Sales and marketing
98,280

 
97,855

 
217,186

 
214,990

General and administrative
43,682

 
33,355

 
88,158

 
78,139

Amortization of intangible assets
26,571

 
26,001

 
54,043

 
51,427

Acquisition-related costs, net
6,802

 
15,448

 
9,600

 
31,181

Restructuring and other charges, net
4,719

 
5,062

 
8,556

 
6,729

Total operating expenses
264,635

 
247,402

 
542,594

 
520,868

Income (loss) from operations
654

 
12,412

 
(15,145
)
 
18,642

Other income (expense):
 
 
 
 
 
 
 
Interest income
774

 
405

 
1,193

 
943

Interest expense
(33,987
)
 
(33,878
)
 
(67,946
)
 
(67,995
)
Other expense, net
(274
)
 
(4,113
)
 
(3,370
)
 
(7,421
)
Loss before income taxes
(32,833
)
 
(25,174
)
 
(85,268
)
 
(55,831
)
Provision (benefit) from income taxes
6,394

 
674

 
9,372

 
(7,887
)
Net loss
$
(39,227
)
 
$
(25,848
)
 
$
(94,640
)
 
$
(47,944
)
Net loss per share:
 
 
 
 
 
 
 
Basic
$
(0.12
)
 
$
(0.08
)
 
$
(0.30
)
 
$
(0.15
)
Diluted
$
(0.12
)
 
$
(0.08
)
 
$
(0.30
)
 
$
(0.15
)
Weighted average common shares outstanding:
 
 
 
 
 
 
 
Basic
316,593

 
315,473

 
315,696

 
314,006

Diluted
316,593

 
315,473

 
315,696

 
314,006

See accompanying notes.

1



NUANCE COMMUNICATIONS, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
 
Three months Ended March 31,
 
Six Months Ended March 31,
 
2014
 
2013
 
2014
 
2013
 
Unaudited (In thousands)
Net loss
$
(39,227
)
 
$
(25,848
)
 
$
(94,640
)
 
$
(47,944
)
Other comprehensive (loss) income:
 
 
 
 
 
 
 
Foreign currency translation adjustment
(1,127
)
 
(17,972
)
 
5,477

 
(10,861
)
Recognition of pension loss amortization

 
33

 

 
166

Total other comprehensive (loss) income, net
(1,127
)

(17,939
)
 
5,477

 
(10,695
)
Comprehensive loss
$
(40,354
)
 
$
(43,787
)
 
$
(89,163
)
 
$
(58,639
)




































See accompanying notes.



2

Table of Contents

NUANCE COMMUNICATIONS, INC.
CONSOLIDATED BALANCE SHEETS 
 
March 31, 2014
 
September 30, 2013
 
(Unaudited)
 
(In thousands, except per
share amounts)
ASSETS
Current assets:
 
 
 
Cash and cash equivalents
$
768,302

 
$
808,118

Marketable securities
41,204

 
38,728

Accounts receivable, less allowances for doubtful accounts of $9,060 and $8,529
387,715

 
382,741

Prepaid expenses and other current assets
113,218

 
104,971

Deferred tax asset
75,339

 
74,969

Total current assets
1,385,778

 
1,409,527

Land, building and equipment, net
144,173

 
143,465

Goodwill
3,378,194

 
3,293,198

Intangible assets, net
921,653

 
953,278

Other assets
181,868

 
159,135

Total assets
$
6,011,666

 
$
5,958,603

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
 
Current portion of long-term debt
$
251,031

 
$
246,040

Accounts payable
57,915

 
91,016

Accrued expenses and other current liabilities
226,846

 
214,425

Deferred revenue
296,548

 
253,753

Total current liabilities
832,340

 
805,234

Long-term debt
2,117,522

 
2,108,091

Deferred revenue, net of current portion
208,304

 
160,823

Deferred tax liability
190,181

 
162,774

Other liabilities
64,310

 
83,667

Total liabilities
3,412,657

 
3,320,589

 
 
 
 
Commitments and contingencies (Notes 4 and 16)

 

 
 
 
 
Stockholders’ equity:
 
 
 
Common stock, $0.001 par value; 560,000 shares authorized; 322,012 and 319,365 shares issued and 318,261 and 315,614 shares outstanding, respectively
322

 
319

Additional paid-in capital
3,078,024

 
3,017,074

Treasury stock, at cost (3,751 shares)
(16,788
)
 
(16,788
)
Accumulated other comprehensive income
12,290

 
6,813

Accumulated deficit
(474,839
)
 
(369,404
)
Total stockholders’ equity
2,599,009

 
2,638,014

Total liabilities and stockholders’ equity
$
6,011,666

 
$
5,958,603

See accompanying notes.

3

Table of Contents

NUANCE COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
 
Six Months Ended March 31,
 
2014
 
2013
 
(Unaudited)
(In thousands)
Cash flows from operating activities:
 
 
 
Net loss
$
(94,640
)
 
$
(47,944
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation and amortization
109,417

 
102,576

Stock-based compensation
92,159

 
74,913

Non-cash interest expense
19,443

 
19,577

Deferred tax provision (benefit)
3,446

 
(24,228
)
Other
(5,258
)
 
(1,102
)
Changes in operating assets and liabilities, net of effects from acquisitions:
 
 
 
Accounts receivable
6,518

 
30,281

Prepaid expenses and other assets
(11,695
)
 
(11,517
)
Accounts payable
(32,097
)
 
2,147

Accrued expenses and other liabilities
(10,301
)
 
9,501

Deferred revenue
88,190

 
61,830

Net cash provided by operating activities
165,182

 
216,034

Cash flows from investing activities:
 
 
 
Capital expenditures
(24,719
)
 
(29,588
)
Payments for business and technology acquisitions, net of cash acquired
(135,537
)
 
(474,259
)
Purchases of marketable securities and other investments
(11,504
)
 

Proceeds from sales and maturities of marketable securities and other investments
21,634

 
181

Net cash used in investing activities
(150,126
)
 
(503,666
)
Cash flows from financing activities:
 
 
 
Payments of debt
(2,516
)
 
(146,123
)
Proceeds from long-term debt, net of issuance costs

 
352,392

Payments for repurchase of common stock
(26,435
)
 

Payments for settlement of share-based derivatives
(5,286
)
 
(3,801
)
Payments of other long-term liabilities
(1,519
)
 
(1,320
)
Proceeds from issuance of common stock from employee stock plans
11,922

 
13,085

Cash used to net share settle employee equity awards
(31,047
)
 
(49,518
)
Net cash (used in) provided by financing activities
(54,881
)
 
164,715

Effects of exchange rate changes on cash and cash equivalents
9

 
(1,542
)
Net decrease in cash and cash equivalents
(39,816
)
 
(124,459
)
Cash and cash equivalents at beginning of period
808,118

 
1,129,761

Cash and cash equivalents at end of period
$
768,302

 
$
1,005,302

See accompanying notes.


4

Table of Contents

NUANCE COMMUNICATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.
Organization and Presentation
The consolidated financial statements include the accounts of Nuance Communications, Inc. (“Nuance”, “we”, or “the Company”) and our wholly-owned subsidiaries. We prepared these unaudited interim consolidated financial statements in accordance with U.S. generally accepted accounting principles (GAAP) for interim periods. In our opinion, these financial statements reflect all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of our financial position for the periods disclosed. Intercompany transactions have been eliminated.
We reclassified certain immaterial amounts between product and licensing revenues and maintenance and support revenues previously reported for the three and six months ended March 31, 2013. We have also reclassified certain immaterial amounts related to stock-based compensation between research and development expense, selling and marketing expense and general and administrative expense for the three and six months ended March 31, 2013. The reclassifications have no impact on earnings or cash flows provided by operations.
Although we believe the disclosures in these financial statements are adequate to make the information presented not misleading, certain information normally included in the footnotes prepared in accordance with GAAP has been omitted. Accordingly, these financial statements should be read in conjunction with the audited financial statements and the notes thereto included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2013. Interim results are not necessarily indicative of the results that may be expected for a full year.

2.
Summary of Significant Accounting Policies
Effective October 1, 2013, we implemented Accounting Standards Update No. 2013-02, Comprehensive Income (Topic 220) Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, which did not have a significant impact on our consolidated financial statements.
We have made no material changes to the significant accounting policies disclosed in our Annual Report on Form 10-K for the fiscal year ended September 30, 2013.
Recently Issued Accounting Standards
In July 2013, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2013-11, "Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists" (ASU 2013-11) to provide guidance on the presentation of unrecognized tax benefits. ASU 2013-11 requires an entity to present an unrecognized tax benefit, or a portion of an unrecognized tax benefit, as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except as follows: to the extent a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. ASU 2013-11 is effective for us in our first quarter of fiscal 2015 with earlier adoption permitted. ASU 2013-11 should be applied prospectively with retroactive application permitted. We do not believe that this will have a material impact on our consolidated financial statements.

3.
Business Acquisitions
Fiscal 2014 Acquisitions
During fiscal 2014, we acquired several immaterial businesses in our Healthcare and Enterprise segments for total initial cash consideration of $138.3 million together with future contingent payments. In allocating the total purchase consideration for these acquisitions based on preliminary estimated fair values, we recorded $82.8 million of goodwill and $52.8 million of identifiable intangibles assets. Intangible assets acquired included customer relationships and core and completed technology with weighted average useful lives of 9.5 years. The majority of these acquisitions are treated as stock purchases, and the goodwill resulting from these acquisitions is not expected to be deductible for tax purposes.

5

NUANCE COMMUNICATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


Pro Forma Results
On May 31, 2013, we acquired the Technology Solutions Segment ("TGT") of the Tweddle Group for total consideration of $83.3 million in cash, including a purchase price adjustment as specified in the asset purchase agreement. TGT provides cloud-based infotainment and communications solutions to the automotive industry. The transaction was structured as an asset acquisition, and, therefore, the goodwill is expected to be deductible for tax purposes. The results of operations for TGT are included in our Mobile and Consumer segment from the acquisition date.
The following table shows unaudited pro forma results of operations as if we had acquired TGT on October 1, 2012 (dollars in thousands, except per share amounts): 
 
Three months Ended March 31,
 
Six Months Ended March 31,
2014
 
2013
 
2014
 
2013
Revenue
$
475,653

 
$
453,450

 
$
945,633

 
$
917,813

Net loss
(39,227
)
 
(28,799
)
 
(94,640
)
 
(54,462
)
Net loss per share - diluted
$
(0.12
)
 
$
(0.09
)
 
$
(0.30
)
 
$
(0.17
)

We have not furnished pro forma financial information related to our other recent acquisitions because such information is not material, individually or in the aggregate, to our financial results. The unaudited pro forma results of operations are not necessarily indicative of the actual results that would have occurred had the transactions actually taken place at the beginning of the periods indicated.
Acquisition-Related Costs, net
Acquisition-related costs include costs related to business and other acquisitions, including potential acquisitions. These costs consist of (i) transition and integration costs, including retention payments, transitional employee costs and earn-out payments treated as compensation expense, as well as the costs of integration-related activities including services provided by third-parties; (ii) professional service fees, including third party costs related to the acquisitions, and legal and other professional service fees associated with disputes and regulatory matters related to acquired entities; and (iii) adjustments to acquisition-related items that are required to be marked to fair value each reporting period, such as contingent consideration, and other items related to acquisitions for which the measurement period has ended.
The components of acquisition-related costs, net are as follows (dollars in thousands):
 
Three months Ended March 31,
 
Six Months Ended March 31,
2014
 
2013
 
2014
 
2013
Transition and integration costs
$
4,590

 
$
11,636

 
$
8,429

 
$
17,899

Professional service fees
2,399

 
3,812

 
5,738

 
13,282

Acquisition-related adjustments
(187
)
 

 
(4,567
)
 

Total
$
6,802

 
$
15,448

 
$
9,600

 
$
31,181

Included in acquisition-related adjustments for the six months ended March 31, 2014, is income of $7.7 million related to the elimination of a contingent liability established in the original allocation of purchase price for an acquisition closed in fiscal 2008, following the expiration of the applicable statute of limitations. As a result, we have eliminated the contingent liability, and included the adjustment in acquisition-related costs, net in our consolidated statements of operations.

4.
Contingent Acquisition Payments
The fair value of any contingent consideration is established at the acquisition date and included in the total purchase price. The contingent consideration is then adjusted to fair value as an increase or decrease in current earnings included in acquisition-related costs, net in each reporting period.
In connection with certain acquisitions completed in fiscal 2014, we may be required to make up to $13.6 million of additional payments to the selling shareholders contingent upon the achievement of specified objectives, including the achievement of future bookings and sales targets related to the products of the acquired entities. The contingent payments for these acquisitions were recorded at a total estimated fair value of $8.2 million on the applicable acquisition date, based on the probability of achieving the specified objective using a probability-weighted discounted cash flow model. This fair value measurement is based on significant

6

NUANCE COMMUNICATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


inputs not observed in the market and thus represents a Level 3 measurement as defined in the fair value hierarchy (see Note 7). The changes to the fair value of the contingent consideration will be recognized in acquisition-related costs, net in the consolidated statements of operations in the period in which the estimated fair value changes. In addition, there are deferred payment obligations to certain former shareholders, contingent upon their continued employment. These deferred payment obligations, totaling $6.9 million, will be recorded as compensation expense over the applicable employment period, and included in acquisition-related costs, net in our consolidated statements of operations.
In connection with our acquisition of JA Thomas in October 2012, we agreed to make deferred payments to the former shareholders of JA Thomas of up to $25.0 million in October 2014, contingent upon the continued employment of certain named executives and certain other conditions. The contingent payments will be reduced by amounts specified in the merger agreement in the event that any of the named executives terminates their employment prior to the payment date. At March 31, 2014, we have accrued $18.8 million which represents the portion of the deferred payment that is payable to the named executives that is being recognized as compensation expense over the two year employment period and included in acquisition-related costs, net in our consolidated statements of operations.

5.
Goodwill and Intangible Assets
The changes in the carrying amount of goodwill and intangible assets for the six months ended March 31, 2014, are as follows (dollars in thousands): 
 
Goodwill
 
Intangible
Assets
Balance at September 30, 2013
$
3,293,198

 
$
953,278

Acquisitions
82,818

 
53,173

Purchase accounting adjustments
(677
)
 
(59
)
Amortization

 
(84,579
)
Effect of foreign currency translation
2,855

 
(160
)
Balance at March 31, 2014
$
3,378,194

 
$
921,653


6.
Financial Instruments and Hedging Activities
Derivatives Not Designated as Hedges
Forward Currency Contracts
We operate our business in countries throughout the world and transact business in various foreign currencies. Our foreign currency exposures typically arise from transactions denominated in currencies other than the functional currency of our operations. We have a program that primarily utilizes foreign currency forward contracts to offset the risks associated with the effect of certain foreign currency exposures. Our program is designed so that increases or decreases in our foreign currency exposures are offset by gains or losses on the foreign currency forward contracts in order to mitigate the risks and volatility associated with our foreign currency transactions. Generally we enter into contracts for less than 90 days, and at March 31, 2014 and September 30, 2013, we had outstanding contracts with a total notional value of $238.4 million and $247.8 million, respectively.
We have not designated these forward contracts as hedging instruments pursuant to ASC 815, Derivatives and Hedging, and accordingly, we record the fair value of these contracts at the end of each reporting period in our consolidated balance sheet, with changes in the fair value recorded in earnings as other expense, net in our consolidated statements of operations.
Security Price Guarantees
From time to time we enter into agreements that allow us to issue shares of our common stock as part or all of the consideration related to partnering and technology acquisition activities. Generally these shares are issued subject to security price guarantees, which are accounted for as derivatives. We have determined that these instruments would not be considered equity instruments if they were freestanding. The security price guarantees require payment from either us to a third party, or from a third party to us, based upon the difference between the price of our common stock on the issue date and an average price of our common stock approximately six months following the issue date. Changes in the fair value of these security price guarantees are reported in earnings in each period as other expense, net in our consolidated statements of operations. At March 31, 2014, we had no security price guarantees outstanding.



7

NUANCE COMMUNICATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


The following table provides a quantitative summary of the fair value of our derivative instruments as of March 31, 2014 and September 30, 2013 (dollars in thousands): 
Derivatives Not Designated as Hedges:
 
Balance Sheet Classification
 
Fair Value
 
March 31, 2014
 
September 30, 2013
Foreign currency contracts
 
Prepaid expenses and other current assets
 
$
895

 
$
2,201

Security Price Guarantees
 
Accrued expenses and other current liabilities
 

 
(1,044
)
Net fair value of non-hedge derivative instruments
 
$
895

 
$
1,157

The following tables summarize the activity of derivative instruments for the three and six months ended March 31, 2014 and 2013 (dollars in thousands):
 
 
 
 
Three months Ended March 31,
 
Six Months Ended March 31,
Derivatives Not Designated as Hedges
 
Location of Gain (Loss) Recognized in Income
 
2014
 
2013
 
2014
 
2013
Foreign currency contracts
 
Other expense, net
 
$
2,046

 
$
(329
)
 
$
6,372

 
$
(434
)
Security price guarantees
 
Other expense, net
 
$
(72
)
 
$
(3,015
)
 
$
(4,222
)
 
$
(5,526
)
Other Financial Instruments
Financial instruments, including cash equivalents, marketable securities, accounts receivable, accounts payable, and derivative instruments, are carried in the consolidated financial statements at amounts that approximate their fair value.
The estimated fair value of our long-term debt approximated $2,483.0 million (face value $2,469.8 million) and $2,458.2 million (face value $2,472.2 million) at March 31, 2014 and September 30, 2013, respectively. These fair value amounts represent the value at which our lenders could trade our debt within the financial markets, and do not represent the settlement value of these long-term debt liabilities to us at each reporting date. The fair value of the long-term debt issues will continue to vary each period based on fluctuations in market interest rates, as well as changes to our credit ratings. The Senior Notes, the term loan portion of our Credit Facility, and the Convertible Debentures are traded and the fair values of each borrowing was estimated using the averages of the bid and ask trading quotes at each respective reporting date. We had no outstanding balance on the revolving credit line portion of our Credit Facility at March 31, 2014 and September 30, 2013.

7.Fair Value Measures
Fair value is defined as the price that would be received for an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. Valuation techniques must maximize the use of observable inputs and minimize the use of unobservable inputs. When determining the fair value measurements for assets and liabilities required to be recorded at fair value, we consider the principal or most advantageous market in which we would transact and consider assumptions that market participants would use when pricing the asset or liability, such as inherent risk, transfer restrictions, and risk of nonperformance.
ASC 820, Fair Value Measures and Disclosures, establishes a value hierarchy based on three levels of inputs, of which the first two are considered observable and the third is considered unobservable:
Level 1. Quoted prices for identical assets or liabilities in active markets which we can access.
Level 2. Observable inputs other than those described as Level 1.
Level 3. Unobservable inputs.

8

NUANCE COMMUNICATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


Items measured at Fair Value on a Recurring Basis
Assets and liabilities measured at fair value on a recurring basis at March 31, 2014 and September 30, 2013 consisted of (dollars in thousands):
 
March 31, 2014
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Money market funds(a)
$
657,163

 
$

 
$

 
$
657,163

US government agency securities(a)
1,000

 

 

 
1,000

Marketable securities, $41,204 at cost (b)

 
41,204

 

 
41,204

Foreign currency exchange contracts(b)


 
895

 

 
895

Total assets at fair value
$
658,163

 
$
42,099

 
$

 
$
700,262

Liabilities:
 
 
 
 
 
 
 
Contingent earn-out(d)
$

 
$

 
$
(8,096
)
 
$
(8,096
)
Total liabilities at fair value
$

 
$

 
$
(8,096
)
 
$
(8,096
)
 
 
September 30, 2013
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Money market funds(a)
$
684,697

 
$

 
$

 
$
684,697

US government agency securities(a)
1,000

 

 

 
1,000

Marketable securities, $38,728 at cost (b)

 
38,728

 

 
38,728

Foreign currency exchange contracts(b)

 
2,201

 

 
2,201

Total assets at fair value
$
685,697

 
$
40,929

 
$

 
$
726,626

Liabilities:
 
 
 
 
 
 
 
Security price guarantees(c)
$

 
$
(1,044
)
 
$

 
$
(1,044
)
Contingent earn-out(d)

 

 
(450
)
 
(450
)
Total liabilities at fair value
$

 
$
(1,044
)
 
$
(450
)
 
$
(1,494
)
 
(a)
Money market funds and U.S. government agency securities, included in cash and cash equivalents in the accompanying balance sheets, are valued at quoted market prices in active markets.
(b)
The fair values of our time deposits, marketable securities and foreign currency exchange contracts are based on the most recent observable inputs for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active or are directly or indirectly observable.
(c)
The fair values of the security price guarantees are determined using a modified Black-Scholes model, derived from observable inputs such as U.S. treasury interest rates, our common stock price, and the volatility of our common stock. The valuation model values both the put and call components of the guarantees simultaneously, with the net value of those components representing the fair value of each instrument.
(d)
The fair value of our contingent consideration arrangements are determined based on our evaluation as to the probability and amount of any earn-out that will be achieved based on expected future performance by the acquired entity.
The changes in the fair value of contingent earn-out liabilities are as follows (dollars in thousands):
 
Three months Ended March 31,
 
Six Months Ended March 31,
 
2014
 
2014
Balance at beginning of period
$
1,319

 
$
450

Earn-out liability established at time of acquisition
7,438

 
8,307

Payments upon settlement
(661
)
 
(661
)
Balance at end of period
$
8,096

 
$
8,096


9

NUANCE COMMUNICATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


Our financial liabilities valued based upon Level 3 inputs are comprised of contingent consideration arrangements relating to our acquisitions. We are contractually obligated to pay contingent consideration upon the achievement of specified objectives, including the achievement of future bookings and sales targets related to the products of the acquired entities and therefore recorded contingent consideration liabilities at the time of the acquisitions. We update our assumptions each reporting period based on new developments and record such amounts at fair value based on the revised assumptions until the considerations is paid upon the achievement of the specified objectives or eliminated upon failure to achieve the specified objectives.
Contingent liabilities are scheduled to be paid in periods through fiscal 2016. As of March 31, 2014, we could be required to pay up to $18.9 million for contingent consideration arrangements if the specified objectives are achieved. We have determined the fair value of the liabilities for the contingent consideration based on a probability-weighted discounted cash flow analysis. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement within the fair value hierarchy. The fair value of the contingent consideration liability associated with future payments was based on several factors, the most significant of which are the estimated cash flows projected from the future product sales and the risk adjusted discount rate for the fair value measurement.
8.
Accrued Expenses and Other Current Liabilities
Accrued expenses and other current liabilities consisted of the following (dollars in thousands): 
 
March 31, 2014
 
September 30, 2013
Compensation
$
106,816

 
$
112,756

Acquisition costs and liabilities
35,412
 
15,722
Cost of revenue related liabilities
18,773

 
17,992

Accrued interest payable
15,916

 
15,879

Sales and other taxes payable
12,403

 
10,625

Sales and marketing incentives
11,531

 
11,681

Professional fees
10,645

 
17,682

Other
15,350

 
12,088

Total
$
226,846

 
$
214,425

 
9.
Deferred Revenue
Deferred revenue consisted of the following (dollars in thousands): 
 
March 31, 2014
 
September 30, 2013
Current Liabilities:
 
 
 
Deferred maintenance revenue
$
134,563

 
$
134,213

Unearned revenue
161,985

 
119,540

Total current deferred revenue
$
296,548

 
$
253,753

Long-term Liabilities:
 
 
 
Deferred maintenance revenue
$
57,890

 
$
51,784

Unearned revenue
150,414

 
109,039

Total long-term deferred revenue
$
208,304

 
$
160,823

Deferred maintenance revenue consists of prepaid fees received for post-contract customer support for our products, including telephone support and the right to receive unspecified upgrades/enhancements on a when-and-if-available basis. Unearned revenue includes upfront fees for setup and implementation activities related to hosted offerings; certain software arrangements for which we do not have fair value of post-contract customer support, resulting in ratable revenue recognition for the entire arrangement on a straight-line basis; and fees in excess of estimated earnings on percentage-of-completion service contracts.
The increase in unearned revenue is primarily driven by the timing of a large annual term license prepayment from a Healthcare customer that will be amortized over the one year service period, as well as an increase in Mobile deferred revenue related to growth in our automotive connected services for which the revenue recognition period extends over the service period.

10

NUANCE COMMUNICATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


10.
Restructuring and Other Charges, net
Restructuring and other charges, net include restructuring expenses together with other expenses that are unusual in nature and are the result of unplanned events, and arise outside of the ordinary course of continuing operations. Restructuring expenses consist of employee severance costs and may also include charges for duplicate facilities and other contract termination costs. Other amounts may include gains or losses on non-controlling strategic equity interests, and gains or losses on sales of non-strategic assets or product lines. The following table sets forth accrual activity relating to our restructuring reserves for the six months ended March 31, 2014 (dollars in thousands): 
 
Personnel
 
Facilities
 
Total
Balance at September 30, 2013
$
4,230

 
$
1,191

 
$
5,421

Restructuring charges, net
3,093

 
2,463

 
5,556

Non-cash adjustments
79

 
793

 
872

Cash payments
(5,066
)
 
(1,563
)
 
(6,629
)
Balance at March 31, 2014
$
2,336

 
$
2,884

 
$
5,220

Restructuring charges, net by segment are as follows (dollars in thousands):
 
Three months Ended March 31,
2014
 
2013
Personnel
 
Facilities
 
Total
 
Personnel
 
Facilities
 
Total
Healthcare
$
186

 
$

 
$
186

 
$
468

 
$

 
$
468

Mobile and Consumer
(12
)
 

 
(12
)
 
1,444

 
364

 
1,808

Enterprise
1,568

 

 
1,568

 
1,078

 

 
1,078

Imaging
131

 

 
131

 
218

 

 
218

Corporate
(199
)
 
45

 
(154
)
 
704

 

 
704

Total restructuring expense
$
1,674

 
$
45

 
$
1,719

 
$
3,912

 
$
364

 
$
4,276


 
Six Months Ended March 31,
2014
 
2013
Personnel
 
Facilities
 
Total
 
Personnel
 
Facilities
 
Total
Healthcare
$
400

 
$

 
$
400

 
$
1,121

 
$
558

 
$
1,679

Mobile and Consumer
190

 

 
190

 
2,543

 
364

 
2,907

Enterprise
1,745

 

 
1,745

 
1,078

 

 
1,078

Imaging
131

 

 
131

 
1,040

 

 
1,040

Corporate
627

 
2,463

 
3,090

 
847

 

 
847

Total restructuring expense
$
3,093

 
$
2,463

 
$
5,556

 
$
6,629

 
$
922

 
$
7,551

For the six months ended March 31, 2014, we recorded net restructuring charges of $5.6 million, which included a $3.1 million severance charge related to the elimination of approximately 60 personnel across multiple functions including the impact of eliminating duplicative positions resulting from acquisitions, and $2.5 million primarily resulting from the restructuring of a facility that will no longer be utilized.
In addition to the restructuring charges, we have recorded certain other charges (credits) that are the result of unplanned events, and arose outside of the ordinary course of continuing operations, including litigation contingency reserves and the disposition of certain non-core product lines. For the three and six months ended March 31, 2014, other charges totaled $3.0 million. For the three and six months ended March 31, 2013, other charges (credits) totaled $0.8 million and ($0.8) million, respectively.
 

11

NUANCE COMMUNICATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


11.
Debt and Credit Facilities
At March 31, 2014 and September 30, 2013, we had the following borrowing obligations (dollars in thousands): 
 
March 31, 2014
 
September 30, 2013
5.375% Senior Notes due 2020, net of unamortized premium of $5.0 million and $5.4 million, respectively. Effective interest rate 5.28%.
$
1,054,993

 
$
1,055,385

2.75% Convertible Debentures due 2031, net of unamortized discount of $101.4 million and $113.5 million, respectively. Effective interest rate 7.43%.
588,646

 
576,524

2.75% Convertible Debentures due 2027, net of unamortized discount of $3.8 million and $8.8 million, respectively. Effective interest rate 7.30%.
246,187

 
241,206

Credit Facility, net of unamortized discount of $1.1 million and $1.2 million, respectively.
478,727

 
481,016

Total long-term debt
$
2,368,553

 
$
2,354,131

Less: current portion
251,031

 
246,040

Non-current portion of long-term debt
$
2,117,522

 
$
2,108,091

2.75% Convertible Debentures due 2031
As of March 31, 2014 and September 30, 2013, none of the conversion criteria were met for the 2031 Debentures. If the conversion criteria were met, we could be required to repay all or some of the principal amount in cash prior to maturity.
2.75% Convertible Debentures due 2027
The 2027 Debentures may be redeemed at the holders option in August 2014. As a result, we have classified the obligation in current liabilities at March 31, 2014 and September 30, 2013.
Credit Facility
The Credit Facility includes a term loan and a $75 million revolving credit line, including letters of credit. The term loan matures on August 7, 2019 and the revolving credit line matures on August 7, 2018. As of March 31, 2014, there were $5.8 million of letters of credit issued, and there were no other outstanding borrowings under the revolving credit line.
Under terms of the amended and restated credit agreement, interest is payable monthly at a rate equal to the applicable margin plus, at our option, either (a) the base rate which is the corporate base rate of Morgan Stanley, the Administrative Agent, or (b) LIBOR (equal to (i) the British Bankers’ Association Interest Settlement Rates for deposits in U.S. dollars divided by (ii) one minus the statutory reserves applicable to such borrowing). The applicable margin for the borrowings at March 31, 2014 is as follows: 
Description
 
Base Rate Margin
 
LIBOR Margin
Term loans maturing August 2019
 
1.75%
 
2.75%
Revolving facility due August 2018
 
0.50% - 0.75% (a)
 
1.50% - 1.75% (a)
 
(a)
The margin is determined based on our net leverage ratio at the date the interest rates are reset on the revolving credit line.

At March 31, 2014, the applicable margin for the term loans was 2.75%, with an effective rate of 2.91%, on the outstanding balance of $479.8 million maturing in August 2019. We are required to pay a commitment fee for unutilized commitments under the revolving credit facility at a rate ranging from 0.375% to 0.50% per annum, based upon our net leverage ratio. As of March 31, 2014, the commitment fee rate was 0.375%.
The Credit Facility contains the most restrictive covenants of our long-term debt, including, among other things, covenants that restrict our ability and those of our subsidiaries to incur certain additional indebtedness or issue guarantees, create or permit liens on assets, enter into sale-leaseback transactions, make loans or investments, sell assets, make certain acquisitions, pay dividends, repurchase stock, or merge or consolidate with any entity, and enter into certain transactions with affiliates. The agreement also contains events of default, including failure to make payments of principal or interest, failure to observe covenants, breaches of representations and warranties, defaults under certain other material indebtedness, failure to satisfy material judgments, a change of control and certain insolvency events. As of March 31, 2014, we were in compliance with the covenants under the Credit Facility.

12

NUANCE COMMUNICATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


The covenants on our other long-term debt are less restrictive, and as of March 31, 2014, we were in compliance with the requirements of our other long-term debt.
Our obligations under the Credit Facility are unconditionally guaranteed by, subject to certain exceptions, each of our existing and future direct and indirect wholly-owned domestic subsidiaries. The Credit Facility and the guarantees thereof are secured by first priority liens and security interests in the following: 100% of the capital stock of substantially all of our domestic subsidiaries and 65% of the outstanding voting equity interests and 100% of the non-voting equity interests of first-tier foreign subsidiaries, all our material tangible and intangible assets and those of the guarantors, and any present and future intercompany debt. The Credit Facility also contains provisions for mandatory prepayments of outstanding term loans upon receipt of the following, and subject to certain exceptions: 100% of net cash proceeds from asset sales, 100% of net cash proceeds from issuance or incurrence of debt, and 100% of extraordinary receipts. We may voluntarily prepay borrowings under the Credit Facility without premium or penalty other than breakage costs, as defined with respect to LIBOR-based loans.
The Credit Facility includes a provision for an annual excess cash flow sweep, as defined in the agreement, payable in the first quarter of each fiscal year, based on the excess cash flow generated in the previous fiscal year. No excess cash flow sweep was required in the first quarter of fiscal 2014 as no excess cash flow, as defined in the agreement was generated in fiscal 2013. At the current time, we are unable to predict the amount of the outstanding principal, if any, that we may be required to repay in future fiscal years pursuant to the excess cash flow sweep provisions.

12.
Stockholders' Equity
Stock Repurchases
On April 29, 2013, our Board of Directors approved a share repurchase program for up to $500 million of our outstanding shares of common stock. Approximately $289.2 million remained available for stock repurchases as of March 31, 2014 pursuant to our stock repurchase program. We repurchased 0.5 million shares for $6.8 million and 1.6 million shares for $26.4 million during the three and six months ended March 31, 2014, respectively. Under the terms of the repurchase program, we expect to continue to repurchase shares from time to time through a variety of methods, which may include open market purchases, privately negotiated transactions, block trades, accelerated stock repurchase transactions, or any combination of such methods. The timing and the amount of any purchases will be determined by management based on an evaluation of market conditions, capital allocation alternatives, and other factors. The share repurchase program does not require us to acquire any specific number of shares and may be modified, suspended, extended or terminated by us at any time without prior notice.

13.
Net Loss Per Share
Common equivalent shares are excluded from the computation of diluted net loss per share if their effect is anti-dilutive. Potentially dilutive common equivalent shares aggregating to 12.5 million and 14.1 million shares for the three months ended March 31, 2014 and 2013, respectively, and 13.1 million and 14.4 million shares for the six months ended March 31, 2014 and 2013, respectively, have been excluded from the computation of diluted net loss per share because their inclusion would be anti-dilutive.
 
 
 
 
14.
Stock-Based Compensation
We recognize stock-based compensation expense over the requisite service period. Our share-based awards are accounted for as equity instruments. The amounts included in the consolidated statements of operations relating to stock-based compensation are as follows (dollars in thousands): 
 
Three months Ended March 31,
 
Six Months Ended March 31,
2014
 
2013
 
2014
 
2013
Cost of product and licensing
$
697

 
$
168

 
$
962

 
$
353

Cost of professional services and hosting
7,199

 
4,489

 
13,818

 
6,892

Cost of maintenance and support
406

 
430

 
1,190

 
2,533

Research and development
10,455

 
4,977

 
20,743

 
13,837

Selling and marketing
10,210

 
12,033

 
25,454

 
28,880

General and administrative
15,953

 
7,545

 
29,992

 
22,418

Total
$
44,920

 
$
29,642

 
$
92,159

 
$
74,913


13

NUANCE COMMUNICATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)



Stock Options
The table below summarizes activity relating to stock options for the six months ended March 31, 2014:
 
Number of
Shares
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value(a)
Outstanding at September 30, 2013
4,184,158

 
$
13.08

 
 
 
 
Granted
100,000

 
$
15.19

 
 
 
 
Exercised
(275,953
)
 
$
8.66

 
 
 
 
Forfeited
(1,051
)
 
$
18.90

 
 
 
 
Expired
(4,832
)
 
$
17.18

 
 
 
 
Outstanding at March 31, 2014
4,002,322

 
$
13.43

 
2.7 years
 
$
15.2
 million
Exercisable at March 31, 2014
3,919,399

 
$
13.39

 
2.6 years
 
$
15.0
 million
Exercisable at March 31, 2013
5,404,645

 
$
11.77

 
2.8 years
 
$
45.5
 million
 
(a)
The aggregate intrinsic value in this table was calculated based on the positive difference, if any, between the closing market value of our common stock on March 31, 2014 ($17.17) and the exercise price of the underlying options.
The weighted-average intrinsic value of stock options exercised during the six months ended March 31, 2014 and 2013 was $2.1 million and $10.1 million, respectively.
 
Restricted Units
Restricted Units are not included in issued and outstanding common stock until the shares are vested and released. The purchase price for vested Restricted Units is $0.001 per share. The table below summarizes activity relating to Restricted Units for the six months ended March 31, 2014:
 
Number of Shares Underlying Restricted Units — Contingent Awards
 
Number of Shares Underlying Restricted Units — Time-Based Awards
Outstanding at September 30, 2013
5,587,181

 
9,095,424

Granted
2,560,869

 
6,106,420

Earned/released
(755,689
)
 
(3,976,204
)
Forfeited
(1,730,511
)
 
(714,685
)
Outstanding at March 31, 2014
5,661,850

 
10,510,955

Weighted average remaining recognition period of outstanding Restricted Units
1.9 years

 
2.0 years

Unearned stock-based compensation expense of outstanding Restricted Units
$95.4 million
 
$138.9 million
Aggregate intrinsic value of outstanding Restricted Units(a)
$97.2 million
 
$180.6 million
(a)
The aggregate intrinsic value in this table was calculated based on the positive difference between the closing market value of our common stock on March 31, 2014 ($17.17) and the purchase price of the underlying Restricted Units.
A summary of weighted-average grant-date fair value for awards granted and intrinsic value of all Restricted Units vested during the periods noted is as follows: 
 
Six Months Ended March 31,
2014
 
2013
Weighted-average grant-date fair value per share
$
15.26

 
$
22.32

Total intrinsic value of shares vested (in millions)
$
70.2

 
$
117.6


14

NUANCE COMMUNICATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


Restricted Stock Awards
Restricted Stock Awards are included in the issued and outstanding common stock at the date of grant. The table below summarizes activity related to Restricted Stock Awards for the six months ended March 31, 2014:
 
Number of Shares Underlying Restricted Stock
 
Weighted Average Grant Date Fair Value
Outstanding at September 30, 2013
1,000,000

 
$
24.06

Granted
250,000

 
$
15.71

Vested
(250,000
)
 
$
25.80

Forfeited

 
$

Outstanding at March 31, 2014
1,000,000

 
$
21.54

Weighted average remaining recognition period of outstanding Restricted Awards
1.3 years

 
 
Unearned stock-based compensation expense of outstanding Restricted Awards
$16.2 million
 
 
Aggregate intrinsic value of outstanding Restricted Awards
$17.2 million
 
 
A summary of weighted-average grant-date fair value for awards granted and intrinsic value of all Restricted Stock Awards vested during the periods noted is as follows: 
 
Six Months Ended March 31,
2014
 
2013
Weighted-average grant-date fair value per share
$
15.71

 
$
22.32

Total intrinsic value of shares vested (in millions)
$
3.9

 
$
5.3

15.
Income Taxes
The components of provision (benefit) from income taxes are as follows (dollars in thousands):
 
Three months Ended March 31,
 
Six Months Ended March 31,
2014
 
2013
 
2014
 
2013
Domestic
$
5,250

 
$
(5,432
)
 
$
3,795

 
$
(17,576
)
Foreign
1,144

 
6,106

 
5,577

 
9,689

Provision (benefit) from income taxes
$
6,394

 
$
674

 
$
9,372

 
$
(7,887
)
Effective tax rate
(19.5
)%
 
(2.7
)%
 
(11.0
)%
 
14.1
%

The effective income tax rate was (19.5)% and (11.0)% for the three and six months ended March 31, 2014, respectively. Our current effective tax rate differs from the U.S. federal statutory rate of 35% primarily due to earnings in foreign operations which are subject to a significantly lower tax rate than the U.S. statutory tax rate, driven primarily by our subsidiaries in Ireland. The effective tax rate for the three and six months ended March 31, 2014 included the impact of $1.4 million and ($3.8) million, respectively, in adjustments to the domestic valuation allowance as a results of acquisitions.
The effective income tax rate was (2.7)% and 14.1% for the three and six months ended March 31, 2013, respectively. During the first two quarters of fiscal 2013, we believed that it was more likely than not that we would realize our net domestic deferred tax assets and therefore recognized income tax benefits for domestic tax losses. Our effective tax rate was lower than the U.S. federal statutory rate of 35% primarily due to the effect of non-deductible expenditures offset by the rate differential on foreign profits and tax credits. Whereas in the third quarter of fiscal 2013, we concluded that the recoverability of our net domestic deferred tax assets was not more likely than not, and therefore we established a valuation allowance. As a result, our tax provision for the three and six months ended March 31, 2014 does not benefit from current period domestic losses.
Our effective income tax rate is based upon the income for the year, the composition of income in different countries, changes relating to valuation allowances for certain countries if and as necessary, and adjustments, if any, for the potential tax consequences, benefits or resolutions of audits or other tax contingencies. Our aggregate income tax rate in foreign jurisdictions is lower than our income tax rate in the United States. Our effective tax rate may be adversely affected by earnings being lower than anticipated in countries where we have lower statutory tax rates and higher than anticipated in countries where we have higher statutory tax rates.

15

NUANCE COMMUNICATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


At March 31, 2014 and September 30, 2013, the liability for income taxes associated with uncertain tax positions was $20.6 million and $19.6 million, respectively, and is included in other long term liabilities. If these benefits were recognized, they would favorably impact the effective tax rate. We do not expect a significant change in the amount of unrecognized tax benefits within the next twelve months.
16.
Commitments and Contingencies
Litigation and Other Claims
Like many companies in the software industry, we have, from time to time, been notified of claims that we may be infringing on, or contributing to the infringement of, the intellectual property rights of others. These claims have been referred to counsel, and they are in various stages of evaluation and negotiation. If it appears necessary or desirable, we may seek licenses for these intellectual property rights. There is no assurance that licenses will be offered by all claimants, that the terms of any offered licenses will be acceptable to us or that in all cases the dispute will be resolved without litigation, which may be time consuming and expensive, and may result in injunctive relief or the payment of damages by us.
We do not believe that the resolution of any such claim or litigation will have a material adverse effect on our financial position and results of operations. However, resolution of any such claim or litigation could require significant management time and adversely impact our operating results, financial position and cash flows.
Guarantees and Other
We include indemnification provisions in the contracts we enter into with customers and business partners. Generally, these provisions require us to defend claims arising out of our products’ infringement of third-party intellectual property rights, breach of contractual obligations and/or unlawful or otherwise culpable conduct. The indemnity obligations generally cover damages, costs and attorneys’ fees arising out of such claims. In most, but not all cases, our total liability under such provisions is limited to either the value of the contract or a specified, agreed upon amount. In some cases our total liability under such provisions is unlimited. In many, but not all cases, the term of the indemnity provision is perpetual. While the maximum potential amount of future payments we could be required to make under all the indemnification provisions is unlimited, we believe the estimated fair value of these provisions is minimal due to the low frequency with which these provisions have been triggered.
We indemnify our directors and officers to the fullest extent permitted by law. These agreements, among other things, indemnify directors and officers for expenses, judgments, fines, penalties and settlement amounts incurred by such persons in their capacity as a director or officer of the company, regardless of whether the individual is serving in any such capacity at the time the liability or expense is incurred. Additionally, in connection with certain acquisitions we have agreed to indemnify the former officers and members of the boards of directors of those companies, on similar terms as described above, for a period of six years from the acquisition date. In certain cases we purchase director and officer insurance policies related to these obligations, which fully cover the six year periods. To the extent that we do not purchase a director and officer insurance policy for the full period of any contractual indemnification, we would be required to pay for costs incurred, if any, as described above.

17.
Segment and Geographic Information
We operate in, and report financial information for, the following four reportable segments: Healthcare, Mobile and Consumer, Enterprise and Imaging. Segment profit is an important measure used for evaluating performance and for decision-making purposes and reflects the direct controllable costs of each segment together with an allocation of sales and corporate marketing expenses, and certain research and development project costs that benefit multiple product offerings. Segment profit represents income from operations excluding stock-based compensation, amortization of intangible assets, acquisition-related costs, net, restructuring and other charges, net, costs associated with intellectual property collaboration agreements, other income (expense), net and certain unallocated corporate expenses.

16

NUANCE COMMUNICATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


We do not track our assets by operating segment; consequently, it is not practical to show assets or depreciation by operating segment. The following table presents segment results along with a reconciliation of segment profit to loss before income taxes (dollars in thousands): 
 
Three months ended
 
Six months ended
March 31,
 
March 31,
2014
 
2013
 
2014
 
2013
Segment revenues(a):
 
 
 
 
 
 
 
Healthcare
$
236,997

 
$
229,397

 
$
464,283

 
$
446,771

Mobile and Consumer
109,782

 
116,173

 
225,044

 
247,904

Enterprise
87,200

 
74,486

 
176,402

 
158,182

Imaging
55,994

 
63,974

 
114,289

 
123,590

Total segment revenues
489,973

 
484,030

 
980,018

 
976,447

Acquisition-related revenues
(14,320
)
 
(33,031
)
 
(34,385
)
 
(63,180
)
Total consolidated revenues
475,653

 
450,999

 
945,633

 
913,267

Segment profit:
 
 
 
 
 
 
 
Healthcare
91,477

 
89,626

 
169,937

 
178,761

Mobile and Consumer
17,848

 
36,655

 
31,290

 
76,481

Enterprise
17,079

 
13,399

 
38,213

 
35,068

Imaging
20,704

 
27,564

 
43,384

 
50,624

Total segment profit
147,108

 
167,244

 
282,824

 
340,934

Corporate expenses and other, net
(30,126
)
 
(26,172
)
 
(61,332
)
 
(56,309
)
Acquisition-related revenues and cost of revenues adjustment
(13,037
)
 
(30,439
)
 
(31,869
)
 
(58,105
)
Stock-based compensation
(44,920
)
 
(29,642
)
 
(92,159
)
 
(74,913
)
Amortization of intangible assets
(41,913
)
 
(42,611
)
 
(84,579
)
 
(84,347
)
Acquisition-related costs, net
(6,802
)
 
(15,448
)
 
(9,600
)
 
(31,181
)
Restructuring and other charges, net
(4,719
)
 
(5,062
)
 
(8,556
)
 
(6,729
)
Costs associated with IP collaboration agreements
(4,937
)
 
(5,458
)
 
(9,874
)
 
(10,708
)
Other expense, net
(33,487
)
 
(37,586
)
 
(70,123
)
 
(74,473
)
Loss before income taxes
$
(32,833
)
 
$
(25,174
)
 
$
(85,268
)
 
$
(55,831
)
 
(a)
Segment revenues differ from reported revenues due to certain revenue adjustments related to acquisitions that would otherwise have been recognized but for the purchase accounting treatment of the business combinations. Segment revenues also include revenue that the business would have otherwise recognized had we not acquired intellectual property and other assets from the same customer. These revenues are included to allow for more complete comparisons to the financial results of historical operations and in evaluating management performance.
No country outside of the United States provided greater than 10% of our total revenue. Revenue, classified by the major geographic areas in which our customers are located, was as follows (dollars in thousands): 
 
Three months ended
 
Six months ended
March 31,
 
March 31,
2014
 
2013
 
2014
 
2013
United States
$
346,587

 
$
324,304

 
$
689,772

 
$
664,592

International
129,066

 
126,695

 
255,861

 
248,675

Total revenues
$
475,653

 
$
450,999

 
$
945,633

 
$
913,267



17

Table of Contents


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following Management’s Discussion and Analysis is intended to help the reader understand the results of operations and financial condition of our business. Management’s Discussion and Analysis is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying notes to the condensed consolidated financial statements.
CAUTIONARY NOTE CONCERNING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q including the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Quantitative and Qualitative Disclosure About Market Risk” under Items 2 and 3, respectively, of Part I of this report, and the sections entitled “Legal Proceedings” and “Risk Factors,” under Items 1 and 1A, respectively, of Part II of this report, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involve risks, uncertainties and assumptions that, if they never materialize or if they prove incorrect, could cause our consolidated results to differ materially from those expressed or implied by such forward-looking statements. These forward-looking statements include predictions regarding:
our future bookings, revenues, cost of revenues, research and development expenses, selling, general and administrative expenses, amortization of intangible assets and gross margin;
our strategy relating to our segments;
the potential of future product releases;
our product development plans and investments in research and development;
future acquisitions, and anticipated benefits from acquisitions;
international operations and localized versions of our products; and
legal proceedings and litigation matters.
You can identify these and other forward-looking statements by the use of words such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “intends,” “potential,” “continue” or the negative of such terms, or other comparable terminology. Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks described in Item 1A — “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q.
You should not place undue reliance on these forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We undertake no obligation to publicly release any revisions to the forward-looking statements or reflect events or circumstances after the date of this document.
OVERVIEW
Business Overview
We are a leading provider of voice and language solutions for businesses and consumers around the world. Our solutions are used in the healthcare, mobile, consumer, enterprise customer service, and imaging markets. We are seeing several trends in our markets, including (i) the growing adoption of cloud-based, connected services and highly interactive mobile applications, (ii) deeper integration of virtual assistant capabilities and services, and (iii) the continued expansion of our core technology portfolio from speech recognition to natural language understanding, semantic processing, domain-specific reasoning and dialog management capabilities.

Healthcare.  Trends in our healthcare business include continuing customer preference for hosted solutions and other time-based licenses, and increasing interest in the use of mobile devices to access healthcare systems and records. We continue to see strong demand for transactions which involve the sale and delivery of both software and non-software related services or products, as well as transactions which involve the sale of multiple solutions, such as both hosted transcription services and Dragon Medical licenses. Although the volume processed in our hosted transcription services has steadily increased due to the expanding customer base, we have experienced some erosion in lines processed when customers adopt electronic medical record (EMR) systems, and when in some cases customers use our licensed Dragon Medical product to support input into the EMR.  We believe an important trend in the healthcare market is the desire to improve efficiency in the coding and revenue cycle management process. Our solutions reduce costs by increasing automation of this important workflow, and also enable hospitals to optimize revenue and improve documentation used to support billings. In addition to improved efficiency, there is an impending change in the industry coding standard

18

Table of Contents

from ICD-9 to ICD-10, which will significantly increase the number of possible codes, and therefore, increase the complexity of this process, which in turn reinforces our customers' desire for improved efficiency. We are investing to expand our product set to address the various healthcare opportunities, including deeper integration with our clinical documentation solutions, as well as expand our international capabilities, and reduce our time from contract signing to initiation of billable services.

Mobile and Consumer.  Trends in our mobile and consumer segment include device manufacturers requiring custom applications to deliver unique and differentiated products such as virtual assistants, broadening keyboard technologies to take advantage of touch screens, increasing hands-free capabilities on cell phones and automobiles to address the growing concern of distracted driving, and the adoption of our technology on a broadening scope of devices, such as televisions, set-top boxes, e-book readers, tablet computers, cameras and third-party applications. The more powerful capabilities of mobile devices require us to supply a broader set of technologies to support the increasing scope and complexity of the solutions. These technologies include cloud-based speech recognition, natural language understanding, dialog management, text-to-speech and enhanced text input, where the complexity of the technologies allow us to charge a higher price. Within given levels of our technology set, we have seen pricing pressures from our OEM partners in our mobile handset business. We continue to see strong demand for transactions which involve the sale and delivery of both software and non-software related services, as well as products to help customers define, design and implement increasingly robust and complex custom solutions such as virtual assistants. We continue to see an increasing proportion of revenue from on-demand and transactional arrangements as opposed to traditional upfront licensing of our mobile products and solutions. Although this has a negative impact on near-term revenue, we believe this model will build stronger and more predictable revenues over time. We are investing to increase our capabilities and capacity to help device manufacturers build custom applications, to increase the capacity of our data centers, to increase the number, kinds and capacity of network services, to enable developers to access our technology, and to expand both awareness and channels for our direct-to-consumer products.

Enterprise.  Trends in our enterprise business include increasing interest in the use of mobile applications and web sites to access customer care systems and records, voice-based authentication of users, increasing interest in coordinating actions and data across customer care channels, and the ability of a broader set of hardware providers and systems integrators to serve the market. We are investing to expand our product set to address these opportunities, to increase efficiency of our hosted applications, expand our capabilities and capacity to help customers build custom applications, and broaden our relationships with new hardware and systems integrator partners serving the market.

Imaging.  The imaging market is evolving to include more networked solutions, mobile access to networked solutions, and multi-function devices. We expect to expand our traditional packaged software sales with subscription versions. We are investing to improve mobile access to our networked products, expand our distribution channels and embedding relationships, and expand our language coverage.

Confronted by dramatic increases in electronic information, consumers, business personnel and healthcare professionals must use a variety of resources to retrieve information, transcribe patient records, conduct transactions and perform other job-related functions. We believe that the power of our solutions can transform the way people use the Internet, telecommunications systems, electronic medical records, wireless and mobile networks and related corporate infrastructure to conduct business.

Strategy

In fiscal 2014, we will continue to focus on growth by providing market-leading, value-added solutions for our customers and partners through a broad set of technologies, service offerings and channel capabilities. We have increased our focus on operating efficiencies, expense and hiring discipline and acquisition synergies to improve gross margins and operating margins. We intend to pursue growth through the following key elements of our strategy:

Extend Technology Leadership.  Our solutions are recognized as among the best in their respective categories. We intend to leverage our global research and development organization, and our broad portfolio of technologies, applications and intellectual property to foster technological innovation and to maintain customer preference for our solutions. We also intend to invest further in our engineering resources and to seek new technological advancements that further expand the addressable markets for our solutions.
Broaden Expertise in Vertical Markets.  Businesses are increasingly turning to us for comprehensive solutions rather than for a single technology product. We intend to broaden our expertise and capabilities to continue to deliver targeted solutions for a range of industries including mobile device manufacturers, healthcare, telecommunications, financial

19

Table of Contents

services and government administration. We also intend to expand our global sales and professional services capabilities to help our customers and partners design, integrate and deploy innovative solutions.
Increase Subscription and Transaction Based Recurring Revenue.  We intend to increase our subscription and transaction based offerings in all of our segments. This will enable us to deliver applications that our customers use, and pay for, on a repeat basis, providing us with the opportunity to enjoy the benefits of recurring revenue streams.
Expand Global Presence.  We intend to further expand our international resources to better serve our global customers and partners and to leverage opportunities in established markets such as Europe, and also emerging markets within Asia and Latin America. We continue to add regional executives and sales employees across geographic regions to better address demand for voice and language based solutions and services.
Pursue Strategic Acquisitions and Partnerships.  We have selectively pursued strategic acquisitions to expand our technology, solutions and resources, and to complement our organic growth. We have proven experience in integrating businesses and technologies to deliver enhanced value to our customers, partners, employees and shareholders. We intend to continue to pursue acquisitions that enhance our solutions, serve specific vertical markets and strengthen our technology portfolio. We have, however, recently slowed the pace and reduced the size of acquisitions to focus our resources more on driving organic growth. We also have formed key partnerships with other important companies in our markets of interest, and intend to continue to do so in the future where it will enhance the value of our business.
Key Metrics
In evaluating the financial condition and operating performance of our business, management focuses on revenues, net income, gross margins, operating margins and cash flow from operations. A summary of these key financial metrics for the six months ended March 31, 2014, as compared to the six months ended March 31, 2013, is as follows:
Total revenues increased by $32.4 million to $945.6 million;
Net loss increased by $46.7 million to a loss of $94.6 million;
Gross margins decreased by 3.3 percentage points to 55.8%;
Operating margins decreased by 3.6 percentage points to (1.6)%; and
Cash provided by operating activities decreased by $50.8 million to $165.2 million.
In addition to the above key financial metrics, we also focus on certain operating metrics. A summary of these key operating metrics as of March 31, 2014, as compared to March 31, 2013, is as follows:
Annualized line run-rate in our on-demand healthcare solutions increased 6% from one year ago to approximately 5.5 billion lines per year. The annualized line run-rate is determined using billed equivalent line counts in a given quarter, multiplied by four;
Bookings increased 43% from one year ago to $638.0 million. Bookings growth was led by our Mobile Auto, voicemail-to-text, and Enterprise on-demand offerings, offset by lower bookings in our Imaging MFP, Mobile Handset and Dragon Consumer products. Bookings represent the estimated gross revenue value of transactions at the time of contract execution, except for maintenance and support offerings. For fixed price contracts, the bookings value represents the gross total contract value. For contracts where revenue is based on transaction volume, the bookings value represents the contract price multiplied by the estimated future transaction volume during the contract term, whether or not such transaction volumes are guaranteed under a minimum commitment clause. Actual results could be different than our initial estimate. The maintenance and support bookings value represents the amounts billed in the period the customer is invoiced. Because of the inherent estimates required to determine bookings and the fact that the actual resultant revenue may differ from our initial bookings estimates, we consider bookings one indicator of potential future revenue and not as an arithmetic measure of backlog; and
Estimated three-year value of on-demand contracts increased 4% from one year ago to approximately $2.2 billion. We expect that an increasing portion of our revenue will come from on-demand services. We determine this value as of the end of the period reported, by using our best estimate of three years of anticipated future revenue streams under signed on-demand contracts then in place, whether or not they are guaranteed through a minimum commitment clause. Our best estimate is based on estimates used in evaluating the contracts and determining sales compensation, adjusted for changes in estimated launch dates, actual volumes achieved and other factors deemed relevant. For contracts with an expiration date beyond three years, we include only the

20

Table of Contents

value expected within three years. For other contracts, we assume renewal consistent with historic renewal rates unless there is a known cancellation. Contracts are generally priced by volume of usage and typically have no or low minimum commitments. Actual revenue could vary from our estimates due to factors such as cancellations, non-renewals or volume fluctuations.

RESULTS OF OPERATIONS
Total Revenues
The following tables show total revenues by product type and by geographic location, based on the location of our customers, in dollars and percentage change (dollars in millions): 
 
Three months ended
 
Dollar
Change
 
Percent
Change
 
Six months ended
 
Dollar
Change
 
Percent
Change
March 31,
 
 
March 31,
 
2014
 
2013
 
 
2014
 
2013
 
Product and licensing
$
174.8

 
$
173.1

 
$
1.7

 
1.0
%
 
$
353.3

 
$
369.8

 
$
(16.5
)
 
(4.5
)%
Professional services and hosting
227.6

 
213.3

 
14.3

 
6.7
%
 
445.6

 
413.6

 
32.0

 
7.7
 %
Maintenance and support
73.3

 
64.6

 
8.7

 
13.5
%
 
146.7

 
129.9

 
16.8

 
12.9
 %
Total Revenues
$
475.7

 
$
451.0

 
$
24.7

 
5.5
%
 
$
945.6

 
$
913.3

 
$
32.3

 
3.5
 %
United States
$
346.6

 
$
324.3

 
$
22.3

 
6.9
%
 
$
689.8

 
$
664.6

 
$
25.2

 
3.8
 %
International
129.1

 
126.7

 
2.4

 
1.9
%
 
255.8

 
248.7

 
7.1

 
2.9
 %
Total Revenues
$
475.7

 
$
451.0

 
$
24.7

 
5.5
%
 
$
945.6

 
$
913.3

 
$
32.3

 
3.5
 %
The geographic split for the three months ended March 31, 2014, was 73% of total revenues in the United States and 27% internationally, compared to 72% of total revenues in the United States and 28% internationally for the same period last year. The geographic split for the six months ended March 31, 2014, was essentially flat as compared to the same period last year with 73% of total revenues in the United States and 27% internationally.
Product and Licensing Revenue
Product and licensing revenue primarily consists of sales and licenses of our technology. The following table shows product and licensing revenue, in dollars and as a percentage of total revenues (dollars in millions): 
 
Three months ended
 
Dollar
Change
 
Percent
Change
 
Six months ended
 
Dollar
Change
 
Percent
Change
March 31,
 
 
March 31,
 
2014
 
2013
 
 
2014
 
2013
 
Product and licensing revenue
$
174.8

 
$
173.1

 
$
1.7

 
1.0
%
 
$
353.3

 
$
369.8

 
$
(16.5
)
 
(4.5)%
As a percentage of total revenue
36.7
%
 
38.4
%
 
 
 
 
 
37.4
%
 
40.5
%
 
 
 
 
The increase in product and licensing revenue for the three months ended March 31, 2014, as compared to the three months ended March 31, 2013, consisted of an $8.8 million increase in Healthcare revenue driven by strong sales in Dragon Medical licenses. This was offset by a $9.5 million decrease in Mobile and Consumer revenue, including a $7.7 million decrease in sales of our embedded licenses resulting from a continuing shift toward on-demand and ratable pricing models.
The decrease in product and licensing revenue for the six months ended March 31, 2014, as compared to the six months ended March 31, 2013, consisted of a $28.6 million decrease in Mobile and Consumer revenue, and a $9.2 million decrease in Enterprise revenue. The decrease in Mobile and Consumer revenue was driven by a $16.3 million decrease in sales of our embedded licenses, resulting from a continuing shift toward on-demand and ratable pricing models, together with a decrease of $11.4 million in Dragon desktop consumer products following the successful new product launch in the fall of 2012 and an overall weakness in desktop software sales. The decrease in Enterprise revenues was primarily driven by lower sales of on-premise solutions. These decreases were offset by a $16.8 million increase in Healthcare revenue, including an $11.7 million increase in sales of Dragon Medical licenses, together with a $9.6 million increase in sales of our Clintegrity solutions.
As a percentage of total revenue, product and licensing revenue decreased from 40.5% to 37.4% for the six months ended March 31, 2014. This decrease was driven by lower sales of embedded licenses in our Mobile and Consumer segment, resulting from a continuing shift toward on-demand and hosting services. Within product and licensing revenue, we are also seeing more term-based, subscription and transactional pricing models, which are recognized over time. In addition, the decrease includes the impact of our recent acquisitions, which have a higher proportion of on-demand hosting revenue. We expect this trend to continue through the remainder of fiscal 2014.

21

Table of Contents

Professional Services and Hosting Revenue
Professional services revenue primarily consists of consulting, implementation and training services for customers. Hosting revenue primarily relates to delivering on-demand hosted services, such as medical transcription, automated customer care applications, voice message transcription, and mobile infotainment, search and transcription, over a specified term. The following table shows professional services and hosting revenue, in dollars and as a percentage of total revenues (dollars in millions): 
 
Three months ended
 
Dollar
Change
 
Percent
Change
 
Six months ended
 
Dollar
Change
 
Percent
Change
March 31,
 
 
March 31,
 
2014
 
2013
 
 
2014
 
2013
 
Professional services and hosting revenue
$
227.6

 
$
213.3

 
$
14.3

 
6.7
%
 
$
445.6

 
$
413.6

 
$
32.0

 
7.7%
As a percentage of total revenue
47.8
%
 
47.3
%
 
 
 
 
 
47.1
%
 
45.3
%
 
 
 
 
The increase in professional services and hosting revenue for the three months ended March 31, 2014, as compared to the three months ended March 31, 2013, consisted of a $10.8 million increase in our Enterprise revenue and a $2.5 million increase in our Mobile and Consumer revenue primarily driven by our recent acquisitions.
The increase in professional services and hosting revenue for the six months ended March 31, 2014, as compared to the six months ended March 31, 2013, consisted of a $20.6 million increase in Enterprise revenue primarily driven by our recent acquisitions. Healthcare revenue increased $7.4 million driven by a $3.6 million increase in revenues from our Clinical Documentation Solutions and a $3.8 million increase in revenues from our Clintegrity product line. In addition, Healthcare hosting revenue increased by $13.3 million due to acquisitions, partially offset by the negative impact from the continued erosion resulting from customers' migration to electronic medical records.
As a percentage of total revenue, professional services and hosting revenue increased from 45.3% to 47.1% for the six months ended March 31, 2014. This increase was driven by our recent Healthcare and Enterprise acquisitions, which have a higher proportion of professional services and hosting revenue. The increase also includes the continuing shift toward on-demand and hosting services in our Mobile and Consumer segment. We expect this revenue mix shift to continue through the remainder of fiscal 2014.
Maintenance and Support Revenue
Maintenance and support revenue primarily consists of technical support and maintenance services. The following table shows maintenance and support revenue, in dollars and as a percentage of total revenues (dollars in millions): 
 
Three months ended
 
Dollar
Change
 
Percent
Change
 
Six months ended
 
Dollar
Change
 
Percent
Change
March 31,
 
 
March 31,
 
2014
 
2013
 
 
2014
 
2013
 
Maintenance and support revenue
$
73.3

 
$
64.6

 
$
8.7

 
13.5
%
 
$
146.7

 
$
129.9

 
$
16.8

 
12.9%
As a percentage of total revenue
15.4
%
 
14.3
%
 
 
 
 
 
15.5
%
 
14.2
%
 
 
 
 
The increase in maintenance and support revenue for the three months ended March 31, 2014, as compared to the three months ended March 31, 2013, resulted from strong maintenance renewals in all of our segments, including a $3.4 million increase in Healthcare revenue driven by sales of our Dragon Medical solutions, together with an increase of $2.9 million in Imaging revenue.
The increase in maintenance and support revenue for the six months ended March 31, 2014, as compared to the six months ended March 31, 2013, resulted from strong maintenance renewals in all of our segments, including a $6.0 million increase in Healthcare revenue driven by sales of Dragon Medical solutions, together with an increase of $4.8 million in Imaging revenues.


22

Table of Contents

Costs and Expenses
Cost of Product and Licensing Revenue
Cost of product and licensing revenue primarily consists of material and fulfillment costs, manufacturing and operations costs and third-party royalty expenses. The following table shows cost of product and licensing revenue, in dollars and as a percentage of product and licensing revenue (dollars in millions): 
 
Three months ended
 
Dollar
Change
 
Percent
Change
 
Six months ended
 
Dollar
Change
 
Percent
Change
March 31,
 
 
March 31,
 
2014
 
2013
 
 
2014
 
2013
 
Cost of product and licensing revenue
$
25.2

 
$
22.9

 
$
2.3

 
10.0
%
 
$
50.4

 
$
49.3

 
$
1.1

 
2.2
%
As a percentage of product and licensing revenue
14.4
%
 
13.2
%
 
 
 
 
 
14.3
%
 
13.3
%
 
 
 
 
The increase in cost of product and licensing revenue for the three months ended March 31, 2014, as compared to the three months ended March 31, 2013, consisted of a $1.4 million increase in Healthcare costs primarily driven by higher sales of our Dragon Medical products. Gross margins decreased 1.2 percentage points primarily driven by lower revenues from higher margin license products in our Imaging and Mobile and Consumer businesses.
The increase in cost of product and licensing revenue for the six months ended March 31, 2014, as compared to the six months ended March 31, 2013, consisted of a $2.8 million increase in Healthcare costs primarily driven by higher sales of our Dragon Medical products, offset by a $2.7 million reduction in Mobile and Consumer costs, primarily driven by lower sales of our Dragon desktop consumer products. In addition, stock-based compensation expense increased $0.6 million over the prior year. Gross margins decreased 1.0 percentage point, primarily driven by lower revenues from higher margin license products in our Enterprise and Mobile and Consumer businesses.
Cost of Professional Services and Hosting Revenue
Cost of professional services and hosting revenue primarily consists of compensation for services personnel, outside consultants and overhead, as well as the hardware, infrastructure and communications fees that support our hosting solutions. The following table shows cost of professional services and hosting revenue, in dollars and as a percentage of professional services and hosting revenue (dollars in millions): 
 
Three months ended
 
Dollar
Change
 
Percent
Change
 
Six months ended
 
Dollar
Change
 
Percent
Change
March 31,
 
March 31,
 
2014
 
2013
 
2014
 
2013
 
Cost of professional services and hosting revenue
$
157.4

 
$
138.5

 
$
18.9

 
13.6
%
 
$
312.0

 
$
263.7

 
$
48.3

 
18.3%
As a percentage of professional services and hosting revenue
69.2
%
 
64.9
%
 
 
 
 
 
70.0
%
 
63.8
%
 
 
 
 

The increase in the cost of professional services and hosting revenue for the three months ended March 31, 2014, as compared to the three months ended March 31, 2013, was due to an $8.8 million increase in Mobile and Consumer costs driven by investment in our connected services infrastructure, as we continue to fund an increasing volume of large-scale engagements in our mobile business where the demand for advanced, cloud-based services continues to grow. Our Enterprise costs also increased $4.0 million and Healthcare costs increased $2.4 million driven by our recent acquisitions. In addition, stock-based compensation expense increased $2.7 million over the prior year. Gross margins decreased 4.3 percentage points primarily driven by investment in our connected services infrastructure in our Mobile business, as well as growth in labor costs in our Healthcare on-demand transcription services. In addition, increased stock-based compensation expense impacted gross margins by 1.3 percentage points.
The increase in the cost of professional services and hosting revenue for the six months ended March 31, 2014, as compared to the six months ended March 31, 2013, was due to a $16.6 million increase in Healthcare costs as a result of recent acquisitions and higher labor costs. The increase of $17.1 million in Mobile and Consumer costs was driven by investment in our connected services infrastructure, as we continue to fund an increasing volume of large-scale engagements in our Mobile business, where the demand for advanced, cloud-based services continues to grow. Our Enterprise costs also increased $6.3 million driven by our recent acquisitions. In addition, stock-based compensation expense increased $6.9 million over the prior year. Gross margins decreased 6.2 percentage points primarily driven by investment in our connected services infrastructure in our Mobile business, as well as growth in labor costs from our Healthcare on-demand transcription services. We expect this trend to continue through the remainder of fiscal 2014. In addition, increased stock-based compensation expense impacted gross margins by 1.7 percentage points.

23

Table of Contents

Cost of Maintenance and Support Revenue
Cost of maintenance and support revenue primarily consists of compensation for product support personnel and overhead. The following table shows cost of maintenance and support revenue, in dollars and as a percentage of maintenance and support revenue (dollars in millions): 
 
Three months ended
 
Dollar
Change
 
Percent
Change
 
Six months ended
 
Dollar
Change
 
Percent
Change
March 31,
 
March 31,
 
2014
 
2013
 
2014
 
2013
 
Cost of maintenance and support revenue
$
12.4

 
$
13.1

 
$
(0.7
)
 
(5.3
)%
 
$
25.2

 
$
27.9

 
$
(2.7
)
 
(9.7)%
As a percentage of maintenance and support revenue
16.9
%
 
20.3
%
 
 
 
 
 
17.2
%
 
21.5
%
 
 
 
 
The decrease in cost of maintenance and support revenue for the three months ended March 31, 2014, as compared to the three months ended March 31, 2013, was primarily due to a $0.8 million decrease in Imaging costs. Gross margins increased 3.4 percentage points driven by cost improvements in our Imaging and Healthcare businesses.
The decrease in cost of maintenance and support revenue for the six months ended March 31, 2014, as compared to the six months ended March 31, 2013, was primarily due to a $1.2 million decrease in Imaging costs together with a reduction in stock-based compensation of $1.3 million. Gross margins increased 4.3 percentage points driven by cost improvements in our Imaging and Healthcare businesses.
Research and Development Expense
Research and development expense primarily consists of salaries, benefits, and overhead relating to engineering staff as well as third party engineering costs. The following table shows research and development expense, in dollars and as a percentage of total revenues (dollars in millions): 
 
Three months ended
 
Dollar
Change
 
Percent
Change
 
Six months ended
 
Dollar
Change
 
Percent
Change
March 31,
 
March 31,
 
2014
 
2013
 
2014
 
2013
 
Research and development expense
$
84.6

 
$
69.7

 
$
14.9