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Cerence Stock: Swiss technology boosts digital penetration in automotive (NASDAQ: CRNC)

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The following segment is excerpted from this fund letter.

Summary of the thesis

  1. Industry-leading voice recognition technology combined with automatic OEM integration expertise. Cerence’s software is highly flexible and customizable and owned by each automotive OEM, setting Cerence’s technology apart from big tech competition.
  2. Increased penetration of voice assistants and cross-selling of new Internet-connected services are driving sustained revenue growth through both volume growth and increased ARPU.
  3. TAM’s expansion through entry into adjacent mobility markets provides an additional option for revenue growth.
  4. Great visibility into future revenue as OEM design gains take several years to reach start of production.
  5. High-margin licensing business with minimal CAPEX requirements drives strong FCF conversion which is expected to increase starting in FY22.

Company presentation

Cerence is a software developer that powers voice commands and Internet services in motor vehicles. Cerence is best known as the white-label solution behind voice assistants in automobiles thanks to its industry-leading voice recognition and natural language understanding technology (“Hey Mercedes… turn up the volume”). The voice assistant software runs on a peripheral network inside the vehicle, which means that the software can run without an external connection to the Internet. The company is increasingly developing similar voice services that rely on cloud connections to deliver an enhanced in-vehicle customer experience. Examples of cloud-connected services include Cerence Pay, which offers in-car voice-activated payments, and Smart Home Connectivity, which allows drivers to control a host of home devices. Cerence maintains relationships with all major global automotive OEMs.

Cerence - Examples of cloud-connected services

Cerence Analyst Day Presentation (2-18-20)

Cerence originally operated as a division of Nuance Communications, but was spun off in 2019 as Nuance recognized the limited synergies between the automotive and healthcare end markets. The rotation has allowed Cerence to dedicate capital and resources to serve an automotive OEM market that requires deep integration and customization.

Technology leader in automatic connected services

Consumers are increasingly comfortable with voice assistants in their daily lives and also expect seamless connectivity to all aspects of their digital life. Despite these trends in the consumer electronics market, the automotive market has been slower to adopt these services given a more complex environment for deploying these solutions. However, OEMs increasingly see voice services and increased digital connectivity as key differentiators in the market. As such, the penetration of connected vehicles continues to increase as these services not only improve the driver experience but also improve safety as they facilitate better driver concentration and minimize driver distraction.

Voice-activated services in vehicles require a higher level of technical expertise than home digital assistants (Alexa, Siri, Google) given the presence of more ambient noise which can interfere with voice recognition. Cerence, with its voice signal enhancement technology that neutralizes ambient noise, is the leader in voice recognition technology for the automotive market and can offer this technology in more than 70 languages. In addition to this industry-leading voice recognition technology, voice assistants also require extensive connections to over 200 sensors in the car to activate voice commands. This complex connectivity ecosystem that requires deep collaboration with OEMs and Tier 1 suppliers demonstrates why Cerence is better positioned as an independent company that can devote all of its resources to this complex end market. Thanks to Cerence’s superior voice recognition technology and automotive expertise, Cerence currently holds a market share of approximately 80% of the voice-enabled market. Cerence faces minor competition from two niche players, iFlytek (China) and SoundHound (US), but remains clear global leader in the third-party voice market.

With its lead in voice recognition technology cemented and the market approaching saturation in the next 5 years, Cerence has recently introduced complementary technologies to basic voice assistant software in the form of cloud-connected services. Cerence took advantage of improvements in computing power and internet connectivity to enable cloud-connected services in the car. Examples of new services include voice-activated payments (Cerence Pay), tour guides and door-to-door services. These services are usually purchased by the OEM for an initial term (eg 5 years) and can be renewed by the owner when the contract expires.

Cerence is also expanding into adjacent mobility markets and has identified 2-wheel vehicles, lifts, agricultural equipment, school buses and cruise ships as potential new markets. While details on these adjacent markets were limited on the company’s 2020 Investor Day, CRNC provided an update on its third and fourth quarter 2021 calls indicating that it had won new contracts in the markets. 2 wheels and lifts as well as a third unidentified market. These newly won contracts will start contributing to revenue in 2022.

The automotive market is still in its infancy to enable connected services and mobility markets outside of the automobile have yet to embrace many of these same services. The track for both new services and new modalities (facial recognition, gesture recognition, etc.) is long and presents new sustainable growth opportunities for Cerence beyond management’s long-term forecast for 2024.

Big Tech Competition

Despite Cerence’s dominance in the automotive market, there is an ever-present threat from Amazon, Apple and Google who already have ubiquitous products in the consumer digital assistant landscape. Consumers have widely adopted these brands in their daily lives, and big tech is increasingly looking to break into the automotive market.

While big tech’s desire to enter the automotive market appears to be an inevitable competitive threat, Cerence’s role as a neutral third-party platform acts as a wedge against these big tech companies, which are increasingly considered as competitors by OEMs given their wider self. ambitions. OEMs are hesitant to allow the fox (tech companies) into the (OEM) coop in the short term for two reasons. First, OEMs want to control the consumer’s in-car experience and ensure that consumers are loyal to the OEM’s brand and not the technology solution (“Hey Mercedes”, not “Hey Google”). Second, by allowing big tech to manage the operational layer, OEMs cede control of the valuable data collected by the platform. The quote below from Cerence’s OEM partner, Mercedes-Benz, is a good example of the OEM mindset towards big tech platforms:

“Our device is the car. Our platform, you can also say operating system, is MBUX. And on top of that, we built our own voice assistant, Hey Mercedes! So if you compare that to the industry view – let’s take a tech giant, let’s take Apple. The device is iPhone, the platform is iOS, and the system is Siri. We see it exactly the same way. And that shows you that we have our own strategy here, that means we are not looking for a third-party solution or an out-of-the-box solution. We’re developing our own ecosystem, our own system here, and we need it to be personalized and to fit perfectly with our brand and our portfolio. – Cerence Investor Day (18-02-20)

Even if OEMs were comfortable with the competitive threat of big tech players, it’s not clear that tech companies are well suited to serve as a single global platform for vehicles across the globe. Cerence uses the example that while Apple’s Siri and Amazon’s Alexa are well known nationally, these companies do not have the same global brand appeal that would allow an OEM to use them as a platform. -single digital form across an entire vehicle portfolio. Even domestically, American drivers have different preferences between the three major technology platforms, discouraging OEMs from tying themselves to a single digital platform.

While technology companies are competitors to OEMs, Cerence plays Switzerland’s role as a neutral partner enabling OEMs to have maximum customization, ownership and flexibility of the voice interface. Cerence provides OEMs with a high level of customization that helps preserve and enhance the OEM brand as part of the automotive experience. Additionally, through the use of Cerence’s technology, all data collected by the platform belongs to the OEMs, which would not be the case if the OEMs were using a large technology platform. In addition to the personalization and data ownership benefits, Cerence’s technology can also co-exist with almost any other third-party application (Amazon Music, Spotify, Google Maps, etc.), effectively making the open architecture of the operating system.

Summary of the thesis

Cerence is the primary catalyst for the growing adoption of technology in vehicles through its cutting-edge voice recognition technology and growing portfolio of connected services. Recent successes in connected service design represent the beginning of a century-long trend towards more connected services not only in automotive markets, but also in adjacent mobility markets. The company’s role as a neutral third-party supplier of software owned and customized by its OEM partners creates a defensible competitive advantage that protects the company from similar big tech offerings. CRNC’s close relationship with OEMs, combined with the lag between design and production, provides CRNC with a highly visible revenue backlog for many years to come. Outside of its core automotive market, CRNC is also seeing increasing adoption of its products in new markets such as motorcycles and lifts, with additional new markets likely to be added in the future. Using a 25x FCF multiple on FY24 free cash flow results in a price target of $124, up +63% from the current price of $76.

Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.