---







UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549





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FORM 10-Q





| | x |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | 
| | - |  | --------------------------------------------------------------------------------------- | 




FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2002





OR





| |  ̈ |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | 
| | - |  | ---------------------------------------------------------------------------------------- | 




FOR THE TRANSITION PERIOD FROM ____________ TO____________.





COMMISSION FILE NUMBER 333-96217





NUANCE COMMUNICATIONS, INC.


(Exact Name of Registrant as Specified in Its Charter)





DELAWARE

94-3208477(State Of Incorporation)

(IRS Employer Identification Number)





1005 HAMILTON AVENUE


MENLO PARK, CALIFORNIA 94025


(650) 847-0000


(Address and Telephone Number of
Principal Executive Offices)





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Indicate by check mark whether registrant
(1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.   YES x    NO  ̈





33,439,263 shares of the registrants common stock, $0.001 par value, were outstanding as of April 30, 2002.








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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES





FORM 10-Q, MARCH 31, 2002





CONTENTS





Item Number



PagePART I:    FINANCIAL INFORMATIONItem 1.

Financial StatementsConsolidated Balance Sheets: March 31, 2002 and December 31, 2001

1Consolidated Statements of Operations: Three months ended March 31, 2002 and 2001

2Consolidated Statements of Cash Flows: Three months ended March 31, 2002 and 2001

3Notes to Consolidated Financial Statements

4Item 2.

Managements Discussion and Analysis of Financial Condition and Results of Operations

13Item 3.

Quantitative and Qualitative Disclosures about Market Risk

27PART II:    OTHER INFORMATIONItem 1.

Legal Proceedings

27Item 6.

Exhibits and Reports on Form 8-K

27SIGNATURES

28




i




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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES





CONSOLIDATED BALANCE SHEETS


(UNAUDITED)


(IN THOUSANDS, EXCEPT SHARE AND PER
SHARE AMOUNTS)





March 31, 2002


December 31, 2001ASSETSCurrent assets:Cash and cash equivalents

$
116,476


$
132,618Short-term investments


39,811



16,230Accounts receivable, net of allowance for doubtful accounts of $927 and $1,312, respectively


7,241



6,399Prepaid expenses and current assets


4,384



4,920Total current assets


167,912



160,167Property and equipment, net


7,716



8,502Intangible assets


1,309



1,393Restricted Cash


12,207



11,983Long-term investments


6,175



25,747Other assets


234



439Total assets

$
195,553


$
208,231LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable

$
1,028


$
1,385Accrued liabilities


10,747



10,300Current restructuring accrual


9,437



8,974Deferred revenue


9,643



10,836Total current liabilities


30,855



31,495Long-term restructuring accrual


18,070



20,169Other long-term liabilities


1,742



1,742Total liabilities


50,667



53,406Commitments (Note 11)Stockholders EquityCommon stock, $.001 par value, 250,000,000 shares authorized; 33,383,453 shares and 33,198,051 shares issued and outstanding,
respectively


33



33Additional paid-in capital


324,482



324,371Deferred stock compensation


(929
)


(1,532
)Accumulated other comprehensive loss


(407
)


(335
)Accumulated deficit


(178,293
)


(167,712
)Total stockholders equity


144,886



154,825Total liabilities and stockholders equity

$
195,553


$
208,231





The accompanying notes are an integral part of these consolidated financial statements.




1




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NUANCE COMMUNICATIONS INC. & SUBSIDIARIES





CONSOLIDATED STATEMENTS OF OPERATIONS


(UNAUDITED)


(IN THOUSANDS, EXCEPT SHARE
AND PER SHARE DATA)





Three Months Ended March 31,2002


2001Revenue:License

$
5,861


$
5,662Service


1,236



3,398Maintenance and Other


1,976



1,957Total Revenue


9,073



11,017Cost of revenueLicense


86



Service


2,018



3,788Maintenance and Other


885



1,101Total cost of revenue


2,989



4,889Gross profit


6,084



6,128Operating expensesSales and marketing (1)


8,783



11,795Research and development (1)


3,601



5,064General and administrative (1)


3,001



3,510Amortization of intangibles and goodwill


84



653Non-cash compensation


639



1,591Restructuring charges


1,319



Total operating expenses


17,427



22,613Loss from operations


(11,343
)


(16,485
)Interest and other income, net


867



3,046Loss before provision for income taxes


(10,476
)


(13,439
)Provision for income taxes


105



198Net loss

$
(10,581
)

$
(13,637
)Basic and diluted net loss per share

$
(0.32
)

$
(0.43
)Shares used to compute basic and diluted net loss per share


33,195



31,956(1)  Excludes non-cash stock-based compensation as
follows:Sales and marketing

$
339


$
591Research and development

$
245


$
787General and administrative

$
55


$
213Total

$
639


$
1,591





The accompanying notes are an integral part of these consolidated financial statements.




2




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NUANCE COMMUNICATIONS INC. & SUBSIDIARIES





CONSOLIDATED STATEMENTS OF CASH FLOWS


(UNAUDITED)


(IN THOUSANDS)





Three Months Ended March 31,2002


2001Cash flows from operating activities:Net Loss

$
(10,581
)

$
(13,637
)Adjustments to reconcile net loss to net cash used in operating activitiesDepreciation and amortization


1,086



980Amortization of intangible assets


84



478Non-cash compensation expense


657



1,591Provision for doubtful accounts


(385
)


491Amortization of inventory


86



Changes in operating assets and liabilities:Accounts receivable


(458
)


7,386Prepaids and other assets


450



(242
)Accounts payable


(357
)


282Accrued liabilities


447



4,454Restructuring accrual


(1,635
)


Deferred revenue


(1,193
)


1,029Net cash (used for) provided by operating activities


(11,799
)


2,812Cash flows from investing activities:Restricted cash


(224
)


Purchase of investments


(23,626
)


Maturities of investments


19,572



5,819Purchase of property and equipment


(300
)


(19,498
)Purchase of technology






(7,000
)Net cash used for investing activities


(4,578
)


(20,679
)Cash flows from financing activities:Purchase of common stock






(13
)Proceeds from exercise of stock options


261



2,138Repayment of borrowings






(44
)Net cash provided by financing activities


261



2,081Effect of exchange rate fluctuations on cash and cash equivalents


(27
)


(101
)Net decrease in cash and cash equivalents


(16,142
)


(15,887
)Cash and cash equivalents, beginning of period


132,618



219,047Cash and cash equivalents, end of period

$
116,476


$
203,160Supplementary disclosures of cash flow information:Cash paid during the period for:Interest

$



$
14Income taxes

$



$
6Supplementary disclosures of non-cash transactions:Warrant issued to OnStar

$



$
526Unrealized loss on available-for-sale securities

$
45


$






The accompanying notes are an integral part of these consolidated financial statements.




3




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NUANCE COMMUNICATIONS INC. & SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)





|1. |  | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
|-- |  | -------------------------------------------




Basis
of Presentation





The unaudited consolidated financial statements have been prepared by Nuance Communications, Inc. (the
Company) in accordance with instructions to Form 10-Q and Article 10 of Regulation S-X. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany accounts and
transactions have been eliminated. The financial statements reflect all adjustments, consisting only of normal recurring adjustments considered necessary for a fair presentation of the financial position as of March 31, 2002 and December 31, 2001,
and the results of operations for the three months ended March 31, 2002 and 2001. The results for the periods presented are not necessarily indicative of the results to be expected for the full year or for any future periods. The accompanying
consolidated financial statements should be read in conjunction with the audited consolidated financial statements contained in the Companys Form 10-K filed with the Securities and Exchange Commission on April 1, 2002.





Principles of Consolidation





The consolidated
financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions have been eliminated.





Use of
Estimates in the Preparation of Consolidated Financial Statements





The preparation of the consolidated financial statements
in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and
liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.





Cash and Cash Equivalents





The Company considers all highly liquid investments
with an original maturity of three months or less to be cash equivalents. Cash and cash equivalents consist of money market accounts, certificate of deposits and deposits with banks. Cash and cash equivalents are recorded at cost which approximates
fair value.





Investments





The Companys investments are comprised of U.S. Treasury notes, U.S. Government agency bonds, corporate bonds and commercial paper. Investments with maturities of less than one year are considered to be short-term. All investments are
primarily held in the Companys name at a major financial institution. At March 31, 2002, all of the Companys investments were classified as available-for-sale and carried at fair value, which is determined based on quoted market price,
with net unrealized gain or loss included in the Accumulated Other Comprehensive Loss, in the accompanying consolidated balance sheets.





Restricted Cash





The Company had $12.2 million and $12.0 million restricted cash at March 31, 2002 and December
31, 2001, respectively. The restricted cash secures letters of credit required by landlords to meet rent deposit requirements for certain leased facilities. The restricted cash represents investments in certificates of deposit.





Revenue Recognition





We apply the
provisions of Statement of Position 97-2, Software Revenue Recognition, as amended by Statement of Position 98-9 Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions to all transactions
involving the sale of software products and sales of hardware where the software is not incidental.





Our license revenue
consists of license fees for our software products. The license fees for our software are calculated using two variables, one of which is the maximum number of simultaneous end-user connections to an application running on the platform, and the
other of which is the value attributed to the functional use of the software.




4




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NUANCE COMMUNICATIONS INC. & SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(Continued)







All revenues generated from our worldwide operations are approved at our corporate
headquarters, located in the United States. We recognize revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the product has been delivered, the fee is fixed and determinable and collection of the resulting
receivable is probable.





We use a signed contract or purchase order as evidence of an arrangement for licenses and maintenance
renewals. For services, we use a signed statement of work to evidence an arrangement. Software is delivered to customers either electronically or on a CD-ROM. We assess whether the fee is fixed and determinable based on the payment terms associated
with the transaction. We assess collectibility based on a number of factors, including the customers past payment history and its current creditworthiness. If we determine that collection of a fee is not reasonably assured, we defer the
revenue and recognize it at the time collection becomes reasonably assured, which is generally upon receipt of cash payment.





We
recognize license revenue either upon issuance of the permanent software license key or on system acceptance, if the customer has established acceptance criteria (which occurs only in a small minority of cases). In those contracts having acceptance
criteria, criteria typically consist of a demonstration to the customer that, upon implementation, the software performs in accordance with specified system parameters, such as recognition accuracy or call completion rates.





We use the residual method to recognize revenue when a license agreement includes one or more elements to be delivered at a future date if evidence of
the fair value of all undelivered elements exists. If evidence of the fair value of the undelivered elements does not exist, revenue is deferred and recognized when delivery occurs. License revenue from value-added resellers and OEMs is recognized
when product has been sold through to an end user and such sell-through has been reported to the Company.





The timing of license
revenue recognition is affected by whether we perform consulting services in the arrangement and the nature of those services. In the majority of cases, we either perform no consulting services or we perform standard implementation services that are
not essential to the functionality of the software. When we perform consulting services that are essential to the functionality of the software, we recognize both license and consulting revenue utilizing contract accounting based on the percentage
of the consulting services that have been completed.





Service revenue consists of revenue from providing consulting and
training. Our consulting service contracts are bid either on a fixed-fee basis or on a time-and-materials basis. For a fixed-fee contract, we recognize revenue using the percentage of completion method. For time-and-materials contracts, we recognize
revenue as services are performed. Training service revenue is recognized as services are performed. Losses on service contracts, if any, are recognized as soon as such losses become known.





Maintenance revenue consists of fees for providing technical support and software updates. We recognize all maintenance revenue ratably over the contract term. Customers renew
maintenance agreements annually.





Other revenue consists primarily of reimbursements for out of pocket expenses incurred, in
accordance with the FASBs Emerging Issues Task Force (EITF) Issue No. 01-14, Income Statement Characterization of Reimbursements Received for Out-of-Pocket Expenses Incurred.





Cost of license revenue consists primarily of license fees payable on third-party software products, documentation, media costs and inventory
writedowns. Cost of service revenue consists of compensation and related overhead costs for employees engaged in consulting, training and maintenance for our customers.





Reclassification





Certain prior year amounts have been classified to conform with current
period presentation.





|2. |  | RECENT ACCOUNTING PRONOUNCEMENTS
|-- |  | --------------------------------




On June 29, 2001, the FASB issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. Major provisions of these Statements are as follows: all business combinations initiated
after June 30, 2001 must use the purchase method of accounting; the pooling of interest method of accounting is prohibited except for transactions initiated before July 1, 2001; intangible assets acquired in a business combination must be recorded
separately from goodwill if they arise from contractual or other legal rights or are separable from the acquired entity and can be sold, transferred, licensed, rented or exchanged, either




5




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NUANCE COMMUNICATIONS INC. & SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(Continued)




individually or as part of a related contract, asset or liability; goodwill and intangible assets with indefinite lives are not amortized but are tested for impairment annually using a fair value
approach, except in certain circumstances, and whenever there is an impairment indicator; other intangible assets will continue to be valued and amortized over their estimated lives; in-process research and development will continue to be written
off immediately; all acquired goodwill must be assigned to reporting units for purposes of impairment testing and segment reporting; effective January 1, 2002, existing goodwill will no longer be subject to amortization. Goodwill acquired subsequent
to June 30, 2001 will not be subject to amortization.





Because we did not initiate any business combinations after June 30,
2001, the adoption of SFAS No. 141 does not have a material impact on our financial position or results of operations. SFAS No. 142 had no effect on the quarter ending March 31, 2002 as all goodwill was written off as of December 31, 2001.





For the year ended December 31, 2001, we performed an impairment analysis of identifiable assets and goodwill and we recorded a
charge of $7.6 million to the impairment of goodwill and other intangible assets. As of March 31, 2002, we have approximately $1.3 million remaining in intangible assets which are being amortized over 4 remaining years and no goodwill recorded in
our financial statements.





In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets. SFAS No. 144 supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions of APB Opinion No. 30,
Reporting the Results of OperationsReporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. SFAS No. 144 retains the requirements of SFAS No. 121
whereby an impairment loss should be recognized if the carrying value of the asset is not recoverable from its undiscounted cash flows and develops one accounting model for long-lived assets that are to be disposed of by sale. SFAS No. 144
eliminates goodwill from its scope, therefore it does not require goodwill to be allocated to long-lived assets. SFAS No. 144 broadens the scope of APB 30 provisions for the presentation of discontinued operations to include a component of an entity
(rather than a segment of a business). SFAS No. 144 had no effect on the accompanying financial statements for the quarter ended March 31, 2002.





In November 2001, the FASBs Emerging Issues Task Force (EITF) issued Topic No. D-103, Income Statement Characterization of Reimbursements Received for Out-of-Pocket Expenses Incurred.
Topic No. D-103 requires companies to characterize reimbursements received for out of pocket expenses incurred as revenue in the statement of operations. We have historically netted reimbursements received for out of pocket expenses against the
related expenses in the accompanying consolidated statements of operations. In January 2002, the EITF issued Topic No. D-103 as ETIF Issue No. 01-14. We adopted EITF Issue No. 01-04 beginning January 1, 2002 and comparative financials statements for
prior periods have been reclassified to comply with the guidance in Topic D-103. During the three months ended March 31, 2002 and 2001, reimbursed out-of-pocket expenses totaled $9,400 and $14,700, respectively.





In July 2001, the FASBs EITF reached final consensus on EITF No. 00-25, Vendor Income Statement Characterization of Consideration Paid to a
Reseller of the Vendors Products, EITF 00-25 generally requires that the consideration, including equity instruments, given to a customer be classified in a vendors financial statements not as an expense, but as an offset of
revenue up to the amount of cumulative revenue recognized or to be recognized. In November 2001, the EITF reached consensus on EITF No. 01-09, Accounting for Consideration Given by a Vendor to a Customer or Reseller of the Vendors
Products. EITF 01-09 clarifies and modifies certain items discussed in EITF 00-25. EITF No. 00-25 and EITF No. 01-09 had no material effect on the accompanying financial statements for the quarter ended March 31, 2002.





|3. |  | NET LOSS PER SHARE
|-- |  | ------------------




Net loss
per share is calculated under SFAS No. 128, Earnings Per Share. Basic net loss per share on a historical basis is computed using the weighted average number of shares of common stock outstanding. Diluted net loss per share is equal to
basic net loss per share for all periods presented since potential common shares from stock options, warrants and exchangeable shares held in escrow are antidilutive. Shares subject to repurchase resulting from early exercises of options that have
not vested are excluded from the calculation of basic and diluted net loss per share. The total number of shares excluded from diluted net loss per share was 7,779,000 shares for the three months ended March 31, 2002 and 7,075,000 shares for the
three months ended March 31, 2001.




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NUANCE COMMUNICATIONS INC. & SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(Continued)







The following table presents the calculation of basic and diluted net loss per
share (in thousands, except share and per share data):





Three Months Ended March 31,2002


2001Net loss

$
(10,581
)

$
(13,637
)Basic:Weighted average shares of common stock outstanding


33,311



32,363Less: Weighted average shares of common stock subject to repurchase


(116
)


(407
)Weighted average shares used to compute basic and diluted net loss per share


33,195



31,956Basic and diluted net loss per share

$
(0.32
)

$
(0.43
)





|4. |  | GOODWILL AND INTANGIBLE ASSETS
|-- |  | ------------------------------




There was no goodwill on the financial statements for the quarter ended March 31, 2002, as no goodwill was acquired during the quarter and all prior goodwill was written off in the year ended December 31, 2001.





Information regarding the Companys other intangible assets follow (in thousands):





As of March 31, 2002

As of December 31, 2001Carrying Amount

Accumulated Amortization


Net

Carrying Amount

Accumulated Amortization


NetPurchased Technology

$
2,618

($
1,309
)

$
1,309

$
2,618

($
1,225
)

$
1,393Total

$
2,618

($
1,309
)

$
1,309

$
2,618

($
1,225
)

$
1,393





Amortization expense of other intangible assets was $84,000 and $175,000
respectively, for the three months ended March 31, 2002 and 2001. The estimated amortization for each of the five fiscal years subsequent to December 31, 2001 is as follows:





Year Ended December 31,

Amortization Expense2002

$
3382003


3382004


3382005


3382006


41Total

$
1,393




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NUANCE COMMUNICATIONS INC. & SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(Continued)







|5. |  | NON-CASH COMPENSATION
|-- |  | ---------------------




In
connection with the grant of stock options prior to our initial public offering, we recorded deferred stock compensation of approximately $8.7 million within stockholders equity, representing the difference between the estimated fair value of
the common stock for accounting purposes and the option exercise price of these options at the date of grant. This amount is presented as a reduction of stockholders equity and is being amortized over the vesting period of the applicable
options in a manner consistent with FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans. We recorded amortization of deferred stock compensation of $161,000 for the three
months ended March 31, 2002 and $651,000 for the three months ended March 31, 2001. For the three months ended March 31, 2002, we recorded a reversal of approximately $249,000 of deferred stock compensation and additional paid-in-capital on the
balance sheet, which represents accumulated amortization and unamortized deferred stock compensation relating to forfeitures of stock options by terminated employees.





In connection with our SpeechFront acquisition, we recorded deferred compensation of $4.1 million. This amount is part of the purchase agreement and is payable to the founders in common
stock, approximately 38,710 shares, and contingent upon their continued employment. Of that amount, $1.7 million, approximately 16,590 shares, relates to retention of the founders of SpeechFront, and, is payable in common stock upon the eighteen
month anniversary of the acquisition date, which is May 2002. The remaining $2.4 million, approximately 22,120 shares, also relates to retention of the founders and was released from the escrow account on the twelve-month anniversary of the
acquisition date, which was November 2001. These amounts are being amortized over 18 months and 12 months, respectively. Upon consummation of the acquisition, we established an escrow account for these contingent payments. Approximately $290,000 and
$872,000 were amortized in the three months ended March 31, 2002 and 2001, respectively, related to these deferred compensation amounts.





In December 2000, we issued to a customer a warrant to purchase 100,000 shares of common stock at an exercise price of $138.50 per share subject to certain anti-dilution adjustments. The warrant is exercisable at the option of the holder,
in whole or part, at any time between January 17, 2001 and August 2002. In January 2001, we valued the warrant at $526,000, utilizing the Black-Scholes valuation model using the following assumptions: risk-free interest rate of 5.5%, expected
dividend yields of zero, expected life of 1.5 years and expected volatility of 80%. The warrant was fully amortized as of March 31, 2002 to compensation expense. We amortized $205,000 and $68,000 related to this warrant in the three months ended
March 31, 2002 and 2001, respectively. During the quarter ended March 31, 2002, we performed services of $18,000 for this customer and reduced the warrant expense for the period by this amount.





We expect to amortize $1.3 million, $209,000 and $8,000 of non-cash compensation in 2002, 2003 and 2004, respectively.





|6. |  | STOCK OPTION EXCHANGE PROGRAM
|-- |  | -----------------------------




On March 1, 2002, we announced a voluntary stock option exchange program for all employees. Under the program, employees are given the opportunity to elect to cancel outstanding stock options at an exercise price of $15.00 or greater under
the 1998 Stock Plan and 2000 Stock Plan held by them in exchange for new options to be granted under the 2000 Stock Plan at a future date at the then current fair market value. The new options will be granted no earlier than the first business day
that is six months and one day after the cancellation date of the exchanged options. The exercise price per share of the new options will be 100% of the fair market value on the date of grant, as determined by the closing price of our common stock
reported by Nasdaq National Market for the last market trading day prior to the date of grant. These elections were made by March 29, 2002 and were required to include all options granted during the prior six-month period. The exchange program is
not available to executive officers, directors, consultants or former employees.





|7. |  | PURCHASED TECHNOLOGY
|-- |  | --------------------




During
2001, we entered into an agreement with a third-party that gave us non-exclusive intellectual property rights to text to speech software code. We paid $7.0 million for this purchased technology, which has been capitalized in the accompanying
Consolidated Balance Sheets, as the technology has alternative use and will be amortized over its useful life estimated to be five years. We are in the process of incorporating the text to speech technology into our platform. During the development
stage, this technology is being amortized to research and development expense, and when the product is generally available for sale, the technology will be amortized to cost of sales. We amortized $175,000 to research and development expense in the
three months ended March 31, 2001 and $84,000 to amortization of intangibles in the three months ended March 31, 2002. The agreement includes a royalty clause in which we will pay 5% of all net revenue attributable to sublicenses of this technology
to a third party. The term of the royalty payments is eight years.




8




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NUANCE COMMUNICATIONS INC. & SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(Continued)







|8. |  | ACQUISITION
|-- |  | -----------




On November 10,
2000, in an acquisition accounted for under the purchase method of accounting, we acquired all the outstanding shares of SpeechFront Inc. (SpeechFront) for approximately $7.1 million, including acquisition costs of approximately
$129,000. SpeechFront was a developer of voice instant messaging systems. The consideration included approximately 16,590 shares of the Companys common stock valued at $1.7 million and cash of approximately $5.3 million. The purchase agreement
also contained additional payments of approximately $4.1 million, to be made in common stock, approximately 38,710 shares, contingent upon the continued employment of the founders of SpeechFront. Upon consummation of the acquisition, we established
an escrow account for these contingent payments. Maximum future payments, contingent solely on continued employment of the founders, is $1.7 million, approximately 16,590 shares, and is payable upon the eighteen month anniversary of the acquisition
date, which is May 2002. The remaining $2.4 million, approximately 22,120 shares, also relates to the continued employment of the founders, and was released from the escrow account on the twelve-month anniversary of the acquisition date, which was
November 2001. The contingent payments are accounted for as compensation expense over the term of the employment condition and not as part of the purchase price.





For the year ending December 31, 2001, we reviewed the carrying value of the assets related to the SpeechFront acquisition based on existing business conditions and determined that the
voice instant messaging system technologies under development during the year 2001 were not aligned with our revised strategy and will not be utilized. As a result, we decided to cease the development of instant messaging system technologies and
impaired the remaining asset balance as of December 31, 2001.





|9. |  | SEGMENT REPORTING AND INTERNATIONAL INFORMATION
|-- |  | -----------------------------------------------




We have two operating segments: licenses and services. Revenue and cost of revenue for the segments are identical to those presented on the accompanying consolidated statements of operations. We do not track expenses
nor derive profit or loss based on these segments.





Sales of licenses and services through March 31, 2002 occurred
through resellers and direct sales representatives located in our headquarters in Menlo Park, California, and in other locations. These sales were supported through the Menlo Park location. We do not separately report costs by region internally.
International revenues are based on the country in which the end-user is located. The following is a summary of license and service and maintenance revenue by geographic region (in thousands):




9




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NUANCE COMMUNICATIONS INC. & SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(Continued)







Quarter Ended March 31,2002

2001License RevenueUnited States

$
3,570

$
3,067Europe


880


658Asia


613


358Australia


202


918Canada


306


11Latin America


290


650Total

$
5,861

$
5,662Service and Maintenance RevenueUnited States

$
1,936

$
2,820Europe


450


1,080Asia


149


277Australia


169


445Canada


313


189Latin America


195


544Total

$
3,212

$
5,355





10.    RESTRUCTURING:





In April 2001, our Board of Directors approved a restructuring plan that would align the Companys expenses with revised anticipated demand and create a more efficient
organization. In connection with the restructuring plan, we recorded a restructuring charge of $34.1 million for lease loss and severance costs and an asset impairment charge of $20.4 million on tenant improvements for the year ended December 31,
2001.





In connection with the restructuring plan, we decided not to occupy a new leased facility. This decision has resulted in
a lease loss of $32.6 million for the year ended December 31, 2001, comprised of a sublease loss, broker commissions and other facility costs. To determine the sublease loss, the loss after the Companys cost recovery efforts from subleasing
the building, certain assumptions were made related to the (1) time period over which the building will remain vacant (2) sublease terms (3) sublease rates. The lease loss is an estimate under SFAS No. 5 Accounting for Contingencies and
represents the low end of the range and will be adjusted in the future upon triggering events (change in estimate of time to sublease, actual sublease rates, etc.). We have estimated that the high end of the lease loss could be $55 million if
operating lease rental rates continue to decrease in these markets or should it take longer than expected to find a suitable tenant to sublease the facility.





We recorded $1.5 million in costs for the year ended December 31, 2001 associated with severance and related benefits. We reduced headcount by approximately 80 employees, with reductions ranging between 10% and 20%
across all functional areas and affecting several locations.




10




---



NUANCE COMMUNICATIONS INC. & SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(Continued)







On January 24, 2002, our Board of Directors approved a restructuring plan that
reduced our workforce by 35 employees or approximately 10%. These charges are being recorded primarily to realign the sales organization and our cost structure with changing market conditions to create a more efficient organization. We recorded a
restructuring charge of $1.3 million for the three months ending March 31, 2002, which primarily consisted of payroll and related expenses in connection with headcount reduction. During the three months ended March 31, 2002, $700,000 of this amount
was paid out with the remainder expected to be paid during 2002.





The restructuring activity for the quarter ended March 31,
2002 are as follows (in millions):





Lease Loss


Severance and Related Benefits


Total RestructuringTotal charge for the year ended December 31, 2001


32.6



1.5



34.1Amount utilized in the year ended December 31, 2001


(3.6
)


(1.4
)


(5.0
)Accrual balance at December 31, 2001

$
29.0


$
0.1


$
29.1Total charge for the quarter ended March 31, 2002






1.3



1.3Amount utilized in the quarter ended March 31, 2002


(2.1
)


(0.8
)


(2.9
)Accrual balance at March 31, 2002

$
26.9


$
0.6


$
27.5





Total cash outlay for the restructuring plans is expected to be $35.4 million, of
which $7.9 million was paid through March 31, 2002 and $27.5 million remained accrued at March 31, 2002. We expect $8.8 million of the lease loss to be paid out over the next twelve months, and the remaining $18.1 million to be paid out over the
remaining life of the lease of approximately 10 years. All of the employee severance and related benefits accrual will be paid out by June 30, 2002.





11.    COMMITMENTS





We lease our facilities under non-cancelable operating leases with
various expiration dates through July 2012. Future minimum lease payments under these agreements, including the Companys new facilities lease, as of December 31, 2001, are as follows (in thousands):





Fiscal Year Ending December 31,2002

$
9,6582003


9,7272004


9,2532005


8,4772006


8,778Thereafter


52,494Total minimum lease payments

$
98,387





In May 2000, we entered into a lease for a new headquarters facility. The lease
has an eleven-year term, which began in August 2001,




11




---



NUANCE COMMUNICATIONS INC. & SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)(Continued)




and provides for monthly rent payments starting at approximately $600,000. A $12.2 million certificate of deposit secures a letter of credit required by the landlord for a rent deposit. In
conjunction with the restructuring plan (see Note 10), we decided not to occupy this new leased facility and have recorded a lease loss of $32.6 million related to future lease commitments, net of expected sublease income. The future minimum lease
payments table referenced above does not include estimated sublease income.





12.    LITIGATION





In March 2001, the first of a number of stockholder complaints was filed in the United States District Court for the Northern District of California
against Nuance and certain of its officers. Those lawsuits were consolidated and an amended complaint was filed on behalf of a purported class of people who purchased our stock during the period January 31, 2001 through March 15, 2001, alleging
false and misleading statements and insider trading in violation of the federal securities laws. The plaintiffs are seeking unspecified damages. We believe that these allegations are without merit and we are defending the litigation vigorously.
Plaintiffs recently filed a further amended complaint, which we intend to move to dismiss. An unfavorable resolution of this litigation could have a material adverse effect on our business, results of operations, or financial condition.





In June and July 2001, putative shareholder derivative actions were filed in California state court alleging breaches of
fiduciary duty and insider trading by various of our directors and officers. While we are named as a nominal defendant, the lawsuits do not appear to seek any recovery against us. Proceedings in these actions have been stayed.





In August 2001, the first of a number of complaints was filed in federal district court for the Southern District of New York on behalf of a
purported class of persons who purchased Nuance stock between April 12, 2000 and December 6, 2000. In April 2002, plaintiffs filed a consolidated amended complaint. The consolidated amended complaint generally alleges that various investment bank
underwriters engaged in improper and undisclosed activities related to the allocation of shares in our initial public offering of securities, the conduct of our secondary offering, and the issuance of analyst reports. The complaints bring claims for
violation of several provisions of the federal securities laws against those underwriters, and also against us and some of our directors and officers. Similar lawsuits have been filed concerning more than 300 other companies public offerings.
We believe that the allegations against us are without merit and intend to defend the litigation vigorously.





We are subject to
various other legal proceedings, claims and litigation that arise in the normal course of business. While the outcome of these matters is currently not determinable, management does not expect that the ultimate costs to resolve these matters will
have a material adverse effect on our consolidated financial position, results of operations, or cash flows.





13.    SUBSEQUENT
EVENTS





On April 17, 2002, we filed a report on Form 8-K setting forth the change of our independent auditor.




12




---




MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION AND RESULTS OF OPERATIONS





The following discussion should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this report.
The results shown herein are not necessarily indicative of the results to be expected for the full year or any future periods.





This Report on Form 10-Q contains forward-looking statements, within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act, including but not limited to our expectations for results over the balance of the
year, regarding expense trends, sources of revenue, cash positions and our outlook for the Company, as well as our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this Report on Form
10-Q are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. These statements involve risks and uncertainties and actual results could differ materially from those
anticipated in these forward-looking statements as a result of a number of factors, including, but not limited to, those set forth in Factors That Affect Future Results and elsewhere in this Report on Form 10-Q. In particular, see
Factors That Affect Future ResultsOur ability to accurately forecast our quarterly sales is limited, our costs are relatively fixed in the short term and we expect our business to be affected by seasonality. As a result, our quarterly
operating results may fluctuate and  Sales to customers outside the United States account for a significant portion of our revenue, which exposes us to risks inherent in international operations.





OVERVIEW:





Nuance develops, markets and supports
software that enables enterprises and telecommunications carriers to automate the delivery of information and services over the telephone. We were incorporated in July 1994 and began operations in October 1994. Prior to 1996, our revenue was derived
from technical consulting services. In 1996, we deployed the first version of our software platform and began to generate software license revenue. Today, we offer a range of software products. To support the sale, deployment and operation of our
products, we also provide a number of services that include consulting, training, maintenance updates and technical support.





We
sell products to our customers both directly through our sales force and indirectly through resellers and systems integrators. One customer, Nortel Networks, acting as a reseller, accounted for 11% of total revenue in the quarter ended March 31,
2002. No other customers or resellers accounted for more than 10% of our revenue for the quarter ended March 31, 2002. Two customers, Nortel Networks and Edify, accounted for 41% of total revenue for the quarter ended March 31, 2001.





We sell our products to customers in North America, South America, Europe, Asia and Australia. International sales accounted for
approximately 39% of our total revenue for the quarter ended March 31, 2002. We anticipate that markets outside the United States will continue to represent a significant portion of total future revenue. We intend to keep our sales and marketing
activities constant with respect to international licensing of our software and provisioning of our services in the foreseeable future. International sales are currently denominated in U.S. dollars. However, we may denominate sales in foreign
currencies in the future.





On January 24, 2002, our Board of Directors approved a restructuring plan that would reduce our
workforce by approximately 10%. These charges are being recorded primarily to realign the sales organization and our cost structure with changing market conditions to create a more efficient organization. The restructuring charge of $1.3 million,
which primarily consisted of payroll and related expenses in connection with headcount reduction, was recorded in the first quarter ended March 31, 2002.





RESULTS OF OPERATIONS:





The following table sets forth, for the periods indicated, the percentage of net revenue
represented by certain items in our statements of operations for the three months ended March 31, 2002 and 2001.




13




---




Three Months Ended March 31,2002


2001Revenue:License

65
%

51
%Service and maintenance

35


49Total Revenue

100


100Cost of revenueLicense

1


Service and maintenance

32


44Total cost of revenue

33


44Gross profit

67


56Operating expensesSales and marketing

97


107Research and development

40


48General and administrative

33


32Amortization of intangibles

1


4Non-cash compensation

7


15Restructuring charges

15


Total operating expenses

193


206Loss from operations

(126
)

(150
)Interest and other income, net

10


27Loss before provision for income taxes

(116
)

(123
)Provision for income taxes

1


1Net loss

(117
)%

(124
)%





COMPARISON OF THREE MONTHS ENDED MARCH 31, 2002 AND 2001





Revenue





Total revenue for the three months ended
March 31, 2002 was $9.1 million, compared with $11.0 million in the three months ended March 31, 2001, a decrease of 18%.





License revenue for the three months ended March 31, 2002 was $5.9 million, compared with $5.7 million in the three months ended March 31, 2001, an increase of 4%. This increase in license revenue was due primarily to an increase of
customer purchases that were delayed from prior periods due to an uncertain economic environment. License revenue represented 65% of total revenue for the three months ended March 31, 2002 and 51% of total revenue for the three months ended March
31, 2001.





Service and maintenance revenue for the three months ended March 31, 2002 was $3.2 million, compared with $5.3
million for the three months ended March 31, 2001, a decrease of 40%. This decrease in service and maintenance revenue was due primarily to the decline in demand and reduction of professional service and maintenance personnel to bring capacity in
line with the reduced demand. Service and maintenance revenue represented 35% of total revenue for the three months ended March 31, 2002 and 49% of total revenue for the three months ended March 31, 2001.





Cost of Revenue





Cost of license revenue consists
primarily of fees payable on third-party software products and documentation, media costs and inventory writedowns. Cost of license revenues were $86,000 and $0 for the quarters ended March 31, 2002 and 2001, respectively, which represent inventory
costs associated with the Vocalizer product. We anticipate that cost of license revenue will increase moderately in absolute dollars, in part due to royalty payments in relation to our Vocalizer product.




14




---




Cost of service and maintenance revenue for the three months ended March 31, 2002 was $2.9
million, compared with $4.9 million in the three months ended March 31, 2001, a decrease of 41%. This decrease was due to a reduction of employees resulting from the January 2002 and April 2001 restructuring plans, as well as realignment of the
professional services employees to support the sales and marketing organization. Headcount for professional service and maintenance personnel decreased by approximately 84 employees, a reduction of approximately 79%, in the quarter ended March 31,
2002 compared with the quarter ended March 31, 2001. Cost of service and maintenance revenue as a percentage of service and maintenance revenue was 90% in the three months ended March 31, 2002 and 91% for the three months ended March 31, 2001. We
anticipate that cost of service and maintenance revenue will remain constant as a percentage of total revenue. However, this will depend upon our revenue growth, among other factors. Accordingly, there can be no assurance that we will be successful
in maintaining our cost of service and maintenance revenues as a percentage of total revenues.





Operating Expenses





Sales and MarketingSales and marketing expenses primarily consist of compensation and related costs for sales and marketing personnel and
promotional expenditures, including public relations, advertising, trade shows and marketing collateral materials. Sales and marketing expenses for the three months ended March 31, 2002 were $8.8 million, compared with $11.8 million in the three
months ended March 31, 2001, a decrease of 25%. The decrease was primarily attributable to a reduction in commission-based compensation and incentives to sales personnel resulting from a reduction in sales revenue between the three months ended
March 31, 2002 and 2001, as well as decreases in travel and related expenses, consulting and recruiting costs, and in our allowance for bad debt. As a percentage of total revenue, sales and marketing expenses were 97% in the three months ended March
31, 2002, and 107% in the three months ended March 31, 2001. We anticipate that sales and marketing expenses will remain relatively constant in absolute dollars, but will vary as a percentage of total revenue from period to period.





Research and DevelopmentResearch and development expenses primarily consist of compensation and related costs for research and
development personnel and contractors. Research and development expenses for the three months ended March 31, 2002 were $3.6 million, compared with $5.1 million in the three months ended March 31, 2001, a decrease of 29%. This decrease was
attributable to a reduction of personnel associated with product development activities resulting from the January 2002 and April 2001 restructuring plans. Headcount for research and development personnel decreased by approximately 29 employees, a
reduction of approximately 23%, in the quarter ended March 31, 2002 compared with the quarter ended March 31, 2001. As a percentage of total revenue, research and development expenses were 40% in the three months ended March 31, 2002, and 48% in the
three months ended March 31, 2001. We anticipate that research and development expenses will remain relatively constant in absolute dollars, but will vary as a percentage of total revenue from period to period.





General and AdministrativeGeneral and administrative expenses primarily consist of compensation and related costs for administrative personnel,
legal services, accounting services and other general corporate expenses. General and administrative expenses for the three months ended March 31, 2002 were $3.0 million, compared with $3.5 million in the three months ended March 31, 2001, a
decrease of 15%. The decrease was largely due to the reduction of administrative personnel resulting from the January 2002 and April 2001 restructuring plans. Headcount for administrative personnel decreased by approximately 9 employees, a reduction
of approximately 13%, in the quarter ended March 31, 2002 compared with the quarter ended March 31, 2001. As a percentage of total revenue, general and administrative expenses were 33% in the three months ended March 31, 2002 and 32% in the three
months ended March 31, 2001. We anticipate that general and administrative expenses will remain relatively constant in absolute dollars, however, we expect that these expenses will vary as a percentage of total revenue from period to period.





Amortization of Intangibles and GoodwillGoodwill and other acquired intangible assets of $5.5 million were recorded in
connection with the acquisition of SpeechFront in November 2000. There was no amortization of goodwill for the three months ended March 31, 2002 as all goodwill was written off as of December 31, 2001. Amortization expense was $84,000 for the three
months ended March 31, 2002, primarily resulting from the amortization of purchased technology, and $653,000 for the three months ended March 31, 2001, resulting from amortization of purchased technology and goodwill.





Non-Cash CompensationIn connection with the grant of stock options prior to our initial public offering, we recorded deferred stock compensation
of approximately $8.7 million within stockholders equity, representing the difference between the estimated fair value of the common stock for accounting purposes and the option exercise price of these options at the date of grant. This amount
is presented as a reduction of stockholders equity and is being amortized over the vesting period of the applicable options in a manner consistent with FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other
Variable Stock Option or Award Plans. We recorded amortization of deferred stock compensation of $161,000 for the three months ended March 31, 2002 and $651,000 for the three months ended March 31, 2001. For the three months ended March 31,
2002, we recorded a reversal of approximately $187,000 of deferred stock compensation expense relating to forfeitures of stock options by terminated employees.





In connection with our SpeechFront acquisition, we recorded deferred compensation of $4.1 million. This amount is part of the purchase agreement and is payable to the founders in common stock,
approximately 38,710 shares, contingent upon their continued




15




---

employment. Upon consummation of the acquisition, we established an escrow account for these contingent payments. Of that amount, $1.7 million, approximately 16,590 shares, relates to retention
of the founders of SpeechFront, and, is payable in common stock upon the eighteen month anniversary of the acquisition date, which is May 2002. The remaining $2.4 million, approximately 22,120 shares, also relates to retention of the founders and
was released from the escrow account on the twelve-month anniversary of the acquisition date, which was November 2001. These amounts have been amortized over 18 months and 12 months, respectively. Approximately $290,000 and $872,000 were amortized
in the three months ended March 31, 2002 and 2001, respectively, related to these deferred compensation amounts.





In December
2000, we issued to a customer a warrant to purchase 100,000 shares of common stock at an exercise price of $138.50 per share subject to certain anti-dilution adjustments. The warrant is exercisable at the option of the holder, in whole or part, at
any time between January 17, 2001 and August 2002. In January 2001, we valued the warrant at $526,000, utilizing the Black-Scholes valuation model using the following assumptions: risk-free interest rate of 5.5%, expected dividend yields of zero,
expected life of 1.5 years and expected volatility of 80%. The warrant has been fully amortized as of March 31, 2002 to compensation expense. We amortized $205,000 and $68,000 related to this warrant in the three months ended March 31, 2002 and
2001, respectively. During the quarter ended March 31, 2002, we performed services of $18,000 for this customer and reduced the warrant expense for the period by this amount.





We expect to amortize $1.3 million, $209,000 and $8,000 of non-cash compensation in 2002, 2003 and 2004, respectively.





Restructuring Charges





On January 24, 2002, our Board of Directors approved a
restructuring plan that reduced our workforce by approximately 10%. These charges are being recorded primarily to realign the sales organization and our cost structure with changing market conditions to create a more efficient organization. We
recorded a restructuring charge of $1.3 million for the three months ended March 31, 2002, which primarily consisted of payroll and related expenses in connection with headcount reduction.





Interest and Other Income, Net





Interest and other income, net, consists
primarily of interest earned on cash and cash equivalents and short-term investments. Interest and other income, net was $867,000 in the three months ended March 31, 2002 and $3.0 million in the three months ended March 31, 2001, a decrease of 71%.
This decrease was due to a reduction in interest income, resulting from lower cash balances and decreased interest rates.





Provision for Income Taxes





We have incurred operating losses for all periods from inception through March 31, 2002 and therefore have not recorded a
provision for federal income taxes for any period through March 31, 2002. We recorded income tax expense relating to foreign taxes for the periods ended March 31, 2002 and 2001 of $105,000 and $150,000, respectively.





LIQUIDITY AND CAPITAL RESOURCES





From inception
to our initial public offering, we financed our operations primarily from private sales of convertible preferred stock totaling $70.0 million through March 31, 2000 and, to a lesser extent, from bank financing. On April 18, 2000, we raised
approximately $80 million through the completion of our initial public offering of common stock. On October 2, 2000, we raised approximately $144 million through the completion of our follow-on public offering. As of March 31, 2002, we had cash and
cash equivalents aggregating $116.5 million and investments totaling $46.0 million.





Our operating activities used cash of $11.8
million for the three months ended March 31, 2002, and generated cash of $2.8 million during the three months ended March 31, 2001. This negative operating cash flow in the three months ended March 31, 2002 was largely the result of our net loss.
The positive operating cash flow in the three months ended March 31, 2001 resulted principally from a decrease in accounts receivable and an increase in accrued liabilities, largely offset by our net loss.





Investing activities used cash of $4.6 million during the three months ended March 31, 2002, and $20.7 million during the three months ended March 31,
2001. Our use of cash in investing activities for the three months ended March 31, 2002 resulted from the net purchases of short-term investments. The use of cash for the three months ended March 31, 2001 resulted primarily from additions to
property and equipment and purchased technology, partially offset by maturities of short-term investments.





Our financing
activities generated cash of $261,000 during the three months ended March 31, 2002, and $2.1 million for the three months ended March 31, 2001. The generation of cash was largely the result of proceeds from the exercise of stock options for both the
three months ended March 31, 2002 and 2001.





Our capital requirements depend on numerous factors. We may
continue to report significant quarterly operating losses resulting in




16




---

future negative operating cash flows. We do not plan to spend more than $5 million on capital expenditures in the next 12 months. We believe that our cash and cash equivalents, our short-term and
long-term investments, and our borrowing capacity will be sufficient to fund our activities for at least the next 12 months. Thereafter, we may need to raise additional funds in order to fund more rapid expansion, including increases in employees
and office facilities; to develop new or enhance existing products or services; to respond to competitive pressures; or to acquire or invest in complementary businesses, technologies, services or products. Additional funding may not be available on
favorable terms or at all. In addition, we may, from time to time, evaluate potential acquisitions of other businesses, products and technologies. We may also consider additional equity or debt financing, which could be dilutive to existing
investors.





The following table summarizes our obligations and commercial commitments to make future payments under contracts:





Contractual Obligations

TOTAL

Current

1-3 years

4-5 years

After 5 yearsOperating leases

$
98,387

$
9,658

$
27,457

$
17,487

$
43,785Other Commercial Commitments

TOTAL

Less than 1 year

1-   years

4-5 years

After 5 yearsStandby Letters of Credit

$
12,207

$


$


$


$
12,207





The restricted cash secures our letters of credit of approximately $12.2 million
invested with a bank, as required by landlords to meet rent deposits requirements for our leases on facilities (see Note 1).





Critical Accounting
Policies





Our critical accounting policies are as follows:





| |  |  | revenue recognition;
| | - |  | --------------------




| |  |  | estimating valuation allowances and lease loss;
| | - |  | -----------------------------------------------




| |  |  | accounting for income taxes; and
| | - |  | --------------------------------




| |  |  | valuation of intangible assets and goodwill.
| | - |  | --------------------------------------------




Revenue
Recognition





We apply the provisions of Statement of Position 97-2, Software Revenue Recognition, as amended by
Statement of Position 98-9 Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions to all transactions involving the sale of software products and sales of hardware where the software is not
incidental.





Our license revenue consists of license fees for our software products. The license fees for our software products
are calculated using two variables, one of which is the estimated maximum number of simultaneous end-user connections to an application running on our software and the other of which is the value attributed to the functional use of the software.





All revenues generated from our worldwide operations are approved at our corporate headquarters, located in the United States.
We recognize revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the product has been delivered, the fee is fixed and determinable and collection of the resulting receivable is probable.





We use a signed contract or purchase order as evidence of an arrangement for licenses and maintenance renewals. For services, we use a signed
statement of work to evidence an arrangement. Software is delivered to customers either electronically or on a CD-ROM. We assess whether the fee is fixed and determinable based on the payment terms associated with the transaction. We assess
collectibility based on a number of factors, including the customers past payment history and its current creditworthiness. If we determine that collection of a fee is not reasonably assured, we defer the revenue and recognize it at the time
collection becomes reasonably assured, which is generally upon receipt of cash payment.





We recognize
license revenue either upon issuance of the permanent software license key or on system acceptance, if the customer has established acceptance criteria (which occurs only in a small minority of cases). In those contracts having acceptance criteria,
criteria




17




---

typically consist of a demonstration to the customer that, upon implementation, the software performs in accordance with specified system parameters, such as recognition accuracy or call
completion rates.





We use the residual method to recognize revenue when a license agreement includes one or more elements to be
delivered at a future date if evidence of the fair value of all undelivered elements exists. If evidence of the fair value of the undelivered elements does not exist, revenue is deferred and recognized when delivery occurs. License revenue from
value-added resellers and OEMs is recognized when product has been sold through to an end user and such sell-through has been reported to the Company.





The timing of license revenue recognition is affected by whether we perform consulting services in the arrangement and the nature of those services. In the majority of cases, we either perform no consulting services
or we perform standard implementation services that are not essential to the functionality of the software. When we perform consulting services that are essential to the functionality of the software, we recognize both license and consulting revenue
utilizing contract accounting based on the percentage of the consulting services that have been completed.





Service revenue
consists of revenue from providing consulting and training. Our consulting service contracts are bid either on a fixed-fee basis or on a time-and-materials basis. For a fixed-fee contract, we recognize revenue using the percentage of completion
method. For time-and-materials contracts, we recognize revenue as services are performed. Training service revenue is recognized as services are performed. Losses on services contracts, if any, are recognized as soon as such losses become known.





Maintenance revenue consists of fees for providing technical support and software upgrades and enhancements. We recognize all
maintenance revenue ratably over the contract term. Customers renew maintenance agreements annually.





Our standard payment terms
are net 30 to 90 days from the date of invoice. Thus, a significant portion of our accounts receivable balance at the end of a quarter is primarily comprised of revenue from that quarter.





We record deferred revenue primarily as a result of payments from customers received in advance of recognition of revenue. As of March 31, 2002, deferred revenue was $9.6 million. The
deferred revenue amount includes unearned license, prepaid maintenance and professional services that will be recognized as revenue in the future as we deliver licenses and perform services.





Estimating Valuation Allowance for Doubtful Accounts and Lease Loss





We
perform ongoing credit evaluations of our customers and adjust credit limits based upon payment history and the customers current creditworthiness, as determined by our review of their current credit information. We continuously monitor
collections and payments from our customers and maintain a provision for estimated credit losses based on a percentage of our accounts receivable, our historical experience and any specific customer collection issues that we have identified. While
such credit losses have historically been within our expectations and appropriate reserves have been established, we cannot guarantee that we will continue to experience the same credit loss rates that we have experienced in the past. Material
differences may result in the amount and timing of revenue and or expenses for any period if management made different judgments or utilized different estimates.





We restructured our business and have established reserves at the low end of the range of estimable cost (as required by accounting standards) against outstanding commitments for leased
property that we have not occupied. These reserves are based upon managements estimate of the time required to sublet the property and the amount of sublet income that might be generated between the date the property was not occupied and
expiration of the lease for each of the unoccupied property. These estimates are reviewed and revised quarterly and may result in a substantial increase or decrease to restructuring expense should different conditions prevail than were anticipated
in original management estimates.





Accounting For Income Taxes





In preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating actual
current tax liabilities together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are
included within the consolidated balance sheet. We then assesses the likelihood that deferred tax assets will be recovered from future taxable income, and to the extent we believe that recovery is not likely, we must establish a valuation allowance.
To the extent we establish a valuation allowance or increase this allowance in a period, we include an expense within the tax provision in our Consolidated Statement of Operations.





Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded
against our net deferred tax assets. We have recorded a valuation allowance due to uncertainties related to our ability to utilize some of our deferred tax assets, primarily consisting of the utilization of certain net operating loss carryforwards
and foreign tax credits before they expire. The valuation allowance is based on estimates of taxable income by the jurisdictions in which we operate and the period over which deferred tax assets will be recoverable. In the event that actual results
differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance,




18




---

which could impact our financial position and results of operations.





Valuation of Goodwill and
Intangible Assets





We periodically assess the realizability of long-lived assets, including intangibles in accordance with
the provisions of Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long Lived Assets. For assets to be held and used, including acquired intangibles, we initiate our review annually
or whenever events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable. Recoverability of an asset is measured by comparison of its carrying amount to the expected future undiscounted cash flows
(without interest charges) that the asset is expected to generate. Any impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair market value. Significant management judgment is required in the
forecasting of future operating results which are used in the preparation of projected discounted cash flows and should different conditions prevail, material write downs of net intangible assets could occur.





It is reasonably possible that the estimates of anticipated future gross revenue, the remaining estimated economic life of the products and
technologies, or both, could differ from those used to assess the recoverability of these costs and result in a write-down of the carrying amount or a shortened life of acquired intangibles in the future.





In 2002, SFAS No. 142, Goodwill and Other Intangible Assets became effective. This did not have an impact on our financial statements as all
goodwill has been amortized or impaired.





The above listing is not intended to be a comprehensive list of all of our accounting
policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for managements judgment in their application. There are also
areas in which the exercise of managements judgment in selecting an available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto on our Annual Report on Form 10-K
and which contain accounting policies and other disclosures required by generally accepted accounting principles.





FACTORS THAT AFFECT
FUTURE RESULTS





WE HAVE A HISTORY OF LOSSES. WE EXPECT TO CONTINUE TO INCUR LOSSES AND WE MAY NOT ACHIEVE OR MAINTAIN PROFITABILITY.





We have incurred losses since our inception, including a loss of approximately $10.6 million in the three months ended
March 31, 2002. As of March 31, 2002, we had an accumulated deficit of approximately $178.3 million. We expect to have net losses and negative cash flow for at least the next 12 months. We expect to spend significant amounts to enhance our products
and technologies and expand international sales and operations. As a result, we will need to generate significant additional revenue to achieve profitability. Even if we achieve profitability, we may not be able to sustain or increase profitability
on a quarterly or annual basis.





OUR ABILITY TO ACCURATELY FORECAST OUR QUARTERLY SALES IS LIMITED, OUR COSTS ARE RELATIVELY FIXED IN THE SHORT TERM
AND WE EXPECT OUR BUSINESS TO BE AFFECTED BY SEASONALITY. AS A RESULT, OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE.





Our
quarterly operating results have varied significantly in the past and we expect that they will vary significantly from quarter to quarter in the future. As a result, our quarterly operating results are difficult to predict. For example, in March
2001, we announced our revised expectations for our first quarter financial results based upon our then-current outlook, including a revenue shortfall and a larger than expected net loss for the quarter due to general economic conditions which have
led customers and customer prospects to postpone capital investment in Nuance products and service offerings based on Nuance products. These quarterly variations are caused by a number of factors, including:





| |  |  | general economic downturn and delays or cancellations in orders by customers who are reducing spending;
| | - |  | -------------------------------------------------------------------------------------------------------




| |  |  | delays in customer orders due to the complex nature of large telephony systems and the associated implementation projects;
| | - |  | --------------------------------------------------------------------------------------------------------------------------




| |  |  | timing of product deployments and completion of project phases, particularly for large orders;
| | - |  | ----------------------------------------------------------------------------------------------




| |  |  | delays in recognition of software license revenue in accordance with applicable accounting principles;
| | - |  | ------------------------------------------------------------------------------------------------------




| |  |  | our ability to develop, introduce, ship and support new and enhanced products, such as our voice browser and new versions of our software platform, that respond to changing
technology trends in a timely manner and our ability to manage product transitions;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | the amount and timing of expenses; and
| | - |  | --------------------------------------



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| |  |  | the utilization rate of our professional services personnel.
| | - |  | ------------------------------------------------------------




Due to these factors, and because the market for our software is new and rapidly changing, our ability to accurately forecast our quarterly sales is limited. In addition, most of our costs are for personnel and
facilities, which are relatively fixed in the short term. If we have a shortfall in revenue in relation to our expenses, we may be unable to reduce our expenses quickly enough to avoid lower quarterly operating results. We do not know whether our
business will grow rapidly enough to absorb the costs of these employees and facilities. As a result, our quarterly operating results could fluctuate significantly and unexpectedly from quarter to quarter.





We also expect to experience seasonality in the sales of our products. For example, we anticipate that sales may be lower in the first quarter of each
year due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers. We also expect that sales may decline during summer months. These seasonal variations in our sales may lead to fluctuations in our
quarterly operating results. Because we have limited operating history, it is difficult for us to evaluate the degree to which this seasonality may affect our business.





WE DEPEND UPON RESELLERS FOR A SIGNIFICANT PORTION OF OUR SALES. THE LOSS OF A KEY RESELLER, OR THEIR INABILITY TO RESELL OUR PRODUCTS AND SERVICES, WOULD LIMIT OUR ABILITY TO SUSTAIN AND GROW OUR REVENUE.





In 1999, 56% of our revenue was achieved by indirect sales through resellers. The percentage of revenue through indirect
sales increased to 72% in 2000, to 75% in 2001 and to 87% in the three months ended March 31, 2002. We intend to continue to rely on resellers for a substantial portion of our sales in the future. As a result, we are dependent upon the continued
viability and financial stability of our resellers, as well as upon their continued interest and success in selling our products. The loss of a key reseller or our failure to develop new and viable reseller relationships could limit our ability to
sustain and grow our revenue. Significant expansion of our internal sales force to replace the loss of a key reseller would require increased management attention and higher expenditures.





Our contracts with resellers generally do not require a reseller to purchase our products. We cannot guarantee that any of our resellers will continue to market our products or devote
significant resources to doing so. In addition, we may, from time to time, terminate some of our relationships with resellers. Any termination could have a negative impact on our business and result in threatened or actual litigation. Finally, these
resellers possess confidential information concerning our products, product release schedules and sales, marketing and reseller operations. Although we have nondisclosure agreements with our resellers, we cannot guarantee that any reseller would not
use our confidential information in competition with us or otherwise. If our resellers do not successfully market and sell our products for these or any other reasons, our sales could be adversely affected and our revenue could decline.





WE DEPEND ON A LIMITED NUMBER OF CUSTOMER ORDERS FOR A SUBSTANTIAL PORTION OF OUR REVENUE DURING ANY GIVEN PERIOD. THE LOSS OF, OR DELAYS IN, A KEY
ORDER COULD SUBSTANTIALLY REDUCE OUR REVENUE IN ANY GIVEN PERIOD AND HARM OUR BUSINESS.





We derive a significant portion of
our revenue in each period from a limited number of customers. For example, in the three months ended March 31, 2002, five customers made up 36% of our total revenue, and one of those customers, acting as a reseller, accounted for approximately 11%
of our total revenue.





We expect that a limited number of customers and customer orders will continue to account for a
substantial portion of our revenue in a given period. Generally, customers who make large purchases from us are not expected to make subsequent, equally large purchases in the short term, and therefore we must attract new customers in order to
maintain or increase our revenues. As a result, if we do not acquire a major customer, if a contract is delayed, cancelled or deferred, or if an anticipated sale is not made, our business could be harmed.





SALES TO CUSTOMERS OUTSIDE THE UNITED STATES ACCOUNT FOR A SIGNIFICANT PORTION OF OUR REVENUE, WHICH EXPOSES US TO RISKS INHERENT IN INTERNATIONAL OPERATIONS.





International sales represented approximately 39% of our revenue in the three months ending March 31, 2002, 42% of our
revenue in 2001, 47% of our revenue in 2000 and 21% of our revenue in 1999, and we anticipate that revenue from markets outside the United States will continue to represent a significant portion of our total revenue. We are subject to a variety of
risks associated with conducting business internationally, any of which could harm our business. These risks include:





| |  |  | difficulties and costs of staffing and managing foreign operations;
| | - |  | -------------------------------------------------------------------




| |  |  | the difficulty in establishing and maintaining an effective international reseller network;
| | - |  | -------------------------------------------------------------------------------------------



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| |  |  | the burden of complying with a wide variety of foreign laws, particularly with respect to intellectual property and license requirements;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------




| |  |  | longer sales cycles;
| | - |  | --------------------




| |  |  | political and economic instability outside the United States;
| | - |  | -------------------------------------------------------------




| |  |  | import or export licensing and product certification requirements;
| | - |  | ------------------------------------------------------------------




| |  |  | tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by foreign countries;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------




| |  |  | potential adverse tax consequences, including higher marginal rates;
| | - |  | --------------------------------------------------------------------




| |  |  | unfavorable fluctuations in currency exchange rates; and
| | - |  | --------------------------------------------------------




| |  |  | limited ability to enforce agreements, intellectual property rights and other rights in some foreign countries.
| | - |  | ---------------------------------------------------------------------------------------------------------------




IN ORDER TO INCREASE OUR INTERNATIONAL SALES, WE MUST DEVELOP LOCALIZED VERSIONS OF OUR PRODUCTS. IF WE ARE UNABLE TO DO SO, WE MAY BE UNABLE TO GROW OUR REVENUE AND EXECUTE
OUR BUSINESS STRATEGY.





We intend to expand our international sales, which requires us to invest significant resources in
creating and refining different language models for each particular language or dialect. These language models are required to create versions of our products that allow end users to speak the local language or dialect and be understood and
authenticated. If we fail to develop localized versions of our products, our ability to address international market opportunities and to grow our business will be limited. We must also expend resources to develop localized versions of our products,
and we may not be able to recognize adequate revenues from these localized versions of our products to make them profitable.





WE ARE CURRENTLY ENGAGED
IN VARIOUS SECURITIES CLASS ACTION LITIGATIONS, WHICH, IF RESOLVED UNFAVORABLY, COULD ADVERSELY AFFECT OUR BUSINESS, RESULTS OF OPERATIONS OR FINANCIAL CONDITION.





We have been sued in various shareholder lawsuits in federal district court in California and New York (See  Part IIItem 1Legal Proceedings). We believe that the
allegations against us are without merit and intend to defend the litigation vigorously. An unfavorable resolution of the lawsuits could have a material adverse effect on our business, results of operations, or financial condition.





OUR STOCK PRICE MAY BE VOLATILE DUE TO FACTORS OUTSIDE OF OUR CONTROL.





Since our initial public offering on April 13, 2000, our stock price has been extremely volatile. During that time, the stock market in general, The Nasdaq National Market and the
securities of technology companies in particular have experienced extreme price and trading volume fluctuations. These fluctuations have often been unrelated or disproportionate to the operating performance of individual companies. The following
factors, among others, could cause our stock price to fluctuate:





| |  |  | actual or anticipated variations in operating results;
| | - |  | ------------------------------------------------------




| |  |  | announcements of operating results and business conditions by our customers and suppliers;
| | - |  | ------------------------------------------------------------------------------------------




| |  |  | announcements by our competitors relating to new customers, technological innovation or new services;
| | - |  | -----------------------------------------------------------------------------------------------------




| |  |  | increases in our plans for, or rate of, capital expenditures for infrastructure, information technology and other similar capital expenditures;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | economic developments in our industry as a whole;
| | - |  | -------------------------------------------------




| |  |  | general market and economic conditions; and
| | - |  | -------------------------------------------




| |  |  | general decline in information technology and capital spending plans.
| | - |  | ---------------------------------------------------------------------




These broad market fluctuations may materially adversely affect our stock price, regardless of our operating results. Our stock price may fluctuate due to variations in our operating
results. For example, on March 15, 2001, we announced our revised expectations for




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our first-quarter revenues based upon our then-current outlook. As a result, the trading price of our common stock declined rapidly and significantly.





SPEECH SOFTWARE PRODUCTS MAY NOT ACHIEVE WIDESPREAD ACCEPTANCE BY BUSINESSES AND TELECOMMUNICATIONS CARRIERS, WHICH COULD LIMIT OUR ABILITY TO GROW OUR BUSINESS.





The market for speech software products is relatively new and rapidly changing. Our ability to increase revenue in the
future depends on the acceptance by both our customers and their end users of speech software products. The adoption of speech software products could be hindered by the perceived costs of this new technology, as well as the reluctance of
enterprises that have invested substantial resources in existing call centers or touch-tone-based systems to replace their current systems with this new technology. Accordingly, in order to achieve commercial acceptance, we will have to educate
prospective customers, including large, established telecommunications companies, about the uses and benefits of voice interface software in general and our products in particular. If these efforts fail, or if speech software platforms do not
achieve commercial acceptance, our business could be harmed.





The continued development of the market for our products will
depend upon the following factors:





| |  |  | widespread deployment of speech software applications by third parties, which is driven by consumer demand for services having a voice user interface;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | demand for new uses and applications of speech software technology, including adoption of voice user interfaces by companies that operate web sites;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | adoption of industry standards for speech software and related technologies; and
| | - |  | --------------------------------------------------------------------------------




| |  |  | continuing improvements in hardware technology that may reduce the costs of speech software solutions.
| | - |  | ------------------------------------------------------------------------------------------------------




OUR PRODUCTS CAN HAVE A LONG SALES AND IMPLEMENTATION CYCLE AND, AS A RESULT, OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE.





The sales cycles for our products have typically ranged from three to twelve months, depending on the size and complexity of the order, the amount of services to be provided by us and
whether the sale is made directly by us or indirectly through a value added reseller, a voice application service provider or a systems integrator.





Purchase of our products requires a significant expenditure by a customer. Accordingly, the decision to purchase our products typically requires significant pre-purchase evaluation. We may spend significant time
educating and providing information to prospective customers regarding the use and benefits of our products. During this evaluation period, we may expend substantial sales, marketing and management resources. Because of this lengthy evaluation
cycle, we may experience a delay between the time we incur these expenditures and the time we generate revenues, if any, from such expenditures.





In addition, during any quarter we may receive a number of orders that are large relative to our total revenues for that quarter or subsequent quarters.





After purchase, it may take substantial time and resources to implement our software and to integrate it with our customers existing systems. If we are performing services that are
essential to the functionality of the software, in connection with its implementation, we recognize software revenue based on the percentage completed using contract accounting. In cases where the contract specifies milestones or acceptance
criteria, we may not be able to recognize either software or service revenue until these conditions are met. We have in the past and may in the future experience unexpected delays in recognizing revenue. Consequently, the length of our sales and
implementation cycles and the varying order amounts for our products make it difficult to predict the quarter in which revenue recognition may occur and may cause license and services revenue and operating results to vary significantly from period
to period.





OUR CURRENT AND POTENTIAL COMPETITORS, SOME OF WHOM HAVE GREATER RESOURCES AND EXPERIENCE THAN WE DO, MAY MARKET OR DEVELOP PRODUCTS AND
TECHNOLOGIES THAT MAY CAUSE DEMAND FOR, AND THE PRICES OF, OUR PRODUCTS TO DECLINE.





A number of companies have developed,
or are expected to develop, products that compete with our products. Competitors in the speech software market include IBM, Microsoft, Philips Electronics, SpeechWorks International, Veritel, Vocalis, T-NETIX and Scansoft. We expect additional
competition from other companies, our competitors may combine with each other, and other companies may enter our markets by acquiring or entering into strategic relationships with our competitors. Current and potential competitors have established,
or may establish, cooperative relationships among themselves or with third parties to increase the abilities of their advanced speech and language technology products to address the needs of our prospective customers.




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Many of our current and potential competitors have longer operating histories, significantly
greater financial, technical, product development and marketing resources, greater name recognition and larger customer bases than we do. Our present or future competitors may be able to develop products comparable or superior to those we offer,
adapt more quickly than we do to new technologies, evolving industry trends and standards or customer requirements, or devote greater resources to the development, promotion and sale of their products than we do. Accordingly, we may not be able to
compete effectively in our markets, competition may intensify and future competition may harm our business.





WE MAY INCUR A VARIETY OF COSTS TO ENGAGE
IN FUTURE ACQUISITIONS OF COMPANIES, PRODUCTS OR TECHNOLOGIES, AND THE ANTICIPATED BENEFITS OF THOSE ACQUISITIONS MAY NEVER BE REALIZED.





As a part of our business strategy, we may make acquisitions of, or significant investments in, complementary companies, products or technologies. For instance, in November 2000 we acquired SpeechFront, a Canadian
company, and in February 2001, we acquired non-exclusive intellectual property rights from a third-party. Any future acquisitions would be accompanied by risks such as:





| |  |  | difficulties in assimilating the operations and personnel of acquired companies;
| | - |  | --------------------------------------------------------------------------------




| |  |  | diversion of our managements attention from ongoing business concerns;
| | - |  | -----------------------------------------------------------------------




| |  |  | our potential inability to maximize our financial and strategic position through the successful incorporation of acquired technology and rights into our products and services;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | additional expense associated with amortization of acquired assets;
| | - |  | -------------------------------------------------------------------




| |  |  | maintenance of uniform standards, controls, procedures and policies; and
| | - |  | ------------------------------------------------------------------------




| |  |  | impairment of existing relationships with employees, suppliers and customers as a result of the integration of new management personnel.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------




We cannot guarantee that we will be able to successfully integrate any business, products, technologies or personnel that we might acquire in
the future, For example, the Speech Front assets and text to speech technology we acquired have been impaired (see notes to the consolidated financial statements). Our inability to integrate successfully any business products, technologies or
personnel we may acquire in the future could harm our business.





OUR FAILURE TO RESPOND TO RAPID CHANGE IN THE MARKET FOR SPEECH SOFTWARE COULD CAUSE
US TO LOSE REVENUE AND HARM OUR BUSINESS.





The speech software industry is relatively new and rapidly changing. Our success
will depend substantially upon our ability to enhance our existing products and to develop and introduce, on a timely and cost-effective basis, new products and features that meet changing end-user requirements and incorporate technological
advancements. If we are unable to develop new products and enhanced functionalities or technologies to adapt to these changes, we may be unable to retain existing customers or attract new customers, which could harm our business. In addition, as we
develop new products, sales of existing products may decrease. If we cannot offset a decline in revenue from existing products with sales of new products, our business would suffer.





Commercial acceptance of any new products and technologies we may introduce will depend, among other things, on:





| |  |  | the ability of our products and technologies to meet and adapt to the needs of our target markets;
| | - |  | --------------------------------------------------------------------------------------------------




| |  |  | the performance and price of our products and our competitors products; and
| | - |  | ----------------------------------------------------------------------------




| |  |  | our ability to deliver customer service directly and through our resellers.
| | - |  | ---------------------------------------------------------------------------




WE ARE EXPOSED TO GENERAL ECONOMIC CONDITIONS, WHICH MAY CONTINUE TO HARM OUR BUSINESS.





As a result of recent unfavorable economic conditions and reduced capital spending, it is possible that our sales will decline. This economic downturn became particularly acute following the events of September 11, 2001. We experienced a
decline in revenues during 2001 due in part to delays in purchases by our customers and to prevailing economic conditions. If the economic conditions in the United States worsen or if a wider or global economic slowdown occurs, we may experience a
material adverse impact on our business, operating results and financial condition.




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IF WE DO NOT MANAGE OUR OPERATIONS IN ACCORDANCE WITH CHANGING ECONOMIC CONDITIONS, OUR RESOURCES MAY BE STRAINED
WHICH COULD HARM OUR CHANCES OF ACHIEVING PROFITABILITY.





Our operations have changed significantly due to volatility in our
business. We experienced significant growth in the past; however, in April 2001, we reduced our workforce by approximately 20%. Additionally, in January 2002, we announced a restructuring plan that has reduced our workforce by approximately another
10%. We may be required to expand or contract our business operations in the future, and as a result may need to expand or contract our management, operational, financial and human resources, as well as management information systems and controls,
to support any such growth or contraction. Our failure to manage these types of changes would place a burden on our business and our management team, which could cause our business to suffer.





OUR PRODUCTS ARE NOT 100% ACCURATE AND WE COULD BE SUBJECT TO CLAIMS RELATED TO THE PERFORMANCE OF OUR PRODUCTS. ANY CLAIMS, WHETHER SUCCESSFUL OR UNSUCCESSFUL, COULD RESULT IN SIGNIFICANT COSTS AND
COULD DAMAGE OUR REPUTATION.





Speech recognition, natural language understanding and authentication technologies, including
our own, are not 100% accurate. Our customers, including several financial institutions, use our products to provide important services to their customers, including transferring funds to accounts and buying and selling securities. Any
misrecognition of voice commands or incorrect authentication of a users voice in connection with these financial or other transactions could result in claims against us or our customers for losses incurred. Although our contracts typically
contain provisions designed to limit our exposure to liability claims, a claim brought against us for misrecognition or incorrect authentication, even if unsuccessful, could be time-consuming, divert managements attention, result in costly
litigation and harm our reputation. Moreover, existing or future laws or unfavorable judicial decisions could limit the enforceability of the limitation of liability, disclaimer of warranty or other protective provisions contained in our contracts.





ANY SOFTWARE DEFECTS IN OUR PRODUCTS COULD HARM OUR BUSINESS AND RESULT IN LITIGATION.





Complex software products such as ours may contain errors, defects and bugs. With the planned release of any product, we may discover these errors, defects and bugs and, as a result, our
products may take longer than expected to develop. In addition, we may discover that remedies for errors or bugs may be technologically unfeasible. Delivery of products with undetected production defects or reliability, quality, or compatibility
problems could damage our reputation. Errors, defects or bugs could also cause interruptions, delays or a cessation of sales to our customers. We could be required to expend significant capital and other resources to remedy these problems. In
addition, customers whose businesses are disrupted by these errors, defects and bugs could bring claims against us which, even if unsuccessful, would likely be time-consuming and could result in costly litigation and payment of damages.





OUR PRODUCTS MAY INFRINGE THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS, AND RESULTING CLAIMS AGAINST US COULD BE COSTLY AND REQUIRE US TO ENTER INTO
DISADVANTAGEOUS LICENSE OR ROYALTY ARRANGEMENTS.





The software industry and the field of speech and voice technologies are
characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of intellectual property rights. Although we attempt to avoid infringing known proprietary rights of
third parties we may be subject to legal proceedings and claims for alleged infringement by us or our licensees of third-party proprietary rights, such as patents, trade secrets, trademarks or copyrights, from time to time in the ordinary course of
business. Any claims relating to the infringement of third-party proprietary rights, even if not successful or meritorious, could result in costly litigation, divert resources and managements attention or require us to enter into royalty or
license agreements which are not advantageous to us. In addition, parties making these claims may be able to obtain injunctions, which could prevent us from selling our products. Furthermore, former employers of our employees may assert that these
employees have improperly disclosed confidential or proprietary information to us. Any of these results could harm our business. We may be increasingly subject to infringement claims as the number of, and number of features of, our products grow.





IF WE ARE UNABLE TO HIRE AND RETAIN SELECT PERSONNEL, OUR BUSINESS COULD BE HARMED.





We intend to hire select personnel during the year. Competition for these individuals can be intense, and we may not be able to attract, assimilate, or retain additional highly qualified
personnel in the future. The failure to attract, integrate, motivate and retain these employees could harm our business. The decline in the value of our common stock may also make it more difficult to retain our employees.





WE RELY ON THE SERVICES OF OUR KEY PERSONNEL, WHOSE KNOWLEDGE OF OUR BUSINESS AND TECHNICAL EXPERTISE WOULD BE DIFFICULT TO REPLACE.





We rely upon the continued service and performance of a relatively small number of key technical and senior management personnel.
Our future success will be impacted by our ability to retain of these key employees, such as Ronald Croen, our Chief Executive Officer. We cannot guarantee that we will be able to retain all key personnel. For example, our former Chief Financial
Officer, Graham Smith, left Nuance in January 2002. None of our key technical or senior management personnel are bound by employment agreements, and, as a result, any of these employees could leave with little or no prior notice. If we lose any of
our key technical and




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senior management personnel, our business could be harmed. We do not have key person life insurance policies covering any of our employees.





ANY INABILITY TO ADEQUATELY PROTECT OUR PROPRIETARY TECHNOLOGY COULD HARM OUR ABILITY TO COMPETE.





Our future success and ability to compete depends in part upon our proprietary technology and our trademarks, which we attempt to protect with a combination of patent, copyright, trademark and trade secret laws, as
well as with our confidentiality procedures and contractual provisions. These legal protections afford only limited protection and may be time-consuming and expensive to obtain and/or maintain. Further, despite our efforts, we may be unable to
prevent third parties from infringing upon or misappropriating our intellectual property.





Although we have filed multiple U.S.
patent applications, we have currently only been issued a small number of patents. There is no guarantee that more patents will be issued with respect to our current or future patent applications. Any patents that are issued to us could be
invalidated, circumvented or challenged. If challenged, our patents might not be upheld or their claims could be narrowed. Our intellectual property may not be adequate to provide us with competitive advantage or to prevent competitors from entering
the markets for our products.





Additionally, our competitors could independently develop non-infringing technologies that are
competitive with, equivalent to, and/or superior to our technology. Monitoring infringement and/or misappropriation of intellectual property can be difficult, and there is no guarantee that we would detect any infringement or misappropriation of our
proprietary rights. Even if we do detect infringement or misappropriation of our proprietary rights, litigation to enforce these rights could cause us to divert financial and other resources away from our business operations. Further, we license our
products internationally, and the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States.





THIRD PARTIES COULD OBTAIN LICENSES FROM SRI INTERNATIONAL RELATING TO SPEECH SOFTWARE TECHNOLOGIES AND DEVELOP TECHNOLOGIES TO COMPETE WITH OUR PRODUCTS, WHICH COULD CAUSE OUR SALES TO DECLINE.





Upon our incorporation in 1994, we received a license from SRI International to a number of patents and other proprietary rights, including rights in
software, relating to speech software technologies developed by SRI International. This license was exclusive until December 1999, when we chose to allow the exclusivity to lapse. As a result, SRI International may have, or may in the future,
license these patents and proprietary rights to our competitors. If a license from SRI International were to enable third parties to enter the markets for our products and services or to compete more effectively, we could lose market share and our
business could suffer.





IF THE STANDARDS WE HAVE SELECTED TO SUPPORT ARE NOT ADOPTED AS THE STANDARDS FOR SPEECH SOFTWARE, BUSINESSES MIGHT NOT USE
OUR SPEECH SOFTWARE PRODUCTS FOR DELIVERY OF APPLICATIONS AND SERVICES.





The market for speech software is new and emerging
and industry standards have not yet been established. We may not be competitive unless our products support changing industry standards. The emergence of industry standards, whether through adoption by official standards committees or widespread
usage, could require costly and time-consuming redesign of our products. If these standards become widespread and our products do not support them, our customers and potential customers may not purchase our products. Multiple standards in the
marketplace could also make it difficult for us to ensure that our products will support all applicable standards, which could in turn result in decreased sales of our products.





Our V-Builder applications-building tool and our Voice Web Server software are each designed to work with the recently emerged VoiceXML standard. There are currently other, similar
standards in development, some of which may become more widely adopted than VoiceXML. If VoiceXML is not widely accepted by our target customers or if another competing standard were to become widely adopted, then sales of our products could decline
and our business would be harmed. In that case, we may find it necessary to redesign our existing products or design new products that are compatible with alternative standards that are widely adopted or that replace VoiceXML. This design or
redesign could be costly and time-consuming.





CERTAIN STOCKHOLDERS MAY DISAGREE WITH HOW NUANCE USES THE PROCEEDS FROM ITS PUBLIC OFFERINGS.





Management retains broad discretion over the use of proceeds from our April 2000 initial public offering and September 2000
secondary public offering. Stockholders may not deem these uses desirable and our use of the proceeds may not yield a significant return or any return at all. Because of the number and variability of factors that determine our use of the net
proceeds from these offerings, we cannot guarantee that these uses will not vary substantially from our currently planned uses.




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OUR CHARTER AND BYLAWS AND DELAWARE LAW CONTAIN PROVISIONS WHICH MAY DELAY OR PREVENT A CHANGE OF CONTROL OF NUANCE.





Provisions of our charter and bylaws may make it more difficult for a third party to acquire, or discourage a third party
from attempting to acquire, control of Nuance. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions include:





| |  |  | the division of the board of directors into three separate classes;
| | - |  | -------------------------------------------------------------------




| |  |  | the elimination of cumulative voting in the election of directors;
| | - |  | ------------------------------------------------------------------




| |  |  | prohibitions on our stockholders from acting by written consent and calling special meetings;
| | - |  | ---------------------------------------------------------------------------------------------




| |  |  | procedures for advance notification of stockholder nominations and proposals; and
| | - |  | ---------------------------------------------------------------------------------




| |  |  | the ability of the board of directors to alter our bylaws without stockholder approval.
| | - |  | ---------------------------------------------------------------------------------------




In addition, our board of directors has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions,
including voting rights, of those shares without any further vote or action by the stockholders. The issuance of preferred stock, while providing flexibility in connection with possible financings or acquisitions or other corporate purposes, could
have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock.





Since the
completion of our initial public offering on April 13, 2000, we have been subject to the antitakeover provisions of the Delaware General Corporation Law, including Section 203, which may deter potential acquisition bids for our company. Under
Delaware law, a corporation may opt out of Section 203. We do not intend to opt out of the provisions of Section 203.





OUR FACILITIES ARE LOCATED NEAR
KNOWN EARTHQUAKE FAULT ZONES, AND THE OCCURRENCE OF AN EARTHQUAKE OR OTHER NATURAL DISASTER COULD CAUSE DAMAGE TO OUR FACILITIES AND EQUIPMENT, WHICH COULD REQUIRE US TO CURTAIL OR CEASE OPERATIONS.





Our facilities are located in the San Francisco Bay Area near known earthquake fault zones and are vulnerable to damage from earthquakes. In October
1989, a major earthquake that caused significant property damage and a number of fatalities struck this area. We are also vulnerable to damage from other types of disasters, including fire, floods, power loss, communications failures and similar
events. If any disaster were to occur, our ability to operate our business at our facilities could be seriously, or potentially completely, impaired. The insurance we maintain may not be adequate to cover our losses resulting from disasters or other
business interruptions.





WE RELY ON A CONTINUOUS POWER SUPPLY TO CONDUCT OUR OPERATIONS, AND AN ENERGY CRISIS IN CALIFORNIA COULD DISRUPT OUR
OPERATIONS AND INCREASE OUR EXPENSES.





California recently experienced an energy crisis that increased our expenses and
could have disrupted our operations. In the event of an acute power shortage, that is, when power reserves for the State of California fall below 1.5%, California has on some occasions implemented, and may in the future continue to implement,
rolling blackouts throughout California. We currently do not have backup generators or alternate sources of power in the event of a blackout, and our current insurance does not provide coverage for any damages we, or our customers, may suffer as a
result of any interruption in our power supply. If blackouts interrupt our power supply, we would be temporarily unable to continue operations at our facilities. If California experiences a similar energy crisis in the future, any such interruption
in our ability to continue operations at our facilities could damage our reputation, harm our ability to retain existing customers and to obtain new customers, and could result in lost revenue, any of which could substantially harm our business and
results of operations.





INFORMATION THAT WE MAY PROVIDE TO INVESTORS FROM TIME TO TIME IS ACCURATE ONLY AS OF THE DATE WE DISSEMINATE IT, AND WE
UNDERTAKE NO OBLIGATION TO UPDATE THE INFORMATION.





From time to time, we may publicly disseminate forward-looking
information or guidance in compliance with Regulation FD promulgated by the Securities and Exchange Commission. This information or guidance represents our outlook only as of the date that we disseminated it, and we undertake no obligation to
provide updates to this information or guidance in our filings with the Securities and Exchange Commission or otherwise.




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ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





MARKET RISK





The following discusses our exposure to market risk related to changes in interest rates, equity prices and foreign currency exchange rates.
This discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results could vary materially as a result of a number of factors including those set forth in the risk factors section of this Quarterly Report
on Form 10-Q.





Foreign Currency Exchange Rate Risk





To date, all of our recognized revenues have been denominated in U.S. dollars and primarily from customers in the United States, and our exposure to foreign currency exchange rate changes has been immaterial. We
expect, however, that future product license and services revenues may also be derived from international markets and may be denominated in the currency of the applicable market. As a result, our operating results may become subject to significant
fluctuations based upon changes in the exchange rates of certain currencies in relation to the U.S. dollar. Furthermore, to the extent that we engage in international sales denominated in U.S. dollars, an increase in the value of the U.S. dollar
relative to foreign currencies could make our products less competitive in international markets. Although we will continue to monitor our exposure to currency fluctuations, and when appropriate, may use financial hedging techniques to minimize the
effect of these fluctuations, we cannot assure you that exchange rate fluctuations will not adversely affect our financial results in the future.





Interest Rate Risk





As of March 31, 2002, we had cash and cash equivalents, short-term investments and long-term
investments of $162.5 million. Any decline in interest rates over time would reduce our interest income from our cash and cash equivalents, short-term and long-term investments. Based upon our balance of cash and cash equivalents, short-term
investments and long-term investments at March 31, 2002, a decrease in interest rates of 1.0% would cause a corresponding decrease in our annual interest income by approximately $1.6 million.





PART II: OTHER INFORMATION





ITEM 1.    LEGAL PROCEEDINGS:





In March 2001, the first of a number of
stockholder complaints was filed in the United States District Court for the Northern District of California against Nuance and certain of its officers. Those lawsuits were consolidated and an amended complaint was filed on behalf of a purported
class of people who purchased our stock during the period January 31, 2001 through March 15, 2001, alleging false and misleading statements and insider trading in violation of the federal securities laws. The plaintiffs are seeking unspecified
damages. We believe that these allegations are without merit and we are defending the litigation vigorously. Plaintiffs recently filed a further amended complaint, which we intend to move to dismiss. An unfavorable resolution of this litigation
could have a material adverse effect on our business, results of operations, or financial condition.





In June and July 2001,
putative shareholder derivative actions were filed in California state court alleging breaches of fiduciary duty and insider trading by various of our directors and officers. While we are named as a nominal defendant, the lawsuits do not appear to
seek any recovery against us. Proceedings in these actions have been stayed.





In August 2001, the first of a number of
complaints was filed in federal district court for the Southern District of New York on behalf of a purported class of persons who purchased Nuance stock between April 12, 2000 and December 6, 2000. In April 2002, plaintiffs filed a consolidated
amended complaint. The consolidated amended complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in our initial public offering of securities, the
conduct of our secondary offering, and the issuance of analyst reports. The complaints bring claims for violation of several provisions of the federal securities laws against those underwriters, and also against us and some of our directors and
officers. Similar lawsuits have been filed concerning more than 300 other companies public offerings. We believe that the allegations against us are without merit and intend to defend the litigation vigorously.





We are subject to various other legal proceedings, claims and litigation that arise in the normal course of business. While the outcome of these matters
is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on our consolidated financial position, results of operations, or cash flows.





ITEM 6.    EXHIBITS AND REPORTS ON FORM 8-K:





| | (a) |  | No exhibits were filed during the quarter.
| | --- |  | ------------------------------------------




| | (b) |  | No reports on Form 8-K were filed during the quarter ended March 31, 2002.
| | --- |  | --------------------------------------------------------------------------



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SIGNATURES





Pursuant to the requirements of the Securities Act of 1934, the Registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.





NUANCE COMMUNICATIONS, INC.





Date:    May 15, 2002


By:

/S/    KAREN BLASINGKaren Blasing Vice President and Chief Financial
Officer (Principal Financial and Accounting Officer)




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