Rule Breaker Portfolio Who Rules Embedded Software?

Embedded operating systems traditionally powered things like robots, car engines, and radar systems. But as computing resources expand past the PC to newer appliances -- such as handheld computers, cellular phones, and kitchen appliances -- significant opportunities blossom. Wind River leads this important and emerging industry with a market share of 35%.

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By Mike Trigg (TMF Tonto)
February 15, 2001

Many people are surprised to learn that Wind River's (Nasdaq: WIND) operating system (OS), VxWorks, powers devices like Hewlett-Packard (NYSE: HWP) printers, Cisco Systems (Nasdaq: CSCO) routers, and Eastman Kodak (NYSE: EK) digital cameras. In fact, VxWorks can be found in over 150 million individual products. Its anonymity persists, however, because it's embedded and invisible to users.

An embedded OS is a sharp contrast to a desktop OS (think Windows NT) because it allows companies to standardize the design of their own products. In a Forbes article earlier this year, Wind River Chairman Jerry Fiddler distinguished the two: "On the desktop," he said, "the operating system defines the device. That doesn't fly in this world of smart devices. Here, the device defines the operating system."

Put another way, every device is unique in the embedded space. While a desktop OS manages every program on a personal computer (PC), an embedded OS performs fewer tasks with greater reliability. The techies here at Fool HQ describe a desktop OS as a general set of instructions. In contrast, an embedded OS has more limited instructions that might only tell a DVD player, for example, to play a movie.  

With its Tornado development platform, Wind River has become the standard of choice for many embedded applications. Its track record of creating reliable and complex applications has given it an impressive customer list that includes General Electric (NYSE: GE), Motorola (NYSE: MOT), Sony (NYSE: SNE), Nortel Networks (NYSE: NT), Qualcomm (Nasdaq: QCOM), Intel (Nasdaq: INTC), and Nokia (NYSE: NOK).

Important and emerging industry
Embedded OSs traditionally powered things like robots, car engines, and radar systems. But as computing resources expand past the PC to newer appliances -- such as handheld computers, cellular phones, and kitchen appliances -- significant opportunities arise. Market research firm International Data Corporation estimates that the information appliance market will grow from $2.4 billion in 1999 to $17.8 billion in 2004.

The demand for embedded systems is driven by more powerful hardware, increased bandwidth, and the growing complexity of devices. Hardware is becoming so cheap and powerful that more devices are able to operate with computing power equal to that of older PCs. Even dishwashers and refrigerators are being built with certain automated functions that require an embedded system.

Added bandwidth means more devices connected to the Internet. Web-enabled phones and personal digital assistants are just two products that will leverage this increased information. This also means that devices will grow in complexity because data will be accessed in new destinations.  

The real magic behind Wind River's products lies in the company's royalty-based revenue model, dictating that it receives payment on each device that gets shipped with its software. In other words, Wind River collects for the entire life of a product. This revenue stream makes up about 20% of the company's top line, but that number should ramp up as more developers require additional development tools in increasingly complex products.

Top dog and first mover
Wind River was founded in 1981. Early on, the military was one of its biggest customers because weapon systems demanded software that responded quickly and never crashed. (Sounds simple, but imagine a missile guidance system going haywire and blowing up your neighbor's house.) Having been at the game longer, Wind River's operating system and array of tools and customer support surpass the competition. It leads the embedded market with a market share of 35%.

The company's biggest challenge comes from companies developing their own embedded systems. That's an arduous process, however, and any mishap could force a company to lose at the ever-important time-to-market game. As the product development process becomes more complex, it's likely more and more companies will look to Wind River. Excluding companies that develop embedded systems in-house, Wind River has a market share of more than 60%.

Open-sourced Linux is also vying to take Wind River down, offering low development costs. While Linux is standardized and supported by tens of thousands of programmers, many companies are unwilling to donate their intellectual property to the entire Linux community. There's also an accountability issue. If a problem arises, the solution might only be found among the entire Linux community, rather than at a single vendor.

Microsoft (Nasdaq: MSFT) has entered the mix as well, perhaps vindicating the market's potential. It has devoted a tremendous amount of resources for the development of a Windows-based embedded OS, but achieved only limited success. The company has the resources to improve its offering, but thus far proves to be more of a potential threat than anything else. It has also yet to devote the sales and support infrastructure required to serve the range of companies in the embedded space.

Where to from here?
Opportunities for further market share lay ahead, particularly from companies that are developing embedded systems in-house. I said earlier that as devices become more complex, there's more pressure on developers to bring products to market quickly. In order to provide the best product, companies are forced to spend more resources on the value-adding and distinguishing aspects of new devices, rather than the fundamental embedded systems. That bodes well for Wind River.

When we finish the analysis of Wind River next Thursday, I'll talk about the company's sustainable competitive advantages: 1) a range of design and development tools and 2) a real-time offering. A real-time operating system (RTOS) refers to a program that can respond immediately to input requests and transactions. Both the Linux-based products and Microsoft offer what's called "soft" RTOS, which gives the appearance of real-time. Also on Thursday, in an attempt to better understand Wind River's business, I'll talk about some of the specific industries that will drive its growth. 

Mike Trigg spends his days offering readers what Gordon Gekko called "the most valuable commodity": information. At the time of this writing, he owned shares of Nokia. To see his other holdings, view his profile. The Motley Fool is investors writing for investors.

Rule Breaker Portfolio


2/15/01 as of ~8:30:00 PM EST

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Trade Date # Shares Ticker Cost/Share Price Total % Ret *
8/5/944020AOL0.4549.955524.17%
9/9/972640AMZN3.1814.50502.50%
12/16/981160AMGN21.4472.06236.04%
7/2/98470SBUX27.9549.2576.18%
12/17/991260CRA39.7644.3811.63%
2/26/99600EBAY50.2650.500.47%
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8/5/944020AOL$1,816.44$200,799.00$271,575.00
12/16/981160AMGN$24,875.50$83,592.50$58,717.00
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7/2/98470SBUX$13,138.62$23,147.50$10,008.88
12/17/991260CRA$50,093.00$55,918.80$5,825.80
2/26/99600EBAY$30,158.00$30,300.00$142.00
2/9/0141SPY$5,448.29$5,466.94$18.40
9/22/00560HGSI$44,830.50$26,005.00($18,825.50)
 
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Total: 
$70.81
$463,580.55
 

* Our long term totals include both our realized and unrealized gains. For instance, we have sold portions of AOL and Amazon in the past, and those realized gains are included in our total returns for these stocks.



Note
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