We end the review of Wind River Systems (Nasdaq: WIND) today talking about our remaining Rule Breaker qualities. Last Thursday, I concluded Wind River was top dog in the embedded software market, and that opportunities for additional market share lay ahead as the product development process becomes more complex. While Microsoft (Nasdaq: MSFT) and the Linux-based companies are attacking the embedded market vigorously, Wind River's product breadth surpasses the competition's. Let's begin with that as it relates to our second criteria.
Sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors
Wind River first made a name for itself with its commercial real-time operating system (OS), which has gone on to be the mind- and market-share leader of the embedded world. Wind River has added products, tools, and customer support by consolidating the embedded market with a string of acquisitions totaling well over $1 billion. When all's said and done, one of every three smart devices will contain a Wind River OS.
Developing an embedded device is an expensive and timely undertaking. Making matters worse, increased competition has forced companies to spend more resources on product functionality. While more is spent on the distinguishing aspects of a device, a company can save time and money by outsourcing to a third party. But no company will choose to do so unless the third party has the necessary tools and support to fulfill its embedded needs (development tools along every stage of the product life cycle).
Of course, there are other companies that can partially fulfill embedded needs, and some may claim to do it better than Wind River. However, Wind River's ability to offer an OS with an integrated set of tools and support is a huge advantage. More and more, developers are requiring a unified platform that eliminates compatibility issues that arise from using tools from different vendors. In short, Wind River has the most comprehensive set of products, tools, and support that's purely devoted to embedded systems, ranging from bringing up the hardware to managing devices after deployment.
Wind River's other advantage is offering tools that are pre-designed for a specific vertical, i.e., a particular industry. Nearly one year ago, the company announced offers for the networking, consumer, and transportation-industrial-defense markets. The cost savings and time-to-market advantage of offering development tools that cater to specific industry standards has positioned Wind River to ramp up its royalty-based revenue model, which dictates it receives payment on each device shipped with its software. While Wind River might receive between $1 and $3 for a horizontal solution, specific vertical solutions could allow it charge up to five times that.
Excellent past share price appreciation, measured by a relative strength of 90 or higher
As of yesterday's Investor's Business Daily, Wind River has a relative strength -- indicating the momentum of a stock compared to every other company on the three major U.S. exchanges -- of 58. That's well below 90, but not surprising considering shares are hovering near their 52-week low and down nearly 40% over the past 12 months. Indeed, the market has gotten ahead of itself with Wind River before, expecting the advent of Internet devices to propel the company into enterprise software's elite. That potential still exists, but the road to get there remains lengthy with 54% of total embedded design wins in 1999 going to in-house developers. Then again, that trend is shifting in Wind River's direction.
Good management and smart backing
Wind River has the most experienced group of managers in the embedded industry, including the founders of Integrated Systems and Embedded Support Tools, which the company acquired over the past two years. More importantly, many of its mangers have experience designing and developing embedded systems. Chairman Jerry Fiddler founded Wind River and served as CEO for 11 years until 1994. Tom St. Dennis has been the president and CEO since September 1999 and was with Applied Materials (Nasdaq: AMAT).
The company also has a list of noteworthy investors. As of November 2000, Wind River was the largest holding (8.1%) of Kevin Landis' Firsthand Technology Value Fund, which holds nearly 6 million shares, or about 8% of Wind River. Hummer Winblad Venture Partners, the first venture capital firm devoted entirely to software, also has a stake, and co-founder John Hummer is a former director on Wind River's board.
The stronger the consumer brand, the better
Wind River falls well short on the consumer brand front, but that's not surprising. Software firms, excluding companies like Microsoft, Intuit (Nasdaq: INTU), Electronics Arts (Nasdaq: ERTS), or Adobe (Nasdaq: ADBE), rarely possess widespread consumer familiarity. Wind River is also at a disadvantage because its products are embedded and invisible to users, despite finding their way into 150 million individual products. The easiest way to build a brand is by delivering good products, and Wind River has support among developers.
A significant constituent of the financial media has recently called the company overvalued
You won't find the financial media calling Wind River overvalued, but the market has beefed up expectations in the past, only to be disappointed. Shares fell from a 52-week high of $66.13 per share in March 2000 to a new low the following month of $25.38 over concerns regarding Wind River's ability to manage its acquisitions (seven since 1999).
Another reason for the high expectations was projections for royalty-based revenue. In fact, it was less than a week ago I received a spreadsheet modeling more than $1.4 billion in royalty-based revenue in 2005. Before we get a better idea of how much royalty-based revenue Wind River can pull in for specific verticals, projections are nothing more than gobbledygook at this point.
10x/5y
Given its stranglehold in this emerging industry, can Wind River appreciate 10 times in 5 years? Ten times its current market capitalization of $2.7 billion puts Wind River at $27 billion in five years. Its trailing 12-month sales are $360 million, giving it a price-to-sales (P/S) ratio of about 7. Assuming that can be maintained, it will have to post $3.85 billion in sales in five years, growing revenue 60% annually.
Despite the opportunities in the embedded space, that's quite a stretch. But even if Wind River were to appreciate 5 times in 5 years at a market cap of $13.5 billion, and again with a P/S ratio of 7 (which is still on the high side for a $13.5 billion company), the company would need $1.92 billion in sales and 40% annual growth. That's more within the realm of possibility, but hardly a foregone conclusion.
Rule Breaker?
While Wind River doesn't pass all of our Rule Breaker criteria, the company's a solid investment prospect. Wind River is clearly the standard for third-party embedded systems and it appears well-positioned to benefit from the advent of Internet devices. I'll be keeping a close eye on the company, particularly new customer wins that show companies are choosing to outsource embedded systems to a third party, but at this point there are probably better Rule Breakers out there.
Mike Trigg spends his days offering readers what Gordon Gekko called "the most valuable commodity": information. To see his other holdings, view his profile. The Motley Fool is investors writing for investors.
