PHONE.COM (PHCM) Project Hunt Report--Part 1
Subtitle: Gorilla Candidate on Sale?--Converting from Story to Tornado.
By John Stichnoth and Susan Huebert ("shuebert")
[Note: John and Susan traded several drafts and private messages in arriving at the following text. It is probably longer than it would have been because of the different approaches taken by each of us. We have tried to be
inclusive of each other's comments. Ambiguities still exist. We look to our threadmates to help sort those out. And, of course, do your own due diligence.]
Business
PHCM is a software company. It sells: (1) UP.Browser--A mini-browser for use in mobile phones, PDA's and other "mobile" devices with small screens; (2)UP.Link--a server suite for wireless operators, to allow the mobile
devices to connect to the Web (which, among other things, helps "translate" standard web pages into a form usable by those teeny-tiny screens on mobile phones, for instance by stripping out the graphics and setting font
sizes); and, (3) UP.SDK--software development tools to encourage development on its platform.
It also supplies content, through its UP.Smart and MyPhone services, which extend the "whole product" features of the wireless devices connecting to the internet. Recent acquisitions have further extended the product mix
available for use on PHCM's WAP-enabled devices. Revenues are principally from wireless telcos using the server products.
PHCM's products are WAP-based, a format standard established by three mobile phone makers (Motorola, Nokia and Ericsson) and PHCM. PHCM was previously known as Unwired Planet.
Overview of the Product Offerings
Most sites on the Web cannot be read effectively on the very small screens available on wireless phones and PDA's. So, it is not sufficient to simply strip out the graphics from every web page and present it to the wireless
world. One area of effort is in creating web sites specifically tailored for handsets. An example of this is providing stock quotes to the handsets.
Wireless email may be the killer app. And, that doesn't require special formatting. But, it does require development of some way to store the emails on servers until the user retrieves them. One issue here that is not present on
the desktop world is the lack of memory in the handsets. You cannot endlessly download emails to a handset; you'll run out of memory. On the other hand you need a method to compose emails, using some "foreign" writing
method, or some key input method derived to work with the numeric keypads (PHCM has a solid relationship with Tegic, which appears to be the leader in this area. Tegic has since been acquired by AOL, and development
among the three companies bears watching). These are thin-client applications that require a completely different set of software to run.
PHCM appears to be closest to providing the "whole product", of software for the handsets, server software for communicating between the handset and internet addresses, software for storing information, and new content
that is specific to the hardware. The product is now in its fourth version. PHCM believes that the WAP standard is based on software that PHCM contributed. This initial development lead has been maintained.
The products fit a niche--a very large niche--of the telecommunications/internet world. They are specific to wireless. The present generation of products is for use on small-screen devices. They will be supplanted by
alternative technologies-a major question is whether PHCM will lead the next generation. TFM suggests that to the extent the next generation is continuous, PHCM's lead now will translate into success later. There are
discontinuous threads. Microvision, which has been mentioned from time to time on this board, is developing an interesting application that would let the user see standard graphics-intensive web pages (although they don't
address the bandwidth limitations or the memory issues involved in the current generation of devices). Speech recognition and synthesis offers an alternative for some applications (although users have shown a marked
preference for being able to read and skim a document, rather than being read to).
Management knows the low-bandwidth-centric model that presently exists for WAP will not last forever. That they are addressing higher bandwidth applications was a significant topic of the company's recent conference call.
The major WAP 2.0/3G initiative in which they are engaged, according to last week's conference call, is in conjunction with NTT Docomo.
The Business Model
Each of PHCM's products has a slightly different revenue model. The UP.Browser, installed on the handsets, will over time not be a significant revenue generator. Licensees generally pay a fixed one-time fee for each phone
model into which they install the browser. As more phones (as opposed to more phone models) proliferate worldwide, PHCM's related revenues will not increase commensurately.
On the server side, there are two pricing models. The less frequently used pricing is a "recurring" model-in which the Service Provider essentially "rents" PHCM's software, paying a monthly fee for each customer on the
system. If the SP's customer is on the system for the next three years, the SP will pay a small amount each month for that customer. Over time, this has the potential to grow to a very attractive revenue stream. Only 20% of
contracts are structured this way, apparently with the more risk-averse SP's (presumably those less able to absorb the upfront payments of the second alternative).
The other alternative available to the telcos and SP's is a so-called "one-time" fee. This can be based on capacity or per subscriber, and represents 80% of contracts. The telco pays a single fee for each customer added, no
matter how long the customer stays on the service, or the telco pays once per server capacity installation; as capacity grows (eg., servers are added) the telco pays a licensing fee for each additional software installation.
The "one-time" terminology is misleading. It actually mirrors the way software is most commonly sold today. The software vendor (PHCM) realizes revenue each time a new "seat" (or, in PHCM's case, hand?) is added.
Additional revenues are realized in future years through upgrades to the software, through expanded service offerings, and through new ancillary software packages. This has been shown to be a very effective revenue
model-just ask Mr. Softee. (Of course the size of the opportunity is not similar to Microsoft's. But, it may be comparable to some of the other software vendors.)
Many operators have no special gees to use internet services. Their phones will come automatically "turned on" for the internet, if the phone is WAP-enabled.
Once the server suite is in place, PHCM can concentrate on higher margin, value-added sales. MyPhone was the initial effort in this area, allowing network operators to rapidly deploy customized, branded Internet protals for
their wireless subscribers. PHCM's Malcolm Bird was quoted in November as stating, "We're hoping many users won't ever know they were on the internet." This appears to be the "continuous to the user, discontinuous to
the vendor" issue discussed in TRFM as an attribute of whole products.
MyPhone services: (1) allow PHCM to compete on criteria other than price, (2) provide higher margins than the server suite because installation costs are so much lower (the bulk of the costs are incurred in initiating
commercial service in the first place), and (3) tie PHCM closer into the telco, by accessing different areas within the telco such as billing (if the telco wants to provide customers access to their account status), marketing (by
providing demographic or purchase behavior back to the telco's data warehousing), and legacy systems (if the telco wants to tie in its POTS service with wireless), for instance. An example of these value-added services is the
recent contract with NTT Docomo to provide real-time horserace wagering capability.
PHCM has accelerated this activity in recent months through acquisition. Paragon's software allows a customer to synchronize information between wireless devices and the desktop. OneBox offers a unified messaging
solution.
Management
Management is impressive. They are some of the more respected players in the Silicon Valley arena. Alain Rossmann, CEO, has a history of successfully starting tech companies. Prior to founding PHCM he became well
known as the CEO of EO Corp. In the past, e.g., with EO, he has sold control to a larger company in order to have access to deeper pockets. Partly because of his experience with EO (which AT&T closed rather than
adding capital in the startup), he has said he plans to keep Phone.com independent. To that end, he has made sure that he has deep pockets in house. PHCM's $497 MM in cash should allow them to compete for quite
awhile.
In listening to conference calls, it is clear that they have hold of both the tactical and strategic issues that they should be concentrating on. In the Web References, near the end of this report, are links to several articles about
management, and interviews. They are worth looking at.
John is probably one of the more management-oriented investigators on this thread. I very much like to see notable accomplishments as a leading indicator. Henry Yuen (GMST) and Irwin Jacobs (QCOM) are my poster
children in this regard. A notable achievement by Rossmann may rank with these: He managed to get Ericsson, Motorola, and Nokia into a room and agree on PHCM's software as the WAP standard going forward. That
was three very large companies that he was able to deal with-with his very small company-on an equal footing. Pretty impressive.
Financial Review:
Financial Condition: The company has about $497 million in the bank, and no debt. The balance sheet shows Net Worth of $1.4 Bn, but this is an accounting creation-They've got $934 MM of goodwill on the books. This
will be amortized over time, and will not effect their cash position, although it will make it hard to show GAAP Net Income.
They also show $63 MM in Deferred revenue as of March 31. This is not simply an accounting convention. Deferred revenue occurs from contracts that last over an extended period. This was up from $48 MM sequentially.
Part of the rise occurred because telco customers' conversion to full commercial status was somewhat back-end loaded this quarter. GAAP in this case attempts to match expenses with income recognition. In this, GAAP fails
because (1) a very large part of the expenses of the contract were already incurred in obtaining the contract in the first place, and (2) PHCM's expenses in fulfilling its obligations under the contracts tend to be front end
loaded. A healthy part of these costs are already captured in the Sales and Marketing line of the Income Statement. A fair portion of the Deferred Revenue number will flow to the bottom line. Management evidently feels that
their accounting treatment in this area is conservative, with which point of view we concur.
Results of Operations: The only number that matters to some Gorilla hunters may be the License revenue. This grew 55% sequentially in the most recent quarter, and 936% YOY, to $11.8 MM this quarter. (The
Maintenance and Support services and Consulting services numbers are irrelevant, because by definition they cannot support a Gorilla Tornado-they are services). The License revenues remain tiny by Gorilla standards, but
are extremely revealing because they bear out the company's contention that revenues will come with subscriber growth. Back in November PHCM's Bird indicated they were expecting serious volumes in the second quarter,
just begun. "The millions will come in the first and second quarter of [2000]." PHCM has hit that target.
In the most recent quarter, the number of users of PHCM products grew from 700K to 2 MM. If you believe in the digital wireless tornado (and we think that is a given on this thread), you will also believe, we think, in the
growth of Internet access to the internet. A major question 3 months ago was whether growth in users would translate to growth in license fees. That question has been answered. As total wireless internet subscribers grows
to the 100's of millions, PHCM's revenues will also grow.
One reason the services numbers are irrelevant as Gorilla criteria is that they are accompanied by pretty hefty costs. As Maintenance revenue grew to $4 MM last quarter, directly related costs grew to $2.6 MM. Add related
SG&A expenses, and you quickly realize that the services pricing is geared to recovering directly related costs. It can never generate big bottom line numbers. License revenues are where to focus our attention.
Amortization of goodwill and intangibles has skyrocketed in recent periods, and is the clear reason for the heavy GAAP net loss for the quarter. PHCM is very aggressively amortizing the acquisition-related charges, over 2-3
years. If we take out the acquisition-related amortization numbers, we estimate a net "cash" loss of $13 MM for the quarter. This jibes with the change in cash and equivalents for the period of down $8.5 MM. (The difference
can be attributed to the increase in deferred revenues and the change in receivables.)
One of the issues surrounding any development stage company is whether they have the financial strength to see development through to profitability. With almost $500 MM in the bank, and a cash drain of $13 MM or $8
MM per quarter, PHCM is in no danger of running out of money any time soon.
3Q2000 2Q2000 3Q1999
Revenues: $18.7 MM $12.8 MM $3.5 MM
% Change over: 46% 428%
Deferred Revs $63.0 MM $46.6 MM
Number of Users 2.0 MM 700K
% Growth (Sequential) 285%
Net Loss* $5.9 MM $20.0 MM $5.7 MM
Net Loss per share $0.08 $0.31 $0.50
Cash and Equiv. $496.9 MM
Total Assets $1.5 Bn
Common Equity $1.4 Bn
*Excludes amortization of goodwill and deferred stock compensation related to acquisitions, and a charge for in-process research and development in most recent quarter.
<Gorilla Issues:
Is there a discontinuous innovation?
Yes. PHCM is riding the coattails of the digital wireless tornado, which is the key discontinuous innovation. It is also riding the introduction of internet access on wireless devices, which is an inevitable result of the wireless
tornado. Since these innovations are discontinuous, WAP's creation to address them is by definition discontinuous.
Is the product Open?
Yes, WAP and PHCM's implementations are open. That emphasis is on creating a platform that application developers will want to adopt as the standard. PHCM actively pursues indpendent development, and in this it is
succeeding. The number of registered developers grew from 29,000 to 62,000 last quarter alone.
Is the standard Proprietary?
No. And Yes. WAP is a standard owned by the WAP forum members. The founding members jointly agreed the WAP standard. Subsequently, many companies have joined the WAP forum, and contributed elements of
technology to the standard and phones based on it. Specifics of the agreement of the members are not made public, but it appears that each company in the Forum controls licensing of any technology it contributes. (In patent
terms, companies do not release their technology into the public domain. Instead, they grant a license to other WAP members). The license granted is supposed to be at a "fair" rate.
The confusion is that no specific licensing rate is specified in the agreements. Geoworks has roiled the industry recently by stating that it will impose a 10% royalty on any WAP phones using its technology. Geoworks is not
one of the larger contributors to the standard. It is unclear how much of a royalty they can receive. Other companies--including PHCM--have arguably contributed much more important parts to the standard. An issue to
watch is how the Geoworks demands are worked out. For investment purposes, we believe that the result will be non-material to PHCM.
The proprietary part for PHCM is the various software they have developed based on WAP, particularly the UP.Link server suite, the MyPhone products, and products more recently obtained by acquisition of Paragon
(data synchronization software) and OneBox (unified messaging). PHCM's server suite and other offerings can over time extend far into the telco customer's infrastructure. The further PHCM can get intertwined with the
telco, the harder it will be for the telco to make a change later.
Direct parallels can be drawn here with Oracle's position within enterprise servers. Oracle does not provide operating systems. It provides a key piece of software (the database) that makes the server valuable to the
enterprise. PHCM's UP.Link suite, in aggregate, provides much of the same function for wireless data functionality. Neither product set contains much patentable innovation. But, taken as a whole they impose (or in PHCM's
case are a candidate to impose) substantial barriers to entry that (may) elevate them to Gorilla status.
Are there high barriers to entry and high switching costs?
Yes. The products themselves are increasingly complex and would take substantial time and costs to duplicate, during which the existing players will continue to develop their products. The telcos, who are the principal
buyers, have a distinct preference for selecting a small number of product providers, and staying with them as long as they perform. The server products must interact with all of the phones being used in the telco's service
area, limiting the telco's freedom to change server offerings. There is a profound first-mover advantage. The "whole product" will also include applications written specifically for the mini-browsers and which must be useable
by the server suites.
WAP is analogous to TCP/IP. It is an open standard that anyone can write to, to allow transfer of information. However, that does not in my view preclude a gorilla from forming in the space. Cisco has been anointed a
Gorilla in the infrastructure cloud, by imposing a proprietary solution onto a non-proprietary environment. Oracle did the same thing in the RDBMS space. PHCM's solutions in many ways are analogous to Oracle's. A large
value chain is developing around their server installations and extended products. The telcos and SP's are developing expertise with PHCM's products that they will be reluctant to give up by switching to another vendor. And
the MyPhone sites are being optimized for use on PHCM's server solutions.
Does it have the potential to grow into a mass-market phenomenon and become the standard?
Yes. In the recent conference call, management stated that WAP-capability has become standard in virtually all phones being designed and produced, limited only by those without decent screen sizes. (In Europe, the usual
screen sizes are larger than we are used to in the US). It is easy to anticipate a 100-fold increase in the number of WAP-enabled phones over the next several years, as cell phone usage continues to grow, as digital phones
continue to replace analog, and as WAP-enabled phones continue to penetrate all segments. In Japan, NTT Docomo reports something like 30% penetration among its users already. All indications are that internet capability
is being accepted elsewhere at similar rates.
Some wireless standard will emerge, and WAP is currently the leader and odds-on favorite to become the standard. Some argue that this battle is already over, and WAP has won. Both WAP and PHCM's positions have
strengthened in the last several months. WAP becoming the standard does not assure that PHCM will become a Gorilla, as other companies can develop according to the standard. Certainly, any company's Gorilla position
will be diluted in the short and medium term by the WAP Forum agreements and resulting cross-license payments.
The other issue is that the profitability of the business model has not been clear. There are direct parallels with the Netscape business model. They were unable, ultimately, to make money on their browser, and PHCM has
stated that this will not be a major revenue producer going forward. There are distinct differences from Netscape's situation. First, PHCM's market cap isn't close to Netscape's at its peak. Second, wireless internet is not
naturally related to any Microsoft activities (the Navigator browser is installed on the same desktop where msft had dominant position. Msft has no position in wireless devices, and in fact is slightly weakened by the existence
of Windows CE, which is apparently an inappropriate product for this segment). Third, there appears to be much more hand-holding required in deploying the Server Suite than was needed for the desktop-related server
products (presumably related to the wireless telcos' lack of technical depth on the Internet side, as well as the need to set up an entirely parallel set of servers, and tieing it into the custom content).
PHCM "created" $35 MM in revenues last quarter, as users on its systems increased from 700K to 2 million. (The $35 MM is an approximation-the $18.7 MM reported, plus the $16.4 MM increase in deferred revenue).
Many although not all, of these revenues will recur based on the contracts with the wireless telcos. As PHCM continues to convert "testing" telcos to operational contracts, and as more users sign up for internet capability, the
number of users on PHCM systems will multiply. And PHCM's revenues will increase by orders of magnitude as well.
What's the competition?
Nokia may be the biggest threat, which may be working to PHCM's advantage. Nokia considers itself the ruler of the wireless world. As the world's largest handset maker they are developing a complete set of software in
direct competition with PHCM. So far, Nokia is the only major handset player that is trying to develop its own "whole product". The other major manufacturers have licensed PHCM's mini-browser.
Nokia has led the GSM/Europe world while PHCM is doing well in the CDMA world. The recent GSM win of Telital is therefore extremely significant, and indicative of a trend that may continue. Telital is Italy's and
Europe's largest and the world's second largest wireless provider. Established telcos as a rule want duplicate sourcing, and interoperability. In both specifying Nokia handsets and buying their server software, the telcos may
feel that they are relying on just one company in this area, without control of future developments. (For instance, what is to stop Nokia from inserting some hidden code in the handsets and the servers, and then developing to
it-thus moving from the open WAP standard to a proprietary standard? They can't if they only control one end of the server-handset equation.) The telcos may prefer to keep their handset choice independent of their server
software choice, to insure interoperability.
PHCM must do well in GSM, even if we believe CDMA will win out in a 3G world. The GSM telcos will tend to stick to their suppliers. When they move to 3G, if Nokia has its GSM WAP-based whole product in place, it
will be difficult to dislodge.
Microsoft has announced that they are developing directly competing products and services (but which so far is vaporware, as far as we can tell). We do not view Microsoft's announcements as an immediate reason to get out
of PHCM. (1) So far, msft has not provided any substantive product. (2) There is a huge first-player advantage in this sector (see next question). (3) There is no natural connection between msft's gorilla areas and this sector,
so their status there will have less importance in buyers' decisions here. (4) The telcos have a demonstrated history of avoiding being locked into and dependent upon a proprietary-standard provider. (5) Msft has more and
more shown itself to be mortal in its drive to hegemony. (6) Selection of the product isn't based solely on buying a software "box". PHCM provides extensive customer support, under service contracts. And (7) PHCM has a
pretty good war chest, of $500 million, to compete in a fair battle. They are far behind at this point, but as an established gorilla the threat is real.
Both Ericsson and Motorola have shown a preference to work with PHCM's mini-browser. Both meanwhile are developing their own server offerings, although Motorola licenses PHCM's UP.Link for inclusion in its Mobile
Internet Exchange Communications Platform and has expanded its license for the UP.Browser. . (Kyocera, which is taking over the Qualcomm business, has a history of working with DDI and IDO. These are the alternative
wireless providers to NTT Docomo, and they have selected PHCM).
NTT Docomo is both a customer and a potential competitor. They develop software as well as act as a wireless service provider. PHCM has recently announced a win at NTT Docomo for a peripheral product (realtime
horse racing over the wireless web), which they consider significant. PHCM is also working closely with NTT Docomo in developing the next generation WAP, for use in the 3G networks that we should start seeing deployed
in volume in 2003, perhaps. In working with NTT Docomo, PHCM gains a powerful ally in the country that is leading the world in wireless data developments. NTT Docomo offers minimal threat of competition
internationally. To date they have shown a marked preference to concentrate on cementing their lead in Japan rather than try to expand quickly overseas. Its position as a wireless provider and not a pure software developer
would likely hamper any international aspirations they may have.
Another company that has announced that they are a PHCM competitor is Infospace, which has been discussed from time to time on this thread. Jain, Infospace's chairman predicted that they would drive PHCM out of
business in two years. To date, Infospace has not appeared in PHCM's 10K as a competitor, and we do not understand the Infospace claim.
Wireless Knowledge (Microsoft/Qualcomm joint venture), in which Qualcomm joined to ensure the "whole product" aspects of wireless devices. So far, Wireless Knowledge has not been a great driving force in the sector.
we suspect that they are gearing for more broadband-oriented offerings (HDR-related?), although we have not confirmed this.
Other software companies, such as Oracle, which see themselves as supplying the infrastructure for the internet.
The wireless network operators themselves, which might develop their own proprietary systems. NTT Docomo has been the principal mover in this model, but it is unclear how they can translate their success outside of
Japan. And other providers have demonstrated a marked preference for using third-party, "open" offerings. Network operators present selective competition, but cannot compete for Gorilla status.
The principal "competitive" risk to PHCM, it seems, is that msft or some other competitor will decide on a scorched-earth attack, taking all profits out of the segment. The anti-trust watchdogs may lessen that risk from msft,
and a scorched earth pricing attack might not work for them anyway, if they cannot provide the technical support that PHCM offers. (Note also, that msft's recent announcement of a new wireless operating system is not
immediately competitive with WAP or PHCM's offerings. The threat is that msft will fold a browser into the operating system, while simultaneously attacking the server side. That threat, if it ever emerges, is some time away.).
Have value chains developed?
Yes, and they're growing all the time. An indication of the value chain can be seen on PHCM's web site, in their press releases. In the last year they have released about 80 press releases of various value chain developments,
such as handset makers licensing the micro-browser, new companies joining their Alliance Program, and other companies releasing products to work with the PHCM products. In the last quarter the number of developers
registered to write to the PHCM platform doubled to 62,000. There is of course more work to do in this area.
PHCM has partnerships with several infrastructure manufacturers, including Siemens, Alcatel, Sema and Motorola. These companies are all reselling PHCM's products, which should position the company well for future
network upgrades. And, the mass of these second-tier suppliers should in our view give them critical mass to succeed against Nokia's or Microsoft's go-it-alone strategies. (Note: Siemens has also announced an agreement
with Microsoft. We believe that they remain committed to PHCM's product and that the MSFT announcement is a matter of them hedging their bets.)
Continued in Part 2 |
