This is copied from the WIND thread
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Microsoft Investor
July 27, 1998
Big, big future for tiny embedded systems: They're minuscule bits of software that make
chips in smart appliances and teller machines work.
By Michael Parrish
When your cell phone rings, when your car dashboard warns of an open door, when
you pull a few twenties from the ATM or mail a singing birthday card, silent electronic
servants are hard at work.
Each of these electronic gizmos depend on small subsystems of chips and software that
perform unglamorous but critical functions. And as the number of computer-enhanced
gadgets grows -- from smart coffee pots to digital cameras to super-efficient
locomotives -- the companies behind them are thriving as well.
There are all kinds of software operating systems in the world. Microsoft Windows is
one that runs a lot of personal computers and is highly customizable by the user. But
embedded systems are miniature programs that users can't affect or program; the
programs just do their simple tasks over and over. They are embedded into more
elaborate systems that users are only vaguely aware of but find quite handy -- like the
one that wakes up your coffee pot at 6 a.m. and controls the flow of hot water.
Key market drivers include consumers who want more electronic bang for their buck.
Some people apparently do want toasters that sing like canaries.
The chips on which this software runs could be standard-issue from Intel (INTC),
Advanced Micros Devices (AMD) or other manufacturers -- though some hardware is
designed just for these systems. But what sets the embedded world apart is the
software. It's rugged, simple, reliable and runs without human intervention. Since no one
wants to keep reinventing the wheel with these things, companies like Sunbeam (SOC)
and General Electric (GE) buy embedded operating systems and the tools to integrate
them into the larger systems that they then load into their appliances and machines. And
there is a lot of demand.
Quadrupling of revenues
San Francisco brokerage Hambrecht & Quist estimates that companies making only
embedded software will continue to grow by up to 30% annually to create a $1.2 billion
industry by the year 2001.
That translates to quadrupling revenues of the group over the next 30 months if you limit
the embedded-software universe to pure-play public companies such as industry leaders
Wind River Systems (WIND) and Integrated Systems (INTS), as well as such smaller
companies as Microware Systems (MWAR).
But Paul Zorfass, who follows the industry for International Data/First Technology,
believes the number really soars if you include companies that produce embedded
software as an important sideline; these include Lucent Technologies (LU); the Microtec
Research arm of Mentor Graphics (MENT); or RadiSys (RSYS), which makes boards
and other hardware for the embedded systems that help to run automated teller
machines. Zorfass figures the larger market will bloom from the $2.4 billion it was in
1995 to $6.9 billion by the year 2000 -- a 23% compound annual growth rate.
As a tip to the potential size of this market, industry titans Sun Microsystems (SUNW)
and Microsoft (MSFT) are weighing in with their own offerings. These guys don't step
into a sector unless they believe there's a growing and potentially huge market. And
there are a lot of signs that there is. (Microsoft is the publisher of Investor.)
Cheaper, more powerful chips
Key market drivers include consumers who want more electronic bang for their buck in
all their household toys - some people apparently do want toasters that sing like
canaries -- as well as the recent availability of cheap 32-bit chips. These more powerful
chips will let appliance or aircraft manufacturers deliver that bigger bang by upgrading
their next products from the 8-bit chips that have been standard for years.
Happily for embedded software companies, it's a lot harder to write code for a 32-bit
chip than for the 8-bit models, so a lot of the designs are being outsourced to the
embedded software companies.
"We're not talking about just shortage [of embedded-systems software]," says Sheila B.
Ennis, a senior technology analyst at Hambrecht & Quist. "We're talking about just an
untenable relationship between what needs to be done and the resources to do it."
And it's not simple work designing this software. For one thing, embedded systems
operate at a different level of reliability than, say, word-processing programs. The
software almost always has to be bulletproof -- highly dependable -- compared with
general-purpose software. "These guys all got started in the aerospace and defense
industry," says Ennis, "and their job was to keep things from dropping out of the sky."
Companies positioned with resources and experience to meet this high end of
embedded demand include market leader Wind River Systems -- a $978 million,
Alameda, Calif.-based company that sells software and software tools to medical,
automotive, telecommunications, industrial automation, electronics and aerospace
manufacturers. This hasn't been a good year for Wind River's stock price, which has
fallen from $40 to $37 in the past 12 months.
But in the bigger picture, investors who bought a $10,000 chunk of the company five
years ago have almost $90,000 worth of stock today. With the current decline, "it's a
huge buy," says Raj Gollamudi, an analyst at Dain Rauscher Wessels, the Minneapolis
investment bank. "It's the company you want to watch."
Ennis agrees, noting that Wind River software was on Pathfinder, the Mars lander. "It's
a blue-chip company that doesn't miss its earnings numbers, has lots of backlog and
cushion that they've built up over the past couple of years -- and that's reflected in their
stock price," Ennis says. She has a buy on the stock, but likes it best under $35. Lately,
Wind River has dipped below that, on investors' fears of its 10% to 15% Asian
exposure as well as the unknown impact of the new, high-profile players.
The software players
One of those bigger players is Microsoft. Ennis thinks Microsoft is making a lot of the
right moves with Windows CE, the product the company is adapting to embedded use.
But she doesn't count CE as a big, immediate threat to Wind River's clients for whom
reliability is critical. "CE can't just take over the embedded systems market wholesale
tomorrow," she laughs. "Anyone who has children would not put Windows or any
derivative thereof in their anti-lock brakes."
Ennis and others also recommend the other current big gun among embedded software
makers, Integrated Systems, a $380 million company based in Sunnyvale, Calif. One of
Integrated Systems' claims to fame is its software's role in the Iridium World
Communications (IRIDF) global satellite communications system. Still, Integrated
Systems has been a more volatile stock than Wind River, in part because it was late to
market with a new-generation tool set -- causing it to miss the numbers in some recent
quarters. Also, the company has had to hunt for a new chief executive. Now, however,
the new products are in place, though the stock price remains depressed.
"Integrated Systems may end up doing all right," says Dion Cornett of First Analysis. "In
some respects, they've aligned themselves with Microsoft, which could be a big plus."
Indeed, last year, Integrated Systems came out with embedded-systems software for
use with Windows 95 and Windows NT.
Microware Systems (MWAR), in Des Moines, Iowa, is a smaller, $67 million player,
No. 3 among the public software companies. Microware is a guarded opportunity for
Ennis and others because it typifies one liability of the sector: Success often depends on
the success of others. Though some industry observers see a move to one-time bulk
sales to the manufacturers -- to install software in as many cell phones or cameras as
they decide to produce -- at the moment, much of the sectors' revenue comes from
royalties per unit.
"You have to win these designs and then you have to be glad that you won them," says
Ennis, noting that Microware made deals to provide software for products that never
took off. One example: Motorola's two-way pagers.
The hardware guys
The hardware side also has plays worth investigating.
RadiSys Corp., a $158 million company, makes boards that go into locomotives as well
as more conventional embedded products. Three guys from Intel started the company,
then bought Intel's own embedded hardware unit in 1996. Some now blame the
company's pressured stock price on old Intel product lines that are dying out.
"Long-term, I like this business and I like this type of market," says Ken Thomas, an
analyst with Red Chip Review, which specializes in the analysis of small companies. For
one thing, there's more stability to embedded systems hardware because it's not tied to
the 18-month cycle of other chip manufacturers. Embedded hardware can be
unchanged for five to seven years, and when manufacturers like General Electric come
back to upgrade, they come back to the same old store.
RadiSys got whammied recently by a customer that doubled its order, then went back
to the original level -- leaving a hole in the company's production cycle. But Thomas
sees this only as giving investors "a nice entry point." SBS Technologies (SBSE) plays in
the same field, though it does not directly compete with RadiSys.
A final "undiscovered jewel" from Ennis, at Hambrecht & Quist: Peerless Systems
(PRLS), a $229 million beneficiary of the move to systems on silicon -- putting software
intelligence on the chip. Peerless sells embedded software-based imaging systems to
customers like IBM (IBM), Xerox (XRX) and Canon (CANNY), for use in their
scanners, fax machines and copiers.
Ennis rates Peerless a strong buy because even in the much-vaunted paperless office of
the future, "ultimately you're going to want to print something." Unless, of course,
someone invents a way for all those things to be simply embedded in our brains.
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Wind isn't looking too bad these days either.
Tom A.
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