Analyst's Latest Comment on SPYG & MSFT deal
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10:48am EDT 8-Apr-99 Blair, William & Co. (Abhishek Gami) SPYG
Spyglass Lands Microsoft Megadeal
William Blair & Company, L.L.C. Abhishek Gami (312) 364-8224
SPYGLASS, INC. (SPYG)
Price 4/8 Earnings Per Share P/E Ratio Div. Yield LTGR Rating
$16 5/8 9/98 9/99E 9/00E 9/99E 9/00E $0.00 0.0% NA "2"
($8-$32) $(0.56) $(0.20) $0.19 NM 87.5x
* Spyglass will receive a minimum of $20 million over three years to provide
Windows CE-based integration and development services to Microsoft (MSFT $91
1/2).
* A minimal portion of the deal is for technology licensing, which Spyglass
booked in the March quarter. This licensing revenue gives us confidence that
Spyglass' quarterly results, to be released on April 21, will not disappoint.
* Including a similar deal struck with General Instrument (GIC $34) in late
1998, SPYG now has a minimum of $40 million of professional services revenue in
backlog, improving revenue visibility significantly. We think there could be at
least one more such deal in the pipeline for calendar 1999.
* We will revise our forecast following this month's earnings release, but we
preliminarily project that at least half of the contract amount will be upside
to our existing revenue estimates. We will be more conservative on changing our
EPS estimates because the company has excellent opportunities to reinvest in
its business.
* SPYG's service-based model is winning over industry-leading customers. We
think the strategy will result in strong future licensing opportunities. We
reiterate our speculative "2," or Long-term Buy, rating and $17 12-month price
target. Upward revisions to our model could result in 10% to 20% of upside to
our price target as well.
Microsoft CE is a Key Technology in the Device Space
Microsoft's Windows CE is an embedded operating system. The technology is a
stripped down version of Windows that is used to control devices like hand-held
PCs, set-top boxes, and automobile navigation systems. Companies like
Integrated Systems (INTS $12 1/16), Microware (MWAR $1 13/16), Wind River (WIND
$13 1/4), and QNX long have provided these embedded operating systems to
hardware manufacturers, but the Internet has made it possible to bring
applications once that were reserved for PCs only to all kinds of devices.
Microsoft, realizing the importance of the emerging market and seeing the
opportunity to extend its desktop operating system and application skills to the
market, aggressively has been building out its suite of technologies. So far,
Microsoft has not dominated the space (though vendors are very much in tune with
its game plan), but it is clear to us that Microsoft intends to embrace the
market (which its chairman, Bill Gates, once described as being more than 5
times as large as the PC market opportunity). Many products already use Windows
CE.
To some degree, Microsoft's embedded technologies compete with those from
Spyglass; however, because of its large size, we believe Microsoft has and will
continue to focus on creating platforms or off-the-shelf software applications.
Spyglass focuses on delivering customized solutions tailored to the customers'
individual needs. Unlike PCs, which are essentially the same from one vendor to
the next, devices have very different characteristics like screen size, power
consumption, available memory, and consumer price points. So, off-the-shelf
technologies, like those sold by Microsoft, require a homogeneous OEM market or
require customization. Because of the heterogeneous nature of the device
market, Spyglass has found a strong business in helping OEMs customize embedded
technologies for their own purposes. This is why we believe Microsoft chose
Spyglass. The company will help promote OEM usage of Windows CE and associated
applications by working with OEMs to customize the Microsoft technologies for
their devices.
Second Major Deal Helps to Validate Spyglass' Strategy
Spyglass made a conscious decision a couple years ago, based on its estimation
that the device market would require substantial integration capabilities, as
well as a realization that meaningful royalty revenue would not kick in for a
number of years, to focus on building its consulting and professional services
division. The move was a good one. Network computers and Internet televisions
already have come and gone. A product strategy in either area would have
resulted in disaster. Set-top boxes, handheld computers, and cell phones appear
to be the real deal, and Spyglass has won major clients in each area (for
example, Nokia (NOK.A $162 3/16), General Instrument, and Microsoft). As other
vertical markets evolve, we expect Spyglass to aggressively go after licensing
deals in those industries (for example, Xerox (XRX $59 13/16) uses Spyglass
inside its Document Centre copier/printers). The backdrop to this licensing
work is always professional services, which allows Spyglass to monetize its R&D
work. It also allows the company to get deeper into client organizations, and
it builds a stronger bond between Spyglass and its customers. We believe
Spyglass will be able to execute on its technology licensing strategy more
effectively because of the expertise it builds by leading with professional
services. Most of its direct competitors are following a technology licensing
model, but without integration services, we think that these other companies
face a high degree of risk to their models. We like Spyglass' relatively
diverse customer list and industry knowledge base.
Spyglass will need approximately 20 to 25 employees to fully staff the deal.
The employees might be located in Spyglass' Los Gatos offices, but that has not
yet been determined. Spyglass will be able to pass through the start-up costs
and overhead costs to Microsoft, so we do not expect near-term earnings to be
affected negatively due to hiring or other ramp-up issues. The company might
convert some of its existing employees over to the program to hit the ground
running, but the majority of the headcount will need to be hired. Some could
come from Microsoft, but again, that has not yet been determined. Based on its
success in rapidly staffing its GI deal (it has hired about 22 experienced
employees in the past 5 months--not an easy task at a time when good technology
skills are in high demand), we think that Spyglass will not have an inordinate
amount of difficulty in executing on this contract.
Microsoft will retain ownership of new technology created under its contract,
but we believe that the expertise Spyglass generates from working closely with
Microsoft on the CE platform will result in opportunities to separately create
new technologies for OEMs (on which Spyglass could earn licensing fees and
royalties). We think that Spyglass could become one of the most experienced
independent CE developers, outside of Microsoft, as a result of this deal.
Unlike Spyglass' deal with Microsoft a number of years ago (to license the
Mosaic browser to MSFT) in which Spyglass capped its revenue from Microsoft,
this deal is open-ended and is related to professional services. The browser
licensing deal from years ago was a case of Spyglass licensing technology to a
company that ultimately would compete with all of Spyglass' other customers
using that technology. In the new contract, Spyglass is doing custom work for
Microsoft, which does not preclude Spyglass from working with the many other
OEMs that will need similar integration services.
March Quarter Looks Good--Revenue Visibility Improving
We now are pretty comfortable with our fiscal second quarter operating per share
estimate of a $0.06 loss, on $6.1 million in revenue. Following the Microsoft
deal, we think that there could be $1 million or so of upside to our current
fiscal 1999 revenue estimate of $26.7 million. The company indicated that
unlike the GI deal, it is ready to begin work on the Microsoft deal immediately,
so revenue upside could kick in as soon as the current quarter. If Spyglass
can ramp up quickly, we believe that 30% to 40% of its quarterly revenues by
September will be in backlog. This is an enormous amount of visibility for the
company and should help improve its ability to forecast results and maybe even
become more aggressive in its sales process.
One of the biggest risk factors for shareholders has been the fact that the
average contract represents nearly 10% of Spyglass' revenue--a single missed
deal would have a significant negative impact on the bottom line. Until
Spyglass' OEMs begin to ship products en masse, this risk factor will continue
to be an issue. Now that Spyglass has a meaningful backlog, however, we think
that the risks are lower (but they still exist) and could give investors more
confidence in the shares. Less than 10% of our revenue estimates for fiscal
1999 and 2000 are related to device deployment, so if Spyglass' customers gain
traction with their products, there could be additional upside to our model.
Spyglass Goes Deep
We believe that there could be additional multimillion-dollar deals, similar to
GI and Microsoft, in the works. We believe that management wants to improve
revenue visibility and go much deeper with clients to maximize its sales and
marketing efforts to win a client in the first place. Large, long-term deals
put Spyglass near the nexus of activity in various vertical markets and allow
the company to enhance its sales efforts by getting a close look at who is
developing what in the industry. While the company has not indicated who it is
targeting, we think that companies like Cisco (CSCO $116 3/4), 3Com (COMS $21
1/8), Sun Microsystems (SUNW $139 1/8), Compaq (CPQ $29 11/16), Motorola (MOT
$78 3/4), Nokia, Sony (SNE $102 15/16), and Mitsubishi (MSBHY $14 3/8) are
representative of the sort of customer Spyglass would be likely to target.
Spyglass already has deals with a number of these companies, and each is a
central force in its respective industries. We have not built into our model
additional megadeals, but based on management's assertions, we would not be
surprised if the company landed at least one more this calendar year.
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