Wall Street continues to give the stock a B minus. There is a huge divergence between your outlook and Wall Street's outlook. Why the disconnect? What can be done about it? Have you wondered about this issue?
At first glance, indeed there does appear to be a huge divergence between my outlook for WIND and the Street's. Let me focus first on why, and I will make a follow-up post on what can be done about it.
Under certain circumstances, it seems to me the market often is far from efficient, leaving ample opportunity for the astute investor to ignore the Street's outlook. For example, George Gilder, among others like Ramsey and me on this thread, berated the Street to appreciate QCOM well before 1999. Also well before 1999, CDMA was a commercial success with sufficient maturity and economies of scale to claim a sizeable piece of the wireless pie. Given QCOM's 26-fold increase in 1999, it follows that either QCOM was dramatically undervalued and under-appreciated by the Street at the beginning of 1999, or QCOM was dramatically overpriced by the end of 1999, either of which implies a grossly inefficient market. Like WIND over the last two or three years, QCOM was stuck for over three years prior to 1999 in a trading range of (pre-splits) $40 to $70. To put the Street in context, H&Q had a hold on QCOM going into 1999, for lack of earnings visibility.
I have no idea whether WIND will increase 26-fold this year or next, but I would expect it to explode out of its doldrums soon. To understand why, and why the Street is unwilling to play along, you need to have a visceral understanding of the important drivers.
The best way to describe one primary driver is with Kevin Kelly's (Editor at large with Wired magazine) lily pond metaphor for geometric growth in networks. At the start of summer, miniscule lilies begin doubling in size each day. At the end of summer, the pond is covered completely by lilies. The day before the end of summer, lilies covered one-half the pond. The day before that, one-fourth of the pond was covered. The week before the end of summer, the Lilies were just becoming noticeable.
The lilies were doubling unnoticeably almost every day throughout the summer. With only one week to go, they became noticeable, and within a few short days, they exploded to cover the entire pond. This is characteristic of networked systems experiencing geometric growth. Years go by with tremendous growth but nothing noticeable, then an explosion occurs without any change in the underlying rate of growth. WIND has seeded so many lily ponds that are growing rapidly, some noticeable to astute observers, but none yet to the Street. Before your eyes, thousands of WIND's design wins are multiplying in hundreds of market segments. You know that I2O has been growing over 200% annually, and IS NOW SIGNIFICANT. DSL and cable modems have been at least doubling every year with no end in sight, and it is no secret that WIND owns most of these markets. Assume Matt Belkin is right and WIND gets $1 per modem. Last year there were probably a million or two modems sold worldwide, generating $800K to $1.6 million in royalties for WIND. That's now starting to get significant, and the growth continues. Ditto for digital cameras, printers, navigational equipment, consumer products, and hundreds of other devices.
The Street lacks the wherewithal to forecast lily pond explosions. Analyst estimates of future revenues and earnings are provided only through management guidance, which for a conservative company NEVER, EVER anticipates inflection points. Outside of I2O, I have never seen the slightest hint that any analyst or money manager has attempted to calculate any such impacts on WIND for any market segment. If management has credibility with analysts, the comfort-level growth rates expressed by management are factored into spreadsheets that include gross and operating margins provided by management, down to the proper tax rate to use. In my view, the Street doesn't think deeply enough about future growth to even qualify to be labeled inefficient. It seems to me one has to fail at being efficient before you can become inefficient.
Geometric network growth is just one driver of WIND's revenues. Another one is increased value-add. It is well-known that WIND has been moving many important products up the value-chain, providing higher value-add than before. We are talking about order of magnitude increases in important, high-growth markets. So, rather than get $1 per unit in a high-growth market segment, royalty jumps to $5, $10 or $20. The Street doesn't have a clue about the implications of these well-publicized moves up the value-chain. Just the opposite, I sense that a major concern of the Street is that the historical competitive character defining the embedded systems market may only get worse because of giveaways like Linux. Not only is the Street not willing to price in increases in value-add (which enable pricing power), but it may be worried that ASP may fall rapidly enough to blunt obvious unit ramping in many markets segments.
As I discussed in a previous post using the Switching Cost Method of valuing design wins, the merger with ISI translates instantly into a major increase in value-add, which will gravitate to increased revenues. I would be shocked if the Street has put much value on this increase in value-add, which I showed previously is enormous with WIND's major partners.
Finally, it seems to me that WIND is beginning to benefit from direct and indirect network effects. Later this year, I2O will positively reek with network effects. Similarly, the Intellectual Property (IP) in TMS promotes strong network effects. Clearly, some kind of network effect is driving WIND's dominance in network processors, and network effects will be a huge component of WIND embedded Java strategy. The point of Cisco's alliance with WIND on the edge of the Internet (where Cisco is a VAR for WIND in the global program with Cisco partners), is to instill network effects.
Network effects boost the value-add, sometimes hugely. Most, if not all, of the world's most successful and valuable companies owe the lion's share of their good fortune to network effects. As with Intel, Cisco and Microsoft, in time, network effects could end up being the primary driver of WIND's value-add.
If there are more than a handful of investors even aware of the potentially sizeable impact of network effects (or even what it really means) for WIND, I would be shocked. In all my analysis, inside and outside the company, I have never sought to account formally for network effects, and I assure you that no analyst covering WIND has either. At this point in WIND's development, I encourage the company to be on the lookout for network effects and develop strategies to boost it along wherever it appears, but not yet to attempt formal calculations. Network effects is why it was important to unbundle the Tornado IDE from platform architecture. Network effects is a primary reason for jumping all over verticals for I2O. Network effects underlies the importance of the Cisco VAR program with WIND, and it is central to the importance of IXA and a number of other developing markets.
I contend that the reason a select few stocks skyrocket every year is that the Street shifts from being dubious or ignorant of a company's inflection in business to being a believer. Sometimes this happens after the fact, when it becomes clear that a company's numbers have encountered a change in kind, and sometimes it occurs before the fact. When it happens beforehand, it is because some authoritative source makes the case credibly. The source could be within a company that has high credibility with the Street, or it could be an esteemed analyst or pundit capable of moving institutional money. Or, the source often is an industry leader, like Intel, deciding it is in its best interest to push a company's capability, like what Intel did with Rambus, particularly at the recent IDF. Prior to experiencing the beginning impact of an inflection in business, the Street will not buy into an unendorsed WIND story.
Does this make the Street inefficient? I think so, but clearly the Street has demonstrated over and over again that is is satisfied ignoring wonderful opportunities, and then jumping onto sure winners as they get anointed. In this sense, there is not necessarily an inconsistency between the Street's outlook for WIND and mine. But if one is right and the other is wrong, I'm betting big on me being right. BTW, I am joined by some pretty stellar company. Witness:
Kevin Landis
Co-founder and portfolio manager of the Firsthand Funds
Landis, whose offices are in Silicon Valley, founded the Firsthand Funds with Kam (above) and now manages them, focusing on high-tech. He used to be a high-tech analyst at Dataquest. His top pick, Wind River Systems (WIND: Research, Estimates), has what he hesitated to call an "emerging monopoly" on embedded operating systems, the operating systems that run antilock-brakes for cars or climate-control systems for buildings.
Kevin Landis defines the phrase "astute investor" and picks his gorilla tech stocks either because they are branded, or because he takes a screwdriver to products in the mainstream of the new economy, and examines the parts. A chip with "PMC-Sierra" stamped on it has obvious implications for PMC-Sierra, but the same chip doesn't indicate what OS is used. Somehow Kevin did what the rest of the market has proved incapable of doing, prying open the lid and finding VxWorks. Of the top 20 gorillas Kevin picks, most are mainstream tech stocks with market caps in the $50 to $400 billion range. Four are semiconductor stocks with market caps around $8 to $10 billion. His top pick is WIND with a market cap of $3 billion on a good day.
Allen |
