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6/14/2002
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Taking Stock: Wind River's Future, Like Embedded Systems, Is Solid Despite Losses

Wind River keeps putting money into R&D, its lifeblood.

Technology investors haven't had much to smile about this spring. Intel has announced it will miss expectations, and Nokia has been forced to reduce its growth forecast. Missed forecasts also were the story at Wind River Systems Inc.

A certain amount of bleakness has snuck back into the IT sector. However, warnings about earnings normally don't equate to bankruptcy for a company. Yes, business is performing worse than expected, but technology is cyclical; at some point the economy will recover and IT spending will resume. A number of tech companies with good products and management teams are suffering, but they won't disappear. Wind River Systems is an example of such a company.

Wind River (WIND--Nasdaq) was founded in 1981 and has focused on designing software offerings for embedded systems, which consist of one or more microprocessors and software that's used in operation or control of equipment and electronic devices. Embedded systems are used in a variety of settings and industries; they're found in cell phones, routers, ATM switches, automotive brake systems, automotive infomatics, factory automation, digital cameras, set-top boxes, and aerospace applications. Wind River designs the software portion of an embedded system, such as its operating system, VxWorks, and development tools named Tornado.

Wind River's revenue mix is diverse, though it's somewhat skewed toward networking and telecom infrastructure, which accounted for 46% of first-quarter bookings this year. Weakness in this segment accounted for 90% of the recently announced shortfall. Other markets include defense and aerospace (21%), automotive and industrial (17%), and digital consumer (13%). Top customers include Alcatel, Cisco, Hewlett-Packard, Lucent, Motorola, Nortel, Philips Electronics, and Siemens, with none accounting for more than 10% of revenue. Looked at from a different angle, product revenue typically accounts for 70% of revenue, with services making up the balance.

The competitive landscape is relatively benign. Wind River dominates the embedded-software market with a majority share in the vertical markets in which it operates. However, several competitors are vying to increase their shares of this relatively attractive market. They include Mentor Graphics, Microsoft, and Symbian. Microsoft is trying to muscle its way into cable set-top boxes and cell phones but hasn't gained much of a foothold. The major competition comes from in-house efforts by the manufacturers of electronic devices and factory automation, such as IBM, Lucent, and Nokia. However, the trend is toward more outsourcing of embedded systems and software, which benefits Wind River.

During the previous quarter, Wind River generated $66.4 million in revenue, a decrease of 17% from the prior quarter. Except for communications, Wind River's other segments are seeing little or no growth. Gross margins were 70.7% in the first quarter of this year, down from 75.6% in last year's fourth quarter, due to a lower revenue base. Despite these very nice figures, expenses are too high in R&D and sales, general, and administration for the current level of revenue. The company has announced layoffs to bring down the break-even point.

However, Wind River continues to invest in R&D because it's the lifeblood of the company. Fortunately, the company has $110.4 million in net cash to weather the downturn and has actually generated positive cash flow during fiscal 2002. Wind River expects revenue to grow as much as 5% during the next quarter, while earnings per share will probably show a loss of 8 cents to 10 cents.

Even though business is difficult these days at Wind River, the company has a dominant position in the embedded software industry. At the current valuation level of about $6, I find the stock attractive. An improvement in its business is to some degree dependent on an improvement in the general economy as well as improvements in the communications sector.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com.

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