VDC in BusinessWeek Article

FEBRUARY 6, 2006

Open Source's New Frontiers
By Sarah Lacy

MontaVista's Uncertain View

This startup, which embeds Linux in consumer electronics, is poised for big growth and maybe an IPO -- if Wind River doesn't spoil the party

Jim Ready, CEO of closely held software maker MontaVista Software, started off 2006 relaxed from a Hawaiian vacation and espousing an upbeat outlook. His company, which specializes in code that's "embedded" in consumer electronics and other gear, was entering its seventh year. And Ready was confident that in 2006 MontaVista would turn profitable and possibly move closer to an oft-rumored IPO. "When we started this company, we knew this would change the embedded computing world, and that has happened at a pretty good clip," Ready says.

Bold words for a man who's currently undergoing a search for his replacement, has recently accepted the resignation of his marketing chief, and is in the midst of a restructuring that calls for an undisclosed reduction in staff. None of that is uncommon in the rough-and-tumble world of emerging tech companies. But Sunnyvale, (Calif.)-based MontaVista has a reputation for results that don't quite live up to outsize goals. And as rival Wind River Systems (WIND ) begins treading on MontaVista's turf, pressure on Ready and his team to make good on promises has never been greater.

ANOTHER RED HAT? At stake: how big a slice of the $1.5 billion embedded-software market will end up with MontaVista, which has hitched its fortunes to Linux, the low-cost operating system that's updated by developers around the world via the Internet. Ready's model is Red Hat (RHAT ). Just as Red Hat sells and supports Linux for companies, MontaVista develops and supports a version of Linux that's sold to engineers working on a vast array of manufactured products, from phones and to telecom equipment to cars and other consumer devices.

It's not hard to see why MontaVista -- or any other budding open-source company -- would emulate Red Hat. Sales at Raleigh (N.C.)-based Red Hat jumped 44%, to $73.1 million, in its fiscal third quarter, which ended in December. Net income more than doubled, to $23.2 million, in the same period. But Red Hat is the exception -- not the rule -- among open-source players.
MontaVista wants to change that. The market for embedded software is poised to boom.

Currently, many would-be customers write their own code in-house. But that can be costly. And a growing number of manufacturers would rather rely on a standardized operating system, freeing engineers to focus on the concepts that can really distinguish a product, such as design and layout. MontaVista and Alameda (Calif.)-based Wind River both reckon the embedded market could become as big as $5 billion a year over time.

BIG OPPORTUNITY. And Linux has obvious benefits. For one, it's often cheaper than proprietary alternatives. Also, manufacturers don't want to be locked into an operating system over which they have little control. Nor do they want to be beholden to any one vendor, as many computers makers are with Microsoft (MSFT ) and its Windows operating system.

Little wonder that Linux is finding its way into more devices. Motorola (MOT ), Samsung, and Panasonic have all introduced Linux smart phones (see BW Online, 11/8/05, "Linux Answers Phone Makers' Call"). The Open Source Development Labs has embarked on several projects to standardize Linux for wireless handsets and telecom gear.

It has the makings of a big opportunity. When Ready was getting started in 1999, using Linux for devices was a radical idea. John Shoch of Alloy Ventures remembers getting the call in 1999 when Ready first proposed an embedded Linux company. It hadn't even occurred to Shoch, though he had made several investments in embedded software.

"I wish I'd thought of putting those two words together," Shoch says of "embedded" and "Linux." "On the spot we shook hands [on an investment deal]. We didn't know how to sell or execute or meet the needs but knew this was a whole new opportunity and we were going to figure it out."

"TRUE COMPETITOR." And figure it out they did. MontaVista, with soaring growth rates, outmaneuvered several small competitors in the early part of the decade. But that growth has tailed off in recent years, analysts say. The private company doesn't disclose revenue figures. But analysts say sales are in the range of about $30 million to $40 million a year. Ready says growth was about 20% last year.

That wouldn't be bad -- if MontaVista were a $1 billion software company. But for an up-and-comer, it's a red flag, says analyst Chris Lanfear of research firm VDC, who questions whether the growth rate is even that high. "It's certainly not a good indicator of market acceptance of what they're offering," says Lanfear. "I wouldn't discount the entrance of Wind River. MontaVista has never really had a legitimate, true competitor."

MontaVista's story is part cautionary tale for other emerging open-source companies that face an equally long, tough slog to profitability and high growth. The only pure-Linux success story is Red Hat, which took more than a decade to prove itself. Sweden's MySQL, which specializes in open-source databases, has upended that market, with nearly half of all Web sites running on its products. But MySQL's sales are just $40 million -- negligible compared to the $15 billion database market dominated by the likes of Oracle (ORCL ) and Microsoft.

"ARE YOU READY?" MontaVista, too, has had a tough time persuading clients to give Linux a chance. "Folks don't jump willy-nilly into this," Ready says. "How long does it take an elephant to have a baby? It's a long time, but you get this giant thing in the end."

Ready and his investors insist MontaVista is moving according to plan, despite burning through much, if not all, of the $75 million raised from investors and still not posting a profit. They say they have 2,000 customers and note that all of the Linux smart phones on the market use MontaVista Linux. Indeed, that market should grow nicely in the next few years as some handset makers, like Motorola (MOT ), look to shift more of their phones to a standard operating system like Linux.

Ready & Co. also insist that the restructuring and changes in upper management are aimed at getting MontaVista to profitability faster and bringing in new blood that has experience taking a company public. "Bankers are calling me regularly and saying, 'Hey John, we know MontaVista is the next pure-play Linux offer. Are you ready?'" Shoch says.

MAJOR IMPACT. Wall Street very well may be hungry for another public company that can benefit from rising demand for Linux. Red Hat's stock more than doubled in 2005 as it became apparent the company had finally hit on a winning business model. But Red Hat has had to earn that kind of appreciation. It's now growing at a much faster clip and it's scoring bigger deals. Most important, Red Hat doesn't have the competitive landscape MontaVista does.

After years of pooh-poohing Linux, Wind River did an about-face two years ago and now sells Linux tools and support alongside its own home-grown software. The impact in the embedded-device world is akin to Microsoft offering a Linux version of Windows. Wind River generated $235 million in sales in fiscal 2005, which ended in April, and it's already in all of the major accounts that MontaVista has spent six years scrapping for.

Though it's a latecomer to the Linux party, Wind River says it's making up for lost time. "The first mover has to find the way and sometimes learns through a series of mistakes," says Wind River Chief Marketing Officer John Bruggeman. "Sometimes they are not recoverable. [That] was very clear to us when we stepped back and asked the customer, 'Why are you pressing us to enter the Linux market so aggressively?'"

NAME-BRAND CHIEF. And while MontaVista has more Linux clients now, the device business is uncertain. Companies like Motorola could easily switch to Wind River for future phones if they were offered more favorable pricing or just felt more comfortable with a large public company.

Right now, many big handset makers are hedging their bets, using some Linux from each, analysts and customers say. A new CEO at MontaVista could make all of the difference. By his own admission Ready is a founder and an entrepreneur at heart. Running a larger company day-to-day isn't his forte or passion. If MontaVista could get a name-brand chief with public-company experience, it could instill confidence in customers, and get MontaVista over its current hump, into the black, and on the way to $100 million in annual revenues, before Wind River gains too much more ground. MontaVista also has yet to replace Kelly Herrel, the vice-president for marketing who departed in early January.

MontaVista is named for its first location, Monta Vista, an unincorporated area of Silicon Valley that was misspelled a century ago by land developers who meant to evoke the Spanish words for "mountain view." The outlook for MontaVista may be rosy for now, but it could swiftly darken if the Wind River onslaught gathers steam. That could relegate MontaVista to the ranks of Silicon Valley companies that pioneered a market only to watch a rival reap the rewards.