Magellan Asset Management Limited Oct 2017
Sometimes the winners and losers from disruption aren’t obvious
If you look at a photograph of the Easter Parade in New York in 1900, it is full of horses and carriages. Yet by 1913, photographs show the parade was full of cars. Think about how petrol stations needed to be rolled out to enable such change over barely more than a decade. Transportation was fundamentally transformed over those 13 years largely because in 1908 Henry Ford rolled out the first Model-T Ford off the production line, which enabled cars to be mass-produced at affordable prices.
Many first-order effects of the shift from horses to cars were obvious. If you manufactured buggy whips at the time, you went out of business. If you collected manure in the streets, you lost your job.
The second-order effects weren’t as predictable. Secondary effects were what the automobile enabled over time. New technology could move goods around far more efficiently and people could move further away from city centres. And so started the urban sprawl that eventually led to regional shopping centres.
Today’s technological advances are generating such classic first- and second-order effects. Consider a simple development in technology, the automated checkout. Around 2010, the US retailing giant Walmart rolled out automated checkouts and the other major retailers did likewise to stay competitive. The first-order effects were that checkout workers lost their jobs and retailers reduced their costs.
But what of the second-order effects? Chewing gum sales have lost 15% of their volume since the introduction of automated checkouts in the US because the checkouts have disrupted the business model of impulse purchases. People did not drive to supermarkets to buy chewing gum. But when they stood in checkout lines, they would grab some gum. Mobile phones have played a role, too, in reducing Wrigley sales because people are distracted nowadays while waiting to pay.
The job of fund managers is to spot the winners and losers from second-order effects and it’s not always obvious. In 1999, at the peak of the technology bubble, Warren Buffett was asked why he didn’t invest in technology. He said he could not predict where the internet was headed while he was confident a business such as Wrigley would not be disrupted by technology. And look what’s happened. Wrigley sales had gone up for 50 years, every year, before this change happened.
The pace of change is accelerating
Technology adoption appears to be accelerating so more first- and second-order effects are set to appear. As Chart 1 shows, the time it takes to reach 50 million users has plunged since electricity was invented and took 46 years to reach that number. Smart phones took only four years to reach 50 million users. Incredibly, it took Facebook only five years to move from one billion to two billion users.
Chart 1: Technology adoption is accelerating
Source: US Census, The Wall Street Journal.
Many factors explain why technology businesses can expand at faster rates these days. First, globalisation and the internet have enabled products to spread rapidly to much larger audiences around the world. A second factor is the digitalising of goods and services from books and newspapers to music and videos: with Facebook, Google and Netflix, all their services are digital. Digitalisation allows for identical copies of a digital good to be produced at zero cost. The other factor is the power of today’s computers. The mobile phone today, for instance, is more powerful than the world’s most powerful super-computer was in 1986. And now we’re connecting all these devices in ‘cloud computing’, where massive data farms don’t need computers to sit locally, and you can share all this information.
The incredible power of two digital platforms
Such fast change means we need to be aware of the ‘GAF effect’; not specifically what Google, Amazon and Facebook might be doing but how they are disrupting industries and business models. First, take the advertising industry. Google and Facebook know an enormous amount about their users. Anyone who uses Google is under the watch of a Google timeline (unless they’ve opted out). On Google timeline in your user settings, you can go back five years and, if you carried your mobile phone (and most people do), it will tell you what you did five years ago. Google timeline records what time you left your house, whether or not you walked to the bus, which bus you boarded, and if you went to work – because it knows the address you went to. On any day, it will reveal where you went for lunch, when you went home and, if you went out to dinner, it will tell you the restaurant. And this goes for every other day of your life for the past five years. If you took any photos, it will place those photos on the timeline. Google is collecting enormous amounts of data about you, as are Facebook and others. That enables these platforms to target advertising, which makes marketing campaigns incredibly efficient.
The first-order effect of this is that in the past decade traditional print advertising has lost about 24% market share and is set to lose much more, perhaps even all of its advertising share. It is extraordinary that outside China two companies (Facebook and Google) have taken nearly the entire share of a global industry that had many players in the world – magazine producers, newspaper publishers, classified advertisers. Television advertising, which is the largest pot of advertising money, has not yet been disrupted. We’re seeing the rise of YouTube but it is still relatively small, as shown in Chart 2. It’s probably got US$6 billion to US$8 billion of advertising revenue at the moment – television advertising is an industry with US$150 billion of revenue excluding China. But disruption is coming to television in a classic second-order way.
Chart 2: What’s happening in the advertising market? 2006-16 global advertising market share (ex-China)
Television is next
The central reason that the television advertising business model is the next to be upended is because the streaming-video services – think of Netflix, Amazon Prime, Stan, and Hulu, and Apple wants to enter this game – are spending enormous amounts of money to create or acquire content. Amazon and Netflix, alone, this year will spend US$10 billion curating content. They are by far outspending anyone else on the planet. Facebook just bid US$600 million for the Indian cricket video streaming rights. While Facebook was outbid by News’s 21st Century Fox, this auction will probably be defined as one of the last-ditch efforts of the traditional media to protect major sporting rights from the digital platforms. The battle is extending to movies as Apple and Netflix are bidding for the next James Bond film. Whether they create or buy the content, streaming-video services are using it to attract viewers from television and pay TV, which reduces their advertising revenues. It is not a great business model if your revenues are falling and your costs are rising to ensure Facebook doesn’t get the cricket.
Another concern for television advertising is that we’re seeing the advent of new video advertising platforms. The streaming services are not advertising businesses; they are subscription businesses. But YouTube and more recently Facebook (and it’s just launched Facebook Watch) are advertising business models. A huge amount of the revenues that are in television and pay TV are at risk.
The television advertising model as it has stood for decades gives a few companies in the world a huge advantage because there are massive barriers to entry to promote products on television if businesses want to advertise at scale. But now it will be much easier for businesses to advertise on one of these new platforms. They can conduct specific and cheaper marketing campaigns if they are promoting a new product on Facebook, YouTube or Google compared with advertising on television.
The Amazon effect
Amazon is a business with an estimated US$260 billion in sales (including the recently acquired US grocery-store chain Whole Foods), which makes it the second-largest retailing business in the world after Walmart. Amazon is a fascinating company. It runs a ‘first-party’ business, where Amazon buys the goods, stores them in its warehouse and then sells them to its users via the Amazon website or mobile apps. Then Amazon has a ‘third-party’ business called Fulfillment by Amazon, where other retailers put their own inventory into Amazon’s warehouse and then Amazon sells that inventory to its customers. So customers suddenly have a much greater selection, and Amazon charges other retailers rent for having their goods in the Amazon warehouse, then charges a commission for selling to its users.
Amazon also is a massive logistics company. It is expanding warehouse space by about 30% a year and it is well advanced from a technology point of view. With a robotics company, Amazon has developed the ‘Kiva’ robot and has about 45,000 operating in its warehouses. Humans are good at putting goods in a package, adding a label and sending them off. But it’s inefficient for the human picker to run around the warehouse to find the shelf where that good is stored in these massive multiple football-field-sized spaces. So these robots automatically go around the warehouse and bring the shelves holding the product to the packers.
Amazon has a loyalty scheme called Amazon Prime that started out with two-day free shipping, then same-day and two-hour free shipping in a number of cities around the world. Amazon Prime members receive free video, free music and free e-books with the service.
Amazon is also a data analytics company. It gathers enormous amounts of information about what the customer wants to buy. Amazon members see web pages that look different from anybody else’s. There are 50 million goods available in Amazon so customers receive a particular look into the world.
Amazon’s CEO Jeff Bezos wants to fulfil all his customers’ shopping needs. He has worked out that if people are to see Amazon as part of their everyday shopping, Amazon needs to become part of their grocery shopping habit. Amazon started with Amazon Fresh, an online grocery shopping business that’s niche. Bezos needed something bigger. That’s why this year he bought Whole Foods, the largest fresh food retailer in the US. It had a reputation for expensive produce, lots of organic products and incredible displays. On the first day Bezos took control, he slashed prices by 35% to 45% on key selling lines. If people turn to Amazon for fresh groceries, then everything else will follow.
Bezos wants to connect your home by the ‘internet of things’. Many goods like washing detergent and milk will have computer chips on them that, via the internet, will prompt you to reorder them when they are running low. Washing machines and fridges will automatically generate shopping lists. He’s adopting a voice platform for your house with a digital personal assistant. Working out the first- and second-order effects of all these developments is daunting.
A massive number of such revolutions are underway across key industries. You may think Amazon, Facebook and Google are big at moment but we’re in the early stages of where these businesses are heading and what they will disrupt.
Important Information: This material has been prepared for general information purposes and must not be construed as investment advice. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer or invitation to purchase, sell or subscribe for in interests in any type of investment product or service. This material does not take into account your investment objectives, financial situation or particular needs. You should read and consider any relevant offer documentation applicable to any investment product or service and consider obtaining professional investment advice tailored to your specific circumstances before making any investment decision. This material and the information contained within it may not be reproduced or disclosed, in whole or in part, without the prior written consent of Magellan Asset Management Limited. Any trademarks, logos, and service marks contained herein may be the registered and unregistered trademarks of their respective owners. Nothing contained herein should be construed as granting by implication, or otherwise, any licence or right to use any trademark displayed without the written permission of the owner. No part of this material may be reproduced or disclosed, in whole or in part, without the prior written consent of Magellan Asset Management Limited.