November 25, 2013 – TMT: How the Mighty Can Fall
We believe that TMT is in the midst of a once-in-a-generation sea-change paradigm shift, driven by mobile platforms, cloud computing, and wireless broadband. The last such shift, catalyzed in the ‘80’s by PCs, cell phones, and telephone/cable deregulation, drove waves of disruption. The first direct wave hit office systems, long distance pricing, and independent TV. As the innovations matured, a second wave wiped out minicomputers, PBXs, and paging services. The combination of competitive telecom and affordable PCs spurred the consumer internet and a powerful third wave that crushed residential landlines, newspapers, record production, yellow pages, book/music retailing, and video rentals, amongst other multi-billion dollar businesses. The death of these sectors is instructive – the time between the emergence of a disruptive alternative and impact on company performance often takes years, depending on the pace of development and on infrastructure, scale and network dependencies, but deterioration is swift once it begins. We expect similar waves from the current sea-change, the first having already smashed cell phones and consumer PCs. Many industries, such as channelized TV, data center systems, infrastructure software and enterprise applications, sit in the lull between the emergence of the threat and the swift deterioration. Others, like credit cards, health care diagnostics, grocery retail, automotive electronics, and personal banking, have yet to see real threats but stand in the logical path of future innovation. We believe that investors in all of the threatened industries should be vigilant for signs of deterioration and skeptical of turnaround plans which, historically, have seldom worked.
Paradigm change in TMT is driven by contemporaneous, mutually reinforcing innovation. Clay Christenson’s theories define a process by which innovative products, which initially cannot deliver qualities inherent in incumbent products but address niche demand at lower prices, evolve to disrupt the established market. We believe that multiple disruptive innovations, along with major regulatory policy changes, playing out in a close time frame can catalyze generational paradigm shifts as the individual disruptions develop and reinforce each other to drive faster and more wrenching industry changes than are historically typical and, than are typically anticipated by markets.
Generational shifts proceed in waves that destroy incumbent business models. TMT has experienced phoenix-like rebirth on a rough 25-30 year innovation driven cycle. We believe that such a cycle is underway now; driven by mobile platforms, cloud data processing, and wireless communications. The previous cycle, catalyzed by early ‘80’s introduction of competitive telephony, PCs, cell phones, and cable deregulation, created most of the top performing stocks of the subsequent two decades, while laying waste to traditional industries in a series of waves. The first wave hit businesses directly competitive with the initial use cases of the innovations – long distance service, office productivity systems, and independent TV stations. A second wave, as the innovations matured, hit mainframes and mini-computers, PBXs, paging, and TV broadcast affiliates. Eventually, the interplay amongst the catalyzing innovations yielded the desktop Internet, which precipitated the fall of residential land line telephone, newspapers, CDs, yellow pages, book stores, travel agents, and other businesses.
Waves take years to hit, but deterioration is swift. The time between the introduction of an innovative alternative solution and its impact on the stock price and financial results of incumbents is typically years. For product categories where the substitution by the innovation is direct – e.g. word processing systems by PCs, paging by text messaging, or feature phones by smartphones – the effect may follow in a year or three, but for solutions that require further development, infrastructure, scale or behavior changes to compete directly – such as client/server architecture, IP telephony, cable networks, search advertising, and others – damage to incumbents has typically taken 3-6 years to register. However, once the effect on incumbent businesses begins, the fall has usually been harsh – e.g. mini computers, pagers, newspapers, CDs, etc.
Few incumbent businesses survive an innovation wave. There are, essentially, no mini-computer makers, long-distance carriers, PBX makers, paging companies, or independent TV broadcasters left. The companies that made it across the paradigm shift were able to do so, not because they could keep a dying business model alive, but rather, because they launched other businesses that could exploit the same waves of innovation. For every IBM and HP pivoting from minicomputers to PCs, there were many DECs, Wangs and Data Generals. For every Ericsson that made up for the implosion of circuit switching with its wireless business, the NETs, Rolms, Lucents, and Nortels were legion. All newspapers have suffered, as have the book publishers, the recorded music labels, and the book/record/electronics retailers.
Threats from the current generational shift have emerged. iOS/Android have killed off the rivals that couldn’t adapt – Palm, Blackberry, Motorola and Nokia are all casualties, and tablets have extinguished consumer demand for PCs. Cloud data centers hurting server demand and slowing growth for all other categories of data center systems and infrastructure software. TV audiences are now declining, with viewers defecting to streaming video – this will accelerate, as will cord cutting, with ad dollars responding in due time. With new spectrum and new technology, wireless operators can deliver higher speeds and greater capacity – they will challenge for residential broadband before decade end. Further out waves threaten credit card payments, grocery retail, automotive electronics, health care diagnostics, personal banking and finance, and other areas yet to be imagined.
Investors must be very cautious. Because the effects of generational change can be slow to materialize, industry executives and analysts are typically inclined to dismiss the potential for future impact, often leading to strong market performance ahead of a wave. However, once demand shifts take root, they typically metastasize quickly, leaving investors little time to react appropriately. Historically, turnaround efforts often centered on radical cost cutting or buying into new businesses with M&A, have had a poor record of success. Proactive companies that have built new businesses poised to exploit opportunities created by the shift have fared much better, but only where commitment has been strong and early.
For our full research notes, please visit our published research site.