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Dispelling the disruption myth

The Theory of Disruptive Innovation was introduced by Harvard University’s Clayton Christensen and Joseph Bower in 1995 and has proved to be enormously influential when thinking about innovation-driven growth. Business leaders globally have studied the theory intensively to ensure they can appropriately prepare, whether as the incumbent or the disrupter.

Regrettably, according to the original authors, disruption theory is in danger of becoming a victim of its own success:

‘Despite broad dissemination, the theory’s core concepts have been widely misunderstood and its basic tenets frequently misapplied … too many people who speak of ‘disruption’ have not read a serious book or article on the subject’.

The problem is many researchers, journalists, consultants, and investors are using ‘disruptive innovation’ to describe any situation in which an industry is changing. Disruptive innovation then becomes the key selling point for capital raisings (both private and public), funding products or services which don’t remotely fit the real definition of disruption in the first place.

The lure of investing in the next Amazon, Google, Facebook or Netflix is strong, although even genuine disruptive innovations are far from guaranteed to be a success (in the 1990s there were any number of would-be online retailers that disappeared into obscurity) while non-genuine disruptive innovations are high-risk, low-probability investments.

Disruption Theory

According to the original theory:

“‘Disruption’ describes a process whereby a smaller company with fewer resources is able to successfully challenge established incumbent businesses. As incumbents focus on improving their products and services for their most demanding (and usually most profitable) customers, they exceed the needs of some segments and ignore the needs of others. Entrants that prove disruptive begin by successfully targeting those overlooked segments, gaining a foothold by delivering more-suitable functionality—frequently at a lower price. Incumbents, chasing higher profitability in more-demanding segments, tend not to respond vigorously. Entrants then move upmarket, delivering the performance that incumbents’ mainstream customers require, while preserving the advantages that drove their early success. When mainstream customers start adopting the entrants’ offerings in volume, disruption has occurred.”

The theory has been refined and updated over the 24 years since original publication, but the basic foundations remain intact.

Typically (although not always) disruptive competitors tend to start in the low end of the market, where incumbents have lost focus, allowing the disrupter to come in with a ‘good enough’ product. Disruptive innovations are initially considered inferior by most of the incumbents’ customers. Initially customers are not willing to switch to the new offering merely because it is less expensive. Instead they wait for the quality to rise enough to satisfy them. When the disrupter gets their business model right, they then move from the low end of the market to the mainstream, eroding the incumbents’ market share and then their profitability.

Case study: the automotive industry

According to classic disruption theory, the automotive industry isn’t in fact being disrupted despite widespread views that it is. McKinsey and Company calculate investors have poured over $220 billion into more than 1100 ‘disruptive’ automotive companies across 10 technology clusters in the last decade with $120 billion coming in the last two years alone. Fund managers who have participated in these capital raisings write eloquently about their investments in companies like Tesla, Uber, Lyft and Waymo as ways to profit from the disruptive forces reshaping the auto industry. More specifically:

  1. The shift from internal combustion engines (ICEs) to electric vehicles (EVs)
  2. The shift in the economic model of car ownership to on-demand, and
  3. The shift from humans behind the wheel to autonomous driving.

These forces are not technically disruptive, as defined by Christensen and Bower, even though they may eventually lead to fundamental transformation within the auto industry. Transformation in itself is not necessarily something to be feared, particularly when it brings around step-change improvements in an industry. The incumbent manufacturers themselves are largely embracing these changes and are often at the forefront of the innovations that are occurring which makes it very difficult for would be disrupters to win.

1. Electric vehicles

EVs in particular fail to meet the characterisation of a disruptive innovation. Globally, they represent less than 2% of annual sales, although this will certainly climb over time. The technology behind them is well understood and making EVs is far easier than assembling ICEs with fewer moving parts and engineering intellectual property required.

Tesla arguably hasn’t actually changed anything; it has just added to the mix of vehicle choices available to consumers. Tellingly, UK billionaire Sir James Dyson recently announced the scrapping of his EV, not because it was too hard but because the market is too competitive and the economics of making EVs had deteriorated since the original business models were built. Similarly, Chinese EV maker Nio has suffered losses because of lack of demand, battery problems and an ultra-competitive marketplace.

To date Tesla has only participated in the high-end sports car market, which unquestionably hasn’t been ignored by the incumbent car manufacturers. Tesla hasn’t filled a niche in the neglected low-end of the market, thereby failing to meet even the original definition of a disruptive innovation. Tesla’s success to date has been remarkable in that investors have been happy to fund 16 years of losses (because of the poor economics of selling electric vehicles) while incumbent car companies have been developing their EV options in the event the cost of batteries falls far enough to make production economically viable. Any perceived technological advantage that Tesla has is likely to prove ethereal in the face of genuine competition.

EVs today are a hard sell for manufacturers because consumers don’t want them yet. Outside of the high-end market, EVs are expensive relative to ICEs and they have range limitations and charging infrastructure shortcomings that consumers cannot yet stomach. Saving the environment is to the benefit of all, but EVs are unlikely to be the near-term fix for reducing our respective carbon footprints. In Australia, with 20 million cars on the road and 1 million new cars sold every year, even if every new car sold from here on was an EV, we would take 20 years to become fully electric.

Building cars consumes natural resources and creates carbon emissions. EVs are estimated to produce between 1.6x and 2.7x the carbon dioxide of ICEs during manufacturing, which makes a more rapid regulatory push by governments into EVs, from a carbon perspective, counterproductive. The carbon payback on a new EV is estimated to range from 1.6 years to 17 years depending upon the assumptions regarding the size of the EV battery, power sources (coal, gas, wind, solar etc.), mileage driven and the type of ICE vehicle you drive now.

2. Car ownership models

Car-sharing models have been around in Australia since 1993 and globally since the 1940s. The economics of car sharing is compelling when you consider that the average car is utilised only 5% of the time and that the average Australian household spends around $350 per week on car ownership. This type of inefficiency makes technologists quiver in outrage. Globally, car sharing has grown strongly from an estimated 38,000 vehicles in 2012 to 332,000 in 2018 (although this is a negligible percentage of the 1.2 billion cars owned globally). Despite the growth, ride share companies have found it difficult to create a path to profitability. Indeed, one of the largest companies ShareNow (co-owned by BMW and Daimler) has announced it is pulling out of the UK and North America. Despite having 90 million users of its ‘mobility services’ apps, ShareNow has failed to make car-sharing viable because of the “volatile state of the global mobility landscape” (too much competition) and the “rising infrastructure complexities facing North American transportation”.

Ride-sharing companies are in the same boat. Despite expanding the market beyond traditional taxis, large companies like Uber and Lyft are funding billion-dollar losses every year with no clear route to profitability. This user price subsidy no doubt builds customer numbers but is ultimately unsustainable without material changes to the business model through higher service prices or much lower costs. Driverless cars would help (drivers being the biggest cost), and this is the long-term panacea for Uber and Lyft investors. However, it is now clear that this technology is much further away than previously expected which may explain why the share prices of both stocks are down 30% and 45% respectively from IPO.

This technology itself isn’t disruptive, despite expanding the ride sharing industry, because it is unlikely to create a genuine alternative to car ownership in the foreseeable future.

3. Autonomous vehicles

Multiple autonomous vehicle trials are happening around the world at present with the leader being Waymo, Google’s self-driving vehicle arm, announcing the completion of 20 million miles of testing in 2020. More than 30 private companies are working on technological advancements to assist autonomous vehicles which are commanding record levels of investment and funding. In addition to start-ups and small tech companies, large companies are also focusing on the future by advancing their thinking and knowledge. Companies like Apple, Bosch, Intel, Volvo, Tesla, Ford and Huawei are all working on technology to support a future of autonomous vehicles.

The hype surrounding autonomous vehicle technology has softened over the past 18 months or so. As recently as 2017, the NRMA was forecasting that by 2022 we would achieve Level 4 autonomy, meaning the driver would no longer be needed (except in extreme circumstances), and by 2025 we would have full autonomy where the car wouldn’t even have a steering wheel. Since then the technological challenges have proved to be far more significant than previously thought and governmental regulatory requirements are enormous. Level 5 is now considered possible by 2040 but there are still many hurdles ahead.

The engineering challenge has been described by Waymo executives as “…more difficult than landing people on the moon” and the president of Cruise (General Motors’ self-driving car company) described employing an autonomous fleet as “10,000 times harder” than demonstrating how a single vehicle can drive around the block.

Even autonomous vehicles may not be a disruptive technology. They may certainly change the way we drive, reduce the dreadful road death toll and may improve the existing utilisation rates of vehicles. This final point could have an effect on the numbers of cars manufactured each year and who the end customers are (being possibly big fleet owners rather than individuals) although it is not a given. Whatever the case, cars will still need to be manufactured and cars that are utilised 80% of the time presumably will need to be replaced more often than cars that sit idle 95% of the time. Without huge retail distribution costs, car company margins would improve although they may give a lot of that away to the big fleet buyers in the form of lower prices. Even so this is evolution not disruption and not something to be terribly fearful of.

Why does this matter? The BMW example

The simple answer is that if you view the auto industry (or any industry for that matter) through an evolutionary lens rather than a disruption lens then you get a different view of the future of the incumbent car companies and their respective intrinsic values.

For example, today BMW is as cheap as it has been for 40 years. Why? Well, the cycle has turned and could get worse. Europe is enforcing strict emission standards on car companies that will mean large fines if they fail to meet them.

But far more telling are the disruption fears that have gripped the industry. If you assume the last point is incorrect then the outlook changes considerably and it looks like business as usual for BMW. The company has been through cycles before and despite those cycles it has compounded revenue at 8% per annum since 1980 and profits at 12% pa. Also, because BMW is a premium brand, their ability to pass on costs of the emission standards to customers is much stronger than their mass market counterparts. BMW is well positioned in EVs (selling as many as Tesla globally) and has a very profitable auto financing business and €20 billion in net cash. Despite this, it only has a market value of US$49 billion compared to Tesla which is valued at US$140 billion (with $10 billion in debt). If BMW only trades back to the valuation multiples it has historically then the share price could triple.

If our thesis around disruption is wrong, what are the consequences of owning BMW? At its current valuation we believe you are paying for the financing business and the cash and getting the car business for free. Envisioning a scenario where the BMW car business is worthless is very difficult. Interbrand ranked BMW as the 11th most valuable brand globally in 2019 ahead of tech names like Intel, Facebook, Cisco and other consumer brands like Nike and Pepsi. BMW is well positioned already in EVs and has significant investments in mobility services. With its premium consumer brand, BMW is likely to be a key player in the automotive industry for the foreseeable future whatever form the industry will take.

Contrarian views can reveal opportunities

Investing in genuine disruptive technologies like Google, Amazon, Netflix and Facebook has been extraordinarily profitable, particularly in the past 15 years. Studying those innovations in detail to determine what made them succeed is important for determining whether other innovations could potentially follow a similar path. Blindly assuming technologies will be disruptive when they are not will likely result in poor outcomes when investing in the technology itself or avoiding good incumbent businesses which aren’t actually facing disruption.

Challenging consensus views is never easy, which is why it isn’t that popular, but done properly it can deliver exciting opportunities. Thinking beyond the seemingly obvious is a powerful way to deliver above average returns.

 

Charles Dalziell is Investment Director at Orbis Investments, a sponsor of Firstlinks. This report constitutes general advice only and not personal financial or investment advice. It does not take into account the specific investment objectives, financial situation or individual needs of any particular person.

For more articles and papers from Orbis, please click here.

 

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