Ask any “brick and mortar” retailer in the past decade what new development has had the greatest (and most adverse) impact on their business, and 11 out of 10 times the answer will be “Amazon” and eCommerce in general. Or ask legacy enterprise solutions companies, which used to rake in tens of billions of dollars every year with customer, client-facing IT and tech solutions, why their stock price has been tumbling in recent years (coughibmcough), and you will hear one word: the “cloud.”
Indeed, we live in a time of tremendous overhaul in legacy business relationships, and while much of this has been driven by the low cost of capital made possible by ten years of ultra low interest rates, much if not all of this deflationary technological innovation is here to stay, with a few (FAANG) winners and many losers, those unable to adapt fast enough to the changing times.
While investors in US equities have had to contend with several major cross-currents over the past year, including the gradual phase out of central bank intervention in capital markets i.e., “Quantitative Tightening”, the favorable impact of the “three arrows of Trumponomics” such as tax cuts, fiscal expansion and deregulation offset by growing fears about protectionism and GDP and EPS-crushing trade wars, even as bank deregulation provides solace to bank investors, a key focus for investors, policy makers and businesses themselves across the globe has been the growing dominance of Internet-based companies as a result of a series of disruptive innovations sweeping across the U.S. economy, presenting investors with another major source of confusion: how to value, and trade, legacy businesses when confronted with disruptors. Alternatively, what is the upside for the disruptors.
As Barclays writes in a recent report, the disruptors (Internet and cloud-based companies, mainly the FAANGs: Facebook, Apple, Amazon, Netflix, And Google) are breaking down moats of the disrupted (legacy consumer businesses and IT hardware & software companies), by dominating the user experience and creating strong moats for themselves in the process. This, according to Barclays, is “leading to a shift in value from consumer discretionary and consumer staples to info tech.”
The various trends and conflicts between legacy industries and new businesses are broken down by Barclays into the following three key types of disruptions:
- Internet is disrupting consumer focused businesses (retailers, cable TV⁄media, consumer staples, consumer PC industry): FAANG stocks are disrupting legacy consumer industries by either modularizing supply or distribution moats of the incumbents and creating strong moats for themselves by owning the user experience.
- Cloud computing disrupting IT hardware and software companies: Amazon⁄Microsoft are the disruptors due to the flexibility and low cost of cloud’s pay-for-use model
- Shale⁄fracking disrupting oil & gas industry and power companies: shale oil & gas revolution and well productivity disrupting oil & gas supply-demand balance
And while Barclays provides a detailed analysis of all three “disruption” modalities, we will focus on the first two – the role of the internet and “the cloud” in disrupting consumer-facing businesses and IT Hardware/Software– as that is the one transition that is of greatest impact to most US consumers.
The Internet as a Disruptor
According to Barclays, historically the competitive advantage of legacy consumer focused businesses depended on either: 1) creating a monopoly⁄oligopoly in supply (creating a “scarce resource” in the process), or 2) controlling distribution by integrating with suppliers. Here, the fundamental disruption of the internet has been to turn this dynamic on its head by dominating the user experience. Barclays explains further:
First, while the mega-tech internet companies have high upfront capital costs, their user base is so large that the capital costs per user are insignificant, specially relative to revenue generated per user. This means that the marginal costs of serving another customer is effectively zero, thus neutralizing the advantage of exclusive supplier relationships that were leveraged by legacy distributors. Secondly, the internet has led to the creation of infinitely scalable networks that commoditize⁄modularize supply of “scarce resources” (thus disrupting the legacy suppliers of those resources), making it viable for the disrupting internet company to position itself as the key beneficiary of the industry‘s disruption by integrating forward with end users⁄consumers at scale.
As a result of the disruption, the user experience has become the most important factor determining success in the current environment: the disruptors win by providing the best experience, which earns them the most consumers⁄users, which attracts the most suppliers, which enhances the user experience in a virtuous cycle. This is also why so many legacy businesses find themselves unable to compete with runaway disruptors, whose modest advantage quickly becomes an insurmountable lead due to the economics of scale made possible by the internet.
This has resulted in a shift of value from the disrupted to the disruptors who modularize⁄commoditize suppliers, integrate the modularized suppliers on their platform, and distribute to consumers⁄users with which they have an exclusive relationship at scale.
This further means that the internet enforces strong winner-take-all effects: since the value of a disruptor to end users is continually increasing it is exceedingly difficult for competitors to take away users or win new ones. This, according to Barclays, makes it difficult to make antitrust arguments based on consumer welfare (the standard for U.S. jurisprudence), but ripe for EU antitrust regulation (which considers monopolistic behavior illegal if it restricts competition).
The Cloud as a Disruptor
Back in the “old days”, on-premise IT Hardware and Software companies built high barriers to entry by creating integrated suites of hardware⁄middleware and application software involving multi-year relationships with enterprises, complete with licensing & support contracts and cash-rich streams of maintenance and service costs. High switching costs and entrenchment through customization of on-premise hardware and software based on enterprise-specific needs resulted in outsized profits for the incumbents. Fast forward to today, when Amazon⁄Microsoft commoditized data center infrastructure, effectively transforming computing resources into storage, computing, database, and application software components running on centralized servers which could be used on an ad-hoc basis not only by their internal teams but also enterprise customers. Here’s Barclays:
The cloud is becoming a disruptive force for IT hardware, software, and the services industry as the cloud’s greater efficiency, flexibility, and lower cost is reshaping IT spending patterns and vendor incumbency. Cloud displacement risk is high for companies participating in storage and servers, followed by managed services and application⁄middleware software as competitive pressures mount from elongating replacement cycle and greater price discounting.
Even for large enterprises and governments, where decades of IT infrastructure and applications make the move from on-premise to the cloud difficult, the cloud’s pay-for-use model is changing how these enterprises evaluate and deploy on-premise IT workloads, and increasing the use of modular and customized IT solutions, which stands to hurt the cash-rich services and software maintenance streams of the disrupted legacy IT hardware and software businesses.
Summarizing these various trends while also highlighting how the “disrupteds” are fighting back, Barclays lays out the following chart below which illustrates:
- The key disrupted industries that have been disrupted by the internet-based companies,
- What were the moats of these legacy businesses,
- How the disruptors commoditized those moats,
- How the disrupted legacy businesses are adapting, and
- Whether the value will continue to shift from the disrupted to the disruptors.
To be sure, assessing the net impact of these innovations on each sector is difficult as in some cases the disruptors and the disrupted belong to the same sector – for example, Amazon and retailers are both in consumer discretionary while Microsoft and IT hardware and software companies are both in info tech. With that caveat in mind, the Barclays summary of the net impact of the affected disrupted sectors is laid out below.