The Innovator’s Dilemma – how digitalisation and technology represent both a risk and opportunity for businesses

Perhaps the overriding theme in equity markets since the global financial crisis in 2008 has been the strong performance of technology stocks. The tech-heavy NASDAQ Composite Index has returned almost twice that of the S&P 500 Index since the market lows in March 2009. The FAANG stocks, that is Facebook, Amazon, Apple, Netflix, and Google (Alphabet), have returned on average more than 1500% since Facebook, the last of the five to go public, was listed in 2012.

These companies, along with many others, have disrupted more traditional business models through their use of technology, whether it be video streaming, eCommerce, smartphones, or through the superior processing of big data. Therefore, digital and technological disruption has and continues to be an important investment theme, and seeking to identify the future disruptors and the businesses that are most at risk of being disrupted, forms an important part of our investment process.

However, technology, while a risk, also represents a significant opportunity for non-digital native companies. Digitalising a traditional model successfully can come with myriad benefits, including optimising existing operations, moving into new markets, and strengthening a competitive advantage. Executed well it can in hindsight seem to have been an obvious route for a company to take, but it is a path lined with uncertainty, particularly for seemingly well performing, cash generative businesses beholden to the sometimes short-term demands of shareholders.

Netflix itself is an interesting example of a company whose efforts to digitalise its business faced difficulties. The company’s original business model involved the rental of DVDs by mail, and it was very successful. A New York Times article from 2002, discusses the growth of the mail order DVD market due to the difficulties of watching videos via the internet. At the time, Netflix had 670,000 monthly subscribers to whom they were mailing 190,000 discs each day. By 2010, this subscriber number had grown to 14 million.

In 2011, CEO and founder Reed Hastings announced a change in strategy in which the company would split its traditional mail rental business from its relatively early stage service that allowed subscribers to stream video over the internet. Hastings felt that the company’s future was in streaming, however, Netflix customers were not impressed, and neither was the equity market. The company lost 800,000 members, and approximately 80% of its market value in the months that followed. While Hastings would concede that perhaps he had tried to transition the business too quickly, Netflix’s 193 million subscribers and its $233bn market capitalisation confirm that it was streaming, and not its mail order service, that represented its future.

Despite some significant bumps in the road, Netflix can be considered a business that overcame the Innovator’s Dilemma, essentially cannibalising its larger, more established, more profitable business, in order to better position itself for the long term. There are other examples of this, as traditional businesses are increasingly understanding the benefits that can accrue from digitalising operations and investing in technology.

Nike, the world’s leading sportswear company, has invested heavily into its app ecosystem, adopted a strategy that aims to grow its direct to consumer sales, and has pulled back on its wholesale exposure. While reducing wholesale exposure has the potential to negatively impact sales in the short term, the direct to consumer route allows for greater control over product presentation and pricing, and it provides access to the data that is generated by transactions which can inform future product development and marketing. Nike’s apps, which includes Nike Training Club and Nike Run Club, also encourage regular exercise and make consumers feel part of the brand. The strategy has proven extremely successful with digital sales through either the Nike website or the company’s app growing 82% in the first quarter of the 2021 financial year, reaching 30% of the overall sales mix three years ahead of schedule.

Chegg, a leader in online education, is another example of a business that was successfully digitalised. In 2015, just one year after its IPO, the company announced a shift away from its traditional textbook rental business to focus on higher-margin digital services, including e-textbooks, test preparation materials and virtual tutoring. The company had realised that renting out physical copies of textbooks was at risk of becoming obsolete, while being extremely capital intensive. In a move that mimicked that of Netflix, Chegg is now considered a digital business despite its decidedly low-tech beginnings.

Other examples can be found across a range of sectors. In retail, Inditex, the owner of Zara, combines technology with proximate production facilities to have an extremely nimble supply chain that can respond quickly to consumer demands and fashion trends. In the restaurant industry, McDonalds has successfully used technology such as its self-service touch screens to improve sales. It also recently acquired a technology company that can suggest items to customers based on the time of day, weather, and items already selected.

In the utility sector, former state-owned Italian energy company Enel has for years taken a progressive approach to technology. It was one of the first European utilities to seek to reduce its reliance on hydrocarbons and is now one of the global leaders in renewable energy technologies. It has also invested heavily to digitalise its operations, adopting technologies such as big data, machine learning, and automation in order to create intelligent infrastructure that reduces power outages and energy losses through the proactive management of assets and predictive maintenance.

The examples above are evidence that while technological disruption poses a risk for non-digital businesses, the use of technology also represents a significant opportunity for those with the foresight and readiness to make brave decisions in order to transition business models. Arguably the opportunity is the greatest for the largest businesses as they are likely to have the financial strength to make the required investments, the ability to attract the best talent, and the scale of data points which are crucial to informing marketing campaigns, product development and technologies such as artificial intelligence. But for those established businesses, the decision to invest outside of their core competencies is also the hardest. The Innovator’s Dilemma is real, standing still risks being left behind, and, as challenging as it may be, businesses must try to position themselves for tomorrow and not just focus on today.

This note has been produced by Killik & Co on the basis of publicly available information, and all sources are believed to be reliable, but we have not independently verified such information and we do not give any warranty as to its accuracy. Some of the stocks mentioned in this note are covered by Killik & Co’s Equity Research team and others are not. The mentioning of the stocks does not represent a recommendation to buy or sell any securities, and the note is intended as a marketing communication rather than research. This note does not purport to be a complete description of the securities, markets or developments referred to in the material. All expressions of opinion are subject to change without notice. Nothing in this note should be construed as investment advice or as comment on the suitability of any investment or investment service.  Prospective investors should take advice from a professional adviser before making any investment decisions. There are risks with almost every investment that you may not get back the original capital invested. The value of your investments may fall as well as rise and the past performance of investments is not a guide to future performance.