The Silent Disruption: Why traditional car makers and customers will get an Electric Shock! Part II

Part II: The incumbent’s perspective

Last week I wrote about why customers don’t appreciate the rate of change in disruptive technology until they experience it.  But it doesn’t stop there. Like their customers, established companies under threat from disruption tend to miss it too. And this feeds into the mainstream media, who are naturally attracted by the fallacious appeal to authority of the established brand names…. Surely if anyone knows, [insert established brand] would know!?

Despite the rapid advance of EVs in relative cost and performance terms, internal combustion engine (ICE) manufacturers still see electric vehicles (EV) as a small market, with negative margins which most of their customers don’t want. Why?

Clayton Christensen observed this behaviour repeatedly in his study of why great businesses with excellent managers fail to adapt to disruptive technologies. And just like their customers, it’s not because they’re idiots!

“It is in disruptive innovations, where we know least about the market, that there are such strong first-mover advantages. This is the innovator’s dilemma. Companies whose investment processes demand quantification of market sizes and financial returns before they can enter a market get paralyzed or make serious mistakes when faced with disruptive technologies. They demand market data when none exists and make judgments based upon financial projections when neither revenues or costs can, in fact, be known…Discovering markets for emerging technologies inherently involves failure, and most individual decision makers [within established bureaucracies] find it very difficult to risk backing a project that might fail because the market is not there.” – Clayton Christensen

Given the news last week that Telsa will build their European manufacturing facility ‘Gigafactory 4’ in Berlin, recent statements from BMW executives are extra ironic. I suspect that those who laugh at EVs and Elon Musk now will look back and laugh at ICE companies and Klaus Frölich in a few years. For now, such comments are usually taken as evidence that EV adoption will be slow. In a disruptive context however, dismissive comments like this are entirely predictable. Indeed, when viewed against the recent EV unit growth in all markets (1) and the fact the Tesla has not spent a single dollar on traditional advertising to date, I think they are a very positive contrarian signal. The quote below was sourced from a Forbes article in June 2019:

“There are no customer requests for [EVs]. None,” BMW’s director of development, Klaus Frölich, told a shocked round-table… “Europeans won’t buy these things… From what we see, [EVs] are for China and California and everywhere else is better off with plug-in Hybrid Electric Vehicles with good EV range.”

I believe the chart below is insightful when assessing the prospects of EVs. It tells me two things. 1) The demand is very high because people are willing to spend more than normal to purchase the item and 2) The addressable market is much bigger than most people think.

So it won’t surprise you to learn that I think Frölich is missing the biggest disruptive shift in automotive history, but I also believe he is overstating the role of hybrids in the transition. Why? Whilst it’s natural to cling onto the technology you know, pure EV costs will inevitably be lower than hybrids over time due to predictable cost reductions. These are reductions which can’t be achieved when combining both technologies, due to the complexity of doing so and the compromises needed. ‘Inevitable!?’ I hear you say ‘That’s a bold statement!’ Perhaps so, but in the context of history, I don’t think it’s that bold.

Source: SS Savannah 1819 (The first hybrid “steam ship” to cross the Atlantic).

Next week I will explain why EV costs will keep falling and performance will keep improving in the part III, the final act in the Trilogy of the Silent Disruption.

Source: European EV growth rates
https://insideevs.com/news/373420/august-2019-plugin-ev-car-sales-europe/
https://insideevs.com/news/373278/plugin-car-sales-europe-h1-2019/
Tesla surveys
https://www.bloomberg.com/graphics/2019-tesla-model-3-survey/market-evolution.html#intro

 

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas.  He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience. *As at 30 April 2019.

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The Silent Disruption: Why traditional car makers and customers will get an Electric Shock! Part I

Part I: The customer perspective

 “If I’d asked people what they wanted, they’d have said a faster horse”– Henry Ford

 To most people, this quote from Henry Ford is a funny quip. It’s fun to look back and laugh at the silly old people of the past who thought cars would never replace horses.

But if you know how disruptive innovation works Henry Ford’s point is a serious one.

The reality of America in 1900 was that cars just didn’t make sense to most people. There were no gas stations. Roads were mostly mud or gravel tracks. There was no highway system. Cars were unreliable and very complicated pieces of machinery… and whilst black smiths were plentiful, there were no motor mechanics. Cars were too expensive for most consumers and considered ‘vulgar’ by those in high society. They were also noisy and not much faster than the average horse. The Model T Ford only had 20 horse power and a top speed of 40 mph. There were no traffic lights or laws governing how to drive. In fact, such were the barriers to adoption that Ford constructed a highway and gas station network to facilitate demand (1) and the Ford Motor Co. internally produced everything, because there was no established supply chain. How could there be?

As a result of these bold strategic moves, The Ford Motor Co. dominated the market for decades.
Source: Tony Seba, Stanford University

One paradox of disruptive innovation is that the customer is not always right. That’s because the average customer does not closely track the rate of change in disruptive technologies. In fact, it is normal for people to underappreciate the rate of change in a new technology that they do not yet use. Customers certainly can be fickle however, and whilst initially sceptical and resistant to the friction inherent in change, they will quickly flip when the perceived benefits outweigh the barriers to adoption. As Clayton Christensen observed in his seminal book ‘The Innovators Dilemma’, this can be confusing for the incumbent companies who closely track their customer’s desires.

“Most companies with a practiced discipline of listening to their best customers and identifying new products that promise greater profitability and growth are rarely able to build a case for investing in disruptive technologies until it is too late.” Clayton Christensen


Source:Innovators Dilemma, Clayton Christensen: Sustaining (i.e. incumbent) technology improves slowly vs. disruptive technology

I believe Electric vehicles (EVs) have quietly moved to a place where they outperform internal combustion vehicles (ICE) on almost every performance vector (2) without most people realising. Indeed, on an apples-to-apples comparison today, the only vectors on which they don’t, is fully loaded range and refuelling speed. And I stress today, because as we’ll see in part III, these frictions will be solved too. In this context, Elon Musk has a proverbial ‘walk in the park’ compared to Henry Ford. Furthermore, his conviction to rapidly expand global production, the Tesla charging network and service centres should make a lot more sense to the cynical naysayers and incumbent competitors.

Yet many traditional car makers still don’t see EVs as a meaningful threat to the status quo. Yes they’re improving but they are still a niche market and will be for decades. Next week I will explain why – like they’re customers – they are blind to this disruptive shift. And as you’ll find out, it’s not because they’re stupid.

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas.

He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience. *As at 30 April 2019.

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[Video] Insulin Prices in America. What the…?!

Insulin prices in the US have gone up by 1171% over the last 20 years. Patients pay half, insurance companies pay half- and they employ a middle man to negotiate the price down and prevent price rises. So, how has this price increase happened? Craig Bonthron tells us why this greed will catch up with companies in the long term, and talks about the sustainable companies disrupting this trend.


For a more in-depth analysis of the insulin situation in the US see our two-part blog here: part 1, part 2

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas.

He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience.  *As at 30 April 2019.

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#ClimateCrisis/GDP=#DIV/0!

Today we’re witnessing a global Climate Strike led primarily by children because – according to science – the future of our planet is in peril. So it’s probably a good time to ask why most of us are willing to carry on our daily lives as normal. I don’t mean to be melodramatic here… it’s a genuine question. We are all guilty parties and my behaviours are probably no better than the average developed market human (i.e. bad).

Is it wilful ignorance? Is it political intransigence? Or is it corporate conspiracy and media manipulation that prevents change?  Some studies in behavioural psychology indicate that being able to ignore or suppress the really bad stuff is a helpful evolutionary trait. It helps protect us against hopelessness and depression. Perhaps it’s that!  But what if it’s not about ignorant politicians, propaganda or evolutionary mental health? What if it is just about time? I mean to say, that what if the future just doesn’t cost us very much?

Catastrophic climate breakdown imminent…..

The legendary investor and environmental campaigner Jeremy Grantham calls this “the tyranny of the discount rate”.  What does he mean by this? It’s a way of saying that by systematically discounting the value of each future year, we are making it less important. And this is a tyranny because it engenders a kind of future blindness.  When we are dealing with multi-decade or multi-century problems, our reaction is kind of… ¯\_(ツ)_/¯

We live in a world largely measured on the wrong short-term measures of value. I addressed this in GDP’s Dirty Little Secret, because this measure of human economic prosperity is clearly not fit for purpose. But when measuring the value of human achievement according to this measure you suddenly learn that human achievement is apparently worthless. Worth nothing! Not less than it should be or shockingly little….. N-O-T-H-I-N-G! The arithmetic is very simple, and it plays out in the chart below.


Source: Source: Kames Capital. * World Bank global GDP estimate of $84.8 trillion US dollars in 2018

On this economic basis, the economic value of my future grandchildren is literally inconsequential today. The history of our planet is measured in billions of years, yet the future value of its current economic output is worth zero in the blink of a geographer’s eye.

Climate catastrophe according to economists

Imagine this global protest against climate change shut down air travel for one week. Imagine that it cost airlines $6.5 billion in lost revenue (3 million flights a day x $300 a ticket). Imagine the second order multiplier effect on business and consumers worldwide amounted to 80 times that cost (a wild exaggeration). The lost GDP now with 100% probability and zero discounting applied would be $526.5bn. There would be a lot of angry people out there. Very angry! But ultimately, this is one week of lost air travel and we would survive it.

But then imagine there is a 90% probability of catastrophic climate breakdown in 50 years. And imagine that the estimated cost of that catastrophe is 50% of global GDP. This is “apocalyptic-nightmare-end-of-civilisation-and-perhaps-our-species” type stuff. Yet, discounted at 8%, this future event only costs us $540 billion in today’s terms. The same as the hypothetical air travel strike above. That’s about half the market value of Apple Inc. today or 0.6% of global GDP. And if catastrophic climate breakdown can be pushed out another 50 years by buying electric cars and eating less meat, that particular catastrophic climate breakdown is only worth $8.4bn in 2019 or 0.001% of today’s GDP. Just a few years on from that and the cost of climate breakdown / GDP = #DIV/0!

 In defiance of tyranny

“The market mechanism does not solve for the appropriate allocation of attention when everything is seen through the lens of capital. Human history is littered with misallocation of attention.  From the Aztecs to Easter Island, we have a habit of being distracted and seeing the scale of a problem too late”   Albert Wenger (Investor & Author of World After Capital)

We are guilty as charged. But whilst children strike, we’ll try to do our (tiny) bit by allocating our client’s capital as sustainably as we can and shouting about it from our small soapbox. We will try to back companies which we think have the best chance of disrupting the status quo and pivoting us to a non-catastrophic (and perhaps even wonderful) future beyond the next quarterly reporting season. But let’s be realistic, this tyranny of future blindness that we have built for ourselves needs an overhaul. Our species is having more impact on the world than any other in the last 4.5 billion years. We need a new framework for thinking about the future costs of the damage being done today. One which is measured in geologic rather than socioeconomic timescales. Our current decision making system which is anchored to a flawed concept of economic value and discounted to nothing in a human lifetime is not it. But neither is anarchy. Anyone got any good ideas? I’m thinking they probably need to be radical, collaborative and disruptive.

#ClimateStrike

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas.

He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience.

*As at 30 April 2019.

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Insulin prices in America. What the……!? (Part 2)

In last week’s blog (Part 1) we tried to answer the complex question of what is flawed with current insulin pricing system in America. But that left out one vital bit- the why. This week I want to explain why it is so dysfunctional and how the forces at play – given the wonder tyranny of compounding – are so opaque in the short term, yet so aggressively malevolent over the long-term.

Inverted Incentives
Let’s cut to the chase. A reduced rebate rake on a very big market generates much more revenue than an increased rake on a small market. Think about that. This means Pharmacy Benefit Managers (PBMs) are incentivised to increase the size of the market and the best way to do this is by allowing price rises. Yes, you read that correctly – the party designated to negotiate prices down, benefits from prices going up! And this is not a socialist conspiracy theory, this is widely recognised by the sell-side analyst community:

“The rebate basis of the system has a fundamental conflict of interest which has perversely encouraged high list prices for drugs (and concomitant price increases)…. Thus the theoretical fiscal sweet spot for PBMs are high priced drugs, with high rebates and high co-pays….[this is the] “frictional costs” in the drug pricing ecosystem as money (ultimately) paid by the “society” for drugs that do not end up as revenues for Biopharma companies.

-Analyst, Evercore ISI

A Case of Compound (Self) Interest
Why has this been allowed to happen?  We could stop here and just blame lobbyists but that would be too easy. Fundamentally, it happens because the slow-acting and pernicious effects of compounded inflation falls under the radar in the short term. And most things are managed on the short-term. The average human generally struggles to comprehend the non-linear power of compounding, so how can we expect politicians – managing a short-term electoral cycle and influenced by well-funded lobbyists – to fare any better?

I have built a quick model to show how the math works and the chart below is the output. I have used the real price rises per vial of insulin. To show the extent of the inverted incentives, I have assumed the drug price discount actually increases from 50% to 70% and that the PBM rake declines from 20% to 15%. Despite these ‘improving’ terms, the compounding effect of the annual price increases still mean that the revenue growth for drug companies and PBMs is inordinately large.

Insulin prices: Company revenue share & patient costs


Source: Kames Capital
Note: General US inflation between 1997 and 2017 has been +55.6% or a compund annual rate of 2.2%
CAGR = Compound annual growth rate
Vial = 10ml or 1000 units (approx 1.5 vials used per month on average)

The illusion of ‘improved’ terms offered by drug suppliers and PBMs is very important for this political narrative. Mr Machiavelli would be impressed. They can point to these as proof that they are ‘doing their best’. Short-term discounts and reduced rebates rakes are much more intuitive than non-linear compound interest.  Drug makers and PBMs can reasonably claim to be offering bigger percentage discounts and taking lower percentage rebates rakes, all while seeing their revenues, patient prices and the frictional costs paid by society grow massively.

Conclusion: Societal Friction Leads to Disruptive Innovation
This is a remarkable system and a sorry state of affairs, however I believe the historic ‘market forces’ narrative behind the current US healthcare system is running out of road. The statistics have been conflated for too long. The absolute dollar burden on society – not to mention the very real and painful costs to individuals that are so often wilfully overlooked – is becoming too large to ignore. Value based care. Regulation. Populist revolts. I believe these will increasingly pressure the valuations, revenues and cash flows of the companies that have been systematically over-earning from patients and society. The duplicity will become common knowledge. But it won’t stop there.

Disruptive innovation is naturally attracted to such problems and it is here that market forces still have a say. The outrageous frictions caused by a rigged system ultimately create opportunities for mission orientated disruptive entrepreneurs. Indeed, we are already seeing numerous young and innovative companies challenging the norm and leveraging technology to provide better and more cost-effective outcomes for patients. These types of companies have eminently more sustainable business models and are the ones that I think will be the long-term winners in the health care space. They will be supported by those advocating change.

It is undoubtedly true that the change cannot come quickly enough. Sadly, it is too late for many but in the words of Sam Cooke, ‘A Change Is Gonna Come!’ Actually, that would have been a good title for this blog too – and a much more positive one.

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas.

He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience (as at 30 April 2019).

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