Disruption – Thinking Deeper

Disruption – Radical change to an existing industry or market due to technological innovation

The key words here are “radical change” and “technological innovation”.

In the first decade of this millennium, disruption was spoken of only in certain technology circles.  Starting with 2010, it has become a buzzword that almost every investor considers while evaluating  prospective investments. The rise of the data economy has more or less cemented the “threat of  disruption” as one of the more important risk factors to be evaluated while evaluating the quality of a  business.

In the context of Indian investing, the rise of the new age businesses only commenced in the latter part  of the 2001-2010 decade. We did not really have great data infrastructure till the beginning of the next  decade, once that took off, so did the adoption of these new age businesses.

Make no mistake, the threat of disruption is real. But is the threat equally potent across industries or are  there some industries that are more susceptible to disruption?

In this note, we look at a couple of industries to see if/how disruption has affected them. The objective  is to consider a few examples and use them to see if one can abstract learnings at a higher level and  make them generic enough to use in the business analysis framework.

Technology driven disruption tends to first target the mass market with low hanging fruits where you have a large homogenous customer segment

PayTM money, ET Money, Flipkart, Groww, Scripbox are all investing to capture mass & affluant segment

Ease of investing & Participating in a growing market are the early themes that will play out

Reducing expenses & Better way of investing will only follow at a later point of time

Within the same overall industry, we have some segments that are getting disrupted while there are  some others that are unlikely to get disrupted any time soon.

Thinking in terms of industries or sectors may not be the right construct in the context of  disruption, one always needs to look deeper and identify segments which are more prone to  getting disrupted

Change in colour – No

Change in material – Minimal

The notable change that has happened is that the industry has shifted towards the organized segment.  Innerwear has now become a lifestyle decision and not just a utilitarian decision. At most, the channel  through which customers buy might change over the next decade but there is not going to be much of  technology led change in the industry. This is a characteristic of the industry itself and rubs off onto the  industry players.

As long as an incumbent ensures presence across channels and manages to build a respectable  brand, the risk of the business model getting disrupted is not high in this industry.

Now ask yourself why does Page Industries (market leader in innerwear) command a PE multiple of 55+  while ICICI Direct (one of the leaders in equity broking) trades at less than half that multiple?

There is always a method to the madness, valuation multiples always reflect the longevity profile of the  particular industry/business. Higher the longevity, more the willingness of investors to accord a higher  terminal value for the business. All other things (market position, growth, capital efficiency) remaining  the same, a higher longevity means a higher valuation multiple and vice versa.

Pick any business in India that trades at earnings multiple higher than 55 today, chances are that the  longevity profile of that business is equally impressive.

I am not in the business of content generation, neither am I a strategy consultant who has an incentive  to write 20-page case studies covering multiple industries. The primary objective of whatever content I  produce is to enhance the business analysis framework that I have and to make it more comprehensive  over time. My objective (and I guess of anyone reading this) is to become a better investor, for this  reason inferences matter more than the details of each specific case.

One can consider more industries to see what the impact and source of disruption has been. I would  accord more importance to identifying some common trends that can help evaluate the risk of  disruption when one gets down to analysing individual businesses.

With this context in mind, one can make the following observations

• There needs to be a good enough incentive for someone to make the effort of disrupting  the status quo. You will rarely see a 500 Cr annual market get disrupted, the juice has to be  worth the squeeze. No sensible investor will help fund disruption when the addressable market  size and the profit pool aren’t large enough to justify the effort involved.
• Information based economies/business models are more likely to get disrupted than are  brick and mortar-driven businesses. This is obvious to anyone who observes the world  closely. The risk of rapid technology obsolescence is highest in information-based economies. An information economy business that gets disrupted dies out in a few years’ time. Network  effect-based businesses are tough to disrupt but once disrupted, they rarely survive.
• It is much easier to acquire market share through freebies and discounts in industries  where the decision making is completely in the hands of the end consumer. It is not as  easy to acquire market share where influencers are present (like advisors, contractors,  carpenters etc) and there is a substantial installation/service component to the product. A  standalone plug and play product is more likely to get disrupted than a product that has  dependencies.
• Emergence of concentrated buying centres is a serious threat that can eventually disrupt indirectly. For all the noise that e-commerce players have made in India, they just offered a  more convenient way of buying existing goods and services initially. But once they owned a  captive customer base and the distribution network, they launched private labels which can eat  into the profit pool of the incumbent brands. If not anything else, the power balance between  the brand and the channel partner has been changing. Malls did the same to brands before the  e-commerce hit the street.
• The most dangerous kind of disruption (from the point of view of an incumbent) is when  the disruptor has a radically different cost structure compared to the incumbent. Once  the market tips, the incumbent just cannot compete with the newer model unless they adopt  the same model; this is easier said than done. The wealth management industry, especially at  the retail and emerging affluent segments is at a serious threat of disruption from robo advisers  over the next few years for this very reason. The cost to income ratio for a robo adviser beyond  a threshold scale can keep falling for decades. Once they have enough organic cash flows to  fund their customer acquisition cost, it is game over for the traditional model.
• Emergence of concentrated buying centres is a serious threat that can eventually disrupt indirectly. For all the noise that e-commerce players have made in India, they just offered a  more convenient way of buying existing goods and services initially. But once they owned a  captive customer base and the distribution network, they launched private labels which can eat  into the profit pool of the incumbent brands. If not anything else, the power balance between  the brand and the channel partner has been changing. Malls did the same to brands before the  e-commerce hit the street.

True disruption is one that incumbents struggle to cope with even if they have good managers. A lala company losing the race to a contemporary company is not disruption, it is more likely a  case of lazy/bad management.

Of all the combinations, a network effect prone business model that gets disrupted is most likely to be  a disaster for the incumbent. See what Facebook did to other budding social networks like Orkut.

What Zerodha did to incumbent equity brokers in India is commendable but not mortally wounding,  incumbent brokers are still growing profitably and are able to adapt. They are also able to wean business  away from the smaller brokers and are trying to pivot into digital financial marts going forward. If you  have an incumbent customer base that has lakhs of rupees in demat with you, why not sell them loans  and other products in exchange for a fee at minimal incremental balance sheet risk? You have some  new age businesses who are paying astronomical customer acquisition costs to build a base of affluent  Indians while those who have ready access to them have been twiddling their thumbs for a while.

While Amazon is obviously the rage all around, Walmart is very much around and competing. They have  been wounded no doubt but they aren’t dead by any means yet, contrary to what some were saying in  2015. One can’t say the same about the marginal players in the industry though.

The threat of disruption is real but it can sometimes be over rated and over hyped. Some industries and  segments are prone to disruption while some others rarely get disrupted. The ability to make this  distinction and to identify the reasons for the same is an important skill in business analysis and  valuation.

Marginal players dying out is part of the capitalism cycle, but when the incumbent market leader starts  looking irrelevant in a short span of time, that is true disruption.

A careful look at the unit economics of the incumbent and disruptor should be able to reveal the game  that is going on. Unless a disruptor starts changing the unit economics of the incumbent for the worse,  it rarely causes mortal wounds.

It eventually comes down to industry structure, entry barriers, profit pools and unit economics. The best  VC’s never get carried away by technology that looks good and sounds swanky unless that solves a real  customer problem and can address a large market. They start by estimating the size of the pond and  then get down to evaluating how well the team can execute in scaling the business, once the concept  gets proven.

Disruption by itself does not mean anything unless one can see the $ it can bring in as a result.