COVID, Technology, and Transformation
VOICEOVER: Welcome to Lord Abbett’s Market Update. I’m Tony Fisher.
Lots of people are familiar with Amazon and Google and Microsoft and Facebook. That's almost five trillion in market cap. But there's another more than 50 companies selling cloud software.
SO YOUNG LEE:
So the backdrop in the media landscape is that there has been a lot of cord cutting with cable and pay TV.
Basically overnight, grocery delivery went from 2% penetration to double digit.
STEVE WORTMAN: You continually have to spend on R&D to stay relevant in a world that is quickly innovating.
VOICEOVER: In our podcast today, Matt DeCicco, Managing Director and Portfolio Manager for Lord Abbett’s Innovation Strategies is joined by a diverse team of analysts to share their insights on the astonishing changes in technology that are shaping the post-COVID world. We’ll look at these trends- and their implications for investment portfolios for the months ahead. *audio ends*
To say that the year 2020 has been a roller coaster ride would be an understatement. In an attempt to understand these up-and=down shifts in the market, Lord Abbett’s Innovation Investing team has been tracking several of what they’ve dubbed “huge megatrends” in the current economic environment. Matt DeCicco explains.
DeCicco: Coming into the pandemic, the Lord Abbett Innovation portfolios had significant exposure across a number of secular megatrends, which we will talk about today. These megatrends, or themes, are cloud computing, software as a service, video streaming, e-commerce and digital payments, to name a few. The themes expressed in our portfolios are a result of our stock selection process, in which the companies that we have the highest conviction in earn the most capital. So the themes we identify are discovered in a methodical way. Built from the bottom up, so to speak, and will change over time, as the companies we identify change. The pandemic has served to steepen the slope of the adoption curve of these megatrends. So we will talk about that today with our experts.
VOICEOVER: First up, Megatrend number one: Cloud Computing. To kick off this discussion, DeCicco poses an intriguing question.
DeCicco: It's been pretty amazing, how quickly the world was able to adapt to the volume and urgency of the work from home and stay at home demands during the pandemic. Could this have been possible ten years ago, if the pandemic had struck at this size back then?
VOICEOVER: The answer was provided by Lord Abbett’s expert who follows cloud computing.
BEN EBEL: Hi, I am Ben Ebel, research analyst. I'm responsible for technology for Lord Abbett's Innovation Growth Team.
VOICEOVER: Ebel approached the question by tracing the evolution of cloud computing.
Ebel: Luckily, we had the infrastructure in place to handle this today. Not just the number of consumers on Amazon and competitors like Wal-Mart and Target to handle the volume, but also on the infrastructure side. You see, several years ago, in the early days of cloud adoption, companies were reluctant to move their businesses into the cloud. Corporations had concerns about putting their sensitive business information and customer data into the cloud.
They were worried about security, reliability, speed, access, customization. But in the interim, the physical network infrastructure was being put in place to carry this huge network demand coming from very fast-growing consumer internet cloud companies.
Companies like Amazon and Facebook and Google, as well as a small select group of commercial cloud companies, like Microsoft and Salesforce CRM. And what this did was built out the backbone of telecom and internet bandwidth that offered not only the reliability and speed, but the geographic coverage and reach. And then on top of that, there was this new cloud computing architecture called Multitenant. It had been created and adopted by many cloud companies, not just the Amazons and the Googles, but dozens of smaller companies to provide purpose-built business applications for the security and reliability that corporations need to move their workloads onto the cloud.
You know, when combined, it created a maturity of cloud computing that was ready to handle the volume seen during COVID-19, and implement them at a very quick pace. Which is, of course, the premise of technology, that it is best when it serves as an enabler.
VOICEOVER: Ebel says that many people are familiar with the “Big 4” --Amazon, Google, Microsoft and Facebook--with a combined five trillion [dollars] in market cap, but there are also nearly 50 smaller companies offering cloud-based solutions that virtualize infrastructure, moving software from “on prem,” or on-premises, to the cloud. These companies sell applications like cloud security software or call center software for call agents working from home. There’s also cloud-based email solutions. In all, Ebel estimates that these companies represent about $1.5 trillion in market cap.
Ebel: This cloud network not only saves corporations money, because now, they don't have to own and operate their own service and their own software to provide this, but they can benefit from these third parties running that software. And the overnight updates that they provide, the collective knowledge that the software provider gains from seeing a huge volume of items and incidents across their whole network. And to quickly implement those learnings into the code. That's what's called the network effect. And that's gets amplified when you have all these users in the cloud. So it's more cost effective, and it provides greater utility.
You know, it's funny, I recall when I was talking to these smaller companies two, three, four years ago, I was noting, coincidentally, how a number of them were saying the same thing. They no longer had this missionary sell, where they had to go in and spend time explaining to their prospects how the cloud is safe and secure. The prospects were, like, "Oh, you run on Amazon? Okay, fine. Oh, you run your servers and network the same way Google does? Okay. Now let's talk about features. Now let's talk about pricing," et cetera. So moving to the cloud was becoming much less a hurdle.
DeCicco: Right. If companies had become more confident then, about moving some of their business to the cloud, how far along are corporations and consumers into doing this?
Ebel: What I do is I ballpark the penetration by looking at how many Office 365 users Microsoft says they have in the cloud. Office 365 is the most popular corporate cloud app by a number of users. And Office 365 has north of 260 million users.
Well, previously, in an on-prem world, Microsoft said there was 1.2 billion Office users. That's a 22% penetration rate for one of the most popular pieces of corporate software. And I gut checked that by looking at the growth rates of these cloud companies. Again, the gorillas, like Amazon and Microsoft have US$40 billion revenue run rate cloud businesses growing 30%. Google and Facebook are growing their multibillion dollar advertising related sales cloud models, greater than 20%. And in those one-third of the 50 smaller cloud software companies that I referenced before, they're growing 30%, several of them are growing 50%.
So I look at that sales momentum, and I conclude that it must be early salad days for cloud. given that the average public company is growing their revenues just 5%.
VOICEOVER: As it happens, the cloud hosts the movies, TV shows, and live events offered by streaming services. Streaming is a hotly competitive space, with big media companies jostling for a share of consumers’ wallets. For Megatrend number two, DeCicco turned to a specialist
SO YOUNG LEE: Hi, I’m So Young Lee, I'm a research analyst for the Innovation Growth Funds. And I cover communications, healthcare and consumer.
DeCicco: So Young, I want to bring you into the conversation, because Ben mentioned video streaming-- which is another area that is seeing robust adoption. Can you speak to the change in consumer behavior, as it relates to pay TV, and how it has benefited the streaming companies? Who are the winners in the streaming world, just with so many competitors out there?
Lee: So the backdrop in the media landscape is that there has been a lot of cord cutting with cable and pay TV. And movie theatre windows have been shortening. There's been distribution innovations for streaming and content evolving, leading potentially to a bigger TAM, or total available market, than the current pay TV market. So on the first one, on cord cutting-- the pandemic has exacerbated the situation, especially with sports off air, which is a huge moat for cable TV package.
Since 2012, there's been a persistent decline in pay TV [subscriptions] and they got to a low single-digit rate of decline, and then precipitously dropped to the mid-single digits, and now 6% and 7% in the latest quarter.
And this virus is making it worse, because we can't produce any content with the stay-at-home orders. And so, the linear channels are unable to produce the content that they were able to before.
So worsening that- content hole that they were already in. The second was the movie theatre closures. And so the theatrical window has been shortening from about six months to now two-and-a-half to three months today. And now, the theatre closures, as a result of this pandemic, it's pushing movies to streaming, and creating a PVOD window, which is a premium video on demand window.
And that's compressing the theatre window even more. So for instance, Trolls [World Tour] in April came out for $20 on PVOD, and they didn't even go into the theatre, because they had already spent $50 million in advertising, and they didn't want to do that again.
Interestingly, Universal and AMC made a deal to commit to only three weeks of their movies in the theatre, and then move it to PVOD. And that's an historic deal, and I think that's a significant step function in change in the windowing, speeding up the process to go to PVOD and/or streaming.
The third is on to distribution innovation. We've seen SVOD, or streaming video on demand, and competitors are entering here to add to the Netflix and the Amazon Primes of the world. Including Disney Plus, HBO Now, Peacock, and then there are many other smaller ones, like CBS All Access and Showtime, just to name a few.
There's AVOD, which is ad supported video on demand, and they're emerging as an alternate as well, including Pluto-- Peacock is also AVOD--and Tubi, which is owned by an incumbent media company. And they are free to consumers, and ad supported, so it's an emerging model.
VOICEOVER: Linear channels include real-time video providers like broadcast TV networks. Consumers stuck at home during the pandemic are gaining access to higher-value content. Meanwhile, global media companies continue production in countries where they aren’t shut down, streaming globally on their platforms, albeit at a slower pace. This has enabled them to widen the gap in content breadth and quality versus competitors, helping the streamers to take their place among the largest and best-capitalized companies in the world, and they’re able to get economies of scale by being a global direct-to-consumer provide. Lee adds that content providers are moving away from so-called “tentpole” or hit-based content to much longer-tailed content in TV as well as movies. . Next, Lee turned to the relentless pace of innovation in content distribution.
So hits still matter, but there are fewer of them. And the tail of the content is much longer and has more depth than ever before. The content is more passion-based, and tailored to smaller groups of interests, versus broader appeal. But what it does, it drives up the affinity for the content.
VOICEOVER: Where is all this innovation leading? Lee examined the growth potential.
Lee: And so, the question is, how big is the TAM, or total available market? And so when I think about that, I start thinking about the number of users that might-- subscribe to these kinds of services. And there are a billion international pay TV users, which is one way to size the market, which screens for households which are interested in content, as well as the economic capacity to afford pay TV.
And the largest streamer is 20% penetrated of that. In the U.S.-- streaming is about 55% percent penetrated in households. Could we get there into Europe in less time? I think so. However, with mobile broadband-- and subscriptions growing-- there are a lot of mobile first geographies, including Asia and Africa.
And the number of smartphone users is also increasing, and so over time, do you think that that TAM could be the mobile user/broadband user-- that is an interesting question, and I certainly think it could be.
VOICEOVER: Megatrend number 3: e-Commerce comes of age. What about the other areas swept up in these transformational megatrends? Another team member shared his thoughts.
MICHAEL GLACCUM: Hi, I'm Michael Glaccum, I am a research analyst for the Innovation Strategies, covering areas of communication services, consumer and technology.
DeCicco: Mike, we've talked about streaming, we've talked about cloud, what are some other areas where digital adoption has been pulled forward? And are there any specific areas that really stand out?
Glaccum: When you look across several areas of consumer and tech, a common theme that emerged from executives and industry leaders is that we've seen three to five years of digital transformation in three to five months. And like you said, this is clear in areas like streaming, as So Young just highlighted. There is, like, e-commerce digital that we all understand. But it's been just as impactful in some less obvious areas, like education technology and online learning, like advertising. like digital payment, just to name a few examples.
I I'd be happy to dive into any of these industries or categories, but if you just take a look at e-commerce, so we could put some numbers and context around the pull-forward in demand. When you think about e-commerce, it's more or less existed for 25 years, right?
So up until a decade ago, you still only had mid-single digits penetration. So from 1995 to 2010, you really only had a small level of penetration of overall retail. And that was really centered around traditional media like books and music and video games. Then for the decade of 2010, you had the level of penetration go from, call it 5% to 15%, and you saw categories would become a little bit more widespread, right? You saw consumers willing and able to buy online when it came to apparel or consumer products. So over the first 25 years of e-commerce, from 1995 to 2020, you really saw, call it mid-teens penetration.
In the first six months of this year, that number has jumped somewhere, in our estimate, to around 25%. And we think it can carry on to 30%. And what we've really seen is the penetration rate double in six months, compared to the first 25 years as users have been forced to kind of pull forward their demand from a necessity standpoint.
VOICEOVER: Glaccum notes a surprising shift sparked in part by the pandemic.
Glaccum: Another thing that's been really interesting about this is it's been category agnostic, right? So there always been certain categories that lend [themselves] well to an e-commerce model. But when you think about something like grocery delivery, that's a category that forever people speculated would never go online, because people wanted to see the expiration of their milk, they wanted to feel what their fruit and vegetables felt like. Basically overnight, grocery delivery went from 2% penetration to double digit as consumers really had a need to use this kind of service, to get what they wanted in a timely fashion. The other thing we think is really important to note is that a lot of this pull forward is going to be permanent, and the reason why we speculate that is e-commerce offers a unique value proposition to consumers.
VOICEOVER: Glaccum talks about the roots of the ecommerce revolution—and where it may be headed next.
Glaccum: Back in 1997, when Jeff Bezos wrote his first shareholder letter, he always talked about convenience, selection and price. And now you pull forward all these new users and new use cases and categories, we think that a lot of this demand is going to stay for the foreseeable future as it is just a better value proposition than the alternative. So the thing that we've really taken notice of is the companies at the center of this transition have really seen an outsized benefit.
DeCicco: Digital payments. Those are a natural beneficiary of the growth in e-commerce. What are you seeing in digital payments, Mike?
Glaccum: The digital transformation has really manifested itself in payments. When we were coming into the pandemic, digital wallets were always available. But they've now become a central part of our financial lives, right? We use Venmo as a verb all the time now. And this is really the result of the secular tailwinds of e-commerce, and contactless payments that have really accelerated during this time.
So it bears itself out in the numbers. When you look at what's happened in the first six months of this year, financial app downloads, and that includes things like Venmo and Robinhood, but also things like Chase banking, were up 50% quarter-over-quarter just in the second quarter. In April alone, PayPal added seven and a half million net new customers. This compares to a typical month of three million net adds. So what we've really seen is the result of the necessity of having a way to pay for goods, to transfer money, to kind of interact online in a digital manner with your financial life.
These apps have seen an explosion in usage and adoption. And this is another one where we think there's some staying power here, because it offers a unique solution to the consumer, right? There is an easier way to pay online when you're a PayPal user.
There is a better way to transfer money when you're a Venmo user. There is a better way to deposit and withdraw when you're on online mobile banking with Chase. So what we've really seen is what we think is a permanent uptick of an industry that has been in development for the last 20 years.
VOICEOVER: Glaccum says “there are enormous opportunities out there” for these companies to continue to take an increasing share of the e-payments market as consumers embrace this new technology. For Glaccum, the big questions is what other markets theses companies could penetrate—which leads us into our next conversation, putting a button on all these megatrends.
STEVE WORTMAN: Hi, this is Steve Wortman, a research analyst for the Innovation Growth Team. I cover industrials, materials, consumer and various business services companies.
DeCicco: Steve, so we're talking a lot about how the accelerated penetration of these trends has occurred because of the pandemic. What are some of the implications to the business models? What are some of the changes to the business models that have occurred as a result of that?
Wortman: It's really been one of the most fascinating model transitions in the consumer world in decades. And a lot of these consumer Internet IPOs occurred in 2018 through 2019, with a lot of fanfare.
But they went from really loved to hated pretty quickly, and-- and for good reason. A lotta the models just simply weren't showing a path to profitability. They were gearing for hyper growth at any cost, and the profitability was not within an appropriate investment time horizon. And investors quickly moved on from these hot IPOs and the stocks took a big dive. So if you fast forward now, post-COVID, obviously we've talked about accelerated penetration in many of these areas.
And a lot of these businesses were still subscale. They were growing fast, but they weren't really big enough to grow into their SG&A leverage to get profitability.
But this pull forward, along with the fact that their customer acquisition costs started to level out, or even decline, really changed the business model much quicker than the street believed. And return on investment capital inflected positively and materially.
So if you were looking maybe three to four years out for profits for some of these models, profits may now have been moved forward, you know, 18 to 24 months. And in a low interest-rate environment, that meant a lot for the valuations of the stocks.
What is happening with these customer acquisition costs, is that brands now can sell themselves on the Internet more than they were able to do so in the past. Customers are looking for choices on the Internet. And companies don't have to go after them as hard.
So this entire transition has completely changed the margin structure of many of these businesses. So when we talk about whether it's home gym, and people were speculating whether or not that was going to be a category, now all of a sudden, it is.
And when you have to spend a lot of money on TV, and TV is a very expensive situation to get to your customers. Then all of a sudden, you can pull out of TV, your earnings reports are going to change very quickly. But t's also very important for these companies w-- when the shift is going on to a more direct digital sale, the it's margin enhancing. Because many of these models going into COVID weren't purely internet based, they were a mix, they were in transition. A lot of them had brick and mortar exposure. We know that the world pretty much stopped, and their businesses, and these managements had very little visibility on how this thing was going to transition.
So in order to stay relevant-- it's extremely important that your margin structure is moving in the right direction. Because you continually have to spend on R&D to stay relevant in a world that is quickly innovating, even in consumer products. Because if you're innovating in consumer products and adding value, your margins will continue to decline. So it's a vicious cycle. So this transition over to digital is very important. And not only is the sale of a physical good more profitable, but that can also be exploited and extrapolated into services businesses as well. Whether that's in real estate, whether or not the real estate transaction is more profitable for a Realtor if they don't have to physically visit the spaces many times. Or if they're more efficient, because they're not out there searching for leads, and the leads come to them.
So there's a lot of benefits happening on the margin as businesses have moved to the internet from a margin perspective that hasn't been fully appreciated. Now, all this is going on because as we know, and this is something we should just briefly discuss, is that retail store closures continue. This has been an ongoing trend, this is nothing new. We all know the numbers [indicate that] the mall has been a major problem, and doors continue to get shut. Specific numbers to throw out-- in 2017, closures actually reached 8,000 for the first time, and that's on a base of about 440,000 total doors [store units]. So you're talking about a 2% cut. And then in 2019, that number jumped to 9,300. And it looks like today, for 2020, this number can probably jump to over 20,000 doors. So that is a big-time acceleration.
Why is that important? Well, it's been going on for a number of years. So with the persistence of this trend, and the fact that is now accelerating, you're seeing more and more industries starting to go by the wayside and close doors. We all know that a lot of the mall guys, like Gap and Victoria's Secret, and Men's Wearhouse, and Children's Place, and Forever 21, [have] had problems and that apparel penetration online has been biting at their market shares. But we're now we're starting to see it in companies like Walgreens and Pier One, as the online penetration since COVID has accelerated into other areas. So the persistence of this trend and the persistence of the closures, this is reaching a tipping point, where everything is just easily moving over online, and it's allowing managements to quickly make that transition, because they know they have to.
Just to kind of close up, you know, Matt did briefly discuss that there's been a staggered realization of the beneficiaries post-COVID. There's a lot of obvious work-from-home names that benefited immediately, and their stock prices ripped [higher]. But as we move forward, less obvious winners have materialized.
VOICEOVER: So what are the key investment takeaways from this era of rapid change? Wortman says that in a highly fluid environment, “We're all learning here, we're all seeing things evolve.” He and the rest of the Innovation team will be tracking these three megatrends—cloud computing, streaming, and e-commerce—and assessing the investment choices that have the greatest potential to benefit in thesde remarkable times.
I think we should wrap it up here. Thanks to Matt DeCicco, So Young Lee, Ben Ebel, Mike Glaccum, and Steve Wortman their time and insights. Congratulations to Matt, who was named Partner and Director of Equities after this podcast was recorded, and to Ben and Steve, who have taken new roles as Portfolio Managers.
Special thanks to staff writer Will Andrews for his contributions in today’s episode.
This is just a taste of the exciting trends that we’re watching. For continuing commentary on this subject, stay tuned, and stay up to date on lordabbett.com. Subscribe and rate us on Apple Podcasts, Spotify, or your favorite streaming app of choice. Thanks for listening.________________________________________
Sources for data referenced in this podcast include: Cloud computing and software, FactSet, Okta Inc., company financial documents and earnings calls; streaming and cable television, Nielsen, company financial documents and earnings calls; e-commerce and digital payments, U.S. Census Bureau and company financial documents and earnings calls.
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