A colleague comes up with a show stopper….
Advisors are always seeking the “killer” insight that causes their audience to stop in its tracks. A couple of weeks ago, in a meeting with a “C” Suite executive of a FTSE 100 company, one of my colleagues hit the ball out of the park. In a discussion about digital disruption, he said,
“The challenge established businesses face is that they are competing with people for whom making profits is not a priority”
The room went quiet and after a moment of reflection, everyone in the room nodded sagely. One short sentence had summed up the challenges and frustrations executives in established companies face in trying to compete against new digital competitors.
..that may be even more insightful than it first seemed…
On my way back to the office, it struck me that my colleague’s insight might have wider implications that go beyond the issues that businesses facing digital disruption are struggling with. In particular, I wondered, what does it mean at a macro level? If some businesses are not seeking to maximise profits, are they destroying value? Might this offer some insight into why productivity growth has been so disappointing in recent times? It is normally assumed that digital is a force for good, driving beneficial change in the economy, but are we sure?
…if we look at UK retail…
Further analysis seemed to confirm that the adoption of digital appears to have the potential to be wide ranging – 74% of retailers in a recent EY survey said their margins are being squeezed and 77% expressed doubt as to their future ability to grow profitably. Traditionally, we have assumed that greater price transparency and the asset-light business models of online retailers have squeezed prices and hence margins. However, as I read the most recent annual reports of UK retailers it became clear that digital is having a wide-ranging impact on this sector.
A huge shift in customer behaviour has taken place in the last few years. With companies now achieving up to a third of their sales online and an increasing share of this activity being from mobile phones. In response retailers have:
– Spent heavily on new distribution centres to improve their ability to offer fulfillment across the range of channels customers now use to shop. The US Department of Transport estimates a 40% increase in freight transport by 2040 due to online home delivery services. It seems reasonable to assume therefore that the shift to digital is driving up distribution costs across the retail sector.
– Changed and increased their IT expenditure. Looking across the sector, it seems that some companies may be spending up to a third of capital spend on IT, double the share in recent history with up to half of all capex now being accounted for by IT and distribution. Again digital is driving spend but in this case, it is also diverting resource from other areas such as stores which may well limit the ability to innovate or improve those areas as fast as would otherwise have been the case. Given how significant physical assets are as a share of total capital, limiting the capital available to improve them could hamper productivity.
So digital drives higher expenditure not just lower prices. But we probably knew this. What really struck me was how the impact of digital was being felt even deeper into the business beyond logistics and IT.
– Many companies now offer “click and collect” in stores and some retailers report that it is now used for over 50% of all online purchases. As well as creating potential costs in store in the collection process, it is also driving new expenditure and investment. For example, Waitrose will be the first retailer to have in store chilled lockers for online food collection. Great customer service but another cost driven by the need to change to have a digital offer.
Finally, the sector is having to respond to the impact online is having on the role of its stores, with more shopping out of store, so stores have to compete to become destinations which customers want to visit. Several companies have launched new in store eating and leisure spaces and some have even bought restaurant businesses to add to their store offer. Again innovation in serving customers but creating another potential squeeze on margins.
A macro level effect?
Looking again at EY’s recent survey, it seems highly likely that we could find similar stories from retailers up and down the UK. Retailers have found digital has put pressure on selling prices but they have been driven by competitive pressures to add digital capability and its associated costs on top of their existing business, rather than moving to a new business model.
Lower prices and higher costs mean lower margins and also, if repeated across companies and sectors, may well mean lower productivity in aggregate, especially if the new entrants causing this activity are not profitable themselves. Incremental resources will be adding less value and, even after the compensatory effects of increased volumes stimulated by lower prices, it seems possible that digital is currently acting to bring down aggregate productivity in the retail sector. If similar effects are being experienced in other sectors, which seems very possible, this may help explain some of the decline in productivity in the UK.
A detailed look at other sectors is for another day but recent EY work on digital M&A suggests more research on digital and aggregate productivity would be worthwhile. It appears that companies are using deals to acquire digital capacity to add to their existing business. As in the retail sector, this is most likely adding cost in the short-terms and so potentially hitting margins. However, there is another effect. This trend reflects a shift away from M&A designed to capture cost and/or revenue synergies. This more traditional deal activity would more likely tend to drive productivity improvement given its efficiency focus. More analysis is required but this does appear to be another example of how the impact of digital may be different to that which we have been taking as given to date.
We need to understand better the impact of digital over time. The prevailing view is that digital is a force for good, driving productivity and creating economic benefit. This may be true but it may also be the case that the impact may vary over time. A better understanding of the digital lifecycle is required to inform both public and private decision-making.
With scope for change over time.
It is important to recognise that we are not at the end game yet for digital. I would guess we are a long way off it. The chart below illustrates the stages of digital evolution across the competitive landscape.
In the early “start up” stage, digital is a relatively low cost as companies experiment with their response. This probably starts with an online offer to test the market and gradually evolves into more substantial activity.
The second “parallel” stage, the one I suspect most retail companies are currently in, is when digital capability is significantly increased and the resources consumed become significant as a share of total costs. The company is earning lower prices due to digital but increasing its costs to compete for sales at these lower prices. Although digital may be cannibalising the legacy to some extent, it is too early to rationalise the legacy assets and resources, as the optimal future business model is unclear, companies are experimenting. The two models exist alongside each other and margins generally fall as the resources deployed increase faster than sales.
The next stage and the one that offers potential for productivity improvement is the “optimisation” period. Having spent time operating two or more businesses, the shape of a more effective business model becomes clear. Companies can begin to close and/or transform their legacy businesses but, at the same time, reshape and potentially rationalise their digital arms as well. After sufficient experimentation and evolution, businesses move towards a new model.
The chart illustrates possible end states, illustrated by paths 1 to 3, depending on how successful redesign of the business model turns out to be. With continuous improvement the long-term position may offer support for higher productivity. Equally it may be that consumers value the combination of various elements of different offers and hence the total resource base is higher per unit of revenue than it was pre-digital and hence the scope for productivity gain does not exist.
For businesses, it is all about the legacy…
How companies deal with their legacy assets is likely to be the primary driver of the future economics of the business. Certainly for traditional retailers, what happens to the size and geographic profile of their store estate and the size of their workforce will be critical as these represent the major shares of their total asset bases and ongoing expenditures. As discussed above, most focus is on digital, the more interesting piece of the challenge, even to the extent of diverting resources from maintaining and improving the legacy. However, identifying the appropriate role for the legacy is the key to finding the optimal future business model.
In the recent EY survey of retail executives, 81% said they recognised the need to be bolder to drive improvement but 49% were stopped from driving change because of their heritage. The challenge of balancing legacy and change is there for all to see. At the moment, established and new companies are feeling their way towards this and it seems that we are still in the second stage of the four identified above.
…for policy-makers the challenge is to understand the productivity impact.
In the current state with experimentation rife, it is possible, based on the high level retail example, that the rise of digital is detracting from aggregate productivity growth in some sectors. Certainly, assessing the impact of digital is not simple and the assumption that nimble new competitors will drive industry wide productivity gains requires further analysis.
For policy makers, there is a clear need to work to understand how digital is impacting the economy in practice, and even more importantly how this will evolve over time. It may be that there is a path to higher overall productivity as new business models evolve and hence there is less to worry about in today’s reported numbers. Conversely, it might be that digital businesses are driving a mis-allocation of resources and skewing decisions in an economically disadvantageous way. More detailed analysis of a wider range of sectors is required. Policy makers need to understand what happens in practice not in theoretical models if they are to make the correct decisions to achieve their objectives.
For example, if digital will drive productivity in the long-term we should be less worried than we currently are about low productivity. This might imply much greater focus on stimulating investment in broadband to accelerate the growth of digital, rather than say, new physical infrastructure such as railway line.
On the other hand, if digital is not going to drive productivity as fast as hoped, an alternative approach may be required. If forecast low future productivity is because of higher logistics and transport costs for example, then policy should focus on improving roads as this is typically what goods companies tell us has the greatest efficiency benefit for them.
There might also be policy implications in several of the scenarios for a need for public support to help restructure the legacy. Business rates and capital allowances could be important policy tools in these scenarios.
But most importantly, the implications could be different to the general presumption in favour of digital, based on high-level observation rather than detailed analysis. Government needs to do more to establish an understanding of the potential impact of digital that reflects the current and future expected economics of the impact. Failing to do so greatly increases the risk of economically inefficient decision-making especially in respect of productivity.