November 10, 2017

Stocks fell yesterday although they finished well off their morning lows. Investors were concerned that the Senate tax bill might be less favorable to corporations than the House bill. I suspect that if there is a final product, it will look different than either offering. I am also not sure whether old-fashioned profit taking was a better explanation for yesterday’s market behavior than some concern about taxes at this early stage in the legislative process. Another issue of concern was the allegations of sexual misconduct against Alabama Senate Republican candidate Roy Moore. The Alabama runoff election is scheduled in a few weeks, and it was expected to be a close contest before these accusations. Should the Democrat win, it would change the makeup in the Senate to 51-49 in favor of the Republicans. That means purely partisan legislation would allow for only two Republican dissents if they lose the Alabama seat vacated by Jeff Sessions. Until Rand Paul is physically able to return, the margin would be just one vote. While these are all what-ifs, they are important considerations.

With that said I want to focus this morning on disruption. We see it in our lives in so many ways. Certainly, the election of Donald Trump has upended the way things happen in Washington. We are all still adjusting. The rise in allegations of sexual misconduct may relate to events that happened years ago, but there is no doubt that the heightened focus today is what is going to drive changes in behavior going forward. For investors, the focus is more on economic disruption, although one can’t completely separate what is happening on the corporate scene from what is happening politically and socially. Social media has meaningfully changed behavior in both good and bad ways. Facebook and Google are making headlines almost daily. How much should they or can they police deviant postings?

It isn’t any revelation that change is disruptive. Technology accelerates both change itself and the pace of adoption. It took decades for the phone to be universally adopted. This year is the iPhone’s 10th anniversary and smartphones are now in the hands of billions of people around the world. It took Snapchat just a couple of years to be the media of choice for teenagers.

Companies don’t survive forever. There is only one original Dow component left, General Electric#, and it has serious problems at the moment. As the world changes, corporations must change as well. They have to adapt. It is particularly hard for a corporation to change when its bread and butter base, the one that provides most or all of its earnings and cash flow, is under attack. Avon sold cosmetics door-to-door. What happened when the stay at home housewife went to work? What happened when online sales made most of the advantages of going door-to-door obsolete? Kodak made cameras that used film. It was an iconic company, one of America’s finest. Film and photographic paper were both proprietary and expensive to make. In a sense, Kodak was a consumer company with a chemistry DNA. When digital photography came of age and digital images became the equal of anything Kodak could make, it was left defenseless. The Kodak that exists today is a fragment that emerged out of bankruptcy. It will never be a great company again.

In the computer world, minicomputers took major share from mainframes. Digital Equipment, Data General and Prime Computer killed names like Control Data, Univac and Burroughs. Then they were killed as the emergence of PCs made by companies like Compaq and Dell became king of the mountain.

But not all companies die. IBM has remade itself several times. It is no longer dominant but it is still highly profitable and, today, it is once again shifting to be a cloud-based technology services company. Dell still makes PCs, but is much more focused on serving the needs of the cloud rather than the needs of the desktop. Perhaps Microsoft is the best large tech company example of successful adaptation. Under prior leadership it was a Windows-based PC-centric company. Today, its Azure cloud platform is the fastest growing in the industry, and its historic base of software applications from word processing to email and messaging are now all cloud-based and growing rapidly.

Last night Disney# and Nordstrom reported earnings. Both face disruptive challenges. Let me look at Nordstrom first and contrast it in the process with Sears. There is no question that what we buy and how we buy it has changed rapidly over the past decade. The rapid emergence of online retailing, led by Amazon, has revolutionized the way we buy and sell. Not only has it changed how we buy, but the Internet has enabled us to quickly locate the best price and the fastest delivery time with just a few clicks. Computers and advanced intelligence enable sellers to know exactly what we buy, what we like, and where we want it delivered. Over time, they will only get more and more intelligent. Sears was the original “online” merchant through its catalog. In the old days there were no Sears department stores; there were just catalog centers and pick-up points, the forerunner of Amazon lockers, if you will. When malls became a preferred retail venue, Sears joined in. The catalog faded in importance. But as the Internet became a force, Sears barely changed. As tastes in clothes and hard goods changed, Sears was slow to adapt. The company was acquired by a new owner more interested in the real estate value of the Sears stores than their earnings power. Now Sears is on the brink of extinction.

Contrast that to Nordstrom. Nordstrom faces exactly the same issues as Sears. But it has reacted boldly. It has the most significant online presence of any major department store chain and it has embraced technology better than its peers. It built a low-priced alternative with the creation of Nordstrom Rack, a highly successful discount variant to the full-priced department store line. This year, the headwinds are so strong that Nordstrom is losing some ground and its stock price has fallen. But the company is working hard to continue to evolve, pushing more of its revenue base online, revamping its merchandise to aim at broadening its audience base, and streamlining its Rack inventory.

Disney’s ESPN sports franchise has been under attack as viewers move away from broad cable bundles. Younger viewers ignore cable altogether and watch only via the Internet. Disney’s response has been bold and broad, if a bit late. It is preparing a separate over-the-top sports offering. When its contract with Netflix expires in 2019 that allows Netflix to carry Disney products, it will introduce its own Internet site that will exclusively offer everything from Snow White and Frozen to Star Wars and movies based on Marvel Comics. And, of course, there are the Pixar movies. Disney will also offer unique programming especially made for the site. Finally, it will price its product at a significant discount to Netflix. It is certain to make a splash. How successful it becomes economically is the obvious question.

I can go on. The cable companies are moving from a video focus to a broadband focus. Drug store chains like CVS# want to evolve into health services companies. Intel# is moving away from its PC base to support the cloud, self-driving cars, artificial intelligence and the Internet of Things.

Not all these changes will be successful. Some will be partially successful, successful enough to allow said company to live and fight another day. Some transformations will be wildly successful. Even the disruptors will have to change. Amazon started as a book seller. Today it is the largest cloud services firm in the world. Sometimes the disruptors themselves die. Theranos had a product that was going to put traditional lab companies out of business. It didn’t work.

At this point in my discussion, I want to introduce two thoughts. First, anyone with a great idea can get started and get up to scale more rapidly than ever. With very little money, one can design a better widget, contract with a third party to manufacture the product, and build a web site to market the product. To gain scale requires a reasonably large sum of money (large to the creator, at least), but for a few million dollars, one can make a pretty good and fast impression. As a result, a large producer of consumer products will have hundreds of opportunists nipping at its heels. Most will fail but some will become at least reasonably successful. My second point is, that while it might take large companies some time to react, they have the scale and resources to do so. What they need is the will power to move. In some cases, they will be forced to concede that their old very profitable way of doing business can’t be completely defended. When iTunes began to sell digital songs for $0.99, record producers who spent more money promoting albums, disks and tapes were fighting a losing battle. Streaming was going to win. Shifting more to live concerts became the way to make money.

I don’t know if Disney or Nordstrom will be able to redesign their companies successfully. But I do know that (1) they are now moving boldly, and (2) they have certain advantages working in their favor. Netflix has a highly regarded name. But none of the Netflix offerings has the cache of Frozen or Star Wars. Sports can be offered by almost anyone, but ESPN has key agreements with major sports leagues that gives them exclusives for many years. Can Disney make as much or more down the road as it shifts the way it delivers its proprietary content? That’s the obvious question and we won’t know for some time. But what we do know is that large companies with great resources get the opportunity to try again and again until they get it right.

Sometimes change isn’t all that dramatic. Restaurants are adopting online order and kiosks to speed service. ATM’s complemented bank branches.

As investors, it is important to know what disruptive threats the companies you own face. Then you need to ask whether you believe they are responding properly. In some cases, the disruption is so massive and the change required so violent, that it may be prudent to simply back away or move on until the consequences are better understood. Finally, one must understand that all disruptors are destined to be disrupted themselves. Disney’s new online venture threatens Netflix. All the hundreds of new online retail names are following Amazon’s model. Those that succeed take sales from Amazon. At some point in time, someone else will find a better way to sell or deliver a product. Or perhaps someone will make a better book reader. Disruptors look for two things; a large potential marketplace and a market poorly served. Find the product or service that no one likes and you have a disruptors opportunity.

As for all those legacy companies being attacked, the ones trying to change, like Disney and Nordstrom, have an opportunity to succeed and even flourish in the future. But success is never guaranteed. On the other hand, companies that either don’t change or who try to adapt much too slowly will become dinosaurs. Some companies, like Kodak, will have very little time to adapt. In many fields innovation has been lacking. Putting smaller Oreos in a 100-calorie bag may seem like innovation, but it isn’t. Innovation is creating a healthy snack that also tastes good. Repackaging is cheap; innovation is expensive. In the end, however, it’s innovation that will win every time.

Today, Tracy Morgan is 49.

James M. Meyer, CFA 610-260-2220

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# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

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