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2020 Forces Converging - Crossing Creative Disruptions - Ed Maguire

We revisit our work on innovation as 2020 approaches and find that compute power, global connectivity and powerful analytics drive an inflection in progress. Technology magnifies and accelerates the divide between winners and losers for startups, public companies and workers as we navigate creatively disruptive shifts in industries and the economy. Software is the core force shaping changes in technology, business and the economy. We explore 20 key themes influencing growth opportunities for investors, industry and society at large.

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2020 Forces Converging - Crossing Creative Disruptions - Ed Maguire

  1. 1. 2020 forces converging Crossing creative disruptions Special report March 2015
  2. 2. Innovation 2 ed.maguire@clsa.com 3 March 2015 Contents Executive summary ............................................................................ 3 Waves, cross currents and undertow ................................................. 4 Cash builds amid decline in startups ................................................ 25 Charting the course for innovation ................................................... 37 20 themes for 2020 .......................................................................... 46 All prices quoted herein are as at close of business 27 February 2015, unless otherwise stated Deep dive into innovation We provide an update to our 2020 draws nearer and 2020 innovation report series. Ed Maguire ed.maguire@clsa.com +1 212 549 8200 Clarence Chan +1 212 549 8201 Find CLSA research on Bloomberg, Thomson Reuters, FactSet and CapitalIQ - and profit from our evalu@tor proprietary database at clsa.com Produced by CLSA Americas LLC. For important disclosures please refer to page 145.
  3. 3. Executive summary Innovation 3 March 2015 ed.maguire@clsa.com 3 2020 forces converging We revisit our work on innovation as 2020 approaches and find that compute power, global connectivity and powerful analytics drive an inflection in progress. Technology magnifies and accelerates the divide between winners and losers for startups, public companies and workers as we navigate creatively disruptive shifts in industries and the economy. Software is the core force shaping changes in technology, business and the economy. We explore 20 key themes influencing growth opportunities for investors, industry and society at large. Akamai, Informatica, Red Hat, Salesforce and Splunk are our top software BUYs. In the year since we published 2020 draws nearer (Closer to the Turing point), US stock indexes have reached all-time highs with robust capital markets and M&A activity while the official unemployment rate has trended below 6%. The confluence of technology enablers, a healthy venture-capital (VC) ecosystem and a risk-taking culture gives rise to unique American advantages. However, powerful automation and artificial intelligence eliminate a growing spectrum of jobs, erode established industries, exert deflationary pressure on wages and potentially dampen long-term GDP growth. Investors often underestimate the zero-sum dynamics of this tech-led industrial revolution. Robust gains in VC funding and investment complement healthy capital markets and mergers & acquisition (M&A) activity. However, the pace of new business formation continues to decline. Structural dynamics favor larger firms as headwinds include slippage in science, technology, engineering and mathematics (STEM) education, broken immigration policies, costly patent litigation and over-regulation. We update our technology “meta-themes” - transparent IT, intelligent systems and convergence - to highlight the importance of platforms for innovation. Software remains at the top of the tech value chain as the driving force in innovation, gaining strategic importance for non-technology companies as well. A new generation of high-growth businesses is built on connectivity, massive data-processing power, near-ubiquitous reach and powerful analytics. We explore 20 themes with disruptive potential for industries and incumbent businesses that offer promise for investors and firms. We group these innovations into five categories: building blocks, connectors, human technology, intelligent machines and new horizons. CLSA recommended innovation stocks Name Ticker Rating Target price Last close Currency Akamai AKAM US BUY 83.0 69.51 USD Amazon AMZN US O-PF 365.0 380.16 USD Apple AAPL US BUY 148.0 128.46 USD Facebook FB US BUY 107.0 78.97 USD Google GOOGL US BUY 650.0 558.40 USD IBM IBM US O-PF 175.0 161.94 USD Informatica INFA US BUY 52.0 42.95 USD Red Hat RHT US BUY 72.0 69.12 USD Salesforce.com CRM US BUY 77.0 69.38 USD Samsung Electronics1 005930 KS O-PF 1,650,000.0 1,357,000.00 KRW Splunk SPLK US BUY 87.0 67.25 USD Tesla TSLA US O-PF 275.0 203.34 USD 1 Covered by CLSA; all others by CLSA Americas. Source: CLSA Cash builds amid decline in startups 20 innovation themes for 2020 Crossing creative disruptions at the midpoint of the decade Waves, cross currents and undertow Charting the course for innovation Akamai, Informatica, Red Hat, Salesforce and Splunk are our top software BUYs
  4. 4. Section 1: Waves, cross currents and undertow Innovation 4 ed.maguire@clsa.com 3 March 2015 Waves, cross currents and undertow Since we published our report 2020 draws nearer (Closer to the Turing point) in February 2014, US stock indexes have reached all-time highs with robust capital markets and M&A activity while the official unemployment rate has trended below 6%. The confluence of technology enablers, a healthy venture- capital ecosystem and a risk-taking culture gives rise to unique American advantages. However, powerful automation and artificial intelligence eliminate a growing spectrum of jobs, erode established industries, exert deflationary pressure on wages and potentially dampen long-term GDP growth. Investors often underestimate the zero-sum dynamics of this tech-led industrial revolution. Our subtitle for this report, “Crossing creative disruptions”, refers to three ideas: Crossing the chasm, author Geoffrey Moore’s classic analysis of high- tech strategy; creative destruction, the term associated with economist Joseph Schumpeter; and the principles of disruptive innovation, advanced by professor Clayton Christensen. New technologies (and companies) must “cross the chasm” between early adopters and the mainstream, and most will fail. Creative destruction describes the ‘process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one’, according to Schumpeter. Disruptive innovations enable an upstart to displace incumbent leaders and can come from below, above or as a sudden “big bang”. All of these dynamics are concurrently at play. Innovation is the major growth driver for free markets. R&D-intensive “advanced industries” account for 9% of employment but 17% of GDP. Global connectivity allows businesses to scale more rapidly than ever, while accelerating the impact from business-model vulnerabilities and disruptive competition. The year 2014 saw robust increases in venture-capital fundraising and investment, but paradoxically, the rate of new business creation has been declining. It’s not clear whether funding can drive a turnaround, but businesses face several secular headwinds, including shortcomings in science, technology, engineering and mathematics (STEM) education, broken immigration policies, costly patent litigations and over-regulation. We discuss this topic in more detail in Section 3. We are still optimistic about the potential for value creation and societal transformation. Sustained progress in computing, storage and connectivity powers increasingly sophisticated ideation, design, prototyping, research, product development and business creation. However, the accelerating pace of change amplifies risks, both from fundamentals and overly optimistic expectations. There is growing evidence that technology amplifies inequality - in wages as well as prospects for new businesses. “Category kings” that dominate over 70% of the market cap in their sectors are reaching scale more quickly than ever, relegating also-rans to fight over diminishing share of value. Software is truly ‘eating the world’, in the words of venture capitalist Marc Andreesen. The twin forces of digitization and dematerialization absorb the functions of a wealth of products and services, expressed in powerful, connected “apps”. In addition to tech hardware and services companies, non-tech consumer and industrial firms are investing in and acquiring software to transform their businesses. Value consistently migrates upward to platforms, analytics and applications. Our favorite software category kings - Akamai, Informatica, Red Hat, Salesforce.com and Splunk - remain our top BUY ideas. A new generation of startups creatively shapes the US economy Innovation-intensive “advanced industries” generate disproportionate growth in GDP Akamai, Informatica, Red Hat, Salesforce.com and Splunk are top BUY ideas There’s growing evidence that technology amplifies inequalities - for wages and startups Investors often underestimate zero-sum dynamics of this tech-led industrial revolution
  5. 5. Section 1: Waves, cross currents and undertow Innovation 3 March 2015 ed.maguire@clsa.com 5 Wayfaring the cross currents of a new industrial revolution In early 2015, employment and a range of industries are navigating widespread disruption of an industrial revolution driven by information and communications technologies (ICT). It’s not exactly “bloodless”. Leaders have been dethroned, the status quo is fluid, massive wealth is being created with unprecedented velocity and there is bubbling discontent in the broader US economy as machines displace jobs and a disproportionate share of income accrues to an elite few. For investors, there have never been more attractive opportunities and potential minefields as the pace of innovations accelerates. Innovation (which has become inseparable from technology) holds the key to value creation. With Moore’s Law and its corollaries as a backdrop, software becomes the defining vector that creates winners and losers, category kings and also-rans. In this report, we characterize 2015 in a big-picture context, pulse-check the current state of funding and entrepreneurship, examine drivers and developments within frameworks and explore 20 critical innovative themes. Why is innovation so important? Innovation is critical to value creation in an economy increasingly shaped by advanced technology. The most innovative industries typically contribute outsized gains to GDP, create businesses that generate attractive returns for investors, and in the case of information technologies, enable productivity gains across a continuum of industries. Brookings Institute’s recent study, America’s Advanced Industries, defines advanced industries as having the top 20% of R&D spending per worker, with a proportion of personnel with STEM knowledge greater than the national average. The 50 industries include pharmaceuticals, motor vehicles, aerospace, oil and gas extraction, software design and telecommunications, among others. These advanced industries employ just 9% of the active workforce, but generate 17% of total US GDP. Advanced industries employ 80% of the country’s engineers, generate roughly 85% of US patents and account for 60% of US exports. The segment has seen enormous gains in productivity: output increased 30% faster than the economy as a whole from 1980-2013. Since the end of the recession in 2010, advanced services have created 65% of the new jobs in the economy, with the most coming from computer-systems design, which generated 250,000 new jobs. Technology accelerates time to market cap (TTMC) Technology is having a marked impact on the pace of value creation for new companies, expressed through fundraising, M&A and IPOs. Put simply, the rate at which startups create value is accelerating. Time to Market Cap: The New Metric that Matters is a recent study by Play Bigger Advisors LLC that analyzes VC-backed US technology companies founded since 2000. Authors Al Ramadan, Christopher Lochhead, Dave Peterson and Kevin Maney analyzed data from over 500k private companies, 18k private investors, 50k M&A deals and 50k VC funding rounds, dividing them into three four-year eras based on when they were founded. The study found large and growing distinctions between winners and losers. Category kings are winners (Facebook, Twitter and Uber, for example) that dominate their markets and command over 70% of the total market value in their category, leaving everyone else to share the remaining 30%. This dynamic is far from new - author Geoffrey Moore explored this phenomenon in The Gorilla Game, a seminal book on high-technology business strategy. Software becomes the defining vector that creates winners and losers The beginning of 2015 finds widespread disruption from the tech industrial revolution Advanced industries employ just 9% of the workforce, but generate 17% of US GDP Advanced industries have outsized impact on economic growth Category kings command over 70% of the total market value in their category The rate at which startups create value is accelerating
  6. 6. Section 1: Waves, cross currents and undertow Innovation 6 ed.maguire@clsa.com 3 March 2015 Figure 1 Category kings take all the economics Period Market cap of category kings (US$bn) Market cap of everyone else (US$bn) Total market cap (US$bn) Category king (%) Era 1 (2000-03) 70.5 28.9 99.4 71 Era 2 (2004-08) 303.9 82.8 386.7 79 Era 3 (2009-13) 65.2 25.8 91.0 72 All eras 439.6 137.5 577.1 76 Source: Play Bigger Advisors LLC, http://playbigger.com/time-to-market-cap What’s different now is that winners are winning faster than ever. Companies headed for a US$1bn valuation will do so in a third of the time; it took 2.9 years on average for companies founded in 2009-13 versus 8.5 years for those founded in 2000-03. Not surprisingly, time to market cap is accelerating faster for consumer than enterprise companies. Figure 2 Time to market cap in years Market cap milestone Era 1 (2000-03) Era 2 (2004-08) Era 3 (2009-13) Era 3 to Era 1 speed ratio US$500m 4.5 2.3 1.6 2.8 US$1bn 8.5 3.5 2.9 3.0 US$3bn 24.6 8.3 7.9 3.1 US$5bn na 13.1 13.0 3.1 Source: Play Bigger Advisors LLC, http://playbigger.com/time-to-market-cap While the ramifications are obvious for the winners, this dynamic also has implications for losers. The study found that a six-year-old startup that has not become a category king has almost no chance of becoming one. Investing in category kings for enterprise technology We like to bring our innovation work back to the software sector and highlight our bullish stance on five category kings from our coverage universe. They all share common characteristics: they dominate their respective markets in terms of market cap, share and technology; early advantages have been reinforced over time; technologies enable an ecosystem of applications and partners; and all continue to invest aggressively in innovation.  Akamai (AKAM): Media delivery, application performance and security services benefit from the adoption of mobile devices, e-commerce, Software as a Service (SaaS), social media and gaming, driving hard ROI- enabling business over the internet.  Informatica (INFA): Core business value centers on enabling analytics and data governance, untangling “hairballs” against increasing complexity.  Red Hat (RHT): More than a software company, it is a curator of streams of innovation through the open-source model. As leading-edge cloud technologies shift from proprietary to open source, Red Hat dominates the strategic high ground.  Salesforce.com (CRM): The 800-pound gorilla of SaaS is evolving into an innovation platform, with culture, strategy and momentum propelling sustainable growth.  Splunk (SPLK): A true technology platform, the ecosystem of developers and users creates value machine data in the white spaces between infrastructure management, analytics and security. The 800-pound gorillas consistently dominate their markets What’s different now is that winners are winning faster than ever Startups destined for US$1bn market cap achieve this milestone ever more rapidly We highlight five category kings from our coverage universe A six-year-old startup that has not become a category king has almost no chance
  7. 7. Section 1: Waves, cross currents and undertow Innovation 3 March 2015 ed.maguire@clsa.com 7 Other enterprise companies that fit the category king definition, according to Play Bigger, include Workday (WDAY), ServiceNow (NOW), Palo Alto Networks (PANW), Box (BOX), Tableau Software (DATA), Veeva (VEEV) and others. We’d highlight companies like Microsoft (MSFT), Oracle (ORCL), Autodesk (ADSK), VMware (VMW), EMC (EMC), Cisco (CSCO) and Intel (INTC) as category kings from earlier eras. Private enterprise companies with values over US$2bn (based on disclosed fundraising rounds) include Dropbox, Palantir Technologies, Nutanix, Pure Storage, Cloudera and Square. Consumer category kings that are publicly traded include Facebook (FB), Google (GOOG), Amazon (AMZN), Apple (AAPL), Twitter (TWTR), LinkedIn (LNKD), Yelp (YELP) and GoPro (GPRO), among others. Private consumer- based category kings with values over US$2bn (based on disclosed fundraising rounds) include Uber, AirBnB, SnapChat, Pinterest, GrubHub, HomeAway and Houzz. We’ve seen large deals evidence rapid time to market cap: Facebook’s US$19bn deal for WhatsApp, Google’s US$3.2bn deal for Nest Labs and Facebook’s US$2bn deal for Oculus VR. Watching new-generation technologies disrupt incumbents Successfully predicting which trends will pay off is a matter of timing as well as trial and error. Looking beyond “barbell” dynamics of new-generation category kings, there’s ongoing disruption within tech itself. Cloud computing, the trend towards “Everything as a Service” and embrace of open source for infrastructure have disrupted traditional on-premise tech companies (which are all undertaking broad efforts to effect business transitions to the cloud). Figure 3 SaaS versus big tech stock performance SaaS index components include Salesforce.com (CRM), Workday (WDAY), ServiceNow (NOW), NetSuite (N), Concur (CNQR), Ultimate Software (ULTI). Big tech index components include Microsoft (MSFT), IBM (IBM), Oracle (ORCL), SAP (SAP), Cisco (CSCO), Hewlett-Packard (HPQ). Source: Thomson Reuters, CLSA Software as a Service and IT security have rewarded investors over the past five years. Software stocks have seen pronounced and sustained contrast between the high-growth SaaS and cloud names and on-premise incumbents. SaaS consistently outperformed the S&P500 over the past five years while big (on-premise) tech has underperformed since 2013. 50 100 150 200 250 300 350 400 450 500 Feb 10 Aug 10 Feb 11 Aug 11 Feb 12 Aug 12 Feb 13 Aug 13 Feb 14 Aug 14 Feb 15 S&P500 Top big tech companies Top SaaS stocks by market cap +22.7% +92.0% +298.0% Enterprise category kings grow more slowly, but have more sustainable businesses Consumer category kings have generated stunning valuations The performance contrast between SaaS and on- premise tech becomes more extreme Traditional big tech and SaaS software performance bifurcated in 2013
  8. 8. Section 1: Waves, cross currents and undertow Innovation 8 ed.maguire@clsa.com 3 March 2015 Playing secular trends can pay off, but watch the hype We’ve been highlighting the 3D printing sector as a key innovation trend since 2011, and since that time the sector has captured popular imagination and investor attention. Interest in and awareness of the potential for 3D printing, a technology that incorporates a range of techniques including additive manufacturing, reached fever pitch in 2014, and investors aggressively sought out the limited vehicles to gain exposure to the trend. This pushed valuations to a peak, followed by a crash and protracted period of underperformance. Figure 4 3D printing stock performance Index components include 3D Systems (DDD), Stratasys (SSYS), ExOne (XONE), Proto Labs (PRLB), VoxelJet (VJET). Source: Thomson Reuters, CLSA However, there are secular themes that provide a bit more consistency. The IT security industry benefits from the need for constant innovation to protect data, systems and reputations from myriad evolving threats. Despite some froth during early 2014, the sector has modestly outperformed the market over the past three years. Figure 5 IT security has been a good sector for investors IT Security index components: AVG (AVG), Check Point Software (CHKP), Barracuda Networks (CUDA), Cyber-Ark (CYBR), FireEye (FEYE), Fortinet (FTNT), Imperva (IMPV), Guidance Software (GUID), NICE Systems (NQ), Palo Alto Networks (PANW), Proofpoint (PFPT), Symantec (SYMC), Qualys (QLYS), Varonis (VRNS), Qihoo360 (QIHU), Finjan Software (FNJN). Source: Thomson Reuters, CLSA 0 100 200 300 400 500 600 700 Feb 10 Aug 10 Feb 11 Aug 11 Feb 12 Aug 12 Feb 13 Aug 13 Feb 14 Aug 14 Feb 15 Nasdaq Composite 3D printing stocks +189.7% +120.6% 80 100 120 140 160 180 200 Feb 13 May 13 Aug 13 Nov 13 Feb 14 May 14 Aug 14 Nov 14 Feb 15 Nasdaq Composite Security names +71.7% +50.7% 3D printing stocks peaked in early 2014 and have struggled since IT security benefits from the need for constant innovation The dynamic nature of IT security offers continual business opportunities in the sector
  9. 9. Section 1: Waves, cross currents and undertow Innovation 3 March 2015 ed.maguire@clsa.com 9 Of course, innovation does not insulate investors from the risks of globalization and competition. Despite being one of the most disruptive technologies longer term, solar stocks have been an ongoing disappointment to investors over the past five years. Figure 6 Solar technology an idea well ahead of its time Source: Thomson Reuters, CLSA If one assesses stocks according to the Gartner “Hype Cycle”, the 3D sector may be nearing the “Trough of Disillusionment” before reaching the “Plateau of Productivity”, while solar remains mired in the trough for some time. A brief survey of the rich landscape of innovation We explore 20 key innovations worthy of investors’ attention in Section 4. Not all are public entities, but all have consequential implications whether disruptive or in catalyzing the creation of new value. We classify these innovations into five broad categories, which we summarize on the following pages (see Section 4 for further details and the prominent players in each segment):  Building blocks: The foundational technologies for next-generation innovation.  Connectors: The forces that tie together (and push apart) the strands of technological innovation, business evolution and societal change.  Human technologies: The new ways that technology interacts with and extends human capabilities.  Intelligent machines: Cars, aircraft, robots and industrial equipment are becoming connected, smarter and increasingly autonomous.  New horizons: The new waves of innovation with the most potential to impact the world we live in. A key thread across each category is the essential role that software and notably analytics play in enabling innovation. In our view, these are longer- term themes that could profoundly reshape markets, the economy and society at large. As is typical of long-term technology evolution, early stage activities are small, but with exponential progress, inflection points are likely to surprise. 0 50 100 150 200 250 Feb 10 Aug 10 Feb 11 Aug 11 Feb 12 Aug 12 Feb 13 Aug 13 Feb 14 Aug 14 Feb 15 Nasdaq Composite Guggenheim Invest Solar ETF +119.7% -56.0% We detail 20 key innovations worthy of investors’ attention A key thread across each category is the essential role of software and analytics Apple’s US$834m investment in First Solar marks a high-profile clean tech commitment
  10. 10. Section 1: Waves, cross currents and undertow Innovation 10 ed.maguire@clsa.com 3 March 2015 Building blocks We profile key innovations that are foundational in nature. Nanotech provides the avenue for a broad range of new materials with particular significance for semiconductors. As limits of Moore’s Law approach, graphene, organic transistors, 3D stacking, neurosynaptic chips and quantum computing promise new paths for computing. 3D printing is increasingly mainstream and consumer hype is frothy, though industrial uses are well established. Open- source development models are pervading software, hardware and new business models. Advances in nanotechnology underpin an enormous range of innovations in materials that promise new solutions in medicine and healthcare, electronics, industrial design and the military. While much of the discussion has been futuristic, there has been very real progress towards engineering nanoscale machines. Large corporations including GE, HP and Lockheed Martin are leading research and development in nanorobotics. Figure 7 Building blocks Innovation What it means Who could benefit Potentially at risk Related companies Nanotechnology New materials could transform aerospace, medicine, military and manufacturing. Research in semiconductors seeks to break through the limits of Moore’s Law. Any machines at molecular scale can be engineered to perform specific functions. Potential uses are nanomedicine biochips, nucleic acidbots, bacterias, bioprinting Consumers, businesses, aerospace, military, healthcare, semiconductors, biotech firms, pharmaceutical companies, medical patients Prevailing technologies IBM (IBM), Advanced Nanotech (AVNA), American Superconductor (AMSC), Altair Nanomaterials (ALTI), Arrowhead Research (ARWR), FEI Company (FEIC), GE (GE), Hewlett-Packard (HPQ), Northrop Grumman (NOC), American Pharmaceutical Partners (APPX), Harris & Harris Group (TINY), Nanogen (NGEN), LSI Logic (LSI), Lumera Corp (LMRA), Nanometrics (NANO), Nanophase Technologies (NANX), NVE (NVEC), Ultratech (UTEK), Veeco Instruments (VECO) Beyond Moore's Law As the computing industry approaches the physical limits of performance improvement in silicon chips, there are ongoing efforts to extend the exponential trend through new technologies Consumers, businesses, aerospace, military, semiconductors, computing hardware and software, scientific research na Intel (INTC), AMD (AMD), IBM (IBM), Google (GOOG), Lockheed Martin (LMT), D-Wave Systems (Private) 3D printing Custom fabrication, prototyping, spare parts Consumers, designers, industrial designers, manufacturers, service providers, materials producers Spare parts, machine tooling, mass manufacturing 3D Systems (DDD), Stratasys (SSYS), ExOne (EXONE), Proto Labs (PRLB), VoxelJet (VJET), Arcam (Sweden), envisionTEC, EOS (Germany), Renishaw (UK), Organovo (ONVO), Autodesk (ADSK), Staples (SPLS), Adobe (ADBE), Microsoft (MSFT) Open-source everything The open-source model is transforming software development, crowdsourcing, prototyping, datacenters and the replacement of proprietary systems Entrepreneurs, operators of cloud datacenters, corporations and service providers, SaaS independent software vendors (ISVs), consumers, industrial designers, military, consultants Traditional proprietary hardware and software vendors including HP, Dell, Oracle, IBM, Microsoft, VMware, Cisco, EMC, Juniper, etc Facebook (FB), Google (GOOG), Intel (INTC), AMD (AMD), Red Hat (RHT), Hortonworks (HDP), Microsoft (MSFT) Source: CLSA In 2014, the interest and hype around 3D printing finally peaked, and stocks gave back much of their gains from 2013. While hype around consumer 3D printing is frothy, industrial additive manufacturing is well established for prototyping with less than 1% of firms using it for production. We profile innovations that are foundational in nature We profile innovations that are foundational in nature Small things with big impact: nanotech, nanomaterials and nanobots 3D printing - At the peak of hype, but real technology
  11. 11. Section 1: Waves, cross currents and undertow Innovation 3 March 2015 ed.maguire@clsa.com 11 Open-source principles inherently enable innovation, not just in software, hardware and services, but through the derivative benefits to technology users in any endeavor. The open-source model has transformed software development and is increasingly being applied in hardware, networking, crowdsourcing, media and new business models. Connectors In an environment of accelerating change, certain technologies play the role of connectors, acting as enabling catalysts that harness new innovations and pave the way for entrepreneurs. The combination of advanced mathematics, access to massive computing power through peer-sharing, the open-source ethos and powerful new software gives rise to technology-based currency alternatives. Typically created with cryptographic algorithms with security inherent in the designs, there are nearly 100 alternative currencies in various stages of evolution with Bitcoin as the dominant one. In the aftermath of the crash of a speculative bubble, there is increasing interest and investment in the underlying technological principles. Artificial intelligence (AI) governs everything from speech recognition to search, airplane navigation and auto-pilot systems, motion-detection systems like Microsoft’s Kinect for Xbox and intelligent assistants for smartphones. A new generation of self-learning computing promises to instrument the physical world, and integration with advanced robotics will power a new generation of autonomous and semi-autonomous machines. Figure 8 Connectors Innovation What it means Who could benefit Potentially at risk Related companies Bitcoin, cryptocurrencies and blockchain Open-source currencies provide alternative payment systems not tied to governments Startup businesses, low-income workers, citizens in unstable countries, investors Banks, credit card and money transfer firms Private companies for now: CoinDesk, Coinbase, BitPay, many others Deep learning and the next phase of AI Artificial intelligence governs everything from speech recognition to search, airplane navigation and auto-pilot systems, motion-detection systems and intelligent assistants for smartphones Advertisers, businesses, consumers, government, society at large Jobs across a wide range of capacities from blue- collar drivers, security guards and others to knowledge workers like translators, paralegals, medical professionals, investment analysts Google (GOOG), Microsoft (MSFT), IBM (IBM), Baidu (BIDU), Facebook (FB), Amazon (AMZN), LinkedIn (LNKD), many startups Security Trust is paramount in a connected world. Rising levels of increasingly complex IT security threats compel increasingly innovative defenses Consumers, businesses, government, society at large Everyone and everything connected to the internet, including consumers, businesses, utilities, governments AVG (AVG), Barracuda Networks (CUDA), Check Point (CHKP), CyberArk (CYBR), FireEye (FEYE), Fortinet (FTNT), Imperva (IMPV), Imprivata (IMPR), MobileIron (MOBL), NQ Mobile (NQ), Palo Alto Networks (PANW), Qihoo360 (QIHU), Symantec (SYMC), Qualys (QLYS), Proofpoint (PFPT), Cisco (CSCO), IBM (IBM), CA (CA), EMC (EMC) and many others The sharing economy Everything becomes a service as people create new communities for sharing Consumers, advertisers, startups Retailers, hotels, asset vendors Netflix (NFLX), Avis/Zipcar (CAR), Ebay (EBAY), Amazon (AMZN), Groupon (GRPN), Chegg (CHGG), BMW, Yelp (YELP); startups like Uber, AirBnB, TaskRabbit, Lyft, others Source: CLSA Open-source everything Connectors act as enabling catalysts There are nearly 100 alternative currencies in various stages of evolution Artificial intelligence is seeing another resurgence - this time as foundational technology
  12. 12. Section 1: Waves, cross currents and undertow Innovation 12 ed.maguire@clsa.com 3 March 2015 Trust provides the basis for essential functions of commerce and society. With the explosion of connections, applications, communications, information and systems, there’s increasing need for trust to facilitate e-commerce, electronic money transfers and modern conveniences such as ATMs. Threats continue to become more pervasive, driven by technological advances and the growing involvement of organized crime and governments. The IT security market is dynamic, conducive to startups offering fertile ground for innovators and investors. Much of the value in the trade of traditional goods and services is the friction involved with connecting the asset with demand at the time and place of need. With a world of users connected to the internet, this gives rise to services that intermediate and provide a trusted framework. We believe companies like Netflix, Uber and AirBnB offer a blueprint for what the next generation of high-growth businesses will look like. Human technology Advances in natural user interfaces make controlling compute increasingly seamless, as translation services bridge language barriers close to real time; natural language understanding makes interactions more human; and motion-sensing advances control computing from the human body. Over the past three years, augmented-reality and virtual-reality technologies have captured public imagination and we are seeing viable products on the cusp of mass markets. Facebook’s Oculus VR, Google Glass and Microsoft HoloLens reflect a range of approaches to the user experience that will lead to a new generation of applications and entertainment. Figure 9 Human technology Innovation What it means Who could benefit Potentially at risk Related companies Next-generation user interface Speech, touch, gesture, language translation, brain computer interfaces (BCI), natural language understanding Anyone that wishes to interact with computing: consumers, business, transportation, healthcare, education, telecommunications, manufacturing, military, etc Service jobs, especially call centers, legacy hardware providers Microsoft (MSFT), Nuance (NUAN), Google (GOOG), Apple (AAPL), IBM (IBM) Virtual reality Gaming, entertainment, commerce, travel Consumers, game developers, content creators na Facebook (FB), Microsoft (MSFT), Samsung, Sony (SNY), Google (GOOG) Wearables Healthcare, retail, customer service, finance Healthcare patients, consumers, medical personnel, investors Administrative, customer-service jobs Apple (AAPL), Google (GOOG), Samsung, Sony (SNY), Nike (NKE), Intel (INTC), Qualcomm (QCOM), Microsoft (MSFT), GoPro Body 2.0 Mobility, strength augmentation Disabled and/or handicapped, military, construction workers, etc na Raytheon (RTN); private companies including Berkeley Bionics, Ekso Bionics, Rex Bionics, Cyberdyne Computational genomics Gene sequencing, genetic analysis Individuals, health patients, pharmaceutical companies na Agilent Technologies (A), Bio-Rad Laboratories (BIO), Danaher (DHR), Illumina (ILMN), Life Technologies (LIFE), PerkinElmer (PKI), Safeguard Scientifics (SFE), Sigma Aldrich (SIAL), Techne (TECH), Thermo Fisher (TMO), Waters (WAT) Source: CLSA Security is an ongoing “arms race” between bad actors and security professionals Assets are rented not owned in the “sharing economy” Natural user interfaces make controlling compute increasingly seamless Augmented reality and virtual reality have captured public imagination
  13. 13. Section 1: Waves, cross currents and undertow Innovation 3 March 2015 ed.maguire@clsa.com 13 2014 was the year that hype around wearable computing reached fever pitch, and a flood of new market entrants has resulted in a highly fragmented market with no breakout successes. Fitness bands, smartwatches, glasses, connected clothing and a myriad of other devices battle for market share and mindshare as the industry awaits the Apple Watch. Advances in bionics, prosthetics and exoskeletons are empowering the physically disabled as well as giving industrial workers and soldiers superhuman strength. Mobile healthcare technology is seeing robust innovation among consumers and professionals, though adoption is concentrated at the ends of the spectrum among the very healthy and very sick. Complementing the surge of entrants in wearable activity trackers (Jawbone, Fitbit, Nike+) are similar advances in FDA-approved apps for diagnostics and treatment. Despite robust VC investment and high-profile media coverage, the market remains nascent and highly fragmented. We expect Apple, Google, IBM, Microsoft and Qualcomm to foster a robust ecosystem of startups and partnerships. The declining cost of computing, more powerful systems and the capacity to store and process massive quantities of data create conditions conducive to accelerating innovation in the life sciences. With Illumina’s latest machines lowering the cost of a sequenced human genome below US$1,000, genomics is actively decoding elusive mysteries of DNA, the “source code” for the human body, with promise of proactive avoidance and better treatment for cancer, Alzheimer’s, multiple sclerosis and other chronic diseases. Intelligent machines There has been a dramatic increase in awareness around consumer and commercial drones, technically known as unmanned aerial vehicles (UAVs), as growing availability of cheaper and more powerful systems makes the technology ever more accessible. While UAVs are a substantial market for military aerospace suppliers, it’s the consumer and commercial markets that give rise to new investment opportunities. The fundamental nature of transportation is changing as autonomous vehicles prove technological viability and sensor-based vehicle communications systems promise to ease traffic jams and improve safety. The bigger challenges lie ahead with laws, lawmakers and insurance companies. Advances in robotics are having a transformative effect on manufacturing and industry as a new wave of personal and collaborative robotics comes to market. A key thread across each category is the essential role that software and notably analytics play in enabling innovation. 2014 was the year that the Internet of Things as a term became widely adopted in the mainstream media, and our report Deep Field: Discovering the Internet of Things focused on the growing relevance and opportunities across consumers and businesses in a full spectrum of industries. The 2015 Consumer Electronics Show hosted over 900 companies exhibiting Internet- of-Things solutions, primarily in the smart home, automotive and wearable categories. While the major inflection point is not expected until 2017-20, seeds for immense transformations are already sowed. Connected health poised for steady adoption Computational genomics are decoding the software of nature 2014 was the year that hype around wearable computing reached fever pitch Autonomous vehicles and robotics will remake transportation and manufacturing Consumer and commercial drone markets give rise to new investment opportunities A world connected - the Internet of Everything
  14. 14. Section 1: Waves, cross currents and undertow Innovation 14 ed.maguire@clsa.com 3 March 2015 Figure 10 Intelligent machines Innovation What it means Who could benefit Potentially at risk Related companies Drones Drone aircraft, delivery services, consumer hobbyists, precision agriculture, public safety Merchants, military, residents of remote areas, farmers, transportation companies, public safety na Google (GOOG), Amazon (AMZN), Lockheed Martin (LMT), AeroVironment (AVAV), Northrop Grumman (NOC), Boeing, Textron (TXT), General Dynamics (GD), SAIC (SAIC), GoPro (GPRO), Ambarella (AMBA), IXYS Corp, (IXYS), InvenSense (INVS) and others Smarter cars and autonomous vehicles Self-driving cars, trucks, buses, industrial vehicles Consumers, businesses, automobile manufacturers, auto supply chain, military Spare auto parts, the auto industry itself Google (GOOG), Toyota Motor (TM), Ford Motor (F), General Motors (GM), Raytheon (RTN), AeroVironment (AVAV), Boeing (BA), Northrop Grumman (NOC), Textron (TXT), BAE Systems (BAESY), Adept Technology (ADEP), Bosch, STMicro, InvenSense, Skyworks Solutions, Nvidia, Qualcomm, Broadcom, Infineon, Texas Instruments Robotics Automated manufacturing, surgical robots, trainable robotic assistants, domestic robots Manufacturers, healthcare, consumers, military Labor, especially employees doing repetitive tasks in manufacturing, service, etc Amazon (AMZN), iRobot (IRBT), Google (GOOG), Raytheon (RTN), Moog (MOG), Intuitive Surgical (ISRG), Cognex (CGNX), Accuray (ARAY), AeroVironment (AVAV), Northrop Grumman (NOC), Rockwell Automation (ROK), General Dynamics (GD), Boeing (BA), Teledyne (TDY), Textron (TXT) The Internet of Things Myriad implications for both industrial and consumer Consumers, businesses, manufacturers, logistics, military, public safety, wireless sensor network providers, analytic software vendors na IBM (IBM), CA Technologies (CA), Cisco (CSCO), EMC (EMC), GE (GE), National Instruments (NATI), Google (GOOG), Intel (INTC), AMD (AMD), Siemens (SIE), Teradata (TDC), SAP (SAP), Splunk (SPLK), Informatica (INFA), Broadcom (BRCM), Qualcomm (QCOM); wireless network, sensor and analytic software vendors Source: CLSA New horizons With aggregate student debt in the USA having surpassed US$1tn, there’s increasing interest in online alternatives. Khan Academy has seen good success offering online instruction for K-12. College-level massive online open courses (MOOCs) have seen significant momentum and VC investment. Challenges are high dropout rates and accreditation, but the joint Georgia Tech/Udacity Master in Computer Science program points in an encouraging direction. Figure 11 New horizons Innovation What it means Who could benefit Potentially at risk Related companies MOOCs College-level online courses Students, education startups Traditional universities, colleges DeVry (DV), Strayer Education (STRA), Capella (CPLA), 2U (TWOU), Apollo Education Group (APOL), Rosetta Stone (RST); private companies including Coursera, Udacity, edX The clean web Energy conservation, smart grid, energy usage analytics Consumers, businesses, the environment Utilities ABB Systems (ABB), Badger Meter (BMI), IBM (IBM), CA Technologies (CA), Cisco (CSCO), GE (GE), EMC (EMC), Emerson Electric (EMR), Google (GOOG), Intel (INTC), AMD (AMD), Itron (ITRI), EnerNoc (ENOC), SilverSpring (SSNI), Opower (OPWR); private firms including Gridpoint, Tendril, many others The new space race Cargo, exploration, space mining Aerospace firms, suppliers, scientific research na Boeing (BA), Northrop Grumman (NOC), Lockheed Martin (LMT), Raytheon (RTN); private companies Virgin Galactic, Planetary Resources, SpaceX Source: CLSA There is a surge of interest in measuring and optimizing energy usage among individuals, businesses and especially operators of power-hungry datacenters. Despite concerns over a “cleantech bubble”, progress is real, with growing mainstream acceptance of “green” alternatives such as Tesla’s electric cars. Leading tech companies are committing to and investing in clean power, with Apple’s US$845m investment in solar power in California the most prominent. MOOCs don’t fail me now Powering the future with “the clean web”
  15. 15. Section 1: Waves, cross currents and undertow Innovation 3 March 2015 ed.maguire@clsa.com 15 We highlight key areas with innovation momentum: energy analytics for homes and businesses; technology for energy companies (smart grid); and energy-efficient technologies for the “green datacenter”. A new wave of privately funded companies is pursuing a range of ventures including commercial space-cargo flights, low-Earth-orbit space tourism, asteroid exploration for resource extraction and longer-term plans for manned space ventures to the Moon and Mars. Major aerospace firms Boeing, Lockheed Martin and Northrop Grumman are actively engaged, alongside leading private companies SpaceX, Virgin Galactic and Planetary Resources. Software - Value is migrating upward as it “eats the world” We’ve long expounded the view that value migrates upward in the technology “stack” from hardware to infrastructure software to software applications. There is an ongoing tech-sector business model transition from products to products plus services to services. Declining cost of compute and storage allows system architecture to evolve from optimized, tightly coupled systems (mainframe) to computationally “wasteful”, loosely coupled cloud-computing services. As we discuss in more detail in Section 3, hardware and services vendors are increasingly moving into software for technology and business reasons. This does not preclude disruption, but mitigates the impact for a while. Manufacturers and retailers increasingly attach software and cloud services to their physical products. Non-technology companies are compelled to invest in applications and services to differentiate their products in a global market. It’s no longer tech and internet companies vying for the most promising startups in Silicon Valley; companies in other sectors are seeking out investment and acquisition opportunities. General Motors recently terminated a US$3bn outsourcing agreement with HP to do more in-house development, in the process increasing the number of programmers from 1,500 to 8,000. Companies in retail, agriculture, industrial equipment, automotive, consumer- packaged goods, energy, utilities, telecommunications, media and nearly every sector must adapt and evolve or face disruption, or worse. There are numerous recent examples of non-technology companies making investments or acquisitions in software:  GE created a separate business division - GE Software - to advance its vision for “software-defined machines”.  Under Armour bought fitness tracking app developer MyFitnessPal for US$475m.  Monsanto acquired the Big Data weather analytics company Climate Corporation for US$930m. Companies like Coca-Cola, General Motors, Castrol and many others seek to replicate the Silicon Valley innovation model by establishing their own startup incubators and venture funds. If software is in fact transforming every industry, investors need to evaluate non-tech companies based on their command and embrace of these new technologies. Signs pointing to an improving backdrop, but doubts remain There are several contrasting views regarding prospects for growth and innovation at the beginning of 2015. With the S&P500 and Dow Jones Industrial Average hitting new highs, there’s clearly a bullish stance driving public market investment. There’s a transition from an economy of products to an economy of products plus services To die on Mars? The new space race Non-tech corporations are investing to compete in a digitized, connected world Non-tech companies are establishing startup incubators and venture funds There’s clearly a more bullish tone driving public market investment Non-technology companies feel compelled to invest in applications and services
  16. 16. Section 1: Waves, cross currents and undertow Innovation 16 ed.maguire@clsa.com 3 March 2015 Figure 12 Dow Jones Industrial Average versus US unemployment rate Source: Research.stlouisfed.org, Thomson Reuters Sentiment is steadily improving, judging by the influx of VC funding and concurrent increase of investments. GDP in the USA has been steadily inching up and the official unemployment rate has dipped below 6% as a sluggish post-recession recovery begins to pick up the pace. However, there’s ongoing debate regarding the future of US growth between the techno-optimists and those that view technology as ultimately contributing to slowing GDP growth. Techno-optimists cite the Law of Accelerating Returns There’s an optimistic school of thought that the convergence of information technologies, clean energy and connectivity bringing billions of new minds online will catalyze enormous gains in wealth, health and quality of life. The most passionate advocates like Ray Kurzweil and Peter Diamandis of Singularity University see the current technological disruptions to industry and employment as temporary, paralleling the dislocations seen in prior industrial revolutions. People have dealt with change in the past, ergo this time it’s just another cycle set to play out along historical lines. Technologists and investors tend to project the future in stepwise terms. Human beings naturally have linear intuitions about the future because linear thinking progresses logically from experience. However, innovations and paradigm shifts occur at an accelerating, often exponential pace. This creates a disconnect. The difference between linear and exponential growth is tremendous: 30 linear steps equals 30, while 30 exponential steps equals one billion. This is the nature of information technology, and it has powerful implications for the pace of innovation more broadly in society. This phenomenon is known as the Law of Accelerating Returns. The way the exponential progress in technology accelerates change can be illustrated by comparing mass adoption of inventions over the past 150 years. One only has to look at the rapid growth of Facebook and the explosive growth in tablet computing that the iPad catalyzed to appreciate accelerating paradigms. 0 2 4 6 8 10 12 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 20,000 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 (%)(Index) DJIA (LHS) US unemployment rate Tapping into accelerating change As US indexes hit new highs, unemployment finally dips below 6% Techno-optimists see current disruptions to industry and employment as temporary
  17. 17. Section 1: Waves, cross currents and undertow Innovation 3 March 2015 ed.maguire@clsa.com 17 Figure 13 Adoption paradigms are accelerating Source: Ray Kurzweil, KurzweilAI.net In The Age of Spiritual Machines, author Ray Kurzweil coined the phrase ‘the second half of the chessboard’ in reference to the point where an exponentially growing factor begins to have a significant economic impact on an organization's overall business strategy. While the numbers on the first half of the chessboard are large if each square doubles the number of grains of rice (from the story of the clever inventor’s idea when a king asked him to name his own reward), the amount on the second half is over 4bn times larger. Today’s computer chips pack over 4bn times more computing power per dollar than was available in the mid 1960s, packing more power in a pocket smartphone than NASA used to send astronauts to the Moon. Innovation fuels an optimistic view of the future We share an optimistic view, though tempered somewhat. Cloud computing, the mobile internet, non-traditional user interfaces, advances in programming science and artificial intelligence, and falling costs of compute and bandwidth place unprecedented power in the hands of everyone, from a child with a cellphone to entrepreneurs to researchers seeking to solve the challenges of medicine. For investors, it’s critical to time investments in disruptive technologies appropriately, as there are risks being too early or too late. Mired in the trough of a tech “supercycle” but with an upturn ahead There’s also a longer-term view that the economy is undergoing a protracted realignment as it emerges from the trough of a multidecade technology supercycle. Economist Carlota Perez defines the “turning point” as the current phase of the grand ICT supercycle that commenced with the crash of the internet bubble in the early 2000s and persists today. Perez’ view is that this turning-point period may last a few more years, with structural changes to the economy working themselves out until we emerge into a new economic “golden age” in the decades ahead. Perez has framed current conditions as part of a cycle that has played out with prior secular technology shifts. Her work draws from economists Nikolay Kondratieff and Joseph Schumpeter in framing multidecade waves of technological change that occur in surges about once every 50 years. These Telephone Radio Televison PC Mobile Phone The Web Facebook ? 0.1 1 10 100 1860 1880 1900 1920 1940 1960 1980 2000 2020 (Years) Technological change has reached ‘the second half of the chessboard’ Carlota Perez frames current problems as a consistent pattern seen in prior technology shifts The turning-point period may last a few more years The challenge always remains a combination of timing and careful selection The rate at which new inventions reach widespread adoption is accelerating
  18. 18. Section 1: Waves, cross currents and undertow Innovation 18 ed.maguire@clsa.com 3 March 2015 technology waves come in two major stages, installation and deployment, punctuated by a turning point (invariably a bubble, crash and recession). The current ICT revolution is the fifth upheaval experienced by the capitalist system since the first industrial revolution in the late 18th Century. Since we first encountered this thesis in 2011, we have become more convinced of its applicability to our current conditions. Figure 14 The historical record: Bubble prosperities, recessions and golden ages Source: Carlota Perez The installation period typically begins within a mature economy, where there are battles between new and old, with a great deal of experimentation in the free markets. What follows is a frenzy of investing, inflated asset prices and speculation. This aptly describes both the dot.com bubble as well as the real- estate asset bubbles. We are experiencing a painful transition likely to last a few more years as the economy readjusts and the ICT revolution propagates broadly across society and the economy. The current economic dislocation is unsettling, but innovations highlighted within this report lay the groundwork for the next golden age. During the deployment period, there is expansion of both new and rejuvenated sectors, as this phase allows the potential of new technologies to come to fruition. This is a period of creative construction, where the benefits of wealth are spread more broadly, and capital and finance decisions are directed towards production rather than speculation. There’s a fair case to be made that the modest improvements in the economy, emergence of new types of business models such as sharing-economy apps, increased VC funding and an improving employment backdrop point to the emerging character of the new economy. However, the disruptive impact does not appear to have played out fully at this point. Maturity 1771 The Industrial Revolution Britain 1829 Age of Steam and Railways Britain 1875 Age of Steel and heavy Engineering Britain/USA/Germany 1908 Age of Oil, Autos and Mass Production USA 1971 The ICT Revolution USA INSTALLATION PERIOD Bubble collapse DEPLOYMENT PERIOD No., date, revolution, core country TURNING Bubble prosperity POINT Golden age prosperity 1st Canal mania Great British leap 2nd Railway mania The Victorian Boom Internet mania, Telecoms, emerging markets, Financial casino & housing Sustainable global "golden age"? 5th London funded global market infrastructure build- up (Argentina, Australia, USA) Belle Epoque (Europe) "Progressive Era" (USA) 3rd The Roaring Twenties Autos, housing radio, aviation electricity Post-war Golden Age 4th 1793-97 1848-50 1890-95 Europe 1929-33 USA 1929-43 2007/08 -???? Every major technology development surge has seen the same pattern play out The installation phase is a period where new firms are formed and older firms fail
  19. 19. Section 1: Waves, cross currents and undertow Innovation 3 March 2015 ed.maguire@clsa.com 19 The new normal is here and it’s not growing There’s also a growing school of thought that views the technology-led productivity gains of the 1990s and early 2000s as temporary - that the real impact of the ICT revolution will be a lower sustained pace of economic growth. Robert Gordon, professor of economics at Northwestern University, created a stir with his paper “Is US Economic Growth Over” in 2012 and several subsequent updates. He predicts that for the next 25-40 years, real per-capita disposable income of the bottom 99% of the US income distribution would grow at an average annual rate of 0.2%, a tenth the pace of the 2% per year for the century before 2007. Gordon makes the argument by comparing the ICT revolution to the first two industrial revolutions, with the view that the first two revolutions spurred growth that lasted 100 years as innovations were absorbed into the economy. His view is that after an initial boost in productivity and growth from 1994- 2004, the potential impact from further technology innovations will be minimal while multiple headwinds will limit US economic growth. Gordon makes the case that the impact of the second industrial revolution beginning around 1870 was exceptional because the major inventions of the era coincided within a short time and powered a massive transformation of society and the economy. These inventions included electricity, the internal combustion engine, running water, indoor heating and plumbing, rearranging molecules with petroleum, chemicals, plastics and pharmaceuticals, and the evolution of communications and entertainment devices including the telephone, phonograph, radio and motion pictures. These innovations saw adoption from zero to near 100% in developed countries, creating massive new industries as a result. From productivity gains to entertainment devices In contrast, the third industrial revolution (which he characterizes as computers and the internet) provided an initial boost to productivity by automating away rote tasks and repetitive work. There was a boost to economic growth at the advent of the “new economy” in the late 1990s, but after 2004 most of the impact of innovations has been around devices and entertainment and the economic benefit faded. In his view, the biggest gains from computers and the internet have already been well absorbed by the economy and society and the changes ahead are far less consequential. This line of thought aligns with economist Tyler Cowen’s book The Great Stagnation. Gordon segments the average growth rates of US labor productivity into several intervals to illustrate his case: from 1891-1972, labor productivity growth averaged 2.33% per year; from 1972-1996, it was 1.38%; from 1996-2004, it was 2.46%; and from 2004-2012, it was just 1.33%. In his view, the era of computers replacing human labor is over, replaced by a succession of consumer entertainment and communications devices that have little to no effect on productivity. In our view, the declining cost of compute, storage and connectivity is just now (2015) enabling a whole range of new uses of the technology in different industries - with the impact from “sharing economy” and Internet-of-Things applications yet to come. Technology has deflationary impact on corporate wages There’s increasing evidence that adoption of technology drives value creation by automating tasks, but this has deflationary impact on wages. Andrew McAfee of MIT compared labor’s share of corporate expenses versus corporate profits as a share of GDP. 2015 data show ever-widening divergence since the There are growing views that the ICT revolution will lower the sustained pace of economic growth The first two industrial revolutions spurred growth that lasted 100 years The impact of the second industrial revolution beginning around 1870 was exceptional After 2004, most of the impact of innovations has been around devices and entertainment Is the era of computers replacing human labor over? Increasing evidence that technology drives value creation but is deflationary to wages
  20. 20. Section 1: Waves, cross currents and undertow Innovation 20 ed.maguire@clsa.com 3 March 2015 last recession. Corporate profits, meanwhile, have never been higher in absolute terms or as a percentage of GDP. This analysis highlights that the two lines typically move in the opposite direction: when more money is paid out to workers, there’s less left over for profits. The labor component includes realized compensation and fringe benefits as well as benefits like healthcare coverage for retirees. Figure 15 Corporate profits gain as a share of GDP, while labor’s share of business declines Source: Research.stlouisfed.org, Andrew McAfee (MIT) It’s our view that technological advances are also a key factor behind the growing divergence between rising corporate profits and labor’s declining fortunes. When technologies arise that reduce the need for human workers at lower costs, the cost of technologies also tends to decline over time. This allows productivity gains without impacting corporate profits, while reducing labor’s share of the pie. We’d note that there is also a “productivity paradox”, which refers to the transformative technologies - that there is typically a delay between the installation of the new systems and realization of productivity benefits. MIT professor Erik Brynjolffson found that there can be a five- to seven-year lag between deployment of an enterprise-resource-planning (ERP) system and subsequent benefits. A contrarian view to Robert Gordon’s argument is that he may not anticipate the delayed impact of technologies on a broad societal scale. The explosive proliferation of smartphones and social computing is just taking hold, which would suggest that broader gains in productivity lie ahead and their impact may surprise us in magnitude and apparent suddenness. Digital disruptions can catch the best informed by surprise Technology revolutions can be painfully disruptive. Forecasting the future is difficult, and even those with the deepest expertise can fail to anticipate adoption of disruptive technologies - by orders of magnitude. In the mid- 1980s, AT&T asked McKinsey to forecast the number of cellphones in the USA in 2000 - the forecast was 900,000 - the actual number turned out to be 109m. In 2000, Kodak had US$14bn in revenue and US$2.2bn in profit, and filed for bankruptcy in 2012. Often it’s the industry experts that dismiss disruptive technologies. 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12 90 95 100 105 110 115 1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 (Index) Business sector: Labor share CP/GDP (RHS) Technologies get cheaper over time, so productivity gains don’t impact corporate profits Automation enhances profits by reducing wages The productivity paradox could play out on a larger scale Even those with the deepest expertise can fail to anticipate adoption of disruptive technologies
  21. 21. Section 1: Waves, cross currents and undertow Innovation 3 March 2015 ed.maguire@clsa.com 21 Tech disruptions come from below, from above and as a “big bang” Stanford professor and author of Clean Disruption Tony Seba characterizes three types of technology disruption:  Disruption from below, which refers to the classic disruptive innovation articulated by Clayton Christensen in his book The Innovator’s Dilemma, where new entrants have lower cost and functionality and ultimately displace incumbents who are focused on taking care of their customers. Change can come rapidly. The print newspaper industry increased from US$20bn in 1950 to US$60bn in 2000, then dropped in half by 2010 because of web advertising.  Disruption from above, which differs in that the disrupting products start at the high end of the market, eventually disrupting incumbents as prices decline over time. Tesla is an example of a superior product and service that works its way down market as costs decline.  Big bang disruption, which starts with better performance, lower price and more customization. The impact of Google Maps on hardware GPS units is an example. Technology adoption exacerbates imbalances Despite the promises of innovation, Robert Gordon and other others are quantifying painful economic imbalances that are becoming more pronounced. The modern digital revolution has yet to deliver on the promise of better jobs and higher productivity. Instead, the new economy is creating immense wealth with far fewer workers, with income growth stagnating for the vast majority of employed. The stratification of income growth over the past decade has concentrated the majority of income gains in the top percentile while the median income in 2011 is 8% lower than in 2007, having peaked in 1998. These figures show earnings from labor are declining as a share of total economic output, but the share gains from highly skilled sectors have been growing. Figure 16 Median income and employment have diverged from GDP growth Source: Research.stlouisfed.org, Andrew McAfee (MIT) Cutting a broad swath through unskilled jobs The phenomenon of technology replacing jobs is not at all new. What’s different now is that it’s software and artificial intelligence replacing tasks and jobs at a dramatic pace. The downside for employment is that fewer people (100) 0 100 200 300 400 500 600 700 0 50 100 150 200 250 300 350 400 1953 1963 1973 1983 1993 2003 Private employment Labor productivity Median household income Real GDP (Index=100) Despite the promises of innovation, there are increasingly painful imbalances Software and artificial intelligence are replacing tasks and jobs at a dramatic pace Disruptions come from below, from above and as a “big bang” The “Great Decoupling” of income and employment from GDP growth accelerated in the 1980s
  22. 22. Section 1: Waves, cross currents and undertow Innovation 22 ed.maguire@clsa.com 3 March 2015 are required in many industries (eg, airlines, manufacturing and the supply chain). As service-sector tasks are increasingly automated, this reduces the need for cashiers, toll takers and potentially taxi drivers as we’ve previously seen technology replace stenographers, typists or bookkeeping people. Economist Tyler Cowen highlights the growing phenomenon of the technology-aided high performer. He notes that we are seeing what's called labor-market polarization, a concept identified with MIT labor economist David Autor. Increasingly, workers are falling into two camps: those that do very well and those that do not do well at all. Digitization and dematerialization: Everything becomes software The forces of digitization (of information and media) and dematerialization (reducing goods and services to software) have profound implications for the economy and for society on a global basis. Rendering physical goods into digital bits and bytes has profound implications across the value chain, impacting manufacturers, the supply chain, distribution, retailers and end users. Digitization turns services into software An example of the impact of digitization is tax-preparation software. Intuit created packaged software that replaces many of the functions previously performed by a certified public accountant (CPA) or other tax-preparation professionals. Typically for less than US$100, the consumer gains access to the same (or more up-to-date) level of expertise that not only formerly costs hundreds of dollars but also employed many middle-class professionals. Over the next decade, we expect to see further disruption and transition as physical goods and services are increasingly attached to and replaced by software. Dematerialization turns gadgets into bits An example of dematerialization is the transformation of consumer electronics into software applications. Historian Steve Cichon looked at a 1991 ad by Radio Shack. He calculated that 15 items, including pocket calculators, cameras, mobile telephone, video camera, clock radio, portable CD player, video cassette player and other items, were worth US$3,054 at the time (equivalent to US$5,100 in 2012 dollars). He found that the functions of all of these items were included in a US$600 iPhone, a 10:1 compression of value. “The second economy” connections largely hidden from view Digitization has transformative and disruptive implications. Dematerialization (of personal electronics, recorded music, books, video, etc) alters the economics of many businesses based on physical goods. As more computers become connected, a fundamental shift occurs as business processes that were previously handled by human beings are now being executed electronically. Because these processes usually involve computers talking to one another, they are unseen. W Brian Arthur, professor at the Santa Fe Institute, raised the idea of a “second economy” in a 2011 article for the McKinsey Global Institute. He argued that information technology is creating a digital second economy. Processes in the physical economy are being entered in the digital economy, where conversations occur between servers and nodes, checking steps and updating data before reconnecting with humans. Processes that used to be handled by humans, such as booking an airline ticket and checking in for a flight, are now handled almost entirely by electronic means. Rendering physical goods into digital bits and bytes has profound implications across the value chain Software programs can replace expert professional services A fundamental shift as human business processes become digital communications Information technology is creating a hidden, digital “second economy” Consumer electronics are being reduced to software applications
  23. 23. Section 1: Waves, cross currents and undertow Innovation 3 March 2015 ed.maguire@clsa.com 23 Arthur describes the second economy as ‘vast, silent, connected, unseen and autonomous (meaning that human beings may design it but are not directly involved in running it). It is remotely executing and global, always on and endlessly configurable. It is concurrent - a great computer expression - which means that everything happens in parallel. It is self-configuring, meaning it constantly reconfigures itself on the fly, and increasingly it is also self- organizing, self-architecting and self-healing.’ Despite disruption, traditional GDP measures may not capture change One of the great challenges with the advent of digitization is that measuring digital goods and services as a proportion of GDP is difficult, if not impossible. Eric Brynjolfsson and Andrew McAfee, authors of The Second Machine Age, estimated the total value of digitized goods to the US economy at roughly US$300bn per year that does not get measured as traditional output. Much economic value is not captured by traditional means While the music industry saw revenue decline from US$16bn in 1998 to around US$6bn in 2008, listeners have been able to access music through YouTube, Spotify, Pandora, iTunes and other sources that are difficult to measure. Similar economics apply to magazines, newspapers and other print media that have seen readers migrate online. Hours spent on the internet continue to climb (doubling from 2001 to 2011) and consumers access ever more free goods in the form of Facebook postings, blogs, online videos, games and other pursuits. As the volume of digital goods increases, this renders the traditional GDP measure less useful. Challenges to US long-term growth are broad-based In his January 2014 paper, “Is US Economic Growth Over? Faltering Innovation Confronts the Six Headwinds,” Robert Gordon cites the following challenges to growth: the end of the “demographic dividend”; rising inequality; factor price equalization stemming from the interplay between globalization and the internet; the twin educational problems of cost inflation in higher education and poor secondary student performance; the consequences of environmental regulations and taxes that will make growth harder to achieve than a century ago; and the overhang of consumer and government debt. More funding, but fewer startups 2014 saw a turnaround as 254 US venture funds, up 23% YoY, raised a total of US$29.8bn, up 68% YoY, surpassing 2008 levels. According to the MoneyTree Report by PriceWaterhouseCoopers (PwC) and the National Venture Capital Association (NVCA), startup investments in 2014 were US$48.3bn, up 61% from 2013. University of Maryland economist John Haltiwanger’s team used Census Bureau data to calculate annual startup rates by dividing the number of new firms by the total number of firms for each year. In the late 1980s, the startup rate was 12.0%. This declined to 10.6% before the 2007 Great Recession, then fell sharply below 8% in 2009. The percentage of all firms that were five years or younger was 47% in the late 1980s and declined to 39% in the mid 2000s. According to US Census Bureau data, all net new job creation in the USA between 1980 and 2005 came from young businesses less than five years old. The skills gap remains an issue with many unfilled jobs Despite growing cannibalization of many types of jobs, there is also a growing unfilled need for more highly trained employees. A report from Georgetown University's Center on Education and the Workforce, authors Anthony The second economy is ‘vast, silent, connected, unseen and autonomous’ An estimated US$300bn in digital goods are not measured in annual US GDP The music industry saw revenue decline from US$16bn in 1998 to around US$6bn in 2008 All net new job creation in the USA between 1980 and 2005 came from young businesses There are multiple headwinds challenging long-term US economic growth
  24. 24. Section 1: Waves, cross currents and undertow Innovation 24 ed.maguire@clsa.com 3 March 2015 Carnevale, Nicole Smith and Jeff Strohl predict a shortage of 3m workers with post-secondary degrees by 2018, increasing to 5m by 2020. The lack of skills in science, technology, engineering and mathematics is pronounced. This points to shortcomings in K-12 education, while disproportionate cost increases in higher education are an obstacle and burden to students. R&D investment lags, while regulation creates new burdens The USA is now in 10th place among the Organization for Economic Co- operation and Development (OECD) nations in R&D investment as a percentage of GDP, a decline from 2nd place in 1992. Between 2009-11, the Obama administration issued 106 new regulations that are each expected to have an economic impact of at least US$100m a year. Sarbanes-Oxley costs roughly US$1m, on average, a year for public companies, a significant burden for smaller public firms. What the new economy will look like There’s always risk in trying to predict what the future economy will look like, but there are threads that will characterize the coming decade. Many of the changes will be generational, as the digitally native millennials increasingly exert impact on commerce, culture and innovation. Other shifts result from what Gartner refers to as the “Nexus of Forces”, IDC defines as the “3rd Platform” and BCG describes as a “software-driven digital metasystem” - a mobile-first environment of near-infinite compute power and connectivity with the capacity to scale massively sophisticated analytics in real time.  Products become experiences. This also touches on a potentially more profound shift away from a consumerist culture based on ownership of physical products. Sharing-economy businesses like Uber, AirBnB and Lyft address needs through a shared-asset model. Connected health-fitness trackers include gamified cloud applications. In “How Smart, Connected Products Are Transforming Competition,” a November 2014 Harvard Business Review cover story, co-authors Michael Porter of Harvard Business School and Jim Heppelman, CEO of PTC, outline how an emerging generation of cloud-service-enhanced products will create new partner ecosystems and fundamentally new value chains in the economy.  Design drives differentiation. Companies like Apple, Chrysler, Oxo and others have embraced the premise that smartly designed computers, cars and kitchen tools can stand out in established categories. While engineering remains critically important, creative design is paramount for developed-market firms to prosper in an environment where production is global, choices are myriad and competition is omnidirectional.  More value from fewer resources. Businesses are finding ways to produce more with less energy and materials. Additive manufacturing (3D printing) reduces manufacturing waste; smart grids and intelligent thermostats like Nest optimize energy consumption; and cloud computing allows startups and enterprises to innovate faster with lower costs and overhead. The ability for startups like Pinterest and WhatsApp to scale to hundreds of millions of users with only a few dozen employees is a harbinger of hyper-efficient organizations. The skills gap is forecast to create a shortage of 5m workers by 2020 There will be growing emphasis on the total experience rather than discrete products Creative design is paramount for developed- market firms to prosper Businesses are finding ways to produce more with less energy and materials There are threads that will characterize the coming decade
  25. 25. Section 2: Cash builds amid decline in startups Innovation 3 March 2015 ed.maguire@clsa.com 25 Cash builds amid decline in startups Robust gains in VC funding and investment complement healthy capital markets and M&A activity. However, the pace of new business formation continues to decline. Structural dynamics favor larger firms as headwinds include slippage in science, technology, engineering and mathematics (STEM) education, broken immigration policies, costly patent litigations and over-regulation. Availability of financing options is crucial to innovation activity and competitiveness, and 2014 saw robust activity in IPOs, M&A, venture-capital funding and investment. As the bar to the capital markets grew higher in the wake of Sarbanes-Oxley legislation, the ability to secure returns through initial public offerings has been difficult since the number of annual offerings peaked at 650 in 1996. For venture-backed firms, the past decade has been challenging, as the number of offerings dropped from 92 in 2007 to just seven in 2008. However, this has rebounded to 81 in 2013 and 115 in 2014. Research firm CB Insights identified 590 US tech companies backed by venture capital or private equity with valuations over US$100m in the IPO pipeline in 2014. Of these, 43% raised additional financing or exited via IPO or M&A, with the remaining 57% still active. We see 2015 shaping up to be another strong year, with 588 US tech companies in the IPO pipeline backed by venture capital or private equity with valuations over US$100m. Figure 17 Annual US venture-capital exit activity Year Total M&A deals (No.) M&A deals with disclosed values (No.) Total disclosed M&A value (US$m) Average M&A deal size (US$m) No. of IPOs Total offer amount (US$m) Average IPO offer amount (US$m) 2007 488 200 30,745.5 153.7 92 12,365.5 134.4 2008 423 134 16,236.9 121.2 7 765.0 109.3 2009 361 109 12,364.9 113.4 13 1,979.8 152.3 2010 545 151 17,713.5 117.3 66 7,409.5 112.3 2011 500 169 24,093.2 142.6 50 10,441.1 208.8 2012 490 132 22,694.2 171.9 49 21,459.9 438.0 2013 393 95 16,909.8 178 81 11,068.2 136.6 2014 455 132 46,024.1 348.7 115 15,299.1 133.0 Source: Thomson Reuters, National Venture Capital Association In 2014, venture-backed IPOs raised US$15.3bn from 115 listings, reflecting the strongest full-year total for the number of venture-backed IPOs since 2000. Figure 18 US venture-backed company M&A deal activity Source: Thomson Reuters, National Venture Capital Association 1.0 4.4 4.9 6.7 7.6 3.5 8.6 26.4 86 98 116 93 113 114 133 95 0 5 10 15 20 25 30 35 0 20 40 60 80 100 120 140 160 180 200 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 (No. of deals) (US$bn)Total deal value (RHS) Total M&A deals Deals with disclosed values For startups, access to venture capital and angel investors is particularly important Venture-backed M&A exits increased in 2014 from 2013 With 588 US tech firms in the IPO pipeline, 2015 is shaping up to be another strong year Robust gains in VC funding and investment, but pace of new business formation declining
  26. 26. Section 2: Cash builds amid decline in startups Innovation 26 ed.maguire@clsa.com 3 March 2015 The pace of M&A exits grew significantly as acquisitions of venture-backed companies were valued at US$46.0bn in 2014 from 132 deals with disclosed values out of a total of 455 deals. This marks the strongest year for venture- backed M&A since 2012. The average M&A deal size grew to US$348.7m in 2014 from US$178.0m in 2013, representing a YoY increase of 96%. Excluding Facebook’s record-breaking acquisition of WhatsApp for US$19.5bn, total disclosed M&A value would be US$26.5bn or US$202.5m in the average M&A deal size, still representing a YoY growth of 14%. Venture fundraising recovers Funding had also been challenging for the past five years, particularly for smaller firms, but 2014 saw a turnaround as 254 US venture funds, up 23% YoY, raised a total of US$29.8bn, up 68% YoY in dollar terms and surpassing 2008 levels. Figure 19 Annual US venture-capital fundraising activity Year Number of funds Venture capital (US$m) 2008 213 25,050.4 2009 161 16,088.7 2010 175 13,272.0 2011 191 19,060.5 2012 218 19,838.2 2013 207 17,694.1 2014 254 29,826.4 Source: Thomson Reuters, National Venture Capital Association The Center for Venture Research found that US angel investors funded 70,730 entrepreneurial ventures worth some US$24.8bn in 2013, up 8.3% from US$22.9bn in 2012. The number of active investors increased 11.4% from 2012 to 299k, but data showed that investors who did invest in 2013 have decreased individual investments slightly from US$85k in 2012 to US$83k in 2013, representing a 2.8% YoY decline. Angels invested in a variety of sectors, with software leading at 23%, followed by media (16%), healthcare (14%), biotech (11%) and retail (7%). According to the MoneyTree Report by PwC and the NVCA, startup investments in 2014 were US$48.3bn, up 61% from 2013. The number of deals at 4,356 grew 4% from a year ago. Internet-specific companies captured a total of US$11.9bn in 2014, the highest level since 2000, while the software industry also grew to the highest level since 2000, with a total of US$19.8bn investments from 1,799 deals in 2014, representing a 77% YoY increase in dollar terms and a 10% YoY increase in deal volume. However, entrepreneurial activity has declined Despite the robust capital market and VC rebound, entrepreneurial activity has been declining. The formation of new firms has seen a continued dip since reaching its most recent peak in 2010, returning to the pre-recessionary levels of 2006. The Kauffman Index of Entrepreneurial Activity tracks the pace of formation of new businesses in the USA. It’s not particularly clear what the drivers are, but the trend has been underway for some time. Last year was also strong for venture-backed M&A Funding grew dramatically (68% YoY) for VC firms in 2014 US venture funds raised US$29.8bn in 2014 VC investments increased 61% YoY in 2014 It’s not immediately clear why startup activity has declined
  27. 27. Section 2: Cash builds amid decline in startups Innovation 3 March 2015 ed.maguire@clsa.com 27 University of Maryland economist John Haltiwanger’s team used Census Bureau data to calculate annual startup rates by dividing the number of new firms by the total number of firms for each year. In the late 1980s, the startup rate was 12.0%. This declined to 10.6% before the 2007 Great Recession, then fell sharply below 8% in 2009. The percentage of all firms five years or younger was 47% in the late 1980s and declined to 39% in the mid 2000s. Figure 20 Kauffman Index of Entrepreneurial Activity Source: Kauffman Foundation The increasing capital efficiency of software and internet firms (with the proliferation of open-source software and public cloud computing) reduces initial capital needs for many startups. This, in turn, lowers barriers to entry for startups, while altering the value equation. Because the amount of capital needed is less, a VC investment in itself is no longer a de facto competitive advantage for startups competing for the same markets to the extent that capital access itself is strategic. The value that venture investors provide is management insight, access to executives and customers, mentoring and other intangibles. R&D spending modestly improving, but lagging other nations Battelle/R&D Magazine forecasts 3.2% growth to US$465bn in US R&D expenditures in 2014. With an Office of Management and Budget (OMB) estimated 2.2% inflation rate in 2014, this effectively represents an increase of 1.0% in real terms. In 2013, the US federal government spent US$121bn on R&D funding, representing a drop to 27% of the overall US total from the prior year due mainly to the impact from sequestration. The most active investors in innovation are in the computer/electronics industry, which accounted for 26% of R&D spending in 2014. Healthcare is the second-largest R&D spender, accounting for 21% of the total, followed by autos at 16% and industrials at 11%. According to Booz & Company’s annual study of the 1,000 largest publicly traded firms based on R&D investment, R&D spending grew at 1.4% to US$647bn in 2014, the second year in a row of slower-than-average growth after the strong gains in 2011 and 2012. The three top industries by R&D spending were computing & electronics, healthcare and auto. 0.30 0.29 0.29 0.30 0.32 0.34 0.34 0.32 0.30 0.28 0.26 0.27 0.28 0.29 0.30 0.31 0.32 0.33 0.34 0.35 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 (%) Lightweight innovation has reduced capital needs for software and internet startups Many well-known technologies have their roots in government R&D Downward trend of entrepreneurial activity continued in 2013 Chinese firms grew R&D investment in 2014 at an impressive 45.9% YoY
  28. 28. Section 2: Cash builds amid decline in startups Innovation 28 ed.maguire@clsa.com 3 March 2015 Figure 21 Global innovation spending by industry Source: Booz & Company A recent study by the Brookings Institution noted that the US share of global patenting and R&D is falling much faster than its share of global GDP and population - meaning it’s not simply the result of demography or macroeconomic convergence. From 1981 to 2011, the US share of world GDP fell 7% versus a 1% decline in share of world population. While this reflects gains from smaller countries, the USA lost 12% share of global patenting and R&D spending, while US R&D imports saw an 18% Cagr from 2000 to 2012, twice as fast as R&D export growth. Federal support for basic research as a percentage of GDP has declined 13% over the past decade. In 1992, the USA had the second-highest R&D investments as a percentage of GDP among OECD nations. It has now fallen to 10th place. While the USA is losing some of its competitive edge, emerging nations are increasing their research investments in order to stimulate economic growth. China is projected to outspend the USA in R&D within the next 10 years. Innovation benefits from technology enablers We identify several accelerators of innovation from a technological perspective. The convergence of enabling factors and technologies leading to declining cost of innovation - open source, cloud computing, mobility and commoditization of hardware/software and bandwidth - provides the catalyst to create value and accelerate innovation, all facilitated by software. Key enabling trends include:  Exponential declines in the cost of computing, bandwidth and storage, which lower barriers to adoption and enable unparalleled scale for new ventures.  Cloud computing, which enables users to procure IT resources and content on an as-needed basis.  Open-source software, which empowers users with flexibility and increasingly robust functionality at little or no cost.  The mobile internet, which connects users with information and applications regardless of device, connection or location. Computing and electronics 26% Healthcare 21% Auto 16% Industrials 11%Software and internet 9% Chemicals and energy 7% Aerospace and defense 3% Consumer 3% Telecom 2% Other 2% The most innovative companies are in the computer/electronics industry Over the next decade, computing will become increasingly embedded in daily life The USA lost more share of global patents and R&D spending than GDP or population The rank of R&D investment as a share of GDP has dropped as well
  29. 29. Section 2: Cash builds amid decline in startups Innovation 3 March 2015 ed.maguire@clsa.com 29  Growing penetration of internet users and social networking, which results in near-ubiquitous reach of services. Computing is becoming more intuitive and pervasive with the evolution of more powerful software, rapid growth of endpoint devices, availability of instant-on connectivity and declining costs of hardware, bandwidth and storage. We see the continuous elevation of simplicity of experience to the user as logic controls the underlying systems, processes and infrastructure with increasing power. These concurrent trends have a transformative impact, accelerating innovation across the broader economy in traditionally non-tech as well as technology industries. Commoditization of computing, bandwidth and storage The commoditization of computing, bandwidth and storage has proven to be a continuous dynamic. The principle of Moore’s Law, which holds that processor performance can double every 18 months, has held fast since the 1970s, while price performance of Dram continues to improve along a similar dynamic. Figure 22 Moore’s Law Source: Wikipedia (Wgsimon) In fact, the dynamic of exponential cost and performance improvement is occurring across a broad range of technologies. While improvement occurs at different rates, the consistent historical trend remains a common dynamic across different hardware technologies. Butters’ Law (named for Gerald Butters, former head of Lucent's Optical Networking Group at Bell Labs) posits that the amount of data coming out of an optical fiber doubles every nine months, essentially cutting the cost of data transmission in half over that period. Technology has a transformative impact, accelerating innovation across the economy Cost of computing, bandwidth and storage continues to decline Moore’s Law has held fast since the 1970s
  30. 30. Section 2: Cash builds amid decline in startups Innovation 30 ed.maguire@clsa.com 3 March 2015 Figure 23 Time to double (or half) Dynamic Ram memory “half pitch” feature size 5.4 years Dynamic Ram memory (bits per dollar) 1.5 years Average transistor price 1.6 years Microprocessor cost per transistor cycle 1.1 years Total bits shipped 1.1 years Processor performance in MIPS 1.8 years Transistors in Intel microprocessors 2.0 years Microprocessor clock speed 2.7 years MIPS = Millions of instructions per second, a measure of processing capacity. Source: Ray Kurzweil, KurzweilAI.net Cloud computing accelerates incubation of new ideas Cloud computing has lowered barriers for technology adoption, reduced time to market and placed unprecedented computing power in the hands of startups, departmental IT staff and others heretofore lacking access to scalable systems. Importantly, the availability of cloud-based resources is lowering barriers for startups and fuels accelerating innovation. The capital efficiency that can be applied to developing, introducing and then iterating on these new applications is declining. The capital efficiency for a venture firm trying to launch new companies is becoming much better. The Law of Accelerating Returns on these technologies is at play. Cloud computing facilitates a range of new use cases around social computing, mobile services and high-performance analytics, all of which have the potential to create new economic value. Cloud computing reflects the industrialization of information technology. While this has disruptive effects on certain providers of infrastructure components and services, there are many beneficiaries of broad-based adoption of cloud computing.  Businesses benefit from lower costs for technology, IT staff and overhead, while gaining benefits of agility. Lowering the marginal cost of failure accelerates innovation and allows for rapid value creation. The extensible aspects of cloud computing allow businesses to scale online operations far more quickly than possible on their own, for less capital, with less risk.  Consumers benefit directly and indirectly from the availability of cloud- enabled applications. Cloud-enabled search, entertainment, information services, location-based services and applications democratize access to culture, knowledge and commerce. Dematerialization of physical goods (for instance, the digitization of books, music and video) into cloud- delivered services reduces friction around information flow. It’s our view that cloud computing and related technologies such as open- source software and higher-level programming languages are a parallel to James Watt’s steam engine in the first industrial revolution, with compute power substituting for coal. As such, disruption within the IT infrastructure market is likely to continue along a path of creative destruction as proprietary infrastructure hardware and software providers see their ability to charge premium “rents” and enjoy attractive profit margins steadily erode.  A wholesale economic model disrupts a bespoke industry. We point to the 2006 introduction of Amazon’s EC2 as the turning point where scalable compute and storage became available on a self-serve, pay-per-use model. Availability of cloud- based resources is lowering barriers for startups Exponential cost and performance improvement occurs across technologies Cloud computing enables social computing, mobile services and high- performance analytics Open-source software and higher-level programming languages parallel James Watt’s steam engine
  31. 31. Section 2: Cash builds amid decline in startups Innovation 3 March 2015 ed.maguire@clsa.com 31  Native cloud architecture commoditizes infrastructure hardware and software. A mature Platform-as-a-Service (PaaS) layer decouples the application logic from the underlying infrastructure and makes infrastructure components increasingly interchangeable and subject to the forces of commoditization. Open source - Freeing innovation and enabling cloud computing Open-source principles inherently enable innovation, not just in software, hardware and services, but through the derivative benefits to technology users in any endeavor. There are over one billion lines of freely available open-source code that developers and business users can access to create applications and new businesses. Free open-source software reduces costs for startups as well as new projects within IT organizations. Even with paid technical expertise and support, the ROI tends to be overwhelmingly favorable for open source. Open-source alternatives to proprietary technologies gain ground The shift to cloud computing accelerates as open source is increasingly viable for the enterprise. There are increasingly viable open-source alternatives to proprietary software, all the way up the stack from OS (Linux, Android) to database (MySQL, MongoDB, Cassandra), Big Data/data-warehousing management (Hadoop, Talend), content management (Drupal), application server (JBoss), analytic tools (R language, Pentaho, Jaspersoft), customer relationship management (CRM) (SugarCRM) and many more. It is not unusual for startups, particularly in the internet or e-commerce arena, to avoid use of proprietary software entirely. The mobile internet - “Any device, always on, anywhere” The explosive adoption of internet-enabled smartphones and the growing availability of wireless internet are key innovation vectors for new services and applications, including micropayments, content streaming, multiplayer gaming, location-based services and a plethora of targeted applications. In the coming decade, the deployment of high-speed mobile networks will help realize the vision of always-on high-speed internet connections and adoption of data-based applications. Figure 24 Global IPv6-capable devices will reach 6.2bn by 2019 Note: Internet Protocol version 6 (IPv6). Source: Cisco 2015 2.01 2.61 3.30 4.09 5.04 6.21 0 1 2 3 4 5 6 7 2014 2015 2016 2017 2018 2019 Number of devices (bn) Open source has been critical to enable innovation, not just in software Adoption of smartphones and the wireless internet helps realize the vision of pervasive computing The leading cloud platforms, including Google and Amazon EC2, are built on open source Smartphone penetration will connect billions to the internet for the first time
  32. 32. Section 2: Cash builds amid decline in startups Innovation 32 ed.maguire@clsa.com 3 March 2015 Advanced mobile networks support a new generation of innovative applications, including content, shopping, HDTV, collaboration, social networking, video conferencing, robust gaming, additional personalized offerings and Internet-of- Things applications. This in turn expands the innovation of connected devices beyond tablets, smartphones and laptops. Increasingly, there will be wireless- connected audio, video, sensors, industrial equipment, automobiles and appliances. The availability of greater bandwidth will facilitate adoption of advanced applications, which should drive further growth of data traffic. The proliferation of mobile applications is representative of the variety of innovations enabled by smartphones and the mobile internet, and this will be reflected both in consumer and enterprise adoption. New types of mobile applications expected to see healthy growth include money transfer by short message service (SMS), mobile search and browsing, location-based services, mobile music and video services, near-field communications services, mobile health monitoring and many others. Mobile explosion a hotbed for innovation The world is increasingly mobile, with over 6.9bn estimated subscribers in 2014, representing approximately 96% of the world’s population, according to the International Telecommunication Union. The penetration rate for fixed-line telephone service in 2014 was estimated to be less than 16% of the world’s population. IDC estimates the worldwide mobile-phone market will grow at 5.4% YoY in 2014 to over 1.93bn mobile-phone shipments, with smartphones accounting for 67% or nearly 1.3bn units. Figure 25 Figure 26 Mobile broadband connections, excluding M2M Global average mobile network connection speeds Note: Machine to machine (M2M). Source: GSMA Intelligence Source: Cisco VNI Mobile 2015 Not only are the number of connections growing, bandwidth is as well. The GSM Association estimates mobile broadband connections at a 15% Cagr from 2013-20, while average global mobile network connection speed is forecast to increase by a 9% Cagr from 2014 to 2019. In the USA, mobile penetration is heading towards ubiquity, with 41% of households “wireless only” in 2013 as estimated by the National Center for Health Statistics. For carriers, mobile revenue continues to benefit from subscriber adoption, growing 2.2 times in wireless data usage in 2013 over 2012, driven by the proliferation of smartphones, tablets, netbooks and other mobile devices. 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 (m) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 2014 2015 2016 2017 2018 2019 (kbps) Innovations and connectivity enable a new class of mobile applications to emerge Total global mobile subscribers approximate 96% of the world’s population More devices, faster connections: more bits More advanced mobile networks will support a new range of innovative applications

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