Legg Mason Investment Counsel - Creative Destruction in Information Technology

The technology cycles of the 1990s and the following decade set the stage for today’s emerging paradigm shift in Information Technology (IT). Old modes of computing, communication and storage are being replaced with “virtual machines”, loosely assembled as “clouds”, which will soon communicate through “software-defined networks” to “distributed” storage arrays. Unlike past technology cycles where adoption of new technology required substantial capital investment, the coming cycle likely will be cannibalistic to the $3.7 trillion annually spent on IT. In fact, given the potential productivity gains, it’s possible the overall IT spend could contract, with the successful firms garnering a larger share of the spend, and unsuccessful firms exiting the market. This white paper will review a few of the innovative technologies expected to enter the mainstream in the coming years, which we believe will have a significant impact on the IT landscape and provide ample opportunities for a new generation of successful companies.

APRIL 2012

Thomas W. Krygowski, PhD, CFA
Equity Research Analyst

"The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production…, the new markets, the new forms of industrial organization that capitalist enterprise creates." – Joseph A. Schumpeter, Capitalism, Socialism and Democracy [1942].

Introduction

The technology cycles of the 1990s and the following decade set the stage for today’s emerging paradigm shift in Information Technology (IT). Old modes of computing, communication and storage are being replaced with “virtual machines”, loosely assembled as "clouds", which will soon communicate through “software-defined networks” to “distributed” storage arrays. Unlike past technology cycles where adoption of new technology required substantial capital investment, the coming cycle likely will be cannibalistic to the $3.7 trillion annually spent on IT. In fact, given the potential productivity gains, it’s possible the overall IT spend could contract, with the successful firms garnering a larger share of the spend, and unsuccessful firms exiting the market. This white paper will review a few of the innovative technologies expected to enter the mainstream in the coming years, which we believe will have a significant impact on the IT landscape and provide ample opportunities for a new generation of successful companies.

Background

The modern internet era began in 1990 when Tim Burners-Lee of CERN demonstrated his idea for sharing information over a network using a “hypertext”-based networking protocol. The “http” protocol allowed authors to link their web pages to other web pages and collaborate on a global scale. As more users were added to the network, a greater amount of information became accessible to a global base of consumers, and more applications of this “World Wide Web” of information began to emerge. Industries such as retail, newspapers and postal services worldwide soon began to experience substantial disruption from the emerging World Wide Web during this period.

Throughout much of the 1990s, the infrastructure build out to support growing internet use was designed to establish an initial footprint, so that more and more people could access web pages and exchange emails. During this period, the increase in network traffic was driven primarily by a growing number of consumers, and to a lesser extent by the amount of bandwidth web browsers and email programs consumed. By the end of the 1990s, helped in part by the infrastructure buildup preceding Y2K and an overheated stock market, a substantial amount of communications, computing and storage infrastructure was in place, providing some level of access to the internet for most people in developed countries. When the overheated stock market finally collapsed, infrastructure investments were reigned in, but growth in internet usage never slowed. Consumers and corporations began to understand the productivity gains that could be realized from the internet – often referred to as “network effects”—and began to demand more services and capabilities from Internet Service Providers. The key for investors during this period was to understand which technologies would be most impactful in a post-tech bubble regime and which companies were best positioned to capitalize on those markets when spending resumed.

The early years of the next decade (2000-2010) were characterized by upgrades to networking infrastructure, more efficient server designs (including blade servers), adoption of open-source software (such as the Linux operating system), and a rapid increase in the speed of wireless data networks. Networks designed for voice and cable TV services were upgraded for broadband, GSM/CDMA cell phone networks were upgraded for 2G and 3G data services, and semiconductor companies supported these efforts by driving down chip costs through integration. This infrastructure cycle set the state for an explosion of products and services that had a direct and more profound impact on consumers than was realized in the 1990s. A good example is the iPhone, where Apple was able to leverage its software and industrial design expertise from the iPod to define a new product category, the smartphone. The iPhone would not have been possible without wireless 2G/3G broadband networks, or highly integrated semiconductors developed earlier in the decade. The rate of adoption of the smartphone has been much faster than the PC, allowing Apple to grab the lion’s share of the mobile phone industry profits, as shown in Figure 1, demonstrating that in the right environment, new technology can be quickly adopted and prove highly disruptive to the incumbents - in this case, traditional voice or email-only devices.

Other tech industries have experienced profound change during the prior decade, including the softward industry in it's move to provide "Software as a Service" computing, through-data center consolidation; entire new industries have emerged such as social media (Facebook) and online video streaming (Netflix). As we begin the current decade (2010+), again following an economic recession, the stage is set for the emergence of new applications and/or services that can leverage recent advances in information technology. As with the prior decade, the key for investors will be to understand which technologies will be most impactful in a post-recession regime, given its current state and evolution, and importantly which companbest positioned to capitalize on those opportunities.

Creative Destruction in the Coming Decade

Three industries that we believe warrant particular attention in the coming decade are Personal Computing, Big Data, and Television.  All three industries have existed for some time, largely in their current form, but all three are in a position to marshal recent advances in computing, communications and storage to significantly disrupt their respective industries.

A. Personal Computing

The rapid growth of the iPad, and before that the Netbook, showed that consumers are willing to adopt new form factors if they are cheaper, more convenient, and bring new capabilities.  This is a clear sign that the installed base of 1 billion PC users is segmenting, and that the conventional laptop computer will no longer serve either the installed base or the next billion PC users. Apple recognized this before most in developing the iPad and is working hard to exploit its first-mover advantage in the tablet space. But if one considers that the entire PC industry is ripe for disruption, there are clearly opportunities for others to enter the market and offer original, compelling technology alongside the iPad.

One catalyst for such a disruption is the upcoming Windows On ARM (WOA) platform being developed by Microsoft and ARM Holdings, the designer of ultra-low power microprocessors used in most mobile devices today.  Together with solid state memory in place of spinning disk hard drives, and always-on 3G/4G connectivity, the WOA platform could potentially address emerging PC segments with a highly tailored solution, including industry verticals such as financial, retail and secondary education; it could usher in an era of “virtual desktop integration” (VDI) for mainstream business use. What the platform will lack in computing power, at least initially, will be more than offset with battery lifetimes measured in weeks, with near-infinite storage capacities thanks to cloud storage providers like Dropbox and software hosted on remote servers that is constantly optimized and updated. Product cycles will be much shorter with WOA platforms, and the capacity for innovation much greater with this platform since it will support silicon from several ARM licensees and will be capable of running any standards–compliant, web-based application. Most of the key technologies needed for the PC market to evolve, including highly integrated silicon, high-performance networks, and cloud-based storage and applications are in place today. We expect the computing industry to look substantially different exiting the current decade, as devices like the iPad and WOA-based PCs are embraced by consumers and corporations in new ways.

B. Big Data

Big Data, also known as data analytics or data warehousing has been around for years, and has been used by airlines, trader and retailers to mine data sets for actionable trends.  But with the growth of social networks, cloud computing, digital surveillance video and digital photos, electronic data now takes many forms, and its volume is growing rapidly.  Market researcher IDC estimates that electronic data in all its forms is growing 50% per year and appears to be accelerating.  Clearly a 50% growth rate is unsustainable, so the opportunity emerging is to mine this expanding trove and distill insights from disparate sources to deliver both improved levels of service and entirely new applications.

One enabling technology gaining rapid adoption is a software framework called “Hadoop.” Hadoop was designed to help large scale software applications search through massive amounts of data from a variety of sources and in a variety of formats. It was originally developed by Yahoo!, Google and others to improve the results from web search engines, but today it is finding use in many other types of industries. One example application is facial recognition in video captured in a city-wide network of video cameras. Another would be to combine sentiment data from Twitter and Facebook with retail data frcompanies like Walmart and Target in order to push highly relevant discount offers to consumers’ smartphones, if they athe area and open to such offers.

C. Television

In the global downturn of 2008-2010, cable television subscribers began questioning the logic of paying $70+ per month for 100+ channels of broadcast television, particularly when on-demand options like iTunes, Netflix and Hulu were available for the cost, or free with new terrestrial HD digital broadcasts. The unexpected decline in US pay-TV subscribers in the 2nd and 3rd quarters of 2010 was largely attributed to lower consumer spending, but there was another factor at play, namely the migration by consumers toward internet-based video sources like Netflix and Hulu. With the broadband infrastructure in place today in the US, consumers can now access virtually any movie and most TV shows on anon-demand basis over the internet, in HD quality, on their home televisions. This “non-linear”, on-demand mode of viewing is arguably better suited to consumers’ varied tastes than sifting through dozens of broadcast stations for somethto watch. Given the $41 billion (SNL Kagan, 2010) spent on TV advertising each year, many companies are eyeing thisThe Top (OTT) video opportunity. These include retail, search, even semiconductor companies, all with the goal of siphoningoff the monthly subscription fee and a piece of the advertising revenues currently flowing to cable TV operators and broadcasters. In this post-broadcast world, opportunities include content delivery, particularly to mobile devices, content discovery, due to its role in monetizing older catalogues of movies and TV shows, end devices, allowing on-demand viewing from anywhere at any time, and targeted advertising, since non-linear programming provides much better measurement of consumer viewing habits. The rate of adoption of mainstream OTT video is unclear at this time; what is clear is low-calternatives to conventional broadcast television are improving and will likely represent a compelling option once the uniqucapabilities of OTT video are recognized by mainstream consumers.

Summary

Once again the stage is set for substantial innovation within the Information Technology Sector.  Our belief is that this investment cycle will be cannibalistic to legacy infrastructure and that adoption will be driven by improved productivity and egmentation, while overall IT spending remains constrained. We think three of the most promising areas include Personal Computing, Big Data and Television and see several investment opportunities in these areas for the coming decade.

Disclosures

This paper was prepared by one or more members of the Research Department of Legg Mason Investment Counsel, which consists of Legg Mason Investment Counsel & Trust Company, N.A. and its subsidiary,Legg Mason Investment Counsel,LLC. The presentation is an expression of opinion and is valid as of the date set forth on the cover page. The opinionsexpressed are subject to change at any time. Any data cited have been obtained from sources believed to be reliable, but their accuracy and completeness cannot be guaranteed.

Any securities mentioned may or may not have been recommended, purchased or held for client accounts on the date of the presentation. Client account holdings are subject to change at any time. It should not be assumed that any investments were, or in the future will be, profitable or will equal the performance of any securities mentioned. The presentation should not be used as the basis for investment decisions with respect to any security, industry or sector mentioned.

Past performance is no guarantee of future results.

Thomas joined Legg Mason Investment Counsel in March 2006. He covers the Information Technology sector, including semiconductors, communications equipment, storage, handsets and related industries. Thomas has 12 years’ experience as an equity research analyst and before that was a scientist at Sandia National Laboratories working on silicon micromachining technology. Thomas earned a B.S. in Physics, an M.S. in Electrical Engineering from Rensselaer Polytechnic Institute, and a PhD in Electrical Engineering from the Georgia Institute of Technology. He is the recipient of four US Patents, one for developing a novel Solar Cell processing technology and three in the field of Micro Electro Mechanical Systems (MEMS). Thomas has authored over 22 technical publications in the semiconductor field related to MEMS, Solar Energy, and Compound Semiconductors. He also has taught technical short courses, presented original research and consulted in various technical fields. He is a member of the Institute of Electrical and Electronics Engineers (IEEE) and is a CFA Charterholder.

For more information, contact Bill Smith 410-454-3141 Email Bill Smith

Please note that the content in this section and on the connected pages is paid sponsor content. The conclusions and observations on these pages are the opinions of the sponsor and in no way reflect the opinions or beliefs of WYPR or the WYPR Newsroom.