Traditional asset-heavy companies may seem safe from explosive industry change, but there is trouble on the horizon. To stave off disaster, incumbents must transform their core operations while also growing into new businesses and industries.
Not all industries have been exposed to the “big bang” changes that are often associated with the spread of new technologies. When we analyzed exits from the S&P 500 between 2000 and 2015, we saw that more than half came from just three industries: consumer products, information technology, and financial services. In other sectors, changes in the rise and fall of companies have been much more gradual.
That may seem like comforting news to many leaders, but the reality is more complex. Our analysis of the performance of more than 1,200 companies in six of the most asset-heavy sectors —telecommunications, utilities, energy, materials, automotive, and industrials — revealed an equally worrying trend. (See “About the Research.”) Incumbents throughout these industries are falling prey to “industry compression”—a form of slow, but dangerous change that results in a prolonged decline of both operating profits and revenues.
A compressed core business, even in a long-established industry, can become altogether obsolete if a company fails to transform in time. To appreciate the intensity of compression, consider the accelerating decline of “voice” as a means of communicating via mobile telephone. From 2013 to 2015, average mobile voice revenue per user declined globally by 19%. A further 26% decline is expected through 2020.1 The business impact of this decline has been the stalling of a decade of growth: Revenues and earnings before interest, taxes, and amortization (EBITA — a measure of operating profits) in the sector have dropped by an average of 8% from 2013 to 2015, down from over 120% growth during the previous decade.
Companies at risk from the dangers of compression may not recognize the extent of the threat to their core businesses, as the life cycle of decline can be as stealthy as it is insidious. In the initial phase, companies experience a period of “empty” growth, as revenues continue to increase despite a stagnation in EBITA growth. In the next phase, companies see a further decay in performance, in which year-on-year EBITA declines at a faster rate than revenue. Then comes a period of brief recovery that provides a false hope that essential, structural challenges within the industry can be managed with business as usual; some companies drop prices in order to prevent a decline in revenue. Soon after comes a sharp and prolonged decline — well beyond what would be expected of simple cyclical change — of both operating profits and revenues. (See “The Life Cycle of Compression in Asset-Heavy Industries.”)
These four phases of compression are especially visible when the performance of the six industries we analyzed from 2004 to 2015 is contrasted with that of the S&P 500. The two groups of companies followed similar trajectories until 2010. But the S&P 500 maintained the margins achieved in the post-2008 recession recovery, while the six industries we examined fell into prolonged decline.
The prolonged decline phase is where operating margins steadily shrink with no sign of recovery in sight. This phase is the result of the slow disruption effects that are weakening the core business, rather than a challenge brought by a more predictable cyclical change.
As an incumbent’s ability to arrest decline in its operating profits weakens, expensive, nonliquid assets become more of a burden. They restrict cash flow and the ability to invest outside the core business, which only accelerates compression. And the longer a company hesitates to act, the more compression steadily eats away at the existing business model, eroding the economic headroom to rotate a core business to new growth markets.
Ironically, when performance begins to decline, management teams often believe the only solution is a vicious cycle of cost reduction and share buy-backs. Unable to resist the pressure to deliver short-term results, they fail to strike the right balance, ultimately sacrificing long-term potential. This is evident in the telecommunications, utilities, and energy sectors, where “future value” — the growth investors embed into the share price based on expectations for products and services that have yet to be developed — as a share of overall enterprise value is less than 1%. In other words, their total value is tied almost entirely to their core business, leaving them dangerously exposed if the core comes under attack.
The substantial decline in the performance of shipping companies shows how quickly fortunes can change under myopic management. Despite sluggish growth in the wake of the 2008 recession, companies continued to invest in new, ultra-large vessels to boost scale and reduce slot costs. Executives expected the boom in international trade that preceded the economic crash to resume— but the flood of cargo never came. In 2015, for the first time in history, global GDP grew faster than worldwide container traffic, signaling a structural rather than cyclical shift in demand for maritime trade. Eight of the 10 largest listed shipping companies subsequently reported EBITA losses in the first half of 2016. The third biggest, Hanjin Shipping Co. Ltd., based in Seoul, South Korea, filed for bankruptcy protection, leaving 66 ships carrying $14.5 billion worth of goods stranded at sea in 2016. While this decline in performance has been driven in part by complex changes to demand and trade patterns globally, it is also the result of the companies’ inability to identify the danger of compression and modernize for the digital age.2
As we examined the common patterns of compression in the core businesses of these six sectors, and the prolonged decline of these businesses’ EBITA margins, we sought to understand the common challenges incumbents faced in responding to compression. We also investigated how high performers successfully managed to combat compression in their core business. What can other companies learn from the mistakes — and at times valuable foresight — of companies that have gone through a compression cycle?
The Siren Songs of Compression
Given compression’s gradual emergence, one would expect incumbents to accurately predict and respond to it. But more often than not, incumbents find themselves lulled into a false sense of security. Confident of the enduring stability of their industry, they fail to act, even when their core businesses are heading for the rocks, as if entranced by a siren song — like the songs of the tempting sea creatures that lured sailors to their doom in The Odyssey.
Our review of industries exposed to compression highlights three siren songs that lull incumbents and drive them deep into the danger phases of compression.
Siren Song 1: The Seduction of Perceived Industry Stability
Executives leading asset-heavy businesses were susceptible to a false sense of security as they watched other industries succumb to rapid, radical innovation. Over half of the companies that exited the S&P 500 between 2000 and 2015 came from three relatively asset-light sectors — consumer goods (22% of companies), information technology (18%), and financial services (16%). Those industries were much more vulnerable to turmoil as they were hit much harder by disruption.
In contrast, significant barriers to entry have traditionally sheltered incumbents in asset-heavy industries from radical change. Indeed, much smaller percentages of companies that exited the S&P 500 in the same period were from asset-heavy industries: telecommunications (just 4% of the companies), utilities (5%), materials (9%), energy (9%), health care (9%), and industrials (also 9%, which includes capital goods, such as machinery, and commercial and professional services, such as facilities services and transportation).
The apparent stability of these industries seduced companies into inaction. Consider how the oil price shocks of the 1970s did not directly catalyze a meaningful shift to alternative fuels in the United States — and where shifts have occurred, they have been slow. In the U.S., renewable energy achieved only a 5% share of total energy consumption over a period of 50 years. Similar patterns are evident with the slow rates of adoption of electric vehicles, bioplastics for consumer packaging, and fiber-optic cable versus copper wire in the telecommunications sector. Against this historical backdrop, the siren song of stability in what seems to be a threat-free calm proves irresistible for many incumbents.
Siren Song 2: The Intoxicating Appeal of Assets
Companies in the six asset-heavy industries have tended to compete by owning the assets that matter most to their strategies. These assets have been a potent source of competitive advantage for a long time, with large incumbents benefiting from the barriers to entry created by the need for significant capital investments.
But such assets can quickly become a curse. Indeed, given the types and scale of investments required to sustain the supporting infrastructure of a successful industry incumbent, many companies become tied down by expensive and sometimes underused assets. This problem is not limited only to physical assets: Incumbents may also be hobbled by underexploited intangible assets, such as contractual agreements and legacy brands that no longer foster growth needs of the core business.
As an example, the economics of the thermal generation plants that have historically made up the core of integrated utilities in Europe have been undermined by changes in the regulatory environment in recent years, along with advances in energy efficiency and distributed generation. Even modern plants, some completed as recently as 2013, had to be temporarily mothballed or taken out of the market completely. As a result, the balance sheets of the leading European energy companies have been weighed down with more than 20 gigawatts of stranded assets.3 Profits have taken a significant hit: Following an almost 200% increase in profits from 2002 to 2010 — which continued even through the global financial crisis — the 33 European utilities in our sample saw a 38% decline from 2010 to 2015.
As an industry’s profit-making ability becomes outweighed by liabilities such as long-term debt, operating leases, and pension plans, its freedom to move into new directions is constrained. And as the value of a company’s assets declines, it becomes even more difficult to rationalize overcapacity. Acknowledging this would require the incumbent to write off the assets underlying their traditional offerings — a decision that may be inhibited by both internal costs and external market and political repercussions. The result is often rapid collapse in financial performance due to a company’s inability to sell lethargic assets.
Siren Song 3: The Deceptive Promise of Old Business Models
Large incumbents with long track records of success in their core businesses continue to exploit that core. This instinct works — until it doesn’t. History leads at-risk businesses to overestimate the true lifespan of their business models and to underinvest in building new ones. BlackBerry, for example, famously failed to anticipate that consumers — not business customers — would drive the smartphone revolution. And it failed to quickly capitalize on the popular BlackBerry Messenger instant-messaging service, initially keeping it locked down to its own hardware, while the cross-platform WhatsApp grew into a business that was acquired for $22 billion.
The digital economy places a premium on analytics, algorithms, and software, which sit at the core of all businesses, both asset-light and asset-heavy, that collect data. Asset-light industries saw much of the first wave of new business models that take advantage of data and analytics to create new market opportunities. But disruptive, data-driven new models are coming to asset-heavy industries as well. And as hardware becomes more commoditized, the barriers to entry for new market entrants are lowered.
For example, the coupling of accessible hardware, such as microgrids, with software, like blockchain technology, has led to the emergence of the “prosumer” — individuals who produce, sell, and consume their own energy. There are now an estimated 12 million prosumers in Europe alone, and a quarter of all investment in new renewable energy capacity globally in 2015 — more than $67 billion — went to small-scale projects.4
Odysseus’ solution to the dangers of the siren song was to protect his sailors while still embarking on the journey — he filled their ears with wax while leaving their eyes wide open. But what paths should companies follow after silencing the distractions?
We believe companies today must “rotate to the new,” a journey we think of as a conscious and deliberate act of renewing and transforming the core business while also growing into new businesses and industries. This perpetual journey requires leaders to make a wise pivot to get the timing, scale, and direction of investments right, in both the core and new businesses.
To start the journey, incumbents should address three questions:
How do I know my company is entranced by the siren songs of compression?
When demand for core business begins to weaken, many incumbents continue in business-as-usual mode, pinning their hopes on a rebound in the market. For example, Peabody Energy Corporation and Arch Coal Inc., both based in St. Louis, Missouri, were among the North American mining companies that raised a total of $6.4 billion of debt in 2010 and 2011, betting that prices for metallurgical coal would continue to rise thanks to growing demand in China, despite the risk of a hard landing in the Chinese economy. Both Peabody and Arch filed for Chapter 11 bankruptcy in 2016. They are just the latest in a string of U.S. coal producers to collapse, in an industry that has lost 20,000 jobs and over 94% of its market value since 2011 from $68.6 billion to just $4.02 billion in 2016.5
Many companies have a fortress mentality that fundamentally undermines the adoption of new ideas. Their information-seeking infrastructure is often underdeveloped. In an era of information networks and crowdsourcing, they rely on conventional and often one-dimensional ways of gathering market intelligence.
Those that are able to recognize the siren songs have a censoring capability that draws on insights from diverse and unexpected areas within and outside of the organization. A robust ecosystem is critical to this capability. Leading companies have established strong relationships within their industries, with the venture community and startups, and with technology providers and business schools. Internal teams then work to mine and analyze the information provided by this ecosystem to guide their decision making.
Take Haier Group Corp., based in Qingdao, China, the world’s largest maker of white goods. It has created an open innovation management platform (called the Haier Open Partnership Ecosystem or HOPE) in which more than 600,000 users communicate with suppliers and other customers searching for new business opportunities.6 The German chemical company BASF’s cocreation program, “Creator Space,” is another example. Designed to encourage collaboration with BASF’s customers and partners, the program takes on challenges related to urban living, energy, and food — such as the water supply in Mumbai, India. Teams test concepts during a period of rapid experimentation, both in the lab and with customers, influencers, and potential delivery partners.7
And consider how the automotive sector is adapting to technology-led change. In response to the advent of the connected car and autonomous vehicles, many carmakers are shifting their focus from the upfront earnings that come with vehicle sales toward usage-based revenues derived from software and passenger-mobility services. They have recognized the need to form alliances or participate in ecosystems with technology companies to drive the next wave of innovation. In 2016, partnerships to develop self-driving cars were formed between BMW, Intel, and Mobileye NV, based in Jerusalem, Israel. Other partnerships between Mercedes-Benz and Uber, and VW and Uber’s rival Gett Inc., based in New York City, were formed to develop ride-sharing alliances.
How do I enhance the options for my core business?
Businesses in all industries need to take a fresh look at their assets, including customer relationships and marketing data, and consider whether there are new ways to monetize them. In doing so, they will create new options that represent a strong defense against compression — before profits start to stagnate or revenues decline.
Already prevalent in the technology sector, this approach is now expanding into more traditional sectors of the economy, such as logistics. To prepare itself for the impending growth of additive manufacturing, for instance, UPS is investing in Fast Radius LLC, a 3-D printing company based in Atlanta, Georgia, with 100 printers located in UPS hubs across the U.S. The Fast Radius platform lets customers print parts on demand, which UPS then ships with a response time close to 24 hours. By owning the last mile of fulfillment, UPS has positioned itself to capture a new market while enhancing the optionality of its core business.
Robert Bosch GmbH, based in Gerlingen, Germany, which manufactures automotive components, is also innovating in intriguing ways, developing “living” products and services that adapt to consumer demand. Its iBooster system adjusts the pressure in regular brakes or in regenerative braking systems, which are commonly used to convert kinetic energy to power in hybrid or electric vehicles. In 2016, iBooster was updated with a new feature that connects via the car’s Wi-Fi to a driver’s home network and sends diagnostic and braking details to Bosch. This enables Bosch to rapidly prototype future versions of iBooster. It can also mine the data for other autonomous driving applications. Bosch intends to build on this experience to sell its know-how in logistics, data processing, and manufacturing.8
How do I respond when compression becomes potentially fatal for my business?
Once an industry hits a prolonged, structural period of decline in revenues and profitability, a more wholesale turnaround is required for incumbents whose capabilities are so closely tied to the old businesses.
Consider BT Group plc (formerly British Telecom): Its core business was built around selling access to physical fixed-line telephone and broadband networks in the U.K. But the steady penetration of mobile technology, and the expansion of services, rapidly eroded its primary sources of revenue and competitive position. Indeed, from 2010 to 2013 the entire fixed-line market saw volumes decline by 31 billion minutes.9
In response, BT has worked on a deep transformation of its core business. In its consumer business, it has focused on expanding its network services offerings, building on its long-standing outsourcing relationships with other telecoms to provide a unified service for voice, mobile, and data. Strategic partnerships with venture capital investment companies, which put their own money into launching spin-off companies, have been critical to BT’s transformation. These spin-offs produce telecommunications technologies and services that have been key components of larger offerings from BT to its customers. And BT can market these offerings without shouldering the long-term burden of funding, developing, and upgrading them.
BT has built content-based broadband offerings around the lynchpin of BT Sport, which streams live coverage of British and worldwide football along with rugby, cricket, and other sports. Launched in 2013 with the aim of growing its 700,000 customers to compete against the Sky plc telecommunications company (which at the time had 10 million customers), BT Sport provides three channels for free to broadband customers, who can access the content on any of their devices, from set-top boxes to smartphones. The technology platform that underpins BT Sport was set up in just 150 days, highlighting BT’s ability to make significant strategic adjustments at pace. This has helped drive seven consecutive years of growth in BT’s broadband market share.10
While “big bang” disruption has grabbed the headlines for some time now, compression represents a more pernicious threat. Rather than blowing up specific product or service offerings within an industry, compression gradually, then quickly, renders entire industry segments irrelevant. Incumbents must learn to tune out the siren songs — and tune in to the changes they need to make to successfully sail through the compression zone.