Nothing stays the same forever and the best companies are those which are flexible and innovative enough to adapt.

Without this capacity they risk becoming obsolete and are likely to face a steady decline in profit and cash flow until they eventually go bust or the remaining viable bits of the business are broken up and sold.

The guiding motto of Andrew Grove, the man behind the rise of US micro chip titan Intel was ‘only the paranoid survive’.

As an investor, you should look for management to remain alive to shifting patterns in their industry, so they are positioned to mitigate their impact or even benefit from them.

Some innovators may even be at the forefront of change by disrupting a cosy sector which had become stuck in the mud.

In this article we will meet the transformers; businesses which have successfully adapted to changes in the past, sectors which are facing significant upheaval and the constituents best placed to meet the resulting challenges. We also look at companies which are in the process of driving innovation themselves.

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WHAT DRIVES CHANGE?

There are several potential catalysts which can shake up a sector or industry. These factors are often interlinked.

Regulatory

Sometimes change is enforced by new rules or legislation. The energy sector, including names like Centrica (CNA) and SSE (SSE), has lost its reputation for solid reliable performance in part thanks to regulator Ofgem speeding up the process of switching providers and ahead of potential new legislation which would place strict caps on energy pricing.

Societal or structural shifts

Fresh regulation is often driven by the concerns of voters, so the increasingly stringent rules on the marketing of tobacco have followed smoking becoming less socially acceptable amid growing concerns over its health impact.

The increasingly dominant role played by the internet across any number of industries is linked to consumers becoming increasingly internet savvy. According to the Office for National Statistics in 2002 just 48% of adults in Great Britain had used the internet. That figure had increased to 89% in the last three months of 2017.

New innovative rival

In recent years the power of the web has been harnessed by brands such as Uber and Airbnb to disrupt the taxi and holiday accommodation sectors respectively. Traditional rivals have attempted to respond by upping the convenience and ease of use of their own services. This disruption is also happening across many other sectors.

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SUCCESSFULLY ADAPTING TO CHANGE

AutoTrader (AUTO) 371.5p

Despite being in existence in one form or another since 1977, AutoTrader (AUTO) is now very much ‘new media’. The slightly dog-eared looking print product for which it was famous was discontinued in 2013 leaving the group 100% digital.

Its main area of business involves persuading car retailers to take out subscriptions on selling, buying and marketing services.

Its site has the most inventories and is therefore the one which prospective car buyers will go to when looking for their next vehicle. This reinforces its position as a must-have product for dealerships and gives it significant pricing power when it comes to securing subscriptions.

Average revenue per retailer was up nearly 10% year-on-year in the six months to 30 September 2017.

The company remains innovative and, alongside its advertising packages, Auto Trader continues to develop its ‘managing’ products i-Control and Retail Check which help retailers source the most desirable cars, price them correctly and manage stock effectively and therefore boost profitability. (TS)

Coral Products (CRU:AIM) 10.8p

The firm used to be a big name in the manufacture of CD, DVD and video cases. Sadly technological advancements in how we consume films and music left the company in a pickle.

Fortunately Coral had the sense to foresee significant change in the media industry and worked hard to diversify its interests, venturing into food container production and automotive components, as well as products for the recycling, telecoms and rail industries.

Admittedly the business isn’t exactly flourishing with recent results showing a drop in pre-tax profit. However, it is a good example of a company which found a way to adapt to market changes rather than cling on to the hope its legacy markets wouldn’t die completely. (DC)

Johnson Matthey (JMAT) £30.34

We believe Johnson Matthey (JMAT) could be at the forefront of the electric vehicle revolution with its potentially disruptive enhanced lithium nickel oxide (eLNO) cathode battery material.

Johnson Matthey’s eLNO material offers more energy density while using less cobalt. Cobalt prices are anticipated to rise on a predicted shortfall in supply, making Johnson Matthey’s material desirable for vehicle manufacturers hoping to keep costs low.

It is still early days. The company has patented the technology behind eLNO and is currently building a pilot plant.

Berenberg analyst Sebastian Bray says the new product could capture 10% of the electric vehicle cathode market by 2025, which is worth approximately £600m.

We believe that eLNO will help Johnson Matthey expand beyond its catalysts business, which generated approximately 60% of group sales in 2017.

Catalysts are used in diesel cars to reduce the number of pollutants but falling diesel car demand and a growing shift to electric cars has prompted fears the company will struggle.

We think investors are overreacting to this threat as auto catalyst sales are expected to keep growing for at least 10 years, according to investment bank Morgan Stanley. (LMJ)

Even big brands undergo change

The concept of reinventing a business can range from reallocating where money is spent to more radical overhaul of a company’s interests.

There have been plenty of examples over the years of businesses trying to make a name for themselves in the world and hitting a stumbling block. This might have been competition, low or negative profit margins, or pursuing a business interest that wouldn’t result in desired scale.

For example, American businessman Ray Kroc opened the first franchised McDonald’s site, having persuaded the original founders of the fast food business, the McDonald brothers, to let him replicate the model used to run the founding site in California.

Kroc then recruited franchisees to run more restaurants under the McDonald’s brand. He soon realised that a 1.4% royalty on a 15c hamburger wasn’t enough to cover his salary and provide money to fund field inspectors to ensure quality standards were maintained.

The solution was to set up a real estate business, owning land for future restaurants and insisting new franchisees had to lease this land for their business. That provided higher returns and gave an element of control as the lease could be cancelled if the McDonald’s franchisee didn’t maintain quality standards.

OTHER EXAMPLES

Once a computer business, Apple reinvented itself as a consumer electronics company and introduced a series of highly disruptive products such as the iPod and iPad. Apple arguably must reinvent itself again as its core products are now seen as commoditised items.

Fifteen years ago Lego was heavily in debt and sales were falling fast. It underwent a massive transformation, introducing Lego-themed movies, rolling out theme parks, opening retail stores and ensuring all the major blockbuster films had Lego-themed products on the toy shop shelves.

Even Netflix has undergone major change, even though the business is only 20 years old. It started out renting DVDs to customers but is now best known as an online business, streaming media content to customers and being an expert in data analytics. Interestingly, you can still rent physical DVDs from Netflix if you are a customer in the US although we imagine that service won’t be around for too long. (DC)

 

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SECTOR IN FLUX – MEDIA

The media sector is yet to fully come to terms with the impact of the internet more than two decades on from its widespread adoption.

In publishing, print media operators have struggled to find a web-based model which can replace the declining revenue from print advertising.

The response in most cases has been to seek efficiencies and merge with rivals to drive down costs. Trinity Mirror (TNI), the company behind the Daily Mirror, recently agreed the £126.7m takeover of the Express and Star titles.

The fact the company is targeting substantial cost savings on titles which have arguably already been starved of investment is not necessarily encouraging for the long-term future of the enlarged entity.

The risk is that by stripping costs out the company undermines the quality of its key brands. If a publisher is not producing quality content then it will struggle to hang on to readers and ultimately advertisers whether this content is being accessed online, or through a physical product. This truth is reflected in Trinity’s ultra-low forward price to earnings ratio of 2.2 times.

PAYING FOR CONTENT

Some media companies have erected paywalls on their websites, meaning you have to pay to read certain content, typically via a subscription rather than paying for individual articles. The evidence suggests paywalls are an easier sell for providers of specialist content than generic news sites.

On the broadcast side, traditional broadcasters like ITV (ITV) and its Scottish cousin STV (STVG) are also seeing their share of the advertising pie shrink. The shifts in the advertising market have also beset advertising agencies themselves.

Global leader WPP (WPP) announced the latest in a series of disappointing updates on 1 March. Chief executive Martin Sorrell admitted 2017 was ‘not pretty’ but WPP is arguing that the problems it faces are cyclical and relate to ad hoc project work rather than reflecting a structural shift in  its industry.

The recent share price action suggests the market is not convinced by this argument and fears advertisers will increasingly cut out middlemen like WPP to deal directly with social media platforms such as Google and Facebook.

Better positioned are those companies which have been plugged into the new media landscape since their inception like online property portal Rightmove (RMV) or companies which have successfully pivoted from traditional publishing activities to push into data analytics like recent addition to our Great Ideas portfolio, RELX (REL). (TS)

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SECTOR IN FLUX – OIL & GAS

BP (BP.) believes demand for oil will peak in the late 2030s amid restrictions on the use of plastic and more widespread global adoption of electric vehicles. Under BP’s projected scenario renewable sources of energy are expected to see significant growth in the coming decades.

Where does this leave traditional fossil fuel operators like BP and its counterpart Royal Dutch Shell (RDSB)?

It is important to note that BP’s forecasts are not for oil demand to collapse but rather stagnate. It will likely take several generations for the world to wean itself off what remains a finite resource.

GOING GREEN

Both companies could be included in a list of the largest global investors in renewables in the eighties, nineties and early noughties.

Arguably this ‘greener’ trend reached its zenith with BP’s ‘Beyond Petroleum’ public relations campaign which launched in July 2000.

While both companies paid lip service to the need to progress to more sustainable sources of energy they continued to invest a much greater proportion of their cash in hydrocarbons.

More recently the renewables strategy was largely abandoned by BP and Shell. However, shortly before Christmas BP announced a $200m investment in Europe’s largest solar power developer as it returns to a space it exited six years ago.

The UK energy firm is set to buy a 43% stake in London-based Lightsource which is developing solar projects in the US, Europe and Asia. It follows Shell’s October purchase of European electric vehicle charging business NewMotion and French counterpart Total’s September €237.5m deal for a 23% holding in French renewables specialist Eren.

These are modest investments in the context of the billions these companies spend every year but are interesting in terms of the wider context as they suggest they are thinking about a post-fossil fuel future again.

WHAT IS SHELL DOING?

Shell’s response has been to target natural gas.

In a June 2015 speech Shell chief executive Ben van Beurden said of natural gas: ‘It is flexible. Its supply is abundant and diverse. Its range of uses is still expanding. It is a low-carbon, clean-burning ally to renewables such as solar and wind. And it makes economic sense.’

Gas accounts for more than half the company’s production and it is active in areas like gas-to-liquids and liquefied natural gas – expanding in this area was a key rationale behind its £36bn merger with BG in 2016. (TS)

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SECTOR IN FLUX – RETAIL

The internet and portable devices like mobile phones and tablets have changed the way consumers buy goods. Many traditional retailers now have multiple sales channels rather than just physical shops, and they’ve had to become better at managing returns sent by post and in-store.

This radical shift in the industry has encouraged new entrants to be online-only operators, putting more pressure on the traditional retailers.

Consumers have become more demanding in wanting rapid service and the ability to send back anything they don’t want. In the fashion space, many consumers are now buying multiple sizes of clothing and sending back the ones that don’t fit, creating extra costs for retailers. Traditionally they would have tried on clothes in a store.

Retailers stuck with long-term leases lack the flexibility to adapt to the ever-changing marketplace. And even online-only operators aren’t guaranteed success because of significant levels of competition.

HOW ARE COMPANIES ADAPTING?

BooHoo.com (BOO:AIM) and ASOS (ASC:AIM) have pioneered the ‘test and repeat’ model. Most low-cost retailers source their clothes from low-cost producing countries and typically must place a large order to make it cost efficient to import. In contrast, Boohoo and ASOS can get a small run of clothing very quickly via local manufacturers. They design something, get it made on a limited run and put it up for sale online.

If it sells ok, they place a big order, otherwise they scrap the product. It means they don’t have the stock obsolescence problem facing other retailers. Traditional retailers often must order clothes many months in advance and they are stuck with stock if it doesn’t prove popular or the weather doesn’t match the style of clothes.

Among the examples of traditional retailers adapting to market developments is Next (NXT) which launched a mail order catalogue called Directory in 1988. It introduced online shopping in 1999 and the entire catalogue became available via the internet.

Prior to its takeover by Sainsbury’s (SBRY), fellow web/physical store catalogue operator Argos struck a deal with eBay so the latter’s customers could collect orders from Argos stores. These are the types of initiatives you’re now seeing as retailers strike deals with third parties to try and encourage more people to visit their stores. (DC)

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SECTOR IN FLUX – TOBACCO

The developed world has seen a significant decline in smoking as governments have cracked down on the way cigarettes are marketed and sold. Awareness of health risks has also spread.

In the last decade, e-cigarettes or vaping products have begun to take market share from traditional cigarettes.

The response of big tobacco companies, including UK-listed names like Imperial Brands (IMB) and British American Tobacco (BATS), has largely been to shift to developing countries where a growing middle class have more cash to spend on cigarettes and where legislation is less restrictive.

This has enabled these companies to deliver healthy revenue, profit and cash flow and enabled them to pay generous dividends.

British American alone is expected to contribute 5% of the dividends from the FTSE 100 in 2018.

As such tobacco companies have become a staple holding for many income funds. Their challenges are therefore worth following for large numbers of investors, not just those who are directly invested in the sector.

HOW IS BATS COPING?

Alongside its full year results on 22 February, British American Tobacco signalled how it is responding to the pressures on its industry. The company, which completed a $49bn merger with US rival Reynolds in 2017, says the combined entity has spent $2.5bn on so-called next generation products or NGPs – essentially vapour and tobacco heating products, since 2012.

British American Tobacco says it is confident of leading this category. In 2017 it generated revenue of £397m from NGPs. It expects this figure to hit £1bn in 2018 and £5bn by 2022. However, to place this in perspective group revenue in 2017 was £20.2bn.

Imperial Brands is gearing up for new NGP launches in 2018. Investec thinks ‘these will remain focused on e-vapour and the blu brand, but the company could yet surprise with launches in other areas’.

‘We think Imperial, if it so wished, could launch a heat-not-burn product within one year and at an easily manageable cost,’ it adds.

Recent share price performance implies the market is sceptical on both companies’ ability to make the transition. In the last 12 months Imperial Brands is down 30% and British American is down 19%. (TS)

Transforming back office functions

Few consumers enjoy contacting a customer service centre. Nobody sets out their day with plans to ring up and spend 20 to 30 minutes of their day hearing a flute solo only to know that the call has been connected to the wrong department. It’s where many big brands fall down.

The big outsourcing switch overseas (typically to India) may have saved organisations hard cash but it didn’t always improve the customer experience.

Industries where customers can freely and easily take their business elsewhere (energy suppliers or phone companies spring to mind) have felt the pinch more than most, hence the transformation in this back-office function.

And the UK market has a couple of quality players; Eckoh (ECK:AIM) and Netcall (NET:AIM). While neither is very large (£101m and £71m respectively) the pair have developed their own smart and automated solutions that please both operators and users.

These customer contact solutions enable enquiries and transactions to be performed on whatever device the customer chooses, allowing organisations to increase efficiency, lower operational costs and provide a truly multi-channel experience.

They also bring something unique to the party too. In Eckoh’s case, that’s an automated phone payments system. Netcall, in contrast, has developed a very handy business process management system called Liberty, allowing clients to engage with their customers via social networks, webchat and outbound messaging.

Eckoh has added ‘live’ web help since 2016’s acquisition of Kick2Contact and is now pursuing growth opportunities in the US.

Robotic process automation is another emerging area to shake up how organisations do simple administration, freeing up more time for staff to add value elsewhere. It’s a theme that has rapidly turned expert Blue Prism (PRSM:AIM) into an AIM sensation, with its share price soaring close on 2,000% since joining the stock market at 78p in March 2016. (SF)

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THE DISRUPTORS – LEADING INDUSTRY CHANGE

ACCESSO (ACSO:AIM) £23.05

You may remember those warm summer family days out at a theme park. You’d start off at the back of a seemingly endless queue to get in, join more long lines for the premium rides, another to get your lunchtime burger or hot dog, only to do it all over again in the gift shop to buy the kids their day-out memento.

Accesso (ACSO:AIM) is one of the market leaders looking to address this logjam through the clever application of technology solutions, from buying tickets, queue-busting, merchandise purchasing and more. For a fee, the aforementioned bumps can be smoothed, making the experience far more fun and customers far more likely to come back in the future. That’s great for attraction operators.

With some very big-name clients including Merlin (MERL) and Six Flags, Accesso is applying its tried and tested solutions to theme parks, sporting events, music gigs, ski resorts, museums and theatres, of which there are thousands of potential new operators and venues. (SF)

KAINOS (KNOS) 352.6p

Large public sector organisations are not known for their sparkling efficiency but partnering with electronic transformation expert Kainos (KNOS) is helping drag many parts of local and central government into the 21st Century digital age.

By migrating paper-based systems and transactions online, high volume processes and transactions can be handled faster, more efficiently and with extra convenience, saving money at the same time. For example, Kainos was responsible for replacing paper car tax discs with an online-only solution for the DVLA and is helping the Cabinet Office develop internet voting systems. It has also developed Evolve, a digital patient journey platform designed to introduce automated and speedier service in the NHS.

Kainos also provides digital solutions to business using the Workday enterprise resource planning platform, with customers including Netflix, Primark and Diageo (DGE).

There’s plenty of opportunity in the UK alone but Kainos has already expanded in parts of the EU (Netherlands, Poland) and the US and today counts 30m end users worldwide. (SF)

PURPLEBRICKS (PURP:AIM) 424.8p

Purplebrick’s (PURP:AIM)business model is easy to understand. It charges an upfront fee to market a house for sale. Unlike traditional estate agents it does not have expensive high street branches to maintain or lots of salaried staff. It instead uses an online platform backed by a fleet of representatives it calls ‘local property experts’.

These ‘experts’ earn commission for each new instruction they win and take a share of ancillary revenue from services including introducing clients to mortgage brokers and offering access to premium property listings.

Its apparently successful disruption of this market helped the shares increase five-fold between its December 2015 stock market debut and July 2017.

Purplebricks’ emergence has forced incumbent operators like leading outfit Countrywide (CWD) to offer their own online-focused services. However, while they are shuttering branches, they are still burdened with costs which Purplebricks doesn’t face.

Of late some of the sheen has come off Purplebricks’ investment case. Critics point out the company remains loss-making despite big increases in revenue.

Jefferies analyst Anthony Codling recently produced research which suggested only 50% of the company’s customers in November 2016 sold their homes within 10 months against company-quoted success rates of 80%.

Codling also reckons the company may have overstated revenue. These criticisms have been ‘firmly’ refuted by Purplebricks.

Fans of the company would point to its ability to disrupt the potentially huge US market after an initial launch in 2017. (TS)

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