Greetings - this is a mid week follow up on a few comments and questions I received on my ARM holdings essay which appeared at the top of SITALWeek #180. This post addresses the question: what happens when the disruptors are disrupted? We are a couple of decades into the Information Age, and some of the early disruptors find themselves being disrupted anew as the pace of change accelerates. It’s an interesting topic for both companies and investors.
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The Pace of Disruption in the Information Age is Accelerating as the Disruptors Become Disrupted
What happens when the low-cost, high-value supplier in an industry is disrupted by an even cheaper alternative like open source? This is a growing trend in the Information Age where early disruptors of legacy Industrial Age capitalism are now finding themselves disrupted by even cheaper alternatives at an accelerating pace! One of the takeaways from my writing on ARM last week for those that didn’t read it was this: predicting the future is hard and getting harder in an age of disruption, so you want to make as few predictions as you can and instead focus on being adaptable. Whether you are running a company or building a portfolio, often there are unexpected developments, like a new competitor with a new business model. In this age of transparency, we find that the business tactics of the 1900s don’t necessarily work anymore. In 20 years of analyzing public companies, the majority of which ultimately fail (and these failures are happening at an accelerating rate), there are only 2 key indicators of potential longevity we’ve come across, and these two cultural traits are highly related - humility and adaptability - the humility to know what you don’t know, and a culture that facilitates constant adaptation within the complex “ecosystem” a company operates in. There are also many smaller pillars of humility and adaptability, such as decentralized organizational structure or pricing products well below what the market will bear. This latter trait we’ve called a “low tariff extractor” by which we mean the company is generating much more value for its customers and partners than it is for itself, which ultimately compounds and creates positive feedback loops, platforms, and network effects that become less exposed to disruption (we expanded on this topic in the NZS white paper recently found here). While most 20th century MBAs and investors (or even worse - investors with MBAs!) believe pricing power - the ability of a company to steadily raise prices - is a key indicator of long term value creation, in most cases, we think the opposite is true. Instead of steadily raising prices, companies that regularly provide more value for the same (or less) cost are more likely to survive long term.
How ARM disrupted Intel to take the mobile market
And this brings us to ARM Semiconductor. Why should we care about ARM? ARM is the semiconductor technology that powers every smart phone in use today and hundreds of millions of other consumer and corporate devices. Without ARM there is no iPhone, and without the iPhone or other smart phones most of the innovation you see around you today wouldn’t exist. ARM makes money 2 ways: 1) ARM charges a large upfront license to companies that want to incorporate their intellectual property (which consists of low-power processors, graphics, and other building blocks for things like smart phones, networking gear, and much more); and 2) ARM then charges a very low royalty rate for each chip that is made containing that licensed intellectual property. In most cases, this per-chip license is well below the value it creates for the customer. For example, a company like Apple (the A-series processors and many other chips in iPhones, iPads, and their watch are all ARM-based) might pay tens of millions up front to license the latest semi building blocks from ARM, and then pay a nominal fee that might add up to a few bucks per phone. Effectively, the vast majority of Apple products today can only run on ARM, and much of Apple’s value is driven off this nominal fee. We love that - ARM is a go-to example of a company that creates far more value for its ecosystem than it does for itself - ARM’s customers have combined market caps in the trillions while ARM itself was sold to Softbank for only $30 billion dollars. But, now, ARM is facing a threat from an even lower cost alternative: open source. Much like we saw in the IT world with Linux eating away at Sun Microsystems, Microsoft, and others in the server market (and Linux is also the core of the dominant smartphone operating systems globally despite many efforts by Microsoft to win in mobile), ARM now faces potential competition from open source competitor RISC-V.
Open Source and RISC-V
Open source solutions have traditionally been software based - communities of software engineers develop and maintain large repositories of programming code for anyone to use and modify as long as they do so in agreement with the goals and rules of the project. Recently, this ideology moved into hardware with projects like Open Compute (started by Facebook), which is focused on design of servers, networking gear and other data center devices. Open source semiconductors, as far as I know, are a relatively new phenomena. In December, the chief technology office of hard disk drive and flash memory giant Western Digital made the following comments:
...we announced our first RISC-V processor core. And we announced that it would be completely open source. So in effect, think about this as doing to the processor world what Linux did to operating systems...Now let me give you a little interesting data point. When we started this with RISC-V and developing our own cores rather than acquiring them from the outside, we said, "Okay, we're on a marathon. We're not on a sprint. And so we need to have modest goals to get going." Right? So we said, "Let's just try to achieve parity with the cores we're using today." Right? So we shipped 1 billion cores a year. And so our first modest goal say, "We're learning something new by putting this together. Let's just basically achieve parity to what we have." That was essentially the goal we set for ourselves. Here's what happened: 30% improvement in power consumption, 40% improvement in performance and 25% reduction in footprint. Version 1.0. Not bad, right?
Wow, that’s quite a statement from a company that ships products with over 1 billion processors every year! A search of conference call transcripts over the last year shows a rise in references to RISC-V, including Microchip shipping the first RISC-V-based FPGA and Marvell Semiconductor potentially losing business at Western Digital. Google is also releasing a version of their machine learning software Tensorflow on a RISC-V chip and is an early supporter of the architecture.
Softbank, who now owns ARM, was asked on their September 2018 earnings call about RISC-V, and a company representative responded with the same thing we heard from software companies fending off Linux 20 years ago - it’s an eerie echo from the past:
RISC-V. It's an open source, and they're working hard and we respect that. However, when they try to develop responsible products, IP issue as -- and security has to be insured. Hacking or virus or various issues are emerging these days, so who will ensure that? This is another point that needs to be considered, so I think that will be a bigger problem or a bigger issue. RISC-V is countering the IoT chip. So Arm's royalty is 0.01 or 0.02, to begin with, so 0.01 or 0.02. To save 0.01 or 0.02, the free, open-source companies, will they go to the OS or go for something that is not responsible or where security is not insured, just to save 0.01 or 0.02?
Well, it seems like ARM’s customers, at least in the case of Western Digital and Microchip, are exploring RISC-V. And, there appears to be broad and growing support for the project despite ARM being a low tariff extractor and platform enabler. So, what’s going on here - why did this happen? One of the articles I referenced last week implied the upfront license cost to get started with ARM is a barrier. This fee probably ranges from $1M to tens of millions depending on the product and the customer. While that may seem like a lot, it’s a drop in the bucket compared to the revenue these chips ultimately garner in the marketplace; so, the upfront cost barrier seems like a strawman argument. And, certainly, that 1-2% royalty Softbank mentions above is enough to keep the lights on and earn ARM a decent profit, but, again, ARM’s value at $30B (based on that royalty cash flow) barely measures compared to the value it creates for their customers. Instead, it seems like what we are dealing with is the inevitable trend toward free and flexible, community supported solutions for the long tail of new applications. When there were a handful of large, concentrated markets with more homogeneous architectures like cell phones, PCs, servers, hard drives, etc., a centralized IP provider like ARM seemed to make sense. And, certainly, ARM was cheaper and more power efficient than the CISC-based x86 alternatives from Intel. Without ARM, it’s safe to say we wouldn’t yet have the multi-billion unit smartphone market - the alternatives prior to ARM simply didn’t have the power efficiency needed. But, now we are entering a renaissance of semiconductors like nothing the industry has ever seen. We are going from millions of early computers to hundreds of millions of PCs to billions of phones to trillions of connected IoT devices - anything that can be connected and anything that benefits from being smarter with AI, machine learning, and software will be connected and will get smarter. The massive, virtuous circle of centralized cloud computing and decentralized, intelligent, connected devices working together to make technology more useful, combined with new interfaces (such as voice input) represent a tsunami of new opportunities - all powered by new semiconductors. These new semis need a hugely diverse set of capabilities and appear much more like the Linux analogy as opposed to monolithic, dominant operating systems that preceded it like Sun, Unix, and Windows Server. Western Digital’s CTO made this very same point last December:
The other reason we were able to do this goes back to the very foundation of all of this, special purpose, general purpose. When we are acquiring cores, great cores, nothing wrong with them, from third parties, they are general purpose. They are trying to solve a problem for many of their customers using one set of IP. When we set out to design our core, we were solving our problem, or more precisely, our customers' problem, how do we optimize the data for our customers. And so because we weren't constrained by putting all of this extra superfluous stuff that we didn't need, this was the end result.
Of course the word “free” above is misleading. RISC-V users will spend hundreds of millions of dollars developing new chips, and there will be at least that much spent on software, security, and other higher level services for the chips. Linux is not free. But it is more adaptable and moldable to a broader set of diverse use cases. So, shifting costs from licensing software to maintaining and improving capabilities of that software is key.
It’s not about product risk, it’s about business model risk
So, what do you do if your company or industry faces a challenge like this from a “free” or better value proposition alternative? Companies have traditionally responded in different ways to open-source competitors. One way is to double down on vertical integration - Sun arguably did this with their servers and storage systems (spoiler: it didn’t work). Another not-so-successful route is litigation and fear - that’s what Microsoft did in the early 2000s referring to open-source software as a cancer and restricting the ability for it to work with Microsoft Software. Microsoft also supported lawsuits trying to bring Linux down. There is also an analogy of the current Oracle lawsuit against Google over Sun’s Java that is ongoing now. So, the first 2 options seem to directly backfire historically. What then might work if faced with such a challenge? Well, in a plot twist, we have to look no further than Linux-hating Microsoft for the best example of what actually works. Under Satya Nadella’s leadership over the last 5 years, Microsoft has become one of the biggest contributors to open-source software including Linux. They also recently acquired Github, a key repository and collaboration platform for software engineers, for $7.5B. Microsoft realized they needed to add value, not in the operating system, but in the services, tools, and applications that customers use. Instead of minting money on Windows Server software, they have emphasized compute-as-a-service on Azure, which also runs Linux workloads. They’ve emphasized Office 365, SQL databases, management and security tools for IT administrators, etc. In essence, they’ve shifted up the value stack to provide their customers with a higher level of tools and services necessary for transition to the cloud/subscription software and de-emphasized selling licenses to Windows Server.
How might a company like ARM respond to a threat like RISC-V? ARM is a phenomenal company filled with amazing engineers and managers that are deeply focused on the success of their customers. As an outsider, it’s unfair for me to speculate and judge, but, with the limited knowledge I have, here are some things I might consider if I were steering the company as an armchair CEO: I would embrace RISC-V for heterogeneous uses while still supporting development in the core roadmap of ARM’s general purpose products. I’d double my engineers and put as many on RISC-V as I have on internal products. I’d create a series of new intellectual property for IoT, security, data, AI, machine learning, etc. I’d eliminate the upfront license fee to work with core ARM products and, to offset, raise the per-chip fee, thereby lowering the initial hurdle but creating more value and, consequently, make as much (or more) over time. This strategy is all very risky, but, perhaps not as risky as doing nothing at all. Indeed, if you look at the hiring ARM is doing, I think they understand the threat and there is a good chance they are implementing an adaptive strategy. Bloomberg recently profiled ARM, indicating much of what I discuss here might already be in progress. Such a transition would be difficult to implement as a public company, especially when ARM’s core market in smartphones have slowed dramatically. So, ARM is lucky to have the cover of Softbank if ARM can focus both on their core business and embrace value-added software, services, and IP blocks for RISC-V. But, that’s still risky, as it’s near impossible to shift a culture from a proprietary mentality to an open-source one like Satya did at Microsoft.
I’d be remiss if I didn’t draw the parallel analogy to the mutual fund industry that I work in. While ETFs and passive funds are not exactly “open source,” they are “free” threats to the core business of the industry. The reality is that, for far too long, the mutual fund industry has over earned - flexed pricing power for itself and in its distribution channels (e.g., financial advisors) when it should have done the opposite. One positive example that stands out to me is Fidelity. My impression is that Fidelity has leveraged its large mutual fund market share and brand into a broader service and solution provider for their customers. Fidelity wants their customers to be successful - if that means recommending a free fund over one of their expensive, actively-managed funds, that’s ok. Also, as a private company, it’s easier for Fidelity to invest in their long term future. This strikes me as analogous to what happened in Microsoft’s server division. Fidelity had the scale of trillions of dollars in assets to make this gamble, but few other fund companies have that starting point. I’d suggest we continue to see a hollowing out of the middle of the industry with larger companies merging to create a few more trillion-dollar-scale platforms on one end and, on the other, a long tail of niche boutique offerings meeting more diverse, heterogeneous customer needs. The industry needs to provider something better than free index returns. A good start would be performance-based fees that start at free and have a high water mark. A cultural shift also needs to occur, to align all aspects of the organization, from top to bottom, around customer success rather than free cash flow. Cash flow will come and durability will happen if customers succeed long term.
So, here’s the main takeaway: be adaptable and focus on customer success. Answer this question and work backward: what are the fundamental needs of your customers, and how is a competitive threat meeting those better than you might be? Answering this might require a change in business model, not just a change in your products or services, and that’s the hardest shift for any corporate culture. Rules are changing under the transparency of the Information age, and hiding under high priced, proprietary products when an open source or free alternative is brewing is no longer viable. Companies need to constantly disrupt themselves to stay viable in this age of increased innovation even if that means a wholesale change in how business is done.
Nothing in this newsletter should be construed as investment advice. I may own long or short positions in stocks discussed in this newsletter. This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I may change my opinions without updating them in the newsletter. Lastly, often I try to make jokes, and they aren’t very funny - sorry.
I was the portfolio manager of the Janus Henderson Global Technology products (ticker: JAGTX) from May 2011 to November 2018. Prior to that I held various roles as an analyst and portfolio manager at Janus Henderson Investors for most of the period starting as a summer intern in 1998 up until the end of 2018. I graduated from Williams College in 2000 with BAs in Economics and Astrophysics. A complete resume can be found at www.linkedin.com/in/bradsling
Investment framework co-authored with Brinton Johns “Complexity Investing” can be found here: http://www.evolusophy.com/complexityinvesting/
If you have any articles of interest, comments or questions please send them by responding to this email. I will generally try to read and respond to your comments or questions, but may not always be able to in a timely manner, for which I apologize in advance.