digital-disruption-as-a-driver-of-sustainable-income-growth
Investment Insight

Digital disruption as a driver of sustainable income growth

07 January 2020 | Mark Barnett, Co-Head of UK Equities

 

In a low yield environment since the Global Financial Crisis, equity markets have favoured stocks promising high growth through digital disruption over more traditional sources of dividend income. This narrow focus, that digital is good and traditional is bad, has resulted in wide and irrational price dispersion, as well as the widespread neglect of traditional income producing shares. To my mind, the truth is more nuanced:

  • Customer relevance and a firm’s ability to blend digital with traditional are critical to enhancing shareholder return over time
  • In isolation digital innovation is unlikely to produce sustainable growth in income: the value of disruption lies in whether intellectual property can be effectively deployed as an asset to reduce costs and increase efficiencies
  • When executed appropriately, digital disruption should increase a firm’s free cash flow. This in turn can be passed down to shareholders, either through accretion to the balance sheet or through dividends.

 

Since the financial crisis we have seen a shift in the behaviour of equity markets. In the UK today the promise of future earnings is more valuable that income streams available today. In many cases companies offering digital-led disruption, subscription-based models or monetising adverts have been rewarded at the expense of well-established businesses paying covered dividends.

For an income focussed investor this trend poses challenges and brings opportunity.

In the UK today, many companies are successfully incorporating digital capabilities into their traditional businesses. We meet with hundreds of businesses each year and see excellent examples of where digital innovation is driving meaningful efficiencies. Appropriate capital allocation to new technologies and the efficient use of data can enhance current services, allowing companies to reach new customers through distribution platforms, more efficiently price goods and automate processes.  

Where companies have access to data it is important to establish their ability to harness it as an asset to reduce costs and improve services. When deployed correctly, with appropriate margins and excellent execution, intellectual property increases the Free Cash Flow of a business. This is turn should pass down to the shareholder either through accretion to the balance sheet or through distribution through dividends. The bottom line is total return. 

Across the portfolios under my management1 there are some excellent businesses using data to disrupt their own organisations - successfully incorporating their digital capabilities with their traditional operations with the aim of delivering better outcomes for customers and shareholders. These companies illustrate how effective digital disruption can both enhance a business’ offering and drive sustainable income growth for shareholders.  

BP: building transformative technology

BP is a longstanding investment for the Invesco UK Equities team. A recurrent theme of our conversations with management is the use of data to transform every aspect of how BP operates.

A legacy criticism of the oil majors has been an inability to manage capital expenditure effectively. Today the industry is more profitable in a lower oil price environment and BP is leading the way in driving efficiencies through its operations. A crucial driver of this is the implementation of data to reduce operating cost and capital expenditure.

Bernard Looneytook responsibility for BP’s Upstream operations in 2016 and increased spending on digital technology five-fold. Not only is technology being used more widely, for example increasing the use of sensors on rigs and pipelines, but it is being better utilised to drive operational cost efficiencies.

We recently visited BP’s supercomputer in Houston, which is central to the digitisation taking place. As the largest commercial research and development computing resource in the world. It has the capability equivalent of more than 40,000 laptops. Designed to analyse large amounts of seismic data, the supercomputer can also enable more detailed in-house modelling of rock formations before drilling begins, increasing operational precision. Meanwhile the effective use of real-time data is invaluable in increasing refinery efficiency, improving biofuel yields and allowing BP to make better trading decisions. In this industry field developments cost billions of dollars, so small efficiencies are meaningful to the bottom line. Better knowledge also lowers capital expenditure and allows BP to target higher return projects.

Next: retailer for the future

Over the past decade Next has transformed itself from a traditional catalogue retailing business to a leading digital, multi-brand, distribution, platform and logistics business with a growing international element. Central to Next’s success has been the effective combination of store-based retailing with an online offering that is, to my mind, the model for successful retailers of the future.

Within retail there is a fine balance between spending enough to service possible future growth and spending too much on infrastructure before it is needed. One way that Next demonstrates this discipline is through its selective investment. One recent addition is investment in search engine technology to identify when people buy what they have searched for, allowing for better targeting via social media that has resulted in higher order values. Initiatives like this have enabled Next to grow from 39% online sales in 2015, to 51% of sales taking place online in 2019. Whilst this investment is exciting and transforming the shape of Next capital discipline has remained central. The company has remained strongly cash generative whilst undergoing this transformation. From January 2015 to date, this has enabled Next to return £1.7bn to shareholders through special dividends (£685m) and share buybacks (£1.0bn).  Despite the transformation project they have been able to right-size the capital base and still generate a lease adjusted return on capital employed significantly above 20%. 

To my mind Next is very well positioned to continue this transformation whilst continuing to hold shareholders at the centre of what it is trying to achieve.

easyJet: the world’s most data-driven airline?

In many respects easyJet is a textbook disruptor. Established as a challenger to the traditional airline model in 1995, easyJet launched with just two rented aircraft and £29 online tickets. The company now boasts a Pan-European market share of 9% and a fleet of 331 aircrafts that fly from 159 airports around Europe.

Yet easyJet also has the ambition to become the most data-driven airline in the world. The company is investing substantially in data analytics to give greater focus and weight to the use of data to improve customer experience. 30% of passengers now travel through an automated bag drop area with further automation planned across the network: they are working towards a fully automated check-in, bag drop and boarding experience. To further enhance operational performance, the company has created an air-traffic control slot predictor and a crew standby forecaster. The use of inertia sensors to detect the exact timings of boarding and disembarkation is also anticipated to improving turnaround efficiency. All of these initiatives should drive business efficiencies, improve the customer experience and reduce costs.

Another area where data science is transforming easyJet is through predictive maintenance. Now active on all easyJet’s A319 and A320 (Current Engine Option) fleet and has resulted in 149 pre-emptive maintenance actions in 2018.  All new fleet deliveries will have hardware installed that enables even higher levels of data transfer. They have driven ancillary revenues by launching additional seat bands and an improved bag pricing algorithm as well as apple pay on aircraft. 

Many of these investments ware resulting in better customer outcomes. But more importantly they are reducing cost: easyJet’s the strategic cost reduction programme delivered £138 million of savings in 2019 alone.

5G: building the economies of the future

Approximately 90% of the world’s data has been created in the past two years alone. When considering the potential for companies to effectively utilise this data, thought must be given to the network that will enable it to be collected and processed in the future.

“5G is the network that will enable the economies of the future”

Economists have estimated the global economic impact of 5G in new goods and services will reach $12 trillion by 2035 as 5G moves mobile technology from connecting people to people and information, towards connecting people to everything. 5G is the technological answer, making possible billions of new connections, and making those connections secure and instantaneous. 5G will impact every industry. 

BT and particularly Openreach are at the centre of this development in the UK.   BT will provide the biggest 5G and fibre network in the UK and will be enabling today’s businesses to digitally disrupt tomorrow. They aim to move from today’s model of three different networks which is complex, costly and inflexible, to one Smart Network which is seamless, has consistent connectivity and has significantly lower upgrade costs. 

The switch to 5G will most likely mean lower costs, enhanced cellular footprints, higher data throughput, enhanced capacity, low latency, and higher velocity and hopefully our device batteries will last longer between charges. 5G will impact every industry.  And 5G is purposely designed so that these industries can take advantage of cellular connectivity in ways that wouldn’t have been possible before, and to scale upwards as use of 5G expands. 

The value of disruption

Across the UK equity market there are many well-established, dividend paying companies using selective investment in digital technology to disrupt the industries in which they operate. As an income investor I am particularly interested in disruption when it is used to improve innovation and efficiency, reduce costs and ultimately make these businesses more profitable. 

Dividends are an important discipline on a business and through careful allocation of CAPEX digital and data projects data can be utilised rapidly and responsively within the business to drive sales but also to improve efficiency and reduce costs. This is an important factor in driving sustainable growth in income.

UK Equities (equity income) - 2020 outlook

18 December 2019 | Mark Barnett, Head of UK Equities

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Footnotes

  • 1 Mark is the named portfolio manager of the Invesco Income, High Income and UK Strategic Income Funds (UK) and Perpetual Income and Growth Investment Trust plc.
  • 2 Bernard Looney will take over as chief executive officer in 2020.

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