SPECIAL FOCUS CHAPTER The corrosion of competitive advantage

Brett Savill PricewaterhouseCoopers LLP

This article first appeared in IP Value 2005, Building and enforcing intellectual property value, And has been re-produced with permission from the publishers - Globe White Page

PricewaterhouseCoopers, London

The corrosion of competitive advantage

Brett Savill

s the IT market matures globally, it becomes increasing difficult for companies to earn superior returns. PricewaterhouseCoopers (PwC) research suggests that the

implications of this have not yet sunk in and that companies need to think harder about their competitive advantage. Specifically, this means being more critical of R&D spend depending on the stage in the product lifecycle. It also means understanding where to play in the value chain and when to offshore. Finally, it involves making the competitive advantage more transparent to the capital markets. In his controversial book Does IT Matter?, Nicholas Carr invites us to re-examine some of our most basic assumptions about IT and business value. His thesis is that technology revolutions move in two broad phases whether the industry in question is railways, electricity, the internal combustion engine or IT. In the first, benefits accrue on a micro basis to individual companies. In the second, benefits accrue on a macro basis to society as a whole. IT is now entering the second phase, he argues, with hardware, software and services all threatened with commoditisation by, respectively, the likes of Dell, Linux and utility computing. ITs strategic importance has actually dissipated as its core functions have become more widely available and affordable. Carr argues that what makes a business resource truly strategic giving it the capacity to be the basis for a sustained competitive advantage is not ubiquity but scarcity. Successful companies should be using their IT to differentiate themselves from their competitors, he says, concluding: Whats crucial is to be able to distinguish commodity resources that do have the potential to create advantage. Only then will a company avoid wasted cash and strategic dead-ends.

A tough new environment

The last decade has seen IT companies dramatically outperforming the market. Ten-year shareholder returns for the FTSE 100 have averaged 73 per cent. By contrast, software companies delivered 468 per cent returns over the same period, information technology hardware companies delivered 189 per cent returns and computer services companies delivered 133 per cent returns. It is inconceivable that technology returns over the next decade will come anywhere close to these levels. Equity markets have become much more critical of technology companies performance and much more demanding in terms of the information they expect to receive from them.
Building and enforcing intellectual property value 2005

Special report PricewaterhouseCoopers, London

Figure 1 Revenue growth forecasts (percentage of respondents versus market consensus)

Figure 2 Customer understanding of the value of the product/service

11-15%

44% 51% 11% 22% 17% 8% 28% 19% Market consensus Management estimates

Very well Somewhat 33 4 4 7 0 20 40 %

52

6-10%

Not really Not at all Don't know/ refused

1-5%

No growth

60

80

100

This tough new market, coupled with the corrosion of competitive advantage highlighted in Carrs book, means that management teams must begin to look much harder at where their companies processes and functions really can deliver value before adopting rigorous strategies in pursuit of these goals. At the same time, they need to make sure that they have the metrics in place for capturing and communicating this value to analysts and investors.

Twenty-seven per cent of companies are targeting less than six per cent growth, yet the market believes that closer to 45 per cent of techMARK companies will fall into this category. If the market is correct, management in these companies may need to review their business plans to ensure that they are not overinvesting at the wrong stage of the cycle, risking market disappointment and a lower rating. Of course, if the market is wrong, an excellent opportunity exists for providing evidence of their higher growth prospects, picking up a higher rating as a result. Respondents to our techMARK survey also appeared to be confident that they are successfully getting their value message across to the markets. Over half claimed that their customers have a very good idea of the added value that they deliver through their product or service, while one-third thought that their customers understood this added value, at least in broad terms. The fact that four per cent believed that their customers had absolutely no understanding at all is somewhat worrying for the businesses involved! We also discovered that 52 per cent of respondents believe their value to be highly transparent to customers (when compared with their competitors). The confidence shown by these respondents is especially striking when viewed in the context of CIO Insight (a recent survey of over 400 top executives in IT companies). In that survey, 70 per cent of the respondents were concerned that their metrics failed to capture the value of their respective technologies, while nearly 50 per cent of them lacked confidence in their ability accurately to calculate their return on investment (ROI) on IT investments (and this notwithstanding the enormous importance attached to ROI in the technology

How well do companies know their competitive advantage?

Given these unforgiving market forces, technology companies should be asking themselves whether their traditional sources of competitive advantage are in any way sustainable. They also, it would appear, need to ask whether their assessments of their own future growth prospects are warranted especially so in the face of mounting market scepticism. PwC research suggests that there are considerable discrepancies between managements optimistic view of market growth and that expected by the equity markets themselves. We publish an annual survey, the PricewaterhouseCoopers techMARK CEO Survey 2003/04, Green Shoots, supported by the London Stock Exchange. This provides valuable insights into the operational, strategic and funding issues faced by companies listed on the Stock Exchange's specialist technology market techMARK. In the most recent survey, 27 CEOs from techMARK companies were canvassed from sectors covering networking and communications, to biotech and software. An analysis of the respondents forecast revenue growth targets against those of their brokers is enlightening (see Table 1). 2
Building and enforcing intellectual property value 2005

PricewaterhouseCoopers, London Special report

sector). Clearly, a significant number of technology businesses think they are doing better than they are both in terms of their growth potential and value to their end user. Given this, it is imperative to take a hard, objective look at their sources of competitive advantage.

machine (it now generates more than US$1.5 billion a year from its licensing activities). Microsoft, threatened by the open source software movement, was keen to target IP swaps that would facilitate industry interoperability and innovation. By September 2004 the company had announced that it would be sharing the source code of its Microsoft Office productivity suite with governments from around the world (hoping to beat the Linux challenge in the public sector). In another example, Deutsche Telekom announced a deal with QED Intellectual Property Limited, the patent licensing arm of technology development and licensing company Scipher plc, which saw QED appointed to seek licences for 96 optoelectronic patent families, comprising 542 patents and patent applications covering areas such as photonic crystals, fibre-integrated micro-lenses and optical integrated circuits. Revenues from successful deals are to be split between the two companies. More recently, ARM Holdings plc has set about repositioning itself to focus on the customer market to refine the basis of competition in its market. Its proposed acquisition of USbased Artisan Components would enable the combined company to deliver one of the industrys broadest portfolios of system-on-chip (SoC) intellectual property to its extensive customer base. As Morgan Stanley pointed out in a September 2004 Equity Research report, Artisan offers a library of physical IP to be contrasted with ARMs offering of architectural IP (in the form of its microcontroller cores) at the system level. Artisan management believe that the differentiating aspect of their product offering is their process and circuit knowledge acquired from the many different processes onto which the companys products have been transferred. ARM, on the other hand, sees its expertise more in the understanding of the end application and in the architecture required to secure this application. One of the aims of the acquisition is to leverage both the process/circuit (physical) and the application/architecture (functional) expertise into customers products. This combination also addresses the design gap - the gap between the number of transistors available for use through advanced manufacturing (a large number) and the number of transistors that a designer has the time to design given short product cycles (a smaller number). By having more off-theshelf IP available, these building blocks can be used to make the design of complex SoC more efficient.

Be more critical of R&D spend

In his book Competitive Advantage, Michael Porter identifies only two sources of competitive advantage: lower cost or differentiation. Rigour needs to be applied to R&D expenditure to ensure products and services are tied closely to one of these two value drivers. Otherwise, companies risk uniqueness without differentiation. Strategies for managing R&D, and the intellectual property that underlies it, are proliferating and analysis of this crucial function is a fast-growing industry in its own right. Most frequently, management believes that its proprietary R&D has some special value, simply because it is different. This belief triggers ongoing investment into the ownership and protection of the underlying IP. Sometimes this is warranted but often it overlooks the development stage that the technology has actually reached. The encroaching homogenisation highlighted by Carr means that management is often better advised to investigate alternative IP management strategies. Protecting IP just because it is different does not always make sense. In their early stages, almost all technologies are based around proprietary knowledge. However, as these technologies mature, the value moves towards platforms. For example, the move towards open standards in so many sectors of the technology market means that knowledge sharing has become strategically smart. Sharing what was once proprietary technology with competitors helps to build value in the sector and that, in turn, becomes a source of sustainable long-term value for the companies that are structured to reap the benefits. An increasing number of leading companies are therefore starting to look at their expenditure across their technology portfolio and match it to the correct stage in the lifecycle. Three examples will suffice: In one high-profile development during 2003, Microsoft hired Marshall Phelps to develop a new forward-looking licensing strategy for the company. Mr Phelps had already made his name at IBM, helping to transform the business from a net purchaser of IP rights into the worlds biggest licensing

Building and enforcing intellectual property value 2005

Special report PricewaterhouseCoopers, London

The evolution of technology is forcing companies to reassess the ways in which their R&D can build value. Entering a new stage of market development requires a reassessment of the basis of competition. Management has to be prepared to shift its strategy and funding and to do this for each of the products/services in its portfolio, be they early-stage proprietary technologies, platform technologies or commoditised main street technologies. Investment needs to reflect this: early-stage technologies demand investment in IP protection; platform technologies need licensing/knowledge-sharing; and main street technologies are best exploited through systems and services.

UK businesses are following this trend. The last year has seen a number of leading UK businesses announcing the transferral of significant numbers of back office/call centre jobs to lower-cost locations such as India. Commentators, such as the McKinsey Global Institute, have argued that this offshoring will be to the mutual economic benefit of both the country where the jobs move from - and the country to where they move. Establishing the former thesis is relatively straightforward. McKinsey estimates for a US company moving to India suggest that savings in labour and other fixed costs could average 60 to 65 per cent (offset by increased telecoms and management costs to direct savings of around 45 to 55 per cent). In addition, there could also be opportunities to re-engineer the process when relocating to deliver total savings of 65 to 70 per cent on US cost levels. Whether or not offshoring delivers wider benefits to the local economy is harder to establish. PwC estimates are that the UK economy, for example, would recoup within a year around 0.80 to 0.87 of value for every 1 transferred through offshoring. In the longer term, however, the value recouped by the UK economy would rise. There would also be gains for the Indian economy (and other offshoring locations). In the long run, therefore, and in line with the theories of comparative advantage, offshoring looks likely to bring mutual gains to all parties, even if the initial net effect on the US/UK economy is slightly negative. In summary, there is widespread criticism of a trend that appears to create economic value. IT companies are affected in several ways: most obviously, they are beneficiaries of corporate and government decisions to outsource; but outsourcing also represents a threat, and call centres developed in the UK might be more effectively run from Bangalore. In both examples, management needs to understand where to play in the value chain - and when to offshore. Moreover, the strategic decision may end up being more important than the tactical implementation. Finally, they need to be able to communicate their decisions in a transparent, structured, analytical manner.

Understand where to play in the value chain and when to offshore

Conventional wisdom states that all markets eventually become consulting markets. And all consulting markets end up as outsourcing markets. As Geoffrey Moore puts it in his book

Living on the Faultline, the basis for competition in a mature

market is operational and capital efficiency. And no discussion of operational and capital efficiency could take place without a discussion of outsourcing. The example of the fabless semiconductor market is a case in point. Fabless companies (that design and then outsource fabrication to plants) have come of age. As underlined by a recent PricewaterhouseCoopers report (The European Fabless Survey 2004), the fabless sector has emphatically returned to profit with sentiment boosted in Europe by the flotations of Cambridge Silicon Radio and Wolfson Microelectronics. The fact that this industry has managed to create so much value during this time period could be seen to mark a failure for the often government-subsidised manufacturing plants. However, it also represents a great illustration of the need to understand where to play in the value chain. The decision to choose to operate in one segment of the value chain at the expense of any other often runs counter to traditional thinking, especially in terms of the apparent need to manage risk. However, it is often this strategic decision, rather than tactical implementation, that can have the most impact on a companys value. Nowhere is this debate more vitriolic and muddled than in the criticism, particularly in the US, of offshoring (the outsourcing of jobs overseas). This has been identified as a real threat to the countrys long-term economic stability, and a major factor behind the USs jobless recovery in 2002 and 2003. Recent research, however, suggests that the time has come for a more reasoned, and better-informed, debate to take place around this subject. Certainly, there is every indication that a growing number of 4
Building and enforcing intellectual property value 2005

Communicating value
This chapter has explored the ways in which technology companies have started to address the corrosion of competitive advantage. Of course, however, much of this effort will be wasted if it is inadequately communicated to external stakeholders (including the equity markets). Building stakeholder trust is an essential part of creating and consolidating value. PwC research suggests better external reporting also brings greater clarity about strategic priorities.

PricewaterhouseCoopers, London Special report

It can take various forms. Yet clearly the traditional, financial corporate reporting model is not capable of explaining or communicating these sources of competitive advantage. Recognising this, companies are looking for new ways to capture and report the non-financial information that investors and analysts require. Companies looking to achieve this transparency do now have a number of best-practice examples to learn from. Coloplast, the Danish healthcare company, is one such example. Its annual report breaks down and illustrates the ways in which the company is adding value for customers, employees and shareholders (via value creation and knowledge management). The metrics employed to achieve this are sophisticated. Performance indicators are consistently reported over time for each stakeholder group, with quantitative data and targets. The company discusses its approach to innovation extensively, detailing the processes used to improve innovation, defining new products and services, and reinforcing that information

quantitatively and through diagrams. It also reports how the company protects the value of its innovation through a patent strategy, as well as graphically illustrating customer care initiatives (including levels of customer complaints and customer satisfaction). This sort of open communication has yet to become the norm. However, it is difficult to imagine that the types of discrepancies outlined at the beginning of this article would exist if companies reported a broad array of financial and non-financial measures that demonstrated their unique competitive advantage. As the capital markets push for increased transparency, the benefits for those that follow Coloplasts example become clearer. More widely, the ability to identify what innovation is needed, as well as the commitment to communicate that added value to the market, will be fundamental management responsibilities. In a market where traditional sources of competitive advantage are being eroded, these types of innovation will be key differentiators.

Building and enforcing intellectual property value 2005

Contributor profile Brett Savill

PricewaterhouseCoopers 1 Embankment Place, London WC2N 6RH, United Kingdom Tel +44 20 7583 5000 Fax +44 20 7822 4652 Web www.pwc.com Brett Savill
Partner, London Email brett.savill@uk.pwc.com
Brett Savill is a partner in the TMT (Technology, Media and Telecoms) Valuation and Strategy Team. His London-based

team, of around 40 professionals, helps companies optimise their value by providing rigorous, independent, quantitative advice on strategic issues. This includes market-entry strategies, business plan reviews and investor communications, acquisitions, IPOs and managing-for-value programmes. Mr Savill has over 10 years experience advising companies in this sector. He has an MBA (Ford Scholarship) from Warwick Business School and is heavily involved in PwC's thought leadership in the sector recent publications include Outperformance (Sloan Management Review, 2004) and The

Broadband Future (2004).

Building and enforcing intellectual property value 2005

www.pwc.com

2005 PricewaterhouseCoopers LLP. All rights reserved. PricewaterhouseCoopers refers to PricewaterhouseCoopers LLP (a limited liability partnership in the United Kingdom) or, as the context requires, other member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. Ref 2005LDS20980