Innovation Isn't Enough: The Need for Strong Business Models

COMMENTARY

Market Insight I i

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EATHERBIE CAPITAL

Autumn 2020

INNOVATION ISN’T ENOUGH The Need For Strong Business Models

The personal computer was introduced in 1974 and took approximately 25 years to capture 50%market penetration. Fast forward to 2007 and the introduction of the smartphone was followed by rapid adoption, with the devices reaching 50%market penetration in only seven years. The accelerating pace of innovation adoption dates back to at least the mid-18th century (see Figure 1). More recently, the coronavirus pandemic is accelerating the adoption of technologies such as videoconferencing and telemedicine as companies and individuals seek to fight the virus through social distancing. In this paper, we identify why innovations can fail and submit that innovation alone isn’t enough; companies need strong business models with strategies for overcoming sizeable hurdles to product adoption. Investors must therefore conduct in-depth research to identify which companies have the greatest potential for commercializing their innovations. The Case for Innovation Successful innovation allows companies with strong business models to rapidly grow their sales and earnings while making legacy products and services obsolete. This disruptive process can allow leading companies to capture market share, as illustrated by streaming media disrupting video rental companies such as Block­ buster. The brisk pace of technology adoption is contributing to even greater disparity among the winners and losers of innovation, including in telemedicine,

Matt Weatherbie, CFA CH I E F E X ECU T I V E O F F I C E R CO - CH I E F I NV E S TMEN T O F F I C E R WE AT H E RB I E CA P I TA L , L LC

H. George Dai, Ph.D. S EN I OR MANAG I NG D I R ECTOR CO - CH I E F I NV E S TMEN T O F F I C E R WE AT H E RB I E CA P I TA L , L LC

Figure 1: Years from Market Entry to 50% Penetration

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Joshua D. Bennett, CFA S EN I OR MANAG I NG D I R ECTOR D I R ECTOR O F R E S E A RCH WE AT H E RB I E CA P I TA L , L LC

108

66

61

40

25

14

9

7

1750 Stove

1810 Steam Ship

1880 Telephone

1904 Washing Machine

1950 Cable TV

1974 PC

1989 Internet

2004 Social Media

2007 Smart Phone

Source: Asymco, Visual Capitalist, company disclosures, Alger estimates.

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The brisk pace of technology adoption is contributing to even greater disparity among the winners and losers of innovation, including in telemedicine, e-commerce and virtual conference platforms. We believe this raises the potential to generate strong investment returns from successful stock picking.

EATHERBIE CAPITAL e-commerce and virtual conference platforms (see Figure 2). We believe this raises the potential to generate strong investment returns from successful stock picking. The power of innovation is also illustrated by the stock price outperformance of companies that are committed to research and development (see Figure 3). Early Innovators Face Significant Challenges Simply investing in companies with innovative products may generate disappointing results given the high failure rate of new product adoption. Essential Products was a promising company that had raised several hundred million dollars and was led by the legendary creator of Google’s Android operat­ ing system, yet it folded earlier this year. i The company had launched a smartphone and sought to integrate computing more seamlessly in individuals’ lifestyles but lacked a strong distribution strategy. The demise of Essential Products isn’t unusual, with studies showing that up to 90% of new products, representing billions of dollars in investments, fail. ii New products face the challenge of consumers’ biases regarding losses and gains, according to researchers Daniel Kahneman and Amos Tversky. They found that individuals experience monetary losses more acutely than monetary gains, creating loss aversion, while researcher Richard Thaler has found that consumers place a higher value on products they own than identical products that they don’t own, so even if the real value of a new item is somewhat better than an existing item, individuals may perceive that purchasing it will create a financial loss. iii Companies introducing new products must therefore overcome individuals’ loss aversion and distorted perception of the value of existing items. Crossing the Chasm Geoffrey Moore’s timeless 1991 book “Crossing the Chasm: Marketing and Selling High-Tech Products to Mainstream Customers” provides additional insights. The organizational theorist maintains that the biggest obstacle for innovators is crossing the chasm between product acceptance by “Early

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Figure 3: Innovation Drives Excess Performance

% of R

25%

20%

Figure 3: Innovative Companies Have Outperformed Over the Past Decade

Figure 2: Corporate Sales Dispersion Has Jumped

15%

8

Most Innovative +6% per year

100%

The Rate at which Sales Are Shifting Between U.S. Companies

10%

7

80%

Higher Sales Dispersion

6

60%

5%

5

40%

0%

20%

4

19

0%

3

84%

-20%

2

Cumulative Excess Return

Least Innovative -3% per year

Lower Sales Dispersion

-40%

1

-60%

0

2018

2016

2017

2018

2019

2020

Source: FactSet. Most/least innovative stock excess performance is derived from highest and lowest S&P 1500 quintiles based on R&D as % of sales, normalized for market value, using one month returns for 10 years ending August 2020.

Source: Survey of Business Uncertainty conducted by the Federal Reserve Bank of Atlanta, Stanford University, and the University of Chicago Booth School of Business to calculate the Expected Excess Sales Reallocation Rate through August 2020.

Source: Ponemon Ins

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0 5 Research Becomes Increasingly Important Nevertheless, investing in businesses with high gross margins and neglecting to assess other factors may result in failing to find companies with the greatest potential to reward investors. In-depth research, we believe, is required to identify which innovative companies with high margins possess the greatest potential for generating rapid sales growth that will lead to attractive earnings. To that end, companies must have strong marketing and sales teams that can overcome challenges associated with new product adoption.We believe research should include conducting meetings with company executives, test-driving products, interviewing competing companies and assessing market opportun­ ities. Research should seek to determine not only the appeal of a business’s innovations, but also the strength of a company’s management team. Examples of Winners and Losers We believe Nevro Corp. is a highly innovative company with talented leadership, high gross margins and a strong business model. Nevro developed and offers the Senza Omnia system, which provides electrical stimulation of the spinal cord to manage debilitating back pain. The technology is a compelling alternative to opioid pain medicine and surgery, and we believe it is best-in-class with features that allow doctors to remotely calibrate the frequencies of electrical currents via the cloud. Having already established itself for back pain management, the company is now pursuing the peripheral diabetic neuropathic market, which more than doubles Nevro’s addressable market.We believe it has potential to generate a compound annual growth rate in the mid-to-high teens in the next few years and that its growth and gross margins illustrate that Nevro has a strong business model. Cloud-networking company GTT Communications is also innovative and its gross margins are reasonably high, but we believe its business model is inadequate. In 2017, GTT acquired Hibernia Networks, which owns a cable system connecting 10 15 20 Figure 3: Innovation Drives Excess Performance Importantly, companies with high gross margins will see more of every incremental dollar in sales contribute to the bottom line. As such, high gross margins can result in stronger profit growth and in turn reward investors. We believe high gross margins often reflect strong business models because they suggest that products or services offer significant value. The past is no guarantee of future results, but companies with high gross margins have historically generated the best returns (see Figure 4). The highest quintile +16.7% CAGR over past 5 years ending Aug 2020 Th lowest quintile +1.8% CAGR over past 5 years ending Aug 2020 Universe is Russell 3000 Adopters” and a larger group, the “Early Majority.” This larger group waits for products to be proven by Early Adopters before accepting new technologies. Eventually, other groups, such as “Late Majority” and “Laggards,” accept the disruptive technology. Many businesses fail to cross the chasm because marketing messages must be customized for each group while other businesses fail to generate the required strong sales momentum among Early Adopters. Drivers of Outperformance We believe strong business models are required for companies to generate earnings growth. When assessing a business model and a company’s potential for generating earnings growth, gross margins and the likelihood of sales acceleration are important. Gross margin measures howmuch gross profit is generated on a percentage basis from revenue after accounting for direct costs.

UNDERSTANDING GROSS MARGIN

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Gross margin is derived from first determining gross profit, which is the difference in a company’s revenues and the costs of the goods or services that it sells. The resulting number is then divided by revenues to determine on a percentage basis the amount of gross profit produced after factoring in costs.

Figure 4: Stocks with the Highest Gross Margin Have Outperformed

Highest Quintile +16.7%

Russell 3000 Universe

Lowest Quintile +1.8%

5-Year Annualized Return

Based on Russell 3000 Index performance for five-year period ended August 30, 2020. Source: FactSet and Alger.

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EATHERBIE CAPITAL Going Forward We believe using a research-driven approach to investing in change has never been more important, given the accelerat­ ing pace of innovation and growing disparity among the beneficiaries and losers of change. Finding companies with strong business models that are best prepared to benefit from change, however, requires in-depth fundamental research by analysts with detailed knowledge of the industries they cover.

North America to Europe that won the Subsea Project of the Year and Best Subsea Innovation awards. More recently, GTT acquired Interoute, operator of one of Europe’s largest independent fiber networks. As a small telecom company, however, GTT is struggling to capture market share from large players such as AT&T and Verizon that have consider­ able scale advantages. Its stock has underperformed during the past two years and the company’s fundamentals have weakened, causing GTT to pursue asset sales to reduce debt.

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Matt Weatherbie, CFA Chief Executive Officer Co-Chief Investment Officer

Joshua D. Bennett, CFA Senior Managing Director Director of Research

H. George Dai, Ph.D. Senior Managing Director Co-Chief Investment Officer

i Daisuka Wakabayashi, D. and Griffith, E.“Andy Rubin’s Start-Up, Essential Products, Shuts Down,” New York Times, Feb. 12, 2020. ii Alessi, C.“Why do so many innovative products fail?,” UX Collective and Gourville, J.T. Eager Sellers, Stony Buyers. Understanding the Psychology of New-Product Adoption,” Harvard Business School, June 2006 iii Ibid

The views expressed are the views of Fred Alger Management, LLC (“FAM”), Weatherbie Capital, LLC, and Alger Management Ltd. (together with their affiliated entities “Alger”) as of October 2020. Alger has used sources of information which it believes to be reliable; however, this publication is not intended to be and does not constitute investment advice. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security, or any funds managed by Alger. Holdings and sector allocations are subject to change. Risk Disclosures: Investing in the stock market involves risks, including the potential loss of principal. Growth stocks may be more volatile than other stocks as their prices tend to be higher in relation to their companies’ earnings and may be more sensitive to market, political, and economic developments. 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The Russell 3000 Index is a market capitalization-weighted benchmark made up of the 3000 largest US stocks, which represent about 98% of the US equity.The S&P Composite 1500 is an unmanaged index that covers approximately 90% of the U.S. market capitalization. Index performance does not reflect deduction for fees, expenses, or taxes. Investors cannot invest directly in an index. The following positions represented the note percentages of Alger assets under management as of September 30, 2020: Blockbuster, 0.0%; Essential Products, 0.0%; Nevro Corp., 0.84%; Hibernia Networks, 0.0%; and Interoute, 0.0%. Short positions GTT and AT&T represented the equivalent of -0.01% and -0.06% of assets, respectively. FactSet is an independent source, which Alger believes to be a reliable source. FAM, however, makes no representation that it is complete or accurate.

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