Summary: The coming upgrade cycle in consumer technology means that consumer-oriented technology companies will outperform enterprise-oriented technology companies. Tech portfolio managers had better watch out.
Most technology investors focus on tech companies that sell to enterprises. The enterprise market, particularly if you include small businesses, is far larger than the consumer market. Companies' technology budgets are significantly greater than consumers', and enterprise-oriented technology has evolved more rapidly than consumer-oriented technology.
But that's changing.
Over the next few years, growth in the market for enterprise technology will be disappointing. Start with software. Software revenue growth will be held back by two factors:
First, the ASP model is slashing costs for both small and large companies. Salesforce.com is the most prominent ASP software business, and is under-pricing CRM software vendors like Siebel. Startups are now doing the same for other software businesses. CyberU, for example, has a pure ASP solution for human resource management and training. Meanwhile, IBM and HP have made utility computing (which includes hosted software applications) central to their business strategies. ASPs will slash the upfront cost of software and the recurring revenues from upgrades.
Second, software revenue growth will be hampered by the growth of the open source software movement and the outsourcing of software development to India and other developing countries. The political reaction to the offshoring of jobs and the risk of protectionism won't change that.
What about enterprise hardware? Also not a pretty picture.
Utility computing and more efficient sharing of resources via virtualization will cut the growth in demand for processing and storage hardware. And standardization at the component level and new technologies like blade servers will cut the price of new technology. Add to the mix lower cost production (particularly in China), and it's clear that the current value proposition of the technology industry is that enterprises can get better technology with an overall lower price tag than previously. Bearing that in mind, it's hard to see how the enterprise hardware market can grow strongly over the next few years.
Now consider the consumer technology market. Consumer technology is on the cusp of a dramatic upgrade cycle that will last a decade:
- Video is going high-definition. That will involve upgrades in TVs, broadcasting technology and DVDs.
- Audio is going digital. This means not just portable MP3 players, but an entire upgrade of home entertainment systems and, probably starting next year, car stereos. And by the way - car "stereos" will be relics of the past, as CDs and digital broadcast radio will likely be in surround-sound.
- Many consumers have already switched to digital cameras and camcorders, but there are many more to go. The editing and printing of photos at home is growing in popularity.
- Flat panels are replacing CRTs. Flat panel TVs are more attractive and take up less space; that means they'll be put in more places than before.
- Hard discs and software are replacing dumber recording technology. Tivos are just the start of this; soon we'll see hard disks in cars too.
- Wireless is enabling home networking, aided by the spread of broadband Internet connections.
- DVD players are now cheap and ubiquitous. The next large market is DVD recorders, and DVD and satellite video in the back of cars.
- Cell phones will become multi-functional, used for photos, music, perhaps video and certainly for transactions.
- Broadband to the home, wireless networking and the availability of digital content are changing the way people purchase music and video.
True, consumer technology is suffering from some of the same deflationary forces hitting the enterprise technology market, particularly cheaper production in China. However, the price tag of new, mainstream consumer electronics goods is often higher than the old one.
Flat panel TVs cost more than traditional CRT TVs, DVD recorders and PVRs cost more than VCRs (at least for another couple of months...), an iPod costs a lot more than a Sony Walkman, satellite radio costs more than free broadcast radio, six-speaker surround sound audio costs more than stereo, satellite navigation in cars costs more than a map book, a DVD player in the back of your car costs more than a plain seat back, and the price tag of cell phones is actually rising as they incorporate PDA functionality, WiFi, mobile email and web surfing. And people are paying more for printers and supplies now that they are printing photos at home.
This is a dramatically different consumer electronics business compared to the recent past. Over the last 15 years, the most important technology changes excluding the shrinkage of cell phones have been the introduction of the CD and the Walman/Diskman. Neither were earth shattering. (The introduction of the CD benefitted the music companies more than the electronics industry.) TV hasn't changed for decades, analog cameras aren't much different from what they were 20 years ago, and the price of TVs and VCRs has been steadily falling. Now, all of a sudden, digitization of audio and video and the networking of consumer devices is shaking up the consumer market, and consumers' electronics budgets are rising.
[Side comment: People are willing to pay more for consumer technology - $300 for an iPod versus $30 for a Diskman - because the improvements in functionality due to digitization are so significant. I wonder how Bill Gross would want the CPI to classify these price increases given his opposition to hedonic adjustments.]
Perhaps this is a useful indicator: isn't it interesting that wireless networking has taken off faster in the home than the enterprise?
When I look at the big picture, I can't help concluding that consumer technology will be the sweet spot of technology investing over the next five years, and will be far more attractive than investing in enterprise technology, with its shrinking dollar market size and less dramatic technology upgrades.
That's my sector conclusion. As for particular stock picks, I've taken some consumer technology positions in my portfolio already, which I'll hopefully write about later. I'd also like to discuss the relative exposure of some leading technology companies to the consumer market versus the enterprise market.
But before doing so, here are two questions: (1) Do you agree with the core argument that consumer technology has better investment prospects than enterprise technology? And (2), which stocks do you think are the best way to play the consumer technology upgrade cycle?
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