Old Dogs, New Tricks

Anthony Aboud

It seems everyone out there wants to invest in the hot new thing. You mention a company which has “big data,” “cloud computing infrastructure,” “artificial intelligence,” “machine learning,” “robotics,” and investors go weak at the knees. In the current environment, investors want to buy the latest and greatest technology players. They’ll ignore valuation metrics, so they can buy the next Google or Amazon. We may joke about this new paradigm, but what does it all mean? The consensus view out there is that all you need to do is sell all your shares in the old-school incumbents and buy shares in new age companies, like fintech, e-commerce, or cloud computing companies.

We look at it slightly differently: our view is that cloud computing infrastructure is the enabler for corporates to store and use an enormous amount of data. Artificial intelligence, or machine learning are just fancy terms for using computers or robots to start doing jobs that were previously done by humans. At its simplest, these robots will be able to replace call centres through chatbots answering your questions about a product online. Getting more advanced, these robots will be able to take all available information to help make crucial corporate decisions, like pricing, inventory management, labour scheduling, and the like. Given the robot’s ability to compute all available data, it will likely make better decisions than humans, and these will likely become starker over time.

Taking all this into consideration, I fully understand the consensus view that boring old incumbent companies are going to get steamrolled by these new-age upstarts as they run rings round the old dogs and take market share.

While this is likely in some industries, we think that, ironically, a lot of these trends could benefit the older companies.

Why do we say this? Three main reasons:

1. Their unique datasets

As mentioned previously, in order to get the most out of robotics or machine learning, one needs unique, live, rich datasets. We believe that existing incumbent companies, with over a quarter of the market - like Medibank, CBA, Woolworths, or Telstra - have this sort of data. This is impossible for a new company to replicate. Take Woolworths, for instance: 10.9 million active rewards customers. Woolworths has an enormous amount of data on the Rewards customer, like what they buy, where they buy or where they buy. Aggregating, analysing and crunching all this data will enable the company to be more targeted and personalised in its offers, optimise inventory management and improve labour scheduling.

2. The ability to amortise costs over a larger earnings base

Typically, a digital transformation involves large upfront capital with benefits typically coming through at a later date. This is not such a big deal for companies with large earnings or balance sheets, however, it might be a bigger deal for a smaller company. Take Telstra for instance: it generates about 5 billion of cashflow a year. I would argue that would probably put them in a good position to have the best 5G network and to be successful in their current digital transformation.

3. Existing relationships with the customers

When we looked at the impact of open banking on the UK and Europe, which came into force in January this year, what we’ve found is that fintechs and insuretechs want to collaborate with the big banks rather than compete with them. The big banks have got the customers, the fintechs have got the innovation, and there’s quite some synergy between them. CBA, for instance, has 5.1 million mobile app logins every single day. That’s a pretty powerful and underappreciated asset, in my opinion.

The incumbents have two big problems

  1. Firstly, they’ve got antiquated backend systems. It’s easier for incumbents to start from scratch. A lot of these companies, like the big banks and Telstra, had their core systems built in the 1980s and, as things got more and more complex, they’ve had to build code upon code, and you end up with something that resembles a spaghetti junction, which makes it quite inefficient. Fixing that problem is easier said than done.
  2. Secondly, the challenge of cultural change. It’s very hard for a company which has been doing the same thing the same way for decades to be able to change their staff and culture to be able to react to the new world.

The large companies which can react to and address these problems aren’t going to be in a bad position. We’re spending a lot of our time looking at out-of-favour industries where we feel the old-school companies are laying the foundation for successful digital transformation in their respective industries. There are going to be some winners and some losers in every industry; obviously, we’re spending a lot of time trying to find those winners.

Two companies transforming their businesses

Medibank (ASX:MPL)

Five years ago, Medibank spent a heap of money on a new state of the art operating system called DelPHI. The idea was to digitise the front-end interface with the customers to be able to more efficiently collect and analyse data, as well as improve the processes in the back-end. This was a sleepy old government-owned company - or it was - and so this investment was important. It had an over 25% market share, or 3.7 million customers, and over $5 billion worth of claims which it was managing every year. This size and customer base put it in good stead to be able to amortise the cost of the digital transformation over a large earnings base.

Having an existing customer base enabled it to roll out the new system rather than have to attract a heap of new clients.

Over the last few years, Medibank improved phone response time from six minutes - that’s right, six minutes - to less than two minutes. Through the app, they’re offering concierge services to customers to go to hospital, personalised customer communication, and made relevant offers to the customers. Over this period, complaints have more than halved. The net promoter score improved from a large negative number to a large positive number in FY18. This culminated in a great turnaround in the customer perception of Medibank and a rebound in their market share. In the second half of 2018, Medibank’s market share increased for the first time in over a decade. On the cost side, Medibank has used the data collected from their claims to be able to reduce claims costs, which has been good for margin and increased Medibank’s ability to reinvest some of those savings back into rewards for loyal customers. This is extremely important going into what is likely going to be a tough regulatory environment.

One of the things that Medibank has used its data for has been the payment integrity programme. This has enabled the company to crackdown on potentially unscrupulous practitioners who were coding favourably to themselves, taking money from the health insurer. Its data was important in lobbying the Federal Government to change the way prosthetics are bought in Australia. Before this, Australia was the most expensive place for people to buy prosthetics. The data enabled Medibank to push back on hospitals when it came to negotiation. It could show the hospitals had unacceptable re-admission rates and that patients were overstaying. Medibank, though its concierge programme, is giving the patients the alternative to stay at home rather than go to hospital. This is arguably one of those rare win-win scenarios. It could be argued that staying in hospital for the rehabilitation process is generally not as comfortable and increases the risk of infection. What’s more, the cost to the insurer is over $1,000 a night. Offering at-home care for a patient in rehab is materially cheaper for the insurer and, arguably, a better outcome for the patient.

While the regulatory outlook is uncertain for the health insurance industry, we take comfort from the fact that hard decisions made five years ago plus excellent execution has put Medibank well ahead of its competitors, as far as consumer outcomes are concerned, as well as on a better footing with cost management. Add a strong balance sheet, good management team, and a reasonable valuation. We think Medibank looks okay.

Woolworths (ASX:WOW)

This is another company which has spent enormous amounts of operating and capital expenditure on digital and data over the last couple of years.

Woolworths has a unique dataset: it has 10.9 million active rewards customers, that’s over a third of the supermarket market in Australia.

Five years ago, Woolworths bought 47% of data analytics company, Quantium, and recently set up WooliesX. WooliesX is an investment in a team that is trying to use all the data that they’re collecting to:

  • improve customer experience, and
  • work out ways to become more efficient.

Some of these initiatives include Wi-Fi across all stores, a rollout of Click & Collect at all stores, and a digital payment system. Shareholders are wearing the cost now for future-proofing the business which will generate a good return in the future.

We think that Woolworths has done a very good job turning around the customer experience over the last three years and an excellent job of personalising online marketing. The end result has been an improvement in customer experience, with overall satisfaction targets increasing from 69% to 81% over the last three years. This has been one of the key drivers of the company managing turnaround in the sales line from negative 1% in 2016 to positive 4% comp store sales in FY18.

The company continues to invest, with the state of the art single pick warehouse to be commissioned early in 2019. This should help further improve the supply chain efficiencies for Woolworths and push it further ahead of its largest competitor, which has been under-investing for the last couple of years.

The Woolworths digital transformation is a work in progress, and early signs of the sales line and customer satisfaction have been extremely encouraging. Shareholders are already wearing the costs of these investments and have yet to get the full cost benefit. We think the risk-reward is good, with an unleveraged balance sheet following the potential petrol disposal, a strong market position and future profitability benefits from the current elevated capital and operating expenditure.

Opportunities for The Big Four

The Big Four banks are under siege, and for good reason. There’s the Royal Commission, the pending Federal election, tightening lending standards, higher wholesale funding costs, comprehensive credit reporting, open banking starting in June next year, fintech competition, and of course everyone calling the peak of the housing cycle. You can easily understand why they’ve been such underperformers over the last 12 months.

However, with all this stuff going on, we’re trying to look at it differently. We’re looking at the banks’ data. We believe that the banks have unique, rich and live data. With the onset of tap and go, my bank knows every move I make: it knows where I buy my coffee and lunch, and of course, my payment history. My interaction with my bank has changed from queuing up once a week to withdraw or deposit money to many multiples and micro-transactions every single day. A bank like CBA has this data for over a quarter of Australians. The problem most banks have is whether they have the core systems in place to be able to cope with all this data.

Are they able to harness this data to make smart decisions? The banks that execute well will come out the other side of the Royal Commission and be able to create a positive experience for their customers, increase their customers’ digital engagement and offer personalised marketing and services, and they’ll be very strong at the other end.

If the banks can digitise their service offering, this will open tremendous opportunities for taking costs out at the backend as they automate the process.

In the next 12 months, bank investors are going to have a rollercoaster ride as the Royal Commission recommendations will be revealed, and that will probably coincide with the Federal election, and multiple class actions will likely be announced. We feel this could provide selective opportunities for the brave.

Further insights

If you would like to read more analysis from the team at Perpetual, please visit our website


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julian reynods

constuctive and incisive analysis detailing key investment info on woolies and the banks.

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