Semiconductor bubble?

It has been a great year for semiconductor stock. This is important to the industry as stocks are often used to finance acquisitions and major investments. The industry is also known for its extensive use of options and warrants to keep executives and key people locked in. There is no problem in connecting results to rewards unless the increasing stock price is a result of speculation and not underlying results. A stock bubble might benefit a couple of lucky bankers but to most stakeholders it is damaging. The value created by the bubble will have to be paid back, and then some. People will get great bonuses and then get fired. Investments started and stopped.

 

Screenshot 2017-02-24 08.49.57

 

The obvious question

Nobody wants to spoil the fun and ask the obvious question: “Why are semiconductor stocks growing when the semiconductor revenue is not?”

Although revenue growth is one of the most important value drivers there could be other reasons for stocks to climb. One of the valuation methods used by financial analysts is the Shareholder Value Analysis (SVA). The analysis values a company based on its ability to deliver future cash flows. The model has 7 value drivers (as can be seen in the graphic) that create the valuation of a company. If the market change opinion about a company’s future revenue growth rate, the SVA shows a higher value for the company and the market respond immediately by adjusting the stock price accordingly. In theory at least. If the stock market and the underlying value drivers are out of sync, there is a high probability of a depression or a bubble.

The 7 drivers are:

  1. Revenue Growth.    Although there was an uptick in Q4-16 revenue the industry has been in low single digit growth for some time. This is not likely to change.
  2. Operating Margin.   Operating margins fell by 170 basis point from Q4-15 to Q4 -16
  3. Taxes.   The tax environment has two opposing forces: It is becoming more difficult to offshore profit for lower tax reasons and potentially lower corporate tax in the US.
  4. Working Capital Investments   The investments in working capital are likely to be flat following the revenue growth.
  5. Fixed Capital Investments     It is not becoming cheaper to participate in the industry. Both investment in replacement and new equipment only goes up.
  6. Cost of capital.    After many years with access to cheap captial, there are signs of increasing costs.
  7. Life of strategy.   There are many signs the current strategies are coming to an end. Exploding costs of chip design and the end of Moores law.

 

Value Drivers Bubble-01

 

From our perspective, there are no value drivers for the industry that warrants the current increase in stock prices. This does not mean that investing in individual companies still can be a good idea. All markets have winners and losers.

Article in Fox business here

 

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The GPU, CPU battle has reached the Economist

The Economist has decided to compare Intel against Nvidia and the result is as always interesting. With a level of simplification, they highlight the issues that Intel is facing. A competitor from a niche Intel should have been able to control is now starting to eat Intel’s future meal – the data centre.

Screenshot 2017-02-23 23.05.47

 

Read the article here

 

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China continues to gain share of Wafer Capacity

Research released by IC Insights confirmed that China keeps increasing its share of worldwide wafer capacity. Taiwan and China now collectively have 1/3rd of the global capacity. Trying to prevent China from buying western semiconductor companies will not be sufficient to stop them. There are many other ways of dominating. The research is based on physical location of the factory and not of the headquarter of the owner. Once again it demonstrates that semiconductors are a global business that cannot be isolated by isolationistic policies.

Screenshot 2017-02-23 17.24.11

 

Semiconductors have been declared strategic by both the US and by China. Europe has plenty to deal with and has decided not to have an opinion.

Read the research bulletin here

 

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The Semiconductor Operating Model Grid Q3-16

It is not unusual for people in the industry to talk about the semiconductor business model as it is something common and static for all companies in the market. While there are a lot of commonalities there is also a lot of interesting differences that can reveal a lot about what strategic choices a company is pursuing. Despite quarterly updates from the CEO, the format is dictated by Wall Street analysts trying to get numbers for their financial model so they can predict (guess) the numbers of the quarter. It is rare that something interesting is revealed. I cannot blame the leadership teams as they have lawyers and analyst hovering over them just waiting for a mistake.

What is much more useful is the financial reporting that public semiconductor companies have to deliver every quarter. As the format is reasonably stable it is possible to compare changes over time and also comparing companies to each other. This analysis is made for Semiconductor companies only – in our definition is public companies that have semiconductors as their only business and sell them to electronics customers. This excludes conglomerates as Samsung and foundries like TSMC and represents a choice taken for the availability of data and consistency.

While the manufacturing costs are hidden in the Cost of goods sold, the operating costs are more visible and interesting. Knowing where a company spends its operating dollars tells you a lot about that company.

Don’t tell me where your priorities are. Show me where you spend your money and I’ll tell you what they are. James W. Frick

Other operating costs can exist, but the two most important ones are Research and Development (R&D) and Selling, General and Administrative (SG&A). The implications of a high R&D spend is understood by all people in this industry. It is a clear indication of the level of ambition of a company. SG&A costs are slightly more complicated as it is the sum of the selling costs and the general administration costs of the company, including management, staff functions, rent and utilities. A few companies report the two separately and offer a view into their relationship. The indications are that the G&A costs are dependent upon the size of the company and are somewhere from 2.5% to 7.5% of revenue, As such the G&A costs are relatively stable over time and changes in SG&A is a result of changes in sales and marketing activity.

The Operating Model Grid

A tool to investigate the two costs simultaneously is the operating model grid. The centre of the grid is representing the averages of the companies studied. By comparing companies this way, you can eliminate much of the economic noise that affects the entire market. By comparing similar quarters one year apart, any seasonality is excluded.  The periods compared in this grid is Q3-2016 and Q3-2015.

RD vs SGA 4 Development

 

 

Although it is not suggested that one business model is superior to another, there are four zones in the grid representing four different operating zones when compared to average. Companies in the ambition zone outspend the average company in both R&D and Selling. Smaller companies are typically in the ambition zone as they need high R&D and SG&A just to survive, where larger companies have more options when choosing their operating model.

Companies in the consolidation zone spend less than the average company in both categories. This could be as a result of having a commodity offering where price is more important than selling and R&D is technology focused rather than product focus. It could also be a preparation for an acquisition. Companies in the selling zone prioritise selling spend over R&D. This could be a result of having products that need high support or it could be an indication that the company want to get bought. In the development zone are companies that typically have high volume leading edge products that are sold to few customers. What is more interesting than the zones is the change in operating mode over the year represented by the arrows.

The grid is not an absolute – it is a model to identify interesting questions to be researched. Both Nvidia and AMD have experienced healthy growth, and they have decided not increase the operating costs simultaneously. This could be a lack of confidence that the growth is sustainable or it could be that they are not able to find the right people and projects sufficiently fast.

Hynix and Micron have decided to handle the growth in memory differently. Where Micron keeps their R&D steady and increases their sales investment in line with growth, Hynix puts the pedal to the metal. This is a very strong indication that Hynix has a strong belief in their current strategy.

A merger will typically create a movement towards consolidation. (We compare the sum of the two entities to the newly merged company). The overhead you pay for the acquired company needs to be repaid. Operating costs are fast carbohydrates for merger integration teams.

What is interesting is the three European semiconductor companies all are quite close together and also close to TI. Intel is not surprisingly in the ambition zone but heading towards consolidation.  This could be a result of the change from PC focus to data centres, IoT and AI that cannot absorb the drop in spend on PC.

The Semiconductor Operating Model Grid for Q4 will be released in a couple of weeks together with an in-depth analysis of the fourth quarter for Semiconductor companies.

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Semiconductor Gross Margin update Q4-2016

The strong end of 2016 for the semiconductor market almost certainly had a significant impact on the gross margin of most companies. Overall the average gross margin grew 0.8% from 51.4% in Q4-15 to 52.2% in Q4-16. The high end of the spectrum is dominated by FPGA and analogue semiconductor companies. This would have included Altera prior to being acquired by Intel, with a pre-merge gross margin of 66.7%.

 

The next group of companies is focused on computation and communication, including Intel that heavily dominates the average gross margin for the industry. At the other end of the spectrum is Micron that plays the memory market with a low margin model. Also On Semiconductor has a low gross margin although is looks more like a conscious decision given their very low R&D and selling costs. 

Some companies have experienced a significant change in Gross margin Q4-15 to Q4-16. In the case of Marvell, it relates to significant extraordinary costs they had in Q4-15 that does not impact the last quarter. The Gross margin improvement of NXP is related to the acquisition of Freescale and divestiture of other assets and is likely to settle unless the Qualcomm merger gets a final approval. Similarly for Cypress that is trying to digest Spansion. 

The increase in gross margin of Hynix is related to the increase in memory pricing although this did not seem to impact the gross margin of Micron that stayed relatively flat.

A key competitive driver of semiconductor companies is their gross margin. Gross margin gives insight into the manufacturing efficiency of a company as it represents the revenue less the cost of goods sold. Cost of goods sold represents all of the costs associated with the manufacturing process but does not include any of the R&D, Sales or administration costs.

There is no right gross margin, it is an operating decision or a business result based on how you run your business. For semiconductor companies, their manufacturing decisions can have a significant impact on their gross margin. That said, you want to keep your gross margin as high as possible as it is the fuel for R&D and Sales activity, it pays for your administration and it creates the return to your shareholders.

If you are a customer of semiconductor companies you want to select a supplier with the right kind of gross margin. If the gross margin is too high, it could mean you are paying too much for the product and should find a better supplier.  Low gross margin companies are targets that can be improved by competitors in a takeover. Acquisitions are not your friends if you are buying.

Acquisitions in not a friend of the employee either. The chance of an employee surviving without loss of job, title or pay is low when you are in the target company. It is important to work in a company that has a high gross margin as such a company has difficulties in finding an acquisition target that meaningfully can add to the business as high margin businesses have high price targets.

 

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A shift in China’s Semiconductor Industry?

The announcement of Tsinghua Unigroup's acquisition of a majority stake in XMC under the supervision of the National Semiconductor fund could represent a change in China's quest for semiconductor domination. The two companies could be merged into the newly created holding company Yangtze River Storage Technology with a capital of 2.8B$. Read the story here.

As the antiglobalisation wave spreads, it is starting to have an impact on the semiconductor world. Many semiconductor companies have turned to M&A activity in a search for meaningful value creation for their shareholders. China's semiconductor ambitions are crystal clear and several attempts have been made by Chinese companies to acquire western semiconductor companies. These acquisitions have been blocked by the US government even though they did not violate the rules of market competition. The semiconductor industry has now been declared strategic by both China and the US.

China Chips

This deal could represent a shift in China strategy away from foreign acquisition into a race of technology and capital investments. This will be difficult to follow for western semiconductor companies that rely heavily on being able to syphon their capital investments from their retained earnings. They do not like large bets that involve asking their investors for capital and work to make the quarter. The Chinese are playing to win the decade and they are gaining ground, even without buying western companies.

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You need a big stack of chips to play the Semiconductor Roulette

Most of the technological development over the last couple of decades has been driven by an industry driven by a very simple equation. Moores law states that the density of transistors in semiconductor chips doubles every two years. This means semiconductor companies deliver cheaper, faster and lower power consumption chips every year enabling other industries to grow.

The semiconductor industry itself is not growing significantly anymore even though the number of transistors it manufactures doubles every two years. It has reached a commodity equilibrium hard to break.

Just to stand still semiconductor companies need to invest massively in new technology and in acquiring competitors to get to a higher scale of economy that allows massive investments.

This is not an even race as can be seen in the chart. Three companies dominate the roulette table:

Top R&D Spenders 16Q3-01

 

A few companies dominate the race followed by a long string of companies that are struggling to handle the investments needed to participate in Moore's race. Although the technology is available through subcontractors, using it comes with a loss in the value chain that has an impact on costs and gross margins.

Moore's law is available only to a few companies

If you want to be in the semiconductor game you need to go big or go home. The R&D cost relative to sales is an average of 17.2% for the major semiconductor companies. This is significantly over what other industries normally invest in R&D and way above technologically (still) respected Apple Inc, that only invest 5.5% of sales into R&D.

Top R&D Spenders 16Q3 Share of Revenue

Investing too much into R&D makes you a target for acquisition. To buy a company you have to pay more than it is worth (many different measurements available). For an acquisition to make sense it has to either deliver revenue synergy, cost synergy or both. In the semiconductor industry, cost synergies dominate. This means a high R&D ratio gives an acquirer the opportunity to cut R&D spend with little immediate impact. Longer term there might be ramifications.

The industry is entering a new phase of uncertainty where M&A might not be the path to survival it has been for the last few years. What the Obama administration started the new Trump administration will continue, blocking foreign acquisitions of semiconductor companies. In return China and Europe are likely to block any intra-US mergers. Soon the industry will have to learn how to grow organically again.

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What did Avago pay for?

I am certainly not a finance professional, nor do I have any personal or economic interest in talking the Avago-Broadcom merger up or down. When that is said, I am very interested in understanding the mechanics of semiconductor mergers. They have become the preferred way of growing in the semiconductor industry, but nobody knows if they create value for other stakeholders than the two management teams that get rewarded handsomely. Companies become larger than the were, but that is not the same as becoming better than they were. Size does not equal value for every stakeholder. 

M&A is the only game where the loser gets paid more than the winner

The only public information about a merger or acquisition is positive and talks about the upsides of the companies joining forces. Information about potential risks or losses is incomplete or omitted. If you ever have been part of a merger team, you will know how bloody and messy things can be on the inside at the same time as corporate communications send soothing music to the markets. 

When M&A becomes your main growth engine you have your back to your customers.

Most people in the industry seems to assume that the finance team have done the math and approved the merger from a financial perspective. It is safe to assume that there has been plenty analysis before signing the deal. Much more interesting is it to identify what the analysis is based upon. In the Due Diligence process, the buying entity is allowed to review all financial material, and everything else deemed material from the selling entity.

It is also safe to assume that the selling entity will make sure they get a good deal or they will have to answer to rebel investors and potential lawsuits. It is much more difficult for shareholders of the buying entity to understand if they are getting a good deal or not.

Where lawsuits from shareholders of the selling entity in an acquisition are quite common, you rarely see lawsuits from shareholders of the buying entity.

To buy a good company, you are likely to have to pay more than its is worth in the market. The deal can be attractive if the acquired company can be made worth more by joining the buying company than it could alone. Synergies can be created by expanding the offerings to customers or by lowering costs by economies of scales. The problem with synergies is that they are based on assumptions and expectations of the future and have a lot of risks associated.

The merger balance sheet.

A way of getting additional information about a merger is to take a look at the merger balance sheet. This information alone is not sufficient to establish if the merger makes sense or not, but it can be used to highlight issues and risks associated with the acquisition. The merger balance sheet is what entering the buying company's balance sheet in return for the purchase price creating a new balance. You can see what you paid for.

For a mega merger like Avago-Broadcom we are talking big numbers - we are certainly in the closed area of the casino - and as Avago was the smallest company the merger is going to change the balance sheet dramatically.

 

avago-balance-sheet

All figures are from AVGO balance sheet and in B$ 

Price of acquisition

The first element of the merger balance sheet is the acquisition price, in this case, shown less cash. You can view the transaction to include the acquired company's cash or exclude it as you immediately use the money to fund the transaction.

Working capital

The working capital involves the net value of all the assets that are in the cash cycle of the acquired company. This includes account receivables, account payables, and inventories. Also, assets held for sale and the short-term impact of debt is included. Working capital is a tangible asset, it has a very clear monetary value.

Property, Plant and Equipment

This asset group is also tangible. It is a group of physical assets with very clear accounting rules for establishing value. As Broadcom's business model was fabless, it is not surprising that this asset group is relatively modest in size.

Intangible assets

The next two asset groups are non-physical and much more complex to evaluate. The part that is possible to identify and assign a value to is called intangible assets. As can be seen from the chart, this includes trade names, customer backlog and contracts and technology plus in development technology. Although there are rules for how to establish the value, there is a lot of interpretation possible. The last and maybe most interesting element of the balance sheet is Goodwill. It represents the intangible value of unidentifiable assets. Goodwill also represents the price the buying company is willing to pay for above and beyond what can be specified in the balance sheet. The long-term liability element is predominantly deferred tax as a result of the write-up of Broadcom's assets.

So what?

When seeing the deal as expressed in its balance sheet components, it becomes clear that a semiconductor merger involves a lot of estimations, assumptions and expectations. In short, there is plenty of risks involved as well. Even thought M&A is the preferred growth strategy in the Semiconductor industry presently, it also represents a danger to the companies involved. Synergies will be harder to unlock as manufacturing costs are equalised and the market dominated by fewer larger companies with wider product portfolios. During the merger, companies need to reassign a lot of their people away from operations and into integration related activity. Companies risk forgetting the customer in this phase.

 

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The buying hierarchy has been displaced by the buying networks

Pre-social selling methodologies operate with a model of the buying committee that mirrors the hierarchical structure of the buying organisation. The salesperson's job is to get to the decision maker in the top of the pyramid and convince this very important top officer to buy. Even though you also need to tick the boxes of the other participants in the buying hierarchy, this person calls the shots.

Unfortunately, the business world is not becoming simpler and nor is selling. In order to stay relevant salespeople need to rise above just being order takers. They need to become consultants that are able to create value for the buying organisation. In order to do so, the sales consultant has to understand the buying organisation in detail to be able to influence change.

Selling requires changing the buying organisation. If you are not changing it, then you are just taking orders.

 

The meteoric rise of social media has demonstrated that the world is not powered by hierarchies and nor are organisations. That certainly does not mean that hierarchies are irrelevant. They play an important role in any business.

The operational hierarchy and the creation network.

You don't need to spend many seconds in an organisation to identify the operational hierarchy. Employees and managers busy with processes, outcomes, KPI's and efficiencies. The machine room is important to the health of the company. It is, however, important to understand that this hierarchy with is very clear goals are not the best structure for creating new ideas, products, business models or strategies. They are far too busy with today to worry about tomorrow.

The operational hierachy fight change like the body fights an infection.

Senior managers are very aware of this and create separate groups of people to handle the creation of the future. These groups of people are pulled completely or partly out of the hierarchy to participate. This might be temporary project groups or more formal committees working across the organisation. This creation network holds the keys to the company's future and does not figure on any organisation charts. 

 

Order takers work the operational hierarchy, consultants work the creation network.

The individuals in the creation network are not chosen for their operational qualities. They are chosen for their creativity, expertise and the networks they are part of. They will typically be quite visible on LinkedIn as their orientation is outwards and towards the future. It is important for consultants to identify the changemakers of the organisation they want to create value for.

The changemakers of an organisation don't hold hierarchical power, they hold network power and as such are very important to the CEO. Whenever the organisation is in trouble they become very visible as the glue that holds the organisation together until the next steady state can be reached. They are masters at operating the 4 different but interconnecting networks that operate independently from the hierarchy in all organisations:

 

4-social-networks-01

The Trust network

Before being allowed to operate inside the customer's organisation a consultant needs to gain a level of trust. The trust network is very different from the other networks as it is not solely a professional network. People trust their spouse and family more than they do any expert, they trust a friend more than any salesperson. The trust network is of particular importance early in a professional relationship before the consultant has been able to prove her worth. Each of the members of the buying committee is in a trust network but also have their very personal trust networks that reach far beyond the borders of the buying company. This is a great entry point for a consultant.  To enter a person's trust network, you will need to get an endorsement from a member of the network. Social media makes this a lot easier than before.

  1. Family
  2. Friends
  3. Former Classmates
  4. Colleagues
  5. Organisation or clubs
  6. Competitors

 

The Expert network

As a consultant is interested in changing the customer, it is important to be connected to the expert network. This is where new products, solutions and business models are defined. For companies in the tech industry, this is mainly an engineering community. It is important to identify other experts also. Finance, legal and marketing experts carry decision weight and have a lot of veto power. To enter the network you do not necessarily have to be an expert in all disciplines but you have to have identified fields in which you excel. You will also be attractive to the expert network if you have access to valuable expert resource from your own organisation. 

 

The Power network

As most consultants have realised, just because the expert network is working on something does not mean it makes it to production. Every project has to pass several gates before it gets the green light and it can be stopped at any point in time by people in the power network. The power network is consisting of two main areas: Signature power and veto power. Signature power is held by high ranking people in the buying organisations that control budgets and can allocate resources. The veto power is held by staff functions like finance, legal, quality and reputational departments. Consultants will benefit from being well connected to the power network and understand the roadblocks for the changes that the consultant is bringing.

 

The Action network

The action network is tasked with executing the project or the decision. They might sound like a group without influences that only follow orders but it is important to be part of this network. Even if the decision has been made by people in power, the action network can decide that it is not possible to implement. They can also decide to fake participation and wait until the project slowly disappears again. Being well tapped into the action network will help move important projects through the maze.

As a sales consultant, it is vital to understand these networks and identify the key players. While order takers are busy hunting orders at the purchaser's desk, sales consultants are busy working with changemakers to define future order streams.

 

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We transform your advertising to content valued by the customer, at a fraction of the advertising cost.
Social Selling is so good it is irresponsible not to use it.
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If your company plans to launch an app, read this first.

Most intelligent products have traditionally had their own controls and interface for the customer to use. We all know that buttons and small LED displays don’t necessarily create the best user experience – just try and change the clock on your stove without the manual. With the introduction of low-cost connectivity to the internet, it has been possible to remove most of the interface electronics from products and allow it to be controlled from the suppliers homepage instead. The rapid slide from desktop based internet to mobile has made most homepages too cumbersome, even when using responsive design, for device control. Many companies have realised this and are creating apps to control their devices instead. While apps works well on a mobile device, it is becoming quite obvious that users don’t really download many apps and use even fewer. Over the last 5 years, the top 10 apps have not really changed – dominated by the large US tech companies.

A future is now visible were an app is not the best approach to device control or service interface. It will be important to move developments from apps to bots that can operate inside the framework of the top app owners. Facebook and similar companies are releasing tools that will help companies to integrate their products and services into their infrastructure. At the same time, companies need to explore how they can operate using a digital assistant like M and Siri rather than their own app.

Sales insight: Your customers are experts in their own business and market but rarely do they scan the innovation horizon of other industries. They look at what their competitor is doing rather than what is going to happen in the customer’s world. They might even ask their customers what they want – the problem being that customer’s often don’t know what they want next. No customer asked Apple for an iPhone before it was launched. To be successful in consultative selling you need to know more than your customer. You will need to understand your customers business model and strategy but more importantly, you will need to understand what is developing in the world that can affect your customer and the customer’s business model. To sell, you need to be invited in before the buying decisions are made. The best way of being invited is to demonstrate that you have valuable insights about the future of the customers business. In this case, the customer might not think that their business model will depend on Facebook in the future – they might be wrong.

Read the full article in Wired: Facebook Believes Messenger Will Anchor a Post-App Internet

What if your IP is made worthless?

In the old world of competition, companies were trying to protect their intellectual product property through secrecy and patents. The IP made it possible for companies to charge their customer more for their product than their less innovative competitors. Although the competitive and product-centric business models still dominate the world there are new business models introduced that destroy the product logic of the past. Facebook does not have a product-centric business model and as such is threatening many companies. Facebook is interested in everything that creates content and that lower the cost of creating or sharing content. They have already released open source ethernet switch designs to stimulate more competition and lower costs for their server farms. Now the time has come for them to do the same with 360-degree cameras. In the process, they are destroying the business models companies trying to serve this market with their product-centric and IP base business models.

Sales Insight: Customers that have a product-centric business model can be attacked by companies with more innovative business models. How will your customer compete if there is no IP advantage? How will your customer compete with free? Move the sales conversation from features to business models and you will move your role from salesperson to consultant. You will still need to find a way to connect your offering to the potential new business model of the customer, but it starts with a different kind of conversation. A conversation that explores rather than manipulates.

Read the full article in Wired: How Will Zuckerberg Rule the World? By Giving Facebook’s Tech Away

The day after the smartphone

We have become so used to our beloved smartphone that we cannot imagine a life without it. Predicting its death might be premature, but a day will come when the smartphone will be obsolete. The large tech companies are very aware of this fact and are working hard on what is next. A few technologies are potential replacements. By far the biggest threat is the rise of the automated assistants from Apple, Google, Facebook, Amazon and a few others. The living room has already quietly been entered by Apple. Once the power of the AppleTV has been fully released, you will be able to talk to SIRI in your living room

Mature Insights: Companies that create products or services that are dependent on buttons, screens, terminals and similar will be outmaneuvered by companies that use the smartphone as their interface.

Developing Insights: Companies that already have migrated to the smartphone via internet connectivity and apps need to think about how their products can be operated by SIRI and similar assistants. They also need to consider if they can give feedback to the customer in other forms than displays or even make decisions without involving the customer.

Read more in this article from Business Insider
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