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Smith Barney is a division of Citigroup Global Markets Inc. (the “Firm”), which does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

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Edward M. Kerschner, CFA 212-816-3532 [email protected]

Michael Geraghty 212-816-3534 [email protected]

E Q U I T Y

R E S E A R C H :

U N I T E D S T A T E S

Thematic Investing April 8, 2005

Techno Savvy Profiting from Adapting, Exploiting, and Innovating Technologies

�� Tech Adapters: A significant competitive advantage can be gained by adapting existing technologies.

�� Tech Exploiters: Identifying the optimal application of a relatively new technology is often as important as the technology itself.

�� Tech Innovators: By contrast, tech innovators actually create something new, often by taking science from the laboratory to the marketplace.

�� Key technologies today that may be utilized by techno-savvy companies include: dual clutch transmission, e-money, fuel cells, health spending account (HSA) “smart cards,” oil and gas drilling and completion technology, “phood,” radio frequency identification (RFID), real-time patient monitoring, and voice over Internet protocol (VoIP).

�� Among companies well positioned to use those technologies are BJ’s Wholesale Club, BorgWarner, Cisco Systems, eBay, EOG Resources, Euronet Worldwide, Martek Biosciences, Mechanical Technology, Medtronic, Plug Power, Senomyx, and UnitedHealth Group.

Techno Savvy – April 8, 2005

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Summary .................................................................................................................................................... 3 Tech Adapters, Exploiters, and Innovators.................................................................................................. 3 Lessons from History .................................................................................................................................. 3 Identifying Key Technologies ..................................................................................................................... 4 12 Case Studies ........................................................................................................................................... 5 Risks to Our Thematic Outlook................................................................................................................... 6 Techno Savvy ........................................................................................................................................... 10 Identifying Key Technologies ................................................................................................................... 12 Techno-Savvy Companies......................................................................................................................... 14 Tech Adapters: A Historical Perspective ............................................................................................ 15 Companies That Adapted Existing Technologies...................................................................................... 15 Thomas Edison: “Study and Read Everything You Can on the Subject”................................................. 15 Henry Ford: “I Invented Nothing New” ................................................................................................... 17 David Sarnoff: “A Plan of Development” ................................................................................................ 20 Tech Exploiters: A Historical Perspective............................................................................................. 22 Companies That Identified the Optimal Application of a Technology...................................................... 22 Columbia Graphophone: Exploiting the Phonograph............................................................................... 22 Sony: Exploiting the Tape Recorder ........................................................................................................ 23 Sony: Exploiting the Transistor................................................................................................................ 25 RCA: Exploiting Television ..................................................................................................................... 27 Tech Innovators: A Historical Perspective............................................................................................ 29 Companies That Innovated by Using New and/or Existing Technologies ................................................ 29 IBM: Innovations in Hardware................................................................................................................. 29 Texas Instruments: Innovations in Chips ................................................................................................. 32 Microsoft: Innovations in Software.......................................................................................................... 33 Genentech: Innovations in Biotechnology................................................................................................ 35 Lessons from History; Implications for the Future .............................................................................. 36 Four Key Implications............................................................................................................................... 36 Tech Adapters: Three Case Studies....................................................................................................... 40 BorgWarner’s Dual Clutch Transmission ................................................................................................. 40 EOG Resources’ Oil and Gas Drilling and Completion Technology ........................................................ 43 UnitedHealth Group’s Health Savings Account (HSA) “Smart Card”...................................................... 47 Tech Exploiters: Three Case Studies ..................................................................................................... 53 BJ’s Wholesale Club and Radio Frequency Identification ........................................................................ 53 Cisco and Voice over Internet Protocol (VoIP)......................................................................................... 58 Medtronic’s Real-Time Patient Monitoring .............................................................................................. 66 Tech Innovators: Six Case Studies......................................................................................................... 74 Fuel Cells: Mechanical Technology and Plug Power............................................................................... 74 E-Money: PayPal and Euronet Worldwide............................................................................................... 82 Phood: Senomyx and Martek ................................................................................................................... 95 Appendix A ............................................................................................................................................ 104 Technology Candidates ........................................................................................................................... 104

The following analysts contributed to the case studies in this report: Charles Boorady, Matthew Dodds, B. Alex Henderson, Jon V. Rogers, David B. Smith, Elise Wang, Deborah Weinswig, Tony Wible, and Gil Yang.

Table of Contents


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History shows that the “users” of technology are often more successful than the “makers” of technology. Techno-savvy companies use technologies — both new and existing — to gain a competitive advantage.

Tech Adapters, Exploiters, and Innovators Tech Adapters: A significant competitive advantage can be gained by adapting existing technologies (e.g., Ford’s use of mass production and Edison’s use of electrical lighting).

Tech Exploiters: Identifying the optimal application of a relatively new technology is often as important as the technology itself (e.g., using the phonograph for music reproduction, not dictation, and transistors for radios, not hearing aids).

Tech Innovators: By contrast, tech innovators actually create something new (e.g., Texas Instruments’ integrated circuit and Genentech’s human insulin), often by taking science from the laboratory to the marketplace.

Lessons from History A review of how companies have exploited technologies to their advantage has a number of lessons.

A Significant Competitive Advantage Can Be Gained by Adapting Existing Technologies Ford adapted three manufacturing technologies that had evolved over the course of 100 years, and which were employed by other companies in disparate industries: interchangeable parts (Singer Manufacturing Company), continuous-flow production (Campbell Soup), and assembly-line production (Swift). Similarly, Thomas Edison combined the existing technologies of electricity and the incandescent bulb with the proven business model of the gas industry in order to establish his electrical illumination system, which provided power to entire cities.

Identifying the Optimal Application of a Relatively New Technology Is Often as Important as the Technology Itself Thomas Edison insisted for years that the primary use of his talking machine should be for taking dictation in offices. In the 1950s, it was thought that the tape recorder would lead to “talking magazines.” The engineers at Western Electric suggested that the transistor be used to satisfy burgeoning demand for hearing aids. As it turned out, significant mass markets never developed for office dictating machines, “talking magazines,” or hearing aids. But significant markets did develop for the phonograph, the tape recorder, and the transistor radio.

The Company That Becomes Most Associated with a Technology Is Not Always Its Inventor It’s said that Picasso once observed that “mediocre artists borrow, great artists steal.” “Stealing” is a strong word when it comes to exploiting technology. But it certainly is the case that a company that first develops a new technology is not always the ultimate beneficiary, given that other companies may leverage that

Summary


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technology more successfully. It’s said that Steve Jobs of Apple not only admitted, but even boasted, of having stolen the graphical user interface (GUI) from Xerox PARC (Palo Alto Research Center), and when Mr. Jobs accused Bill Gates of Microsoft of stealing the GUI from Apple and using it in Windows 1.0, Mr. Gates fired back: “No, Steve, I think its more like we both have a rich neighbor named Xerox, and you broke in to steal the TV set, and you found out I’d been there first, and you said, ‘Hey that’s no fair! I wanted to steal the TV set!’”

Innovation Is Not Always Associated with Commercial Success The recurring theme of this report is that the “users” of a technology are often more successful than its “makers.” An excellent example of this is Xerox, which is credited with developing: one of the first personal computers (the Alto), the concept of personal distributed computing, the GUI, the first commercial mouse, Ethernet, client/server architecture, laser printing, and many of the basic protocols of the Internet. Yet Xerox has become famous for “fumbling the future” by failing to commercially exploit any of those ideas. Likewise, in 1942, John Mauchly, an engineering professor at the University of Pennsylvania, proposed and built an electronic calculator. Professor Mauchly was unable (or, some say, unwilling) to exploit the commercial possibilities of computing, and his company quickly disappeared inside Remington Rand. Subsequently, that (UNIVAC) division was neglected by Remington’s top executives and it fell far behind its key competitor, International Business Machines (IBM).

Identifying Key Technologies Smith Barney retained Gartner Consulting, one of the leading providers of research and analysis on the global information technology industry, to assist in identifying dozens of candidate technologies. Of these, many were rejected, not because of doubts about their feasibility but, rather, because they did not have meaningful profit potential for identifiable publicly traded companies in the next three to five years.

We whittled the original list of more than 50 candidates (see Appendix A) down to nine technologies:

�� dual clutch transmission,

�� e-money,

�� fuel cells,

�� health spending account (HSA) “smart cards,”

�� oil and gas drilling and completion technology,

�� “phood” (i.e., food that offers pharmaceutical benefits),

�� radio frequency identification (RFID),

�� real-time patient monitoring, and

�� voice over Internet protocol (VoIP).


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12 Case Studies We then did case studies of 12 techno-savvy companies that seem well positioned to use these technologies:

�� BJ’s Wholesale Club,

�� BorgWarner,

�� Cisco Systems,

�� eBay,

�� EOG Resources,

�� Euronet Worldwide,

�� Martek Biosciences,

�� Mechanical Technology,

�� Medtronic,

�� Plug Power,

�� Senomyx, and

�� UnitedHealth Group.

In order to understand how these companies are seeking to gain a competitive advantage, we interviewed managers responsible for the development and implementation of the respective technologies.

Techno-Savvy Companies — Technology Adapters BorgWarner’s dual clutch transmission is based on concepts that go back to the 1940s, but it has only been recent advances in electronics and hydraulic controls that have made the technology feasible today.

EOG Resources is achieving superior results by applying some well-known drilling and completion technologies in a more effective way than its competitors.

UnitedHealth Group is combining the existing technology of “smart cards” with the proven business model of the managed care industry in order to establish a strong competitive position in the new environment of health savings accounts (HSAs).

Techno-Savvy Companies — Technology Exploiters An excellent use of radio frequency identification (RFID) — first introduced for aircraft identification during World War II — is tracking items through a supply chain; BJ’s Wholesale Club is well positioned to use RFID to lower its labor and distribution costs.

Cisco Systems is exploiting the adoption of voice over Internet protocol (VoIP), because enterprises tend to spend three to five times as much on security and network switching equipment as they do on VoIP itself.

Medtronic is exploiting the latest developments in networking technology to develop real-time patient monitoring devices.

Techno-Savvy Companies — Technology Innovators The concept of fuel cells has been around for almost 200 years, but Mechanical Technology just recently introduced a commercial micro fuel cell, while Plug Power is the first company to bring to market a reliable, economically viable fuel cell for on-site power generation.

With regard to emerging e-money, eBay’s Internet-based PayPal payment system is facilitating global peer-to-peer e-commerce, while Euronet Worldwide’s eTop Up service is facilitating local day-to-day e-payments.


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As for “phood,” Senomyx has a unique approach to developing flavor enhancers by applying the same innovative technologies used by biotechnology and pharmaceutical companies; Martek Biosciences has a library of over 3,500 species of microalgae from which it derives a food additive that may have cardiovascular benefits, and may also decrease the risk of diseases such as dementia and Alzheimer’s in older adults.

Risks to Our Thematic Outlook The key risks to our techno savvy theme are that some of the technologies that we discuss do not succeed as expected or, alternatively, that some of the companies we have identified as techno savvy fail to execute.

We further note that our analysis does not consider stock-specific metrics such as valuation, EPS, and P/E ratios, or balance sheets, market capitalization, and liquidity. Accordingly, when making investment decisions, investors should view thematic analysis as only one input to their investment decision. Since thematic analysis employs a longer-term methodology, its results may differ from the conclusions of fundamental analysis.


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Figure 1. Summary of Nine Key Technologies and 12 Techno Savvy Companies

Dual Clutch Transmission: Using this transmission, which is based on a manual gearbox, the driver can

initiate the gear change manually, or can leave the shift lever in fully automatic mode. In other words, a car can

meet the demand for a sporty, responsive driving experience or, alternatively, for the convenience of an

automatic that offers good fuel economy.

�� BorgWarner is the only supplier on the market with a dual clutch transmission (DCT). The technology is

particularly attractive in Europe, with its small car engines and highly taxed gasoline, because inherent in

the DCT design is the ability to take advantage of the investments that automakers have already made in

manual transmission production facilities. Asian markets also have potential: Manual transmission

penetration is nearly 100% in India, around 75% in China, and more than 50% in South Korea.

Oil and Gas Drilling and Completion Technology: Horizontal wells improve production volumes. 3-D seismic

data (geologic imaging) can help avoid geologic pitfalls. Successful fracturing creates controlled fissures (i.e.,

not too big or small) so that gas can flow around the rock and into the pipe.

�� EOG Resources is achieving superior results in the Barnett Shale — a geologic formation in the southern

U.S. containing vast amounts of natural gas — by applying some well-known drilling and completion

technologies in a more effective way than its competitors. Improved drilling and completion technology is

most beneficial when it is novel. But once the technology is widely employed in the industry, leasehold

prices escalate. EOG’s average acquisition prices in the Barnett Shale are around $200 per acre, but now

that EOG’s E&P technology is more widely accepted, recent deals in the area average $11,000–$17,000

per acre.

Health Savings Account (HSA) “Smart Card”: Just as banks must have real-time data for an ATM to work, in

the forthcoming HSA environment, health plans and their members will have to operate in a real-time

environment too.

�� UnitedHealth Group is approaching completion of a HSA “smart card.” United’s technology is superior in

large part because its technology spending — funded by more than $3 billion in annual free cash

generation — significantly outstrips its competitors. United is the only managed care organization with all

four HSA pieces (i.e., the company can offer the plan, administer it, act as an HSA custodian, and offer an

HSA debit card). Moreover, United’s position as one of the largest benefit providers in the country enables

it to roll out a new technology that quickly enjoys widespread adoption, thereby spreading development

costs over a large membership base. Further, given that United’s technology group is forced to compete

for the business of other United units, that puts pressure on the group to be at the leading edge. Reflecting

the success of this approach, today the in-house technology group competes against companies (e.g.,

Accenture, EDS, and Perot) that provide services to United’s competitors.

Radio Frequency Identification (RFID): RFID is a generic term for technologies that use radio waves to

automatically identify individual items. RFID offers retailers decreased distribution and labor costs.

�� BJ’s Wholesale Club seems well positioned to benefit from the introduction of RFID. Warehouse format

retailers are likely to be early adopters, given that most large suppliers are currently including RFID tags at

the pallet level. BJ’s is a relatively small company with only three distribution centers (versus 26-110 for

its closest competitors), so it would be relatively simple for BJ’s to upgrade its distribution system to RFID.

Subsequently, it would be easier to track BJ’s large number of SKUs, which have been adding to its labor

and distribution costs. Deborah Weinswig, Smith Barney’s broadlines retailing analyst, estimates that RFID

adoption could boost BJ’s 2007 EPS by 27%, versus 22% for Wal-Mart and 15% for Costco.


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Voice over Internet Protocol (VoIP): VoIP involves sending voice communications as digital packets over data

networks, such as the Internet, alongside e-mails and Web traffic. In contrast to traditional phone calls, which

require a dedicated circuit to connect the callers at each end, VoIP service relies on software. Without VoIP,

some companies need to maintain four separate communications infrastructures: The data network; a “private

branch exchange” (PBX) for external phone calls; an “automatic call distributor” to route calls internally; and a

voice-mail system.

�� Cisco Systems is exploiting the adoption of VoIP because the conversion tends to cost three to five times

as much in security and network switching equipment as VoIP itself costs. Given Cisco’s dominant (80%)

share of the networking equipment market (in contrast to its one-third share of the VoIP market), the

company is particularly well positioned to grab the lion’s share of those revenues. A key driver of VoIP

adoption is that, for the majority of enterprises, the telecommunications equipment in place today is much

older than it should be, and so it is increasingly costly to maintain.

Real-Time Patient Monitoring: The evolution of wireless networking technology is facilitating real-time

monitoring of patients’ conditions.

�� Medtronic is developing a wireless system for real-time monitoring of congestive heart failure, a muscular

problem whereby the heart enlarges and loses pumping function, causing fluid to back up in the lungs.

Medtronic appears well in front of the competition in terms of fluid management, the next “game

changing” technology in the CRM (cardiac rhythm management) space. Its Chronicle ICD (Implantable

Cardioverter Defibrillator) will offer physicians access to changes in fluid levels on a real-time basis.

Medtronic is also developing a real-time monitor of blood sugar levels for those suffering from diabetes. In

2007, the company is expected to combine the glucose sensor with an insulin pump to create a single

device. Medtronic appears to hold a major advantage over its competition in the development of an

artificial pancreas.

Fuel Cells. Like batteries, fuel cells generate electricity through a chemical reaction. However, unlike batteries,

fuel cells are recharged with a fuel source (e.g., methanol).

�� Mechanical Technology just recently introduced a commercial micro fuel cell. A new technology —

direct methanol fuel cells (DMFC) — seems likely to replace lithium ion batteries in the plethora of portable

electronic devices (PCs, cell phones, PDAs, cameras, etc.) because of its advantages of lighter

weight/greater portability (a few drops of neat methanol can provide the same power as a lithium ion

battery) and improved energy density (the power produced by a fuel cell is approximately two to three

times that of an equivalent lithium ion power pack). Mechanical Technology has entered into a strategic

alliance agreement with Gillette, whereby Mechanical Technology, Gillette, and Gillette’s Duracell business

unit intend to develop and commercialize micro fuel cell products to power handheld, mass-market, high-

volume, portable consumer devices.

�� Plug Power is the first company to bring to market a reliable, economically viable fuel cell for on-site

power generation. Plug Power’s GenCore system targets telecom and broadband backup systems. At

$15,000 for a 5-kilowatt system that lasts ten years or more, the GenCore unit compares favorably to lead

acid batteries that cost $18,000 for the same output, but last only three to five years and cost $12,000 to

replace each time. Plug Power will subsequently introduce fuel cells into markets such as forklifts and

auxiliary power on heavy trucks and marine applications. Thereafter, the GenSys platform is expected to

roll out on-site prime power electricity generation for residential uses.


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E-Money: Various types of e-money are emerging to facilitate global peer-to-peer e-commerce and local day-

to-day e-payments.

�� eBay’s PayPal payment system (comprising approximately 25% of eBay’s revenues) is effectively the

global e-money that facilitates global peer-to-peer e-commerce. The PayPal service uses the existing

financial infrastructure to enable its account holders to send and receive payments via e-mail in real time.

PayPal currently has users in 45 countries; yet, PayPal is currently being used on only about 23% of eBay’s

international transactions, compared to 50% of U.S. transactions. Furthermore, while most PayPal

customers use the service for trading on eBay, other forms of “off eBay” use are growing. This is a big

market that PayPal has just begun to tap — only 0.5% of international “off eBay” e-commerce

transactions are processed across its platform. In 2004, the company had around $5.7 billion in these

“Merchant Services payments” (25% of PayPal’s total payment volumes), representing an 80% compound

annual growth rate over the past three years.

�� Euronet Worldwide’s eTop Up service is emerging as a form of e-money that facilitates local day-to-day

e-payments. Given the high penetration of cell phones in many countries overseas, prepaid mobile phone

service was an obvious market for eTop Up to address first. However, any transaction that is recurring and

cash based could potentially be moved to the eTop Up model. So Euronet recently expanded into other

segments, including payment methods for music and gambling. This e-money format is particularly

applicable in the developing economies of Eastern Europe, Latin America, and Asia, as well as the

developed economies of Western Europe, where the absence of a “credit culture” and the lack of a credit

history necessitates a consumer prepaid/debit model.

“Phood”: “Phood,” or food that offers pharmaceutical benefits (such as milk with vitamin D or orange juice

with calcium), can also involve using biotechnology for more sophisticated health benefits.

�� Senomyx is a biotechnology company focused on sensory and taste-receptor-based technology. One

aspect of “phood” is flavor enhancers that improve the health aspects of packaged food and beverage

products by reducing additives such as monosodium glutamate (MSG), salt, and sugar, while maintaining

or enhancing the taste of the product. Senomyx has collaboration agreements with Campbell Soup, Coca-

Cola, Kraft Foods, and Nestlé. Following Senomyx’s recent receipt of Generally Recognized as Safe (GRAS)

designation for its savory flavor enhancers, Nestlé will be able to begin consumer acceptance testing of

food products containing Senomyx’s savory enhancers. The first commercial sale of such products could

occur during the first half of 2006, which would result in royalty payments to Senomyx. Based on the

existing agreements with its four collaborators, Senomyx’s immediate addressable market opportunity is

approximately $36 billion in sales. The company could receive royalties on product sales in a range of

1%–4%, suggesting approximately $360 million–$1.44 billion in revenues.

�� Martek Biosciences has a library of over 3,500 species of microalgae from which it derives a food

additive (DHA) that may have cardiovascular benefits, and that may also decrease the risk of diseases such

as dementia and Alzheimer’s in older adults. Martek manufactures the only source of DHA approved by

the FDA for use in infant formula. The company recently announced it has entered into a 15-year,

nonexclusive license and supply agreement with Kellogg. Under the terms of the agreement, Kellogg will

develop food products containing Martek’s DHA. Martek’s oils contain minimal fatty acids; are derived

from all-natural, vegetarian sources; have minimal taste and odor; and have a high oxidative stability and a

long shelf life.

Source: Smith Barney


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Sir Francis Bacon, the 17th century English philosopher, argued that European scientific progress was built upon a foundation of three key technological discoveries — printing, gunpowder, and the magnetic compass. As he noted in his book Novum Organum, published in 1620, this triumvirate was responsible for revolutionizing literature, warfare, and navigation:

Again, it is well to observe the force and virtue and consequences of discoveries, and these are to be seen nowhere more conspicuously than in those three which were unknown to the ancients, and of which the origin, though recent, is obscure and inglorious; namely, printing, gunpowder, and the magnet. For these three have changed the whole face and state of things throughout the world; the first in literature, the second in warfare, the third in navigation; whence have followed innumerable changes, insomuch that no empire, no sect, no star seems to have exerted greater power and influence in human affairs than these mechanical discoveries.

While Bacon wrote that the origin of these discoveries was “obscure,” all three inventions were the products of Chinese, not European, civilization. It is arguable, however, that the Europeans exploited these technologies more successfully than the Chinese.

Exploiting technologies is the focus of this report. To begin with, we examine three types of “technology” companies from a historical perspective:

�� Those that adapted existing technologies — as The Ford Motor Company did in the early 1900s when it combined three manufacturing technologies that had evolved over the course of 100 years, namely interchangeable parts, continuous-flow production, and assembly line production.

�� Those that identified the optimal application of a technology — as Tokyo Telecommunications Engineering Corp., later renamed Sony, did with the tape recorder in the 1950s.

�� Those that innovated by exploiting new and/or existing technologies — as Genentech did when it used the laboratory science of DNA technology to produce human insulin.

Figure 2 provides a summary of this historical analysis. We then employ this template to undertake case studies of 12 techno-savvy companies that seem well positioned to utilize key technologies today.

Techno Savvy

Exploiting technologies is the focus of this

report.


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Figure 2. Technology Adapters, Exploiters, and Innovators

Cotton Gin Electricity Interchangeable Parts Wireless Broadcasting

Inventor/Discoverer Ancient Indians Michael Faraday and others Eli Whitney Guglielmo Marconi

Originally Used for Homespun cotton Lighthouse illumination Rifle production Ship to shore messages

Adapter Eli Whitney Thomas Edison Henry Ford David Sarnoff/RCA

Product Gin for Short Staple Cotton Electric Lighting System Mass-Produced Cars Radio

Phonograph Magnetic Tape Transistor Television System

Inventor/Discoverer Thomas Edison AEG Co. Bell Labs Philo T. Farnsworth

Originally Used for Dictation Military applications Long distance calling Laboratory

Exploiter A.G. Bell, Emile Berliner Totsuko (Sony) Totsuko (Sony) David Sarnoff/RCA

Product Music Reproduction Sony Tape Recorder Transistor Radio Broadcast Television

Electronic Calculator Transistor BASIC DNA

Inventor/Discoverer Mauchly & Eckert Bell Labs Dartmouth Professors Watson & Crick

Originally Used for Gun firing tables Electronic circuits College computing Cancer research

Innovator IBM Texas Instruments Microsoft Genentech

Product Business Computer Integrated Circuit PC Software Human Insulin



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Identifying Key Technologies In order to identify technologies that could be utilized by techno-savvy companies, Smith Barney retained Gartner Consulting, one of the leading providers of research and analysis on the global information technology (IT) industry. As a first step, Gartner Consulting highlighted 48 candidate technologies. A separate survey of Smith Barney industry analysts identified many of the same technologies, as well as five other non-IT candidates (dual clutch transmission, Health Spending Account [HSA] “smart cards,” oil and gas drilling and completion technology, “phood,” and real-time patient monitoring).

After careful analysis, we whittled down this list of over 50 candidates to nine technologies that, in our opinion, have significant profit potential over the next three to five years:

�� Dual Clutch Transmission. While Gartner Consulting identified telematics as a key technology, Smith Barney auto analyst Jon Rogers believes the benefits of telematics will likely accrue to a wide range of companies in this industry, so it will be difficult for any one company to gain a competitive edge. Instead, Jon makes a compelling case for BorgWarner’s dual clutch transmission.

�� E-Money. Gartner Consulting highlighted the potential of micropayments, but Smith Barney analyst Tony Wible recommended extending the analysis to include other forms of e-money.

�� Fuel Cells. While Gartner Consulting highlighted the potential of micro fuel cells, Smith Barney analyst David B. Smith strongly advocated broadening the analysis to cover the entire range of fuel cells.

�� Health Spending Account (HSA) “Smart Cards.” These combine the existing technology of “smart cards” with the new concept of HSAs.

�� Oil and gas drilling and Completion Technology. Gartner Consulting has limited mindshare when it comes to non-IT technologies that are specific to the exploration and production (E&P) sector, which is increasingly dependent on technology. Accordingly, Smith Barney analyst Gil Yang highlights the leading-edge oil and gas drilling and completion technology of EOG Resources.

�� Phood. Biotechnology is, of course, a very diverse sector, and while Gartner Consulting highlighted some key technologies in that industry (e.g., bioinformatics) Smith Barney analyst Elise Wang believes strongly that “phood,” which refers to food that offers pharmaceutical benefits, has significant profit potential over the next three to five years.

�� Radio Frequency Identification (RFID). This will be particularly beneficial in helping to track items through the retail sector supply chain.

�� Real-Time Patient Remote Monitoring. The latest developments in networking technology are facilitating real-time patient monitoring devices.

�� Voice Over Internet Protocol (VoIP). While this technology has implications for many communications markets, our focus is on VoIP for enterprises.

We whittled down the list of more than 50

candidates to nine technologies that have

significant profit potential over the next

three to five years.


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Importantly, of the more than 50 candidate technologies, many were rejected not because of doubts about their feasibility but, rather, because they did not have meaningful profit potential for identifiable publicly traded companies in the next three to five years. Some examples of technologies that, in the opinion of Smith Barney analysts, did not satisfy this criterion are the following (see Appendix A for explanations of these technologies):

�� Bioinformatics. Smith Barney biotechnology analyst Elise Wang believes that, with many pharmaceutical and biotechnology companies utilizing this technology, it is difficult to identify one or two clear beneficiaries.

�� Biometrics. Smith Barney aerospace and defense analyst George Shapiro points out that many of the large companies in his sector have a small presence in biometrics.

�� Blu-Ray. Smith Barney entertainment analyst Elizabeth Osur observes that there is still considerable speculation in the industry as to whether the next standard for digital video will be Blu-Ray or HD-DVD.

�� Computer-Brain Interface. Neuromarketing studies can use neuroimaging to gain insight into drivers of consumer behavior. However, in the opinion of Smith Barney analysts, it is likely that many consumer products companies will use this technology, and that no one company will have a strong competitive advantage.

�� Driver-Load Matching. Smith Barney airfreight and surface transportation analyst Scott Flower notes that freight brokers will be able to offer this technology, thereby allowing smaller truckers to remain competitive with larger companies.

�� Natural Language Processing. Artificial intelligence will likely be employed for the analysis of words and phrases entered in natural language by the customer service departments in numerous industries, ranging from airlines to banks.

�� Powerline Broadband. Smith Barney electric utilities analyst Greg Gordon points out that, given that utilities are regulated entities, they have historically had no real profit incentive to innovate in ways that enhance profitability, as returns are generally capped in most regulatory structures. Therefore, they are unlikely to exploit the full potential of this technology.

�� Virtual Prototyping. This technology facilitates the highly detailed modeling of products. Once again, however, it is likely that the technology will be employed by all the leading players in a given industry (e.g., General Motors and Ford, Boeing and Airbus, etc.).

Many candidates were rejected because they

did not have meaningful profit potential for

identifiable, publicly traded companies in the next three to five years.


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Techno-Savvy Companies After determining our list of nine technologies, we worked closely with the Smith Barney industry analysts to identify companies that seem well positioned to utilize them:

➤ Technology Adapters: BorgWarner’s dual clutch transmission is based on concepts that go back to the 1940s, but it has only been recent advances in electronics and hydraulic controls that have made the technology feasible today. EOG Resources is achieving superior results by applying some well-known drilling and completion technologies in a more effective way than its competitors. UnitedHealth Group is combining the existing technology of “smart cards” with the proven business model of the managed care industry in order to establish a strong competitive position in the new environment of health savings accounts (HSAs).

➤ Technology Exploiters: An excellent use of radio frequency identification (RFID), first introduced during World War II for aircraft identification, is tracking items through a supply chain; BJ’s Wholesale Club is well positioned to use RFID to lower its labor and distribution costs. Cisco Systems is exploiting the adoption of voice over Internet protocol (VoIP) because enterprises tend to spend three to five times as much on security and network switching equipment as they do on VoIP itself. Medtronic is exploiting the latest developments in networking technology to develop real-time patient monitoring devices.

➤ Technology Innovators: The concept of fuel cells has been around for almost 200 years, but Mechanical Technology just recently introduced a commercial micro fuel cell, while Plug Power is the first company to bring to market a reliable, economically viable fuel cell for on-site power generation. With regard to emerging e-money, eBay’s Internet-based PayPal payment system is facilitating global peer-to-peer e-commerce, while Euronet Worldwide’s eTop Up service is facilitating local day-to-day e-payments. As for “phood,” Senomyx has a unique approach to developing flavor enhancers by applying the same innovative technologies used by biotechnology and pharmaceutical companies; Martek Biosciences has a library of over 3,500 species of microalgae from which it derives a food additive that may have cardiovascular benefits, and that may also decrease the risk of diseases such as dementia and Alzheimer’s in older adults.

As part of the case study of these 12 companies, Smith Barney strategists and the relevant fundamental industry analysts interviewed key personnel at the companies in order to gain a deep understanding of how they are exploiting the technologies. We note that the Smith Barney analysts sought out the managers responsible for the development and implementation of the technologies rather than Investor Relations contacts.

We interviewed key personnel at the

companies in order to gain a deep

understanding of how they are exploiting the

technologies.


15

Companies That Adapted Existing Technologies As we discuss in detail below, Henry Ford once acknowledged, “I invented nothing new.” He was not alone:

�� The first cotton gin, used to produce cotton cloth in India centuries before the Christian era, was a variant of a sugar cane press. This gin was used wherever long staple cotton was grown and processed. Eli Whitney became famous for inventing a gin to clean short staple cotton, which could be grown in most of the southern United States.

�� Thomas Edison’s electrical lighting system, which used existing technologies, including electricity (discovered in the 18th century and subsequently used to power lighthouses) and the incandescent light bulb, appears today to be obvious. Mr. Edison’s system was certainly not obvious to his contemporaries, many of whom thought that, at best, he was taking the wrong approach and that, at worst, he was either a fool or a fraud.

�� The concept of interchangeable parts has been around since the 1800s, when Eli Whitney fulfilled a huge government order for 10,000 muskets primarily by making all of the parts of his rifles so nearly identical that they could be interchangeable from one gun to another. Henry Ford employed the concept of interchangeable parts as a key element in the mass production of automobiles.

�� The first commercial use of radio was for the sending of coded wireless messages between ships at sea and from ships to shore. David Sarnoff of RCA imagined the possibilities of a mass market for wireless telephonic broadcasting — what we now call radio.

Eli Whitney won fame, though not fortune, as the inventor of the cotton gin. Whitney failed to profit from his invention because imitations of the machine appeared quickly, and his 1794 patent was not upheld for many years. By contrast, Thomas Edison, Henry Ford, and David Sarnoff established dominant franchises, and profited handsomely, from their adaptation of existing technologies. As we discuss in detail below, a key commonality that these men and their companies shared was that they each took technologies that, at the time, had only a relatively narrow application and used them to create mass-market products.

Thomas Edison: “Study and Read Everything You Can on the Subject” Scientists, who had been experimenting with electricity since the middle of the 18th century, knew that under certain conditions electricity could produce light. In the 1830s, an Englishman named Michael Faraday conducted research that enabled him to build an electric generator, which created a continuous flow of current strong enough to be used for lighting. By the 1860s lighthouses were using steam engines to generate electricity that powered arc lamps.

Tech Adapters: A Historical Perspective

Eli Whitney won fame, though not fortune, as

the inventor of the cotton gin. Whitney failed to

profit from his invention because imitations of the

machine appeared quickly.


16

The light in arc lamps was produced when two carbon rods connected in an electrical circuit were brought in close proximity of one another, resulting in a kind of continuous spark in the gap. Although this produced an intense white light of 1,000 candlepower, it was a dangerous process, which meant that arc lamps had to be placed away from anything that might be ignited by sparks. This created a challenge for scientists: the need to design an incandescent lamp in which light would be derived from a glowing, yet highly flame-resistant filament.

Another challenge in the creation of a workable electric lighting system was that the generating plant that produced the electricity for arc lights was located on the premises and was owned and operated by the consumer of the light. Moreover, individual arc lights were series-connected, which meant that they all had to be switched on or off simultaneously.

By borrowing heavily from a variety of sources, Thomas Edison solved these and other problems. Indeed, Edison himself gave the following advice on innovation:

1st Study (the) present construction. (2nd) Ask for all past experience…study and read everything you can on the subject.1

The incandescent light bulb had been around for decades before Edison made his fame by “inventing” it. Indeed, Edison’s original patent application for the electric light was rejected, it was reported in the January 18, 1879, issue of Scientific American, because “Edison’s invention was an infringement upon that of John W. Starr of Cincinnati, who filed a caveat for a divisible light in 1845.”2

Figure 3. Edison Electric Light

“Do not attempt to light with match”

Source: National Science Foundation

1 Andre Millard, Edison and The Business of Innovation, (Baltimore: The Johns Hopkins University Press, 1990).

2 Ibid.

The incandescent light bulb had been around for

decades before Edison made his fame by

“inventing” it.


17

However, Edison’s eventual achievement was inventing not just an incandescent electric light, but also an electric lighting system that contained all the elements necessary to make the incandescent light practical, safe, and economical.

As for the model for his electrical illumination system, Edison chose the contemporary gas industry, which derived 90% of its revenues from the lighting of interior spaces. Illuminating gas was generated at a central gas works and then piped beneath the city streets to homes and other buildings, where tubing carried the gas to individually controlled lighting fixtures. The hub of Edison’s electrical system was a central station, remote from the consumers of light, which provided power to homes and offices over wires. Just as gas meters were installed at each residence, so too were electric meters, which were integral to Edison’s system.

While the design of this system appears obvious today, Edison’s system was certainly not obvious to his contemporaries, many of whom thought that, at best, he was taking the wrong approach and that, at worst, he was a fool or a fraud. After a lengthy set of consultations with Britain’s leading scientists and physicists, a British parliamentary committee of inquiry concluded in 1878, several months after Edison publicly announced his intentions, that the commercial production of incandescent lighting was utterly impossible and that Edison demonstrated “the most airy ignorance of the fundamental principles both of electricity and dynamics.”3

Henry Ford: “I Invented Nothing New” At the turn of the 20th century, dozens of firms were devoted to building cars in the United States. The approach they took was to hire skilled mechanics and carpenters (much of the car body in those years was made out of wood, just as carriages had been), who would, as a team, assemble one vehicle at a time. The cars that resulted from this form of manufacture were high-priced and fairly heavy touring cars, and they were largely the playthings of the rich.

In sharp contrast to this largely built-to-order model, in 1906 Henry Ford considered the possibilities of a mass market for automobiles:

[The] greatest need today is a light, low-priced car with an up-to-date engine of ample horsepower, and built of the very best material….It must be powerful enough for American roads and capable of carrying its passengers anywhere that a horse-drawn vehicle will go without the driver being afraid of ruining his car.4

While Ford is generally credited with developing the first high-quality mass-produced car intended for the mass market, what Ford pioneered was not the car itself, but a new way to make cars. Indeed, during a patent dispute over the true inventor of the automobile, he once testified:

I invented nothing new. I simply assembled into a car the discoveries of other men behind whom were centuries of work….Had I worked 50 or ten or even five years before, I would have failed. So it is with every new thing. Progress

3 Robert Conot, Thomas A. Edison: A Streak of Luck, (New York: Da Capo Press, 1979).

4 David A. Hounshell, From the American System to Mass Production, 1800–1932, (Baltimore: Johns Hopkins University Press, 1984).

Many thought that, at best, Edison was taking the wrong approach and

that, at worst, he was a fool or a fraud.

While Ford is generally credited with developing

the first high-quality mass-produced car

intended for the mass market, what he

pioneered was not the car itself, but a new way

to make cars.


18

happens when all the factors that make for it are ready, and then it is inevitable. To teach that a comparatively few men are responsible for the greatest forward steps of mankind is the worst sort of nonsense.5

Ford’s new method of production resulted in substantial cost savings that were partially passed onto customers in the form of lower prices, which, in turn, stimulated further demand. Having come on the market at about $850 in 1908 (see Figure 4), the price of a Model T dropped to $360 by 1916 (despite inflation caused by the outbreak of World War I in Europe) and to $290 by 1927 (also an inflationary period). Not surprisingly, demand soared. In 1908, the Ford Motor Company sold close to 6,000 Model Ts, and by 1916 sales were in excess of 500,000.

As we noted already, the idea of interchangeable parts had been in the public domain since the 1800s when Eli Whitney fulfilled a huge government order for 10,000 muskets, primarily by making all the parts of his rifles so nearly identical that the parts could be interchangeable. Ford first learned about interchangeable parts when he started to ramp up for production of the Model Ts predecessor, the Model N. It was then he met Walter Flanders, a machine tool salesman, who had worked previously at the Singer Manufacturing Company, the maker of Singer sewing machines and an early pioneer of interchangeability. Ford hired Flanders as overall production manager at the Ford Motor Company.

Even so, the approach taken to the production of the Model N was the same as that employed by all the other car manufacturers at the time. Supplies of parts and equipment would arrive at the Piquette Avenue factory and the cars would be constructed individually by a team of assemblers, which pieced together the parts scattered around them.

The production process of the Model T in the Highland Park factory was to be radically different. As noted already, Walter Flanders introduced Ford to the concept of interchangeable parts. Another employee, Oscar Bornholdt, who had the job of tooling up the Highland Park factory for the Model T, had seen continuous-flow production techniques employed in other sectors, including the canning industry. Using these techniques, firms such as Campbell Soup canned products for shipment across the United States.

Ford adopted the concept too, so that the production process was reorganized around the flow of work (for example, a machine tool was dedicated to just one operation), and there was a continuous flow of materials from inputs to finished automobiles. Indeed Bornholdt admitted that “at the Ford Plant, the machines are arranged [sequentially] very much like the tin-can machines.”6

5 John Steele Gordon, The Business of America, (New York: Walker Publishing Company, Inc., 2001).


The idea of interchangeable parts had been in the public

domain since the 1800s, when Eli Whitney fulfilled a huge government order

for 10,000 muskets, l and Gas Drilling and

Completion Technology ž PAGEREF Toc100634741 \h´43


19

Figure 4. The Model T

“Ford: High-Priced Quality in a Low-Priced Car”

Source: Courtesy of Ford Motor Company

Whereas Ford and his colleagues borrowed the concepts of interchangeable parts and continuous-flow production from other industries, Ford came up with the idea of the assembly line by himself. He did, however, give credit for the original idea to the “disassembly” lines of the Chicago meatpackers. The 1906 publication of The Jungle by Upton Sinclair revealed the gory details of work in slaughterhouses, as whole pigs and cows came in one end and cuts of meat went out the other. The workers stayed in place while the carcasses moved past them on a chain. William Klann, head of the engine department at Ford, recalled touring Swift’s Chicago plant thinking, “If they can kill pigs and cows that way, we can build cars that way.”7

The final piece of the puzzle in making these technologies work together seamlessly was a relatively new invention, the electric motor. In the 19th century, factories had been built around the steam engine, which powered machinery throughout the factory by way of a complex system of shafts and belts. Ford was the first automobile manufacturer to grasp the potential of the electric motor and to use it to its fullest. (Indeed, in 1919, 50% of all automobiles were manufactured using electric motors, all of them by the Ford Motor Company.) Ford’s engineers could move machines without having to redesign the shafts that powered them so that the factory could be built around the flow of work rather than around a central power plant. The era of mass production had begun.


Whereas Ford and his colleagues borrowed the

concepts of interchangeable parts

and continuous-flow production from other

industries, Ford came up with the idea of the

assembly line by himself.


20

David Sarnoff: “A Plan of Development” Prior to the U.S. entry into World War I, all privately owned wireless transmitting stations on the coasts — many of which belonged to American Marconi — were commandeered for government use. Given that American Marconi was a subsidiary of a British firm, the U.S. government did not want American wireless capacity owned and, therefore, controlled by a foreign entity during wartime.

After the war ended, something had to be done with the Marconi facilities that had been commandeered. To that end, the government decided that a new company would be chartered, which could only have U.S. citizens as its directors and officers. In addition, only 20% of its stock could belong to foreigners, and a representative of the U.S. government would sit on the board of directors. American Marconi would transfer all of its assets to this new company, individual investors in American Marconi would receive shares of the new company’s stock, and General Electric would purchase the shares owned by British Marconi.

It was in this way that, in February 1919, the Radio Corporation of America (RCA) was created. To further solidify its position, within months of its formation, RCA entered into cross-licensing agreements (in exchange for shares of its stock) with almost all the large companies that held key patents for wireless telegraphy and telephony (e.g., AT&T, General Electric, and Western Electric). In effect, this move created a trust that monopolized the radio manufacturing industry.

In 1917, David Sarnoff, a Russian immigrant, had worked his way up through the ranks to become the commercial manager of American Marconi, and was responsible for the maintenance and expansion of its services to businesses. Two years later he was the commercial manager of RCA, and two years after that, in 1921, he was promoted to general manager. Like many others, Sarnoff had imagined the possibilities of a mass market for wireless telephonic broadcasting — what we now call radio.

In the fall of 1916, Sarnoff had drafted a memorandum for the president of American Marconi in which he envisioned “a plan of development which would make radio a ‘household utility’ in the same sense as the piano or phonograph.”8 Sarnoff argued that recent improvements in radio equipment could make such a scheme entirely feasible:

[A] radio telephone transmitter having a range of, say, 25 to 50 miles can be installed at a fixed point where the instrumental or vocal music or both are produced….The receiver can be designed in the form of a simple ‘Radio Music Box’ and arranged for several different wave lengths, which should be changeable with the throwing of a single switch or pressing of a single button.9

8 John Tebbel, David Sarnoff: Putting Electrons to Work, (Chicago: Encyclopedia Britannica Press, 1963).

9 Ibid.

Sarnoff anticipated that most of the profits from

developing radio as a “household utility”

would come from manufacturing and

selling the “Radio Music Box.”


21

Figure 5. RCA Radiola

“Great music — at home, as you never could get it before.”

Source: Courtesy of Thomson

Sarnoff anticipated that most of the profits from developing radio as a “household utility” would come from manufacturing and selling the “Radio Music Box.” But, he speculated, if the broadcasts carried something more than just music (see Figure 5), the potential market would be even greater:

Events of national importance can be simultaneously announced and received. Baseball scores can be transmitted in the air by the use of one set installed at the Polo Grounds [where the New York Giants baseball team played]. The same would be true in other cities. This proposition would be especially interesting to farmers and others living in outlying districts removed from cities. By the purchase of a “radio Music Box” they could enjoy concerts, lectures, music, recitals, etc.10

Significantly, Sarnoff understood the importance of patents, and RCA managed to gain control of all the important patents covering radio technology by either buying the patents themselves or the companies holding them. This included the patent for the all-important vacuum tube, the predecessor of the transistor. Moreover, whenever a patent was infringed upon, Sarnoff chose not to swallow the losses but to go after the offenders instead — lawsuits were a common occurrence in RCA’s business dealings. By aggressively defending its franchise, RCA firmly established itself as a broadcasting giant by the time that Sarnoff turned his attention to the new technology of television, which we discuss in detail below.

10 John Tebbel, David Sarnoff: Putting Electrons to Work, (Chicago: Encyclopedia Britannica Press, 1963).

Sarnoff understood the importance of patents,

and RCA managed to gain control of all the

important patents covering radio

technology by either buying the patents themselves or the

companies holding them.


22

Companies That Identified the Optimal Application of a Technology In reviewing the history of new technologies, one can make two broad generalizations:

�� The person, or company, that becomes most associated with a technology is not always the inventor of the technology.

�� The first use of a new technology is not always the one for which the invention eventually becomes best known.

In fact, these two observations are interrelated because the best commercial use of a new technology is not always obvious, even when the technology is clearly revolutionary. That was the problem Edison faced with the phonograph in 1877.

Columbia Graphophone: Exploiting the Phonograph Edison’s talking machine, with its tinfoil recording surface and hand crank, was just about able to reproduce two minutes of speech shouted into the mouthpiece. But what could such a machine be used for? In a pessimistic moment, Edison told his assistant, Samuel Insull, that the phonograph did not have “any commercial value.”11

In June 1878, Edison suggested possible future uses for the phonograph in an article for North American Review (see Figure 6). Edison ranked music reproduction fourth because he felt that it was not a primary use of his invention.

Figure 6. Possible Future Uses for the Phonograph

1. Letter writing and all kinds of dictation without the aid of a stenographer.

2. Phonographic books, which will speak to blind people without effort on their part.

3. The teaching of elocution.

4. Reproduction of music.

5. The “Family Record” — a registry of sayings, reminiscences, etc., by members of a family in their own voices, and of the last words of dying persons.

6. Music-boxes and toys.

7. Clocks that should announce in articulate speech the time for going home, going to meals, etc.

8. The preservation of languages by exact reproduction of the manner of pronouncing.

9. Educational purposes; such as preserving the explanations made by a teacher, so that the pupil can refer to them at any moment, and spelling or other lessons placed upon the phonograph for convenience in committing to memory.

10. Connection with the telephone, so as to make that instrument an auxiliary in the transmission of permanent and invaluable records, instead of being the recipient of momentary and fleeting communication.

Source: North American Review, June 1878


Tech Exploiters: A Historical Perspective

The best commercial use of a new technology is

not always obvious, even when the technology is

clearly revolutionary.


23

While Edison puzzled over the best use of his invention, Alexander Graham Bell, Emile Berliner, and others were working on improving the phonograph. Wax recording cylinders were introduced, as well as a better holder for the recording stylus and a constant-speed electric motor. A reliable talking machine was finally made available to the general public in the 1890s (see Figure 7).

Figure 7. The Gramophone

“Reproduces Songs, Speeches, Instrumental Music”

Source: Scientific American, 1896

Edison continued to believe the primary use of his talking machine would be in offices. But more farsighted individuals at other companies saw the entertainment possibilities of the invention and presented it to the public as an instrument for the reproduction of music. (One of these companies, Columbia Graphophone, which developed a competing device called the “graphophone,” became the basis of Columbia Records). Devices like these ultimately led to the establishment of the lucrative phonographic record business that supplied consumers around the world with recorded music and reproducing equipment.

Sony: Exploiting the Tape Recorder About 50 years later, as Yogi Berra would say, it was déjà vu all over again. A new recording device (the tape recorder) had been invented, although its commercial value was unclear. A list of possible uses was published. Eventually the new device became a major mass-market consumer product.

The tape recorder was developed in Germany before World War II. In 1936, AEG Co. invented a recording machine that used plastic tape coated with magnetic material. By 1950, Tokyo Telecommunications Engineering Corp. (Totsuko), later renamed Sony, was ready to market its own version of the machine. This was a heavy, bulky, and expensive model labeled the G-type tape recorder, which was designed for institutional use and had a recording time of one hour. Totsuko

Edison continued to believe the primary use

of his talking machine would be in offices.


24

registered the G-type under the trademark name of “Tapecorder,” while the tape itself was named “SONI-TAPE.”

The March 15, 1950, edition of the Mainichi Graph magazine carried an article with a photograph of Totsuko’s “Tapecorder.” According to the article:

This is a tape recording machine soon to be mass-produced in Japan. It may well be called “Talking Paper”….According to the manufacturer, it will prove very handy wherever it is used, and “talking magazines” and “talking newspapers” will become a reality in the future.

Clearly, the best commercial use for the new machine was somewhat unclear. In addition to “talking magazines” and “talking newspapers” another possibility suggested by a Totsuko employee was that “tape recorders should be actively employed by music schools. Musicians must train themselves with a tape recorder just as ballerinas study dancing by looking at a mirror.”

The first substantial order for the G-type tape recorder came from the Japanese Supreme Court. In the postwar period, the Court was unable to train a sufficient number of stenographers, and Totsuko convinced Supreme Court officials that the tape recorder could take their place.

When sales of the product remained sluggish, Totsuko management came to the conclusion that, despite the technical merits of the product, customers would not buy tape recorders unless they knew how best to use them. So Totsuko started to study how tape recorders could best be used and came across an American pamphlet entitled “999 Uses of the Tape Recorder,” which conveniently listed possible uses in alphabetical order.

At the same time, Totsuko stepped up engineering efforts to improve the machine itself. It was obvious that the G-type tape recorder was too heavy, bulky, and expensive for the consumer market. Consequently, Totsuko developed its H-type tape recorder, which was introduced in March 1951. It weighed 28 pounds, less than one-third of the original G-type tape recorder, came in a case with steel handles attached to its sides (to enhance portability), and boasted a chic design.

The introduction of the H-type tape recorder generated an increase in orders, but from schools rather than consumers. Schools were attracted to the educational possibilities of the machine, given that audio visual aids in schools had just begun to be accepted in Japan (as it was incorporated into Occupation policy). The idea was to present 16 mm educational films as a visual aid while the tape recorder generated the audio component.

It was not until the 1960s, and after much advertising (see Figure 8), that the tape recorder’s abilities to record and play music were fully appreciated by consumers, at which point sales began to soar.

It was not until the 1960s, and after much

advertising, that the tape recorder’s abilities to

record and play music were fully appreciated by

consumers, at which point sales began to

soar.


25

Figure 8. Sony Model 250 Solid State Stereo Tape Recorder

“An exciting new dimension to home entertainment”

Source: Courtesy of Sony Electronics Inc.

Sony: Exploiting the Transistor As noted, it took many years after its development for the tape recorder to become established as a consumer device. In that regard, in March 1952, Masaru Ibuka, one of the founders of Totsuko, left Japan on a three-month tour of the United States. The purpose of the trip was to explore how Totsuko could expand the market for tape recorders by seeing how American consumers used the devices. Ibuka also wanted to observe how U.S. companies manufactured tape recorders.

While in the U.S., Ibuka heard from a friend about the newly invented transistor. He learned that Western Electric, the parent company of Bell Laboratories, held the patent rights for manufacturing the transistor and would make them available to anyone who would pay royalties. It was thanks to this fortuitous encounter that the new invention came to be used in the creation of another mass-market consumer product — the transistor radio.

So what was this new invention? We noted above that RCA managed to gain control of all the important patents covering radio technology, including the patent for the vacuum tube, the predecessor of the transistor. Vacuum tubes were, in effect, specially modified light bulbs that amplified signals. It was thanks to vacuum tubes that AT&T could offer transcontinental phone service, because signals on telephone lines could be amplified regularly along the line as they were transferred from one switch box to another. But the vacuum tubes that made amplification possible were extremely unreliable, used a lot of power, and produced too much heat.

Bell Laboratories held the patent rights for

manufacturing the transistor and would

make the rights available to anyone who would

pay royalties.


26

At the end of World War II, the director of research at Bell Labs thought a solution to these problems might lie in new types of materials called semiconductors, which scientists had been experimenting with since before the war. In simple terms, semiconductors are substances, such as germanium or silicon, whose electrical conductivity is intermediate between that of a metal and an insulator.

In December 1947, a team at Bell Labs created the first point-contact transistor. It was about half an inch tall and consisted of a strip of gold foil folded over the point of a plastic triangle, with the assembly then held over a crystal of germanium. The device was the world’s first semiconductor amplifier: When a small current went through one of the gold contacts, a larger current came out the other.

Masaru Ibuka knew very little about transistors but decided that it might be the invention his company needed to expand its consumer product lines and keep its technical staff busy. As the tape recorder business started to gain traction, Ibuka started thinking about some new project that would best utilize the diverse strengths of his engineering and specialist talent.

Once again, however, the best use of this new technology was unclear. The engineers at Western Electric suggested that Totsuko use the transistor to make hearing aids. Totsuko’s management chose to ignore that advice and focus instead on making radios, and, specifically, small radios that were reliable, portable, and battery-powered. Note that about the time their miniature radio was ready to be marketed in 1955 (see Figure 9), Totsuko decided to label all its products with the Sony brand name.

Figure 9. Sony TR 610 Transistor radio

“World’s smallest, most powerful pocket-portable 6-transistor radio”

Source: Courtesy of Sony Electronics Inc.

The engineers at Western Electric

suggested that the transistor be used to

make hearing aids. Sony chose to ignore that

advice and focus instead on making radios.


27

The Sony radio was, however, not to be the first small transistor radio — the world’s first transistor radio had been launched on the U.S. market in December 1954, just in time for the Christmas season, by an American company called Regency. Nevertheless, as Totsuko focused on developing the Sony brand, the gamble on the transistor radio paid off. Amazingly, the U.S. electronic consumer products industry was reluctant to manufacture and market transistor devices that would compete with their vacuum tube models, and it only slowly adopted the new technology.

RCA: Exploiting Television Always looking toward the future, David Sarnoff of RCA saw the possibilities offered by the new technology called television. He made up his mind to do in television what he had already accomplished in radio and, to that end, he began studying the new technology very carefully.

Sarnoff discovered that John Logie Baird, in England, and Charles Francis Jenkins, in the U.S., were both putting together television systems that they were hoping to market. Both systems used mechanical equipment in the transmitters and, although the results still left much to be desired, the idea was exciting, and the demonstrations amazed viewers. But Sarnoff wondered if there was a way to dispense with the mechanical equipment and do the whole job electronically.

In 1921, Philo T. Farnsworth (then age 15) had first come up with the idea for a totally electronic television system. After developing the idea to some extent, he filed his first patent for an all-electronic system in 1927. His basic system could transmit the image of a line, which progressed to the image of a triangle, a dollar sign, and by 1929, photographic images.

1929 was also the year that Sarnoff hired a fellow Russian immigrant, Vladimir Zworykin. Zworykin’s ideas about the development of a totally electronic television system were very similar to those of Farnsworth, and in 1923 he had filed a patent in the U.S. for an electric scanning system. In April 1930, Zworykin spent three full days at Farnsworth’s laboratory, which was then in San Francisco. Farnsworth and his team had heard of Zworykin’s work and had high respect for him as a scientist.

Another likely reason for Farnsworth openly welcoming Zworykin was that Farnsworth had filed more than a dozen patent applications covering various aspects of his work, and he probably felt that his intellectual property was well protected. While it is not known exactly how much technical benefit Zworykin gained from his visit to Farnsworth, just a few weeks after he returned to his RCA laboratory, Zworykin applied for a patent on an improved camera tube.

Farnsworth was also granted an important patent in 1930, one that covered his electronic television system. While Farnsworth was making steady progress, Sarnoff grew impatient with the RCA laboratory’s progress, and decided to visit Farnsworth’s laboratory. Although Farnsworth himself was not there (as he was testifying in court about a lawsuit), Sarnoff must have been impressed by what he saw because, subsequent to his visit, he made an offer: $100,000 for Farnsworth’s patents and his services as well. But Farnsworth turned the offer down. He had been hoping for either an investment or the payment of royalties for the use of his patents.

David Sarnoff of RCA saw the possibilities

offered by the new technology called

television. He made up his mind to do in

television what he had already accomplished in

radio.


28

After Sarnoff’s visit to his laboratory, Farnsworth worked out a deal with one of RCA’s few significant rivals, the Philco Corporation in Philadelphia. Philco set the Farnsworth group up in their own laboratory and provided a solid financial base for their experiments. At Philco, Farnsworth made further progress, including establishing an experimental television transmitting station.

But just as things were looking promising, a split occurred between Farnsworth and Philco. In the words of Farnsworth’s wife, Elma: “An ultimatum was delivered to Philco [by Sarnoff]; either it dumped the Farnsworth Corporation forthwith, or its license to use RCA’s radio patents would not be renewed.”12 Farnsworth’s contract with Philco was not renewed.

Not only did RCA issue the ultimatum to Philco in 1932, it also instituted a patent suit against Farnsworth. The basic claim was that Farnsworth’s patent on a “Television System,” filed in 1927 and issued three years later, was actually an infringement on the one filed in 1923 by Zworykin. Sarnoff and RCA continued to tie up Farnsworth’s patents for years, filing appeals whenever a ruling went in Farnsworth’s favor. But in 1939 RCA finally agreed to a settlement of $1 million paid over a period of ten years for the right to use Farnsworth’s patents. It was the only time that RCA, in all its dealings, had paid for licensing rights.

For RCA it was the right move. RCA and Sarnoff were to become associated with the “birth” of television following their display at the 1939 World’s Fair in New York, a showcase for new technologies (see Figure 10).

Figure 10. RCA Television

“Newest scientific wonder”

Source: Courtesy of Thomson

12 Elma Farnsworth, Distant Vision: Romance and Discovery of an Invisible Frontier, (Salt Lake City: Pemberly Kent Publishers, 1989).

RCA and Sarnoff were to become associated with the “birth” of television

following their display at the 1939 World’s Fair in

New York.


29

Companies That Innovated by Using New and/or Existing Technologies Thus far we have discussed two types of companies:

�� those that adapted existing technologies, and

�� those that identified the optimal application of a technology.

As we outlined above, neither type of company actually produced anything new. In contrast, the companies in the third category that we discuss — “tech innovators” — created something new by utilizing new and/or existing technologies. As Joseph Schumpeter, the renowned economist, pointed out, most innovations are the result of the “recombinations” of existing ideas:

To produce other things, or the same things by a different method, means to combine these materials and forces differently.13

We focus primarily on traditional technology companies that have used both hardware and software to create new technologies (i.e., new computer applications), but there are plenty of examples of other companies that have used technology to innovate, most notably in the biotechnology sector (and we discuss the innovations of Genentech later in this report).

IBM: Innovations in Hardware The first electronic digital computer was designed to calculate firing tables for U.S. guns in World War II. To use them properly, gunners in battleships, tanks, and airplanes had to aim in the right direction and then raise the barrel to the right trajectory, taking account not only of the location of the target, but also the weight of the shells, the temperature of the air and the direction of the wind, among other factors. This meant that every gun had to have a firing table showing all the relevant variables. These tables were exceedingly difficult to compute, with each table taking months to calculate by hand.

In 1942, John Mauchly, an engineering professor at the University of Pennsylvania, proposed to the Ordnance Department that he could build an electronic calculator that would solve the trajectory equations in a matter of seconds. In 1943, the Ordnance Department awarded a contract to Professor Mauchly and one of his colleagues, J. Prosper Eckert.

By May 1944, the ENIAC (Electronic Numerical Integrator and Computer) could do simple calculations, but it was not fully operational until late 1945. Containing more than 17,000 vacuum tubes, weighing 30 tons, and occupying 1,800 sq. ft. of floor space, the ENIAC, as Professor Mauchly promised, could perform calculations very quickly.

13 Alfred D. Chandler Jr., Scale and Scope: The Dynamics of Industrial Capitalism, (Cambridge, MA: Harvard University Press, 1990).

Tech Innovators: A Historical Perspective

Renowned economist Joseph Schumpeter

pointed out that most innovations are the

result of the “recombinations” of

existing ideas.


30

With World War II over by the time the ENIAC was fully operational, the military asked if the machine could be reprogrammed to help design the hydrogen bomb. But following a dispute with the University of Pennsylvania about patent rights, Eckert and Mauchly resigned their academic positions and formed a company of their own. They then worked on developing an improved version of the ENIAC called the UNIVAC (UNIVersal Automated Computer). Eckert-Mauchly ran out of money shortly before it could finish development of the UNIVAC, and the company had to sell out to Remington Rand, becoming its UNIVAC division.

Remington Rand salesmen were, however, much more interested in selling typewriters and adding machines than the exotic and expensive “electronic brain.” Moreover, demand for the machine seemed limited to 1) scientific organizations (including the military) that had a few gigantic equations to solve and 2) bureaucratic customers (such as the Bureau of the Census), who had to perform simple operations on a large number of cases. As for other possible uses, Peter Drucker, the business writer, has pointed out that, “UNIVAC, which had the most advanced computer and the one most suitable for business uses, did not really want to ‘demean’ its scientific miracle by supplying business.”14 Therefore, the UNIVAC division was neglected by Remington Rand’s top executives, fell far behind its key competitor, International Business Machines (IBM), and did not become profitable for many years.

IBM experimented in the field of computing in the 1940s, cooperating with Harvard Professor Howard Aiken to build the Harvard Mark I, an electromechanical computer. Much like Remington Rand, Professor Aiken did not believe a commercial market for electronic computers would ever develop, because he could not imagine that “the basic logics of a machine designed for the numerical solution of differential equations [could] coincide with the logics of a machine intended to make bills for a department store.”15

As Peter Drucker pointed out, Professor Aiken was soon proven spectacularly wrong about the business demand for computers:

…businesses began to buy this “scientific marvel” for the most mundane of purposes, such as payroll…IBM, though equally surprised [as Remington Rand] by the business demand for computers, responded immediately.16

Although IBM’s first electronic computer (the 701) was crude and inflexible compared to the UNIVAC, IBM did have one critical advantage over its key competitor: unlike Remington Rand, it was firmly focused on the market for large office equipment. Not only were IBM salesmen generally superior to Remington’s, but they were particularly expert at understanding the needs of data processing managers in large corporations (see Figure 11).

14 Peter F. Drucker, Innovation and Entrepreneurship, (New York: HarperBusiness, 1993).

15 Howard H. Aiken, The Future of Automatic Computing Machinery, (Germany, 1956).

16 Ibid.

Harvard Professor, Howard Aiken, builder of

the Harvard Mark I, an electromechanical computer, did not

believe a commercial market for electronic

computers would ever develop.


31

Figure 11. IBM 604 Electronic Calculator

Meeting “the most exacting accounting and calculating requirements of business, industry and engineering.”

Source: Courtesy of IBM

A key reason for the success of the IBM salesmen was that, because computers, like the electromechanical equipment of prewar days, were rented rather than sold, salesmen enjoyed close long-term relationships with their customers. IBM had long excelled at meeting the needs of its clients and so, in the 1950s, it spent huge sums developing software for customers, offering seminars that explained the diverse uses of computers, and doing whatever was necessary to make sure that the users found the machines valuable. Furthermore, new applications for the “robot brains” (e.g., tracking inventory, doing payrolls, regulating factory operations, and handling billing) kept emerging. It was a long way from calculating trajectories for guns.

Just as IBM came from behind to eventually shape and dominate the market for “big iron,” much the same thing happened with the advent of the personal computer. When IBM began work on the personal computer, it was in a rush to enter a market that it had previously dismissed as irrelevant to its core business. But needing to compete with the success of the Apple II and Commodore 64, IBM assembled a system that used an off-the-shelf microprocessor, the 8088 from Intel, and outsourced the development of its operating system to a small software firm in Seattle called Microsoft.

The “PC,” as IBM called it, made no great technological leaps over what Apple already offered. Indeed, when Apple saw the PC, it welcomed the competition, because it thought that IBM’s presence gave the personal computer market

New applications for the “robot brains” —

tracking inventory, doing payrolls, regulating factory operations,

handling billing — kept emerging.


32

legitimacy among business customers. (Apple even took out a full-page ad in the Wall Street Journal saying “Welcome IBM. Seriously.”)

But IBM’s entry into the market did much more than instill legitimacy: It created a true “personal computer.” While Apple had built its machine around a closed, proprietary system (and one that appealed primarily to “techies” and hobbyists), IBM created an open system that attracted a wide number of parts suppliers, software programmers, and computer manufacturers. It was the combined efforts of these companies that made the PC both necessary and affordable, first in the office and later in the home.

Texas Instruments: Innovations in Chips We discussed above how Sony exploited the transistor to develop the transistor radio. Jack Kilby of Texas Instruments was one of the first to use transistors innovatively to develop the integrated circuit, the forerunner of modern computer chips.

In 1948, the transistor was nothing more than a smaller and more reliable — although more expensive — replacement for the vacuum tubes that engineers used to design electric circuits. These circuits required many other components too, which limited the size of the transistor — although transistors got smaller, the wires needed to connect them to the other components did not. The solution to this problem would be to make an entire circuit — the transistors and all the other components — on a single semiconductor chip (i.e., an integrated circuit). The key to doing this, as Jack Kilby came to realize, was to make all the parts of the circuit out of silicon.

In 1959, Jack Kilby and Robert Noyce, one of the co-founders of Intel, filed patents for slightly different forms of the integrated circuit (IC). The IC was not only smaller than the transistor, it was also much more powerful because many different kinds of circuits performing several different tasks could be built onto the same chip (see Figure 12). The manufacturing process facilitated these qualities of size and power: lines of chemicals were etched into sheets of semiconductor materials, and these sheets could then be laminated onto each other, forming even more complex circuits.

Figure 12. Texas Instruments’ Integrated Circuit

Source: Wall Street Journal, March 25, 1959

Jack Kilby of Texas Instruments was one of

the first to use transistors innovatively

to develop the integrated circuit, the forerunner of modern computer chips.


33

Subsequent innovations on the original IC design included a memory chip (which contained special kinds of circuits that could store electronic information), a logic chip (which contained circuits that could manipulate that stored information in certain defined ways), and a microprocessor chip (which was programmable so that it could manipulate information in a variety of ways).

Microsoft: Innovations in Software The first personal computer, the Altair, appeared on the cover of the January 1975 edition of Popular Electronics. The Altair was a capable, inexpensive computer designed around the Intel 8080 microprocessor. An accompanying article in the magazine described how readers could obtain the minicomputer from MITS (Micro Instrumentation and Telemetry Systems) for less than $400. The first customers to purchase the Altair were hobbyists, and among the first things they did with these machines was play games.

Following the introduction of the Altair, two barriers blocked the spread of personal computing: the lack of a practical mass storage device (the Altair lost its data when the power was shut off) and the lack of a way to write applications software. With regard to the second barrier, according to a biography17 of Bill Gates, when his friend and fellow student at Harvard, Paul Allen, showed the Popular Electronics cover to Gates, the two immediately decided they would write a programming language for the Altair. For that they turned to BASIC.

The origins of BASIC go back to the early 1960s when, John Kemeny, chairman of the mathematics department at Dartmouth believed that “next to the original development of general-purpose high speed computers, the most important event was the coming of man-machine interaction.”18 To that end — and in order to teach interactive computing to all of Dartmouth’s students, not just those studying computer science — Professor Kemeny and his colleague Thomas Kurtz decided to build a simple computer system around a programming language designed for the needs of students. They called that language BASIC, and it quickly became one of the most widely used computer programming languages thanks, in large part, to its ease of use.

In the early 1970s, the Digital Equipment Corporation (DEC) worked to modify BASIC so that it could be implemented without taking up much memory. This was important because the DEC minicomputer that would run the modified BASIC had a fraction of the power of the mainframe at Dartmouth, and only 56K in core memory.

Mr. Gates and Mr. Allen would lower the memory requirement further still. In a newsletter sent out to Altair customers, they stated that a version of BASIC that required only 4 kilobytes of memory would be available in June 1975. As it turned out, Gates and Allen wrote a version of BASIC that not only fit into very little memory, but also added a lot of programming features, in addition to the fundamental BASIC advantage of ease of use. As Paul Ceruzzi writes in A History

17 Stephen Manes and Paul Andrews, Gates: How Microsoft’s Mogul Reinvented an Industry, and Made Himself the Richest Man in America, (New York: Touchstone, 1993).

18 John G. Kemeny, Man and the Computer, (New York: Scribner, 1972).

Two barriers blocked the spread of personal

computing: the lack of a practical mass storage

device (the first PC lost its data when the power

was shut off) and the lack of a way to write

applications software.


34

of Modern Computing, “with its skillful combination of features taken from Dartmouth and from the Digital Equipment Corporation, (BASIC) was the key to Gates’ and Allen’s success in establishing a personal computer software industry.”19

As is well known, Mr. Gates and his company went on to successfully innovate using many other existing technologies:

�� MS-DOS, Microsoft’s operating system for the IBM PC, was based on 86-DOS, an operating system written by Seattle Computer Products. Microsoft initially paid about $15,000 for the right to use Seattle Computer Products’ work, and later paid a larger sum for the complete rights.

�� Microsoft Word was based on a word processor developed by Xerox PARC engineers and labeled “Bravo.” Microsoft hired one of its original authors away from PARC.

�� Excel was based on Lotus 1-2-3, which was, in turn, based on VisiCalc by Software Arts.

�� In December 1994, Microsoft paid Spyglass for a license to use its work as the basis for a Web browser, which Microsoft renamed Internet Explorer.

�� The graphical user environment that is Windows first appeared at PARC in the Alto computer, and then in the Apple Macintosh, before becoming Microsoft’s flagship product (see Figure 13).

Figure 13. Microsoft Windows 3.0

“…GUI environment on an MS-DOS PC, and subsequent demise of the ‘C’ prompt, is a reality today.”

Source: Used with permission from Microsoft Corporation

19 Paul E. Ceruzzi, A History of Modern Computing, (Cambridge, MA: The MIT Press, 2003).

Mr. Gates and his company went on to

successfully innovate using many other

existing technologies.


35

Genentech: Innovations in Biotechnology While the birth of modern computing began with John Mauchly’s proposal to the Ordnance Department in 1942 that he build an electronic calculator, it is arguable that the origins of modern biotechnology go back to Watson and Crick’s 1953 discovery of DNA, the chemical that directs the workings of the cell and serves as the hereditary blueprint of all life. Prior to this discovery, scientists could not synthetically replicate the body’s own anti-disease mechanisms to restore health and prolong life because they did not understand the chemical mechanism by which it produces exceedingly complex organic molecules.

Genentech (short for GENetic ENgineering TECHnology) was founded in 1976 to exploit the commercial possibilities of recombinant DNA technology (or “gene splicing”). The U.S. had long been the leader in biochemistry, thanks to generous funding of university research by the National Institutes of Health. It was amid a government-funded search for a cure for cancer that the mysteries of DNA were unlocked (since cancer results in uncontrolled cell growth, its treatment requires an understanding of how DNA regulates cellular reproduction and related functions).

Cells, essential building blocks for all tissues, can be thought of as protein factories. A protein is essentially a chain of amino acids. What sets one protein apart from another is the specific order of the amino acids in the chain; DNA is the chemical that determines the order of those amino acids. DNA, therefore, controls the functioning of the cell itself.

Once scientists, including those at Genentech, understood these chemical reactions, they learned how to manipulate them. By slightly altering the DNA blueprint, biologists could systematically make changes in proteins as they searched for a better compound, instead of more or less randomly searching for improved medicines (which has been the approach of the pharmaceutical industry).

So, for example, instead of having to harvest insulin by grinding up the spleens of human cadavers and extracting the hormone in a laborious and expensive process, Genentech scientists discovered in 1978 that they could open up a human spleen cell, snip out the gene (i.e., a DNA segment) that contained the blueprint for insulin, put it in a different and simpler cell, and induce this cell to produce insulin in large and extremely pure quantities. Human insulin was Genentech’s second breakthrough product (see Figure 14). The first, which was also the first useful product made by genetic engineering, was the development in 1977 of a bacterial production of somatostatin, a human growth, hormone-releasing inhibitory factor.

Figure 14. Genentech’s Human Insulin

Source: New York Times, December 2, 1981

It is arguable that the origins of modern

biotechnology go back to Watson and Crick’s discovery of DNA in

1953.


36

Four Key Implications Our review of how companies have exploited technologies to their advantage has a number of lessons. Below we discuss four that have key implications for the future.

No. 1: A Significant Competitive Advantage Can Be Gained by Adapting Existing Technologies We noted that Ford adapted three manufacturing technologies that had evolved over the course of 100 years, and that were employed by other companies in disparate industries: interchangeable parts (Singer Manufacturing Company), continuous-flow production (Campbell Soup), and assembly line production (Swift). Importantly, once Ford had established his system of mass production using these widely available technologies, he was able to significantly lower production costs.

Similarly, Thomas Edison combined the existing technologies of electricity and the incandescent bulb with the proven business model of the gas industry in order to establish his electrical illumination system, which provided power to entire cities.

As discussed in detail below, it seems likely that companies such as BorgWarner and UnitedHealth Group will also be able to use technologies to gain a significant competitive advantage. So, for example, by being the only supplier on the market with a dual clutch transmission system, BorgWarner has a head start over its competitors. In addition, UnitedHealth Group is combining the existing technology of “smart cards” with the proven business model of the managed care industry in order to establish a strong competitive position in the new environment of Health Savings Accounts (HSAs).

No. 2: Identifying the Optimal Application of a Relatively New Technology Is Often as Important as the Technology Itself Thomas Edison insisted for years that the primary use of his talking machine should be for taking dictation in offices. In the 1950s, it was thought that the tape recorder would lead to “talking magazines.” The engineers at Western Electric suggested that the transistor be used to satisfy burgeoning demand for hearing aids. As it turned out, significant mass markets never developed for office dictating machines, “talking magazines,” or hearing aids. But significant mass markets did develop for the phonograph, the tape recorder, and the transistor radio.

Reflecting the critical importance of commercial appeal, Baron S.M. Rothschild, a potential investor in the electric light, once observed testily that:

It would greatly interest me to learn whether really there is something serious and practical in the new idea of Mr. Edison, whose last inventions, the microphone, phonograph, etc., however interesting, have finally proved to be only trifles.20


Lessons from History; Implications for the Future

Thomas Edison combined the existing

technologies of electricity and the

incandescent bulb with the proven business

model of the gas industry.


37

Appreciating the full value of a technology is not easy, and it is this skill that can often bring as much reward (if not more) as the invention itself. In that regard, a historian made the following comments about the development of a market for automobiles:

The automobile was not developed in response to some grave international horse crisis or horse shortage. National leaders, influential thinkers, and editorial writers were not calling for the replacement of the horse, nor were ordinary citizens anxiously hoping that some inventors would soon fill a societal and personal need for motor transportation. In fact, during the first decade of existence, 1895–1905, the automobile was a toy, a plaything for those who could afford to buy one.21

So, in its first decade of existence, the automobile was largely a luxury for the very wealthy. Ford’s genius was to understand the possibilities of a mass market for automobiles. Similarly, a biographer of RCA’s David Sarnoff noted that:

Although Sarnoff was not an inventor, he was the most successful innovator of his era, with the ability to pinpoint the need for an invention and then flog it through developmental stages to the marketplace.22

An excellent use of radio frequency identification (RFID), first introduced during World War II for aircraft identification, is tracking items through a supply chain; BJ’s Wholesale is well positioned to use RFID to lower its labor and distribution costs. Meanwhile, Cisco Systems is exploiting the adoption of voice over Internet protocol (VoIP) because enterprises tend to spend 3x–5x as much on security and network switching equipment as they do on VoIP itself.

No. 3: The Company That Becomes Most Associated with a Technology Is Not Always Its Inventor It is said that Picasso once observed that “mediocre artists borrow, great artists steal.” “Stealing” is a strong word when it comes to exploiting technology. (After all, the Europeans didn’t “steal” printing, gunpowder, and the magnetic compass from the Chinese). But it certainly is the case that the company that first develops a new technology is not always the ultimate beneficiary, given that other companies may leverage that technology more successfully.

In A History of Modern Computing, Paul Ceruzzi writes that Steve Jobs of Apple “not only admitted, but even boasted, of having stolen the graphical user interface (GUI) from Xerox PARC.”23 According to another anecdote, when Jobs accused Bill Gates of Microsoft of stealing the GUI from Apple and using it in Windows 1.0, Gates fired back:

21 George Basalla, The Evolution of Technology, (Cambridge, United Kingdom: Cambridge University Press, 1988).

22 Kenneth Bilby, The General: David Sarnoff and the Rise of the Communications Industry, (New York: Harper & Row, 1986).

23 Paul E. Ceruzzi, A History of Modern Computing, (Cambridge, MA: The MIT Press, 2003).

Ford’s genius was to understand the

possibilities of a mass market for automobiles.

It is said that Picasso once observed that

“mediocre artists borrow, great artists

steal.”


38

No, Steve, I think its more like we both have a rich neighbor named Xerox, and you broke in to steal the TV set, and you found out I’d been there first, and you said. “Hey that’s no fair! I wanted to steal the TV set!”24

We also discussed in detail the development of television and the success of David Sarnoff at the expense of Philo T. Farnsworth and, to some extent, Vladimir Zworykin. Regardless of the original source of their technologies, Apple, Microsoft and RCA were ruthless in exploiting what they clearly recognized as key innovations.

Mechanical Technology and Plug Power are both building on the concept of the fuel cell, which has been around for almost 200 years. Mechanical Technology just recently introduced the first commercial micro fuel cell, while Plug Power is the first company to bring to market a reliable, economically viable fuel cell for on-site power generation.

No. 4: Innovation Is Not Always Associated with Commercial Success Our fourth point follows from the third. Indeed, the recurring theme of this report is that the “users” of a technology are often more successful than its “makers.” An excellent example of this is the aforementioned Xerox PARC, which has been credited with developing one of the first personal computers (the Alto), the concept of personal distributed computing, the GUI, the first commercial mouse, Ethernet, client/server architecture, laser printing, and many of the basic protocols of the Internet. Yet Xerox has become famous for “fumbling the future” by failing to commercially exploit any of PARC’s ideas. Likewise, Eckert-Mauchly was unable (or, some say, unwilling) to exploit the commercial possibilities of computing, and the company quickly disappeared inside Remington Rand.

Clearly, mismanagement of a new technology can be just as devastating as the misappropriation of that technology (as discussed in point three). In addition to the Xerox PARC examples, another cautionary tale with regard to mismanagement is the case of Prodigy, the first online service aimed at the casual home user.

Sears and IBM invested $600 million to create Prodigy, which debuted in November 1989, offering much the same functionality that America Online would subsequently provide, including electronic bulletin boards and e-mail. However, Prodigy management regarded electronic bulletin boards and e-mail as secondary to the real purpose of the online service, which was to sell merchandise and information to subscribers, and advertising to merchants.

In a well-publicized incident, Prodigy users banded together and protested the surcharge that Prodigy imposed on e-mails via mass e-mailings and messages posted to an electronic forum. Prodigy management promptly canceled the subscriptions of those users and issued restrictions on the nature of e-mails that remaining subscribers could send going forward. In protest, 3,000 members changed their online service to GENie. That was the beginning of the end of Prodigy, even though it would take America Online another five years to match Prodigy’s service offering.

24 This anecdote has been widely retold in the media and on the Internet but its precise origin is obscure.

The “users” of a technology are often

more successful than its “makers.”

Mismanagement of a new technology can be just

as devastating as the misappropriation of that

technology.


39

These examples of the misfortunes of innovators such as Xerox, Eckert-Mauchly, and Prodigy should serve as cautionary tales for the companies discussed in the sections that follow (summarized in Figure 15). Specifically, it could well be that some of the technologies that we discuss do not succeed as expected or, alternatively, that some of the companies we have identified as techno savvy fail to execute. It is for this reason that, in most cases, we list several possible beneficiaries of the technologies, in addition to conducting case studies on specific companies that seem well positioned.

Figure 15. Today’s Technology Adapters, Exploiters, and Innovators

Dual Clutch Transmission Drilling and Completion HSA “Smart Card”

Origin/Source Germany, 1940 Oilfield Equipment & Services Card & ATM Technology

Adapter BorgWarner EOG Resources UnitedHealth Group

Product/

Competitive

Advantage

Mass-produced

dual clutch transmission More productive wells

Combination medical, drug

benefit, HSA, debit/credit card

RFID VoIP Real Time Patient

Monitoring

Origin/Source W.W. II aircraft identification Vocaltec (Israel) Internet

Exploiter BJ’s Wholesale Club Cisco Systems Medtronic

Product/

Competitive

Advantage

Reduced store labor and

distribution costs

Significant incremental

spending on security &

network switching

Monitoring for congestive

heart failure,

low blood sugar levels

Fuel Cells E-Money Phood

Origin/Source 19th Century England Late 1990s Ancient China

Innovator Mechanical Technology/

Plug Power

(PayPal) eBay/

Euronet Worldwide

Senomyx/

Martek Biosciences

Product/

Competitive

Advantage

Commercial fuel cells PayPal/

eTop-Up

Flavor enhancers/

Food additives



40

BorgWarner’s Dual Clutch Transmission The earliest automobiles offered only manual transmissions. Similar in principle to today’s manual transmission vehicles, these cars, such as the Ford Model T, had two forward gears and one reverse. We note that, without a transmission, cars would be limited to one gear ratio. So, for example, a gear ratio similar to third gear in a manual transmission would have almost no acceleration when starting and, at high speeds, the engine would race at a dangerous number of revolutions per minute. Instead, the transmission uses the gears to make effective use of an engine’s torque (or turning force) and to keep it operating at an appropriate speed.

As the popularity of cars increased, engineers began searching for a way to have the car “automatically” shift from one gear to another. Although the groundwork had been laid in the early 1900s, the first automatic car transmission was not manufactured until 1938, when General Motors invented “Hydra-matic Drive” (reflecting the fact that hydraulics played a key role). The first mass-produced automobile to offer an automatic transmission was a 1940 Oldsmobile.

Automatic transmissions with a hydraulic converter quickly became the standard in the U.S., while in a crowded Europe, with its small car engines and highly taxed gasoline, there were many proposals on how to automate transmissions, but none succeeded. The manual transmission, with its clutch pedal, always came out on top, and a key factor was fuel efficiency — automatic transmissions, despite all the efforts of designers, still lead to higher fuel consumption than manual transmissions.

Today, however, many European drivers find themselves in a predicament: On the one hand they like the sporty feel and fuel economy of a manual gearbox; on the other hand, they increasingly find themselves stuck in traffic in congested cities, an environment where automatic transmissions are much less tiresome. Moreover, reflecting the fact that more than 80% of the cars manufactured in Europe are manual (and the majority of the assembly lines are configured to produce manual transmissions), automatic transmissions are an expensive option.

The dual clutch transmission (DCT), which is based on a manual gearbox, offers a solution to these problems. The driver can initiate the gear change manually, or can leave the shift lever in fully automatic mode. In other words, a car can meet the demand for a sporty, responsive driving experience or, alternatively, for the convenience of an automatic that offers good fuel economy.

As its name suggests, a dual clutch transmission uses two clutches (although, as in an automatic, there is no clutch pedal). One of these clutches controls the shaft for first, third, and fifth gears (along with reverse), and a different clutch and shaft control second, fourth, and sixth gears (see Figure 16). The benefit of the dual-clutch approach lies in its ability to shift from one ratio to the next without disconnecting the engine from the drive wheels, which normally takes place when a driver has to lift off the accelerator and depress the clutch pedal.

Tech Adapters: Three Case Studies

In a crowded Europe, with its small car

engines and highly taxed gasoline, there were

many proposals on how to automate

transmissions, but none succeeded.


41

Figure 16. The Evolution of the Automobile Transmission

Ford Model T: two forward gears and one reverse

P-R-N-D-3-2-1 Automatic Transmission

Dual Clutch Transmission

Source: Ford Motor Company, Smith Barney, and Volkswagen


42

So, for example, when the engine is started, DCT electronics engage the clutch for first gear. As the vehicle is accelerating, the electronics position second gear into place. Then, when the computer decides it is time to shift, it disengages the clutch that is transmitting torque for first gear at the same time that it engages the second gear clutch. This greatly reduces the “torque interrupt” sensation that is typical of a manual (i.e., when the transmission shifts gears, causing a lurch or jitter as the engine power is reduced, the clutch disengages, the gear is shifted, and the clutch is reengaged).

The first DCT was patented in 1940 and was tested in a truck, but it never went into production. In the 1980s, Porsche successfully developed its own DCT for racecar applications. At the time, however, it was not feasible to transfer the DCT technology into production cars, in large part because the electronics and hydraulic controls were so expensive that the transmission would not be commercially viable. But following advances in electronics and hydraulic controls, Volkswagen partnered with BorgWarner in the late 1990s in the co development of a DCT for mainstream car applications. (In a similar vein, recall that RCA’s David Sarnoff also had to wait until improvements in radio equipment made wireless broadcasting feasible.) The first commercial application of the BorgWarner DualTronic™ appeared in 2003 in the Volkswagen Golf R32 DSG and the Audi TT 3.2.

As noted, in addition to its fuel economy, a key attraction of DCT is its performance features. A reviewer of a Golf equipped with a wet clutch DCT transmission noted that “the acceleration times of a (Golf) R32…are slightly better than those for a manual gearbox, sprinting to 62 mph in 6.4 seconds compared to the 6.6 seconds it takes in a manual. While both versions have the same top speed of 154 mph, the (Golf R32) has a better fuel consumption of 27.6 mpg, [13%] better than the manual version” 25 (see Figure 17).

Figure 17. Performance Improvements of DCT Transmission vs. 6-Speed Manual

VW Golf R32 equipped with a wet clutch DCT transmission

Time

Spee

d

DCT

Manual

Top Speed: Manual 247 km/h / 154 mph DCT 247 km/h / 154 mph

Manual:

DCT: 10.3 liters/100 km

11.5 liters/100 km Fuel Efficiency

Source: Volkswagen

25 Automotive Engineer, April 2003.

DCT is based on concepts that go back to the 1940s, but it has only been recent advances in

electronics and hydraulic controls that have made the technology feasible

today.


43

Competing suppliers, including ZF Sachs, LuK, and Valeo, are also developing dual-clutch transmissions. However, BorgWarner seems well positioned to maintain a dominant share of the DCT market given its 1) head start, 2) technological edge, and 3) growing customer base. Specifically, by being the only supplier on the market with such a system, BorgWarner has a head start over its competitors on improvements to the system (i.e., it is “further up the learning curve”). With regard to the technology, Bill Kelley, BorgWarner’s director of drivetrain technology, believes the company’s expertise in friction materials, high-tech lubricants, and advanced electronic controls combine to give it a strong competitive edge.

For several reasons, Mr. Kelley thinks the majority of DCT customers will likely be in Europe for the foreseeable future. For a start, the technology is particularly attractive to European automakers because, inherent in the DCT design is the ability to take advantage of the investments that Europeans have made in manual transmissions. No expensive retooling is required for a move to DCT designs, while the finished assembly line is more compact than that required for a conventional automatic transmission.

Another driver of DCT adoption should be Europeans’ love of diesel engines (almost 40% of new cars sold in Europe are fueled by diesel). However, conventional automatic transmissions experience a 20% fuel-efficiency loss when coupled with diesel engines. While DCT offers at least 5% better fuel economy than conventional automatics with a gasoline engine, the gain is up to 15% with diesel.

BorgWarner has said it expects the demand for DCT to grow from virtually nothing in 2003 to 18% of the European passenger-car market by 2009. As for other DCT customers, Mr. Kelley thinks that some Asian markets have potential. He points out that manual transmission penetration is nearly 100% in India, around 75% in China, and more than 50% in South Korea. In addition, although manual transmission penetration is not particularly high in Japan, he believes there are opportunities for DCT in that market, in large part because of the fuel economy it offers. However, Mr. Kelley believes that, given the large investments that U.S. automakers have made in automatic transmissions, the U.S. will not be a particularly large market for DCT for many years to come.

EOG Resources’ Oil and Gas Drilling and Completion Technology EOG Resources is achieving superior results by applying some well-known drilling and completion technologies in a more effective way than its competitors. The company uses tools and technologies that are widely available in the exploration and production (E&P) industry, but it customizes them in innovative and creative ways, with the result being that it often enjoys success where others have failed.

Loren Leiker, EOG’s executive vice president, exploration and development, attributes the company’s successful track record in large part to its decentralized structure. The company is split into 11 divisions (nine of which are in the U.S.), with each of these divisions effectively being run as a “micro-cap” company. The divisions are managed by a small core of staff that have worked together for many years and that have vast experience in the relevant geologic basins.

Another driver of DCT adoption should be

Europeans’ love of diesel engines. Conventional

automatic transmissions experience a 20% fuel-

efficiency loss when coupled with diesel

engines.

Asian markets seem to have potential. Manual

transmission penetration is nearly 100% in India,

around 75% in China, and more than 50% in

South Korea.


44

We noted above that Henry Ford combined the best ideas of interchangeable parts, continuous-flow production, and assembly-line production in order to mass produce automobiles. In a similar fashion, EOG’s divisions combine the best ideas of their geologists, geochemists, and engineers in order to overcome a challenge and successfully extract energy from the ground.

Indeed, Mr. Leiker observes that EOG’s exploration strategy involves hiring a lot of creative people to generate ideas about E&P, and then filtering those ideas for the very best concepts. So, rather than investing, say, $500 million on exploring an uproved acreage (as some of its competitors do), EOG prefers to invest a considerably smaller amount (anywhere from a few thousand to a few million dollars) in one of the ideas generated by its team, and then invest additional funds only if the initial results seem promising.

The Barnett Shale A good example of EOG’s approach is offered by its exploration and development of the Barnett Shale, which is a geologic formation in the southern U.S. containing vast amounts of natural gas. According to a mid-2004 U.S. Geological Survey estimate, in East Texas, the Barnett Shale is estimated to have over 26.6 trillion cubic feet of expected, ultimately recoverable reserves.

While a number of companies have been successful in a region of the Barnett Shale in East Texas known as the core, the difficult geology of the non-core region presented a challenge. Companies drilling in the non-core region frequently found that their pipes filled with water rather than natural gas. Because of these challenges, the non-core region was an untapped frontier. However, EOG began to employ the strategy outlined above to its first Barnett leasehold in order to exploit the full potential of the non-core region.

The Technologies In 2000, EOG drilled its first vertical well in the region, gathering rock data and characterizing the geology. Later that year, EOG drilled three other vertical wells, but the watery strata that rest under the non-core Barnett plagued all these wells. So, in 2003, EOG began applying newer technologies in innovative ways, including drilling horizontal wells that skirted the underlying strata. Gas production results showed that this tactic was one part of optimizing performance; for example, a typical horizontal well in the non-core Barnett Shale has been found to produce 300% more gas than a vertical well in the first 16 months.

Emboldened by the success of these test wells, EOG made a relatively small up-front investment of $30 million to buy 175,000 acres of non-core Barnett Shale (i.e., at a price of under $200 per acre). The company then eventually customized two other well-known oil and gas production techniques to fully exploit these previously neglected gas reserves. All three of EOG’s technologies now work in concert to promote the highest gas output possible from this tricky resource play.

EOG’s divisions combine the best ideas of their

geologists, geochemists, and engineers in order to

overcome a challenge and successfully extract energy from the ground.


45

Figure 18. The Evolution of Energy Production

Do-It-Yourself Energy Production

The Early Vertical Oil Rig

Modern Drilling and Completion Technologies: Horizontal wells, 3-D Seismic, Fracturing

Source: Smith Barney and Environmental Protection Agency


46

�� Initially, EOG employed horizontal wells to improve production volumes and avoid the watery strata, as outlined above.

�� EOG then recognized that 3-D seismic data (i.e., geologic imaging) would help it avoid the geologic pitfalls of the non-core region that sabotaged other companies’ results. EOG regularly gathers these data and uses them to choose well locations by visualizing the shale, thereby avoiding sink holes that let valuable gas escape before the pipe can collect it.

�� Finally, successfully fracturing the rock had been a challenge to other companies. (Fracturing technology creates controlled fissures — not too big or small — so that gas can flow around the rock and into the pipe.) EOG successfully fractured the Barnett by further customizing a known technology. This involved choosing the right combination of “propin” (a medium used to keep the rock separated, such as sand, gel, or beads) and the best water volume, pumping rates, and propin concentration.

The Payoff EOG’s Barnett Shale success has created a virtuous cycle for the company: Landowners want top dollar for the mineral development rights, and EOG’s competitors may offer more up-front cash for those leases. However, EOG offers a track record of success in extracting gas, bringing the landowner higher gas volume royalties over the long term, and thereby making EOG an attractive partner.

In addition, EOG’s reputation for environmentally rigorous standards also works in its favor in the eyes of landowners. The result is that EOG had 321,000 acres of non-core property in the Barnett Shale as of the fourth quarter of 2004.

Improved drilling and completion technology is most beneficial when it is novel. But once the technology is widely employed in the industry, leasehold prices escalate. As noted above, EOG’s average acquisition prices in the Barnett Shale have been around $200 per acre, but now that EOG’s E&P technology is more widely accepted, recent deals in the area average $11,000–$17,000 per acre (see Figure 19).

Figure 19. EOG’s Technological Advantage Is Now Being Priced into the Region

Date Price/Acre Acres Buyer Location

11-Jan-05 $11,200 61,000 XTO Energy Core, Parker & Johnson County

30-Nov-04 $17,000 16,000 Chesapeake Johnson County, TX

23-Nov-04 $11,500 22,000 Encana Fort Worth Basin

3-Mar-04 $5,466 1,500 Carizzo Denton County

Early 2004 $172 175,000 EOG Resources Barnett Shale, TX

Source: Smith Barney and company data

Three technologies work in concert to promote the

highest gas output possible from this tricky

resource play.

EOG’s average acquisition prices in the

Barnett Shale are around $200 per acre. Recent

deals in the area average $11,000–$17,000 per

acre.


47

UnitedHealth Group’s Health Savings Account (HSA) “Smart Card” Managed care organizations (MCOs) are in the vortex of the $2 trillion per year health care industry in the U.S., which represents approximately 15% of GDP, and is growing more than 5% annually. The MCO industry is fragmented and rapidly consolidating, with the two largest MCOs, UnitedHealth Group and WellPoint, each enrolling 10% of the U.S. population in their medical plans.

It is in this environment that employers and individuals are poised to switch products from the now-prevalent HMO, PPO, and POS options to consumer-directed health plans/high-deductible health plans (CDHP/HDHP) linked to tax-advantaged savings accounts, such as the Health Savings Account (HSA).

Recall that the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 went beyond assisting seniors with prescription drugs and contained many other provisions with wide-ranging implications. One key provision of the Act — the establishment of HSAs — has nothing to do with Medicare. In effect, an HSA is to health care what a 401(k) is to retirement savings.

Recent data suggest that HSAs are starting to take off. According to a March 2004 Mercer Human Resource Consulting survey of 991 employers, more than two-fifths say that it is either very likely (8%) or somewhat likely (35%) that they will offer an HSA in 2005 (see Figure 20). These figures jump significantly for 2006, as 19% of employers believe it is very likely they will offer an HSA by 2006, and another 54% believe it is at least somewhat likely.

Figure 20. Employer Interest in HSAs

likelihood of offering a high-deductible health plan with an HSA

8 %

3 5 %

5 6 %

1 9 %

5 4 %

2 8 %

0 %

2 0 %

4 0 %

6 0 %

8 0 %

1 0 0 %

V e ry lik e ly S om ew h a t like ly N o t lik e ly

B y 2 0 0 5

B y 2 0 0 6

Source: Mercer Human Resource Consulting

Recent data suggest that HSAs are starting to take

off.


48

Figure 21. The Evolution of Medical Payment Processes

Forms

The Web

The Smart Card



49

Importantly, because of their complexity, consumer-directed health plan (CDHP) products will increase the processing burden on health plans and members. The end result will be that technology will become more critical to health plans, members, and providers/suppliers, such as physicians, hospitals, pharmacies, and labs. In other words, just as a bank must have real-time data for an ATM to work, and an airline must have real-time data for automated ticket kiosks, health plans will also have to operate in a real-time environment (e.g., providing data related to claims, providers, eligibility, account balances, and deductible balances) in order for new CDHP products to work well.

Stephen Hemsley, UnitedHealth Group’s president and chief operating officer, notes that “the health services industry needs to function much more like the banking industry relative to the use of technology. We should expect nearly perfect execution across a wide range of standard transactions, should see funds flow between participants electronically at the push of a button, and should develop simple, intuitive customer reporting designed more like a bank statement than an old-fashioned explanation of benefits form.”

Technology Is the Backbone of Managed Care Technology is the backbone of a successful MCO; indeed, almost all MCO capital expenditures have tended to be on technology. The industry is transaction intensive and was among the first to adopt computer technology to automate manual processes, given that underwriting results improve with more timely information. In the price-competitive managed care industry, where a 10% pretax margin is considered outstanding, every 100 basis points of medical or administrative cost savings can boost profits by 10%.

That said, most key statistics pertaining to technology are not made publicly available by MCOs. Moreover, those statistics that are shared by companies are defined differently from MCO to MCO, so apples-to-apples comparisons are not always possible. The analysis provided here is based on the experience of Smith Barney’s managed care analyst Charles Boorady, which spans more than ten years of following the industry closely on Wall Street and six years of technology consulting experience. Charles also relied on research by Forrester Research and Gartner Consulting as part of this analysis.

A key conclusion of his analysis is that, thanks to heavy investments in technology, UnitedHealth Group is widening its lead over its competitors. This is hardly new news. In the last several years, United has employed informatics and predictive modeling to gain a leg up on its competitors. Specifically, it has used technology to identify situations where intervention can improve medical outcomes and boost profits. So, for example, United is a leader in evidenced-based medicine (i.e., defining protocols based on what medical evidence suggests is the right course).

The CDHP and HSA Era Imagine an unbearable chest pain. Is it something you ate or cardiac trouble? Which clinic? Which doctor? What is the right protocol? What is the cost of various options? Why does the highest-ranked facility have the highest mortality

Because of their complexity, consumer-

directed health plan (CDHP) products will

increase the processing burden on health plans

and members. Technology will become

more critical to health plans.

Thanks to heavy investments in

technology, UnitedHealth Group is widening its

lead over its competitors.


50

rate? (Answer: Because the most severe cases go there seeking the best medical attention.) What do you do? Where do you begin?

This unpleasant scenario will become more daunting in a CDHP world because the dollar amounts paid by the patient and the complexity of options will become much greater. Dr. Reed Tuckson, senior vice president of consumer health and medical care advancement at UnitedHealth Group notes that, “as patients become increasingly involved in decision making about their own health, particularly those who are confronted by complex or chronic disease, they seek, require, and deserve information that identifies the best-performing facilities and physicians for their specific needs.”

The added complexity of a CDHP is precisely why United’s technology will give it an even bigger lead over its competitors. To appreciate the technological challenges, consider the following simple example. Imagine putting several items on the counter at the register of a pharmacy: prescription drugs, over-the-counter drugs, and health and beauty aids.

�� Today you might pay for the prescription drug with a drug benefit card, and later mail the receipt for out-of-pocket co-payments to your flexible spending account (FSA) administrator for reimbursement. Next, you might ring up health and beauty aids and over-the-counter medications and pay for them with a debit or credit card such as Visa, Master Card, or American Express. You might also use a discount card and coupons to get discounts on those items. You would then save the receipt for the over-the-counter medications and mail it in with eligible items circled to your FSA administrator for reimbursement.

�� In the CDHP and HSA era things would be very different and very complicated. For a start, there would be a certain number of dollars in your HSA that would cover certain medical expenses. But how many dollars are left in the account, and which medical expenses do they cover?

United Leads the Industry in CDHP and HSA Technology United is approaching completion of an HSA “smart card” solution to the above scenario. This would be one integrated card, combining the functions of medical, drug benefit, HSA, FSA, debit/credit, and discount cards. Using such a card, in the example above a pharmacy worker could ring up all the items and, with one swipe of the card, determine:

�� the amount of any discount you are entitled to on certain items,

�� what qualifies for HSA dollars versus after-tax dollars,

�� what UnitedHealth pays, and

�� what you owe and how that payment should be divided between your HSA debit card and personal credit card.

In a CDHP world, the dollar amounts paid by

the patient and the complexity of options

will become much greater.


51

Recall that Thomas Edison combined the existing technologies of electricity and the incandescent bulb with the proven business model of the gas industry in order to establish his electrical illumination system, which provided power to entire cities. In a similar fashion, United is combining the existing technology of smart cards with the proven business model of the managed care industry in order to establish a strong competitive position in the new CDHP/HSA environment. So, as with the Edison example, it is not the technology per se that is proprietary. Rather, it is the vision of where the industry is headed, and what types of applications will be key, that is giving United an edge.

As Figure 22 illustrates, an analysis by Forrester Research highlights United’s lead in terms of CDHP and HSA technology given that, unlike its competitors, United has “all the pieces” — the company can offer the plan, administer it, act as an HSA custodian, and offer an HSA debit card.

Figure 22. Comparative Analysis of Health Plans

CDHP platform and HSA attributes

Health plan CDHP platform HSA custodian HSA debit card vendor

Anthem NASCO

Evolution Benefits

HSA administrator

FlexBen JPMorgan Chase

Assurant Health MSAver HSA Bank

BCBS of Arizona HSA Bank

BCBS of Michigan Menu of local and national banks

Blue Shield of California Wells Fargo

Definity Health US Bank, Wells Fargo

Lumenos Employer Products Division Mellon Bank

UnitedHealthCare

Humana JPMorgan Chase

Independence Blue Cross The Bancorp Bank

Source: Forrester Research, Inc.

United’s technology is superior in large part because its technology spending significantly outstrips its competitors (see Figure 23). With more than $3 billion in annual free cash generation, United has the financial wherewithal to stay ahead of the competition. Dr. William McGuire, M.D., UnitedHealth Group’s chairman and CEO, points out that United has “spent more than $2 billion on technology and business process change over just the past five years,” and he believes continued investment in and deployment of leading technology solutions “will be critical to our future success.” Moreover, United’s position as one of the largest benefit providers in the country enables it to roll out a new technology that quickly enjoys widespread adoption, thereby spreading development costs over a large membership base.

United is combining the existing technology of

smart cards with the proven business model

of the managed care industry in order to

establish a strong competitive position in

the new CDHP/HSA environment.

United is the only MCO with all four HSA pieces

in house — the company can offer the plan,

administer it, act as an HSA custodian, and offer

an HSA debit card.


52

Figure 23. Capital Expenditures by MCOs (2004)

$ in millions

$0

$100

$200

$300

$400

UN H W LP* AET C VH* HU M PHS W C HN T CI

*Pro forma numbers


Another key point is that United treats technology as a separate business unit. This structure puts pressure on the company’s technology group to be at the leading edge because it is forced to compete with outside vendors for the business of other United units. Reflecting the success of this approach, today the in-house group competes against companies (e.g., Accenture, EDS, and Perot) that provide services to United’s competitors. United recently won a ten-year $600–$700 million technology outsourcing contract from Harvard Pilgrim Health Plans, a leading Massachusetts HMO that previously used Perot.

Could United’s lead in CDHP and HSA technology be threatened by new entrants? That seems unlikely, but it cannot be ruled out entirely. For a start, medical management technology is specialized and proprietary, so it would be easier for a company such as United to begin offering commodity financial products (indeed, United has already chartered its own commercial bank) than it would for a financial services company to develop CDHP and HSA technology. Instead, it is more likely that commercial banks and credit card issuers would partner with health plans, given that there would be synergies between the HSA “smart card” and ATM technology.

However, it is possible that some companies may opt to enter the space by way of acquisitions. Recall that multi-line insurance companies and life insurers exited the health care business following the birth of the HMO, a vertically integrated product. It could be that some companies may view the CDHP as a more commoditized financial product that is relatively easy to manufacture. Furthermore, the asset gathering potential of HSAs may appeal to 401(k) and FSA administrators, payroll processors, etc.

United has already chartered its own commercial bank.


53

BJ’s Wholesale Club and Radio Frequency Identification Radio frequency identification (RFID) is a generic term for technologies that use radio waves to automatically identify individual items. RFID is not a new technology; it was first introduced during World War II to help identify aircraft through radio frequency waves. RFID technology has evolved since and is currently being used in industries such as railroads (to track cars), autos (to track parts), and agriculture (to track livestock). But, as we discuss in detail below, a particularly good use of RFID is tracking items through a retail supply chain. (Recall that we noted above that it took about 20 years of refinement before the optimal use of the phonograph became apparent.)

Better than Bar Codes While bar codes have been around for 30 years and average 75%–85% accuracy, RFID tags can have accuracy of greater than 90% when used properly. Moreover, RFID provides the ability to read multiple items simultaneously, whereas with bar codes each item must be scanned individually. Other negative features of bar codes include the requirement of a line of sight, as well as limited data carrying capacity.

Today, there are several methods of identifying objects using RFID, but the most common is to store a serial number that identifies a product, and perhaps other information, on a microchip that is attached to an antenna. The chip and the antenna together are called an RFID transponder or RFID tag. The antenna enables the chip to transmit the identification information to a reader. The reader converts the radio waves returned from the RFID tag into a form that can then be passed onto computers that make use of it.

RFID tags are either “active” or “passive.”

�� Passive tags are much less expensive (approximately $0.18–$0.40 per tag, depending on how technologically advanced they are) than active tags, as they do not carry an active battery source. Passive tags draw their power from electromagnetic waves transmitted by RFID readers. The primary disadvantage of passive tags is that they have a short transmission distance of up to ten feet. However, passive tags are very flexible and can be programmed to provide numerous functionalities. Passive tags tend to be used primarily for lower-value and high-volume consumer goods. Currently, about 95% of all RFID tags manufactured are passive tags.

�� Active tags are much more expensive than passive tags (at approximately $10–$100 per tag, depending on how technologically advanced they are), as they carry an active battery source. Active tags can transmit over 100 feet and can even include special encryption for data transmission. Active tags tend to be used primarily for high value goods, such as controlled substances (nuclear materials and firearms). Primarily due to the high cost associated with active tags, only about 5% of RFID tags manufactured are active.

Tech Exploiters: Three Case Studies

A particularly good use of RFID is tracking items

through a retail supply chain.

With bar codes, each item must be scanned

individually; RFID provides the ability to

read multiple items simultaneously.


54

Figure 24. The Evolution of Inventory Management

“What you see is what you have”

Closing the store for three-day inventory accounting

RFID

Source: Smith Barney and Manhattan Associates


55

With regard to readers, there are various types used in RFID systems, reflecting the absence of a uniform standardization for tag formatting, transmission frequency, or application systems. RFID readers range from $500 to $3,000 per unit (depending on how technologically advanced they are), and a complete rollout of an RFID system requires several RFID readers. Software that analyzes the information from the readers ranges from basic applications (canned software) to fully customized software. Due to the current fragmentation and lack of standards, RFID purchases tend to include both the tags and the readers from the same source.

Today there are several obstacles to a broad-based RFID implementation rollout:

�� Tag Costs. Smith Barney analysts believe that passive tags costing less than $0.10 are needed to entice businesses to adopt RFID on a large scale; some observers even suggest that a cost of less than $0.05 is necessary. Current tag prices in the $0.20–$0.25 range are likely too costly for individual unit tracking — it does not make a lot of sense to use a $0.25 tag on a $3 pack of razors or a $1 loaf of bread. Consequently, it is likely that pallet and case level tracking will be the most predominant for the foreseeable future.

�� Who pays? Whether the retailer or the supplier pays for the RFID tags remains a critical issue. Wal-Mart — an early adopter of RFID technology — has specifically stated that it will not pay for RFID tags, which implies that large manufacturers will have to shoulder the costs of tagging pallets and cases. This could be a significant issue for consumer packaged goods companies, as the extra expense of RFID could weigh on margins. (Gartner Consulting forecasts that there is an 80% probability that, by 2007, a majority of leading consumer goods manufacturers will implant RFID tags on loaded pallets that leave their plants. 26) While the initial tagging costs are likely to be borne by suppliers, over time manufacturers may be able to push at least some of the costs of RFID tagging to packaging and pallet suppliers.

�� Implementation Costs. Aside from the individual tag cost there are also the costs of the readers and infrastructure implementation. As noted, RFID readers generally range from $500 to $3,000, depending on the complexity and functionality needed. Furthermore, it is not uncommon for companies to spend close to $1 million for supply chain management consulting and software implementation costs. In other words, a focus solely on tag costs underestimates the true cost of implementing an RFID system.

�� Standards. Currently there is no single global standard being used by RFID systems providers. While tags are very flexible and can be programmed based on the needs of each company, these differences may prohibit articulation among different systems until standards are adopted. Two global standards are currently predominant in RFID: ISO (International Standards Organization) and EPC (Electronic Product Code). However, according to Patrick Sweeney, president and chief executive officer of ODIN technologies, an RFID and EPC

26 Predicts 2004: Critical Infrastructure Protection; Authors R. Mogull, C. Moore, D. Fraley, R. Goodwin, A. Earley, R. DeLotto; January 14, 2004.

At the current cost structure it is likely that

pallet and case level tracking will be the most

predominant for the foreseeable future.


56

integration and software company, having two standards should not ultimately impede RFID implementation. Mr. Sweeney notes that bar codes have over 200 standards. The FCC has designated several frequencies in the U.S. for RFID use. However, international jurisdictions have different frequencies in use for RFID. For example, RFID frequencies in the U.S. are commonly used at 125 kHz for low transmission and 13.56 MHz for high transmission, while Europe is using an ultra-high frequency of 868 MHz. These transmission frequency differences among countries may challenge the notion of a global RFID supply chain management system.

RFID in Retail Despite these issues, as noted above, RFID is currently being employed in a range of industries (from railroads to agriculture). It would seem, however, that the technology would be particularly beneficial in the retail sector, where RFID can be used to track items through the supply chain. Warehouse format retailers are likely to be early adopters, given that, as discussed below, most large suppliers are currently including RFID tags at the pallet level.

Specifically, RFID offers warehouse retailers the following benefits:

�� Decreased Distribution and Labor Costs. RFID may be able to increase efficiency for retailers at both distribution and in-store operations. More specifically, tasks such as stocking, locating products, checking out, and physical counting, among others, could be significantly reduced or made more efficient. In some cases, retailers may be able to keep store labor hours the same, but perhaps deploy sales associates in other tasks such as customer service.

�� Reduced Shrink. By Smith Barney estimates, shrink represents approximately 2% of sales for most retailers. Shrink is driven by several factors, including employee theft, shoplifting, error, and fraud by vendors. RFID could potentially reduce shrink across the board by providing a tracking device, both in store (lessening employee theft and shoplifting) and at the distribution centers (lessening employee theft and vendor fraud).

�� Reduced Out-of-Stock Items. Retailers can face out-of-stock issues due to the complex nature of inventory management, particularly for large operations. As a result, retailers may lose sale opportunities. So, for example, in a pilot study, The Gap found it could increase in-store item availability to almost 100% by applying RFID tags and tracking inventory in its stores. Assuming that 10% of customers leave due to items being out of stock, Accenture has estimated that the benefit of RFID tags would be equivalent to a 3% increase in sales.

�� Reduced Inventory Write-Offs. Due to a better grasp of what is in the stores and distribution centers, as well as a sense of the life span of a product (e.g., food and consumer electronics), retailers may be able to mitigate inventory write-offs through the use of RFID.

Wal-Mart has been an early adopter of RFID technology, and the company is a member of the board of EPC Global, which is responsible for establishing RFID standards. Effective January 1, 2005, Wal-Mart mandated that its top 100 global

The technology would be particularly beneficial in

the retail sector, where RFID can be used to

track items through the supply chain.


57

suppliers start tagging all cases and pallets, representing approximately 1 billion cases per year (37 other suppliers volunteered to meet the deadline). By the end of 2006, Wal-Mart expects to track all cases and pallets from all of its global suppliers. The company is expanding its RFID network from its experimental Texas distribution center to 12 distribution centers and over 600 stores nationwide.

Wal-Mart has paved the way for other retailers to take advantage of RFID. In that regard, some of Wal-Mart’s smaller competitors may be well positioned (even more so than Wal-Mart). As we discuss here, BJ’s Wholesale Club seems to have a particularly strong advantage.

The BJ’s Advantage Smith Barney analyst Deborah Weinswig estimates that RFID adoption could boost BJ’s 2007 EPS by 27% (see Figure 25). (2007 is the first full year that mass merchant retailers should reap the benefits of RFID rollout.) By contrast, Wal-Mart is forecast to experience a 22% boost to 2007 EPS, and Costco just a 15% increase.

Figure 25. Key RFID Metrics

for three companies

BJ’s Wal-Mart Costco Current 2007E EPS Estimate $2.69 $3.58 $2.76 Potential 2007E EPS with RFID $3.41 $4.37 $3.17 % Accretion from RFID 27% 22% 15%

Distribution Centers 3 110 26

SKUs: —At discount stores 65,000 —At supercenters 125,000 Total SKUs 7,000 3,700-4,500 Source: Smith Barney

RFID would likely have a relatively large positive impact on BJ’s for three reasons:

�� Faster Implementation. As Figure 25 illustrates, BJ’s has only three distribution centers, all of which are “cross docks.” (Cross docks are a type of distribution center that operate such that it is almost as if the goods are loaded directly from the suppliers’ truck into the retailers’ truck.) Costco has 26 distribution centers (all of which are cross docks), while Wal-Mart has 110 distribution centers (some of which are cross docks). Clearly, it would be relatively easy for BJ’s to upgrade its three cross docks for RFID. In fact, the company recently announced that it is in the process of building a new cross dock that will be RFID capable in order to replace one of its older facilities.

�� A Large Number of SKUs. Figure 25 illustrates that BJ’s has almost twice as many stock keeping units (SKUs) as Costco. This relatively large number of SKUs has been additive to BJ’s labor and distribution costs, given that BJ’s workforce has had to keep track of a relatively large number of products. But, as we already mentioned, since Wal-Mart has insisted that most large suppliers to the industry tag all cases and pallets, keeping track of these SKUs would become much less expensive for BJ’s if it used RFID. (Recall that in the warehouse club environment, products are organized by pallet.)

RFID adoption could boost BJ’s 2007 EPS by

27%, versus 22% for Wal-Mart and 15% for

Costco.


58

�� A Culture of Technological Innovation. BJ’s has a reputation for being technologically savvy; so, for example, through its “Member Insights” program, BJ’s mines the data it accumulates about its customers in order to identify key buying patterns. BJ’s CFO Frank Forward pointed out to us that the company invests heavily in hardware, software, and staff in order to build an infrastructure that integrates member purchase behavior with industry sales data, as well as demographic and economic data.

Cisco and Voice over Internet Protocol (VoIP) VoIP involves sending voice communications as digital packets over data networks, such as the Internet, alongside e-mail and Web traffic. In contrast to traditional phone calls, which require a dedicated circuit to connect the callers at each end, VoIP service relies on software. That software converts analog voice signals into digital data packets that are transported over a data network and then converts them back to analog so they can be understood at the other end. (Note that there is an interesting parallel between the transistor, which replaced inefficient vacuum tubes in transcontinental phone service in the 1950s, and VoIP, which is replacing inefficient dedicated telecom circuits today.)

In terms of the technology, IP was designed primarily for data transmission; delays and occasional loss of data (e.g., e-mail) were not so critical. By contrast, voice communication is both real time and “mission critical”: Any delay can lead to a garbled phone call. In addition, in the early stages of VoIP, “network jitter” meant that packets did not arrive in sequence, also leading to poor quality of service. In recent years, however, technological advances have addressed these issues, making VoIP a viable alternative.

Today, many enterprises are switching to VoIP (see Figure 26) because of, among other factors, its cost advantages. (Note that, in this analysis, we are just discussing VoIP for enterprises.)

Figure 26. IP Telephony Implementation Schematic

Source: Gartner Consulting: “2005: The Year of IP Telephony — Get Your Hands Dirty,” Jeff Snyder, Gartner Symposium, October 2004.

Without VoIP, some companies need to

maintain four separate communications

infrastructures.


59

Figure 27. The Evolution of Enterprise Communications

The Early Switchboard

The Button Switchboard

VoIP

Source: The Jimmie Dodd Photograph Collection (JD2287a/12), The Center for American History, The University of Texas at Austin, and Smith

Barney


60

Consider that, without VoIP, some companies need to maintain four separate communications infrastructures:

�� the data network,

�� a private branch exchange (PBX) for external phone calls,

�� an “automatic call distributor” (ACD) to route calls internally, and

�� a voice-mail system.

By switching to VoIP in its purest form (as opposed to, for example, a “hybrid” version, as discussed below), such companies would, in theory, need only the data network, likely resulting in a savings in administration and maintenance. Many VoIP systems are administered via a Web-based browser interface that enables managers to enact changes to an employee’s phone setting remotely. (Contrast that with the “old” way of a telecom engineer coming to the physical location in order to make the moves, adds, and changes.)

On top of cost savings, VoIP has many productivity-enhancing advantages. For example, employees can “log on” to their phone from anywhere in the world, be it in the new office across the hall from their old cubicle or their temporary desk at the company’s European headquarters. (This is known as “presence-based services.”) Moreover, in the case of an enterprise with multiple branch offices, it can have all locations served by a single IP PBX, thus enabling extension dialing between far-flung locations.

Another attractive feature of VoIP is “unified messaging,” which integrates voice with other software programs, such as e-mail, instant messaging, and calendar and collaboration applications. Consequently, voice mail, e-mail and all other messages go into one inbox. Users can save their voice mails, reply to them with text, video, or voice, and attach spreadsheets and presentations to their voice mail if appropriate.

Moreover, numbers (e.g., 212-816-3532) are no longer necessary, because VoIP can operate with names (e.g., Edward Kerschner). Initiating a call, whether to just one person or to many via a conference call, requires only a single click on a name or an icon. In addition, “IP conferencing” facilitates videoconferencing over IP, as well as sharing documents over the same line.

The Drivers of VoIP Growth Gartner Consulting observes that the useful life cycle of an enterprise telephony system is largely determined by its size:

End-user research shows smaller systems have shorter life cycles than larger systems. Large system life cycles can be three to five times longer than their small system counterparts. It should be noted, however, that system life cycles can and do vary. For example, there are certainly cases of traditional PBX systems and lines having useful life cycles of nearly 20 years. The following outlines average life cycles of systems by the size of the system:

�� On average, systems and lines in the 1- to 24-line size segment have useful operational lives between three and five years.

On top of cost savings, VoIP has many

productivity-enhancing advantages.


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�� Systems and lines in the 25- to 100-line size segment have average life cycles of four to six years.

�� Systems and lines in the 101- to 400-line size segment have average life cycles of six to nine years.

�� •Systems and lines in the 401-line or more size segment have average life cycles of seven to 11 years.27

By way of a brief history of the enterprise telecommunications equipment market, in the 1980s there was a major PBX upgrade cycle as corporations shifted from analog to digital. As a technology, analog is the process of taking an audio or video signal (in most cases, the human voice) and translating it into electronic pulses. Digital, on the other hand, breaks the signal into a binary format where the audio or video data are represented by a series of 1’s and 0’s.

Digital PBX technology offered enterprises better voice clarity (although some say analog has a richer sound quality) since digital signals can be regenerated if they degrade over long-distance transport. Digital also enabled increased capacity utilization since many more digital signals can fit into the equivalent bandwidth when compared to analog.

The next upgrade cycle, in the 1990s, centered around voice messaging and advanced digital features like call forwarding and conferencing. With the average expected life of most enterprise PBX equipment at around ten years, the subsequent upgrade cycle should have been in 2000. However, given the rampant Y2K fears at the time, that upgrade was postponed as enterprises focused their attention and spending on IT networks. Then, the recession of 2001–02 squeezed corporate budgets, and the communications equipment upgrade cycle was postponed once again.

The end result is that, for the majority of enterprises, the telecommunications equipment in place today is much older than it should be. At the same time, equipment suppliers are giving enterprises some good incentives to upgrade their systems. Given that it is not in their interest to extend the life of this equipment, companies such as Avaya and Siemens are, in effect, making their PBX equipment obsolete. Quite simply, they are raising the cost of sustaining old equipment (e.g., by increasing the cost of replacement components) and they will steadily ratchet up these maintenance costs over time.

Figure 28 illustrates Gartner Consulting’s forecasts that, in the North American premises switching equipment market, the market share (in revenue dollars) of traditional PBX equipment will decline from 39% in 2004 to 8% in 2008, the market share of IP-enabled equipment will rise from 42% to 55%, and the market share of pure IP equipment will increase from 18% to 38%, representing a compound annual growth rate of 23% for pure IP equipment. (Note that, typically, an IP-enabled product started life as a traditional PBX, but it has been further developed to include

27“Traditional PBX/KTS Installed Base in North America Declines as Users Migrate to IP,” by Megan Marek Fernandez; January 5, 2005.

Given that it is not in their interest to extend

the life of this equipment,

manufacturers are, in effect, making their PBX

equipment obsolete.


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IP capabilities.) Similarly, Rick McConnell, general manager of Rich Media Communications at Cisco, believes 2005 will be the year when line shipments of pure IP technology surpass traditional PBX line shipments for the first time.

Figure 28. Market Share by Technology

total end user revenues: North American premises switching equipment extension line shipments

0%

20%

40%

60%

2004 2005 2006 2007 2008

PBX Traditional Line

IP-Enabled

Pure IP

Source: Gartner Consulting, “Traditional Forecast: Premises Switching Equipment, Worldwide, 1999–2008” by Megan Marek Fernandez,

Christopher Lock, and Isabel Montero; December 10, 2004

Gartner Consulting28 and Smith Barney have identified the following companies as being among the leading vendors of VoIP equipment:

�� Avaya,

�� Cisco Systems,

�� Nortel Networks, and

�� Siemens.

Cisco, in particular, seems especially well positioned to benefit from the VoIP opportunity. In 2004, Cisco, which has about one-third of market share, had VoIP revenues of $1.2 billion (on a total revenue base of $22 billion), up from $300 million in 2003. But the benefits of VoIP to Cisco are much more significant than these numbers suggest, given that Cisco estimates that, for every dollar spent on VoIP, $3–$5 are spent on the required simultaneous upgrade of the security and network switching equipment. Given its dominant (80%) share of the networking equipment market (in contrast to its one-third share of the VoIP market), Cisco is particularly well positioned to grab the lion’s share of those revenues.

Upgrading Security Solutions Most VoIP solutions are deployed on servers that run either proprietary operating systems or commercially available systems such as those offered by Microsoft. These servers are as susceptible to hacking or denial-of-service attacks, as are any other servers deployed in an enterprise IT department. If hackers were to break into a company’s voice system, sensitive data would be at risk. Other security concerns

28“Magic Quadrant for Corporate Telephony in North America, 2004,” by Jay Lassman, Richard Costello, and Jeff Snyder; August 16, 2004.

Cisco estimates that, for every dollar spent on

VoIP, $3-$5 are spent on the required

simultaneous upgrade of the security and network

switching equipment.


63

include the “hijacking” of a voice gateway to place unlimited unauthorized free calls across the globe, as well as eavesdropping and tampering with voice systems, user identities, and telephone configurations.

In summary, IP phone systems face all of the same security threats as traditional systems, as well as new security issues due to the inherently open nature of IP, which was designed to enable greater flexibility and productivity compared to proprietary circuit-based systems.

In this regard, in addition to selling the IP telephony infrastructure, phones, management software, and applications, Cisco also provides security solutions for protecting all types of IP traffic. Cisco’s security solutions are based on its Self-Defending Network Initiative. This is an integrated systems-level approach designed to protect the network infrastructure, call processing systems, endpoints (phones, video terminals, and other devices), and applications. Cisco’s rapidly growing security business recently passed the $1 billion per year revenue mark and, driven by the company’s intense focus on security issues and the burgeoning VoIP upgrade cycle, Smith Barney expects at least 25% annual growth in security revenues at Cisco over the next several years.

Upgrading the Basic Switching Infrastructure The second step in the network upgrade/VoIP implementation process is upgrading the Ethernet switches in the wiring closet and data centers with 1) Layer 3 and quality-of-service (QoS) functionality, 2) additional capacity, and 3) power-over-Ethernet (PoE) capabilities.

�� As part of this process, most Layer 2 switches, which are very common in today’s outdated networks, need to be upgraded to Layer 3 switches, which have integrated IP route processing and QoS capabilities. Layer 2 switches are fairly simple devices that make traffic switching decisions based on simple yes and no decisions. Data packets enter the switch and, depending on the header markings, are switched to one port or another regardless of the current network load conditions. Layer 3 switches, on the other hand, include route-processing capabilities. Somewhat like routers, these switches have some ability to monitor network conditions and make moment-by-moment decisions to send packets over the most efficient path depending on the current network load and traffic patterns. This Layer 3 capability, combined with specific QoS protocols that have been developed, can greatly improve network performance and help ensure that sufficient bandwidth is reserved for real-time, latency-sensitive applications such as voice and video.

�� Given that 1) more traffic will be added to the data network with VoIP and 2) the price points on Gigabit and 10 Gigabit Ethernet have fallen significantly, enterprises converting to VoIP tend to upgrade their 10/100 Megabit “Fast Ethernet” switches with Gigabit to the desktop (in the wiring closet) and potentially with 10 Gigabit switches in the datacenter.

�� Finally, the newly installed switches are increasingly power-over-Ethernet (PoE) enabled so that the IP phones can draw power over the data network lines. Traditional telephone systems are powered over the lines that are drawn from

Cisco’s rapidly growing security business

recently passed the $1 billion per year revenue

mark.


64

the local phone company’s central office. This is not the case for VoIP phone systems, which require a power source within the enterprise. The desire for an electric-utility-independent power source for the phones adds additional incentive to upgrade or replace most of the switch ports in the wiring closet. PoE, which is a fairly new technology, is based on a new standard completed in mid-2003. Smith Barney estimates that only about 6% of all Ethernet switches shipped in 2004 were PoE enabled, but rapidly falling price premiums and the increasing penetration of VoIP in the enterprise promise to rapidly grow this penetration.

By the time the changes outlined above are completed, the network upgrade needed to fully implement VoIP becomes fairly significant, and this is where Cisco sees the greatest benefit. Enterprise Ethernet switching is Cisco’s largest revenue segment, accounting for over 40% of total sales in 2004, or about $10 billion. Remember that for each $1 of VoIP gear Cisco sells, it typically sees approximately $3 in additional network switch sales.

Smith Barney analysts expect Cisco’s VoIP sales to grow 50% in 2005, to $1.8 billion, which implies $600 million of incremental year-over-year VoIP sales. The derived demand for network switching should be about three times this number, at $1.8 billion, yielding an 18% annual growth rate in switching from VoIP-related network upgrades alone. It is this line of analysis that leads Smith Barney analysts to believe Cisco will likely grow faster than the current consensus view over the next several years.

The Case for Upgrading Some have asked whether the complexity of upgrading the security and networking infrastructure will be an impediment to growth in the VoIP market, but this has not seemed to be the case when recent VoIP equipment growth rates are considered. Cisco argues that the networking upgrade is justified by the capital and operational cost savings of VoIP, which Smith Barney telecom equipment analyst B. Alex Henderson has estimated can run as high as 43% when compared to the cost of a traditional PBX system.

In that regard, Cisco’s Director of Product Marketing for IP Communications Hank Lambert told us that one of Cisco’s largest VoIP customers had meticulously documented its ongoing hard-dollar operating cost savings (over its previous legacy system), and found that it was saving 75% on station moves (moves, adds, and changes), 50% on PBX service contracts, 42% on long distance tolls, 38% on local trunking charges, and 93% on conference calling.

Mr. Lambert told us about a modeling tool that Cisco has developed called the Cisco Network Investment Calculation Tool. The company has run at least 5,500 separate customer cases through this tool and found that customers have a return on investment period on their VoIP investments ranging from six months to three years, with the average payback period in the 12- to 14-month range.

With regard to how the scope of these savings has evolved, Rick McConnell told us how Cisco’s enterprise VoIP sales approach has developed over the last five years:

Smith Barney analysts expect Cisco’s VoIP

sales to grow 50% in 2005.

Customers have a return on investment period on

their VoIP investments ranging from six months

to three years, with the average payback period

in the 12- to 14-month range.


65

�� Five years ago, VoIP was primarily about toll bypass, or lowering telecom service bills for the customer.

�� The next stage was network simplification, or taking hundreds of PBXs at hundreds of branch locations and replacing them with a few clusters of call manager servers for simplified voice system management.

�� Cisco believes it is now at the stage where it is selling hard-dollar cost savings and, increasingly, enterprise-wide productivity improvements. The productivity benefits primarily come from new applications that ride on top of the networking/voice infrastructure, such as video conferencing, unified messaging and communications, and virtual call centers.

It is important to point out, however, that enterprises have the option of not switching completely to VoIP. Alternatively, they may go to hybrid systems that combine some of the features of VoIP with legacy PBX systems. These hybrid PBXs combine features of both traditional and IP telephony and can run either solution depending on the software pack installed. (According to Cisco’s Rick McConnell, whereas 18–24 months ago enterprise customers were evaluating VoIP versus traditional PBX technology, today the decision is virtually always between a “pure” IP solution and a hybrid system.)

Of the four leading vendors of IP telephony, Cisco is the only vendor without an installed base of legacy PBX customers. For this reason, the initial deployment of Cisco equipment is always a “greenfield” build, and any existing equipment is often scrapped. Avaya, Nortel, and Siemens, on the other hand, have significant installed bases of traditional telephony customers and each derive the majority of their current enterprise VoIP revenues from evolving their installed base of customers to hybrid VoIP solutions. Often they are able to leverage some of the installed gear in the process.

There are advantages to a hybrid/gradual approach. For instance, there is less up-front capital spending required. In addition, it is likely that many enterprises with large concentrations of employees in a particular location will adopt a hybrid model because it is less disruptive to the work environment and also allows for any problems to be identified early on in the transition.

The enterprises that initially adopt a hybrid approach will, however, eventually need to migrate to pure VoIP given that 1) the old legacy systems will ultimately need to be replaced and 2) pure VoIP is ultimately less expensive, particularly given that it eliminates the need for telecom service contracts. While the management of PBX systems is typically outsourced by enterprises, the management of VoIP systems is, by definition, an integral part of the management of an enterprise’s computer network.

In that regard, Cisco’s Rick McConnell told us that he had recently spoken with a customer who started down the path of evolving their voice network through a hybrid approach but, after getting part of the way into the project, realized the hard-dollar operating cost savings from a pure IP approach were so significant that they decided to make a clean cut over to pure VoIP.

Of the four leading vendors of IP telephony, Cisco is the only vendor

without an installed base of legacy PBX

customers.


66

Medtronic’s Real-Time Patient Monitoring In this section, we discuss how Medtronic is taking advantage of the latest developments in networking technology to develop real-time patient monitoring devices. We start by discussing how the company is developing a wireless system for real-time monitoring of congestive heart failure. We then analyze Medtronic’s development of a real-time monitor of blood sugar levels, a giant step toward the development of an external artificial pancreas.

Congestive Heart Failure: Attacking the Problem Through Better Diagnostics Today, pacemakers and implantable cardioverter defibrillators (ICDs) are two of the largest and best-known markets in the medical device field, with combined sales exceeding $8.5 billion in 2004. While these devices were originally designed to treat slow heartbeats (pacemakers) and rapid heart beats (ICDs), over the past five years congestive heart failure has become an increasingly serious condition, in part because of the nation’s obesity epidemic.

Congestive heart failure (CHF) is not an electrical disorder of the heart but, rather, a muscular problem whereby the heart enlarges and loses pumping function. As a result, fluid starts to back up in the lungs, causing a shortness of breath and/or a drowning sensation. It is estimated that over five million people in the U.S. have some form of heart condition, 500,000 people develop heart failure each year, and another 250,000 die annually from this disease. Treating episodes of acute heart failure is the largest treatment cost for hospitals in the U.S., at roughly $40 billion annually.

Today, all of the major cardiac rhythm management (CRM) companies (Medtronic, Guidant, and St. Jude Medical) have pacemakers and ICDs that treat a small subset of CHF patients — those whose ventricles do not beat in sync, causing a reduction in pumping function. Devices for the treatment of this condition — called CRT-P (pacemakers) and CRT-D (ICDs) — include an additional lead that snakes around the left ventricle and uses electrical signals to keep the ventricles beating in sync. But while the data from these devices have shown a reduction in hospitalizations and mortality, they do not work for the majority of the CHF population and, more importantly, do nothing to sense a worsening condition of CHF that can lead to hospitalization and/or death.

In that regard, the state of monitoring a patient’s CHF condition has been woefully simplistic for years. The current method of evaluating a heart failure patient’s fluid level (outside of a physician’s office or hospital) is by measuring fluctuations in body weight via a standard scale. An increase in weight suggests to a physician that fluid is backing up, which, in turn, suggests that the risk of a trip to the hospital is increasing.

While patients are supposed to weigh themselves daily, compliance has been a long-standing issue, not just in terms of taking the daily measurement, but also in calling the physician when weight fluctuations are seen. What makes this an even less-exact science is that the range of weight change before an adverse episode can be very slight, in some cases, just a couple of pounds of added weight. Not

Treating episodes of acute heart failure is the

largest treatment cost for hospitals in the U.S., at

roughly $40 billion annually.


67

surprisingly, this system has done little to slow the rapid increase in hospitalization costs due to CHF.

Over the past ten years, CRM market leader Medtronic has undertaken a large R&D effort to address the diagnostic side of the CHF patient market, and it appears the company is finally closing in on making these efforts pay off, both in terms of share gains in the existing CRM market for devices and in market expansion.

The Recent U.S. Release of the Sentry ICD Launched the Effort…

Late in 2004, Medtronic began its foray into the CHF diagnostics market with the U.S. launch of the Sentry ICD. The Sentry is a full-featured CRT-D ICD that also includes an algorithm dubbed OptiVol, which measures impedance, or “wetness,” in the lungs.

While not a direct measurement, OptiVol has been shown to have a sensitivity rate of 73% for detecting the onset of an acute CHF episode at least one week before hospitalization occurs. The patient is notified of a worsening trend either by an alert (i.e., device beep) or by a physician, who has access to the alert remotely through the company’s Carelink network, which is described in more detail below. Currently, neither the patient alert nor the Carelink connectivity features of the Sentry ICD have been approved by the FDA, but they are expected to be approved by year-end.

…and It Should Be Followed by the Next-Generation Chronicle

While OptiVol represents the first breakthrough in fluid monitoring, Medtronic’s follow-on product, the Chronicle, raises the bar significantly. The initial version of the Chronicle is not an ICD or pacemaker, but a pacemaker-sized device that includes a unique lead with a blood-pressure transducer on the tip. The tip of this lead is placed near the base of the pulmonary valve and tracks changes in valve pressure, with higher pressure suggesting that fluid is backing up.

Unlike OptiVol, which is more geared to alerting the patient/physician before a possible upcoming event, Chronicle offers real-time monitoring. Hence, in the hands of more aggressive CHF specialists, Chronicle allows the physicians to track the patient and their responses to the various CHF drugs they are typically using, thereby allowing the physicians to optimize the dosing. The pre-market approval (PMA) application for Chronicle has already been submitted to the FDA, and Marshall Stanton, Medtronic’s cardiac rhythm management medical director expects approval in fiscal 2006 (ending April).

Since Chronicle is a diagnostic-only device, Medtronic plans to follow this product up with the Chronicle ICD in fiscal 2007. Chronicle ICD will include all of the features of the company’s CRT-D devices and also incorporate the Chronicle technology as well. Smith Barney analyst Matthew Dodds believes Medtronic will begin a small clinical trial in the next couple of months in order to garner FDA approval.

Medtronic’s OptiVol has been shown to have a

sensitivity rate of 73% in the detection of the

onset of an acute CHF episode at least one

week before hospitalization occurs.

Medtronic’s Chronicle offers real-time

monitoring. Hence, Chronicle allows the

physicians to track the patient and their

responses to the various CHF drugs they are

typically using.


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The Carelink Network Will Provide the Data Access

While these devices will offer the patient-alert feature, the real benefit will lie in allowing the physician access to changes in fluid levels on a real-time basis. Medtronic will accomplish this via its CareLink network (see Figure 29). CareLink was initially introduced in 2002 to help electrophysiologists track implanted pacemakers and ICDs for the monitoring of arrhythmias (i.e., electrical disorders). With Carelink, a patient with a networked implanted device has a small monitor at home that uses a wand (held on top of the device for a few minutes) to upload data to the network. Eventually, Medtronic’s home monitor will do away with the wand approach and will use a wireless connection in a fashion similar from going from a wired Internet connection to “wi-fi.”

Figure 29. The Evolution of Medtronic’s CHF Monitoring Technology

Source: Medtronic

Medtronic’s Marshall Stanton points out that the company has already invested more than $100 million into the Carelink network, and the number of physician offices and patients that are part of the system has been growing rapidly (see Figure 30). With fluid monitoring, Medtronic will offer access to Carelink via a secured website to CHF specialists and cardiologists who treat CHF patients. Medtronic also plans on expanding its 2,500-plus CHF sales force in the U.S. in order to put more focus on these physicians.

Figure 30. Medtronic Carelink Adoption

Patients Enrolled (left hand scale) and Active Clinics (right hand scale)

0

5 ,000

10 ,000

15 ,000

20 ,000

25 ,000

Q 1 Q 2 Q3 Q 4 Q1 Q 2 Q 3 Q 4 Q 1 Q2 Q 3

FY03 FY04 FY05 YTD

0

50

100

150

200

250

300

350

400

Patien ts Enro lled (LHS)

Active C lin ics (RHS)

Source: Medtronic

Medtronic’s Carelink will allow the physician

access to changes in fluid levels on a real-time

basis.


69

The Market Opportunity Through Expansion and Share Gains Looks Substantial

Medtronic appears well in front of the competition in terms of fluid management, which Matthew Dodds believes is the next “game changing” technology in the CRM space. While both St. Jude and Guidant have early network systems, both are very simplistic compared to Carelink, and only the St. Jude system (called Housecall) has been rolled out. In addition, neither company has unveiled any device that will include fluid management, and Matthew Dodds knows of no clinical trial under way at either company in this area. Medtronic has already completed two studies, including the phase III Compass HF pivotal study, which was unveiled at the American College of Cardiology meeting on March 8.

So, how important is fluid management? For ICDs, Medtronic’s Marshall Stanton estimates that 70% of all patients implanted with ICDs today have some level of ventricular dysfunction related to heart failure, and the percentage of heart failure patients that account for ICD implants continues to rise. In Matthew Dodds’ opinion, Medtronic’s estimates seem realistic, as roughly 35%–40% of ICD implants today are CRT-D devices, and they are specifically for use for CHF related to desynchronized ventricles.

With the U.S. ICD market representing a $3.6 billion run rate today, and expected to cross $6 billion in 2008, the opportunity for share gains is significant for Medtronic. Today, Medtronic controls a roughly 48%–49% of the U.S. ICD market, and each additional share point equates to $40–$45 million, or 50–70 basis points of sales growth. In 2007, when the Chronicle ICD is expected to be out, a 10-percentage-point gain in market share would translate into an extra $512 million in sales, or an extra 500 basis points to Smith Barney’s 12% sales growth estimate for that year.

While Chronicle implants will be a tougher initial sale, given that it may be difficult to convince some patients to get an implant just for monitoring, physician comfort with the benefits via implants of Chronicle ICD could lead to market expansion. As we noted above, CRT products are used when the heart’s pumping function is compromised. This is known as systolic heart failure.

There are, however, an equally large number of patient’s that have diastolic heart failure, which occurs when the heart becomes “still” and does not fill properly. While this disorder does not lend itself to CRT treatment, some patients would fall under either ICD implantation (under the new indications from clinical trials — i.e., MADIT II and SCD-HeFT) or pacemakers. These patients could also represent share gain opportunities for Medtronic. The remaining patients — those with diastolic heart failure that do not qualify for an ICD or pacemaker — would represent a new patient population for the Chronicle. Smith Barney estimates that 30% of all CHF patients, or 1.65 million Americans, would fall into this category.

Medtronic appears well in front of the

competition in terms of fluid management, the next “game changing” technology in the CRM

space.

When the Chronicle ICD is out in 2007, a 10-

percentage-point gain in market share would

translate into an extra $512 million in sales, or

an extra 500 basis points to Smith Barney’s 12%

sales growth estimate for that year.


70

The Artificial Pancreas: Merging Insulin Pumps with a Continuous Glucose Sensor The other disease that Medtronic is doing pioneering work on is diabetes, a chronic condition whereby the body cannot regulate the blood’s glucose levels. There is no known cure for diabetes, which afflicts an estimated 150 million people worldwide. In the U.S., the American Diabetes Association (ADA) estimated that 18.2 million people were afflicted with diabetes in 2002, and roughly 1.3 million new cases are being diagnosed each year. The ADA estimates that expenditures related to diabetes in 2002 were $132 billion, including $92 billion in direct costs and $40 billion in indirect costs. Most of the direct costs associated with diabetes involve complications arising over time, including eye, kidney, and nerve damage.

There are two classifications of diabetes — Type 1 and Type 2. In the U.S., Type 1 diabetes accounts for 5%–10% of all diagnosed cases, and Type 2 accounts for 90%–95% of cases. Type 1 diabetes typically shows up in childhood or adolescence and is defined as a situation in which the body does not produce enough insulin. Insulin is necessary for the body to be able to convert sugar, the basic fuel for the cells in the body. In Type 2 diabetes, either the body does not produce enough insulin or the body has developed a resistance to insulin. While genetics play into the risk of developing Type 2 diabetes, obesity is also a strong risk factor.

Diabetes is controlled by testing blood glucose levels and insulin injections. We outlined above how Genentech pioneered the development of human insulin by way of genetic engineering. In the U.S., the majority of Type 1 diabetics are insulin dependent (i.e., requiring insulin injections) and about 3 million Type 2 diabetics are also considered insulin dependent. The “gold standard” for testing blood glucose levels — blood glucose meters — have been around for years.

With a blood glucose meter, the patient pricks his or her finger and puts a drop of blood on a test strip, which is read by a meter. Ideally, blood glucose levels should be checked by insulin-dependent diabetics four times per day, although the estimated “real world” rate is close to two times. Several companies, including Johnson & Johnson, Roche, and Abbott Labs are major players in the blood glucose meter/strip market.

For insulin delivery, a one to two times daily syringe injection has been the gold standard for years. Over the past 15 years, a new method of insulin delivery has arisen — insulin pumps, which now represent a $700 million worldwide market. These are small pager-sized devices that use a small needle and catheter to deliver insulin at a more steady-state rate, which has been proven in many studies to significantly reduce morbidity and long-term complications associated with diabetes.

Medtronic’s MiniMed Is Already Dominant in Insulin Pumps…

In 2001, Medtronic entered the diabetes market with the acquisition of insulin pump pioneer MiniMed. Today, MiniMed dominates the U.S. market for insulin pumps with a roughly 75%–80% share of all pump placements. But with only 270,000 pumps placed in total in the U.S., insulin pumps are only being used by roughly 14% of all Type 1 diabetics and very few Type 2 diabetics (although the number of users has been growing by a healthy 15%–20% over the past three years).

The other disease that Medtronic is doing

pioneering work on is diabetes, a chronic

condition whereby the body cannot regulate the

blood’s glucose levels.

Medtronic’s MiniMed division dominates the U.S. market for insulin pumps, with a roughly 75%–80% share of all

pump placements.


71

Figure 31. The Evolution of Diabetes Management

The Human Pancreas

Blood glucose test strip and insulin injection

The External Artificial Pancreas

Source: Smith Barney and Medtronic


72

…and Is Leading the Charge in Continuous Glucose Monitoring

While Medtronic already enjoys significant advantages in brand awareness, reputation, and sales force size, the company appears to be closing in on a major technological advantage to distance itself further from the competition. For years MiniMed has been working on a continuous glucose monitoring system (CGMS) as an alternative to blood glucose meters. Unlike blood glucose meters, the CGMS uses a tiny electrode and electrochemical technology to continuously read glucose using fluid in the subcutaneous tissue (i.e., the area of fat between the skin and muscles). As we describe in more detail below, within the next 12 months, we expect Medtronic to marry its insulin pump and CGMS to create the first “artificial pancreas.”

In 1999, MiniMed received U.S. approval for a diagnostic version of the CGMS for “three-day monitoring” (whereby the sensor, a disposable soft-needle, is inserted into the abdomen and replaced after three days), called the CGMS System Gold. In February 2004, Medtronic received FDA approval for its Guardian CGMS, which is available for commercial use but only features an alarm feature when glucose rises too high or falls too low. The next generation of this technology is the Guardian RT CGMS, which was submitted to the FDA several months ago and was just launched in Europe and Canada. The Guardian RT will provide a real-time blood glucose reading every five minutes rather than the alarm feature offered by the Guardian. Brad Enegren, Medtronic vice president of R&D for diabetes, expects that the Guardian RT will be approved during fiscal 2006 (ending April). Since this product is a stand-alone sensor and is unlikely to garner private or government reimbursement right away, it is not expected to be a meaningful revenue generator

In fiscal 2007, Mr. Enegren expects that Medtronic will move one step further by marrying the Guardian RT with the Paradigm 715 pump. In combining the products, there will only one “box” that will combine the algorithms of the sensor and pump. This first “sensor-augmented pump” system is slated to begin a 140-patient clinical trial and 600-patient “outcome” trial around the end of April. Following that, Mr. Enegren expects the next-generation system to shift from sensor augmented to “open loop,” which will include algorithms that generate therapy suggestions to the patient based on the data generated by the sensor.

More clinical data are likely to be required for this advance, so Mr. Enegren expects approval in late fiscal 2006 or early fiscal 2007. The next step is the true artificial pancreas, or “external closed loop,” as Medtronic will automate the sensor readings with insulin delivery from the pump, taking the patient out of the loop. Since more clinical data will likely be required, Matthew Dodds expects this approval to occur in late fiscal 2008.

While this certainly seems like several iterations down the road from where Medtronic is today (see Figure 32), it is important to note that the technology is really already in place, as the company has already been performing small, controlled studies, testing the automated sensor-augmented pump. In addition to an external system, Medtronic continues to develop an internal system using its implantable pump, which is still in clinical trials.

In 2007 Medtronic will combine the glucose

sensor and insulin pump to create one device.


73

Figure 32. The Evolution of the External Artificial Pancreas

*Not yet approved by the FDA or European Health Authorities

Source: Medtronic

Unlike the fluid management opportunity in CRM, Medtronic’s market share in pumps is already at a level that suggests limited opportunity for further share gains. Hence, the opportunity for the artificial pancreas is really centered around: 1) patient adoption of the pump technology, driven by the advantage of the sensor, and 2) additional revenues from the implantable sensor component of the system.

Competitively, Medtronic appears to have a major advantage over its competition in the development of an artificial pancreas. Abbott Labs is one generation behind with its Navigator CGMS (the company is looking to bypass the “alert” approval, but this appears unlikely). Furthermore, Abbott does not own its own insulin pump business, but has instead opted to partner with Smith/Deltec. In the opinion of Matthew Dodds, not owning the pump component is likely to make it difficult to control the iterative steps necessary to eventually move to the artificial pancreas.

Fringe pump player Animas is also working on a CGMS, but it is in the early stages of development. Finally, it is also important to note that Medtronic should also be able to take advantage of the Carelink network described above, as the company plans on launching a portal for physicians who treat diabetics when the “sensor augmented pump” is launched.

Medtronic appears to have a major advantage

over its competition in the development of an

artificial pancreas.


74

Fuel Cells: Mechanical Technology and Plug Power Some of the biggest complaints from users of personal digital assistants (PDAs), cell phones, and laptop computers center around the life expectancy and energy storage capacity of the lithium ion battery powering the equipment. Lithium ion batteries are the predominant power source in the premium power pack industry, accounting for about 90% of market share. However, as portable electronics (such as cell phones) have become more complex (e.g., incorporating functions such as color displays and embedded digital cameras) and power demands have increased, a typical lithium ion battery today can support only about two to three hours of talk time. As Figure 33 illustrates, improvements in laptop components, such as disks and CPUs, have not been matched by improvements in battery energy density.

Figure 33. Improvements in Laptop Components

index, 1990 = 1

1

10

100

1,000

10,000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Disk Capacity

CPU Speed

Available RAM

Battery Energy Density

Source: Thad Starner, assistant professor of computing at the Georgia Institute of Technology College of Computing

Recall that lithium ion replaced nickel cadmium as the power source for premium electronic products in the early 1990s, reflecting lithium ion’s key advantages of lighter weight and improved energy density (about two times better). Now a new technology — direct methanol fuel cells (DMFC) — seems likely to replace lithium ion batteries because of its similar advantages of lighter weight/greater portability and improved energy density. (DMFC technology provides at least twice the amount of power currently offered by lithium ion batteries).

Direct methanol fuel cells are micro fuel cells. A micro fuel cell is a portable power source for lower power electronic devices, which converts chemical energy into usable electrical energy. It generates power through the electrochemical reaction of a fuel in the presence of a catalyst.

Tech Innovators: Six Case Studies

Direct methanol fuel cells (DMFC) seem likely

to replace lithium ion batteries because of their advantages of

lighter weight/greater portability and improved

energy density.


75

Figure 34. The Evolution of Portable Power Sources

“Wet” Cell Battery

Lithium Ion Battery

Direct Methanol Fuel Cell

Micro Fuel Cell Powering a PDA Micro Fuel Cell Powering an Entertainment System

Source: Smith Barney and Mechanical Technology


76

So, like batteries, fuel cells generate electricity through a chemical reaction. However, unlike batteries, fuel cells are recharged with a fuel source instead of electricity. A number of companies are currently developing a micro fuel cell that uses methanol, a hydrocarbon (most commonly used as windshield washer antifreeze), as its fuel. Those include large companies such as Motorola, Toshiba, Casio, NEC, Sony, and Panasonic, as well as smaller companies such as Mechanical Technology.

Methanol has the advantage of high energy density, thereby facilitating longer use time, as well as products with increased functionality. Specifically, methanol micro fuel cells offer three main advantages over lithium ion batteries:

�� Weight. As noted, a typical lithium ion battery has approximately two to three hours of peak time (or talk time for mobile phone users). In contrast, two to three cubic centimeters (cc) of neat methanol, each cc equivalent to approximately one drop, can provide the same amount of power. So, a few drops of methanol can provide the same power as a lithium ion battery. It is likely that a DMFC cartridge for a cell phone will carry upward of 40 ccs of methanol, which translates into roughly 35–40 hours of peak operating capacity (i.e., talk time).

�� Portability. DMFCs are more portable and easier to recharge than existing battery technologies. Specifically, a battery is merely an energy storage device. Once the stored energy is used, the battery must be recharged or replaced. As a result, the end user must carry a charger and/or replacement batteries. Conversely, a micro fuel cell is an energy-producing device that operates on a small cartridge of methanol. As explained above, a few drops of methanol can produce the same amount of energy as an entire lithium ion battery. Accordingly, it is easier to carry (or conveniently purchase) a few replacement cartridges than to carry a few batteries and/or a charger.

�� Power Density (i.e., the amount of energy produced by a given volume of battery). The power produced by a fuel cell is approximately two to three times that of an equivalent lithium ion power pack (see Figure 35). (Prismatic lithium ion batteries, typically used in a cell phone, and cylindrical lithium ion batteries, typically used in a laptop computer, have 200-plus Watt Hours per liter [Wh/l of energy] and 400-plus Wh/l, respectively. In contrast, a fuel cell operating at 20% efficiency has approximately 750 Wh/l; taking the efficiency level up to 30% yields 1,100 Wh/l. We talk about methanol efficiency because traditional micro fuel cell technology has required the methanol be diluted with water, thereby lowering the power density.) Although the weight and portability advantages are important, it is likely that energy density (i.e., run time) would be the strongest selling point to a potential end user.

Methanol has the advantage of high

energy density, thereby facilitating longer use

time, as well as products with increased

functionality.

The power produced by a fuel cell is approximately two to three times that of an equivalent lithium ion

power pack.


77

Figure 35. Comparative Performance of Lithium Ion Batteries vs. DMFCs

watt hours per liter

0

4 0 0

8 0 0

1 2 0 0

L ith iu m P r ism a tic L ith iu m C y lin d r ic a l D M F C 2 0 % e ff ic ie n t D M F C 3 0 % e ffic ie n t

Source: Mechanical Technology

Note here that there are several hurdles that must be overcome in order for DMFC technology to take market share from existing lithium ion technology.

�� Pricing. Lithium ion battery packs for notebook computers and mobile phones (which, as noted, make up more than 90% of the portable electronics target market) sold for average prices of $88.39 and $12.51, respectively, in 2002. By 2005, these prices are expected to drop by 25.0% (for notebook computers) and 26.5% (for mobile phones) to $66.43 and $9.20, respectively. While DMFC-powered products are not yet commercially available, and the companies involved have not provided pricing information (for competitive purposes), the pricing of fuel cells must ultimately be at a level that is at least competitive with lithium ion batteries. That said, Dr. William P. Acker, CEO of Mechanical Technology, points out that when lithium ion batteries were first introduced, they were three times as expensive as the prevailing nickel cadmium batteries, yet the market was willing to pay for their improved performance.

�� Regulations. At the present time, methanol cannot be transported either internationally or domestically in the passenger cabins of commercial aircraft. However, an initial step in gaining regulatory approval occurred in December 2004, when the United Nations Committee of Experts on the Transportation of Dangerous Goods (CETDG) recognized properly packaged methanol as transportable cargo. The next step is that the transportation regulatory bodies of individual countries must each allow properly packaged methanol to be transported in the passenger cabins of commercial airplanes. Mechanical Technology’s Dr. Acker expects that these airline transportation issues will be resolved within two years.

�� Threats from Existing Technology. Manufacturers of existing technologies are working vigorously to make lithium ion batteries last longer. Some observers claim that lithium ion batteries have not fully matured because the metals and chemicals used are constantly changing. Moreover, others point out that semiconductor companies are working to make devices that use battery power

When lithium ion batteries were first

introduced, they were three times as expensive

as the prevailing nickel cadmium batteries, yet

the market was willing to pay up for their improved

performance.


78

more efficiently. However, Mechanical Technology’s Dr. Acker believes that, even with the improvements that many observers are predicting, lithium ion batteries are still not likely to come close to the performance offered by micro fuel cells.

So, these issues do not seem insurmountable. Consequently, companies such as the ones listed above are all developing DMFC technology for portable electronic products. Given the size of the potential market (estimated to grow to $10 billion in 2010 from $5 billion in 2004), first-mover advantage will be key. In that regard, on December 14, 2004, Mechanical Technology introduced its first commercial product (a DMFC power pack for an Intermec RFID inventory scanner). This was a significant event because it was the first time that a DMFC-powered product was to be tested in a “real world” setting against lithium ion batteries.

Mechanical Technology’s strategy is to first enter selected markets in order to validate and test its DMFC power system (named Mobion). These end markets, which include both industrial and military applications, have been targeted by Mechanical Technology due to their ability to adopt technologies earlier than consumer markets, as well as the inherent value that fuel cells offer when compared to existing power sources.

�� The target industrial market for Mechanical Technology includes portable electronic devices (e.g., handheld inventory scanners — such as the aforementioned Intermec RFID inventory scanner — notebooks, PDAs, and tablets) that are designed for rugged use. Major users include distributors, manufacturers, transport companies, utilities, public safety, retailers, hospitals, and financial institutions.

�� With regard to military markets, we note that, on average, a soldier carries approximately ten batteries — each weighing 2.3 lbs. — to power radios, a handheld global positioning system (GPS), flashlights, night-vision goggles, and laser sights. It is estimated that, when using DMFC technology, this weight load could potentially be cut by 50%–80%, depending on the application, while still offering the same amount of power.

However, the consumer electronics power pack market, with a current estimated market value of $5 billion, ultimately represents the largest potential opportunity for portable fuel cells. Devices such as PDAs, handheld entertainment systems, and mobile phones — i.e., lithium-ion powered devices — are the most likely candidates for DMFC-based power systems given their increasingly complex technology and power requirements.

In that regard, in September 2003, Mechanical Technology entered into a strategic alliance agreement with Gillette under which Mechanical Technology, Gillette, and Gillette’s Duracell business unit intend to develop and commercialize micro fuel cell products to power handheld, mass-market, portable consumer devices. Specifically, Gillette is developing ways to package the methanol to be used in the DMFC units. Mechanical Technology’s Dr. Acker observes that developing industry standards is a key factor behind the Mechanical Technology/Gillette-Duracell relationship, as this will pave the way for the introduction of micro fuel cells into the mass market. (We

The consumer electronics power pack

market, with a current estimated market value of $5 billion, ultimately represents the largest

potential opportunity for portable fuel cells.

Mechanical Technology entered into a strategic alliance agreement with Gillette to develop and

commercialize micro fuel cell products that power

handheld consumer devices.


79

noted above that the key to IBM’s successful development of a true “personal computer” was its open system that attracted a wide range of partners, in sharp contrast to Apple’s closed, proprietary system.)

At the other end of the spectrum, another group of companies is focused on developing fuel cells for much larger applications, most notably on-site and mobile power generation. Most of these companies fall into one of two camps: either they are part of a larger corporation (e.g., General Motors, Ford, Honda, United Technologies, Siemens, Dow Chemical, 3M, or General Electric), or they are entrepreneurially driven (e.g., Ballard Power, Hydrogenics, and Plug Power). Many of the entrepreneurially driven companies employ proton exchange membrane (PEM) fuel cell technology to create a fuel cell power plant consisting of several individual “cells” stacked together.

These individual fuel cells need pure hydrogen to run efficiently and generate 0.5–0.9 volts of direct current electricity. The individual cells are combined in a “stack” configuration to produce the higher voltages more commonly found in low- and medium-voltage distribution systems. The stack is the main component of the power section (or “engine”) of a fuel cell power plant.

The key attributes of PEM fuel cells include low operating temperatures, few moving parts (if any), extremely quiet and environmentally friendly operation, and rapid start-up times. In addition, the solid membrane also allows a flexible configuration for the system (the stack can be mounted horizontally or vertically), and the system copes well with large fluctuations in power demand and loads. These features make PEM fuel cells the most flexible and versatile of the fuel cell systems. (Typically they are sized at less than 100 kilowatts [kW] of power.)

The long-term potential of fuel cells is underscored by the billions of dollars already invested by the blue chip industrial companies listed above. However, a key issue is market acceptance. Lead acid batteries and diesel generators are proven technologies that have worked for decades and are cost efficient today. (On the other hand, the disadvantages of these technologies are environmental concerns, reliability, and maintenance costs.) In select markets — most notably battery backup — fuel cells can compete with these existing technologies.

Plug Power is the first company to bring a reliable, economically viable product to market that can be manufactured in mass quantities. Moreover, Plug Power President and CEO Dr. Roger Saillant, believes that the likely passing of the Energy bill in the next 12–24 months will act as a powerful catalyst for the fuel cell market, given that the bill will likely include tax legislation that is favorable for fuel cell users.

Plug Power’s GenCore system targets telecom and broadband backup for thousands of switching stations across the country. At $15,000 for a 5 kW system, the GenCore unit compares favorably to lead acid batteries that cost $18,000 for the same output. Furthermore, the GenCore system lasts ten years or more, while the batteries last only three to five years and cost $12,000 to replace at these intervals.

The key attributes of PEM fuel cells include

low operating temperatures, few

moving parts (if any), extremely quiet and

environmentally friendly operation, and rapid

start-up times.

In select markets — most notably battery backup

— fuel cells can compete with existing

technologies.


80

Figure 36. The Evolution of Backup Power Generation

Entirely Dependent on the Power Grid

Diesel Generator

Plug Power’s GenCore System

Source: Smith Barney and Plug Power


81

The longevity of the GenCore system makes a difference for a company like Verizon, which operates close to 200,000 sites requiring on-board backup power. Dr. Saillant expects that in three to five years, Plug Power will have a substantial hold on the premium backup market because the cost of its GenCore system continues to drop steadily (see Figure 37). In particular, material costs have declined as the company has turned to external suppliers as the source of key components (i.e., rather than making them in house).

Figure 37. GenCore Direct Material Cost (DMC) Reduction

index, 2001 = 100%

0%

20%

40%

60%

80%

100%

2001 2002 2003 2004 2005

Expected 2005 DM C Reduction

Source: Plug Power

Following the GenCore product rollout, Plug Power plans to introduce fuel cells into markets such as forklifts and auxiliary power on heavy trucks and marine applications. Thereafter, the GenSys platform is expected to roll out to on-site prime power electricity generation for residential uses. The sweet spot of this market will come when fuel cell power drops below $500 per kW, the point at which a homeowner can justify the sale on a payback basis compared to the $0.08–$0.11 per kilowatt hour (kWh) paid for grid power.

Stand-alone hydrogen generators for fuel cell applications could eventually evolve into a massive global residential opportunity, creating a decentralized power structure and facilitating the sourcing of electricity in remote areas. This could someday preclude the need to extend the power grid in parts of the globe, in much the same way that cell phone technology has eliminated the need to extend the wire line telecom infrastructure. Dr. Saillant believes there is some potential for the development of the residential market in the next five years, but the real growth opportunity likely lies further in the future.

Stand-alone hydrogen generators for fuel cell

applications could eventually evolve into a

massive global residential opportunity.


82

E-Money: PayPal and Euronet Worldwide In 2004, the average number of micropurchases (defined as transactions of less than $5) conducted without cash was less than one per adult per month in Organization for Economic Cooperation and Development (OECD) nations. By 2010, that number is expected to grow to at least ten micropurchases per month, or 25% of the adults in OECD nations — equal to about 1 billion adults29. These transactions will likely include the purchase of everything from train tickets to parking. The facilitator of these and larger transactions will be “e-money”

Cash Is Trash (Credit Cards and Checks Too) Over the millennia, different payment methods have evolved as civilization has advanced. In the earliest societies, barter among people living in close proximity involved the exchange of resources and services for mutual advantage. Subsequently, cattle, including anything from cows, to sheep, to camels, were the first form of money and formed the basis of trade between clans and tribes in different regions.

Today, of course, there are a multitude of payment methods in use in different parts of the globe:

�� In the U.S., credit cards are an extremely popular form of payment (see Figure 38).

�� In France, checks are common, representing over one-third of cashless transactions.

�� In the Netherlands, bank transfers are popular and also account for over one-third of cashless transactions.

�� Finally, in Germany, direct debit is common, accounting for over one-third of cashless transactions in that country.

Figure 38. Relative Importance of Payment Instrument

percentage of total volume of cashless transactions in 2002

0%

20%

40%

60%

80%

100%

U .S . F rance N e the rlands G e rm any

C red it/D eb it C a rd C hecks C red it T rans fe r D irec t D eb it Source: Bank for International Settlements

29 According to Gartner Consulting, “Microcommerce Will Transform the Commercial Landscape,” by S. Landry, A. Linden, J. Fenn, N. Jones, R. Knox, C. Uzureau, D. Garcia, W. Andrews, and G. Daikoku; December 27, 2004.

In 2004, micropurchases were less than one per adult per month. That number is expected to

grow to at least ten micropurchases per

month by 2010.


83

By contrast, in Eastern European countries such as Bulgaria and Romania, cash is the most popular payment instrument, as evidenced by the fact that, in 2002, over 50% of banknotes and coins in circulation were held outside credit institutions, as compared to just 14% for Eurozone countries (see Figure 39).

Figure 39. Banknotes and Coins in Circulation Outside Credit Institutions

as a percentage of narrow money supply in 2002

0%

20%

40%

60%

80%

B u lga ria R om an ia Eu ro a rea

Source: European Central Bank

It is more than a little odd then that, whereas our “primitive” ancestors’ cattle were readily acceptable as payment in any part of the world, woe betide the sophisticated American who tries to pay by credit card in Romania, the Frenchman who tries to pay by check in the Netherlands, or the Bulgarian who offers a stack of lev to a German. But thanks to the explosion of Internet commerce on a global basis (see Figure 40), there are ever-growing numbers of Americans, Romanians, French, Germans, Bulgarians, and Dutch trying to conduct business with each other.

Figure 40. eBay’s Active Users

in millions

0

20

40

60

2001 2002 2003 2004 2005

Source: eBay


84

Of course, one possibility is that the rest of the world will move to a more American model, with credit cards becoming an ever-more-popular form of payment. While this is possible, it seems unlikely, particularly in emerging economies (e.g., Eastern Europe and Latin America) where the lack of a credit history is a key factor inhibiting the issuance of credit cards. Furthermore, in many Western European countries, credit cards have, in general, not been popular given that for many Europeans indebtedness is an uncomfortable concept.

Moreover, credit cards have a range of disadvantages for consumers and merchants. From the consumer’s perspective, credit cards are only useful for business-to-consumer transactions, but not for peer-to-peer commerce. From the merchant’s perspective, credit cards are not economical for micropayments, and they are expensive for larger transactions, given that credit card companies charge 1.7%–2.5% of the transaction as a processing fee.

As for checks, the number of checks written has been falling steadily on a global basis (see Figure 41). From the consumer’s perspective, checks are time-consuming to issue and risky to accept from unknown parties. From the perspective of merchants, checks require special handling, take time to deposit and clear, and carry the risk that they will be lost or will bounce.

Figure 41. Checks as a Percentage of the Total Volume of Cashless Transactions

0%

20%

40%

60%

80%

1998 1999 2000 2001 2002 2003 2004 2005

Canada

France

U.K.

U.S.

Source: Bank for International Settlements

Clearly, the absence of a globally accepted payment method — and the resulting complexity of cross-border payments — is a key issue today. So, too, is the growth of peer-to-peer commerce within both developed and developing economies, as well as the incongruous situation whereby many developing economies have 21st century information technologies but 19th century (or earlier) financial systems. It is these factors, among others, that are driving the emergence of e-money and, in particular, the types of e-money that facilitate 1) global peer-to-peer e-commerce and 2) local day-to-day e-payments.

In emerging economies, the lack of credit history is a key factor inhibiting

the issuance of credit cards.

The absence of a globally accepted

payment method — and the resulting complexity

of cross-border payments — is a key

issue today.


85

Figure 42. The Evolution of Peer-to-Peer Payment Methods

Checks

Wire

��

�� !��"#�$��!�� %��&��

��'��(��)��(��**********�(�� +��'��'��,%�-��+��"�� $��((((****�

��.�� .��%�� /��!��"#�$��

�� /� ��!��&��

PayPal

Source: Smith Barney and eBay


86

Global Peer-to-Peer E-Commerce Prior to the advent of Web transactions, most peer-to-peer sales were conducted in person because the counterparties were in close proximity to one another. Therefore, cash and other paper-based forms of payment tended to make sense because timing was not an issue (i.e., funds were normally exchanged in person), the risks associated with transactions were low, and paper-based forms of payment were cheap to accept.

As technology evolved and the Internet gained popularity, sales began to occur on both a national and global basis. However, paper-based forms of payment are not practical for long-distance transactions among anonymous parties: sending cash long distances does not make sense for obvious reasons, while accepting a check from a stranger creates the risk that the check will bounce.

Enter PayPal, which was founded in 1998 to provide an alternative, Internet-based payment service for consumers and small businesses. PayPal’s service uses the existing financial infrastructure to enable its account holders to send and receive payments via e-mail in real time. PayPal’s success and rapid adoption among eBay users led to the company’s initial public offering in September 2001 and, eventually, to its acquisition by eBay in October 2002. In 2005, PayPal is forecast to generate nearly $1 billion in revenues (up from $700 million in 2004), which represents a significant portion of eBay’s total revenues, forecast to reach over $4 billion.

In terms of numbers of accounts and frequency of use, PayPal is truly an online payments giant:

�� The company processed $19 billion worth of online transactions in 2004; and

�� As for its customer base, in just six years PayPal has grown from no accounts to 64 million accounts, a level that puts it on a par with American Express and at more than twice the number of accounts of JP Morgan Chase (see Figure 43);

Figure 43. Number of Global User Accounts at Leading Transaction Processing Firms

user accounts in millions, year-end 2004

65 64

53

3028

23

13 13

0

20

40

60

80

AmericanExpress

PayPal Discover JP MorganChase

Bank ofAmerica

Wells Fargo Deutsche Bank Barclays

Source: eBay presentation, February 3, 2005

Paper-based forms of payment are not

practical for long-distance transactions

among anonymous parties.


87

�� PayPal’s monthly user tally is twice that of American Express and four times that of Citigroup. On a stand-alone basis, PayPal would rank as the 36th most visited Web property in the U.S., ahead of popular franchises such as ESPN.com and Comcast’s sites.

The picture is similarly impressive on the merchant side. PayPal now has close to twice the number of merchant accounts as credit card behemoths Visa and MasterCard, and more than three times the number of merchant accounts as American Express (see Figure 44).

Figure 44. Number of Merchant Accounts

in millions

5.6 5.6

4.23.5

10.7

0

4

8

12

PayPal Visa Mastercard Discover American Express

Source: eBay presentation, February 3, 2005

PayPal has been able to outgrow traditional transaction heavyweights, in large part because of its attractive fee structure for small to medium-sized businesses (see Figure 45).

Figure 45. Average Transaction Fee as a Percentage of Sales

0%

2%

4%

6%

8%

$0-25k $25-50k $50-100k $100-250k $250-500k $500-1M $1-5M $5-100M >$100M

Merchant Accounts

PayPal

M onthly M erchant Paym ent Volume Source: eBay presentation, February 3, 2005

Small PayPal merchants that have monthly payment volumes of $0–$50,000 can save more than 200 basis points in traditional credit-card transaction fee rates.

PayPal has been able to outgrow traditional

transaction heavyweights, in large

part because of its attractive fee structure

for small to medium-sized businesses.


88

Historically, PayPal has been more costly for larger merchants. Over the past two years, however, PayPal has adjusted its pricing structure to become more attractive to larger merchants. It is estimated that PayPal now holds a 25-basis-point cost advantage over traditional credit card companies for even the largest merchants.

How PayPal Works

PayPal can be used to send or receive funds to or from anyone with an e-mail account in any one of the 45 countries where PayPal operates. There are two ways in which consumers access the PayPal system:

�� They may log on to the company’s website;

�� They may click a PayPal icon on a merchant or auction website that automatically transfers them to the PayPal site.

Once in the PayPal site, an individual may send funds to a merchant or friend by providing the merchant or friend’s e-mail address, transaction amount, and preferred funding source. Individuals may fund a transaction using a credit card, debit card, bank account, or existing PayPal account balance. After the sender has completed these steps, the funds are moved into a separate PayPal account for the receiver. At the same time, the receiver is notified via e-mail that he or she has funds in a PayPal account. A link in the e-mail transfers the receiver to the PayPal website, where he or she may either spend or withdraw the funds (via a PayPal-branded debit card, paper check, or electronic funds transfer.)

The International Opportunity

As Figure 46 illustrates, PayPal is currently being used on only about 23% of eBay’s international transactions, compared to 50% of its U.S. transactions.

Figure 46. Percent of eBay Transactions Closed Via PayPal

0%

20%

40%

60%

80%

1Q03 2Q03 3Q03 4Q03 1Q04 2Q04 3Q04 4Q04

International United States Source: Company reports and Smith Barney

One of the factors limiting PayPal adoption in overseas markets in the past has been its lack of localized sites. PayPal currently has users in 45 countries around the world, but users in more than half of those countries are forced to either spend their PayPal “currency” on eBay or another PayPal vendor, or deposit their funds into a U.S. bank.

PayPal is currently being used on only about 23%

of eBay’s international transactions, compared

to 50% of its U.S. transactions.


89

Over the past few years, PayPal has begun to invest more heavily in localizing its service to meet the needs of its overseas users. So, for example, PayPal has introduced a multicurrency platform that allows international users to accept payments and hold funds in a number of different currencies, including U.S. dollars, Canadian dollars, euros, pounds, Australian dollars, and yen.

The key issues that PayPal needs to address when launching a localized version of the service include:

�� appropriate regulatory approval (often the most time-consuming and unpredictable aspect of the localization process),

�� launching a new PayPal site with a local URL (e.g., www.paypal.uk) and local language,

�� integrating the new site with the local eBay site, and

�� offering local currency conversion and establishing payment methods.

Beyond the regulatory hurdles, PayPal has developed an international platform and strategy that has been tested over time and enables the company to enter new geographic markets with relative ease.

PayPal is currently operating localized versions of its service in ten countries outside the U.S., including the U.K., Canada, Australia, Austria, Belgium, France, Germany, Italy, the Netherlands, and Switzerland. Most of these sites were launched in the past year, and localization has clearly helped to fuel growth in the individual markets. For example, PayPal launched a local version of its service in the U.K. during the third quarter of 2003. In the fourth quarter of 2004, PayPal grew its U.K. accounts at a 144% annual rate. Total U.K. payment volumes were up 205% over the year-ago period, and PayPal was used on 58% of U.K. eBay transactions, up from 40% a year earlier. (Indeed, one-tenth of the entire population of the U.K. has signed up for a PayPal account.)

PayPal launched localized versions in France and Germany during the second quarter of 2004 and experienced similar results. So, for example, two quarters after it launched local sites in those markets, PayPal’s penetration of eBay transactions in France more than doubled, with user accounts up 111%. In Germany, PayPal’s penetration nearly tripled, and user accounts are up 145% since launching the local service.

While PayPal has made great progress on the international front in the past two years, huge growth opportunities still lie ahead. While penetration rates in newly localized countries are growing rapidly, they still remain well below the penetration rates in the United States. So, for example, in terms of the broader e-commerce market, PayPal processed around 9% of all U.S. transactions in 2004. By comparison, PayPal only accounted for around 5% of total international transactions.

Global Merchant Services: Another Opportunity

While most PayPal customers use the service for purchasing items on eBay, other forms of use are growing for PayPal “currency.” PayPal can be used to:

�� pay taxes in York County, South Carolina;

PayPal is currently operating localized

versions of its service in ten countries outside the

U.S., including the U.K., Canada, Australia,

Austria, Belgium, France, Germany, Italy, the

Netherlands, and Switzerland.


90

�� send a donation to the Pat Brody Shelter for Cats in Lunenburg, Massachusetts;

�� purchase digital music at iTunes or DVDs at GlacierBayDVD.com;

�� buy gift vouchers.

eBay includes these types of “off eBay” PayPal transactions within its Merchant Services line of business. Merchant Services is a big market that eBay believes will eventually encompass all global e-commerce transactions that do not take place across the eBay platform. According to Jeff Jordan, president of PayPal, in 2004 eBay generated around $5.7 billion in Merchant Services total payment volumes (TPV) — or 25% of PayPal’s TPV — representing an 80% compound annual growth rate over the past three years (see Figure 47).

Figure 47. PayPal Global Merchant Services (“Off eBay”) Total Payment Volumes

$ in billions

$0.0

$2.0

$4.0

$6.0

2001 2002 2003 2004

Source: Company reports and Smith Barney

Despite strong growth from Merchant Services over the past few years, eBay believes it has just begun to tap this market’s potential; Mr. Jordan estimates that only around 0.5% of international “off eBay” e-commerce transactions are processed across the PayPal platform. The company has announced plans to invest at least $100 million to improve its Merchant Services product, add distribution, and educate merchants about the advantages of using PayPal.

Local Day-to-Day E-Payments While PayPal is a facilitator of global peer-to-peer e-commerce, other forms of e-money are emerging to facilitate local day-to-day e-payments by consumers to businesses (and, in particular, to service providers).

As we noted above, many developing nations find themselves in the incongruous situation of having 21st century information technologies but 19th century (or earlier) financial systems. So, for example, despite relatively high levels of cell phone and Internet penetration (see Figure 48), the lack of checking systems in most Central and Eastern European countries means that bills (e.g., utility bills) must be paid in cash at the biller’s office, a bank, or a post office through the use of a bill payment network. Trips to these locations and long lines represent a huge inconvenience for consumers.

Only around 0.5% of international “off eBay”

e-commerce transactions are processed across the

PayPal platform.


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Figure 48. Cell Phone Users and Internet Users per 100 Inhabitants

in 2003

0

40

80

120

Czech Rep Slovak Rep Poland Hungary Bulgaria Romania Italy France U.S.

Cell Phone

Internet

Source: International Telecommunications Union

Moreover, although some Central and Eastern European countries have direct debit systems that directly take funds out of consumer accounts every month, these systems are rarely used due to billers’ distrust of them and a lack of control over the payment for the consumer. As a result, cash is the dominant payment form in Central and Eastern Europe, accounting for over 50% of household payments in some countries.

It is not just consumers in developing Central and Eastern Europe that have relatively few payment alternatives. As Figure 49 illustrates, relative to the U.S., the countries in the European Union have only about half the number of ATMs, as well as far fewer credit cards and places to use those cards. The situation is much the same throughout Asia and Latin America.

On the point of credit cards, as we noted above, for many Western Europeans, indebtedness is an uncomfortable concept, while the lack of credit histories inhibits credit card growth. (As Figure 49 illustrates, debit cards are twice as prevalent in the European Union as credit cards.) Moreover, some cultures consider credit cards redundant due to flexible bank overdraft policies — the U.K., France, and Italy are the biggest users of checks. Finally, as is the case in Eastern Europe, direct debit is, in general, not a popular payment method for most consumers in Western Europe.

Figure 49. ATM and Credit/Debit Card Penetration Ratios by Region

in 2002

ATMs per Credit Cards Outlets per Transactions Debit Cards Outlets per Transactions

Million People Per Person Million People Per Person Per Person Million People Per Person

East & Central Europe 276 0.1 4,216 5 0.5 3,601 8

European Union 700 0.5 13,213 13 0.9 12,781 35

U.S. 1,220 4.4 47,124 62 0.9 12,128 54 Source: European Central Bank and Bank for International Settlements

It is not just consumers in developing Central

and Eastern Europe that have relatively few

payment alternatives.


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Figure 50. The Evolution of Local Day-to-Day Payment Methods

Barter

Title: An English Naval Officer Bartering with a Maori; from Drawings illustrative of Captain Cook’s First Voyage, 1768–71; Date: 1769; Author: The Artist of the Chief Mourner

Cash

Euronet Worldwide

Source: British Library, Smith Barney, and Euronet Worldwide


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So, reflecting in large part the difficulty of obtaining credit, prepaid phone service is the predominant payment method in the U.K., as well as other European countries. Until recently, the prepaid service was paid for, in most instances, by purchasing a “scratch card” for cash (these cards are similar to the long distance prepaid phone cards an American would see in a convenience store). For retailers, however, the disadvantages of prepaid cards include 1) a large inventory carrying cost, 2) the risk of theft, 3) the need to keep prepaid cards for all the different mobile operators, and 4) the need to keep different denominations of cards (e.g., £5, £10, and £20). But, thanks to an innovative approach by Euronet Worldwide, that prepaid model has changed, both in the U.K. and in other countries, which, as we discuss below, has significant implications for a whole range of local day-to-day e-payments.

Euronet, which has been operating in Europe since 1994, has established an ATM network that is the only intercontinental debit network. ATMs are, however, only part of Euronet’s business strategy — a major long-term growth driver for the company is the introduction of value-added services. Indeed, Euronet states that its mission is “to bring electronic payment convenience to millions who have not had it before.” (In a way, these aspirations echo those of Dartmouth’s John Kemeny and Thomas Kurtz, whom you will recall developed BASIC in order to teach interactive computing to all students, not just those studying computer science. Bill Gates’ subsequent development of a version of BASIC with even greater ease-of-use was key to bringing interactive computing to a larger market.)

In that regard, Euronet’s greatest success of late has been its eTop Up services that distribute minutes for prepaid mobile phones electronically at point-of-sale (POS) locations, ATMs, and on the phones themselves (although most of this activity has thus far happened at POS locations). Over 70% of Euronet’s revenues are now derived from eTop Up services, and the company is the world’s largest processor of prepaid transactions, supporting more than 171,000 POS terminals at 79,000 retail locations around the world.

With eTop Up, Euronet basically acts as an electronics payment network that ties together mobile operators and retail locations. When mobile phone customers go into a retail outlet (e.g., a supermarket), they provide their mobile phone information and pay the retailer for the amount of minutes they wish to purchase. This information is entered into a device that resembles a credit card terminal and is routed to Euronet, which deposits the funds into the mobile operator’s bank account. Euronet then retrieves a prepaid minute PIN code from the mobile operator and prints this code out on the eTop Up terminal located in the retail outlet. The mobile phone user enters the code into the phone and the account is credited with the newly purchased minutes.

eTop Up is proving to be a very popular solution in Europe, where roughly half of the mobile phone plans are prepaid accounts. (Euronet is currently processing twenty million prepaid transactions per month.) Most eTop Up products did not exist four years ago and now account for roughly half of prepaid sales in the U.K. (one of the first countries to adopt eTop Up). Indeed, Euronet is currently the largest provider of eTop Up solutions in three key markets (the U.K., Germany, and

Euronet states that its mission is “to bring electronic payment

convenience to millions who have not had it

before.”


94

Poland), with that leading position being reflected in the significant proportion (at over 60%) of the company’s revenues that are derived from those three countries.

Given the high penetration of cell phones in many countries overseas, prepaid mobile phone service was an obvious market for Euronet to address first. However, the company has since begun to expand into other market segments:

�� Music. In late 2004, Euronet announced a deal with Napster by which consumers in the U.K. can prepay for music downloads in the same way that they prepay for mobile phone service. So, for example, a British teenager can go to a Euronet POS terminal at a retailer, hand over £10 and, in return, receive a special code number. Subsequently, the teenager can go to the online Napster website, enter the code number, and download a designated amount of music.

�� Gambling. It is legal to wager in Australia, and Euronet has an arrangement with a wagering company in that country that allows gamblers to conveniently top up their wagering cards. So, for example, a gambler can go to a Euronet POS terminal at a retailer, hand over A$50 and, in return, receive a special code number. Subsequently, the gambler can dial the wagering service, enter the code number, and top up his electronic wagering card with the prepaid amount.

Euronet’s Chairman and Chief Executive Officer, Michael J. Brown, pointed out to us that there is a wide range of other possible applications of eTop Up, including:

�� ring tones for mobile phones,

�� electronic games, and

�� utility bills.

He observes that any transaction that is recurring and cash based could potentially be moved to the eTop Up model, and he points out that the attraction of this for Euronet is that, given the infrastructure already in place, any additional revenues the company generates will be highly profitable.

Mr. Brown believes that the biggest opportunities for growth are in economies that are largely cash based and where the convenience of eTop Up services will be a big improvement over existing payment methods. Consequently Euronet continues to focus on opportunities in Central and Eastern Europe, Asia, and South America. In particular, Mr. Brown highlighted Brazil, China, and Russia as three attractive markets.

Euronet has begun to expand into other market

segments, including music and gambling.


95

Phood: Senomyx and Martek The word “phood,” which is used to connote food that offers pharmaceutical benefits, has steadily been gaining usage, as an increasing number of phood products have become available to consumers. Importantly, phood contains natural substances (e.g., calcium-enhanced orange juice) and not pharmaceuticals, so that the products do not have to be regulated by the Food and Drug Administration (FDA) as drugs.

On the demand side, increasing awareness of health issues by consumers — spurred in large part by the nation’s obesity epidemic — is driving interest in healthy eating. Moreover, the federal government recently issued new dietary guidelines for Americans, and for the first time since the recommendations were introduced in 1980, they emphasized healthy eating, as well as weight loss and cardiovascular health.

On the supply side, regulators are making it easier for companies to advertise health claims about their products. Until recently, food companies were allowed to advertise the health benefits of their products only if conclusive evidence — reviewed by the FDA — supported the claim. But in 2003, the FDA changed its policy to allow “qualified health claims,” enabling companies to put such claims on their product labels based on limited and preliminary scientific evidence.

Phood Flavor Enhancers One aspect of phood is flavor enhancers that improve the health aspects of packaged food and beverage products by reducing additives such as monosodium glutamate (MSG), salt, and sugar, while at the same time maintaining or enhancing the taste of the product. Of course, mankind’s obsession with enhancing taste by way of food additives goes back thousands of years.

The Chinese were said to be among the first to discover the uses of herbs and spices, both for medicinal purposes and as flavor enhancers in cooking — chrysanthemums were originally grown for their medicinal properties and were a valued ingredient in a Taoist elixir. In Europe, thanks to the “spice trade,” spices became as valuable as gold or silver by the ninth century, and in early America, almost every colonial home featured an herb garden; by the 1950s, however, the additive MSG was being used in considerable quantities in the U.S.

Today, several companies manufacture flavor and flavor enhancer products from traditional methods (e.g., using additives or modified chemical or natural flavors), including International Flavor & Fragrances, Givaudan SA, Symrise, Quest International, and Firmenich. However, Senomyx, a biotechnology company, is at the forefront of developing flavor enhancers derived from sensory and taste-receptor-based technology. The company has a unique approach to developing flavor enhancers by applying the same innovative technologies used by biotechnology and pharmaceutical companies.

Regulators are making it easier for companies to advertise health claims

about their products.

Senomyx is at the forefront of developing

flavor enhancers derived from sensory and taste-

receptor-based technology.


96

Figure 51. The Evolution of Flavor Enhancers

Herbs and Spices

MSG

Enhancers Derived from Sensory and Taste-Receptor-Based Technology



97

Senomyx’s approach has the key advantage of screening a large number of compounds in a more rapid fashion than traditional methods, by utilizing proprietary assays (based on identified human taste receptors) and high-throughput screening technology. The company’s objective is to identify highly potent flavor enhancers that require minimal concentrations (in the range of parts per million) to be utilized in order to replace or reduce the need for unhealthy additives in foods and beverages. Senomyx’s strategy is to forge collaborations with leading food and beverage companies on an exclusive basis for a specific flavor or flavor enhancer in a particular product category in exchange for R&D funding, milestone payments, and royalties on product sales.

The key concept that Senomyx exploits is that taste is a chemical sense — certain receptors can detect chemicals in the environment. In humans, these receptors are found on the tongue in the form of taste buds. Humans can sense five basic taste qualities: bitter, sweet, salty, sour, and umami (savory).

�� The first step in Senomyx’s discovery and development process is to develop taste receptor assays. These assays measure the interactions between the taste receptors and potential flavors and flavor enhancers. Senomyx currently has developed assays in the tastes of savory, sweet, and salty. In addition, the company is also working on an assay of the bitter taste. Dr. Mark Zoller, Senomyx’s chief scientific officer, indicated to us that this assay is more complex to construct since the bitter taste involves a large number of different taste receptors. As a point of interest, Dr. Zoller indicated that the bitter taste evolved as a way to protect humans from poison. A product that could block the bitter taste could be particularly useful for children’s medicines. In late 2004, the company announced a collaboration with Nestlé in the area of coffee and coffee whiteners, and Smith Barney biotechnology analyst Elise Wang believes this program is focused on the development of a bitter blocker.

�� After these assays have been developed, Senomyx uses automated high-throughput screening to rapidly assess its libraries of diverse natural and synthetic compounds to identify “hits.” This approach provides the ability to screen a larger number of compounds in a more rapid fashion than traditional methods: Senomyx screens approximately 150,000 compounds per year, compared with traditional approaches that screen, on average, 1,000 compounds per year. A panel of trained taste testers is then used to evaluate the taste effect of these compounds. Based on the panel’s analysis, Senomyx will select compounds that have demonstrated a positive taste effect.

�� The next step is to optimize, or chemically enhance, the lead compound to allow lower amounts of it to be used in the consumer product. The optimized compounds that meet the desirable taste attributes in food and beverage will become the product candidates.

�� After the product candidates are determined, Senomyx and its collaborators will choose one or more of them for commercialization (see Figure 52). The first step in this process is that the product candidates are evaluated for safety in animal studies. Following the safety evaluation, Senomyx anticipates that its

Senomyx’s strategy is to forge collaborations with

leading food and beverage companies on an exclusive basis for a specific flavor or flavor

enhancer.


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collaborators will test market the products for approximately six to 12 months to determine consumer acceptance.

Figure 52. Taste Areas and Associated Product Categories

2003 Estimated

Taste Areas Example Product Categories Worldwide Sales

Savory and Salt Ready meals, sauces, spreads, frozen food, beverages, $368 billion

meal replacements, soups, pasta, dried food, snack foods,

processed meats, processed cheeses, and cracker products

Sweet Confectionaries, cereal, ice cream, beverages, $383 billion

and bakery products Source: Euromonitor 2004 (for estimated worldwide sales) and Smith Barney

Although Senomyx’s product candidates are developed using similar techniques applied in the therapeutic drug area, they are regulated as flavor ingredients, resulting in a lower level of regulatory scrutiny. In addition, these products are unlikely to be reviewed as food additives (e.g., NutraSweet), which typically require extensive human testing, since minimal concentrations (in the range of parts per million) of Senomyx’s flavors and flavor enhancers are expected to be utilized in food and beverage products.

In that regard, Senomyx recently announced it has received Generally Recognized as Safe (GRAS) designation for the company’s savory flavor enhancers from the Flavor and Extract Manufacturing Association (FEMA) panel. (These flavor enhancers are designed to reduce or eliminate the amount of monosodium glutamate [MSG] and inosine monophospate [IMP], an expensive flavor enhancer of the glutamate taste.) FEMA has a working relationship with the FDA, so no separate FDA approval is required. As for overseas approvals, Dr. Zoller expects that European approval should follow about two years after FEMA GRAS designation.

Senomyx has collaboration agreements with four of the largest packaged food and beverage companies (see Figure 53).

Figure 53. Market Opportunities for Senomyx and Collaborators

Source: Company reports

Senomyx’s products are regulated as flavor

ingredients, resulting in a lower level of

regulatory scrutiny.


99

�� Senomyx has granted Campbell Soup exclusive product rights to wet soups and savory beverages in the salt enhancement program.

�� Coca-Cola has been granted exclusive product rights to soft drinks and other nonalcoholic beverages, and a co-exclusive agreement for powdered beverages. Elise Wang believes the focus of this collaboration is on developing a sweet enhancer.

�� Kraft Foods has been granted a co-exclusive agreement for powdered beverages in the sweet enhancement program.

�� Nestlé has been granted exclusive product rights for dehydrated and culinary food, frozen food, and wet soups in the savory enhancement program, and for dehydrated and culinary food and frozen foods in the salt enhancement program. Significantly, because of the aforementioned GRAS determination, Nestlé will now be able to begin consumer acceptance testing of food products (e.g., sauces, frozen foods, processed cheese, and snack foods) containing Senomyx’s savory enhancers. Senomyx’s Dr. Zoller anticipates that among the key selling points of these products will be the reduction or elimination of MSG, as well as the enhancement of naturally occurring savory flavors. Senomyx has said that it anticipates the first commercial sale of such products could occur during the first half of 2006, which would result in royalty payments to the company.

Based on the existing agreements with these four collaborators, Senomyx’s immediate addressable market opportunity is approximately $36 billion in sales. Assuming the regulatory success of these flavor enhancers, Senomyx could receive royalties on product sales in a range of 1%–4%, suggesting approximately $360 million–$1.44 billion in revenues. Note that Senomyx’s current license agreements are exclusive arrangements for specific flavor enhancers in a particular product category. Therefore, Senomyx has the ability to license the flavor enhancers from existing collaborations for different food and beverage product categories.

Phood Additives As we noted above, in 2003 the FDA changed its policy to allow “qualified health claims,” enabling companies to put health claims on their product labels based on limited and preliminary scientific evidence. Under the new system, food makers have to seek FDA approval first, and the FDA responds by grading each potential claim: “A” for scientifically proven claims; “B” for those in which there is scientific evidence supporting the claim, but the evidence is not conclusive; “C” when the evidence is limited and not conclusive; and “D” when there is little scientific evidence supporting the claim. So, for example, in 2004 the FDA approved the availability of a qualified health claim for reduced risk of coronary heart disease on foods (such as oily fish) that contain docosahexaenoic acid (DHA) omega-3 fatty acids.

In addition to these possible cardiovascular benefits, DHA is essential for the proper functioning of the brain in adults, and for the development of the nervous system and visual abilities during the first six months of life. DHA is naturally found in breast milk, as well as in cold-water fatty fish, organ meats, and eggs.

Senomyx could receive royalties on product

sales in a range of $360 million–$1.44 billion.

The FDA approved a qualified health claim for reduced risk of coronary

heart disease on foods that contain

docosahexaenoic acid (DHA) omega-3 fatty

acids.


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Figure 54. The Evolution of Food Additives adding vitamin C to your diet

adding calcium to your diet

adding DHA to your diet



101

According to the National Institutes of Health (NIH), nutrition experts have issued recommendations that adults consume approximately 220 mg of DHA per day, and pregnant and lactating women consume approximately 300 mg of DHA per day. The experts also indicated that adequate intake for infants on infant formula should be approximately 0.35% DHA of total fat.

In that regard, a number of companies currently offer DHA products:

�� The major manufacturers of DHA-containing fish oil are BASF and Hoffman-LaRoche.

�� In addition, Nutrinova, an operating unit of Celanese Ventures, is actively marketing a DHA microalgal nutritional oil to the food and beverage and dietary supplement markets in the U.S. and worldwide.

�� The Ross Products division of Abbott Laboratories submitted a Generally Recognized as Safe (GRAS) filing on January 2, 2002, seeking FDA concurrence that its fish oil source of DHA and its fungal source of ARA are GRAS when used as ingredients in infant formula. No decision has been made by the FDA to date, and the GRAS notification continues to be under consideration.

�� Other major pharmaceutical, chemical, specialized biotechnology, and food companies, as well as certain academic institutions and government agencies, are conducting research and development and commercialization of products and technologies that may be competitive in the DHA area.

Martek Biosciences manufactures the only source of DHA approved by the FDA for use in infant formula. The FDA has also approved Martek’s manufacture of arachidonic acid (ARA), an omega-6 fatty acid found in the brain, which plays an important role in brain development for infants. Specifically, in May 2001, the FDA completed a favorable review of and granted Martek’s DHA/ARA GRAS notification regarding the use of its DHA and ARA oil blend in infant formulas.

Martek’s nutritional oils are derived from microalgae; the company has a library of over 3,500 species of microalgae, and it has key patents for numerous biological, chemical, and manufacturing processes related to microalgae commercialization. Importantly, Martek’s nutritional oils have several key competitive advantages over fish oils and other currently available sources of DHA/ARA.

�� For a start, Martek’s oils contain minimal fatty acids, such as EPA, and no toxins, such as methylmercury, polychlorinated biphenyls (PCBs), and dioxin, which are found in fish oil.

�� Martek’s products are derived from all-natural, vegetarian sources, which are free of pollutants and toxins and are easily digestible.

�� Furthermore, Martek’s products have minimal taste and odor compared to fish oil.

�� Finally, Martek has a higher oxidative stability and longer shelf life than fish oil, making the products more amenable to the spray drying process required for the powdered infant formula and other applications, such as food.

Martek Biosciences manufactures the only

source of DHA approved by the FDA for use in

infant formula.

Martek’s oils contain minimal fatty acids, are

derived from all-natural, vegetarian sources, have

minimal taste and odor, and have a high

oxidative stability and long shelf life.


102

Dr. James Flatt, Martek’s senior vice president of research and development, points out that the company’s approach is to go to “nature’s original source” for DHA rather than to go indirectly through, for example, fish oils (which contain DHA because the fish eat other sea life that feed on the microalgae).

In the near term, the infant formula market will remain the primary driver for growth in product sales and earnings for Martek. The company currently has license agreements with 16 infant formula manufacturers, representing approximately 70% of the worldwide and 100% of the U.S. infant formula markets.

In addition to infant formula, Martek has entered into an exclusive license agreement with Mead Johnson for Martek’s DHA as a nutritional supplement (i.e., vitamin) for pregnant and lactating women in North America and parts of Asia. DHA is considered essential for the optimal development of an infant’s brain and eyes, both during pregnancy and after birth. DHA may also help prevent preterm (premature) labor and may help protect against postpartum depression.

However, the greatest growth opportunity for Martek will likely be in the food area, as the health benefits of DHA become more widely publicized. With regard to these health benefits, we noted above that the FDA approved a qualified health claim concerning the cardiovascular benefits of DHA. Dr. Flatt points out that there is a growing body of data that DHA also has benefits for brain and eye development, and not just in infants. Indeed, monkeys that were deprived of DHA were shown to perform relatively poorly on cognitive tests. Other studies suggest that DHA may decrease the risk of diseases such as dementia and Alzheimer’s in older adults, given that people consuming high levels of DHA (by eating fish) experienced significantly lower incidence of these diseases.

Martek recently announced that it has entered into a 15-year, nonexclusive DHA license and supply agreement with Kellogg (in food products). Under the terms of the agreement, Kellogg will develop food products containing Martek’s DHA and must purchase almost all of its DHA needs from Martek for products in the U.S. and other territories. Importantly, Kellogg has agreed to display the Martek DHA logo on all product packages, print advertisements, and certain other promotional materials. Martek indicated that Kellogg intends to launch the initial product containing Martek’s DHA in mid-2006.

Dr. Flatt speculates that DHA could first be introduced into food products that children consume, such as yogurts and cereals. The market opportunity for these product categories is sizable (see Figure 55). For example, in 2004, Kellogg reported total worldwide RTE (ready-to-eat) cereal sales of $5.3 billion (and North America sales of $2.4 billion) and total snack sales of $2.8 billion (snack bar sales of $479 million). Based on the latest AC Nielsen data, Kellogg is the leading food company in RTE cereal, with a market share of 32.3%, and it represents 21.8% of the snack/granola bars category. Martek indicated that, if it were to capture the entire cereal market, its market opportunity would be $670 million in the U.S. and $1.1 billion worldwide.

There is a growing body of data that DHA also has benefits for brain and eye development,

and not just in infants.

Martek recently announced that it has

entered into a 15-year, nonexclusive DHA license and supply

agreement with Kellogg (in food products).

Martek indicated that, if it were to capture the

entire cereal market, its market opportunity

would be $670 million in the U.S. and $1.1 billion

worldwide.


103

Figure 55. Martek’s Potential DHA Food Opportunity

Estimated Market Opportunity* ($MM)

Category Examples U.S. Worldwide

Dairy Milk, eggs, cheese,

yogurt

$680 $1,360

Beverages Nutritional drinks, fruit

juice

$740 $1,480

Cereals Breakfast cereal,

nutritional bars, cereal

snacks

$670 $1,110

Breads Bread, crackers, bagels $2,540 $5,100

* Assumes 100% penetration rate and current DHA pricing

Source: Martek Biosciences

As mentioned above, in comparison to fish-oil derived DHA, Martek’s microalgae-derived DHA has the benefit of being free of pollutants and toxins, such as PCBs, mercury, and dioxins. Furthermore, Martek’s DHA can be formulated to be added to both dry and wet mixes with minimal taste and odor, making it an optimal food and beverage additive.


104

Technology Candidates30

Technology Description Vendors

Artificial Intelligence Artificial intelligence technology consists of

computer-based software and algorithms that

mirror humans’ capacity for learning,

contemplation and judgment.

IBM and MEDai

Audio Mining Applies data-mining operations (like filtering,

clustering, categorization, pattern matching and

conceptual search) to audio streams, without the

need for human indexing of the content.

Autonomy, BBN Technologies,

Nexidia, Nice Systems, ScanSoft,

StreamSage, Utopy, Verint

Systems, and Witness/Eyretel

Augmented Reality In augmented reality, the user’s view of the real

world is supplemented with relevant information,

typically by using a heads-up display to

superimpose text or graphics about the user’s

environment over the real-world objects.

Kaiser Electro-Optics,

Microvision, and MicroOptical

Bioinformatics The application of computer, mathematical, and

statistical techniques to analyze and characterize

the molecular components of living things.

Accelrys, LION bioscience, and

MDL Information Systems

Biometrics Biometrics use an element of “what you are” as

a form of real-time identification and

authentication. They include finger or hand

scans, handwriting on a tablet, keyboard

ballistics, iris scan, facial recognition, and other

systems.

Bioscrypt, DigitalPersona,

Identix, Polaroid, Sony,

Verdicom, Viisage, and Visionics

Blu-Ray Blu-ray technology uses a blue-violet laser to

read and write up to 27GB of data onto a single-

layer DVD (for example, two-plus hours of HDTV

or 13 hours of standard-definition television). A

double-layer disc will offer twice this capacity.

Dell, HP, Samsung, and Sony

Computer-Brain Interface Computer-brain interfaces interpret distinctive

brain patterns generated voluntarily by a user as

commands to a computer or other device.

Brain Actuated Technologies,

Georgia State University, Neural

Signals, and University of

Michigan

Contextual Personalization Portal delivers personalized views based on such

contextual attributes as device, bandwidth, time,

location, and task at hand.

Art Technology Group (ATG),

BroadVision, IBM, and Vignette

30 This list contains representative solutions and providers for each technology category. The inclusion of a vendor or solution in this summary is not an indication of its leadership for any particular category.

Appendix A


105


Controlled Medical Vocabulary A controlled medical vocabulary is used to

normalize the concepts and terms used to

describe clinical conditions.

3M, Apelon, Health Language,

and Medicomp Systems

(Medcin)

Digital Rights Management

Technologies

Technologies designed to protect content after

distribution through the use of policy, encryption,

and watermarking

Microsoft, Real, ContentGuard,

Macrovision, and InterTrust

Driver-Load Matching Automated matching of remote drivers and

tractor-trailers, connecting them with the

nearest available shipment for their next run.

Typically communicated via wireless networks

and in-cab PCs.

Direct Freight Services, OrderPro

Logistics, Schneider National,

Teletouch, and TransCore

Dual Clutch Transmission A transmission system based on a manual

gearbox, by which the driver can either

initiate the gear change manually, or can

leave the shift lever in fully automatic mode.

BorgWarner

E-Forms E-Forms are automated and interactive

templates for the capture, processing, display

and output of defined sets of business data.

Adobe Systems, Cardiff (now

Verity), FileNet, PureEdge

Solutions, and Marketing

Management Analytics

Electronic Ink Digital paper resembles a sheet of plastic-

laminated paper. Beneath the plastic are tiny

microscopic beads that change color to form text

and images. The result is a nearly paper-thin,

rewritable display.

E-Ink and Gyricon Media

Electronic Shelf Labels Programmable wireless electronic devices that

affix to store shelf labels. Alphanumeric display

is typically used to display item pricing or

promotional information in real time.

Eldat Communications, IBM,

NCR, and Telepanel

Embedded Diagnostic Tools Machinery from many manufacturers will include

diagnostic and monitoring capabilities, built-in

and onboard, that self-adjust or provide

diagnostic information to maintenance systems.

Caterpillar, Komatsu, General

Electric, and Rolls-Royce

Emotion Detection The task of recognizing emotional states of a

human (such as through face or voice

recognition), with the objective of using this

information for better user interfaces.

MIT Media Lab and NCR


106


EMPI An enterprise master person index (EMPI)

provides the ability to cross-link the same

member in multiple applications without

rewriting and exchanges predetermined

identifiers during flow between application roles.

Will be especially important for eliminating the

Social Security account number as an external

look-up ID.

Initiate Systems, Quovadx, and

SeeBeyond

E-Signatures E-Signatures are associated with electronic

messaging. They bind the signer to whatever

the document states, prevent alterations once

signed, and prevent the fraudulent transfer of a

signature on one document to another. This

technology is used in a number of authentication

methods

Honeywell, Rockwell

International, and Siemens

Health Spending Account “Smart

Card”

Card technology that provides data on

eligibility, co-payments, and flexible

spending account and health savings

account (HSA) payments.

UnitedHealth Group

Idea Management A process of developing, identifying, and using

valuable insights or alternatives that otherwise

would not have emerged through normal

processes. Typically campaign focused.

Akiva and Imaginatik

Infrastructure Virtualization Ability to leverage underutilized technology and

operational resources, resulting in an optimal

mix of predictable variable cost and operational

leverage.

Various independent software

vendors and IBM

Inkjet processes Depositing semiconductor materials onto a

flexible substrate using an inkjet-style process.

Alien Technology, Cambridge

Display Technology, Philips,

Plastic Logic, and Xerox

Interactive TV Two-way television services, including electronic

program guides (EPGs), video on demand,

interactive advertising, and information and

communication services.

GoldPocket Interactive, Liberate

Technologies, and MSN TV

LEP/OLED Light-emitting polymers (LEPs) are based on long

chain polymers that fluoresce when a current is

passed through them. Using inkjet technologies,

LEPs can be “printed” onto practically any

substrate to form a display of light emitting

pixels.

Cambridge Display Technology,

Lucent Technologies, and Philips


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Lifetime Value The potential value of future relationships based

on calculations of a set of predictive behavioral

models.

Teradata

Location “Aware” Services Services attached to location technologies in the

cellular network, such as enhancing mobile

applications through routing, mapping, and

integration of geographic information systems.

Various independent software

vendors

Mesh Networks Sensor Sensors are ad hoc networks formed by dynamic

meshes of peer nodes. Each includes simple

networking, computing, and sensing capabilities.

Some implementations offer low-power

operation and multiyear battery life.

Millennial Net, Dust Networks,

Ember, Zensys, Intel, and

Crossbow Technology

Micro Fuel Cells Micro fuel cells offer an alternative to

batteries as a power source for mobile

devices. They have the potential to provide

two to three times the energy capacity of

lithium ion batteries.

Motorola, Toshiba, Casio, NEC,

Sony, Panasonic, and

Mechanical Technology

Microelectromechanical Systems Semiconductor devices incorporating structures

that can physically move, in addition to

electronic circuits.

NA

Micropayments Charging small amounts (cents or fractions

of cents) per Web transaction — for example,

by page view or for streaming media. Usually

done in prepaid scenarios.

Amdocs, bcgi, Convergys,

Portal Software, Qpass, and

Trivnet

MRAM Magnetic tunnel junctions use an oxide to

separate a layer of metal with a fixed magnetic

orientation from a metal layer that can be

magnetically flipped. This is enhanced

semiconductor storage.

HP, IBM, Infineon Technologies,

and Motorola

Nanotech-Based Manufacturing Use of nanotechnology to provide manufacturing

capacity.

Epic Systems, Expresiv

Technologies, and MedQuist

Natural Language Processing The analysis and manipulation of words and

phrases entered in natural language by users

employing artificial intelligence.

iPhrase and Mindfabric

Oil and Gas Drilling and Completion

Technology

Energy exploration and production tools and

technologies.

Oilfield equipment and

services companies


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P2P Networks Network consisting of peer nodes capable of

both requesting and responding to supported

transactions, rather than clients and servers.

NA

“Phood” Food that offers pharmaceutical benefits. Senomyx and Martek

Biosciences, among others

PHR Patient health records (PHRs) are Internet-

accessible repositories for storing an individual’s

health information. PHRs are used to provide

patients with a copy of the most important

clinical information pertaining to their medical

care.

LifeMasters, Supported SelfCare,

MEDecision, and WellMed

Power Line Broadband The transmission of broadband traffic over the

power line infrastructure.

Amperion, Current Technologies,

DS2, and Main.net

Communications

Product content and data management Product content and data management is a set

of related disciplines, technologies, and solutions

used to create and maintain consistent

interpretation of product data across trading

partners to facilitate commercial exchange.

GXS/HAHT, IBM/Trigo, QRS,

UCCnet, and Velosel

Real-Time Patient Remote

Monitoring

Real-time remote monitoring for patients

with, for example, congestive heart failure or

low blood sugar levels.

Medtronic

Reference Data Standards Reference data standards help identify and

describe customers, products, instruments, and

other entities by standardizing these processes

to a set of consistent identifiers and codes.

No vendors have emerged. Most

of the development work is

happening through in-house

development and industry

groups, including the Reference

Data Coalition and the Reference

Data User Group.

Retinal Displays Retinal displays are a type of heads-up display

that “paint” a picture directly on the sensitive

part of the user’s retina. The image appears to

be on a screen at the user’s ideal viewing

distance. There is no actual screen in front of

the user, just some simple optics (e.g., modified

eyeglasses) that reflect the image back into the

eye.

MicroOptical and Microvision


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RFID (Case/Pallet) RFID (case/pallet) solutions target tracking

inventory at the case and pallet level.

Alien Technology, Checkpoint

Oat Systems, GlobeRanger,

IBM, Manhattan, RedPrairie,

Samsys, Symbol, and Texas

Instruments

RFID Payments: Worldwide Payment transactions outside the U.S. are

initiated via contact-less technologies embodied

in smart cards, tags, key fobs, and others.

Debits can be made to bank-card accounts or

prepaid accounts.

IT outsourcing consortia.

Telematics Network-enabled cars, providing in-car services

such as cell phone integration, remote

diagnostics, roadside SOS, e-mail, vehicle

tracking, Global Positioning System navigation,

and traffic information.

ATX and General Motors(OnStar)

Truth Verification Truth verification is the analysis of a voice signal

(live or recorded) to look for the variations

caused by truthful versus untruthful utterances.

Nemesysco

Video on Demand These are movies, television programs, and

other video downloaded or streamed via the

Internet. Streaming video is like VOD offered via

cable systems in that consumers may interact

with video in real time: pause, fast-forward,

rewind, answer polls, transact, etc. Download

services more closely resemble the satellite

store-and-forward model.

Atom Films, CinemaNow,

MovieLink, and Akimbo

Video Telephony Full duplex, real-time, audiovisual

communications between/among end users over

high-bandwidth networks. In cable broadband

networks, traffic is IP-based and uses Data-

Over-Cable Service Interface Specification

(DOCSIS) 1.1/PacketCable technology.

NA

Virtual Prototyping Highly detailed modeling of a product and its

environment. It extends beyond CAE to include

realistic rendering, ability to be manufactured,

service processes, product ergonomics, virtual

reality, haptics, and so on. Advanced virtual

prototyping incorporates statistical modeling of

manufacturing and variability of material

properties, environmental conditions, and usage

modes.

No notable vendors at this time.

Vendors likely to deliver this

technology are Altair

Engineering, ANSYS, Dassault

Systemes, MSC.Software, PTC,

and UGS


110


Voice over Internet Protocol The packetization of voice traffic for

transport over an IP network.

Avaya, Cisco Systems, Nortel

Networks, and Siemens

Web Services–Enabled Business Model Web Services–enabled business models are new

approaches to doing business among enterprises

and consumers that would not have been

possible without the benefits of Web services.

Webify

ZigBee (802.15.4) ZigBee (802.15.4) is a global wireless standard

for reliable, secure, low-power remote

monitoring and control applications — including

consumer applications such as electronics,

home automation, machine-to-machine (M2M),

and gaming.

Ember, Honeywell, Philips,

Motorola, Samsung, and

Invensys

Source: Gartner Consulting and Smith Barney


111

Figure 1. Summary of Nine Key Technologies and 12 Techno Savvy Companies....................................7 Figure 2. Technology Adapters, Exploiters, and Innovators....................................................................11 Figure 3. Edison Electric Light................................................................................................................16 Figure 4. The Model T............................................................................................................................19 Figure 5. RCA Radiola ...........................................................................................................................21 Figure 6. Possible Future Uses for the Phonograph...............................................................................22 Figure 7. The Gramophone....................................................................................................................23 Figure 8. Sony Model 250 Solid State Stereo Tape Recorder ................................................................25 Figure 9. Sony TR 610 Transistor radio .................................................................................................26 Figure 10. RCA Television .....................................................................................................................28 Figure 11. IBM 604 Electronic Calculator ...............................................................................................31 Figure 12. Texas Instruments’ Integrated Circuit ....................................................................................32 Figure 13. Microsoft Windows 3.0 ..........................................................................................................34 Figure 14. Genentech’s Human Insulin ..................................................................................................35 Figure 15. Today’s Technology Adapters, Exploiters, and Innovators ....................................................39 Figure 16. The Evolution of the Automobile Transmission......................................................................41 Figure 17. Performance Improvements of DCT Transmission vs. 6-Speed Manual ................................42 Figure 18. The Evolution of Energy Production ......................................................................................45 Figure 19. EOG’s Technological Advantage Is Now Being Priced into the Region .................................46 Figure 20. Employer Interest in HSAs ....................................................................................................47 Figure 21. The Evolution of Medical Payment Processes.......................................................................48 Figure 22. Comparative Analysis of Health Plans...................................................................................51 Figure 23. Capital Expenditures by MCOs (2004) ..................................................................................52 Figure 24. The Evolution of Inventory Management ...............................................................................54 Figure 25. Key RFID Metrics..................................................................................................................57 Figure 26. IP Telephony Implementation Schematic .............................................................................. 58 Figure 27. The Evolution of Enterprise Communications........................................................................59 Figure 28. Market Share by Technology.................................................................................................62 Figure 29. The Evolution of Medtronic’s CHF Monitoring Technology ....................................................68 Figure 30. Medtronic Carelink Adoption .................................................................................................68 Figure 31. The Evolution of Diabetes Management................................................................................71 Figure 32. The Evolution of the External Artificial Pancreas ...................................................................73 Figure 33. Improvements in Laptop Components...................................................................................74 Figure 34. The Evolution of Portable Power Sources .............................................................................75 Figure 35. Comparative Performance of Lithium Ion Batteries vs. DMFCs .............................................77 Figure 36. The Evolution of Backup Power Generation ..........................................................................80 Figure 37. GenCore Direct Material Cost (DMC) Reduction ...................................................................81 Figure 38. Relative Importance of Payment Instrument..........................................................................82 Figure 39. Banknotes and Coins in Circulation Outside Credit Institutions..............................................83 Figure 40. eBay’s Active Users ..............................................................................................................83 Figure 41. Checks as a Percentage of the Total Volume of Cashless Transactions ...............................84 Figure 42. The Evolution of Peer-to-Peer Payment Methods..................................................................85 Figure 43. Number of Global User Accounts at Leading Transaction Processing Firms .........................86 Figure 44. Number of Merchant Accounts ..............................................................................................87 Figure 45. Average Transaction Fee as a Percentage of Sales..............................................................87 Figure 46. Percent of eBay Transactions Closed Via PayPal .................................................................88 Figure 47. PayPal Global Merchant Services (“Off eBay”) Total Payment Volumes................................90 Figure 48. Cell Phone Users and Internet Users per 100 Inhabitants .....................................................91 Figure 49. ATM and Credit/Debit Card Penetration Ratios by Region ....................................................91 Figure 50. The Evolution of Local Day-to-Day Payment Methods...........................................................92 Figure 51. The Evolution of Flavor Enhancers........................................................................................96 Figure 52. Taste Areas and Associated Product Categories ..................................................................98 Figure 53. Market Opportunities for Senomyx and Collaborators ...........................................................98 Figure 54. The Evolution of Food Additives..........................................................................................100 Figure 55. Martek’s Potential DHA Food Opportunity ...........................................................................103

Table of Figures


112

Notes


113

Notes


114

Notes


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ANALYST CERTIFICATION Appendix A-1

We, Edward Kerschner and Michael Geraghty, the authors of this report, hereby certify that all of the views expressed in this research report accurately reflect our personal views about any and all of the subject issuer(s) or securities. We also certify that no part of our compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or view(s) in this report.

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Smith Barney Equity Research Ratings Distribution Data current as of 4 April 2005 Buy Hold SellSmith Barney Global Fundamental Equity Research Coverage (2591) 39% 43% 19%

% of companies in each rating category that are investment banking clients 54% 57% 42%Guide to Fundamental Research Investment Ratings: Smith Barney’s stock recommendations include a risk rating and an investment rating. Risk ratings, which take into account both price volatility and fundamental criteria, are: Low [L], Medium [M], High [H], and Speculative [S]. Investment ratings are a function of Smith Barney’s expectation of total return (forecast price appreciation and dividend yield within the next 12 months) and risk rating. For securities in developed markets (US, UK, Europe, Japan, and Australia/New Zealand), investment ratings are: Buy [1] (expected total return of 10% or more for Low-Risk stocks, 15% or more for Medium-Risk stocks, 20% or more for High-Risk stocks, and 35% or more for Speculative stocks); Hold [2] (0%-10% for Low-Risk stocks, 0%-15% for Medium-Risk stocks, 0%-20% for High-Risk stocks, and 0%-35% for Speculative stocks); and Sell [3] (negative total return). For securities in emerging markets (Asia Pacific, Emerging Europe/Middle East/Africa, and Latin America), investment ratings are: Buy [1] (expected total return of 15% or more for Low-Risk stocks, 20% or more for Medium-Risk stocks, 30% or more for High-Risk stocks, and 40% or more for Speculative stocks); Hold [2] (5%-15% for Low-Risk stocks, 10%-20% for Medium-Risk stocks, 15%-30% for High-Risk stocks, and 20%-40% for Speculative stocks); and Sell [3] (5% or less for Low-Risk stocks, 10% or less for Medium-Risk stocks, 15% or less for High-Risk stocks, and 20% or less for Speculative stocks). Investment ratings are determined by the ranges described above at the time of initiation of coverage, a change in risk rating, or a change in target price. At other times, the expected total returns may fall outside of these ranges because of price movement and/or volatility. Such interim deviations from specified ranges will be permitted but will become subject to review by Research Management. Your decision to buy or sell a security should be based upon your personal investment objectives and should be made only after evaluating the stock’s expected performance and risk.

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