2020 Innovation - Pulling the Future Towards US - Ed Maguire

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2020 innovation Special report November 2011

Pulling the future towards US

US strategy

2 [email protected] 2 November 2011

Contents

Executive summary ............................................................................ 3

Disruption, transition and transformation .......................................... 4

Innovation across industries ............................................................ 19

Fertile ground for innovation............................................................ 31

Technological innovation enablers ................................................... 53

Inhibitors to innovation ................................................................... 62

Appendices

1: Top 20 innovations for 2020 ..............................................................74

2: Interviews .......................................................................................96

3: Company profiles ........................................................................... 185

Important disclosures .................................................................... 247

All prices quoted herein are as at close of business 27 October 2011, unless otherwise stated

Innovative research by CLSA

Ed Maguire [email protected] (1) 212 261 3997

David Kwon (1) 212 261 7586

Ryan Puzycki (1) 212 261 7240

US equity research team

AsiaUSAResearch

TM

The group of companies that comprise CLSA are affiliates of Credit Agricole Securities (USA) Inc. For important disclosure information please refer to page 247.

Executive summary US strategy

2 November 2011 [email protected] 3

2020 innovation Innovation is at the core of the American success story. Despite the challenging economy and increasing competition from Asia, the USA retains the resources, infrastructure and a culture of innovation to drive growth and wealth creation through the coming decade into 2020. Companies that win must embrace and harness technology to their advantage. We highlight context, trends, catalysts for and obstacles to innovation. In addition to interviews with thought leaders, we and our US research colleagues present key innovative companies, technologies and trends critical for investors.

Bubbles, crashes and recessions in the 2000s are the outcome of a multidecade technology “super-cycle.” A connected, empowered world compels American organizations to embrace creative, destructive change and to adopt new, open and lightweight innovation models. The coming decade will look different, but innovation will create growth opportunities for startups as well as established companies. Aging demographics, ubiquitous connectivity and powerful nanotech, computational and scientific advances will shape the trajectory of innovation across all industries.

The USA leads in key innovation metrics across industries, but progress has been slipping as China, India and other developing countries increasingly engage the global marketplace. However, American R&D spend, patent activity and innovative output remain strong, particularly in IT and the life sciences.

Cloud computing and the mobile internet extend a “digital infrastructure” that lowers barriers to innovation and accelerates the pace of change. Meanwhile, the American venture-capital ecosystem continues to foster the rise of new industries, businesses and opportunities for job creation.

Open source, the cloud, mobility and commoditization of hardware/software and bandwidth provide the catalyst to create value and accelerate innovation - all facilitated by software.

However, there are challenging obstacles. The venture-funding model is under pressure from volatile markets and declining funding. Policy makers need to address a looming spectrum shortage, immigration restrictions and regulatory expansion that jeopardize innovation, while overly aggressive patent litigation threatens startups as well as established companies.

Growth in total US patent grants and applications

0

10

20

30

40

50

60

70

80

90

100

1883 1897 1911 1925 1939 1953 1967 1981 1995 2009

0

50

100

150

200

250

300

350

400

450

500Grants Applications Approval rate (LHS)(%) (000)

Source: US Patent & Trademark Office, Credit Agricole Securities (USA)

Innovation across industries

Pulling the future towards US as technology

accelerates change

Disruption, transition and transformation

Fertile ground for innovation

Innovative output continues to be robust,

while government struggles to keep pace

Enablers and inhibitors of innovation

Section 1: Disruption, transition and transformation US strategy


Disruption, transition and transformation As we near the end of 2011, America is struggling with a difficult economy, persistent high unemployment and contentious policy debates. The country’s manufacturing base has been eroded by aggressive, lower-cost and increasingly sophisticated competition from Asia. Global rankings in competiveness have slipped from regulatory creep, as financial capital- markets activity (particularly IPOs) has migrated to Hong Kong, London and other centers. Mounting concerns over structural deficits at the federal, state and local levels loom large, while lack of demand and tenuous business confidence continue to weigh on job creation.

America demands invention and innovation to succeed.

Kit Bond, former US senator

While these are challenging times for the USA, the crucible of recession has proven again and again the catalyst for new ideas, entrepreneurs and business. The USA retains the resources, imagination and culture that propelled the country to global leadership from the post World War II era to the present day. Innovation is the key to reviving economic growth. Innovation is embedded in America’s DNA.

Innovation is the central issue in economic prosperity.

Peter Drucker, writer, management consultant

Innovation is a broadly defined term that embraces invention, adaptation and evolution, but inherently is tied to commercialization in a marketplace. The American Heritage Dictionary defines innovation as ‘The act of introducing something new,’ while Webster’s definition is simply ‘A new idea, method or device.’ What differentiates innovation from pure invention, or merely a new idea, is the translation into commercialized form to create value. Management professor Paul Schumann describes innovation as ‘the way of transforming the resources of an enterprise through the creativity of people into new resources and wealth.’ Author and business-school professor Clay Christensen has stated that ‘innovation by definition, precedes market acceptance.’

Innovation distinguishes between a leader and a follower.

Steve Jobs, former CEO of Apple

In the wake of the premature passing of Apple’s visionary CEO Steve Jobs, the role of innovation as a driving force in the US economy - and its transformative global societal impact - comes once again into focus. Innovation is not pure invention, but a broader drive towards creating value. Innovations can be disruptive, but predominantly are sustaining, non-disruptive and incremental. Technology-enabled “lightweight innovation” is recasting the VC ecosystem, paving the way for a flood of internet startups, but much sustaining innovation is evolutionary in nature.

Navigating the “Big Shift” At the cusp of the second decade of the 21st century, the USA is mired in a persistent economic malaise following the collapse of the debt-fueled real estate boom. This follows by less than a decade the burst of the internet bubble in 2000-01 that followed the dot.com mania of the late 1990s. We view these two bubble/bust cycles as related, both the outcome of the mass adoption of information and communication technologies. John Hagel III and

Innovation embraces invention, adaptation

and evolution

The passing of Apple’s Steve Jobs brings US innovation into focus

once again

The crucible of recession has proven again and

again the catalyst for new ideas

The IT revolution brought benefits, but also

increasing challenges for big companies

America is traversing a difficult period challenged

by internal and external forces



John Seely Brown of Deloitte’s Center for the Edge have framed the concept of a “Big Shift,” finding a nearly 75% decline in US companies’ return on assets (ROA) since 1965. The rise of a digital infrastructure consisting of steadily cheaper bandwidth, storage and compute is the single-largest driver transforming the competitive dynamics of business and challenging even the best-performing companies.

The Big Shift is having a profound and permanent impact on firms in most industries. In their Shift Index, Hagel and Brown highlight several findings that frame the challenges and mounting performance pressures faced by US companies driven by the Big Shift, that are not cyclical in nature:

There has been widespread deterioration in ROA, with the two exceptions being aerospace & defense and healthcare (notably the two most regulated industries).

Companies in leadership positions have seen the competitive “topple rates” double, reflecting the increasingly precarious status of market winners.

Increases in labor productivity have failed to stem the decline in ROA. This is particularly pronounced in technology and telecom, which have seen some of the most dramatic improvements. The biggest beneficiaries of productivity gains are not companies themselves, but their top creative talent and customers.

Innovation as traditionally defined - by product or process - has not been able to offset these declines in ROA.

Dire prognostications anticipate declining power and productivity from the USA as an increasingly global economy integrates the goods, services and human capital of China, India, ASEAN, Latin America, Eastern Europe and other emerging markets. In our view, the USA may no longer hold the sole dominant role shaping the direction of the world economy, but the influx of innovation from across the globe (and the increasingly competitive dynamics that results) provide the backdrop for increased commitment to innovation. While there are a multitude of factors that contribute to a favorable climate for innovation - education, immigration policy, tax policy - it is often adverse economic circumstances and competitive threats that drive innovations.

Asia transcending a manufacturing economy - An existential threat? Over the past decade, the USA has lost over 2.5m factory jobs to China, while Asian factories began producing higher value goods. The rise of innovative companies from economies driven by low-cost labor is a logical process of maturation as former contract manufacturers for the US PC industry, such as Taiwan’s Acer and Asus, emerged as global brands, while companies like Samsung and LG in Korea followed the path of Japan’s tech conglomerates, such as Fujitsu, Panasonic and Hitachi, in creating increasingly distinct, innovative products.

The risk for the USA’s lead in conceptualizing design and user experience is that emerging Asian economies will transcend their “factory culture” in which manufacturing-oriented firms powered by low-cost labor would create innovative design and invention as well to create an existential challenge to the USA and other developed Western nations in the global economy. In the 2010 Bloomberg BusinessWeek ranking of ‘Most Innovative Companies,’ 15 of the top 50 were Asian, an increase from five in 2006, with the majority of the top 25 based outside the USA. While the rise of Asian-driven innovation does challenge implicit American hegemony in cutting-edge innovations, another

It is often adverse economic circumstances and competitive threats

that drive innovation

Emerging innovation from Asian companies is a new

competitive threat to US leadership

The Big Shift is having a profound and permanent

impact on firms



view holds that a more innovative China and India could generate breakthroughs that propagate benefits on a global basis, and that the USA will benefit nonetheless even if the innovations do not originate from within.

Despite the rise of innovation in Asia, the USA retains inherent structural and cultural advantages that provide fertile ground for innovation, and despite the challenges of the current economic and regulatory climate, the country continues to be at the leading edge of secular trends in technology that do not just promote but actually accelerate innovation.

In the 20th century, the USA was the agent for realizing many of the most transformative technological innovations that altered the calculus of daily life, economic growth and geopolitical dynamics. Rule of law, the existence of vibrant capital markets, constant influx of immigrants, bounteous natural resources and a culture shaped by the frontier drove breakthroughs in human progress as well as quality of life. The 21st century is only a decade old, but America has seen significant breakthrough innovations despite navigating two bubble and crash cycles followed by prolonged recession.

The IT revolution The mass adoption of digital infrastructure - Information and Communications Technology - defines the Big Shift. Hagel and Brown note ‘the exponentially advancing price/performance capability of computing, storage and bandwidth is driving an adoption rate for our new “digital infrastructure” that is two to five times faster than previous infrastructures, such as electricity and telephone networks.’

Despite the challenges, the new digital infrastructure is at the heart of America’s next generation of innovation, providing not just tools and platforms that benefit researcher and developers, but whole new paradigms of communications and collaboration. One can point to the rise of innovation ecosystems around Apple, Android and Facebook creating new opportunities for application developers, entrepreneurs as well as existing firms to re-design how they conceive, realize and deliver products and services to their customers.

Technology is accelerating change We have highlighted the impact that technology trends, such as cloud computing, open source, ubiquitous internet connectivity and the mobile internet, have on lowering cost and accelerating incubation for new ideas. 3D printing and open-source hardware dramatically reduce the time and cost involved in prototyping new products. Massive improvements in storage and compute capacity enable accelerating progress in gene sequencing and drug development.

Social networking is having a transformative impact on information flows. Real-time networks like Facebook and Twitter harness the aggregate engagement of millions, helping to accelerate the overthrow of Arab dictators, providing an organizing platform for social causes and transforming broader connectedness of the society as a whole. Ad hoc political movements like the Tea Party and Occupy Wall Street crowd harness social media to organize as multinational corporations, such as Coca-Cola, and collect millions of fans.

Innovation is not the product of logical thought, although the result is tied to logical structure.

Albert Einstein

The USA retains inherent advantages that provide

fertile ground for innovation

Mass adoption of digital infrastructure defines

the Big Shift

The new digital infrastructure is at the

heart of America’s next generation of innovation

3D printing and open-source hardware reduce

time and cost involved in prototyping new products

Social networking is having a transformative

impact on information flows



Innovation continues unabated, whether disruptive or evolutionary, but we believe current technological advancements are accelerating change. As the progress of Moore’s Law reaches its physical limitations, the rise of Quantum Computing promises to sustain the exponential increases in computational power. The impact of a global recession and a painful de-levering of the American economy are offset by the steadily declining cost of storage, compute power and internet connectivity - reducing friction for new business models and ventures. In this report we highlight the catalysts, accelerators, challenges and obstacles to innovation in the USA as well as key companies and trends critical to creating value over the next decade and beyond. The distance from imagination to realization has never been shorter, and the road ahead stretches farther than ever.

The Great Recession: Part of an IT-driven super-cycle? The period since the financial crash in 2008 has been marked by continued economic uncertainty and lackluster growth atypical of recoveries following steep recessions. What we are seeing play out in the broader economy reflects a painful, but predictable and necessary phase of the information technology revolution according to economic super-cycle theories.

Economist Carlota Perez frames the current economic challenges not as the results of unanticipated Black Swans, but as part of a logical pattern that has played out with massive secular technology shifts that occur approximately every 50 years. Her work outlines that multidecade waves of technological change occur in massive surges about once every 50 years, drawing on the initial work of Russian economist Nikolai Kondratiev. He articulated the concept of innovation-driven economic “super-cycles” with waves that come from the adoption of basic innovations that create technological revolutions - and these in turn give rise to new industrial or commercial sectors.

Figure 1

Kondratiev Waves

Source: Wikimedia Commons, Rursus

Economist Joseph Schumpeter adopted these theories hypothesizing the existence of long-run macroeconomic and price super-cycles lasting roughly 40-60 years, dubbing them Kondratiev Waves. These waves are commonly divided into four main periods: expansion/prosperity, turning point or collapse/recession, stagnation/depression, and recession/improvement (which refers to the impact of technology not economic recession).

The distance from imagination to realization

has never been shorter

The Great Recession is a painful but predictable phase of the IT-driven

“super-cycle”

Waves of technological change occur in massive

surges about once every 50 years

Schumpeter adopted theories hypothesizing macroeconomic super-

cycles lasting 40-60 years



Perez divides the technology waves into three main periods: Installation, Turning Point and Deployment. We are currently navigating the Turning Point phase. These surges come in two major stages, Installation and Deployment punctuated by a Turning Point, which is invariably characterized by a bubble, crash and recession.

Figure 2

The historical record: Bubble prosperities, recessions and golden ages

Maturity

1771The IndustrialRevolutionBritain

1829Age of Steamand RailwaysBritain

1875Age of Steel andheavy EngineeringBritain/USA/Germany

1908Age of Oil, Autosand Mass ProductionUSA

1971The ICTRevolutionUSA

Post-war Golden Age

Belle Epoque (Europe) "Progressive Era" (USA)

Sustainable global "golden age"?5th

Internet mania, Telecoms, emerging markets,

Financial casino & housing

4th The Roaring Twenties

Autos, housing radio, aviation electricity

3rdLondon funded global

market infrastructure build-up (Argentina, Australia,

USA)

Great British leapCanal mania

TURNINGPOINT

DEPLOYMENT PERIODBubble collapse

2nd Railway mania The Victorian Boom

1st

Bubble prosperityNo., date, revolution, core country

INSTALLATION PERIOD

Golden age prosperity

1793-97

1848-50

1890-95

Europe1929-33

USA1929-43

2007/08-????

Source: Carlota Perez

There have been five major technology revolutions over the past 240 years. The current Information and Communications Technology revolution is the fifth upheaval experienced by the capitalist system since the first industrial revolution in the late 18th century.

The Installation phase typically begins within a mature economy, where there are battles between new and old, with a great deal of experimentation in the free markets when financial institutions join together with new entrepreneurs to unseat established incumbents. The Installation phase is a period of “creative destruction” where new firms are formed and older firms fail; there is a rapid influx of prosperity as new technology paradigms take over. What follows is a frenzy of investing, inflated asset prices and speculation.

Five major technology revolutions over the

past 240 years

Carlota Perez divides the technology waves into

Installation, Turning Point and Deployment

The Installation phase is a period where new firms are formed and

older firms fail



Figure 3

Five great surges of development: Techno-economic paradigm

Technological

revolution

New technologies and new or

redefined industries

New or redefined infrastructures Techno-economic paradigm: 'Common-

sense' innovation principles

1st - The 'Industrial

Revolution'

Mechanized cotton industry,

Wrought iron, Machinery

Canals and waterways, Turnpike roads,

Water power (highly improved water

wheels)

Factory production,

Mechanization, Productivity/ time keeping and

time saving,

Fluidity of movement ( ideal for machines with

water-power and for transport through canals

and other waterways), Local networks

2nd - Age of Steam

and Railways

Steam engines and machinery

(made in iron; fuelled by coal),

Iron and coal mining (now

playing a central role in growth),

Railway construction, Rolling

stock production, Steam power

for many industries (including

textiles)

Railways (Use of steam engine),

Universal postal service, Telegraph

(mainly nationally along railway lines),

Great ports, great depots, and

worldwide sailing ships, City gas

Economies of agglomeration/Industrial

cities/National markets, Power centers with

national networks, Scale as progress, Standard

parts/machine-made machines, Energy where

needed (steam), Interdependent movement

(machines and means of transport)

3rd - Age of Steel,

Electricity and Heavy

Engineering

Cheap steel (especially

Bessemer), Full development of

steam engine for steel ships,

Heavy chemistry and civil

engineering, Electrical equipment

Industry, Copper and cables,

Canned and bottled food, Paper

and packaging

Worldwide shipping in rapid steel

steamships (use of Suez Canal),

Transcontinental railways (use of cheap

steel rails and bolts in standard sizes),

Great bridges and tunnels, Worldwide

Telegraph, Telephone (mainly

nationally), Electrical networks (for

illumination and industrial use)

Giant structures (steel), Economies of scale of

plant/vertical integration, Distributed power for

industry (electricity), Science as a productive

force, Worldwide networks and empires,

Universal standardization, Cost accounting for

control and efficiency, Great scale for world

market power/ 'small' is successful, if local

4th - Age of Oil, the

Automobile and Mass

Production

Mass-produced automobiles,

Cheap oil and oil fuels,

Petrochemicals (synthetics),

Internal combustion engine, for

automobiles, transport, tractors,

airplanes, war, tanks and

electricity, Home electrical

appliances, Refrigerated and

frozen, foods

Networks of roads, highways, ports and

airports, Networks of oil ducts, Universal

electricity (industry and homes),

Worldwide analogue,

telecommunications (telephone, telex

and cablegram) wire and wireless

Mass production, mass markets, Economies of

scale (product and market volume)/horizontal

integration, Standardization of products, Energy

intensity (oil based), Synthetic materials,

Functional specialization/ hierarchical pyramids,

Centralization/ metropolitan centers/

suburbanization, National powers, world

agreements and confrontations

5th - Age of

Information and

Telecommunications

The information revolution:

Cheap microelectronics,

Computers, software,

Telecommunications, Control

instruments, Computer-aided

biotechnology and new materials

World digital telecommunications (cable,

fiber, optics, radio and satellite),

Internet/ Electronic mail and other e-

services, Multiple source, flexible, use,

electricity networks, High-speed multi-

modal, physical transport links (by land,

air and water)

Information-intensity (microelectronics-based

ICT), Decentralized integration/network

structures, Knowledge as capital/intangible value

added, Heterogeneity, diversity, adaptability,

Segmentation of markets/ proliferation of niches,

Economies of scope and specialization combined

with scale, Globalization/ interaction between the

global and local, Instant contact/instant global

communications

Source: Carlota Perez

During the Deployment period, there is expansion of both new and rejuvenated sectors as this phase allows the potential of new technologies to come to fruition. This is a period of “creative construction” where the benefits of wealth are spread more broadly, and capital and finance decisions are directed towards production rather than speculation. Perez has described the Deployment periods as a ‘Golden Age’ of broad-based prosperity with a solid and sustainable foundation. The global economy is currently navigating the Turning Point phase of the Information and Communications Technology revolution.

During the Deployment period, there is expansion

of both new and rejuvenated sectors



Every major technology development surge has seen the same pattern play out: Canal Mania led to Canal Panic, Railway Mania led to a Railway Panic, the Roaring 20s led to the Crash of 1929. Uniquely in this information technology surge, we have seen two back-to-back bubble/bust cycles: the Nasdaq internet bubble and bust in 2000-01 and the financial crash in 2008. The financial bubble was based on finance, but was an extension of the internet bubble. The adoption of software and the internet allowed creation and sale of complex financial instruments and derivatives to buyers across the globe, inflating the value of underlying (and disconnected) real-estate assets.

Perez anticipates that the next several years will be painful as the economy readjusts itself as the full implications of the Information and Communications Technology revolution propagate broadly across society and the economy. There will be no returning to the way things were before, the conditions in place now demand a re-thinking of policy and an adaptation of the economy to the new realities (which goes far beyond the scope of this report). Technology will play a critical role as it becomes fully deployed across society - and the changing impact of technology on the pace and scope of innovation will be profound.

Has the USA reached a plateau? There are contrarian views about the continued innovative capacity of the US economy. Tyler Cowen’s book The Great Stagnation argues that America may have reached a plateau in terms of income growth from innovation. Cowen makes the point that innovation has been concentrated in the technology and internet sectors, while progress in the broader economy has slowed. This line of thought holds that the rate of change in broad-based societal gains in technology, lifespan and broader quality of life measures have slowed, as has the rate of innovation.

From 1947 to 1973 - a period of just 26 years - inflation-adjusted median income in the USA more than doubled. But in the 31 years from 1973 to

2004, it rose only 22%. And, over the last decade, it actually declined . . . If pre-1973 growth rates had continued, for example, median family

income in the USA would now be more than US$90,000, as opposed to its current range of around US$50,000.

Tyler Cowen, Innovation is Doing Little for Incomes New York Times, 30 January 2011

Total Factor Productivity (TFP), which is used as a measure of an economy’s long-term technological change (essentially the contribution to the economy from new invention), has declined. During the early part of the 20th century, TFP was typically in the 2-3% range, while in the 1930s the USA saw 3% TFP. Since the 1970s, we are seeing less than 0.5% TFP, suggesting society as a whole may be innovating at a rate of 1/6 the Great Depression.

The USA needs more breakthrough innovation Investor Peter Thiel concurs with Tyler Cowen that the pace of technological progress in the USA has slowed. Many of the problems that were expected to have been solved in biotech, computing and energy have taken longer than expected to see breakthrough technologies.

This is attributed to a variety of factors: science itself has become harder because it takes longer to accrue the necessary knowledge for breakthroughs; government regulation in pharmaceuticals and energy creates

There will be no returning to the way things

were before

Declining TFP suggests the USA as a whole may

be innovating at a rate of 1/6 the Great Depression

Innovation has been concentrated in the

technology and internet sectors

A number of observers believes America’s pace

of innovation has decelerated

Conditions now in place demand a re-thinking of

policy and adaptation of the economy



costly roadblocks; and the innovations in the 2000s, such as financial securitization, tended to benefit a few rather than the society at large. Thiel argues for greater investment in hard science innovation focused on delivering breakthroughs that will have transformative impact on a broader swathe of society.

Poised for the next generation of breakthrough innovation The dynamics of accelerating change in technology will continue to fuel innovation, though in more incremental and less disruptive ways. The evolution of the IT industry from centralized mainframes to highly distributed PCs, to networks of smaller devices powered by cloud-based services allows large organizations to be increasingly flexible, while smaller organizations increasingly have the ability to join networks. The impact on global supply chains and networks of partners has been profound as organizations can decompose their value networks from close, vertically integrated hierarchies to loosely coupled networks of best-in-class experts.

What comes next? There is a common view that the current conditions of stagnant growth and high unemployment will persist for several years as the underlying economy re-orders itself. For the USA, the economy is undergoing the painful process of de-leveraging, while simultaneously grappling with the loss of manufacturing jobs to lower-cost regions in Asia. While there is broad consensus that pain will continue for the medium term, what emerges is a more optimistic view of potential for technology-led innovations to drive growth and benefit society at large.

Economist Tyler Cowen sees an innovation dividend emerging, as ideas and entrepreneurs from China, India and other developing nations create more resources for US innovation. Additionally, opening up access to billions of customers in previously untapped markets drives established Western companies to address different needs in innovative ways.

The internet is providing increased access to scientific research and ideas, allowing broader opportunity for innovators outside the premier research universities in the developed world. This democratization of information provides the same access to the universe of information on the web to a smartphone connection in Africa as to a broadband connection in the Western world.

Author and investor John Mauldin believes the proliferation of high-speed ubiquitous bandwidth - cheap wireless internet access reaching 2bn new consumers - will unleash ‘30,000 new Watsons, Newtons and Jobs we never knew were there.’ Global, instantaneous access to information contributes to what writer Clay Shirky describes as a ‘cognitive surplus.’

Increased longevity will spur increased innovation One significant coming societal change will be the ability for technology to extend life expectancy. Sonia Arrison’s 100: How the Coming Age of Longevity Will Change Everything finds that the broader increase in lifespan translates to greater productivity as a society. According to her analysis, from 1970 to 2000, gains in life expectancy have added about US$3.2tn per year to national wealth.

The key implication of this is that when populations live longer, innovation can grow. Arrison notes that innovation is a late-peak field. Although Silicon Valley is focused on younger entrepreneurs, scientific breakthroughs often

A global “innovation dividend”

When populations live longer, innovation

can grow

‘30,000 new Watsons, Newtons and Jobs we

never knew were there’

Accelerating change in technology will continue

to fuel innovation

A more optimistic view of potential for technology-

led innovations



require the experience and maturity that accrue with age. Leonardo da Vinci was 50 when he painted the Mona Lisa; Ben Franklin was 46 when he conducted his electricity experiments. The advances in medicine and biotech could drive further increases in longevity and a corresponding growth in productivity and scientific innovation.

An IT-accelerated biotech wave on the horizon Increased longevity also presents challenges, not the least of which relates to funding retirement as birth rates decline. Advances in biotech promise to give rise to re-injectable vaccines with personal DNA, regenerative organs and other medical advances. John Mauldin predicts that information technology-driven advances in medicine and pharmaceuticals will give rise to another bubble in biotechnology by the end of the current decade.

The close-to-home revolution The rise of powerful technological tools to assist innovation is having a profound impact on productivity. Software for 3D modeling, computer-aided design and simulation tools have made it easier for manufacturers to develop new products. 3D printers allow for rapid prototyping. The increasing power and declining cost of these technologies allow companies to be more agile and serve “the long tail” of highly specialized sub markets. 3D printing will change the nature of manufacturing and distribution, giving rise to a new industry of custom print shops.

Downsizing to a greener, smarter and leaner future There is a widespread view that the economy that emerges from the current downturn will be focused on more sustainable, increasingly energy- and resource-efficient technologies. Carlota Perez believes that the new paradigm will be less about consumption (buying the same goods again and again because of planned obsolescence) - and more about quality of life, less materialism, more human interactions, less energy consumption, more creativity and more services for wellness. The vision is that living “green” will be considered a good life, not a lifestyle induced by guilt.

There are several schools of thought about clean energy, but the more optimistic see energy not as a problem but the solution. In particular, the exponential improvements in solar technology as well as innovative approaches to wind, geothermal, biomass and other sustainable technologies will ensure that we will never run out of energy. John Mauldin makes the argument that energy skeptics take a Malthusian view of fossil fuels that fails to take into account the constant ability to adapt and replace scarce resources with cheaper abundant resources.

Innovation as business imperative For established companies, innovation is a constant uphill battle. According to Innosight, only 25% of new products that established companies introduce succeed in their markets, while 75% fail - and only 10% of companies maintain levels of growth that satisfy shareholders long term. Clayton Christensen of the Harvard Business School has done perhaps the deepest work on innovation. His 1997 book The Innovator’s Dilemma and subsequent books addressing innovation in healthcare, education and other areas are considered the defining work on the subject.

Only 25% of new products that established

companies introduce succeed in their markets

The rise of powerful technologies is having a

profound impact on innovation productivity

The new economy - greener, leaner and nicer?

Energy: Not the problem but the solution



Sustaining innovation - The bread and butter of established markets Clay Christensen defines sustaining innovation as ‘an innovation that brings to market a product or service that a company in the market could sell for higher margins to its best customers.’ Sustaining innovations can be simple, incremental improvements (such as annual software updates) as well as significant, revolutionary breakthroughs (such as the transition in telecom from analog to digital to optical).

Figure 4 Figure 5

Sustaining innovations from Coca-Cola

Sustaining innovation - Redesigned plastic milk cartons

Source: Coca-Cola, Credit Agricole Securities (USA)

Sustaining innovation drives growth in established markets. Core competency in sustaining innovation is a critical success factor for established firms to maintain competitive advantages, market share and protect margins. Incumbent industry leaders have significant inherent advantages in sustaining innovation because of the established market recognition, distribution and barriers to entry.

Sustaining innovations are most often evolutionary, improving products in an existing market in ways that customers are expecting (ie, the introduction of Caffeine Free or Cherry Coke), but can also be revolutionary, solving problems in an existing market using a new technological (ie, the evolution of recorded music formats from LPs to cassette tapes to digital compact discs). The objective of sustaining innovation is to bring to market a product or service that can be sold for higher margins to the best of the existing customers.

Every act of creation is first of all an act of destruction.

Pablo Picasso

Disruptive innovation - Creating new value from below Disruptive innovation creates new and often unanticipated markets by applying a new set of values. Classic disruptive innovations will create a new low-end market with a product that is not as good as established products, but is simpler and more affordable - for instance, offering 50% of the functionality of an established product at 20% of the price. Disruptive innovations take hold where customers are less demanding, then improve over time to challenge mainstream markets. Innovation is disruptive not because technology is a breakthrough but because it disrupts the trajectory of improvement in established markets by challenging the value proposition with simpler and lower-cost alternatives.

Sustaining innovation drives growth in

established markets . . .

Sustaining innovations can be incremental or

significant breakthroughs

. . . and provides higher margins when sold to the

best existing customers

Disruptive innovation creates new markets

by applying a new set of values



Figure 6

Disruptive technology

Source: Wikimedia Commons

Existing firms can face disruption when they are focused on serving their existing customers, in many regards doing exactly what they are supposed to do, and as such do not target markets that are lower end than their core customers. In low-end disruption, the disrupting entrant focused on serving less profitable customers, who are happy with a “good enough” product but are not willing to pay a premium for enhanced capabilities. Over time, this disruptor at the low-end market begins to capture share of the established market by entering segments where the customer is willing to pay slightly more for higher quality.

Figure 7 Figure 8

Disruptive innovation - The Ford Model T

Disruptive innovation - Macintosh personal computer

Source: Ford Source: Apple

The disruptor then innovates to move upmarket to improve margins, and while the incumbents remain focused on their most profitable businesses, the disruptor captures more and more share of the incumbent’s customers. Over time, the disruptor meets the needs of the most profitable segment of the market and drives out the established incumbents.

Disruptive innovations start at the low end and

move upward in markets

Firms can face disruption when they are focused on

serving their existing customers

Disruptor then innovates to move upmarket to

improve margins



Figure 9

Disruptive innovations

Innovation What was disrupted Notes

Steamships Sailing ships Steamships were initially deployed on inland waters, where sailing ships were less effective and did not compete for higher margin sea traffic

Telephone Telegraph At first telephones were initially useful for short distance calls. Western Union declined to purchase Alexander Graham Bell's telephone patents for US$100,000 because its highest-margin business was long-distance telegraphy

Mini steel mills Vertically integrated steel mills Mini mills use locally available scrap and power, and can be more cost efficient even though they are smaller

Minicomputers Mainframes Minicomputers were initially smaller and cheaper than mainframes

Personal computer Mainframes, Minicomputers PCs were smaller and cheaper than minicomputers and mainframes before that

Desktop publishing Traditional publishing Early desktop publishing programs were low quality, but improved over time

Digital photography Chemical photography The first digital cameras were low quality, but have improved to comparable quality

Internet sites like Craigslist Newspaper classifieds Early internet boards had limited reach, but are now well established

Discount airlines Full-price airlines Carriers like JetBlue, RyanAir and others served secondary airports at lower cost

Digital audio (MP3, etc) Physical media like CDs, cassettes)

The rise of free peer-to-peer shared nearly destroyed the music industry in the early 2000s

Android Symbian, Blackberry, PalmOS Open source, free Android devices have taken share from proprietary platforms

Source: Credit Agricole Securities (USA)

US-based companies have been at the vanguard of disruptive innovation for the past 150 years, and innovation has become ingrained into the culture. Companies such as Apple, Microsoft, Amazon, Ebay and Google have all been disruptors in the information era. Notably Apple has been able to disrupt not only the minicomputer and traditional publishing industries with the Macintosh, but it has also re-shaped the music and publishing industries with the iPod and iPad. Classically American firms like Ford and IBM have maintained a tradition borne of disruptive innovation that evolved into continual sustained innovation (and occasional disruptive innovations).

Innovation in the information age - Open, light and agile We highlight two innovation paradigms that have gained currency with the revolution of information technology that we believe will be increasingly strategic. Open innovation has been embraced by established firms for the past decade, and we see the open model continuing to proliferate with increasing connectivity and collaborative technologies. Lightweight innovation benefits from the declining costs of software, compute and bandwidth, allowing for more rapid realization and testing of ideas. In our view, these approaches will become increasingly relevant as companies of all sizes and in all sectors of the economy navigate the “Big Shift.”

Innovation has just become so much more accessible. We have people who come to our venture-investing arm who have completely formed businesses; they’ve got working technology, they’ve got functional websites, they’ve run

marketing campaign, they’ve got customers, they’ve got revenue. And they’ve done all of this for less than US$1,000.

Scott Anthony, Innosight Asia-Pacific

US-based companies have been at the vanguard of

disruptive innovation for the past 150 years

Open and lightweight innovation has gained

currency and will be increasingly strategic



Opening innovation to the outside world Open innovation is a term promoted by Henry Chesbrough in his book Open Innovation: The new imperative for creating and profiting from technology. According to Chesbrough, ‘Open innovation is a paradigm that assumes that firms can and should use external ideas as well as internal ideas, and internal and external paths to market, as the firms look to advance their technology.’ This approach promotes the idea that as boundaries between an organization and the outside world become more permeable, innovation can be increasingly shared from inside and outside.

The crux of open innovation is that organizations should source innovation from wherever the best ideas come from, not just internally but from customers, partners and other co-creators. The evolution of online collaboration technologies including video conferencing has helped facilitate innovation among geographically dispersed teams.

Procter & Gamble led open innovation to the mainstream One of the key proponents of the open-innovation framework was Procter & Gamble through the Connect+Develop program. In 2000, P&G described its operations as a ‘mature innovation-based company with rapidly expanding innovation costs, flat R&D productivity and shriveling top-line growth.’ At the time, the company’s success rate of new products that met financial objectives was just 35%. CEO AG Lafley decided on a new approach, the Connect+Develop program, in which 50% of P&G’s innovations would come from outside the company. P&G decided that it needed to look beyond its 7,500 researchers and support staff and looked across the globe to extend its network of in-house staff and network of suppliers, with the top 15 suppliers representing an estimated 50,000 researchers as of 2006.

One of the manifestations of open innovation is the practice of “Crowdsourcing,” a term coined by authors Jeff Howe and Mark Robinsson in the June 2006 issue of Wired magazine. Crowdsourcing refers to the practice of taking problems that are typically solved by employees and extending them to a group of individuals in order to arrive at a collective solution. Crowdsourcing is the paradigm underlying open-source software development, designing organizational algorithms, solving complex collaborative questions as well as optimizing search engine results.

Open mining yields more than nuggets In 2000, Goldcorp, a gold producer headquartered in Vancouver, Canada, was concerned about an underperforming mine in Ontario. CEO Rob McEwen saw the mine producing 50,000 ounces a year at a high cost of US$360 an ounce. Main deposits were deep underground, but the company’s geologists were not sure of the exact locations. McEwen decided to take a radical step.

He put all of the geological data extending back to 1948 into a 400 megabyte file and posted it on the company’s website. Goldcorp offered US$575,000 in prizes to whoever could discover the best way to extract more gold. The trigger for the initiative was an MIT conference the CEO had attended where Linux namesake Linus Torvalds shared how the Linux operating system was created through open public contribution.

Within a few weeks, over 1,000 people pored over the data not just geologists, but mathematicians, military officers, students and consultants. The result was that over 110 sites were identified, 50% were previously unknown to the company and of these over 80% yielded significant gold

Open innovation is a paradigm that assumes

that firms can and should use external ideas

Organizations should source innovation from

wherever the best ideas come from

Connect+Develop’s goal was that 50% of P&G’s

innovations would come from outside the company

Crowdsourcing is the paradigm underlying

open-source software development

Goldcorp posted 50 years of geological data on its website. . .

. . . and identified US$6bn in new gold deposits for US$575,000 in rewards



reserves. The company estimates the collaborative process saved two to three years of exploration time while generating US$6bn in new gold.

Lightweight innovation Innovation for internet and software firms continues to benefit from the declining costs of compute, storage and bandwidth and the availability of more powerful software tools and applications for collaboration, design and communications. The growth of public cloud-computing services from companies like Amazon, Microsoft, Salesforce.com, Rackspace and Google makes it simple for anyone with a credit card to have access to scalable IT resources.

For startups, the availability of free software and subscription-based Software as a Service has radically reduced the costs of running a business, from accounting to HR to basic IT. All of these factors make it easier to bring an idea to fruition, test it and allow it to fail or succeed with far less capital than ever required.

One of the great things about these new technologies is that they can be implemented incrementally without significant investments. You can edge into

them in ways that reduce significantly the investment and risk at the outset. And if you can mobilize third parties through shaping strategies, you can share the risk even more. What’s exciting is that if you do it right, there’s

actually relatively modest risk and a lot of reward.

John Hagel, Deloitte Center for the Edge

We have articulated the accelerating impact that these technology trends have had on lowering the barriers to innovation, and the venture-capital community is seeing the leading edge of this trend. Lightweight innovation has had dramatic implications in fostering new startup activity. We note there has been a huge upsurge in media and internet-related entrepreneurship in New York City over the past two years, attracting top-tier VCs like DFJ and incubators like TechStars. New York’s largely consumer-focused startups attracted more venture investment in 3Q11 than Boston-area firms for the first time since 1989, according to a report from CB Insights.

The Institute for the Future in Palo Alto has promoted the term “lightweight innovation” to describe the emerging model often seen with internet companies that is less capital intensive, highly reliant on technology and more agile. While open innovation seeks to broaden the sources of new ideas, lightweight innovation ‘seeks to disaggregate and accelerate R&D, more systematically engage end-users, and constantly invent and re-invent new platforms. Lightweight innovation itself is a disruptive way of thinking about idea generation and execution and stands to fundamentally transform the way large organizations innovate and profit from innovation.’

We highlight key characteristics of lightweight innovation as defined by the Institute for the Future:

Acceleration - Lightweight innovation techniques vastly reduce the amount of time needed to realize a proof of concept. It can take as little as a day to write the beta version of Gmail, for instance, which allows for ongoing refinements, testing and improvement in a production context. The accelerated incubation period reduces costs by helping to establish viability of an idea more quickly - “Fast Fail” - in order to prioritize the best initiatives.

Innovation is getting faster, cheaper and more

agile thanks to information technology

Free software and Software as a Service have reduced costs of

running a business

Lightweight innovation is driving an acceleration

of startup activity in New York City

Lightweight innovation vastly reduces the time

needed to realize a proof of concept

The Institute for the Future in Palo Alto has

promoted the term “lightweight innovation”



Disaggregation - Internet-based communication and collaboration technologies allow R&D teams to be distributed to an unprecedented extent, enabling far greater input from contributors regardless of location or even affiliation. This allows projects to parcel out pieces of a problem across different specialists worldwide.

Innovation platforms - Lightweight-innovation approaches support the development of innovation platforms, systems that support collaborative and distributed efforts to tackle big problems, such as the Human Genome project. An example of this new model is the BioBricks Foundation, which is developing a series of tools to coordinate open-source biological research.

A 2006 IFTF report, Innovation in the Urban Wilderness: Lightweight Infrastructure meets Cooperative Strategy (SR-1050), describes characteristics for the design of emerging technical systems. According to the Institute of the Future, there are several defining characteristics of lightweight innovation:

1. Ad hoc responsiveness - Lightweight innovation often arises to address unanticipated problems that may be changing quickly. End users can be involved earlier in the process, allowing extended periods of beta testing and evaluation.

2. Tools that scale - Lightweight innovation incorporates new tools and technologies that reduce the cost and scale at which prototypes become economical. As a result the economic viability of the business case can be evaluated more quickly.

3. The network effect - The use of highly scalable systems such as Twitter, Facebook and other social and distributed technologies allow research and innovation to harness the value of a network of contributors, ultimately distributing the work of innovation across different stakeholders.

4. Mashups - On the web, adoption of a modular or service-based approach to software components allows for the creation of “mashups” that recombine IP from different sources. Cloud computing allows information like maps, real-time stock or weather information and other services to be aggregated from multiple sources. A parallel in music is the rise of digital sampling, which enables DJs and artists to recombine existing elements into new creations.

5. Open standards - Whether standards are open source or proprietary, the existence of common frameworks for innovation help the innovation process expand more rapidly. The open standards around Apple and Android phone platforms have accelerated innovation around their application, service and content ecosystems.

6. Innovation communities - Traditional innovative approaches often employed a closed, hierarchical organizational structure typically seen in large corporations. The open-source model employs a network of contributors that often drives a superior quality result - this has been most successful in software but has been adapted to other areas.

Common frameworks for innovation help the innovation process

expand more rapidly

Lightweight innovation often arises to address

unanticipated problems that change quickly

R&D teams can be distributed to an

unprecedented extent

Section 2: Innovation across industries US strategy


Innovation across industries The USA remains home to a plethora of innovative companies across all sectors of the economy. The broad adoption of information and communications technologies helps to accelerate the research, development, prototyping and market testing of new offerings. We include only a broad selection of US-based companies, including a handful of privately held firms. There are tens of thousands of innovative private companies in the USA. The enabling factors highlighted in this report, coupled with adverse economic conditions, will give rise to a wave of entrepreneurship in coming years. Disruptive technologies such as cloud computing, open-source software, the mobile internet, 3D printing and computational genomics can foster a wave of innovative startups.

Although much of the most disruptive innovation will come from startups and entrepreneurs, we do believe that large companies are still well positioned to take advantage of increasing entrepreneurial activity. This has to do with the advantages of scale in particular - the ability to realize, propagate and fully capitalize on innovations to the full commercial potential.

The reality is that if everybody can innovate, it’s very hard to create competitive advantage at the early stages of innovation. So the best you can

do is what Groupon is doing now, which is throwing money trying to build scale. But large companies have scale. They’ve got sales forces, they’ve got

patents, they’ve got all the things that small companies want. They’ve got the things that are difficult to create. So a large company that learns how to tap

into that innovative ecosystem in the right sort of way and leverages those advantages can really do just some tremendous things.

Scott Anthony, Innosight Asia-Pacific

Technology - Software Software has been at the forefront of the information technology revolution, emerging as an independent industry in the 1970s and 1980s. There are numerous public and private software companies, and software itself is playing a vital role in a growing range of industries, impacting products and processes. Software encompasses an enormous variety of functions from fundamental operating systems to enabling “middleware” to applications that deliver a range of functions to users.

Software delivers value by automating repetitive tasks, performing sophisticated calculations, assisting with advanced decision-making, managing risk and improving efficiencies. Applications are the “top of the IT food chain” in many ways: automating business processes by harnessing data for reporting, analysis and efficacy of processes; enabling collaboration, connectivity and creativity; and accelerating, automating and enhancing design.

Software remains at the nexus of innovation globally, both as enabling technology (development tools, CAD/CAE, collaboration, etc) and innovation itself. The rise of Software as a Service (SaaS) is blurring the distinction between traditional software and internet offerings as delivery of value over the internet includes applications, data, services or content.

Applications are where the ultimate value

accrues in information technology

The USA remains home to a plethora of innovative

companies across all sectors of the economy

Large companies are well positioned to take

advantage of entrepreneurial activity

Software itself plays vital role in a growing range of

industries, impacting products and processes

Software remains at the nexus of innovation



Figure 10

Industry innovators: Software

Company Ticker Comments

Akamai AKAM The exponential growth in traffic on the Web is possible because of services that route data

intelligently. Akamai’s algorithms optimize online routes for content delivery.

Autodesk ADSK Computer-aided design and engineering software is transforming architecture, industrial

design and entertainment. Autodesk’s software will play an increasingly critical role enabling mass customized products with the advent of 3D-printing technologies.

Citrix CTXS Citrix’ technology enables remote access, management, collaboration and provisioning from thin-client, PCs, tablets and other devices, enabling increasingly distributed workforces.

IBM IBM The original software company (when bundled with mainframes), IBM’s investments in

predictive analytics harness high math and statistics to tackle a world of challenges.

Informatica INFA Data is growing increasingly valuable as a corporate asset. Informatica’s technology helps

organizations orchestrate, move and govern data to support applications and the business.

Intuit INTU Intuit keeps innovation teams small - no bigger than two pizzas can feed - generating hundred of ideas for solutions the company can deliver online to its SMB customers.

Microsoft MSFT Microsoft’s Research effort pushes the leading edge in diverse areas such as computational

linguistics, interfaces, healthcare, machine learning, security, theory and other areas.

Oracle ORCL Oracle’s consolidation of applications, middleware and hardware is driving the realization of

integrated, optimized software/hardware systems that support modular applications.

Red Hat RHT The leader in open-source software, Red Hat curates and supports the innovation stream of its global community of contributors on infrastructure and cloud-software projects.

Salesforce.com CRM A pioneer in Software as a Service, Salesforce.com evangelized the virtues of cloud computing,

while expanding into service/support, Platform as a Service and the social enterprise.

ServiceSource SREV Hybrid tech-enabled service optimizes technology-support renewal streams for clients.

Symantec SYMC Security is the ultimate innovation race against organized crime and hackers. Symantec has brought PC security to the masses, while embracing storage as a comprehensive strategy.

Teradata TDC Teradata’s deep expertise in data warehousing and the Aster Data SQL/MR technology

enable organizations to scale analytic efforts to capitalize on the Big Data trend.

Trend Micro 4704-JP Trend Micro’s model leverages a global footprint to deliver smart, cloud-based security.

VMware VMW Market pioneer in server-virtualization software, the foundation technology for cloud computing that enables flexible workload deployment, driving hardware cost efficiencies.


Technology - Hardware Information technology hardware experiences continual improvements and shrinking components as multiprocessor performance continues to double at the rate predicted by Moore’s Law. The computer industry dedicates significant resources to drive innovations on an ongoing basis. Over the past 50 years, the industry evolved from mainframes, to minicomputers, to the PC, to UNIX and Linux servers. The personal computer has evolved into laptops and touch-sensitive tablets, while mobile phones have evolved into smartphones. Networking technology has evolved from proprietary to IP networking routers, switches, caching and traffic management and shaping tools. Constant investment in materials and design has allowed companies like Apple to define new markets while forging distinct aesthetics.

The hardware components of information technology are trending increasingly towards convergence at the enterprise level. Cisco, VMWare and EMC’s VCE joint venture promotes modular boxes that integrate server, storage,

Avi Silver Technology Hardware

Servers, storage and networking are trending

towards convergence



networking and virtualization. The explosion of tablets and smartphones and popularity of the Android platform are giving rise to a plethora of computing form factors that harness touch and voice as well as traditional keyboard-entry paradigms. The Big Data phenomenon is driving innovations in scalability, throughput and performance across the hardware ecosystem.

Figure 11

Industry innovators: Tech Hardware


Apple AAPL The epitome of American innovation, Apple pioneered the personal computer, revolutionized

digital music and smartphones with the iPod and iPhone, and defined and dominates the new category of tablet computing with the iPad.

Cisco CSCO As the petabits surge, Cisco keeps outflanking cut-rate competitors and surfing the flood of online video, VoIP gear and set-top boxes.

Corning GLW Corning has a history of innovations from its roots in industrial glass, expanding into optical networking, touch screen “Gorilla” glass, LCD screens and laboratory research glass.

EMC EMC EMC’s Innovation Network conducts primary research along with university partners on

projects including advanced files systems, RFID security and privacy, storage advances in holography, micro-electro-mechanical systems (MEMS), nanotechnology and other areas.

FusionIO FIO FusionIO’s storage memory platform significantly improves datacenter processing capabilities by moving data closer to the CPU where it is processed. Shared data centralization reduces latency and increases data center efficiency.

3D Systems DDD 3D Systems is a provider of content to print solutions for businesses and consumers. The

company’s rapid prototyping and manufacturing systems reduce time and cost of designing new parts and products and bringing them to market.

Stratasys SSYS Stratasys is a manufacturer of in-office rapid prototyping systems for automotive, aerospace, industrial, electronic, medical and consumer product OEMs.


Technology - Internet and Media The internet has facilitated the creation of a multitude of applications, technologies and businesses. In 2009, Knowledge@Wharton and the PBS Nightly Business report ranked the combination of internet, broadband and world wide web as the top innovation that has changed life over the past 30 years. The impact on society and the economy at large has been transformative, giving rise to new types of businesses that have disrupted and displaced incumbents.

The internet has given rise to browsers, websites, blogs, message boards, instant messaging, multiplayer gaming, Really Simple Syndication (RSS) feeds, Amazon, eBay, Craigslist, Priceline, Expedia, Facebook, Twitter and countless other innovative ideas. The digitization of music nearly destroyed the music industry through peer-to-peer networking, to be resurrected by Apple’s iTunes. Demand for e-books has driven adoption of Amazon’s Kindle, the Barnes & Noble’s Nook and other devices. Netflix’s online video streaming has transformed the traditional movie-rental business.

Internet innovation is about connectivity and low cost - as the “information superhighway” teams of collaborators, partners, vendors and customers can interact in new ways. A critical aspect of internet-enabled self-service is that it offloads much of the work on the customers, while back-end servers and computer systems automate processes.

James Lee Global Media

Internet innovation is about connectivity

and low cost

The internet has given rise to countless innovative ideas



Cloud computing refers to software and services delivered over the internet typically from centralized data centers - the migration to cloud computing is redefining the enterprise software and technology business. The “Internet of Things” refers to the coming trend of billions of devices - appliances, machines, sensors - that will be connected to and controlled over the internet. New technologies including HTML5 provide greater support for multimedia and interactive applications.

Figure 12

Industry innovators: Internet and Media


Amazon.com AMZN E-books are finally becoming a large, mainstream market.

Key innovation: Even as it seeded the e-book market with the Kindle, Amazon has made it easy for people to read e-books on other devices, such as the iPad. Amazon has become the leading provider of Infrastructure-as-a-Service resources through its Elastic Computing Cloud (EC2) which supports thousands of websites, businesses and startups.

EBay EBAY Ebay pioneered the online auction marketplace, enabling millions of sellers to offer

everything from toys to electronics to collectibles. A user review system crowdsources reputations ratings, critical for building trust where users are unknown to one another.

Facebook (Private) Dominant leader in social-networking sites, Facebook has evolved from a site for personal

information sharing to become a platform for groups, causes, business, games and applications.

Google GOOG Google’s simple approach to internet search, powered by a massively sophisticated infrastructure, dominates the market. The company’s application of advanced analytics pervades its services, which have expanded beyond Gmail, YouTube to SaaS applications and Platform as a Service. Google’s Android platform and Chrome browser are proving to be highly disruptive to mobile and web-browser incumbents.

Groupon (Private) Groupon is the most successful aggregator of merchant coupons, operating on a principle of “critical mass,” establishing a threshold of consumer participation to activate deals.

LinkedIn LNKD LinkedIn is the leading social-networking site for professional networking. The site has become one of the leading sourcing tools for HR departments and recruiters.

Monster Worldwide MWW Monster Worldwide’s online recruiting and services have helped redefine the recruiting and job sourcing industry.

Netflix NFLX Netflix revolutionized the video rental market with inexpensive streaming video on demand,

disrupting the video rental and cable-service-provider market. The company generated demand for its streaming-video service by including it free with DVD-by-mail subscriptions.

Pandora P Pandora’s Internet Radio service is based on the Music Genome Project, which powers the

company’s music recommendation engine, which drives customer stickiness and advertising revenue.

Twitter (Private) The 140-character microblogging service provides real time updates - broadcasting “tweets” to followers simultaneously. Twitter has been credited with empowering Arab Spring protestors, while giving rise to sponsored celebrity-endorsement businesses.


Technology - Semiconductors Semiconductors have become ubiquitous in modern society, powering PC, tablets, smartphones, medical devices, automobiles and home appliances. According to the Semiconductor Industry Association, US semiconductor companies generated US$144bn in sales in 2010. This accounts for almost half the worldwide market and the largest American export category. The semiconductor industry also spends the highest proportion of any industry on R&D as well.

Cloud computing refers to software and services

delivered over the internet

Srini Pajjuri Semiconductors



It is by far the R&D leader, spending 15.0% of sales on R&D in 2008. Current technology is reaching physical limits, so there is increasing focus on researching nanoelectric devices. The growth of tablets and smartphones is driving focus on semiconductor chips to power system designs that have low power requirements to support long battery life.

Figure 13

Industry innovators: Semiconductors


Applied Materials AMAT Powerful computing devices are proliferating because of chips that incorporate ever-smaller

features without rising in price. Applied Materials can manufacture chips that have both vertical and horizontal connections, to pack in more computing power.

ARM Holdings ARM ARM Holdings has created customizable chips for mobile devices that consume less energy, which allows OEMs to redesign smartphones and tablets to be more energy efficient.

Intel INTC Intel’s microprocessor innovations paved the way for the PC industry with partner Microsoft.

The company continues to expand partnerships, use cases and form factors. With acquisitions such as Wind River and McAfee, software is becoming an increasing focus.


Healthcare - Life Sciences Technology Bioinformatics is the application of information technology to molecular biology, using mathematical and statistical techniques to understand biological processes. Much of the focus has been in the fields of genomics and genetics, in particular the area of DNA sequencing. Major areas of research include prediction of gene expression, genome assembly, protein structure alignment and prediction, sequence alignment and other areas.

Figure 14

Industry innovators: Life Sciences Technology


Complete Genomics GNOM Complete Genomics offers sequencing as a service, analyzing DNA samples that customers send in given many doctors and researchers lack the resources to analyze and sequence genomes themselves.

Intuitive Surgical ISRG Intuitive Surgical designs, manufactures and markets Vinci Surgical Systems, which are

advanced surgical systems used to perform surgery across multiple specialties, including urology, gynecology, cardiothoracic surgery, transoral surgery and general surgery.

Life Technologies LIFE Life Technologies offers a desktop gene-sequencing machine at US$50,000, which is about

a 10th as much as other machines. Quick and cheap DNA sequencing will lead to new diagnostic tests and targeted treatments.

Medtronic MDT A chest implant that transmits vital signs through the internet will allow constant monitoring by cardiologists and all staff. Medtronic's US$25,000 pacemaker-like device is just the start. Look for similar innovations that treat epilepsy, obesity and depression.

Pacific Biosciences PACB Pacific Biosciences’ sequencing machine can read single strands of DNA in real time, providing a more efficient way to analyze.


The promise of applying advanced computational methods to the analysis of the human genome is to better understand genetic causality in order to design new drug compounds for treatment. The long-term goal is to realize the vision of “personalized medicine” where diagnoses and treatments are specifically targeted to the individual according to their specific genetic profile.

The semiconductor industry is by far the

R&D leader

The long-term goal is to realize the vision of

“personalized medicine”

Paul Knight Life Sciences Technology



Healthcare - Pharmaceuticals There is increasing use of analytics and business intelligence tools to improve both the delivery of care for individual patients as well as fundamental research. Healthcare providers are increasingly able to respond to demands of pandemic prevention by using business intelligence tools to sort clinical data to identify which patients might be most at risk - enabling the providers to target and prioritize vaccination programs. Another focus is helping doctors make more accurate diagnoses and recommend the appropriate treatments. Systems that integrate sample analysis into decision-support applications can help pinpoint details that may elude physicians.

Public health initiatives such as the Cancer Biomedical Informatics Grid and UCSF’s Athena Breast Health Network aggregate shared data and increasingly enable researchers and physicians to improve their research, diagnosis and treatment efforts. The biotechnology industry is one of the leading adopters of advanced technologies, including bioinformatics tools, analysis tools, collaboration technologies and workflow management systems.

Figure 15

Industry innovators: Pharmaceuticals/Biotechnology


Amyris AMRS Amyris is better known for producing renewable synthetic fuel, but the company also

produces an effective malaria drug called artemisinin. The drug was often in short supply because it comes from a rare plant; however, the company recently developed a microbially produced version that can be made in almost unlimited amounts.

Bristol-Myers Squibb BMY Bristol-Myer’s biggest opportunity lies with Eliquis, its twice-daily oral drug for atrial fibrillation/stroke prevention. Partnered with Pfizer, it will be one of three new oral anti-coagulants that are trying to unseat warfarin as standard of care. However, with a best-in-class safety and efficacy profile established in the ARISTOTLE study, we believe Eliquis will emerge as a clear leader.

Dendreon DNDN In 2010, the FDA approval of Dendreon’s prostate cancer vaccine Provenge represented a

breakthrough in personalized medicine and a new class of drug. Scientists at Dendreon and elsewhere are working to apply the technique to other types of cancer.

Elixir Pharmaceuticals (Private) Elixir is a biopharmaceutical company developing drugs that mimic longevity responses.

The company’s founders identified interactions between specific genes and enzymes that can slow the aging process. They are developing compounds that stimulate these interactions and will be used to treat a range of diseases related to aging, including metabolic disease.

Geron GERN Embryonic stem cells provide a potential source of replacement tissue for use in treating an array of degenerative diseases and injuries. Geron has started clinical trials for a spinal-cord therapy derived from these cells.


Materials - Chemicals & Fertilizers Industrial R&D has been a key adapter of enabling technologies to facilitate the research, discovery and testing processes needed to bring new materials and products to market. Key innovations from US-based companies continue to boost food production, provide more effective protection for humans, improve efficiencies for electronic products and many other areas.

The biotechnology industry is a leading adopter of advanced

information technologies

Kim Vukhac Pharmaceuticals

Mark Connelly Nils-Bertil Wallin

Chemicals & Fertilizers



Figure 16

Industry innovators: Chemicals and Fertilizers


3M MMM 3M is fundamentally based on science, driven to innovation through extensive investments

in R&D. The company’s innovations in materials include Scotch Cellophane Tape, Post-Its, masking tape, reflective sheeting, videotape, dry-silver microfilm, optical films for LCD televisions, cleaning products and many other areas.

DuPont DD Named a ‘Top 50 Innovative Company’ by MIT Technology Review in 2010, DuPont is a diversified materials and chemical company. The company delivers innovative products in many areas, including photovoltaics, herbicides, seed hybrids, proteins, coatings, polymers, etc. R&D’s missions include decreasing fossil-fuel dependence, protecting people and the environment, increasing food production, chemicals and electronics.

Monsanto MON Monsanto produces seeds, biotechnology-trait products and herbicides that provide farmers

with solutions to improve productivity, reduce the costs of farming and produce better foods for consumers and better feed for animals.


Consumer - Food & Restaurants Innovation in the food industry has been largely sustaining, as bioengineering has improved crop yields, increasingly large-scale production has created enhanced efficiencies while retail and restaurants continue to embrace shifting customer moves.

Consistently introducing truly innovative products to market has been a challenge for consumer-products companies with most (some estimate up to 90%) new products recently launched as brand extensions rather than truly new brands and a very small percentage (about 3%) reaching blockbuster status (defined as over US$50m in sales in the first year). To address this challenge, many consumer-goods companies are implementing innovation governance often supported by software in order to facilitate cross-functional decision-making across the innovation lifecycle. The results for such top brands as Heinz, Conagra, Coca-Cola, PepsiCo, Church & Dwight have included more high-value, even disruptive, new products.

Figure 17

Industry innovators: Food & Restaurants


McDonald’s MCD The original fast food franchise continues to adapt to changing preferences and tastes, introducing gourmet coffees, healthier options and regionally tailored offerings.

Starbucks SBUX Starbucks has expanded beyond offering prepared coffee drinks, Wi-fi access and sale of coffee beans, food and other accessories. Expansion into music, gift cards and potentially micro-lending characterize a culture that has always sought to reinvent established conceptions around coffee.

Trader Joe’s Private Trader Joe's high-end store brand offers low prices in “neighborhood-like” stores. With more than 350 stores, the company has leapt past Whole Foods to become America’s preferred organic grocer. With a selective offering of about 4,000 different products versus 50,000 in a typical grocery store, this results in over US$1,700 sales per square foot, doubling that of Whole Foods.

Whole Foods WFM Whole Foods Market has helped define a large market for high-end organic and gourmet foods, targeting aspirational and high-end consumers with premium-priced products.


Diane Geissler Food & Agribusiness

Consistently introducing innovative products is a challenge for consumer-

products companies



Consumer - Staples Established consumer-staples firms continue to see sustaining innovation as a force driving the introduction of new (and improved) products. We have earlier cited Procter & Gamble’s Connect+Deliver initiative, which decreed that 50% of innovations come from outside the company, as a defining validation of an open-innovation approach for large corporations. P&G has long been regarded as one of the most innovative companies, and the combination of in-house R&D, field research and direct engagement with the customer continues to drive new product introductions.

Consumer-packaged-goods companies have been active adopters of social media technologies to enhance their open-innovation efforts. Cross-branding (combining multiple brands in a single product) continues to drive new product introduction.

Figure 18

Industry innovators: Consumer Staples


Coca-Cola KO New product innovation is a key piece of its plans for sales growth, but the company also

innovates in its fountain equipment, price/packaging strategies, and packaging. Coke’s “Freestyle” fountain machine allows consumers to develop their own fountain sodas by mixing and matching varieties and flavors.

OXO International HELE Operating as a subsidiary of Helen of Troy, OXO reshapes everyday household tools with its smart design influence. Award-winning products include the Oxo cork pull, which comes with a built-in foil-cutter, and its GG 360 LiquiSeal Travel Mug. The company’s portfolio includes modern cooking tools, household-cleaning tools, bath-cleaning tools and accessories, barware, gardening tools, storage and organization products, trash cans, lighting and office products.

PepsiCo PEP Pepsi recently opened a clinical research center responsible for making its products

healthier - cutting fat, sugar and sodium by as much as 25% in the next 10 years - without changing the taste.

Procter & Gamble PG Procter & Gamble recently implemented a systematic and a broader set of sustainability

goals. These 10-year goals include using renewable energy for 30% of its factories and 20% renewable or recycled materials for all products and packages.


Consumer - Retail Retail has been transformed by the broad adoption of ecommerce and mobility. Retailers have had to adjust their value proposition to an environment where customers can increasingly comparison shop for bargains on their smartphones. In the 1990s and 2000s, retailers broadly invested in back-end inventory and supply-chain systems such as SAP and JDA Software, and this has largely been accomplished. RFID technology experienced a significant level of hype in 2004-05, which created a level of skepticism, but steady adoption of the technology is paving the way for new applications and services. RFID employs two components: a reader (or interrogator) and tag (or label). There are many applications for the technology, which is becoming increasingly prevalent as the cost of the tags decreases. It is in asset management, retail sales and product tracking that RFID shows significant promise, enabling manufacturers, distributors and retailers to gain granular insight into both the supply chain and demand patterns.

Caroline Levy Beverages, Household and

Personal Care Products

Barbara Wyckoff Consumer Retail



With the increasing availability of customer and transactional data, retailers are focusing on how to leverage this data to drive better marketing decisions. The rise of localized promotions through sites like Groupon and Living Social is helping drive traffic into retail locations. There is growing use of social media, such as Facebook and Twitter, both to gain insights into customer behavior as well as an adjunct to advertising in traditional and online media.

Figure 19

Industry innovators: Consumer Retail


Burberry Group plc BRBY.L Reinvention is crucial in the fashion industry and Burberry’s reawakening has been led by

CEO Angela Ahrendts with the help of renowned chief creative officer Christopher Bailey. Ahrendts has augmented edgier styles with technology such as 3D runway shows, runway orders over iPads as well as partnering with Salesforce.com to launch a “Social Enterprise.”

Createthe Group Private Createthe is a creative digital-media company, helping luxury brands deliver innovative and interactive communications platforms, campaigns and commerce solutions in digital, mobile, social media and emerging technologies.

Forever21 Private While Benetton and Zara (Inditex) have been at the forefront of the “fast fashion” retail

revolution, which refers to designs moving from catwalk to the storefront, Forever21 is the innovator of disposable fashion because it has delivered products to a mass market at very low prices.

The Gap GAP Gap leads the retail industry in facilitating shopping via smartphones. The company has

accelerated its mobile technology platform using iPhone and Android apps and early results are encouraging.

J.Crew JCG J.Crew successfully opened The Liquor Store and The Men's Shop in New York, which feature limited-edition items, and it continues to launch specialty boutiques. Recently, the company launched the ecommerce site for women's brand Madewell and an innovative online outlet store, open only on the weekends, which includes chat-ready personal shoppers.


Energy - Oil Services and Equipment An increasingly larger share of worldwide exploration and development in unconventional and deepwater fields continues to boost demand for new technology from the oil services sector. Service intensity has doubled in the last five years as deepwater and unconventional drilling has become increasingly prevalent. It is widely expected that service intensity will rise in the future, which will support demand for innovative technologies.

The structure of the oil services industry continues to evolve as reservoirs are increasingly difficult to exploit and customers require new technology. Barriers to entry are rising for smaller oil service companies without a global infrastructure, based on more regulatory requirements after the April 2010 Deepwater Horizon drilling rig incident and higher costs from technology and infrastructure development. Technological innovation, quality of service and price differentiation are the principal methods of competition in the oil services sector, and competition varies geographically with respect to the different services offered.

By making use of high-performance computing (HPC) appliances, many oil exploration companies are gathering substantial insights on drilling risks and opportunities, while gaining the ability to act more quickly. Many companies now armed with very advanced seismic algorithms are able to run them in a fraction of the time when employing clusters of servers as well as

Mark Urness Oil Services and Equipment

Retailers are focusing on how to leverage data to drive better marketing

decisions

High-performance computing appliances

help gather substantial insights

Barriers to entry are increasing for smaller oil

service companies



mainframes. As a result, the industry has increased seismic mapping accuracy and reduced time to action, leading to more agility and better measuring of the risks of deep-water drilling. This has improved success rates and the savings from not drilling are significant; avoiding one “dry” well could save hundreds of millions for any given company.

Figure 20

Industry innovators: Oil Services and Equipment


Baker Hughes BHI With its new stimulation/fracturing technology, FracPoint, Baker Hughes recently completed a number of 40-stage fracing jobs and is likely to be the first company to frac 24 stages. The company also recently launched an expandable liner hanger system, TORXS, which can be used across a broader range of applications including deepwater, subsalt plays, deviated wells, extended-reach wells and monobore completions.

Core Laboratories CLB Core Labs works on multistage frac jobs and can provide informed perspectives on the

utility of different fracture technologies, like plug and perf and sliding sleeve completion tools. Its fracture diagnostics technologies evaluate the effectiveness of every frac stage, and as companies develop new fracing technologies, demand for the company’s products should increase.

Halliburton HAL Halliburton continues to be a leader in favorable segments, such as deepwater, unconventional resources and mature fields. Using its “RapidFrac” technology, one operator experienced a 75% increase in production with a 50% reduction in pumping time compared to an offset well using traditional plug-and-perforate design.

Schlumberger SLB The largest oil services provider continues to lead innovation in fracturing. The latest technology from Schlumberger, HiWAY Flow Channel Fracturing, can reduce the environmental impact of drilling by developing methods that use less water and chemicals.


Energy - CleanTech Among energy alternatives, solar power has the most established presence having been in use for decades. While the industry has grown substantially in the recent past to the point where competition is fierce, barriers to entry are low and capacity is easily added - creating an environment where oversupply and eroding returns are likely to continue as a headwind for investors. However, we believe increased competition spurs innovation such as solar thin-film technology, solar windows, solar balloons, nano-technology enhanced panels (using light-absorbing carbon-nanotube fabric), micro-inverters and infrared spectrum solar panels. The more rapid companies are able to innovate, the more sustainable competitive advantages can be built.

Figure 21

Industry innovators: CleanTech


A123 Systems AONE Lithium-ion batteries make electric cars possible at mass-market prices. A123’s nanostructured electrodes result in lithium batteries more durable and safer than those in cell phones and laptops.

Amyris

AMRS Advanced biofuels hold the potential to reduce the use of gasoline and change the environmental landscape. Amyris has genetically engineered yeast that turns sugars into a building block of diesel fuel, which is usable in the existing vehicles of transportation.

First Solar FSLR New types of photovoltaics are reducing the cost of solar power. First Solar manufactures

thin-film solar panels based on cadmium telluride, which are cheaper than conventional silicon panels. This technology has made the company one of the world's largest photovoltaic manufacturers.


Mark Heller CleanTech



Financials - Banking and Securities In the wake of the financial industry crisis, financial services have been compelled to deploy enhanced credit risk management solutions. Solving the risk management problem requires pulling together multiple sources of data and applying risk analytics to detect potentially consequential changes. Financial fraud remains a significant challenge for consumers, businesses, banks and credit card companies, and there is consistent need for more effective analytics to detect potential fraud with minimal false positives. Anti-money laundering requirements continue to drive the need for more sophisticated solutions to detect and prevent illegal financial activities.

Financial innovation has been a loaded term, particularly since the financial crash of 2008. Much of the innovations in finance have been to reduce or distribute risk and exposure to taxes and regulations, and increase liquidity for different types of asset classes. Much of the financial innovation since the 1990s has been enabled by more powerful computing and sophisticated software, with internet connectivity opening up new markets. Examples of liquidity-driven innovations include exchange traded funds (ETFs), credit default swaps, securitized debt such as collateralized debt obligations and collateralized mortgage obligations. Technology-driven innovations include flash trading, dark pools, algorithmic and quantitative trading.

Figure 22

Industry innovators: Banking and Securities


BlackRock BLK BlackRock’s iShares division is the leading ETF provider in the world. BlackRock introduced

78 new exchange-traded products in 2010, maintaining its dual commitment to innovation and responsible product structuring.

Intercontinental Exchange

ICE Once a back-room specialty firm, energy trading is now center stage. The Intercontinental Exchange is a leading futures exchange for fossil fuels, electric power and even emissions.

Charles Schwab SCHW Charles Schwab was the pioneer in low-cost online trading that spawned legions of imitators. Online trading has been disruptive to the full-service brokerage industry.

SecondMarket (Private) SecondMarket, a SEC-regulated alternative trading system, has created the largest

“secondary market” for private-company shares. The company helps later-stage, fast-growing companies set up their own stock exchanges, where the company sets all the rules from pricing to market hours. Facebook, Twitter and Craigslist are among the client base.


Financials - Specialty Finance In recent years, there has been increased chatter around mobile payments and specifically near-field communication (NFC) technology among card networks (such as Visa and MasterCard), mobile-device manufacturers (Samsung, etc) and networks (Verizon). There has been a particular focus on the inclusion of NFC chips in the next wave of smartphones for the domestic market. Strategy Analytics predicts that by 2015, 5.1% of handsets sold in North America will be NFC enabled.

This technological advancement potentially has far-reaching implications for the payments industry and could impact all players in the current market, and in the future will include mobile-device manufacturers and cellular carriers. Some view that mobile-payment technology can be most easily implemented in mass-transit applications and retailers where smaller-ticket items are the norm, such as quick-service restaurants. McDonald’s now represents Visa’s largest customer as determined by transaction count. The land-grab is well

Mike Mayo, Chris Spahr, Matt Fischer,

Rob Rutschow Financials - Banks, Brokers,

Exchanges and Asset Managers

Craig Maurer Specialty Finance

Financial innovation has been a loaded term,

particularly since the financial crash of 2008

The land-grab is well under way over who will

capture the economics of mobile



under way over who will capture the economics of mobile-payments transactions between the established card-based payments players and the cellular carriers, as evidenced by the recent announcement of ISIS (a joint venture between AT&T, Verizon, T-Mobile, Barclays and Discover). One thing remains clear - recently announced initiatives are already intended to work with existing major payment systems, or will have to eventually look to do so in order to be relevant at the point of sale, driving an increasing number of transactions over the payment networks.

ISIS announced that HTC, LG, Motorola Mobility, RIM, Samsung Mobile and Sony Ericsson will introduce NFC-enabled mobile devices that implement ISIS’ NFC and tech standards. Additionally, ISIS is working with Device Fidelity to add NFC functionality to mobile devices that are not NFC-enabled, which we believe would be achieved through MicroSD (memory standard of the majority of Blackberry and Android smartphones). Notably, these handsets are not likely to be compatible with Google Wallet. For the major payment networks, NFC-based payments initially are likely to generate more replacement of existing card transactions than add new transactions to network volume. Only when NFC-based payments can materially penetrate new commerce segments, such as mass transit or vending machines, will this new technology truly be a driver to growth, so this shouldn’t pose any risk to near-term results.

Figure 23

Industry innovators: Specialty Finance


Intuit INTU Intuit’s latest money-management site Mint.com sparked great interest with its user base,

more than tripling to 4m and offering exciting new features such as a data aggregator that generates spending reports in real time. The company also launched SnapTax, which is a new mobile app that snaps a photo of W2s to streamline tax-filings, and Go Connect, which is an SMS-marketing system for small businesses in India.

Kiva Microfunds (Private) Kiva Microfunds operates as a person-to-person micro-lending site that empowers individuals to lend directly to small businesses in the USA and internationally. It mainly serves low-income entrepreneurs around the world. Since its launch in 2004, Kiva has helped more than 560,000 people fund US$200m worth of micro-loans with an average size of less than US$400. The non-profit recently expanded into higher education, allowing people all over the world to give as little as US$25 to fund student loans in the developing world, where student loans don't really exist.

PayPal EBAY In November 2009, PayPal opened up its system to third-party developers to allow them to

integrate its payment system into their Web sites, mobile apps and devices. This enabled all kinds of innovation in the past year. With over 15,000 developers, popular apps were created, such as Bling Nation (an add-on sticker used to tap to pay at merchants), iConcessionStand (order food and merchandise from a mobile device at sporting events), and IndieGoGo (fund raise for ideas or projects).


NFC-based payments are likely to generate more replacement of existing

card transactions

Section 3: Fertile ground for innovation US strategy


Fertile ground for innovation Innovation is increasingly valuable as an engine of economic growth, particularly for the USA, historically creating jobs and new markets. New ideas are realized in products and services, exported globally where incremental changes to innovative products and processes benefit different geographies and segments of the global population, especially in emerging markets.

If you're not failing every now and again, it's a sign you're not doing anything very innovative.

Woody Allen, screenwriter, film director

There is reason for optimism. The emergence of cloud computing, the mobile internet, non-traditional user interfaces, advances in programming science and artificial intelligence, falling costs of computing and bandwidth place unprecedented power in the hands of everyone - from a child with a cell phone to entrepreneurs to researchers seeking to solve challenges of medicine. The barriers to innovation have never been lower. Resources at hand for free or nominal cost, combined with global availability of information, communications and collaboration tools provide a springboard for imagination, experimentation and risk taking.

Technologists and investors tend to project the future in stepwise terms. Human beings naturally have linear intuitions about the future, because linear thinking progresses logically from experience. However, innovations and paradigm shifts occur at an accelerating, often exponential pace. The difference between linear and exponential growth is tremendous: 30 linear steps equals 30, while 30 exponential steps equals 1 billion. This is the nature of information technology, and it has powerful implications for the pace of innovation more broadly in the society.

Hardware, storage and computing capabilities continue to improve at exponential rates, while progress in software may prove the sole limitation. Increasingly rapid paradigm shifts (for instance, the explosive adoption of Facebook and the iPad and the derivative business ecosystems they have fostered) reinforce that change is accelerating and will continue to surprise.

Figure 24

Paradigm shifts are accelerating

?

The Web

Mobile Phone

PC

Television Radio Telephone

Facebook

0.1

1

10

100

1860 1880 1900 1920 1940 1960 1980 2000 2020

(Years)

Source: Ray Kurzweil, KurzweilAI.net

Tapping into accelerating change

Why is it valuable?

The challenge always remains a combination of

timing and careful selection

Rapid paradigm shifts such as Facebook and the

iPad reinforce that change is accelerating



Technological evolution has continued regardless of economic circumstance and has not historically been impacted by recession. Progress did not slow because of the Great Depression; creativity and innovation continued and will persist throughout the current economic challenges. If one looks at US$1.00 of computation counts as US$1.00 of economic activity, then in 2011 US$1.00 of computation would be a billion times more powerful than US$1.00 of computation in 1980. While there is variability in progress in specific scientific projects, looking at the aggregate of multiple steps of change over many years suggests that the overall trajectory can drive predictable progress.

Democratizing innovation - The impact will be far reaching The tools to create disruptive change are in everyone’s hands, and the Big Shift brought about by information technology is lowering the barriers for innovation. It is notable that two of the most important technology companies of our era - Facebook and Google - were created by college students.

Information technology is redefining the nature of physical goods. In the past, to share a book or compact disc one would have to send a package. Now anyone can share MP3s or an ebook via email. One can even send someone a violin that can be printed with a schematic on a 3D printer. This will only get easier as the scale of printing improves 100 times per decade.

On Wall Street, investors continually overlook that exponential growth starts out slowly. Adoption that is exponential plays out in businesses over the longer term. Despite the debacle of the 1999-2000 internet bubble, Google is now US$20bn in revenue in a US$2tn industry.

Miniaturization is also seeing significant advances. We are seeing the beginning of computerized, blood-cell-sized devices. In development are nanometer pores that let out insulin that are curing rats with diabetes.

Biology is becoming a computational discipline. The software for the body is thousands of years old, and with the sequencing of the genome, biology has become a computational problem. Researchers can take skin cells and add four genes so the cells become manipulable similar to stem cells, able to assume the form of any other type of cell in the body. We are seeing successful experiments in curing pulmonary hypertension in rats by modifying genes, replicating and injecting them back into the donor.

Solar energy technology power is doubling and we are eight doublings away from meeting the world’s energy needs. The sun has 10,000 times more energy than we need, so over time this represents the key solution to our energy problems - we have a declining cost per watt.

Framing the value of innovation In its essence, innovation is progress - a major growth driver of free markets and a creator of necessity. On the flipside, innovation is also a catalyst for “creative destruction,” leaving behind carcasses of products, processes and business models that become obsolete as progress steamrolls forward.

Innovation is a better way to deliver value. To me, it’s not an innovation until it actually solves a problem and delivers value in the real world. And

so it’s very different from invention.

Saul Kaplan, founder of the Business Innovation Factory

Innovation is essentially progress

The tools to create disruptive change are in

everyone’s hands

Technological evolution continues regardless of economic circumstance

Biology is becoming a computational discipline

We are eight solar technology doublings

away from meeting the world’s energy needs

Information technology is redefining the nature of

physical goods



Innovation is increasingly valuable as it drives economic growth particularly for the USA - creating jobs, new markets and new industries. This extends across the globe, as incremental changes to innovative products and processes benefits different geographies and segments of the global population, especially in emerging markets. Our CLSA colleagues highlight this phenomenon in The next six billion, which discusses Innovative Asia.

A framework for evaluating innovative competitiveness We highlight five broad metrics that impact innovative competitiveness (although various economic studies diverge). While none of these factors stands alone as a complete measure of a country’s innovation competitiveness, together these help to provide a fuller picture of innovation competitiveness across economies.

Investment through R&D - Corporate and government R&D spend is critical for sustainable innovation. While the USA is the global leader in absolute terms, Japan, Korea and Sweden have higher percentage spend (as a % of GDP). However, the USA has remained stagnant, progressing the least on the innovation front, while China has been leading in terms of progress made. On the corporate side, US companies spend about 3% of revenue on R&D with both the technology and pharmaceutical sectors investing over 10%.

Infrastructure - Technology and communications infrastructure is essential for facilitating the flow of information and increasing productivity. Undoubtedly, information technology is a driver of innovation in today’s world. As of 2010, the USA had nearly 240m internet users, a penetration rate of roughly 78%. However, the Scandinavian countries are the world leaders in internet penetration; for instance, nearly 95% of Iceland’s population use the internet. In absolute numbers, China ranked second with 384m users - larger than the entire US population - but had less than 29% penetration, with less than 8% of users subscribed to broadband.

Economic policy - While there is a clear link between a country’s investment in R&D resources and its innovation activity, these do not occur in a vacuum. Indeed, a country’s broader economic policy has significant bearing on innovation outcomes. Generally, it is easiest to do business in those countries: with minimal barriers to entry and exit; where it is easy to secure construction permits, register property, obtain credit, pay taxes and trade across borders; and that protect investors and enforce contracts.

Governance policy - Just as economic freedom is imperative for innovation, robust governance institutions - intellectual property rights protections and the rule of law, for instance - favor economic development and promote innovativeness. While investment in R&D, infrastructure, an open economy and the rule of law are necessary, socioeconomic factors may also contribute to a country’s innovation climate. In particular, those countries that tend to be more open to individual advancement and to immigration also tend to be open to new ideas.

Innovation output - We looked at the outputs (eg, patent activity, science and technology publications and entrepreneurship) to see just how competitive the USA is for innovation compared to other nations. As a quantitative measure, patent activity does not provide a good indication of quality, but it does provide a decent gauge of a country’s openness to innovation. Scientific and technological scholarship publication and citation numbers provide both a quantitative and qualitative means of measuring innovation output. Overall, these measures of innovation activity serve as a decent rubric against which to measure competitiveness.

US companies spend about 3% of revenue on

R&D with tech and pharma over 10%

Nearly 240m internet users in the USA - a penetration rate

of c.78%

Economic policy has significant bearing on innovation outcomes

An open economy and the rule of law are necessary

for innovation competitiveness



Entrepreneurship - Entrepreneurship provides an indication of a country’s innovation climate as well as a measure of a population’s willingness to take risks. It is another important measure of a country’s innovation competitiveness, as a new business is often the means by which an innovator commercializes an idea.

Caught napping? The USA has lagged in progress In 2009, the Information Technology and Innovation Foundation (ITIF) published a survey assessing the global innovation-based competitiveness of 40 countries or trade zones on a variety of metrics. The results of the survey should be a wake-up call for those concerned with sustaining the United States as the world’s innovation leader. Although the USA ranked as the world’s sixth overall most innovation-competitive country, it ranked dead last in terms of progress made over the prior decade. Not only has the country stagnated, it appears to be in grave danger of slipping further down the rankings.

The US strategy in the last century has been focused on innovation. It’s part because it’s what we’re good at . . . But since 9/11, we seem to have shifted strategies rather radically. So we seem to have discouraged high-

quality immigration, forcing companies to go overseas. We have the highest corporate tax rate in the world. We need a new approach that

recognizes what our strategies are and which works around an innovation strategy.

Gary Shapiro, head of Consumer Electronics Association

China’s rankings, on the other hand, paint an almost opposite picture. China ranked 33 out of 40 nations in innovation competitiveness, but ranked No.1 for progress made in the past decade. Singapore, which ranked as the most competitive country on an innovation basis, fell just behind China in the progress ranking. Even Japan, which is not often thought of as an innovation driver, ranked 9th overall and 10th in terms of progress made. India, which ranked last overall, had also made significant progress over the prior decade, ranking 14th.

By contrast, the World Economic Forum’s (WEF) Global Competitiveness Report 2010-2011, which ranked 139 countries across a broad range of competitive metrics including innovation, ranks the United States as the fourth most competitive economy - but it also notes that the USA has been steadily moving down the rankings. While China also ranks much lower in its survey, at 27th, the WEF report paints a familiar picture: China is moving rapidly up the global ranks of competitive economies, while the USA drifts slowly down.

On the other hand, the Economist Intelligence Unit’s 2009 rankings, which heavily weighted patent output, ranked Japan first, Switzerland second, Finland third, the United States fourth - and China 54th. Meanwhile, a poll conducted in 2010 by drugmaker AstraZeneca ranked the USA as the world’s most innovative country, followed by Japan and China. Measuring innovation is more an imprecise art than an exacting science.

Innovation investment: R&D and education The United States is the world leader in R&D spending, in absolute terms, having spent nearly US$369bn, or 2.7% of GDP, on R&D in 2009, according to the OECD. While there are a few other countries that spend more as a percentage of GDP, the next biggest spender, Japan, spent only 40% of the

Though the USA ranked as the sixth most

innovative, it was last in terms of progress made

China ranked No.1 for progress made in the

past decade

The USA remains highly productive in patent

output

The USA is the world leader in

R&D spending



US figure, or US$147bn. China spent 1.5% of GDP, or US$102bn, Singapore spent 2.6% (US$5.9bn) and Korea spent 3.5% (US$41.7bn). Germany and France were also major investors in R&D, having spent 2.1% (US$71.9bn) and 2.5% of GDP (US$43.2bn), respectively. Figure 25 charts R&D spending by country on a relative basis, showing a general positive correlation between R&D expenditure as a percent of GDP and R&D personnel.

Figure 25

Relative R&D expenditure by country

United States

Japan

Sweden

Singapore

Korea

Germany

China

Mexico

Italy

Russia

Hungary

Turkey

Romania

Poland

Greece

Portugal

Spain

Czech Republic

Ireland

Norway

Canada UK

Australia

FranceBelgium

Netherlands

0

1

2

3

4

5

6

7

0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0%

(000)

R&D Expenditure (% of GDP)

R&

D P

ers

on

nel (p

er

millio

n p

eo

ple

)

Source: OECD, NSF, World Bank, Credit Agricole Securities (USA)

R&D investments remain robust In 2010, the National Science Foundation (NSF) released the results of its 2008 Business R&D and Innovation Survey (BRDIS), which surveyed how 40,000 US companies innovated. While aggregate spending on R&D by the United States is formidable, actual spending varies widely across industries.

According to the NSF, US companies spent 3.0% of revenue on R&D, with manufacturing industries spending 3.4% and nonmanufacturing industries spending 2.4%. The semiconductor industry is by far the R&D leader, spending 15.0% of sales on R&D in 2008. Pharmaceuticals follow at 13.1%, communications equipment at 11.3% and software at 11.1%. Industries spending less than 1% included food, beverage/tobacco products and primary metals. In last place, the finance and insurance industry invested only 0.3% of sales on R&D.

Broadly across manufacturing industries, 22% of companies introduced a new or significantly improved product (good or service), while the same percentage of companies introduced a new or significantly improved process. This compares to just 8% of companies in nonmanufacturing industries for both categories. However, within these broad groupings, incidence of innovation varies widely.

R&D spend is about people, though

technology can lever up the impact

The semiconductor industry is by far the R&D

leader, spending 15.0% of sales on R&D

Companies in manufacturing industries

release more new products



We firmly believe that we will only survive if we innovate. It’s not a side strategy, it’s in the fiber of the corporate strategy; from the Board on

down. So that’s a tremendous help because it gives corporate research or R&D saying power. It’s the reason why we continue to spend US$6bn a

year and a portion of that on core research. Even in down times, that number is not questioned.

John Kelly, IBM

The most innovative manufacturing companies were in the computer/electronics industry, where 45% of firms introduced new product innovations. In the computers/peripherals and navigational instruments subcategories, 56% and 59% of companies, respectively, introduced new product innovations. Pharmaceutical, chemical and electrical equipment companies also ranked among the top innovators, respectively, at 45%, 40% and 37%. Wood products and nonmetallic mineral companies were the least innovative. Generally, sectors that tended to be the most innovative in terms of products were also the most innovative in terms of processes.

Among nonmanufacturing industries, software vendors were by far the most innovative category, with 77% introducing new products. Next in line were the telecom/ISP sector, where 37% of companies introduced new products. Trailing the list were the healthcare services, finance/insurance and real estate industries, at 10%, 8% and 7%, respectively. In the non-classified category, which includes wholesale/retail trade, hotel, entertainment and personal services businesses, the overall innovation rate was a meager 6%.

Nonmanufacturing companies represent nearly 92% of all companies in the USA, so it is perhaps startling that the great majority of American companies fall at the low end of the innovation spectrum. However, the National Science Foundation’s Business R&D and Innovation Survey also notes only about 3% of US companies performed or funded research and development activity in 2008. Unsurprisingly, those industries that introduced innovations also tend to be sectors that spend the most on R&D.

Compared to other countries, US corporate R&D spending ranked fifth at 1.7% of GDP versus 2.6% in Japan, 2.5% in Sweden and 2.4% in South Korea. According to ITIF, R&D expenditure by US corporations as a share of GDP actually declined by 4% from 1999 to 2008, while it increased by 160% in China. Singapore and Korea also saw large increases in corporate R&D spending, growing at 47% and 55%, respectively, over the same time.

Although US companies have cut back on in-house R&D, they are engaging in more collaborative R&D projects with universities, government agencies and other businesses. As of 2006, only 13% of innovative US technologies were developed in-house, while 87% were developed through collaborative research. This new model is often referred to as “open innovation.”

The most innovative companies are in the

computer/electronics industry

Software vendors were by far the most innovative

category, with 77% introducing new products

Compared to other countries, US corporate

R&D spending ranked fifth at 1.7% of GDP

US firms are engaging in collaborative R&D with

universities, government and other businesses



Figure 26

R&D spending by industry, government and universities

0

50

100

150

200

250

300

350

400

450

1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005

(US$bn)

0

0.5

1.0

1.5

2.0

2.5

3.0

University

Industry

Federal

R&D/GDP (RHS)

(%)

Source: NSF, Credit Agricole Securities (USA)

Government R&D spend still funds big projects While corporations are by far the biggest R&D spenders, government also contributes significantly to total R&D expenditures. Indeed, many well-known technologies, from the internet to nanotechnology, have their roots in government R&D spending. In the former case, however, one might argue that the real innovation did not occur until the private sector commercialized the internet. There are concerns, however, that innovation funded by the government may not be sufficient (or even effective in the current environment) and given the recent debacle around Solyndra, the solar panel firm that went bankrupt after receiving US$500m in federal loans, cynicism is growing.

The state can successfully push science; there is no sense denying it. The Manhattan Project and the Apollo program remind us of this possibility.

Free markets may not fund as much basic research as needed. . . Most of our political leaders are not engineers or scientists and do not listen to

engineers or scientists. Today a letter from Einstein would get lost in the White House mail room, and the Manhattan Project would not even get

started; it certainly could never be completed in three years.

Peter Thiel, The End of the Future, National Review, 3 October 2011

In 2009, the US federal government spent US$114bn on R&D across a variety of agencies. The Department of Defense was the largest spender, accounting for more than half of total spending. Meanwhile, the National Institutes of Health was the second-largest spender, accounting for approximately a quarter of government spending. The next largest sources of government R&D spending were the Department of Energy (7.6%), NASA (5.5%) and the NSF (4.1%).

Compared to other countries (per ITIF’s survey), the US ranked fourth in government R&D spending, outpaced only by Sweden, Singapore and France. US government spending on R&D grew at a meager 1% from 1999 to 2006, and again the USA was outpaced by Asian countries. Over the same period, government R&D spending in Korea grew at 33%, China at 20% and Singapore at 9%. Interestingly, government spending in India and Japan actually declined 2% and 7%, respectively.

Total R&D spend has continued to climb as a

proportion of GDP

Many well-known technologies have their

roots in government R&D

The US ranks fourth in government % R&D

spend, after Sweden, Singapore and France

In 2009, the US federal government spent

US$114bn on R&D across a variety of agencies



Still a highly educated country, though others are catching up A highly educated workforce with significant participation in science and technology is key to drive innovative effectiveness. The United States is one of the world’s most educated countries, ranking third among OECD countries in terms of tertiary level educational attainment for those aged 25-64, with 39.5% holding a degree from an institution of higher learning. Among rich countries, only Japan and Canada ranked higher, at 40.5% and 47.0%.

However, there is evidence that emerging economies are catching up. According to ITIF, 56% of Russians aged 25-34 graduate with tertiary degrees, whereas the USA falls to 8th place at 39%. South Korea and Japan, at 51% and 53%, surpass their Asian neighbors, although Singapore is close behind at 38%. China and India are in 20th and 21st place, respectively, with only 9% of adults aged 25-34 attaining tertiary degrees. In terms of growth, Korea ranked 2nd at 46% from 1999 to 2005, whereas the USA ranked 15th at only 3% growth. Figures for China and India were not available.

We still have a phenomenal university system, which we are exporting, in a sense, graduate-level education. We are getting the best and the

brightest from some level to come to the United States. We have to get them to stay here. And we have to keep our university system up; not

necessarily by throwing more money at them, but we have to recognize that is part of our strategy.


The USA ranks fourth in research personnel, with 9.74 scientists or engineers per 1,000 employed in an R&D capacity as of 2006, according to the UNESCO Institute of Statistics. Scandinavian countries lead the world in research personnel, with upwards of 17.1 researchers per 1,000 employed in Finland, for example. Among Asian countries, Japan and Singapore lead with 13.7 and 12.9, respectively. China and India lag with around 1.5 and less than 0.5 researchers per 1,000. On the other hand, mainly because it started from a small base, China raised its pool of researchers by 111% from 1999 to 2006. Among developed countries, Korea and Singapore also made impressive gains at around 70% each, whereas the USA only grew by about 8%.

Infrastructure Investment in physical infrastructure is as important for a country’s innovation competitiveness as it is for its basic economic development. As the World Economic Forum (WEF) notes in its Global Competitiveness Report 2010-2011, ‘[e]ffective modes of transport, including quality roads, railroads, ports and air transport, enable entrepreneurs to get their goods and services to market in a secure and timely manner and facilitate the movement of workers to the most suitable jobs.’

As an advanced economy, the United States has developed a vast and efficient transportation network that spans a huge domestic geography and connects it to global markets. However, the rapid industrialization of China has led it to surpass the USA in several infrastructure metrics, although recent events on China’s high-speed rail network serve as a poignant reminder of the risks in sacrificing quality for quantity. Those countries that happen to be along major shipping routes between the world’s largest trading partners - generally, Asian tigers like Hong Kong and Singapore - also rank highly.

The United States ranks No.3 in advanced degrees

Emerging economies are catching up

Infrastructure is as important for innovation

as it is for economic development

Rapid industrialization of China has led it to surpass

the USA in several infrastructure areas

The USA ranks fourth in research personnel, with

9.74 scientists/engineers per 1,000 employed



One of the major roadblocks to growth, innovation and entrepreneurship in Asia is, incidentally, a lack of roads. Poor physical infrastructure - not just of roads but also including railways and ports - seriously limits the opportunities available to would-be entrepreneurs. Incidentally, India’s notorious capital underinvestment led to an infrastructure gap that spurred the development of its IT services and outsourcing sector, which were human-capital intensive. But such growth is limited by the skill set of its broader population.

Connecting the bits Just as physical infrastructure is necessary to connect people geographically and foster economic development, telecom and internet infrastructure is essential for facilitating the flow of information and increasing productivity. Undoubtedly, information technology is a driver of innovation in today’s world.

The USA had approximately 155m telephone lines in 2008, or about 1 for every 2 people, a decline from 191m in 2001. On the other hand, there were over 298m mobile telephone subscriptions, or about 97 mobiles for every 100 people. A similar decline in landlines has occurred throughout the developed world, while mobile phone use has exploded.

With nearly 314m telephone lines, China leads the world in absolute terms, but those lines reached only 24% of the population and have declined from the peak of 367m reached in 2006. Instead, more Chinese are rapidly adopting mobile phones. China leads the world in mobile subscribers with 747m, a penetration of 56% and an increase of more than 400% since 2001.

A similar pattern emerges in India, where telephone lines reach only 3.2% of people. Mobile phone use in India has skyrocketed since 2001, rising nearly 8,000% to over 525m subscriptions from just 6.5m. In 2001, less than 1 in 100 people had a mobile phone, whereas today more than 45 in 100 do. The rise of mobiles in India has coincided with a wave of innovative new mobile-based technologies, including mobile-banking services for microfinance.

As of 2010, the USA had nearly 240m internet users - a penetration rate of over 78%. Of these, 85m, or 30% of total internet users, subscribed to fixed broadband internet. However, the Scandinavian countries are the world leaders in internet penetration; for instance, nearly 95% of Iceland’s population use the internet, while 34% subscribe to a broadband service. Sweden leads the developed world with over 40% of its population connected to broadband service. Japan and Korea also have high internet penetration rates at 77.7% and 80.9%, with respective broadband penetration rates of 24.9% and 33.5%.

In absolute numbers, China ranked second with 384m users - larger than the entire US population - but had less than 29% penetration, with less than 8% of users subscribed to a broadband service. However, the number of internet users has increased by a 31% Cagr from 2001 through 2009, while broadband users have grown at nearly a 105% Cagr over the same time. India, with only 61.3m users, has only 5.3% internet penetration with less than 1% of users subscribing to a broadband service.

The USA still leads in venture capital The most innovative ideas may not survive long in the world without access to financing. Accordingly, the availability of financing options, whether institutional or otherwise, is crucial to innovation activity and competitiveness. For startups, access to venture capital and angel investors is

A major roadblock to growth, innovation and

entrepreneurship in Asia is lack of roads

The USA has 97 mobile lines for every 100 people

The USA has nearly 240m internet users -

a penetration rate of roughly 78%

For startups, access to venture capital and angel

investors is particularly important

Telecom and internet infrastructure is essential

for facilitating information flow



particularly important, as larger financial institutions generally are often unwilling or unable to risk investing in unproven early-stage business ideas.

The Center for Venture Research found that angel investors funded 61,900 entrepreneurial ventures worth some US$20.1bn in 2010. Comprising more than 265k investors, the US angel investor community is the world’s largest. Angels invested in a variety of sectors, with healthcare leading at 30%, followed by software (16%), biotech (15%) and clean tech (8%). The OECD’s estimate of global angel investors from 2007 showed the US leading with 270 angel networks, more than half the world total, followed by France (66), Germany (38), Spain (37), Sweden (22) and the UK (18).

In absolute terms, the USA is the world leader in venture-capital investment, exceeding US$23bn in 2010, according to the National Venture Capital Association. Of this, only 7.4% went to seed investments, with venture firms investing more in early stage (23.6%), expansion (39.5%) and later stage (29.5%) investments. Over 25% of venture deals by number were in the software industry, which accounted for 18.5% of total deal value. Venture-capital firms also invested heavily in biotech (13.7% of deals), clean tech (8.5%) and medical devices (10.1%).

While US investment in venture-stage companies is the largest in absolute terms, as a percentage of GDP it is outranked by quite a few countries. Compared this way, Finland invests nearly twice as much (0.24%) as the USA (0.12%), while Sweden and the UK also invest at significantly higher rates. In both absolute and percent terms, Japan trails rich countries, with only US$300m in venture-capital investments, representing 0.007% of GDP. Presently, VC activity in China and other emerging countries is in its infancy and does not account for a meaningful portion of GDP.

Figure 27

Venture-capital investment by country and stage

0.00 0.05 0.10 0.15 0.20 0.25

FinlandSweden

UKNorway

DenmarkAustralia

IrelandSwitzerland

FranceSpain

USCzech

NetherlandsBelgium

GermanyCanada

KoreaHungary

ItalyPortugalAustriaPolandGreece

Seed stageEarly and expansion stages

(%)

Source: OECD, Credit Agricole Securities (USA)

The American VC ecosystem has been replicated with a fair degree of success in Western Europe, Israel and other developed nations, and the role of VCs as private investors to encourage and facilitate risk-taking is unparalleled in promoting innovation. Despite the regulatory and macro challenges faced by North American VCs, the community remains a key contributor to American competitiveness.

Angel investors funded 61,900 entrepreneurial

ventures worth some US$20.1bn in 2010

The USA is the world leader in venture-capital

investment, exceeding US$23bn in 2010

Many countries in Scandinavia and the UK

have higher VC investment as a % of GDP



Policy sets the backdrop for an innovative climate While there is a clear link between a country’s investment in R&D resources and its innovation activity, these do not occur in a vacuum. Indeed, a country’s broader economic policy has significant bearing on innovation outcomes. In terms of innovation competitiveness, countries that are economically freer generally outperform those with more onerous regulations.

Ease of doing business and economic freedom The World Bank’s Ease of Doing Business (EODB) survey measures business regulations across 183 countries. Generally, it is easiest to do business in those countries: with minimal barriers to entry and exit; where it is easy to secure construction permits, register property, obtain credit, pay taxes and trade across borders; and that protect investors and enforce contracts. Overall, the USA ranks as the fifth easiest place to do business, behind Singapore (1st), Hong Kong (2nd), New Zealand (3rd) and the UK (4th). Among developed countries, South Korea ranks 16th while Japan ranks 18th. China comes in at 79th, while India trails at 134th.

In terms of starting a business, the USA ranks in 9th place, behind New Zealand (1st), Australia (2nd), Canada (3rd), Singapore (4th) and Hong Kong (5th). All of these countries generally have low barriers to entry for new businesses, requiring few procedures, minimal time and low start-up costs. On the other hand, Japan ranks 98th on the list - behind Pakistan, Laos and Yemen. China ranks 151st, due primarily to its excessive set-up time and capital requirements, while India ranks 165th.

Figure 28

Total corporate tax rates versus Ease of Doing Business (log scale)

Canada

Denmark

Japan

Germany

Australia

US

Norway

UKNew Zealand

Ireland

Koera

Singapore

Hong Kong

China

ItalyBrazil

India

Switzerland

France

SpainAustria

Vietnam

20

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70

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1 10 100 1,000

(%)

Source: World Bank, Credit Agricole Securities (USA)

The Fraser Institute’s Economic Freedom of the World (EFW) 2010 report is similar to the EODB survey, except it recasts the question of doing business, or economic activity, in political terms. Unsurprisingly, the rankings of both surveys are highly correlated: countries in which it is easy to do business are countries that have a high degree of economic freedom. But there are important differences between the two surveys. Whereas the EODB is more concerned with the mundane details of doing business, the EFW also takes into account broader politico-economic issues, including size of government and currency soundness.

Low taxes are more competitive for business

The USA ranks as the No.5 easiest place

to do business

Economic policy has significant bearing on innovation outcomes



By this ranking, Hong Kong is the most economically free, followed by Singapore, New Zealand, Switzerland, Chile and the USA. Japan ranks 24th while Korea ranks 37th, both behind their EODB positions. China and India rank at 82nd and 87th, respectively, the latter a significant improvement over the World Bank’s rank. Generally, these findings are not surprising, although a few show how differences in methodology affect ratings.

Rumblings of discontent from business grow louder Beyond the statistics is a more challenging reality, that business sentiment is closely tied to political policy, and there is growing and more vocal dissatisfaction in current leadership from leaders such as Howard Schultz of Starbucks, casino mogul Steve Wynn, Paul Otellini of Intel and others.

We have a lot working against business in the country at the moment, and never before in my lifetime has there been more anti-business attitude that comes from the top. . . Sarbanes-Oxley. . . It’s very difficult and expensive to go public. . . We have a surplus of lawyers here that are litigation-happy

. . . The anti-business sentiment, the anti-employer sentiment, the fact that our taxes are biased against business startups. We need a new approach

that recognizes what our strategies are and which works around an innovation strategy.


Tax whatever you want less of According to the OECD, the effective corporate tax in the United States was 39.2%, the second highest among developed countries with Japan slightly higher at 39.5%. Compare this to the 29.5% corporate tax rate in Canada. Surprisingly, total corporate tax rates in Scandinavian countries were also lower than in the United States, while the UK is 28%

Figure 29

Corporate tax rates by country

Country Combined corporate tax rate (%) Income from corp. tax (% of GDP)

Japan 39.5 2.4

United States 39.2 2.1

France 34.4 1.4

Germany 30.2 1.3

Spain 30.0 2.2

Canada 29.5 2.5

United Kingdom 28.0 2.8

Italy 27.5 3.1

Sweden 26.3 2.8

Korea 24.2 3.7

Ireland 12.5 2.4

Source: OECD

Singapore and Hong Kong maintain their reputations as corporate tax havens with total tax rates on commercial profits of 25.4% and 24.1%, respectively. While corporate tax rates do not have as much impact on the decision of an entrepreneur whether to start a business, there are implications for established companies. High tax rates induce multinational corporations to locate IP and operations in lower-tax jurisdictions, impacting job creation whether there is wage parity. Because the USA’s higher corporate tax penalizes repatriation, this has led to an enormous balance of cash held offshore by US-headquartered corporations, by some estimates up to US$2tn.

Hong Kong is the most economically free

Countries with low corporate tax rates attract capital and

businesses investment

The US corporate tax rate is second only

to Japan among OECD countries

Repatriation taxes compel US corporations to maintain massive

offshore cash balances



Individual tax rates impact entrepreneurs While corporate tax rates tend to influence competitiveness at the corporate level, personal income tax rates affect entrepreneurs, startups and many small businesses that file taxes based on individual income. However, low corporate tax rates are not necessarily correlated with low personal income tax rates. While the USA has one of the highest corporate tax rates in the developed world, Americans earning wages of US$100k paid average effective personal income taxes (including social security contributions) of 24.3%, according to KPMG. Of course, startups will not pay taxes until they are profitable, so tax policy tends to impact established firms.

Meanwhile, the relatively lower corporate tax regimes in Scandinavia versus the USA are met by significantly higher effective total personal income tax rates, with Danes paying 42.0% and Norwegians paying 32.2% on average. Similarly, Ireland’s low corporate tax rate is met by effective personal income taxes of 30.3%.

Figure 30

Top marginal tax rates versus effective total income tax rates

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(%) Effective total income tax rateTop marginal tax rate

Source: KPMG, OECD, Inland Revenue Authority of Singapore, Inland Revenue Department (Hong Kong), Vietnam Trade Office in the USA, State Administration of Taxation (China), Income Tax Department (India), International Living (Brazil)

Again, developed Asian economies tend to be more tax-friendly than their emerging neighbors. Singapore and Hong Kong also have the lowest effective personal income tax rates in the developed world, at 14.6% and 10.7%. Among developing Asian economies, Vietnam emerges as an all-around tax-friendly country, with a relatively low personal income tax of 28.4% to match its relatively lower corporate tax rate. China and India have effective income tax rates of 25.4% and 39.5%, respectively, making the latter less competitive.

Of course, the top marginal tax rate often bears little relation to what the average wage earner pays. In the USA, effective total taxes are less than 60% of the top marginal rate, although that gap is much closer for other rich, especially European countries. However, even though most wage earners pay taxes below the marginal rate, this rate might have more bearing on innovation and entrepreneurship because many small businesses pay taxes on a personal income tax basis.

Personal income tax rates affect entrepreneurs,

startups and many small businesses

Developed Asian economies tend to be

more tax-friendly than their emerging neighbors

The USA ranks below many European countries

in top marginal tax rate



Higher marginal tax rates may, therefore, discourage individuals from entrepreneurial risk-taking, reducing the commercialization of innovation. According to a 2005 study by the Small Business Association, reducing the marginal tax rate on entrepreneurial income for single filers by 1% would increase the probability of entry into entrepreneurial activity by 1.42%, reduce the probability of exit from entrepreneurial activity by 17.32% and extend the duration of that activity by 32.5%.

Stable governance is key for confidence Just as economic freedom is imperative for innovation, robust governance institutions - intellectual property rights protections and the rule of law, for instance - favor economic development and promote innovativeness. While investment in R&D, infrastructure, an open economy and the rule of law are necessary for innovation competitiveness, socioeconomic factors may also contribute to a country’s innovation climate. In particular, those countries that tend to be more open to individual advancement and to immigration also tend to be open to new ideas.

Governance policy Measuring the strength and efficacy of a country’s governance institutions is imprecise. The existence of legal institutions and intellectual property (IP) protections on the books is not necessarily correlated with the enforcement of those laws and protections in real life. The World Bank publishes data from its Worldwide Governance Indicators (WGI) project, measuring governance across a variety of metrics including rule of law, control of corruption, regulatory quality, government effectiveness, voice and accountability and political stability. Predictably, developed countries generally score high on these metrics. While imperfect, they are an adequate measure of whether a country is institutionally inclined towards innovation. (All WGI rankings are out of 100 points.)

Germany leads with an overall ranking of 90.1, with rankings in the top percentile on all six metrics minus political stability, where it ranks 76.9 - the highest among Western countries. Hong Kong actually ranks higher than Germany on most metrics, including political stability, but falls into the second bracket on account of its low ranking on voice and accountability (63.5), the survey’s measure of freedoms of expression, association and media.

At 83.4, the United States ranks behind France and Japan, with across-the-board scores in or near the top percentile. The exception is political stability, a symptom of the occasionally volatile Anglo-Saxon political process, which at 59.0 is a drag on its overall rank. In the wake of the financial crisis, the quality of the regulatory environment, government effectiveness and control of corruption have slightly deteriorated dropping the USA from the top percentile in each category.

China, by these standards, has quite a long way to go. While its government is seen as marginally effective at 58.1, it scores below 30 on political stability. In terms of free political expression, it ranks an abysmally low 5.2, among the lowest in the world. India ranks higher than other BRIC countries on rule of law and freedom of expression in line with government effectiveness. Corruption control and regulatory quality are still poor, however.

Higher marginal tax rates may discourage entrepreneurial

risk-taking

Measuring the strength and efficacy of a country’s

governance institutions is imprecise

The USA ranks near the top percentile in

governance

China, by these standards, has quite a

long way to go



Figure 31

Worldwide governance indicators by country

CountryRule of

LawPolitical Stability

Control of Corruption

Regulatory quality

Voice and accountability

Government effectiveness

Overall

Germany 92.9 76.9 92.9 92.4 93.8 91.9 90.1Hong Kong 90.6 81.6 94.3 99.5 63.5 95.7 87.5United Kingdom 93.9 54.7 91.4 94.3 91.9 91.0 86.2Singapore 92.5 90.1 99.0 100.0 34.1 100.0 86.0France 89.6 65.6 90.5 85.2 90.5 90.0 85.2Japan 88.2 83.5 87.1 81.0 81.0 86.7 84.6United States 91.5 59.0 85.2 89.5 86.3 89.0 83.4South Korea 82.5 52.4 71.4 75.2 68.2 83.3 72.2Brazil 49.5 54.2 56.2 55.2 62.1 57.6 55.8Turkey 58.0 18.9 60.0 58.6 45.0 63.8 50.7India 55.7 13.2 46.7 44.3 60.2 54.3 45.7Thailand 50.9 14.6 51.0 61.9 34.6 59.5 45.4Indonesia 34.4 24.1 28.1 42.9 48.3 46.7 37.4China 45.3 29.7 36.2 46.2 5.2 58.1 36.8Vietnam 41.5 51.4 36.7 31.0 7.6 46.2 35.7Russia 23.6 21.7 11.4 35.2 22.3 44.8 26.5Pakistan 19.3 0.5 13.3 33.3 20.9 19.0 17.7

Source: World Bank Worldwide Governance Indicators, Credit Agricole Securities (USA)

The takeaway from the WGI data is that Asia’s emerging economies are significantly lagging developed countries in the region and globally in terms of governance. It is no accident that those countries with robust governance institutions are generally more conducive to innovation. Even among the developed countries, it is worth noting that those countries that limit or repress political expression and association lag Japan and South Korea in innovation competitiveness. China’s leadership, as it looks to advance technologically via innovation, should pay attention. Innovation may be both a product of political as well as economic freedom.

Immigration - The USA’s secret sauce The USA’s relatively open immigration system increases its innovation competitiveness. According to the Kauffman Foundation, immigrants were more than twice as likely to start a business versus native-born Americans. Immigrants from Latin America and Asia, which are the two fastest-growing demographic groups in the USA, are also the fastest-growing entrepreneurial demographic. In our view, the United States’ unique genesis as a country built on immigration remains a key competitive advantage.

Immigrants provide spark for the US economic engine According to the Kauffman Foundation’s recent analysis of the Fortune 500 largest US public companies, a disproportionate number of companies have founders that are immigrants or children of immigrants. Notable immigrant entrepreneurs include Sergei Brin of Google (Russia), Andy Grove of Intel (Hungary), Pierre Omidyar of Ebay (France), Jerry Yang of Yahoo! (Taiwan) in the tech sector, as well as notable figures such as Alexander Graham Bell (Scotland) and the inventor of the phonograph, Emile Berliner (Germany).

In absolute terms, the USA accepted the most immigrants of any country from 2006 through 2010, according to the World Bank. These 5m immigrants represented 1.7% of the average US population over the same time. Among developed countries, Spain, Italy, Canada and the UK saw significant influxes of immigrants over the same time. Net migration to Singapore totaled 500k, or nearly 11% of its population. Hong Kong also had a net inflow of migrants of approximately 1.6% of its population.

Emerging economies lag the developed world on

governance issues

Asia’s emerging economies significantly lag developed countries

in the region

Immigrants are more than twice as likely to

start a business versus native-born Americans

Immigrant entrepreneurs include Sergei Brin, Andy Grove, Pierre Omidyar of

Ebay and Jerry Yang

Percentiles 90th-100th 75th-90th 50th-75th 25th-50th 10th-25th 0th-10th



Strikingly, Japan’s notoriously closed society saw net migration of only 150k, or 0.1% of its population. South Korea, meanwhile, had a net outflow of -30k, losing 0.1% of its population to migration. China and India both saw net outflows of migrants, with India losing 1m people and China over 1.7m. Only Mexico saw a greater net outflow of migrants, at 2.4m.

Gauging innovative outputs We have surveyed the output measures of innovation - patent activity, science and technology publications, and entrepreneurship - to see just how competitive the USA is for innovation compared to other nations. As a quantitative measure, patent activity does not provide a good indication of quality, but it does provide a decent gauge of a country’s openness to innovation. Scientific and technological scholarship publication and citation numbers provide both a quantitative and qualitative means of measuring innovation output. Entrepreneurship again provides an indication of a country’s innovation climate as well as a measure of a population’s willingness to take risks. Overall, these measures of innovation activity serve as a decent rubric against which to measure competitiveness.

The USA the patent leader, but Asia is surging Three countries dominate the global rankings for patent activity: the United States, Japan and China. China is a relative newcomer to the stage, growing its patent activity from virtually zero in 1991 to a level comparable to Japan today. Of course, China’s phenomenal growth must take into account the quality of these patents as well as their degree of innovativeness.

In terms of patent applications, the United States was the world leader in 2009, receiving 456.1k applications according to the UN’s World Intellectual Property Organization (WIPO). Japan came in second place at 348.5k, while China took third at 314.6k. South Korea came in at a distant fourth place with 163.5k applications. WIPO data for patent grants tell a similar story, although Japan led with 193.3k grants in 2009 to the USA’s 167.3k and China’s 128.5k.

Figure 32 Figure 33

Patent applications

Patent grants

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Source: WIPO, Credit Agricole Securities (USA)

Perhaps more interestingly, WIPO data show that most patent applications in the USA are now made from non-residents. In 2000, 56% of applications were made by US residents versus 49% in 2009, the first year more than half were filed by foreigners. Patent grants show a similar story. In 2000, 54% of patents were granted to residents, but this number dropped to 49% by 2008. Compared to other countries, the USA’s share of foreign patent applications and grants is striking. In 2009, Japan received only 15% of applications from nonresidents, while China received 27%. Of total granted patents, Japan granted only 15% to nonresidents while China granted just under half to nonresidents. Seemingly, the USA remains an attractive place for intellectual

Japan’s notoriously closed society saw net migration

of only 150k, or 0.1% of its population

Three countries dominate the global rankings for

patent activity: the USA, Japan and China

The United States is the world leader in patent

applications

WIPO data shows that most patent applications in the USA are now made

from non-residents



property, but the rate of home-grown innovation seems to be in decline. Interestingly, while patent activity has certainly been spurred in China, the quality of those patents seems to be inferior to foreign applicants.

Figure 34 Figure 35

Patent applications by applicant type

Patent grants by applicant type

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As the world’s largest center of patent activity, it is no surprise that the USA also leads the world in the number of patents in force. As of 2009, the US Patent Office recognized nearly 2m patents. By contrast, 1.1m patents were in force in Japan and only 828k in China. IBM remains the leading US patent holder and filer.

[IBM needs] to have an enormous high-quality [patent] portfolio so that we have freedom of action. Because of the size of our business and the areas that we go into, we can’t go into a business and not be protected from an IP standpoint or at least have enough patents that we can have a reasonable balance of power wherever we want to go . . . that causes us to generate large numbers of patents in a pretty sophisticated process.

John Kelly, IBM

WIPO data showing patent intensity produce some interesting statistics. Based on resident patent filings per US$bn in GDP, South Korea leads the world at nearly 114. Japan is in a distant second at 82.4, down from nearly 106 in 2000. China is in a more distant fourth place at 22.8, while the USA takes fifth place with 18.6 patent filings per US$bn in GDP. Thanks to its relatively high patent activity versus its small GDP, Moldova takes third place.

Looking at patent intensity in terms of resident patent filings per million of population produces similar findings. Korea still ranks as the most patent-intensive nation, with 2.7k filings per million people versus 2.6k in Japan and just 800 in the United States. The United Kingdom has patent intensity of 285, roughly in line with Scandinavian countries including Sweden (276), Norway (260) and Denmark (304). By this metric, China falls to 25th place with only 116 filings per million people - one place ahead of Moldova.

The USA also leads the world in the number

of patents in force

Korea ranks as the most patent-intensive nation,

with 2,700 filings per million

More non-residents are applying for patents in

the USA, a reflection of globalization



Figure 36 Figure 37

Patent intensity by GDP

Patent intensity by population

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ong

India


Scientific and technical scholarship - Publish or perish Measuring the publication and citation of scientific and technical scholarship produces a fair measure of the quality of intellectual work produced by a country. According to the NSF, the United States produced 29% of the world’s science and engineering-related articles in 2008. Compare that to the next largest producer, Japan, which produced 7.8%, or China, which produced only 5.9%. On the other hand, the USA’s share of publications declined from 34% in 1998 while China’s output grew from less than 2%. Though US research is dominant in all fields, Chinese output tends to emphasize the physical sciences, especially chemistry and physics, while more than 50% of US research output is in the life sciences.

Similarly, the number of citations of US publications declined from nearly 47% in 1998 to 38.3% in 2008, while citations of Chinese publications rose from less than 1% to 4.3%; citations of Japanese publications declined from 6.8% to 6.3%. Of those articles that are highly cited (99th percentile), 52% are US publications while just 2.5% are Chinese. This represents a decline for the USA from 62% in 1998 and an increase for China from just 0.1%. Japan’s share, at 4.5%, represents a slight improvement from 1998.

Nevertheless, the sustained outsized proportion of citations to US output suggests that US publications tend to be more influential than their Chinese or Japanese counterparts, although China is demonstrating some improvement in the quality of its research. The NSF calculates that, when citation rates are normalized by share of world articles, the USA produced 78% more highly cited articles than expected while China had 58% fewer.

Entrepreneurship Entrepreneurship is another important measure of a country’s potential for economic growth - not all entrepreneurship is innovative, but the most powerful innovators are also entrepreneurs.

I [think] entrepreneurship and innovation should go hand in hand. They shouldn’t be separate and a lot of people disagree with me. In many cases of entrepreneurship, it’s just having to start something. It doesn’t have to

be innovative. But my thought is innovation is the creation of new and unique businesses, products, services . . . and starting new businesses that

The United States produced 29% of world

science and engineering-related articles

US publications tend to be more influential than

their Chinese or Japanese counterparts

Not all entrepreneurship is innovative, but the

most powerful innovators are also entrepreneurs



can last and create value for the economy, for the entrepreneur, for society. Any sort of business that basically adds value to all of us.

Kamal Hassan, president and CEO of Innovation 360 Institute

According to the Global Entrepreneurship Monitor (GEM), globally, more than 110m people aged 18-64 were actively engaged in starting a business, 140m were a running a new business less than 3.5 years old, and 250m were involved in early-stage entrepreneurial activity. However, the quality and nature of entrepreneurship varies widely depending on the type of economy. GEM breaks down economies into three types: factor-driven, which are agricultural and natural resources intensive; efficiency-driven, which are typified by scaled industrialization, large firms, and niche SMEs; and innovation-driven, which are predominantly service-oriented and knowledge intensive.

In factory-driven economies, necessity tends to be the primary driver of entrepreneurship, whereas opportunity tends to be the main driver in innovation-driven economies. Additionally, entrepreneurship rates are generally higher in factory-driven economies than innovation economies, largely because necessity (a dearth of employment opportunities) drives people into business for themselves, whereas entrepreneurship is generally one choice among many alternatives in developed economies.

In 2009, 48% of entrepreneurs in China started their own businesses because they lacked other career choices. Compare this to developed countries including Denmark, Norway and Switzerland, where only 7%, 9% and 7% pursued entrepreneurship out of need - and 56%, 74% and 67% of entrepreneurs chose to become entrepreneurs to exploit a new opportunity or seek a higher income. Interestingly, 45% of Korean entrepreneurs also started their own businesses out of necessity. In the United States, this figure nearly doubled to 23% from 2008, reflecting the economic downturn and sustained unemployment.

Figure 38

Reason for starting a business

0 20 40 60 80 100

ChinaKoreaBrazil

GermanyJapanRussiaGreece

ChileMalaysia

USHong Kong

UKFrance

(%)

Necessity

Choice

Source: Global Entrepreneurship Monitor; Credit Agricole Securities (USA)

Public attitudes towards innovation correlate with the level of entrepreneurial activity in a country. In Japan, only 50% of people thought successful entrepreneurs enjoyed high status and only 28% thought it was a desirable

Forty-eight percent of entrepreneurs in China

started their own businesses

Entrepreneurship is more choice than necessity in

the developed world

Entrepreneurship rates are generally higher in

factory-driven than innovation economies

Public attitudes towards innovation correlate with

the level of entrepreneurial activity



career choice; at 3.3%, Japan’s total early-stage entrepreneurial activity was among the lowest in the world.

In China and the USA, 66% of people thought that entrepreneurship was a desirable career, while most people believed successful business owners enjoyed high status and received positive media coverage. In China, 18.8% of adults were involved in entrepreneurial activities, versus 8% in the USA, which was high for rich countries.

Figure 39

Individual attitudes to entrepreneurship

0

10

20

30

40

50

60

70

Bra

zil

Chile

Chin

a

Den

mark

Fran

ce

Ger

man

y

Gre

ece

Hong K

ong

Isra

el

Japan

Kore

a

Mal

aysi

a

Norw

ay

Russ

ia

Sw

itze

rlan

d

US

(%)

Perceived opportunities Perceived capabilitiesFear of failure Entrepreneurial intention

Source: Global Entrepreneurship Monitor

Americans generally had the self confidence and courage to pursue entrepreneurial activities, but only 28% saw opportunities and only 6.9% planned to do so in the wake of the financial crisis. In China, on the other hand, only 35% of adults believed they had the skills required to launch a business and only 25% saw an opportunity to do so - yet nearly 23% of people intend to become entrepreneurs in three years. As an efficiency-driven economy undergoing rapid change, this rate is likely increased by necessity.

The mothers, and incubators of invention Innovation incubators have proved fertile ground for the weaning of fledgling ideas and businesses. Historically, incubators have been sponsored by corporations, venture capitalists and universities. They serve to cultivate and commercialize new technologies and startups by providing innovators and entrepreneurs with the necessary resources from funding to networking opportunities.

From Menlo Park to PARC Arguably, the world’s first innovation incubator - itself a major innovation - was Menlo Park, Thomas Edison’s self-described “invention factory”. Edison founded Menlo Park in 1879 with the purpose of inventing ‘useful things every man, woman and child in the world wants . . . at a price they could afford to pay’ and went on to conceive and commercialize hundreds of inventions from the phonograph to the first practical incandescent light bulb. Edison’s was an early proponent of collaborative innovation, eventually presiding over a staff of 5,000 at his labs.

In China and the USA, 66% of people thought that entrepreneurship was a desirable career

Incubators have been sponsored by

corporations, VCs and universities

The world’s first innovation incubator -

itself a major innovation - was Menlo Park

Americans have courage and confidence, but see

fewer entrepreneurial opportunities



Bell Labs was founded in 1925 as AT&T’s R&D center on similar principles as Menlo Park: assemble a “critical mass” of diverse talents and disciplines, encourage a collaborative and entrepreneurial environment and provide them with any and all resources required to bring their ideas to fruition. The Labs were responsible for a number of milestone inventions including the transistor, laser, solar cell, fax machine, UNIX operating system, digital signal processor and fiber optic transatlantic cable. Among its many achievements, Bell’s invention of the transistor was monumental in the field of electronics, in turn revolutionizing the radio, telephony, television and computer industries.

The other iconic innovation incubator is Xerox Palo Alto Research Center (PARC), which was founded in 1970 as an R&D resource for Xerox. PARC, which was located on the campus of Stanford University, exploited its access to the university and Silicon Valley community, while enjoying significant independence from its parent and primary customer, Xerox, which was headquartered on the opposite coast. PARC’s innovation achievements included laser printing, the development of one of the first PCs in the Xerox Alto, the first WYSIWYG (What You See Is What You Get) word processor, the first graphical user interface (GUI), and more recently, e-paper.

Today, Bell Labs and PARC no longer serve as the hotbeds of revolutionary innovation for which they earned their reputations. Bell Labs, now a division of Alcatel Lucent, suffered in the aftermath of Ma Bell’s breakup under antitrust in 1984, losing access to the resources that a one-million-man corporation could afford. PARC, meanwhile, survives as a wholly owned subsidiary of Xerox Co, but has long received criticisms regarding its ability to commercialize its innovations (notably, the Xerox Alto, some of whose features appeared in Apple’s computers after an inquisitive Steve Jobs visited the research center in 1979). Nevertheless, the idea of a laboratory-as-innovation incubator has largely been institutionalized as the archetypical corporate R&D center.

Hatching new businesses The concept of the business incubator has been recognized since at least 1959, when Batavia Industrial Center was founded. While corporate laboratories incubate innovation on behalf of their parent companies, business incubators foster innovative startups for the purpose of helping them mature into viable adult companies. The range of services offered by business incubators varies, but often includes some sort of workspace, back-office support, expert management and guidance, and access to funding.

The sponsors of business incubators can range from venture capitalists to governments to academic institutions and can take the form of nonprofit or for-profit organizations. Venture-backed incubators are generally for-profit entities that seek investor returns. Government-backed incubators are largely nonprofit entities that cultivate new businesses in a particular locality, usually for the purpose of revitalizing economic activity in depressed areas. University-backed incubators also tend to be nonprofits, often intended to commercialize academic research. Many incubators have multiple sponsors from multiple sectors. The National Business Incubator Association estimates that the number of incubators in the USA grew from 12 in 1980 to 1,115 by 2006.

Shrinking the VC model for lightweight innovation There has been strong momentum among business incubator/VCs that provide funding and mentoring for small startups. This has provided a test bed for ideas that ordinarily might not need enough capital to attract a

Bell Labs and PARC no longer serve as the

hotbeds of revolutionary innovation

Incubators in the USA grew from 12 in 1980

to 1,115 by 2006

Xerox PARC is a legendary tech incubator

Notable for-profit incubators include Tech Stars and YCombinator



traditional VC. Notable for-profit incubators include YCombinator, which nurtures startups through the seed-funding phase to the point where they can raise money on a larger scale by introducing them to later stage investors. Its successes include Reddit and Loopt. TechStars is another incubator whose model has been expanded from Boulder to Seattle, San Francisco and New York. TechStars receives applications from would-be entrepreneurs for “classes” that are mentored, provided with office space, IT resources and small funding.

Notable academic incubators include the Advanced Technology Development Center at Georgia Tech and the Research Park at the University of Illinois at Urbana-Champaign. The former has raised more than US$1bn in financing to support more the more than 120 companies that have graduated. The latter fosters collaboration between the universities, mature technology companies including ADM and Abbott Labs, and more than 40 startups.

Incubators or incinerators? Business incubators gained significant notoriety during the dot-com era, as several tech incubators themselves went public in order to provide public access to their privately held pre-IPO portfolio companies. Although their startups were notoriously hard to value, nobody seemed to mind in the frothy environment of the bubble environment. As the bubble deflated, capital became scarcer, and time to market lengthened, the opacity of these public incubators became anathema to investors, who dumped their stocks. Resultantly, some began referring to these incubators as business “incinerators” as their value disappeared in the aftermath of the bust. Notable “incinerators” at the time included Divine InterVentures, Internet Capital Group and CMGI.

Business incubators gained significant

notoriety during the dot-com era

Academic incubators include Advanced

Technology Development Center and Research Park

Section 4: Technological innovation enablers US strategy


Technological innovation enablers We identify several accelerators of innovation from a technological perspective. The convergence of enabling factors and technologies is leading to declining costs of innovation. Open source, cloud computing, mobility and commoditization of hardware/software and bandwidth provide the catalyst to create value and accelerate innovation - all facilitated by software. We believe innovation over the next decade will be ruled by a consistent trend towards technology that is increasingly simple so that the underlying complexity becomes invisible to the user.

Something ventured, something gained A distinctive enabling factor for innovation in the USA is the highly evolved venture-capital ecosystem. The VC community is centered in Silicon Valley, south of San Francisco, with a significant presence in nearly every major city. VCs play a critical role not just financing ideas and entrepreneurs, but by also cultivating, mentoring and actively managing people and investments. The best VC-backed companies have grown to become leading publicly traded companies with thousands of employees and billions of dollars in market cap.

Innovation is the specific instrument of entrepreneurship - the act that endows resources with a new capacity to create wealth.

Peter Drucker, writer, management consultant

The overall economic impact of the venture-capital involvement is significant. Notably, venture-backed companies accounted for 11.9m jobs in 2010, which accounts for 11% of the 107.3m total private-sector jobs in the USA.

Figure 40

VC-backed companies generate an increasing portion of US private jobs

11.8712.6911.68

8.699.37

7.8%8.6%

10.2%10.8% 11.0%

0

2

4

6

8

10

12

14

2000 2003 2006 2008 2010

US Private Employment (%)Jobs (m)

0

2

4

6

8

10

12

Source: The Economic Importance of Venture Capital-Backed Companies to the US Economy (HIS, National Venture Capital Association)

The US$3.1tn in revenue generated by venture-backed companies amounts to 10% of the US$30m in total US annual sales.

Over the next decade, computing will become increasingly embedded

in daily life

Venture capital is a distinctive enabling factor for innovation in the USA

Revenue generated by venture-backed

companies amounts to 10% of US annual sales

Venture-backed companies accounted for

11.9m jobs in 2010



Figure 41

US venture-backed company revenue

US$1.67US$1.49

US$2.64US$2.99

US$3.08

21.0%20.8%

19.7%

15.0%14.9%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

2000 2003 2006 2008 2010

US GDP (%)Revenues (US$tn)

0

5

10

15

20

25

Source: The Economic Importance of Venture Capital-Backed Companies to the US Economy (IHS, National Venture Capital Association)

According to data collected by IHS on behalf of the National Venture Capital Association (NVCA), venture-backed companies have outperformed the total US economy on several fronts. For every dollar of venture capital invested from 1970 to 2010, US$6.27 of revenue was generated in 2010. Annual venture investment equals less than 0.2% of US GDP. Annually, VC-backed companies have generated revenue equal to 21% of US GDP.

It is difficult to overstate the important role venture capital plays in funding innovation in the USA, particularly in areas like life sciences and technology. The NVCA has tracked over 4,800 companies funded in healthcare, over 17,000 information technology companies and over 900 clean technology companies that have received venture funding. The result of these investments has been entirely new industries and transformative innovations that have changed the quality of life of society as a whole.

Figure 42

Venture-backed jobs in major industry sectors

Sector % of total industry jobs VC-backed jobs (No.)

Software 90 734,064

Biotechnology 74 427,353

Semiconductors/Electronics 72 620,773

Computers 54 1,179,287

Telecom 48 445,496

Source: The Economic Importance of Venture Capital-Backed Companies to the US Economy (IHS, National Venture Capital Association)

Enabling tech trends accelerate innovation We highlight factors/enablers that accelerate global innovation and technology-led growth strategies and promote an innovation-centric mindset/culture.

1. Commoditization of computing, bandwidth and storage lower costs of adoption, enabling new levels of scale for new ventures.

For every venture-capital dollar invested from 1970

to 2010, US$6.27 of revenue was generated

We identify key enabling themes that are leading

to the acceleration of innovation

Venture-backed firms generate an increasing

share of GDP in the USA

It is difficult to overstate the important role

venture capital plays in funding innovation



2. Cloud computing, which allows for provisioning, deployment and billing of IT resources and content on a dynamic basis.

3. Open-source software, which empowers users with flexibility and increasingly robust functionality at little or no cost.

4. The mobile internet, which connects users with information and applications regardless of device, connection or location.

5. Growing penetration of internet users and social networking, which results in near-ubiquitous accessibility of a new generation of services.

6. Accelerating change leading to commoditization of hardware, software and bandwidth, which results in far lower costs and barriers for new products and innovations.

Computing is becoming more intuitive and pervasive with the evolution of more powerful software, rapid growth of endpoint devices, availability of “instant-on” connectivity and declining costs of hardware, bandwidth and storage. We see the continuous elevation of simplicity of experience to the user as logic controls the underlying systems, processes and infrastructure with increasing power. These concurrent trends have transformative impact, accelerating innovation across the broader economy in traditionally non-tech as well as technology industries.

There is no doubt that technology has lowered the barrier to entry and startups - it’s a great thing . . . The globalization of all these capabilities has really allowed garage startups to get scaled much faster and need a

lot less funding.

Michael Docherty, founder of Venture2

Commoditization of computing, bandwidth and storage The commoditization of computing, bandwidth and storage has proven a continuous dynamic. The principle of Moore’s Law, which holds that processor performance can double every 18 months, has held fast since the 1970s, while price performance of Dram continues to improve along a similar dynamic. At the 2011 Singularity Summit, Ray Kurzweil related that a tech briefing presented to President Obama early in 2011 noted that since 2000, there has been a thousand-fold increase in hardware capabilities and a 16,000-times increase in software capabilities. Improvements in computing power have so far navigated four technology transitions in the last century, from machine computing, to vacuum tubes, to transistors to the integrated circuit. There is ongoing debate regarding how long Moore’s Law can continue before reaching physical limits; however, quantum computing holds the promise to extend this trend indefinitely.

This dynamic plays out in retail pricing for personal computers. Looking at the Consumer Price Index from December 1997 to March 2011, personal-computer prices have fallen by 93.5%. Looking at this another way, a computer with equivalent power and specs that cost US$1,000 in December 1997 could be purchased in 2011 for US$65.

Cost of computing, bandwidth and storage

continues to decline

Technology has transformative impact, accelerating innovation

across the economy

Moore’s Law has held fast since the 1970s



Figure 43

Moore’s Law

Source: Wikipedia

Figure 44 Figure 45

MIPS growth since 1970

Dram price/performance since 1970

Core i7 Extreme (i980EE)

Core 2 Extreme(Qx6700)

Pentium 4 (600)

Pentium 4 (3066)Pentium III

Pentium 4 (1700)

Pentium II

Pentium

486386

2868086

8080

80084004

0

0

1

10

100

1,000

10,000

100,000

1,000,000

1970 1975 1980 1985 1990 1995 2000 2005 2010

(MIPS)

100

1,000

10,000

100,000

1,000,000

10,000,000

100,000,000

1,000,000,000

1970 1975 1980 1985 1990 1995 2000 2005 2010

(DRAM bits/US$)

MIPS = Millions of instructions per second. Source: Ray Kurzweil and KurzweilAI.net

The power of wireless handheld devices similarly reflects an accelerating rate of performance, while the bandwidth capacity of the internet is growing at exponential step functions.

Wireless handheld devices showing accelerating rate

of performance

Processing power has continued to grow

exponentially according to Moore’s Law



Figure 46 Figure 47

Smartphone/PDA processing power since 1994

Internet backbone BPS since 1965

0

1,000

2,000

3,000

4,000

5,000

6,000

1995 1997 1999 2001 2003 2005 2007 2009 2011

(MIPS)

1.0E+04

1.0E+05

1.0E+06

1.0E+07

1.0E+08

1.0E+09

1.0E+10

1.0E+11

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

(Bits per second)

MIPS = Millions of instructions per second; BPS = Bits per second. Source: Ray Kurzweil and KurzweilAI.net

In fact, the dynamic of exponential cost and performance improvement is occurring across a broad range of technologies. While improvement occurs at different rates, the consistent historical trend remains a common dynamic across different hardware technologies.

Figure 48

Time to double (or half)

Dynamic Ram memory “half pitch” feature size 5.4 years

Dynamic Ram memory (bits per dollar) 1.5 years

Average transistor price 1.6 years

Microprocessor cost per transistor cycle 1.1 years

Total bits shipped 1.1 years

Processor performance in MIPS 1.8 years

Transistors in Intel microprocessors 2.0 years

Microprocessor clock speed 2.7 years

Source: Ray Kurzweil and KurzweilAI.net

Cloud computing accelerates incubation Cloud computing - essentially IT resources delivered over the internet from a centralized data center - has lowered barriers for technology adoption, reduced time to market and placed unprecedented computing power in the hands of startups, departmental IT staff and others lacking access to scalable systems.

Importantly, the availability of cloud-based resources is lowering barriers for startups and fuels innovation. The capital efficiency that can be applied to developing, introducing and then iterating on these new applications is declining. The capital efficiency for a venture firm trying to launch new companies is becoming much better. There are laws of accelerating returns on these technologies at play.

Cloud computing is a key component of lightweight innovation processes, and the ability to rapidly prototype and provide proof of concepts of software and internet businesses has been broadly embraced by startups. Leading VCs have standardized their portfolio companies on the Amazon cloud, while Amazon itself has engaged in direct outreach to investors and entrepreneurs to promote Amazon Web Services as the preferred platform for startups.

Availability of cloud-based resources is

lowering barriers for startups

Exponential cost and performance

improvement occurs across technologies

Cloud computing is a key component of lightweight

innovation



In September 2011, Techstars, a startup accelerator that provides seed funding from over 75 top venture-capital firms and angel investors, announced that in addition to its regular programs in New York, Boulder, Seattle and Boston, it would launch TechStars Cloud, ‘a thematically focused accelerator that will fund companies working exclusively on cloud computing, cloud infrastructure and OpenStack.’

According to a May 2011 survey of 417 users and industry stakeholders by GigaOm, The 451 Group and North Bridge (a venture-capital firm), 40% of users are experimenting with cloud computing, 24% are using for either mission-critical applications or usage spikes, 26% are waiting for the technology to mature and just 10% have no plans to employ. The key drivers for adoption are agility, innovation, competitive advantage, mobility and the availability of standardized cloud APIs. Security, interoperability, vendor lock-in and compliance are key inhibitors; however, 75% of respondents predict that 2/3 of their computing infrastructure will be in the cloud in five years. The 451 Group forecasts cloud revenue (including Software as a Service, Platform as a Service and Infrastructure as a Service) increasing from US$8.8bn in 2010 to US$21.1bn in 2014, a Cagr of 67%.

The ramifications of the shift to cloud computing have transformed the IT landscape. Most of our ongoing conversations reference the transformative impact that cloud computing will have on availability of flexible and increasingly cheap computing power. The first wave of public clouds from Amazon, Google, Rackspace, Salesforce.com and Microsoft Azure has provided field validation of the viability of the model. There is currently a battle over standards, as Platform-as-a-Service vendors seek to attract more users to their approach. Salesforce.com, VMWare, Red Hat, Microsoft and Google are all angling to capture Platform-as-Service users, while ongoing debate and evolution of standards seek to balance ease of interoperability with “vendor lock-in.”

There has been significant commitment to the cloud model over the past three years, evidenced by the rapid pace of investment in datacenter infrastructure by corporations, colocation providers, systems integrators, telecom carriers and others. We are seeing aggressive allocation of R&D resources towards cloud-infrastructure initiatives by software companies of all sizes. Microsoft, which operates the largest R&D organization in the software industry, has disclosed that 90% of its developers are focused on the cloud.

Open-source software - High quality, low cost Open source has been critical to enable innovation, not just in software, hardware and services, but through the derivative benefits to technology users in any endeavor. There are currently over 1bn lines of freely available open-source code that developers and business users can leverage to create applications and new businesses. The availability of open-source software alternatives to paid proprietary offerings has helped reduce costs for startups as well as new projects within IT organizations. And while there is need for paid technical expertise and support, the ROI tends to tip overwhelmingly favorable for open source.

Open source (in particular the Linux operating system) has been a foundation technology for both public and private clouds, and the skill sets for building cloud-based applications lean heavily on open-source programming languages

The ramifications of the shift to cloud computing

cannot be understated

Commitment to the cloud model is evidenced by

rapid investment in datacenter infrastructure

The 451 Group forecasts Cloud revenue growing

from US$8.8bn in 2010 to US$21.1bn in 2014

Open source has been critical to enable

innovation, not just in software

The leading cloud platforms, including

Google and Amazon EC2, are built on open source



such as Perl, Python and PHP. The leading cloud platforms, including Google and Amazon EC2, are built on open-source software, notably Amazon EC2 is built on Red Hat Enterprise Linux. This was driven not just by the low cost and flexibility but also flexibility for developers who are free to make changes, modifications and enhancements as needed.

Flexibility of open source enables innovation for users The open-source development model evolved to facilitate user innovation and agility. A primary advantage of the open-source model is the ability for users to make changes, modifications and additions to the code at will − and these changes often find themselves incorporated as enhancements in newer versions of the software. Customers of traditional closed-source vendors typically must wait for upgrades from the vendor and are limited in the ability to modify, integrate and extend the software according to how open the vendor decides to be.

Maturing open-source software embraced by the mainstream Open-source software projects, such as Linux, Drupal, Apache, Eclipse and others, provide a reliable foundation to support applications and services and their entrepreneurs. Over the past 20-plus years, the resilience and usability of open-source technologies has become established and vetted by broad adoption. Improving usability and management tools have helped extend the appeal from tech-savvy hobbyists to mainstream IT adoption.

We have seen the appeal of the model extend beyond software to hardware, digital content, scientific research, robotics and other areas. The advantages of the “crowdsourcing” development model is that features can be analyzed, tested, vetted and improved by peer review as part of a continuously iterative process. Open-source development is more fluid, and the pace of output on critical projects is increasing.

The mobile internet - “Any device, always on, anywhere” The explosive adoption of internet-enabled smartphones and the growing availability of wireless internet are key vectors driving innovations in realizing services and applications including micropayments, content streaming, multiplayer gaming, location-based services and a plethora of targeted applications. In the coming decade, the deployment of high-speed mobile networks will help realize the vision of “always-on” high-speed internet connections and adoption of data-based applications.

Advanced mobile networks will support a new generation of innovative applications, including content, shopping, HDTV, collaboration, social networking, video conferencing, robust gaming and additional personalized offerings. This in turn will expand the innovation of form factors beyond phones, PDAs, smartphones and laptops - increasingly there will be wirelessly connected audio, video, sensors, industrial devices and appliances. The availability of greater bandwidth will facilitate adoption of advanced applications, which in turn should drive further growth of data traffic.

The proliferation of mobile applications is representative of the variety of innovations enabled by smartphones and the mobile internet, and this will be reflected both in consumer and enterprise adoption. Examples of new types of mobile applications expected to see healthy growth include money transfer by short message service (SMS), mobile search and browsing, location-based services, mobile music and video services, near-field communications services, mobile health monitoring and many others. The ability to combine

Adoption of smartphones and wireless internet

helps realize the vision of pervasive computing

Innovations and connectivity enable a new

class of mobile applications to emerge

The open-source model extends to hardware,

digital content, scientific research, robotics, etc

Open source facilitates user innovation

and agility



location awareness with content streaming will enable applications that can deliver content to users based on their specific location and preferences (for marketing, entertainment or educational purposes).

Internet adoption grows potential end markets for innovators The total number of internet users worldwide exceeds 2.1bn in 2011, up from 361m at the end of 2000. Growth is likely to continue with IDC estimating 2.7bn internet users worldwide by 2015, with over 40% of the world’s population connected. Cisco forecasts 788m mobile-only internet users by 2015, a 56-fold increase from 14m at the end of 2010.

Figure 49

Worldwide internet usage and population statistics

Internet users (m) Dec 00 Oct 11 Growth 2000-11 (%)

Penetration % of total population

Region

Africa 4.5 118.6 2,527.4 11.4

Asia 114.3 922.4 706.9 23.8

Europe 105.1 476.2 353.1 58.3

Middle East 3.3 68.5 1,987 31.7

North America 108.1 272.1 151.7 78.3

Latin America/Caribbean 18.1 215.9 1,037.4 36.2

Oceania/Australia 7.6 21.3 179.4 60.1

World total 361 2,095 480.4 30.2

Source: www.internetworldstats.com

With this growth of users and devices connected to the internet, global IP traffic is forecast to quadruple from 2010 to 2015, growing at a 32% Cagr. We note that Cisco has continuously revised upward its traffic forecasts, and we believe there is further possibility of additional upward revisions.

Figure 50

Worldwide IP traffic 2010-15

(PetaBytes per month)

2010 2011 2012 2013 2014 2015 Cagr (%) 2010-15

Consumer 16,221 23,130 31,592 42,063 54,270 70,045 34

Business 3,930 4,894 6,011 7,357 8,997 10,410 22

Mobile 237 549 1,163 2,198 3,806 6,254 92

Source: Cisco Visual Networking Index, 2011

Mobile explosion a hotbed for innovation The world is increasingly mobile, with over 5.3bn subscribers in 2011, representing approximately 77% of the world’s population. Mobile-device sales increased 18.5% in 2010 to 1.39bn, while smartphone sales increased 74.4% to 303m units. In the USA, mobile penetration is heading towards ubiquity, with 27% of households “wireless only” as estimated by the National Center for Health Statistics in 2010. For carriers, mobile revenue continues to benefit from subscriber adoption, but importantly the increase in wireless data revenue has benefited from the proliferation of smartphones, tablets, netbooks and other mobile devices. Handset manufacturers have continued to benefit from the rise of the Android platform, which overtook Apple as the No.1 smartphone OS.

IDC estimates that there will be 2.7bn internet

users worldwide by 2015

Global IP traffic is forecast to quadruple

from 2010 to 2015, growing at a 32% Cagr

In the USA, mobile penetration is heading

towards ubiquity



Figure 51

US mobility statistics (global stats)

Dec 95 Dec 00 Dec 05 Dec 10

Wireless subscribers (m) 33.8 109.5 207.9 302.9

Wireless penetration % of total US population 13 38 39 96

Wireless-only households % of US households na na 8.4 26.6

Annualized total wireless revenue (US$bn) 19.0 45.3 113.5 159.9

Annualized wireless data revenue (US$bn) na .211 8.5 50.1

Source: CTIA

According to Cisco’s Visual Networking Index (VNI) global mobile data forecast, traffic will increase 26 times from 2010-15 (a 92% Cagr) to 6.3m ExaBytes per month, with mobile video accounting for two-thirds of global mobile data traffic in 2014.

The broad adoption of smartphones paves the way for rapid innovation of new applications and services. Apple’s AppStore has over 400,000 applications, and the evolving ecosystem around smartphone platforms has given rise to many successful new businesses - not just games (like Rovio’s Angry Birds) but thousands of applications for productivity, news, lifestyle and other uses. IDC predicts that global application downloads will reach 76.9bn in 2014 and will be worth US$35bn.

Global mobile data traffic is forecast to increase 26

times from 2010-15

Adoption of smartphones paves the way for rapid

innovation of new applications and services

Section 5: Inhibitors to innovation US strategy


Inhibitors to innovation Innovation does not come cheap, and innovation in the USA faces challenges on multiple fronts. Recent political debates advocate either cutting taxes or spending on government, but the apparent gridlock in the USA and advance of new regulations have been blamed for economic malaise and lack of job creation. Advocates of government stimulus argue that efforts have been insufficient to address the depth of the problem. Our conversation with Gary Shapiro of the Consumer Electronics Association highlights in great detail the policy prescriptions to address the adverse climate to job creation.

Funding and choppy capital markets challenge venture funding The VC industry currently faces a number of challenges. It has been increasingly difficult to see returns in the form of IPOs. The number of annual offerings peaked at 650 in 1996. Since the collapse of the internet bubble in 2001-02 and as passage of legislation such as Sarbanes-Oxley has increased cost of compliance for publicly traded firms, the total number of offerings has ranged between 50 and 100 since 2005. In addition, IPOs are highly sensitive to the vicissitudes of the financial markets. For venture-backed firms, the number of offerings dropped from 86 in 2007 to just 6 in 2008. There were 12 in 2009, 75 in 2010 and 26 in the first half of 2011, but given the increased market volatility, a number of S-1 filings has been withdrawn or delayed.

Figure 52

US venture-backed company M&A deal activity

US$7.7

US$5.6

US$6.5US$8.0

US$4.2

US$5.2

175

137146

157

173

188

0

1

2

3

4

5

6

7

8

9

1Q10 2Q10 3Q10 4Q10 1Q11 2Q11

(No. of deals)Total deal volume (US$bn)

0

20

40

60

80

100

120

140

160

180

200

Source: The 451 Group

Funding has also been a challenge, particularly for smaller firms as the industry contracts. According to Thomson/Reuters and the NVCA, 76 US venture funds raised a total of US$10.2bn in the first half of 2011, a 67% dollar increase YoY but a 15% decline in the number of firms. As VCs struggle with market volatility, leaving M&A the primary means of achieving an exit from their investments, the relative returns of funds have made it difficult for even the best-performing VC firms to secure funding.

With potentially strategic currency (eg, publicly traded shares) concentrated in the hands of fewer firms, this reduces the number of potential buyers, who gain increasing leverage over potential targets. The global financial crisis that accompanied the macroeconomic downturn also sidelined private equity firms from the buyout process, resulting in a significant downturn in deal activity.

It has been increasingly difficult to see returns

in the form of IPOs

Funding has also been a challenge, particularly for

smaller VC firms as the industry contracts

Innovation in the USA faces challenges on

multiple fronts

M&A exits for VC-backed firms remain lumpy



The increasing capital efficiency of software and internet firms (with the proliferation of open-source software and public cloud computing) has reduced initial capital needs for many startups. This in turn has lowered barriers to entry for startups, while altering the value equation. Because the amount of capital needed is less, a VC investment in itself is no longer a de facto competitive advantage for startups competing for the same markets to the extent that capital access itself is strategic. The value that venture investors provide is management insight, access to executives and customers, mentoring and other intangibles.

The spectrum specter America - the land of the free and the home of the internet - is no longer a leader in broadband access, according to Gary Shapiro. He believes we are facing a spectrum crunch that will have severe consequences for growth and innovation. Indeed, the Federal Communications Commission (FCC) estimates that freeing up additional spectrum could create more than 200k jobs.

There are already signs that such a shortage will be upon us sooner than later. Randall Stephenson, CEO of AT&T, has said that spectrum limitations will hamper his company’s ability to handle growth, a fact that spurred its recent attempt to merge with T-Mobile (now pending an antitrust suit from the Justice Department). Anyone who has used an iPhone in New York will be familiar with the limits of AT&T’s bandwidth.

All FCC’d up and not loving it The problem has arisen from the explosive growth in mobile devices over the past decade, especially in regard to smartphones and, more recently, tablets, which use 24 and 120 times the spectrum of cell phones, respectively. However, this growth has not been matched by increased wireless spectrum such that we are now facing an imminent shortage. There are several underlying causes of the looming spectrum problem.

One important problem is that there is a misunderstanding of what spectrum actually is. Spectrum refers to the transmission of certain frequencies within the entire range of radio frequencies lower than 300GHz, rather than to the range itself. When people refer to a spectrum shortage, they are talking about limits on the transmission of signals, not to a lack of frequencies. While most of the usable spectrum in the USA has been allocated by the FCC, much of this spectrum is underutilized. Indeed, the only thing preventing people from using it is government regulation.

In addition to owning large portions of the spectrum outright, the government places strict limits on spectrum usage, which in turn limits the spectrum available for private use. For instance, according to the Government Accountability Office (GAO), the current spectrum-management system inefficiently allocates spectrum by types of service and users, which leaves some spectrum underutilized (such as the infamous “white spaces” seen on TVs). The GAO notes that users of government-owned spectrum (largely government agencies) have no incentive to consider spectrum efficiency since it has no economic bearing on them.

Fortunately, those not in the GAO are aware that there is a problem. President Obama issued a Memorandum in 2010 instructing the Secretary of Commerce, working through the National Telecommunications and Information Administration (NTIA), to ‘collaborate with the FCC to make

Lightweight innovation has reduced capital

needs for software and internet startups

The FCC estimates that freeing up additional

spectrum could create more than 200k jobs

Smartphones use 24x and tablets use 120x the spectrum of cell phones

Spectrum refers to the transmission of certain

frequencies

The current spectrum- management system inefficiently allocates

spectrum



available a total of 500MHz of federal and nonfederal spectrum over the next 10 years, suitable for both mobile and fixed wireless broadband use.’

As the FCC notes in its National Broadband Plan, the ‘current spectrum system policy framework sometimes impedes the free flow of spectrum to its most highly valued uses.’ The current regulatory and licensing regime preserves a spectrum allocation that is in many ways tethered to outmoded technologies (notably, the 700MHz band that was allocated to UHF television has become the base of the 4G network) or uses (the national TV broadcasters were given hundreds of MHz free of charge more than 75 years ago, much of which is now unutilized). These regulations place high transaction costs on licensees and prevent rationalization. The FCC has issued some flexible use licenses, but concedes that the process of improving spectrum allocations has historically taken six to 13 years.

Figure 53

Time historically required to reallocate spectrum

Band First step Available for use Approximate lag time

Cellular 1970 1981 11 years

PCS 1989 1995 6 years

Education Broadband Service/

Broadband Radio Service

1996 2006 10 years

700 MHz 1996 2009 13 years

AWS-1 2000 2006 6 years

Source: Federal Communications Commission - National Broadband Plan

Kill the beast The looming spectrum problem stems fundamentally from a misallocation of spectrum that is the direct result of the current licensing and regulatory regime. On the assumption that the market is the best allocator of resources, any real solution to the problem must involve some manner of deregulation or, at the very least, a re-thinking of the current system. Two solutions have been put forward that have made it into Obama’s recent jobs bill:

Authorize FCC to conduct incentive auctions The FCC wants to auction off this spectrum through a process of “voluntary

incentive auctions”, by which the FCC would sell spectrum and split the proceeds between the current licensee and the government. Incidentally, the NTIA has already identified 2200MHz of underutilized spectrum. Unfortunately, the FCC does not have congressional authority to split the proceeds with private parties and must instead deposit all funds in the treasury. Naturally, this provides a major disincentive for the current licensees to participate in any auctions and thus relinquish unused spectrum to be more efficient (while preventing the treasury from collecting any money).

Eliminate the fixed licensing regime The FCC has proposed charging fees on current holders of inflexible

licenses in exchange for allowing them to choose how they use their spectrum. The idea is that the fees will incur an opportunity cost while providing a signal to potentially higher-value uses for licensees. Those who do not want to improve their utilization of the spectrum would have an incentive to sell unwanted spectrum, thus mimicking the clearing functions of a market.

The current spectrum- system policy framework

sometimes impedes the free flow of spectrum

Spectrum allocation is a long, drawn-out process

The looming spectrum problem stems

fundamentally from a misallocation



Alternatively, free the market Jerry Brito of the Mercatus Center at George Mason University argues that the fee proposal is ‘just tinkering at the margin.’ Allowing spectrum to function as property, without licenses, would incentivize current licensees to treat spectrum as property and thus maximize its value. A free market for spectrum - itself an innovation - could thus solve the misallocation problem and remove the major impediment to innovation and growth in the wireless industry.

Immigration restrictions challenge entrepreneurs Societies that are more open to immigration tend to be more innovative, and the United States has historically epitomized this view. Arguably, the US constitutional system is among the greatest political innovations in history and is itself the product of ideas that immigrated to early America with the early colonists. The US immigration and innovation stories are inextricably linked, so it is unfortunate that in the post-9/11, post-financial crisis era, the USA has recoiled from its historical openness to immigration. This will prove to be in error, as immigration is as vital to economic growth in the country today as it has been in centuries past.

Today, the USA places onerous restrictions on entry into the country, no matter what the reason. For instance, annual caps and large fees on visas for highly skilled potential employees (H-1B) limit the number of jobs available to foreign graduates of America’s university system. Not only do many companies find the process of sponsoring a highly skilled, albeit foreign, employee not worth the time, cost and aggravation, many of these would-be engineers, scientists and entrepreneurs do not find it worth their while either. Instead, many choose simply to pack up and go home - often India or China - to work for competitors to US firms or to start their own businesses that create jobs abroad.

According to the Institute of International Education, nearly 691k international students were enrolled in US institutions in 2009-10, comprising 3.5% of the total enrollment in US higher education. More than half of these students were pursuing graduate degrees. Students from China accounted for 18.5% of enrollees, followed by India (15.2%), South Korea (10.4%), Canada (4.1%) and Taiwan (3.9%). These students are primarily pursuing degrees in business and management (21.1%), engineering (18.4%), physical and life sciences (8.9%) and math and computer science (8.8%). Meanwhile, foreign students at US universities earned 24% of science and engineering master’s degrees and 33% of science and engineering doctoral degrees, according to the National Science Foundation.

As the Kauffman Institute notes, many of these foreign students could be potential founders of a future Google, Intel, eBay or Yahoo - companies all cofounded by immigrants. Indeed, immigrants play a vital role in driving American innovativeness and growth. Immigrant inventors contribute to more than a quarter of US global patent applications. Meanwhile, immigrant-founded US-based companies employed 450k workers and generated US$52bn in revenue in 2006. Thanks to the USA’s increasingly restrictive immigration system, it is likely that many would-be immigrant students will instead return home to potentially become founders of the next Wipro, Infosys or Alibaba.

Societies that are more open to immigration tend

to be more innovative

More than half of international students in

the USA are pursuing graduate degrees

Immigrant inventors contribute to more than a

quarter of US global patent applications

A free market for spectrum could solve the

misallocation problem



The prevailing anti-immigration sentiment in the USA stems largely from the heightened security environment of the post-9/11 era, but also from faulty protectionist economics. In favoring greater security at the expense of freedom in immigration, the USA’s current immigration policy is having the unsurprising consequence of stifling job creation and innovation. To paraphrase an early American innovator and immigrant’s son, Ben Franklin, ‘those who would sacrifice liberty for security (in jobs or defense) deserve neither - and get neither, too.’ Clearly, positive immigration reform is a necessary factor in restoring economic growth, driving innovation and preserving US competitiveness.

Patently difficult President and patentee Abraham Lincoln once reverently described the patent system as adding ‘the fuel of interest to the fire of genius, in the discovery and production of new and useful things.’ Indeed, the US patent system has historically been credited with protecting inventor rights and promoting innovation. Legally, patents grant a monopoly of limited duration on the use of the patented product or process by preventing others from making, using or selling it. In return for this limited monopoly, the inventor must publicly disclose the details of the patent upfront and release it to the public domain at expiry.

Ostensibly, patents encourage innovation both by providing patent holders with a window of opportunity - not a guarantee - to monetize their inventions and by permitting other innovators to improve on the now publicly available idea. Today, however, there is mounting evidence that inventors are not being rewarded but penalized, which is having a chilling effect on innovation. The patent system, seemingly, is not doing its job.

Startups can’t afford lawyers to fight [patent lawsuits]. It’s just a fact. And funders run away when they hear there’s potential litigation. So it’s not in

the national interest to have this; patents are totally essential, but they should be clear. You should understand if you’re violating them or not. And right now, it’s gotten beyond anyone’s level of comprehending whether to

know you’re violating the patent or not.


According to The Economist, ‘America’s patent system squelches competition, slows innovation and enables egregious predation through the legal system.’ These are harsh words, but they echo a prevailing sentiment that the patent system is broken, perhaps fundamentally so. Clearly, the “problem of patents” is fuelling less friendly fires than those alluded to by President Lincoln. What happened?

Patent failure According to James Bessen and Michael Meurer, authors of Patent Failure, the problem with the current patent system is that it fails to secure property rights by muddling the boundaries of ownership, unwittingly welcoming patent infringement and, with it, ever-increasing litigation. This distorts the built-in risk/reward incentives intended to drive innovation under the patent system. They argue, ‘Just as property rights provide incentives to invest in the acquisition, development and maintenance of tangible property, patents potentially provide incentives’ to conceive, develop and put to use new technologies.

Anti-immigration sentiment stems from

security post-9/11 and protectionist economics

The US patent system has historically been credited with protecting inventor

rights and promoting innovation

Today, there is mounting evidence that inventors are not being rewarded

but penalized

A problem with the current system is that it muddles the boundaries

of ownership



Consequently, if patents do not - or are not able to - function as property, then the incentives to innovate will accordingly misalign. Critics point to the vast sums of time and money expended on patent infringement litigation, the huge outlays (and headlines) corporations have been making for defensive patent portfolios, and the rise of so-called “patent trolls.” They claim that these are responsible for the increasing occurrence and costs of patent litigation, which is in turn considered responsible for hampering innovation. But are Tolkienesque trolls and wars really driving patent litigation and thwarting innovation?

Water under the bridge In the great patent debate, the companies that draw the most ire appear to be the non-practicing entities (NPEs), less politely known as patent trolls. It is these NPEs that are seen as the cause of the growing incidence of patent litigation and the wasted time and money that such litigation entails. PricewaterhouseCoopers defines an NPE as ‘an entity that does not have the capabilities to design, manufacture or distribute products that have features protected by the patent.’ Generally, NPEs acquire patents for the sole purpose of litigating against alleged patent infringers, oftentimes large corporations with deep pockets. Because the NPEs do not commercialize their IP portfolios, they are effectively immune from countersuit. Nevertheless, the NPEs argue that they are protecting the rights of independent inventors and encouraging innovation by providing an innovative means for those inventors to monetize their ideas. The companies being sued view them as opportunistic and overly aggressive.

PatentFreedom, a service that tracks the activities of NPEs, claims that practicing companies were involved in litigation with NPEs on 2,600 occasions in 2010, up 48% over the prior three years’ average. As of 2010, tech companies were far and away the top targets of litigation initiated by NPEs, with HP, Apple, AT&T, Sony and Microsoft topping the list. Of the sectors with the most litigated patents, PatentFreedom placed the semiconductor industry first, followed by the software applications, financial services, communications equipment and system-infrastructure software industries.

However, there is reason to be skeptical of both growth in patent litigation and the role NPEs have played in it. Gene Quinn, a US patent attorney and the founder of IPWatchdog.com, says that the growth in patent litigation follows the general growth in patent activity. To wit, in 1980 about 800 patent cases were commenced on the Federal Circuit versus more than 3,300 in 2010, a Cagr of approximately 5%. Over the same time period, patent applications grew at a 5.5% Cagr while patent grants grew at a slower 4.5% Cagr. So, it would seem that growth in patent litigation outpaced patent issuance slightly by 50bps.

Meanwhile, PwC’s 2010 Patent Litigation Study found that the annual number of patent actions filed from 1991 through 2009 increased at a 4.8% Cagr, outpacing growth in patents granted by 1.3%. This shorter time frame shows a slower rate of growth across, but a wider disparity between both metrics. While both sets of data show patent litigation rising, it has grown at least in line with and at most slightly faster than overall patent issuance.

Are Tolkienesque trolls and wars really driving

patent litigation and thwarting innovation?

Companies that draw the most ire are non-

practicing entities

Practicing firms were involved in litigation with

NPEs 2,600 times in 2010, up 48% over three years

The annual number of patent actions filed from

1991 through 2009 increased at a 4.8% Cagr



A recent study by Allison and Lemley1 found that, in cases involving patents that had been litigated at least eight times (most-litigated), NPEs were involved as plaintiffs in nearly 64% of cases, whereas in once-litigated patent cases, NPEs comprised only 21% of all plaintiffs. But more strikingly, NPEs only won 8% of these cases versus 40% for practicing entities. So, while it seems that NPEs are increasingly involved in litigation, the extent to which they have driven its growth is uncertain.

NPEs do seem to have some role in driving up the costs of patent litigation, however. According to PwC, the annual median damages awarded in patent infringement suits increased from US$2.4m to US$10.5m from 1995 to 2009, with the overall median award at US$5.2m. In the past eight years alone, damages awarded to NPEs were more than triple those awarded to practicing entities with a median US$12.9m versus US$3.9m. Nevertheless, the survey also found that while damages awarded to NPEs in infringement cases were significantly higher, success rates versus practicing entities were 10% lower.

Of course, the critics tend not to cite these numbers, instead highlighting the damage awards that make headlines, like a jury’s US$1.8bn award to Centocor Ortho Biotech in 2009 or another jury’s US$1.5bn award to Lucent in 2007 (both awards were overturned on appeal). But according to a study by the Kellogg School, of the 340 patent infringement cases decided between 1995 and 2008, the top eight cases accounted for nearly half of the award value.

General Patent’s war While NPEs have developed a bad reputation, it is worth noting that the cases involving the largest dollar amounts tend not to involve NPEs (indeed, the two cases previously mentioned were both between practicing entities). The data suggest that patent litigation is, generally, a war between established tech giants - the Big Guns. In fact, patent wars between practicing entities have become de rigueur. Observers in the tech industry worry that an “IP arms race” is under way as companies build up defensive patent portfolios in order to launch counter-claims against patent infringement claims by other operating companies.

Recently, Apple led an unlikely consortium of tech giants including Microsoft and Ericsson in a bidding war for the patents of bankrupt telecom Nortel. The group’s staggering US$4.5bn bid for Nortel’s portfolio of 6,000 patents beat out Google’s final offer of US$4bn in a move that had some analysts predicting the consortium would use the patents to quash Android in court. Google’s more recent announcement to acquire Motorola Mobility - and its extensive patent portfolio - for US$12.5bn is viewed as a clear defensive bid. Whether these IP arms chests will lead to all-out patent warfare in court or a Cold War détente remains to be seen.

Of course, while these numbers may amount to a hill of beans for a cash-rich Google or Apple, such sums could be devastating for smaller firms and especially startups. Billionaire Mark Cuban notes that patent litigation is costing his companies ‘a lot of money’ in legal fees, higher insurance rates and settlement costs - at the expense of new hiring. He bemoans the rise of ‘nuclear patents’ (defensive patents) and says that ‘[p]atent law is killing job creation.’

1 Allison, John R, Walker, JH and Lemley, Mark A, Patent Quality and Settlement among Repeat Patent Litigants (16 September 2010). Stanford Law and Economics Olin Working Paper No. 398. Available at SSRN: http://ssrn.com/abstract=1677785

Patent litigation is, generally, a war between established tech giants -

the Big Guns

Litigation settlements could be devastating for

smaller firms and especially startups

NPE success rates versus practicing entities

are 10% lower



But for companies like Apple and Google that are already sitting on hoards of cash - and who tend to be more actively involved in patent litigation - lavish patent portfolio payouts are unlikely to meaningfully affect their hiring practices. Nevertheless, there is something to Cuban’s claim. Of the 10 largest initial damages awards from 1995-2009, Microsoft alone was the defendant in four cases. This suggests that, while growth in patent litigation has kept in line with growth in patent issuance, the number of companies involved in patent litigation has not substantially grown. Such a litigious IP environment may not be the most conducive to growth and innovation at larger companies, as they instead direct substantial time and resources to litigating.

Software patents: Embarrassments to the public? Trolls, warfare and lawyers may be frightening, but these are merely symptoms of the patent problem, not its cause. But perhaps they point to the root of the problem. The Allison and Lemley study quantifies how software patent suits tend to dominate patent litigation, representing 21% of once-litigated patents and 74% of the most-litigated patents. But software patentees only win 13% of their cases versus 37% for non-software patentees. This suggests two problems: 1) that there is a wide disparity between the number of software patents issued and their legal validity; and 2) that the bulk of software patent litigation involves unenforceable infringement claims. The problem, it seems, lies within software patents.

Interestingly, the most vocal opponents of software patents tend to be those in the software industry, which actually only holds 5% of granted software patents, per Bessen and Meurer. Another study found that, within the software industry, 80-95% of firms had no relevant patent, as of 2004. But while patents may be at best a nonissue for the software industry, they have become a major concern to the other industries that seek to obtain them.

However, widespread pursuit by other industries is not in itself a compelling justification for software patents. Indeed, the prevalence of software patent seeking among non-software-based firms suggests a gulf in understanding between those firms and software developers. For Brad Feld of Foundry Group, software patents are an ‘invalid construct’ that should not be considered patentable. Feld and the many software developers who demand the abolition of software patents stand at loggerheads with those in the patent-seeking industries. How did software patents come to dominate the patent wars?

Courting disaster For many years, the US Patent and Trade Office (PTO) refused patents related to computer software, a position the courts upheld until the early 1980s. This changed with the Supreme Court’s 1981 decision in Diamond v Diehr, in which it ruled that a mathematical algorithm was patentable in connection with a physical process. In 1994, the Federal Circuit’s ruling in In re Alappat essentially extended patents to all software by removing the requirement that it be connected to a physical process. The Federal Circuit further clarified the issue of software patentability in its 1998 decision in State Street v Signature Financial Group, in which it ruled that software that produced a ‘useful, concrete and tangible result’ should be considered patentable.

The effect of these rulings was that patent applications and grants related to software began to rise substantially in the following years. After the Diamond decision, overall patent applications rose sharply, doubling by the time of the Alappat ruling and doubling again by 2010; patent grants saw a similar spike.

A litigious IP environment may not be the most conducive to growth

and innovation

Software patent suits tend to dominate patent litigation

Within the software industry, 80-95% of firms

had no relevant patent, as of 2004

For many years, the US Patent and Trade Office

refused patents related to computer software



Unsurprisingly, the court decisions meaningfully impacted patent activity in software. In 1994, the year of the Alappat decision, patent grants related to software jumped 93%.

Figure 54

Growth in total patent grants and applications

0

10

20

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60

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80

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100

1883 1897 1911 1925 1939 1953 1967 1981 1995 2009

0

50

100

150

200

250

300

350

400

450

500Grants Applications Approval rate (LHS)(%) (000)

Source: US Patent & Trademark Office, Credit Agricole Securities (USA)

Patent activity has been so vigorous that, as of the end of June 2011, the PTO had a backlog of 695k patent applications and had been running an average backlog of 715k patent applications over the prior year. The PTO itself acknowledges that it would take nearly two years to clear out this inventory if no other patent applications were received. Patent applications and grants have reached an all-time high in 2010 despite the fact that less than half of all patent applications have been approved in the past decade - levels well below the historical mean of 57%.

Mark A Lemley, in The Myth of the Sole Inventor, argues that the PTO’s huge backlog suggests that patents are not supporting new commercialization, because firms often bring their products to market before they have been issued a patent (which can take years). In his view, this contradicts the claim that patents encourage innovation by providing financial incentives. Other critics see this bloat as embarrassing evidence of the patent system’s failings or as an indictment of software patents as such.

Much of this backlog is the result of the increase in high-tech patents. On the one hand, the dramatic rise in patent applications related to technology reflects as much the economic growth of the sector over the past 30 years as it does the more conducive legal environment. But for many, it suggests evidence of patent bloat, a symptom of excessive issuance of vague and broad patents, specifically those related to software.

Software snafu Bessen and Meurer describe several problems with software patents. For starters, the current system does not appropriately address the rapid evolution typical of software. Indeed, by the time a patent application is processed by the PTO and a grant is issued, a full two years has usually passed. During this lag, it is reasonable to suspect that the software in question has already been surpassed in quality, independently created or built on by other developers, or integrated into other software products (all of which may also have entered the patent application pipeline). The rapidity of

Patent applications and grants reached an all-

time high in 2010 despite less than 50% approval

The current system does not appropriately address the rapid evolution typical

of software

Patent activity has overwhelmed the

Patent Office



software development thus presents the PTO with the serious challenge of identifying unique, independent, and importantly, non-obvious creations. But it also underscores an inherent problem with the legal duration of patent protection (currently 20 years) when applied to software.

The software patent problem is further compounded by the fact that, as Bessen and Meurer note, most patents for software tend to describe what the invention does and not what it actually is. In fact, they argue that applicants may intentionally and strategically use vague language in order to broaden the scope of their claims. The Federal Circuit has contributed to, if not caused, this problem through a series of rulings that have removed the requirement to include supporting code or a description of what the technology actually does. Add to this a patent office that is inexpert in distinguishing real from false claims or, more generously, too overworked to notice the difference.

All this has led, rather unsurprisingly, to a preponderance of patent applications making overly broad and abstract claims about the nature of their software and to the issuance of multiple patents for software that essentially does the same thing. As Bessen and Meurer write, ‘Patent law assumes that two technologies can unambiguously be determined to be equivalent or distinct; this determines the patent boundaries. Yet for software, this assumption simply does not hold.’

Of course, if it is difficult to determine what patented software actually does, then the odds that someone will infringe on that patent are exceedingly high. Thus, rather than properly protecting the patentee’s property, software patents seem to facilitate infringement of that property by others. In many cases, disturbingly, they seem designed to do so. That so many software patents fail to function as property raises important questions about their validity.

One does not need to ponder too deeply to see why legal problems might arise from such a system. Less obvious is the impact this has on innovation - the very thing the system was designed to foster and protect. Vague patents with wide claims ‘reward patentees for inventions they did not invent’ and punish inventors who are forced to license the patents in order to commercialize actual inventions. This represents a clear misalignment of incentives and an impediment to innovation.

Software patents, at least those issued under the current system, do not seem to function in the way they were intended to. Ostensibly, this lends credence to Feld’s view that software should not be able to be patented. But are software patents really “invalid constructs” or might they serve a legitimate function?

To be or not to be The present method of processing and issuing software patents is malfunctioning, but to invalidate software patents as a concept seems a bit like throwing out the baby with the bathwater. Clearly, issuing multitudes of patents for obvious, unoriginal inventions making conflicting and overly broad claims has done more to keep the legal system busy than it has for innovation. But truly unique, non-obvious ideas should be patentable because they represent actual engineering inventions.

This runs counter to a common argument against software patents: that software is just math and math, like the laws of physics, cannot be patented. However, software is not “just math” in the same way that a machine is not just physics. Software is an application of math to real-world problems; in

Most patents for software tend to describe what the

invention does and not what it actually is

Broad and vague software patents seem to facilitate

infringement of that property by others

Software is not “just math” in the same way

that a machine is not just physics

Present method of processing and issuing

software patents is malfunctioning



some cases, the application represents a real and novel breakthrough - such breakthroughs deserve to be patented. Nevertheless, in most cases, the software in question may represent a good idea, but it fails to meet the standard of non-obviousness required for it to be considered a truly novel invention - such cases (ie, most of them) do not deserve to be patented.

So how can developers protect their code? Fortunately, software code, like other written material, is already protected under the copyrighting laws. Unlike patents, a copyright merely prevents somebody from copying your code; it does not prevent them from writing their own code that does the same thing as yours. In other words, the abstract idea represented by your code is not protected and therefore left open for use by others. This is analogous to copyrighting novels, in which the exact text is protected even though the story ideas they represent are not.

Restoring the standard of obviousness would dispel many of the problems associated with the current system by making it much harder to obtain software patents. It would also address the complaint that abstract ideas should not be able to be patented. Indeed, this was an issue that troubled Thomas Jefferson at the time the original patent law came into effect. He worried that putting a monopoly on ideas would have a stifling effect on innovation and referred to patents as “embarrassments to the public”. As chief of the Patent Office, he eventually changed his view, but in his day the patent system worked as it was supposed to in sanctioning only those inventions that were novel and non-obvious. It is likely he would find the system in its present form an embarrassment, not least for its effect on innovation.

Old ideas for innovative times It is not difficult to see that the current patent system is broken. Rather than serving as a means of protecting inventors and encouraging innovation, many patents are today used more as weapons by companies seeking to thwart the innovations of their competitors. The current system - including both the PTO and the Federal Circuit - not only facilitates this, it seems to encourage it. Clearly, the incentives of the system have become misaligned; in a period of ongoing economic malaise, realigning those incentives towards reigniting economic growth should be seen as a worthy, nonpartisan goal.

A patent reform bill called the America Invents Act (AIA) recently passed the US Congress and was signed into law by President Obama. Among its more important provisions, the bill changes the system from a first-to-invent to first-to-file system, the standard used internationally. Critics argued that this reform could actually hurt independent inventors, as it accommodates those who have the resources to quickly prepare and file applications. But more significantly, the bill fails to address the primary problem of patents, specifically in regard to the standard that permits so many bad patents to be issued.

There are other reforms that could improve the functionality of the patent system. Given the rapidity with which software technology advances, the 20-year duration of the monopoly granted under current patent law is inconsistent and should be considerably reduced, perhaps to as little as two to five years (the AIA does not address duration). Others have suggested broader solutions including tort reform, although today’s litigious environment is arguably not just a problem for the patent system. Notably, the AIA did include some provisions for reducing the incidence of patent litigation.

Software code, like other written material, is

already protected under the copyrighting laws

Many patents are used more as weapons to

thwart the innovations of competitors

The America Invents Act changes the system from

a first-to-invent to first-to-file

There are other reforms that could improve the

functionality of the patent system



Nevertheless, real reform of the patent system involves more than the procedural fixes contained in the AIA, and real reform cannot be achieved without instituting a more rigorous standard of obviousness. Fortunately, some progress has recently been made towards this end in the courts. In 2007, the Supreme Court’s ruling in KSR v Teleflex has caused a return to a stricter standard of obviousness. In 2010, the high court’s decision in Bilski v Kappos rejected the patentability of abstract ideas but reaffirmed the patentability of certain business methods, although it did not set specific guidelines. While these were steps in the right direction, many critics saw these decisions as maintaining “business as usual.”

The patent system was created by the US Constitution to ‘promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries.’ Indeed, for many decades the system worked to promote such progress, leading the USA to become the world’s innovation leader. Today’s broken system not only challenges the USA’s leadership in innovation, but also its future economic growth.

Incidentally, fixing the problem of patents - that is, restoring the patent system’s role as a protector and promoter of innovation - does not actually require innovative ideas. As history suggests, deteriorating standards have undermined the patent system since the early 1980s, so reforming standards seems like the obvious starting point. Accordingly, a return to clear, non-arbitrary and consistent standards that can be uniformly enforced would mitigate patent bloat, particularly related to software, and thereby obviate many of the incidental problems, from litigation to NPEs, that result. Of course, getting our legislative, judicial and regulatory officials to seriously address the problem of patents may itself be inventive thinking.

Real reform of the patent system involves more

than the procedural fixes

Today’s broken system challenges US leadership in innovation, as well as future economic growth

A return to clear, non-arbitrary, consistent

standards would mitigate patent bloat

Appendices US strategy


Appendix 1: Top 20 innovations for 2020 We highlight top innovative trends and technologies that we believe will have transformative impact over the next few years.

Progress starts in small steps 1. Carbon nanotubes Nanotechnology is the engineering of functional systems at the nanoscale, dimensions between approximately 1 and 100 nanometers, where unique phenomena enable novel applications. At the nanoscale, the physical properties of materials differ from the properties of matter either at larger scales from the atomic level to millimeters to inches.

Physicist Richard Feynman first proposed the manipulation of matter at the atomic level in 1959, but it was not until the identification of fullerenes in 1985 that the field of nanotechnology really took off. Fullerenes paved the way for the discovery of carbon nanotubes (CNTs) in 1991. With twice the strength of steel and one-sixth the weight, researchers have been fervently exploring applications of this technology ever since.

Carbon nanotubes

The Louie Nanotube1

Source: US National Government

1An electronic device known as a diode can be formed by joining two nanoscale carbon tubes with different electronic properties. Source: Wikemedia commons

MarketResearch.com estimates the global carbon nanotube market will grow at a Cagr of 56.5% from 2010-14 with demand driven by the aerospace and defense industries. However, CNTs have other potential uses in wind turbines, textiles, body armor, concrete, synthetic muscle, light bulb filaments, solar cells, superconductors, displays and transistors.

2. Nanorobotics Nanotechnology was first popularized by Eric Drexler in the mid-1980s through his book Engines of Creation and initially referred to a radical molecular manufacturing concept. This involved scientists and engineers creating a vast number of “assemblers,” which are molecular-scale programmable machines that would be capable of building functional objects (including other assemblers) from the molecules up.

Drexler’s work was criticized by Nobel-Prize-winning chemist Richard Smalley and debates have ensued on the seemingly insurmountable difficulties of the chemical bonding level among other complexities. Ray Kurzweil devoted four pages in his book, The Singularity is Near, to dispute Richard Smalley’s arguments and support Drexler’s vision.

Carbon nanotube market is expected to grow at a

56.5% Cagr from 2010-14

Nanotechnology is the engineering of functional systems at the nanoscale

Nanotechnology was first popularized in the

mid-1980s



According to Ray Kurzweil, the “killer app” for nanotechnology would be Nanobots - computer-based robots small enough to travel in the human body to destroy pathogens and cancer cells, repair DNA errors, eliminate toxins and debris, and otherwise reverse the aging processes - ultimately providing radical life extension.

Kurzweil’s predictions are extrapolated from historical trends. Within two decades, we will be able to manufacture powerful computers we carry today in sizes no larger than a blood cell. As genomic sequencing transforms biology into an information science, we should see the same exponential pace of invention. Inevitably, our machines would be so effective at fixing and augmenting our bodies that we will incorporate them ever deeper into our lives. Memory prosthetics will feed our brains’ data, and nanobots in our blood will download the latest anti-virus software for fighting real viruses.

What could be viewed as a precursor to nanobots are nanoparticles, which are currently being tested in early-stage clinical trials as targeted therapies for cancer. Researchers from California Institute of Technology created the nanoparticles from two polymers plus a protein that binds to receptors on the surface of cancer cells along with small-interfering RNA (siRNA), designed to stop cancer cells from multiplying. When the components are mixed together in water, they assemble into particles about 70 nanometers in diameter. The nanoparticles are then injected into the bloodstream of patients and once absorbed inside the cancerous cells, the nanoparticles fall apart, releasing the siRNA and the rest of the particle are so small they pass out of the body in urine.

Helping vision become reality 3. 3D printing and custom fabrication Are we on the verge of a post-industrial revolution? 3D printing has the potential to transform the way we manufacture things. The technology offers a more efficient and less costly means of producing custom items by using significantly less raw material and avoiding the expensive retooling required by mass production lines. In other words, rather than mass producing for customers, it brings custom production to the masses. 3D printing has the potential to be highly disruptive to the manufacturing industry by enabling “mass customization” and just-in-time manufacturing.

Originally used to construct prototypes and models, the technology has now advanced to the point of producing much more complex final goods. 3D printing works much in the same way as a traditional printer, except that the “ink” used can be any range of materials from plastics to powdered metals. Depending on the method, an object can be created, for instance, by depositing molten plastic layer by layer or by blasting powdered metals with lasers that melt and bond the material.

Companies are eagerly exploring commercial uses for 3D printing. GE has used 3D printing to create hollow parts, which is significantly cheaper than hollowing out forged parts. It is also exploring its use in ultrasound scanners. The technology is being applied in the fields of aerospace, automobiles, musical instruments and textiles. The Wohlers Report estimates 3D printing will become a US$5.2bn industry by 2020.

However, 3D printing is also developing a consumer market. A recent Forbes article notes that the technology is becoming increasingly accessible, as the cost of 3D printers has declined from US$400k five years ago to only US$1k today. MakerBot Industries has created the US$1,299 Thing-O-Matic®, a

Computer-based robots small enough to travel

in the human body

Kurzweil predicts powerful computers in

sizes no larger than a blood cell

3D printing has the potential to transform the

way we manufacture

The Wohlers Report estimates 3D printing will

become a US$5.2bn industry by 2020

3D printing is also developing a consumer

market



user-assembled, automatic, personal 3D-printer kit. The MakerBot enables the user to print three-dimensional plastic objects. Advocates of 3D printing believe that individuals can use personal printers like the MakerBot to start consumer-oriented businesses selling shoes and jewelry.

V-Flash personal 3D printer; full build platform

ProJet HD 3000 professional 3D printer; Moon Rover

Source: 3D Systems

Scientists are also exploring uses for 3D printing. For example, Scientific American notes that paleoanthropologists are using 3D printing to replicate fossils that are too sensitive to handle directly. But perhaps there is no potential application more exciting than in the emerging subfield of 3D bioprinting. Medical researchers are already developing methods of printing human organs using genetically identical tissue from patients. Bioprinting took a major leap forward recently with the announcement that a group of scientists at Germany’s Fraunhofer Institute has developed a method to produce synthetic blood vessels, which would enable scientists to build full organs with working circulatory systems. Although implementation of printed organs remains some years off, replacement parts for humans - as they already are for machines - will soon be readily available at the touch of a button.

4. Open-source hardware The broad availability and acceptance of open-source software has been a catalyst for accelerating innovations in technology and in the broader economy. The benefits of lower cost, increased flexibility and improved transparency for users have been broadly embraced as open source has evolved beyond the province of hobbyists and computer scientists into the corporate mainstream.

Open-source hardware extends the concept of open source to hardware devices. The open-source principle applies not just to related software, but also to design elements such as mechanical drawings, schematics, PCB layout data, hardware description language (HDL) source code and integrated circuit layout.

The prototype problem Prototypes are necessary for industrial, manufacturing and services firms to test the viability and practicality of product designs. Complex prototypes of electronic devices have historically required significant upfront investment, often requiring months of design, testing and fabrication to produce a one-off

Paleoanthropologists are using 3D printing to

replicate fossils

Open-source software has been a catalyst for

accelerating innovations in technology

Prototypes are necessary to test the viability and practicality of product

designs



device. For prototypes that incorporate wireless capabilities, the equipment needs FCC certifications, carrier certifications and other requirements. In the past, creating a self-designed device required designing the device from scratch. After testing the device, manufacturing typically had to be done by hand, as large electronics manufacturers typically have high minimum orders.

Bug Labs, a privately held company based in New York City, creates kits with a base and different modules that users can mix, match and program to create custom electronic prototypes. With Bug Labs kits, companies can deliver customized devices in a couple of days versus months or years. For US$2,000, companies can produce prototypes that would have cost US$500,000 previously.

Bug Labs open-source hardware kit

Source: Bug Labs

The company’s offerings evolved by learning from suppliers and manufacturers, designing products that would enable customers with a flexible set of components for building devices. The Bug Labs kits come with a base and modules that include Wi-fi, cameras, sensors (such as accelerometers, thermometers, etc), GPS and other functions.

Bug Labs sells the hardware (with specification made available freely) and provides services that users can subscribe to, such as picture service, location services, etc. The company provides an open-software framework onto which users can build applications and code. The software is free, but Bug Labs sells support similar to the Red Hat model. Designs are all open sourced under the GPL license and the company’s biggest cost is hardware itself. Every Bug kit comes with web services, enabling users to plug in modules with the services.

When the company was started, the initial targeted audience was high-end consumers: tinkerers, Maker Faire types and home do-it-yourselfers. The US$1,200 price point proved high for consumers, but not for businesses. The pivot to focusing on business and government has been successful, with partnerships with Accenture, DARPA and FedEx driving innovation of new solutions. In one case, Accenture developed GPS-enabled devices that integrate with Accenture Mobility Operated Services (AMOS), a software platform. This enables custom applications that incorporate GPS, sensors and connectivity such as logistics tracking. Accenture has created devices and software applications in healthcare, transportation, utilities and security.

For US$2,000, companies can produce prototypes

that would have cost US$500,000 previously

Designs are open sourced under the GPL license and

the biggest cost is hardware itself

Open-source hardware allows for rapid

prototyping



Bug Labs has also partnered with DARPA and the US military. In Baghdad, the IED innovation cycle was outpacing the ability for the military to innovate equipment to offset this. Marines have had to innovate in the field. However, the military has its own proprietary OSs that are expensive, and there has been a concerted campaign to promote commercial-off-the-shelf (COTS) components. With Bug Labs, DARPA was able to create its own version of a Google StreetView camera for US$2,000. Typically prototypes of custom devices could cost tens of thousands of dollars and take months to develop. At this low cost, the cameras can effectively be disposable, placed on top of a Humvee, for example.

The business case for open-source hardware is many ways more straightforward than software because vendors make money directly selling the hardware. Other potential revenue streams include support and maintenance, related services (such as wireless and GPS) and project-based consulting. Open-source hardware initiatives encompass I/O (input/output), circuit boards (Ardiono), 3D printers (RepRap), DJ mixers (Aurora 224) and video-game consoles (Uzebox). One of the most promising uses of open-source hardware is in the area of prototype development, and Bug Labs is the most prominent private company in this area.

Interactions - Increasingly transparent, more powerful 5. Beyond keyboard and mouse; the new computer interfaces Advancements in non-traditional computing interfaces are driving the innovation of new applications that will match the tactile or sensory interface to a function or automation. This is an area where we expect innovation to be quite surprising and to have a paradigm-shifting impact.

A broad range of natural interfaces promises to expand the experience of computing beyond the traditional keyboard/mouse, touch and speech-based interaction currently available. Multi-touch has already become mainstream thanks to smartphones, and most significantly the iPad. Speech recognition has been available commercially since 1982, but it has taken decades for accuracy and speed to improve, as word error rates have steadily improved over time. The use of speech programs in the military for battle management, air traffic control and telephony are well established. All major smartphone platforms include speech-enabled search and other control functions.

The development of new types of touch and haptic interfaces promises to enable new types of applications - for gaming, enabling the disabled, medical procedures, industrial processes, training, simulation and therapy. Haptic interfaces have applications in virtual reality (by enabling real touch to operate in artificial environments) and through teleoperation (using real touch to operate in real environments via computer). There is ongoing research into the use of haptic interfaces for medical simulation, particularly for training of minimally invasive procedures and remote surgery using tele-operators. There is also focus on using haptic interfaces to control robotics, artistic designs and telepresence surgery.

New types of interfaces will expand the

computing experience

The business case for open-source hardware is

more straightforward than software

DARPA was able to create a US$2,000 version of a

Google StreetView camera

New types of touch and haptic interfaces promise

to enable new types of applications



Haptic workstation is an integrated simulation system providing whole-hand force feedback, immersive 3D-viewing model manipulation and interaction software

Source: Inition

Motion-capture or motion-tracking interfaces are becoming mainstreamed, particularly in the realm of video gaming. Microsoft’s Kinect enhancement for Xbox integrates speech recognition, 3D sensing and motion sensing in an integrated, controller-less user experience, while Nintendo’s Wii and the Sony Move technologies exploit motion-control capabilities. Startups, such as Oblong, are exploring non-physical interfaces for computing.

There is also growing progress on brain computer interface (BCI) technology. Currently, research is focused on physical implants (mostly to benefit the disabled through physical mobility and prosthetics), but there is also growing progress in non-invasive brain interfaces that track brain activity to control computing and physical devices. Emotiv, a San Francisco based private firm, has developed a computer interface that tracks brain waves to control a cursor on a screen. This technology is still in early stages, but we expect continued innovation along this front.

6. Social software Social networking and collaboration technologies foster business agility, collaboration and innovation by allowing more fluid communications across the organization. Technologies, such as Facebook and Twitter, allow problems and data to be distributed across groups of users in real time. There is increasing interest in using “social intelligence” - harnessing the collective wisdom of large groups of users via technology - to solve global problems, such as energy usage and climate change. We expect to see an increasing range of organizations incorporate the power of social-intelligence techniques to enhance broader analytic capabilities.

There is growing progress on brain computer

interface technology

Social technologies allow problems and data to be

distributed across groups of users

Haptic interfaces will control robotics and

potentially remote surgery



Social-networking software has evolved beyond the province of college kids sharing personal information into the mainstream economy. With the ascendance of social-networking platforms (including Facebook, LinkedIn and Twitter), we have seen an acceleration of innovation - in the value creation by social networks and emergence of derivative business models and ventures as well. Social networking has been one of the most significant paradigm shifts in software and computing since the shift from client/server to internet-based architecture, and the range of innovations encompasses marketing, analytics, service and support and other areas. Sites like Twitter and Facebook have even exerted profound impact in a revolutionary context, providing the means to link users during the Iranian uprising in 2009 and the “Arab Spring” in 2011.

Social-networking technologies have their origins in dating sites in the 1990s and have built upon the foundation of peer-to-peer services such as Napster, BitTorrent and other file-sharing technologies. Adoption of social networking has followed a typically exponential path for leading firms, although we saw the rise and decline of earlier entrants including Friendster and MySpace giving way to Facebook. Since it was founded in 2004, Facebook has disclosed over 800m active users worldwide, while LinkedIn, the professional networking site, has over 120m users. As of September 2011, Twitter announced it has 100m active users logging in at least once a month and 50m active users every day.

Facebook is as big as the internet in 2004

21

69

119

215

272

476

800

922

0 200 400 600 800 1,000

Oceania/Australia

Middle East

Africa

Latin America

North America

Europe

Facebook

Asia

(m)

Source: Facebook, Internet World Stats

Social-networking websites and related tools enable individuals to connect with others, communicate and share opinions and recommendations. Users can “like” or “follow” friends, acquaintances, companies, product, entertainers and any number of organizations or individuals. Social-networking websites rely on user contributions and interaction to create content and community - and in some cases have evolved into platforms that provide the foundation for incremental and related businesses.

Social-networking sites are big business as well: LinkedIn launched a successful IPO in May 2011 and most recently reported US$105m in revenue for the June quarter. Facebook has emerged as the largest of social-networking sites, with private shares currently traded on a secondary market with an IPO that has been speculated. According to source quoted by Reuters,

Social-networking software has evolved into the mainstream economy

Social-networking sites have evolved into

platforms for incremental and related businesses

Facebook has disclosed over 800m active users

worldwide

Facebook currently has more internet users than

any continent except Asia



Facebook revenue reached US$1.6bn in 1H11 with income of US$500m. Meanwhile social coupon site Groupon, social gaming firm Zynga and Jive Software have filed S-1s in advance of public offerings.

The key principles behind most social networks are the connections or follow, that directs updates (or “streams”) of content (comments, links, video, images, etc) to the connected user. Users in effect select their content sources for real-time updates as in the case of both Facebook and Twitter. The ability to communicate in real time with dozens or even thousands of “friends” has had profound impact on how individuals connect with one another.

The social-networking paradigm has catalyzed innovation in businesses. Companies like Jive and Yammer target the corporate market, while Salesforce.com’s Chatter offering incorporates a Facebook-like experience into the company’s sales and service offerings. Chatter in particular has been enthusiastically embraced by the company’s 100,000-plus customers. The impact Chatter has had on adopting organizations includes improving information flow (ensuring users are up to date), crowdsourcing questions and issues, reducing email overload and flattening the organizational hierarchy by allowing employees across companies comments and engage in dialogue with senior executives in threaded commentary.

Certain users can have outsize impact on consumer purchases (celebrities with large Twitter followings can command high premiums for product mentions). As of September 2011, Zynga's games on Facebook have over 275 million monthly active users. Four of Zynga's games, CityVille, Empires & Allies, Texas HoldEm Poker and FarmVille, are the most widely used game applications on Facebook, with CityVille having over 14 million daily active users. The value of social networking is being embraced by businesses beyond having simple Facebook pages for marketing. Social media such as Facebook and Twitter provide avenues for promotions, brand building and customer communications.

7. Social TV These days, if you want to become the mayor of a particular place, you merely need to “check in” enough times on foursquare. Now, a flurry of new apps has appeared that allows users to check into their favorite TV shows - and into a community of fans across the web. Apps like Bazaar Labs’ Miso or AdaptiveBlue’s GetGlue let users check in and receive points, badges and recommendations. Meanwhile, Twitter live feeds explode with 140-character hashtagged commentary when popular shows are on the air.

This is social TV, the integration of TV and social media. Marie-José Montpetit, a researcher at MIT, refers to it as a “cyber-watercooler.” But social TV represents more than a mere quest to become the Mayor of Mad Men or the King of Game of Thrones. Certainly, viewers value the ability to actively tweet, status update or chat with their friends and fellow fans as they watch the same programs. More importantly, social TV is impacting not only TV viewership, but the way that networks and content providers interact with their viewers. New software is integrating social media with television, allowing viewers to actively network and communicate with one another while watching the same programs. The technology is based on a server that ties together video and social media feeds in dynamic fashion.

The social-networking paradigm has catalyzed

innovation in businesses

The value of social networking is being

embraced by businesses

Social TV is the integration of TV and

social media



Indeed, some content providers are using social TV to encourage their viewership to engage directly with the program, turning the concept of “watching TV” from a passive to active experience. NBC’s reality singing show The Voice included a live show-specific Twitter stream onscreen and encouraged judges, contestants and fans to interact with each other on it. TV operators are also getting involved directly in the space, with DirecTV announcing a partnership with Miso and Comcast launching Tunerfish. They are also offering additional content on the so-called “second screen,” comprising notebooks, handsets and tablets.

Virtual tailgating with Microsoft Xbox Avatar in “Party Mode”

Source: Microsoft

Social TV has important hurdles to overcome. For starters, the social TV loop is incomplete, in that the experience of social TV is not integrated between devices. The social part of the equation is accessed on the so-called “second screen”, while live TV is watched on television sets. At present, users are generally unable to view a recommendation on the second screen and tune in immediately and seamlessly on their TV. All parties, from app makers to content providers, are seeking ways to monetize and further leverage the social TV loop

8. Augmented reality Augmented reality (AR) describes a direct or indirect view of a physical, real-world environment where elements are augmented by computer-generated input, such as sound, video, graphics or GPS data. The concept of AR has existed for decades, notably in the cinema where visual are augmented with vibrations, smell and sound. AR applications have been used in the aerospace industry and military, helping workers assemble aircraft and assisting pilots with navigation. Augmented reality differs from virtual reality, which replaces the real world with a simulated experience.

Wearable AR applications for military and emergency services can provide information such as instructions, location of enemy fire and maps. Many examples of this type of AR application have been represented in movies - the Terminator and RoboCop films employ augmented reality systems to “see”.

Content providers use social TV to encourage

viewers to engage directly with the program

Xbox Avatar enables groups of friends to watch

sporting events in “party mode”

Social TV has important hurdles to overcome

The concept of augmented reality has

existed for decades

The Terminator and RoboCop films employ

augmented reality systems to “see”



Augmented reality - Nearest Wiki

Augmented reality - Bionic Eye

Source: Nearest Wiki Source: Bionic Eye

With the proliferation of GPS technology, we are seeing a new generation of applications. Examples include: enhanced auto navigation systems that project overlays of destination details onto the windshield of a car; GPS-enabled ski goggles that show speed, direction, air temperature and even the outline of the course; smartphone applications such as Yelp Monocle that overlay information on restaurants, shops and other metadata on the user’s camera view; and a tourist iPad application for a Civil War battlefield with location-triggered narrations at key sites. There is an increasingly broad range of applications that employs smartphone camera and GPS functions to overlay rich data on the user’s view - with relevant, topical or even promotional information.

9. Self-driving cars In the 2002 film Minority Report, Tom Cruise’s character attempts a high-speed getaway in a car that seamlessly navigates between other cars - without a driver. Today, several car companies (eg, BMW, Audi and Volvo) and Google are already testing driverless vehicles in real life.

These autonomous driving systems employ, for instance, video imaging, GPS, laser scanner, radar and ultrasound technologies that enable the vehicle to recognize everything from surrounding vehicles to traffic light colors and move accordingly. The systems have built-in redundancies that act as fail-safes and also allow the human driver to override the system at any time.

Autonomous vehicles have the potential to solve many of the driving-related problems that occur as a result of human error or negligence. In theory, autonomous cars are safer than driver-operated vehicles because they have a 360-degree range of vision, can react more quickly than humans, cannot be distracted (by, for instance, text messaging) and are unable to drive under the influence of alcohol. The potential safety innovations have the power to be transformative. According to the National Highway Traffic Safety Administration, an estimated 9.6m vehicles were involved in police-reported crashes in 2009, leading to more than 23k deaths and nearly 2m injuries. Alcohol impairment was responsible for 23% of fatal crashes.

In a world of driverless cars, the road system could be transformed into something akin to a smart grid, where all vehicles are tapped into the system, monitoring traffic patterns and other vehicle movements. Such a system could conceivably obviate the problems of traffic congestion, as well

Smartphone applications such as Yelp Monocle

overlay information on the user’s camera view

Autonomous vehicles have the potential to solve many driving-

related problems



as the accidents that tend to accompany it. Many of the technologies necessary to produce an intelligent highway system are already in place, from traffic monitoring sensors, fiber optic networks, wireless technologies, motion detectors etc.

Google has been extensively testing its autonomous vehicles, which had logged more than 160,000 driverless miles without incident, until recently, one of its driverless Priuses was involved in a fender-bender. According to the company, the accident occurred while the car was under human operation, ironically. Nevertheless, the idea of driverless vehicles is gaining traction. Google lobbied for and Nevada recently passed Bill 511 authorizing its Department of Transportation to develop rules for operating driverless vehicles.

Engineering humanity 10. Computer-assisted genetic computation Advances in gene-sequencing instruments have created a paradigm shift in healthcare innovation and in the demand for high-performance computing as well as cloud computing. Thousands of human-genome sequences will be completed in 2011 versus less than 100 in early 2010. Second- and third-generation gene-sequencing technology could deliver a paradigm shift in diagnostics, personalized medicine and drug discovery. Academics are advancing innovation in data analysis, while growing access to public cloud resources offers increasingly viable, low-cost, scalable solutions.

There’s a long history to DNA sequencing dating back to the 1970s, but around 2000-05 it was becoming relatively common and ordinary to perform sequencing in the sense that scientists routinely could take a sample of blood or different cells, generate good quality sequences and have the ability to look for variations. However, this was done with one individual or organism at a time, and one big project at a time.

The most powerful change in the last several years is that sequencing technology has improved so dramatically. It is now possible to regularly sequence many individuals and organisms and perform much larger studies very efficiently and much more rapidly. The rate at which sequencing can be done is increasing at fivefold per year.

For example, when the original human-genome sequencing was published around 2001, the computational requirements included 50,000 hours to assemble one human genome, which consists of approximately three billion DNA molecules. Even with the advanced technology that is available today, there’s no way to read a chromosome from one end to the other, which causes inefficiencies in sequencing. It will require several generations of computational technology advancements to read an entire chromosome from end to end.

Costs of sequencing the human genome have declined dramatically. It took about 50,000 CPU hours or roughly US$50,000 worth of computation to assemble the human genome at Celera Genomics in 2001. In practice today, it’s actually around maybe US$5,000 or US$10,000 per human genome. In the near future, a US$1,000 rate per genome could emerge as the benchmark.

Google has been extensively testing

autonomous vehicles

Advances in gene sequencing have created

a paradigm shift in healthcare innovation

The rate at which sequencing can be

done is increasing at fivefold per year



The promise of a US$1,000 genome

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11. Implantable electronics Developed by Fiorenzo Omenetto of Tufts University and John Rogers of University of Illinois, a new generation of biocompatible devices will be able to break down naturally when not needed. One of the big challenges with medical implant technologies is that the body rejects them. This new generation of silicon electronic implants is being combined with a flexible silk substrate, formulated to dissolve over time. Potential uses include nanocellular insulin implants designed to dispense insulin into the bloodstream at paced intervals, breaking down in the body at the end of its useful life. Thus far, there are no evidence of scarring or immune responses in small animals.

Another area of therapy could be in cardiovascular disease, particularly in arrhythmias, where the current treatments range from pacemaker implants to cardiac ablation therapy (destruction of clusters of arrhythmic cells). Rogers and his team have constructed a flexible sensor array that can wrap around the heart to map large areas of tissue at once. The array contains over 2,000 silicon nanomembrane transistors, each monitoring electricity coursing through a beating heart. Other applications for the arrays being explored are in neuroscience, by applying grids to brain surfaces to study conditions of unusual electrical activity, such as epilepsy. The most near-term application for this technology is medical monitoring.

12. Engineered stem cells In the early stages of existence, stem cells have the unique potential to develop into many different types of human cells. Another unique characteristic is that these cells have the ability to divide almost without limit to repair damaged or replace other cells in many tissues. When a stem cell divides, each new cell has the potential either to remain a stem cell or become other cell types, such as muscle cells, red blood cells or brain cells.

These cells were initially derived by using early mouse embryos in 1981, which gave birth to stem cell medicine research. Until recently, stem cell research primarily focused on two types of stem cells from animals and humans: embryonic stem cells and non-embryonic or “adult” stem cells. Notably, embryonic stem cell research has been controversial since the process destroys human embryos.

A new generation of biocompatible devices can

break down naturally when not needed

Stem cells have the unique potential to

develop into different types of human cells

Costs of sequencing the human genome have declined dramatically



New research focused on using stem cells from adults with genetic enhancements to provide the basis for treating various disorders. This new approach focuses on taking cells from adults that may have a specific disorder, adding four genes, replicating the cells then reinjecting the cells into the initial donor to treat this. Because no human embryos are used to create them, these engineered stem cells solve two problems that have long been problematic to researchers: political opposition and shortages of material.

While much of the excitement from stem cells comes from the potential to replace damaged or diseased tissue, the most direct near-term benefit likely is to use the nearly unlimited source of human tissue to screen harmful side effects and toxicities of experimental drugs. The goal is to help expose problems early in the drug development process and save billions of dollars on research and testing. In addition, researchers are able to watch diseases unfold and trace the processes that have gone wrong at the molecular level.

13. Dual-action antibodies Treating diseases such as cancer and HIV often requires multiple drug combinations, with each drug having different targets as well as negative side effects. Along with several other biotechnology companies, Genentech (led by Germaine Fuh) is developing a new class of antibodies that have the ability to latch onto two disease targets simultaneously. The objective is to attack a disease on multiple fronts, helping to prevent drug resistance, offset some of the negative impact from adverse drug combinations and offer a more cost-effective solution to treating life-threatening illnesses. Genentech has developed two of the most successful targeted cancer therapies (Herceptin and Avastin) and therefore holds high promise in developing a major breakthrough.

Meanwhile, Trion Pharma has already received EU market approval for Removab in April 2009, the first bispecific antibody that binds to both cancer and immune cells in order to more effectively kill the cancer cells. The company’s successful Triomab platform provides proof of concept by combining the halves of two distinct antibodies, allowing simultaneous binding of two distinct targets and enabling the generation of a robust immune response. Early studies also suggest a potential long-lasting immune response similar to that of a vaccine to prevent cancer recurrence.

Triomab antibody design

Triomab mode of action

Source: TRION Pharma GmbH

New research is focused on using stem cells

from adults

A new class of antibodies will have the ability to latch onto two disease targets simultaneously

Early studies also suggest a potential long-lasting

immune response similar to that of a vaccine



14. Exoskeletons/prosthetics Ordinary men are unlikely to be fighting terrorists in jet-propelled armored suits any time soon, but Paul Zehr, a neuroscientist and author of Inventing Iron Man - The possibility of a human machine, thinks that a Tony Stark-style exoskeleton could become a reality in 30 years. Already, several companies are developing usable exoskeleton suits.

Berkeley Bionics has developed eLEGS Pro, an experimental wearable exoskeleton designed to help paraplegics stand and walk. The technology is being tested on patients paralyzed by spinal cord injuries at the Rehabilitation Hospital of the Pacific. The technology has its limitations. Unlike the Iron Man suit, the exoskeleton is entirely external and therefore not connected to the user’s nervous system. Instead, the technology uses sensors to anticipate the patient’s desired motions and then acts accordingly.

Meanwhile, Raytheon has developed the XOS 2, an exoskeleton intended for military use that would enable soldiers to carry heavy loads over long distances, while reducing the risks of orthopedic injuries. Using high pressure hydraulics, the suit amplifies the soldier’s strength and endurance, allowing him to do the work of two to three workers. Currently, the suit requires a tethered power source, which would limit its functionality on the battlefield.

Activelink Exoskeleton Suit

Source: Activelink

Although a fully bionic suit may be a long way off, the field of neuroprosthetics is pushing rapid advancements in the development of neural prostheses. The Defense Advanced Research Projects Agency (DARPA) has spearheaded a US$100m program called “Revolutionizing Prosthetics,” through which it has funded neural prostheses development at DEKA Research and Development and the Applied Physics Laboratory (APL) at Johns Hopkins University. The program has turned out DEKA’s “Luke” (after Skywalker) bionic prosthetic arm and APL’s Modular Prosthetic Limb. While DEKA’s prostheses relies on wired sensors, the APL arm uses neural sensors,

Several companies are developing usable exoskeleton suits

Raytheon has developed the XOS 2, an exoskeleton

intended for military use

There are rapid advancements in the

development of neural prostheses

Exoskeletons are currently being explored

for military purposes



essentially enabling the user to control the arm using his thoughts. Both devices remain in testing, but a commercial prosthetic arm seems to be within arm’s reach.

Smarter energy 15. Green concrete The debate around reducing global carbon emissions has produced some blockheaded ideas. For Nicolas Vlasopoulos, blockheadedness is key to his new environment-friendly cement. His startup, Novacem, developed “green concrete,” which actually absorbs more carbon dioxide than it produces during manufacturing.

According to Danish environmentalist Bjørn Lomborg, concrete is the most widely used man-made material on earth, and current production accounts for 5% of global carbon emissions. Given the rapid growth in construction in developing markets, especially China and India, green concrete could make a significant contribution towards reducing CO2 emissions.

Novacem is not the only company tackling cement-related carbon emissions. Calera, another startup, has also developed a carbon-absorbing cement through a patented process that involves creating synthetic limestone using CO2 emissions. Meanwhile, the Louisiana Tech University’s Trenchless Technology Center has developed a geopolymer cement that uses fly ash, an abundant industrial by-product, in lieu of Portland cement.

At present, there are limitations to green concrete. One is operational; so far, no company has been able to scale its technology to industrial levels. More importantly, the companies have yet to prove that green cements work as well as Portland cements - and that they are worth the extra cost.

16. Light-trapping photovoltaics First developed by Harry Atwater of CalTech, this technology is more efficient than thin-film solar cells, which are cheaper than traditional photovoltaics. “Plasmons” are the key to this innovation. Plasmons are created by nano-doping the thin-film cells with silver. This traps light within the solar cell, resulting in significant efficiency improvements. Renewables currently represent less than 1% of total energy output, but the opinion is that improvements in solar will allow this proportion to grow in accelerating fashion.

New advances in photovoltaics - the generation of electric power from sunlight - could boost the competitiveness of solar power versus conventional fossil fuels. Conventional solar cells are able to convert 14-19% of sunlight into electricity versus 8-12% for cheaper thin-film solar cells. An innovation by Kylie Catchpole, a research fellow at the Australian National University in Canberra, could potentially increase the efficacy of thin-film cells.

The innovation relies on harnessing “plasmonic effects” - subatomic waves triggered by light - by nano-doping the thin-film cells with silver. These nanoparticles significantly increase the absorption capacity of thin-film cells by 30%. Although Catchpole is still refining the technology, enhanced thin-film solar cells currently only represent 30% of the photovoltaics market, according to MIT Technology Review. With renewables representing less than 1% of total energy output, improvements in solar technology could accelerate growth in this sector.

“Green concrete” actually absorbs more carbon

dioxide than it produces during manufacturing

Conventional solar cells are able to convert 14-19% of sunlight

into electricity

Renewables represent less than 1% of

total energy



Innovating society 17. Online education Education in the US is a costly endeavor at every level and school reform is a hotly debated topic. Debates over the rules of seniority at teachers’ unions and the role of charter schools are contentious at the state and local level. Over the past 50 years, the average spending per pupil has increased in adjusted dollars from US$2,808 per year in 1961-62 to US$10,441 in 2007-08. However, the results of this increased spending do not appear by most measures to have increased the quality of results.

US college tuition vs home prices vs consumer price index

0

200

400

600

800

1,000

1,200

1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Tuition Homes CPI

(Index 1979 = 100)

Source: Bureau of Labor Statistics for CPI US City Average, College Tuition and Fees; Federal Housing Finance Authority for Homes - All Transactions Index

Fifteen-year-old students in the US ranked 14th in reading, 17th in science and 25th in math out of 34 countries, according to the 2009 Programme for International Student Assessment. While these scores are higher than those from 2003 and 2006, they still rank behind the highest-scoring countries, including South Korea, Finland, Singapore and Hong Kong. Between 1995 and 2008, for example, the US slipped from No.2 in college graduation rates to No.13, according to the OECD, while only eight of 34 OECD countries have a lower high school graduation rate.

The rise of online (and often free) educational resources has potentially disruptive implications. A prominent example is Khan Academy, a free online website with 2,400 videos in which Salman Khan discusses principles of math, science, economics and social science topics. The videos are decidedly low-tech, with only a voiceover explaining handwritten diagrams and formulas on the screen. Not showing the presenter on screen replicates the experience of a tutor, and the videos are short and targeted to a specific topic. The website provides software that generates questions and practice problems that generate badges for answering questions correctly. Khan Academy currently has over 2 million viewers per month, and investors include The Bill and Melinda Gates Foundation and Google.

There is an increasing range of free educational sites. The YouTube Edu channel hosts over 125,000 free instructional videos from universities and independent educators like Khan Academy. iTunes U includes free lectures from Stanford, Oxford, IT and 800 other universities. Google Code University offers tutorials, courses and videos on web programming, distributed systems and other topics related to Google. OpenCulture is a site curated by Dan

Education in the USA is a costly endeavor at every

level and school reform is a hotly debated topic

The rise of online (and often free) educational

resources has potentially disruptive implications

College tuition cost increases have vastly

outpaced home prices and CPI

Results at the secondary level have lagged



Colman of Stanford’s Continuing Studies Program that includes a plethora of free audio books, courses, language lessons, textbooks and educational videos. Connexions is a free website designed to allow instructors and authors to collaborate and share free educational materials.

18. Opening up digital government In many cases, the public sector lacks the resources and agility to adopt cutting-edge technologies. However, there is a growing trend for governments at the city, state and federal level to turn government into a platform that will drive innovation by enabling developers and individuals to use data to create applications, services and other resources. The ultimate objective is to provide access to data and transparency into government operations that allow constituents and the society at large to benefit from new applications and increased effectiveness of government, with incremental goals of lower costs as well. These efforts typically center on making public data available over the internet for the public to make use of.

The US federal government’s Data.gov initiative provides descriptions of the federal datasets (metadata), information about how to access the datasets, and tools that leverage government datasets. This initiative has opened up over 390,000 datasets from 172 agencies and sub-agencies, which currently support nearly 1,100 government and 300 citizen-developed applications. Applications include travel, jobs, product recalls, alternative fuel locators, agency, health and wellness and other categories. Following the successful launch of the US Data.gov initiative, other countries have followed with similar initiatives, including the UK, Australia, Canada, Kenya, Norway and the Netherlands.

On a local level, a number of US cities have similar efforts. New York City’s Open Data initiative provides over 350 data sets that developers and services can use. This has been the basis for the city’s BigApps challenge, which awards prices for the best city data-based applications. Winning apps have included Roadify, which incorporates data from the Metropolitan Transit Authority to enable users to share traffic and parking related info. The city is also employing scannable QR (Quick Response) codes on construction permits so users with smartphones can see specific information about projects. Philadelphia has launched an iPhone app called Philly Watchdog, designed to enable residents to send photos of city staff engaged in fraud or abuse to the Controller’s office.

The next generation of computing 19. Re-engineering the brain: Cognitive Computing One of the most exciting areas of computing research centers around the nexus of neuroscience, supercomputing and nanotechnology. Currently much of this work is taking place in laboratories and universities, but the potential impact could be transformational. The objective of IBM’s Cognitive Computing project is to build a brain as cheaply as possible. This is a quest to engineer mind-like intelligent business machines by reverse engineering the structure, function, dynamics and behavior of the brain, then delivering this in a small, compact form factor consuming very low power that rivals the power draw of the human brain.

The Cognitive Computing project is headed by Dharmendra Modha, who also heads a DARPA project called SyNAPSE (Systems of Neuromorphic Adaptive Plastic Scalable Electronics). The project is an interdisciplinary project that

In many cases, the public sector lacks the resources

and agility to adopt cutting-edge technologies

The US federal government’s Data.gov

initiative opened up over 390,000 datasets

The objective of IBM’s Cognitive Computing

project is to build a brain as cheaply as possible



incorporates analog VLSI (very large-scale integration of electronic components on a single chip), asynchronous VLSI, circuit designers, nano-materials, psychologists, neuroscientists, theoretical computer scientists at the university level. The IBM teams involve field scientists, nano-circuit designers, supercomputing experts, simulation experts, virtual environments, neuroscience, computational neuroscience and other disciplines.

Research in this area draws from three distinct disciplines:

Neuroscience - The basis of the project has been to understand the structural dynamic constraints that neuroscience has taught us about the structural dynamics of the brain. There are a lot of cortical similarities among the rat, cat, monkey and human, which are essentially similar in design.

Supercomputing - Scientists can take the data from neuroscience and engage in mammalian scale cortical simulations. In 2007, rat scale simulations included 55 million neurons, 500 billion synapses on a 32,000 processor Blue Gene in near real time.

Nanotechnology - The challenge has been how to shrink components down to a small form factor. By increasing the density and reducing power consumption of neurons and synapses, the vision is to achieve massive reduction in form factor size with the commensurate increase in processing power.

Cognitive Computing - Venn Diagram

Source: IBM

The human brain is asynchronous, always on and configurable. IBM hopes that cognitive computing will lead to new types of learning systems, programming paradigms and applications that can integrate, analyze and act on vast amounts of data from multiple sources simultaneously. The company has been engaged in computational neuroscience in order to replicate the cortical processes of rats and Macaque monkey brains. Current work reflects a new paradigm of computing that bypasses the von Neumann paradigm of computing, where storage and computing are connected and the bottleneck has been the connection.

IBM hopes that cognitive computing will lead to new types of learning

systems

Cognitive computing combines neuroscience,

supercomputing and nanotechnology



All of computer science has been oriented around bypassing the von Neumann computer architecture, which links internal memory and a processor with a single data channel. This approach allows for data to be transmitted at high but limited rates and is not particularly power efficient. This is known as the von Neumann bottleneck. IBM has integrated memory directly within the processors, combining software and hardware in a design that more closely reflects the cognitive structure of the brain. While this limits data transfer speed, it enables multiple processes in parallel similar to humans with far lower power consumption.

Cognitive computing goes beyond the concept of autonomic computing. Autonomic computing was developed as a concept in 2001 by IBM, with the ultimate goal of creating systems that are capable of managing themselves. An autonomic system is designed to make decisions on its own. Using high-level guidelines, autonomic systems constantly monitor status in order to make adjustments and optimize operations. Autonomic computing concepts have generally been applied to systems and network management, with the goal of helping complex systems diagnose and “self-heal” performance issues. Vendors such as CA, BMC, Cisco, Oracle, IBM and others in the systems and network management area have focused on autonomic approaches.

According to IBM’s head of research, John Kelly, the company’s work on cognitive computing has shown the same type of promise as Watson five years ago, and IBM is investing heavily into this research to develop computers that are essentially self-learning, that do not need to be programmed. The ultimate application of autonomic systems could extend to physical infrastructure, through smart sensors and systems to provide monitoring and response from compact computers that do not need to be programmed.

20. Quantum computing As the computing industry approaches the physical limits of performance improvement in silicon chips, there has been an effort to extend the exponential trend through new technologies. There are varying estimates as to when the limits of Moore’s Law would be reached, anywhere from 2013-18 to several hundred years in the future. Ray Kurzweil believes that photolithography will run its course by 2019, but the quantum or optical computing will continue the exponential growth in computing. One of the most promising is the concept of quantum computing. Quantum computers compute on atoms, not silicon, measuring the spin of electrons. Quantum computing systems are largely theoretical systems that use the behavior of subatomic particles to conduct calculations now performed with transistors on a chip.

Classic computers are built with transistors that work with information “bits” that can be in either an “on” or an “off” state, representing either a 1 or a 0. A quantum bit, or “qubit,” can be in “superposition,” representing 0 and 1 at the same time. The potential of quantum computing lies in performing a mathematical operation on both states simultaneously. This would allow for exponential increases in the power of computing. A 2-qubit system can hold four distinct states at once, a 2-qubit system on eight states at once, 10 qubits can hold 1,024 states and so on. In time, researchers expect machines with thousands of qubits.

von Neumann computer architecture links internal

memory and a processor with a single data channel

An autonomic system is designed to make

decisions on its own

Quantum computers compute on atoms, not silicon, measuring the

spin of electrons



The science behind quantum computing has been extremely challenging. Research efforts have sought to realize qubits in a variety of ways. These include test tubes of molecules in between powerful magnets to trapped ions manipulated by lasers. The challenge has been to keep qubits in superposition long enough to do anything useful, as the issue of interference from vibration or electromagnetic sources is particularly difficult to manage. Additionally, the act of measuring or observing a qubit can neutralize its potential for computing. Researchers have been using quantum entanglement, which links particles so that the property of one reveals information about the other.

Quantum systems are suited to perform certain types of calculations more rapidly than traditional computers and solve a class of problems addressing machine learning, artificial intelligence and logistics that are not well suited to conventional computers. Potential applications include software verification and validation, financial risk analysis, affinity mapping and sentiment analysis, object recognition in images, medical imaging classification, compressed sensing and bioinformatics.

Earlier this year, D-Wave Systems announced it had sold its first full quantum computing system to Lockheed Martin. The company offers a superconducting 128-qubit processor chip that is housed inside a cryogenics system within a 10-square-meter shielded room. The company has been in business for 12 years, and the 128-qubit processor is in its 23rd generation.

IBM has assembled a large research group on quantum computing at the Thomas J. Watson Research Center in Yorktown Heights, NY. This builds on advances at Yale University and University of California, Santa Barbara, that explore approaches for quantum computing that are based on standard microelectronics manufacturing technologies. Both groups layer a superconducting material on a semiconductor surface, which when cooled to near-absolute zero exhibits quantum behavior.

The science behind quantum computing has

been extremely challenging

D-Wave Systems has sold its first quantum

computing system to Lockheed Martin

Quantum systems are well suited to perform

machine learning, AI and logistics calculations



Notes



Appendix 2: Interviews

Scott D Anthony, Innosight Asia-Pacific ........................................... 96

Eva Chen, Trend Micro.................................................................... 103

Michael Docherty, Venture2 ........................................................... 108

John Hagel III, Deloitte Center for the Edge .................................. 113

Kamal Hassan, Innovation 360 Institute ........................................ 120

Saul Kaplan, Business Innovation Factory...................................... 128

Braden Kelley and Rowan Gibson, Innovation Excellence............... 134

Dr John E Kelly III, IBM ................................................................. 142

Nathan Oostendorp, Ingenuitas ..................................................... 152

Patricia Seybold, Patricia Seybold Group........................................ 157

Gary Shapiro, CEA .......................................................................... 164

Dane Stangler, Kauffman Foundation ............................................. 171

Stephen Trilling, Symantec............................................................. 175



Scott D Anthony, Innosight Asia-Pacific Scott is Managing Director of Innosight Asia-Pacific. Based in the firm’s Singapore offices, he leads Innosight’s Asian operations and venture-capital investing activities (Innosight Ventures) and launched Innosight’s business prototyping and piloting practice (Innosight Labs).

Scott has written extensively about innovation. Most recently, he co-authored the Harvard Business Review article, How P&G Tripled Its Innovation Success Rate. He authored Seeing What’s Next (2004) with Harvard Business School professor and Innosight founder Clayton Christensen, The Innovator’s Guide to Growth and The Silver Lining. He has two forthcoming books from Harvard Business Review Press, The Little Black Book of Innovation (late 2011) and Paving the First Mile (2012). He has written articles for publications such as the Wall Street Journal, Harvard Business Review, BusinessWeek, Forbes, Sloan Management Review, Advertising Age, Marketing Management and Chief Executive, and serves as a judge in the Wall Street Journal’s Innovation Awards. He has a regular column at Harvard Business Online (www.hbr.org).

Prior to joining Innosight, Scott was a senior researcher with Clayton Christensen, managing a group that worked to further Christensen’s research on innovation.

His passion is in enabling innovators around the world to realize their untapped potential. In early 2010, Scott and his family relocated from the United States to Singapore to take advantage of the booming opportunities for innovation in Asia. He has spent significant time on the ground in India, Singapore, Korea and the Philippines, and believes these and other countries are poised to be true innovation powerhouses.

Scott is a sought-after strategic advisor who has worked closely with senior leaders in companies such as Procter & Gamble, Johnson & Johnson, Kraft, General Electric, LG, Credit Suisse and Cisco Systems on topics of growth and innovation. He joined the Board of Directors of Media General in 2009.

Scott chairs the investment committee for IDEAS Ventures, a S$10m fund Innosight runs in conjunction with the Singapore government. The fund’s portfolio currently consists of four Singaporean companies: Versonic, The Mobile Gamer, WildFire and iTwin. Innosight intends to make another 10-plus seed investments in the coming years. Scott has served as an active Board member for two companies incubated by Innosight (Village Laundry Service, a laundry-service company based in Bangalore, and Guaranteach, a US-based online-education company), helping them develop and execute their strategy and raise external expansion capital.

He is a featured speaker on topics of growth and innovation. He has run more than 100 training workshops, and in 2008-09 served on the faculty of the Leadership, Innovation and Growth program at General Electric Crotonville. He has appeared on Good Morning America, CNBC and FOX Business.

Scott received a BA in economics summa cum laude from Dartmouth College and an MBA with high distinction from Harvard Business School, where he was a Baker Scholar. Previously, he worked as a consultant for McKinsey & Co, a strategic planner for Aspen Technology and a product manager for WorldSpace Corporation. While at McKinsey, he co-authored a publicly released report on the United Kingdom's economic prospects.

A passion for enabling innovators around the world to realize their

untapped potential

Scott chairs the investment committee

for IDEAS Venture

He is a featured speaker on topics of growth

and innovation



Key points from our conference call In the last 10 years, innovation has just become much more accessible.

People come to venture investors with completely formed businesses; with working technology, functional websites, marketing campaign, customers, and revenue - all of this for less than US$1,000.

Large companies increasingly recognize innovation is not a nicety, it’s a necessity. They know that their business model has a finite lifespan. There is a greater understanding about the systems, structures and processes - what it takes for a large company to really innovate at scale on a systematic basis.

Large companies have tremendous advantages with the decreasing cost of innovation. If everybody can innovate, it’s hard to create competitive advantage. Large companies have scale, sales forces, patents - the attributes that small companies want and are difficult to create.

It is difficult to tell what innovations will be successful at first because they all look great. The ability to run business simulations and interpret the results is an absolutely critical differentiator to determine whether a project is successful.

Key differences that challenge innovation in Asia: Silicon Valley people won’t take you seriously until you’ve had a couple of ventures that have failed. Failure isn’t something that’s an acceptable part of the Asian system. People look at companies that have failed as a failure and don’t want to invest in them. In Asia, there is more of a hierarchy based on age. The more gray hair people have, the more people listen. Sometimes that’s right and makes a ton of sense, sometimes that’s wrong and it doesn’t make any sense at all, and ideas from young people may not get the chance to be heard.

The growth of the YCombinator model, where there is tiny seed capital and a home for startups, has caused many VCs to move towards very late-stage investment in proven concepts. That is not what VCs were built to do. When things get cheaper, there is more competition and excess returns get bid away. A lot of people who plan to start businesses don’t recognize that there’s only going to be a handful of these success stories. If everybody is starting up something, the odds that they have a lottery ticket are low.

Innovation has just become much more

accessible in last 10 years

Large companies have inherent advantages -

scale, sales forces and patents

Failure isn’t something that’s an acceptable part

of the Asian system



Scott Anthony transcriptMaguire: How have enablers and inhibitors to innovation changed with respect to the use of technology? In terms of inhibitors, we can get into the regulatory issues. The main thrust here is how development of technologies such as open source, cloud computing, collaborative and social technology has had an impact on innovation.

Anthony: Let me provide a bit of background first. I’ve been thinking about these issues in innovation in one form or another for about 10 years now. This originated when I started doing research for Harvard Business School professor and Innosight co-founder Clayton Christensen after graduating from Harvard Business School in 2001. I then joined up with a couple colleagues in 2003 to scale Innosight, which was at the time a four-person company, to scale to the 100 people we have around the globe now. Over that time, we’ve had the privilege to work with a range of leading-edge companies and leading-edge thinkers to bring greater predictability and transparency to the often fuzzy world of innovation.

I have worked closely with large corporations in a range of industries, such as media, healthcare and consumer packaged goods. Procter and Gamble has been a long-time client of mine. They have been kind enough to allow us to write publicly about some of the things we’ve done together.

Then in the last couple of years, as I’ve transitioned out to our Asian operations, I’ve also had the opportunity to work with start-ups. You see, in addition to our consulting practice in Asia, we have a venture-capital fund that we run out of Singapore, which essentially functions as a proof-of-concept experiment that the things we research and write about actually work when selecting and shaping new ventures. So that’s the context I bring to the discussion - a mix of working with large companies and new startups and what I’ve learned trying to grow our own business.

To the question of enablers and inhibitors of innovation, in general three things have happened during the past decade: one that’s general and two that are specific to large companies. The general thing, and this is no surprise, is that innovation has just become so much more accessible. We have people who come to our venture-investing arm who have completely formed businesses: they’ve got working technology, they’ve got functional websites, they’ve run marketing campaign, they’ve got customers, they’ve got revenue. And they’ve done all

of this for less than US$1,000. That’s remarkable compared to the world 10 years ago. It’s for all the reasons you mentioned: open-source software, collaboration tools and the ability to fragment a problem and do different pieces of it in different parts of the world. It’s really amazing how the scale of economics can change in such a short period of time.

The second thing that I’ve observed is that large companies increasingly recognize that innovation is not a nicety, it’s a necessity. They know that their business model has finite lifespan. Think about what happened this Fall. Hewlett-Packard announced it was exiting computers. Google bought Motorola’s cellphone arm. And on and on. Everybody knows that the new normal is constant change so they have to get good at innovation.

The third thing that has happened is there’s just more understanding about what it takes for a large company to really innovate at scale. What are the systems, structures, process and all that kind of stuff to allow people to really be a systematic innovator?

So you look at all these pieces together and I’ll say something that at first won’t make any sense - but in my mind this decreasing cost of innovation, the increasing accessibility of innovation means it’s a great time to be a large company. Well, you might say that’s bizarre, because if the scale of economics is so low and you can have guys come up with an idea for a thousand dollars, what advantage could there be in being a large company?

The reality is that if everybody can innovate, it’s very hard to create competitive advantage at the early stages of innovation. So the best you can do is what Groupon is doing now, which is throwing money trying to build scale. But large companies have scale. They’ve got sales forces, they’ve got patents, they’ve got all the things that small companies want. They’ve got the things that are difficult to create. So a large company that learns how to tap into that innovative ecosystem in the right sort of way and leverages the advantages that it has can really do just some tremendous things. Those are a few semi-structured observations about the state of innovation in 2011.

Maguire: It’s interesting you’ve mentioned the concept of tapping into an ecosystem. The idea of an ecosystem seems to be a relatively new recent concept in the past decade. Which companies have been in your mind? What have been the factors that



have contributed to companies - large companies successfully tapping into this ecosystem, because it may not necessarily be imprinted in the DNA of every large company?

Anthony: No, it most certainly is not imprinted in their DNA. I think those who have done a good job of it have had leader-lead initiatives that have made clear why this is strategically important. They have driven all the things that happen for cultural change, they have driven small successes that lead to organizational buy in. They’ve created all the right systems to allow this to happen and they’ve let it expand over time.

Procter & Gamble is an instructive example. When A.G. Lafley became CEO 10 years ago, he mandated that at least 50% of ideas had to have at least some connection to an outside investor or to an outside scientist by the end of the decade. This was the launch of P&G’s very well-regarded “Connect and Develop” program. It wasn’t something that worked perfectly from day one, it takes some experimentation, it takes some work to make it work. They have continued to work on that program and today it has really become something that is now instilled into the fabric of the company. The leader - Lafley - said this is what we’re going to do. He helped create systems to back that up. And they got some early wins before expanding the program.

Maguire: It would seem that for large companies they would also need to be able to cover a couple of the aspects of the system. One is the process of having some sort of structured process of field testing innovation to see if it can be successful; in my mind, having a good corporate development team - M&A team, good patent attorneys, and good legal counsel to secure the rights to the appropriate IP.

Anthony: I think we’re seeing pretty clear signs over the past few months, that having the right patent capability, the right legal team, the right attorneys and so on is absolutely imperative in today’s world - so I think that’s absolutely true. And the practicality is critical too.

One of the things you can generally observe is that it’s impossible to know in the early days whether an idea, whether a technology, whether a business actually has it or doesn’t have it. You can never tell from looking at paper, looking at the projection, or looking at the business plan. . . because they all look great. Every single one of them looks great. So the

critical thing is to essentially run business simulations where you find smart ways to test without having to invest hundreds of billions of dollars.

The ability to run those business simulations and to interpret the results is an absolutely critical differentiator, particularly today because innovations just happen so fast and so furious in so many different places. You can get yourself stuck because you can look at all these ideas bubbling up in the world and say ‘gosh, first of all I put all of my marketing behind it, I put my sales force behind it, that’s a pretty big investment.’ And if you’re wrong, you can get yourself really stuck. So the ability to quickly learn about these things, which honestly I still think is an emerging ability in most places, is absolutely critical. And then as you mentioned, to have all the infrastructure in place to be able to form the right teams and to build the business in the right way is also really important.

Maguire: One of the posts you made on your blog that I thought was really fascinating was the discussion about Singapore, the fact that it is harder for companies to fail makes it harder for companies to succeed. I’d love to get your perspective having worked in Asia, maybe some of what you see in the inherent strengths in either of the work approach, organizational culture, regulatory environments, and maybe some of the obstacles or challenges to fostering innovation on par with what we’ve seen developed out of the western world in the past 100 years. I’m thinking less Japan and more China and some of the Asian Tigers for instance.

Anthony: Absolutely. With the caveat that Asia is a very diverse place, I think you see some very clear strengths. You have generally speaking a lot of educated people, which leads to a pretty strong work force. You have companies that are very determined to claim their rightful place on the world stage. There’s a lot of energy in the markets. You see a lot of entrepreneurialism on the ground in different part of Asia, such as India, Indonesia, and China. There’s a vibrancy about the markets that you can feel when you touch down in those markets.

You have in many cases, not in all, but in many cases, you have a regulatory framework that supports business and supports experimentation. In some markets it obviously gets in the way - in India in particular you’ve got all sorts of hurdles to overcome, but there still is an incredible vibrancy there. When you touch the market you can feel the



potential to have great innovative companies born in these markets. And you’ve got some early examples of this from TenCent, RenRen and some of the things that even big companies like the Tata Group are doing in India. There are a lot of innovative things going on.

There are two big challenges I see. The first is a fear of failure. If you look at Silicon Valley, people won’t take you seriously until you’ve had a couple of ventures that have failed. Failure isn’t something that’s an acceptable part of the Asian system. People look at companies that have failed as a failure. They look at companies that have failed and they don’t want to invest in them. This influences both the entrepreneurial ecosystem and the way big companies approach innovation.

The second challenge is the hierarchical nature of many companies - particularly big companies - in Asia. The more gray hair people have the more people listen. And sometimes that’s right and makes a ton of sense, sometimes that’s wrong and it doesn’t make any sense at all. But you just observe it in a meeting that the conversation changes dramatically depending on who is in the room. And unfortunately sometimes the good ideas at the fringes of an organization don’t get heard because they’re said by the young people and not the experienced people. And you know, honestly, there are plenty of US companies that are exactly the same way, so the degree to which it’s truly a cultural difference I don’t know, but I definitely feel that more when I’m in Asia than when I’m in the US.

Maguire: I remember hearing Jack Welch talk about how he had instituted generational mentors where he would pair with younger folks - he would have a 20-year-old mentor who would keep him very in tuned with new technologies. I think that’s certainly emerged over the last decade. The US is, of course, a pretty youth-obsessed culture as well so those are broad generalizations, but that’s what would seem to be true.

Anthony: I think that’s right, the use of “reverse mentorship” where you can learn much from young people if you’re a seasoned executive is absolutely right - particularly when it comes to technological change. Generally, the younger generations usually adopt technologies first. So certainly, there’s a lot to learn from people who live their lives on social networks and just communicate in fundamentally different ways.

Maguire: There was another interesting blog post about Asia in need of a Woodstock moment. Obviously, the US went through upheaval in the 60s

and 70s where a lot of traditions were upended. I thought that was great. I’d like for you to expand on that idea a little bit. I think it’s intriguing.

Anthony: The basic notion here is to address the issue of hierarchy suppressing innovation. The thought I had was whether there needed to be increased freedom from suppressed authority. Of course this is a tricky topic. That can go too far and that can lead to anarchy and we see some examples of that in the world today.

I do get the sense that there is a lot of excitement, enthusiasm and great ideas from the younger generation in a large organization that is just not getting heard. I just wondered that there needs to be some kind of cultural or seminal event that needs to make clear to people that it’s okay to speak your mind and that it’s okay if you’ve got a great idea, it’s okay if you disagree with authority. Israel is an extreme example of this. Rank doesn’t matter at all. If you‘ve got a good idea and you don’t express it then the idea is ultimately dead. And I just wonder if that were to happen in Asia, somehow in a way that would not destroy the fabric of society, would that unleash all this great energy inside.

Maguire: You did highlight that there’s a culturally ingrained respect for experience and age; that expression leads to the detriment of those ideas that aren’t getting out. But of course, how do you keep that from upending the social fabric - that’s a real issue.

I was also intrigued by your comments about the current environment, where we are getting the same feeling here, that chaos in the market seems to be much better understood than in 2008. Companies that understood where they may have failed to move during the last downturn are not letting themselves be knocked off course at least in these times. If we do go into another pronounced period of economic weakness, what are the characteristics of companies will allow companies to successfully innovate in a tougher environment?

Anthony: I think it’s companies that stick to it. And recognize that economies go up, economies go down. Markets go up and markets go down. Change isn’t going to stop, and those companies that put their heads in the sand and go into bunker mode are simply accelerating their destruction.

I think it’s a great time for companies who are looking for an excuse to rebalance their portfolio.



There are some companies who I work with that when you look at their R&D spending, they’re spending billions of dollars trying to chase some market opportunities that really don’t promise much long-term growth. Let’s approach that in a rational way. There are still a lot of places that if you rebalance in a right way, I think it’ll provide much better returns. I’m just an eternal optimist. I think sometimes downturns are great times for innovation because they force people to do the things that they should’ve been doing already.

Maguire: In a more efficient way or a more expedited way.

Anthony: Yes, again, look at those guys who are coming in pitching ideas, starting new businesses for a thousand bucks. So it might turn out that when a business’s budgets are slashed they have to go outside to get some of the resources to go and do innovation. This is not a bad thing, this is a good thing. Because they’re going to find that they can do it faster and cheaper than they could’ve done it before.

Maguire: Have you given any thought to how the venture-capital model is changing now that the amount of resources needed to really get a company off the ground in the seed stages is far less than anyone - I was talking to the CEO of BugLabs, which is an open-source hardware company. It’s a terrific company. They create these kits that allow companies to build hardware prototypes for two thousand dollars in two day versus a hundred thousand dollars in six months. He had a software company funded in 2000, costing US$50m. His comment is for US$10,000, he can do the same thing today. This first question is, have you given a thought for the implications on the venture-capital industry. I think that ties back to your earlier point - how does that change the calculus of potential entrepreneurs to be successful. And I guess to your point, how will the big companies successfully take advantage of this new dynamic.

Anthony: Number one, I think the venture-capital market is demonstrably changing, in kind of obvious ways. You have the YCombinator model, where you provide tiny seed capital and a home for startups. This started about six years ago, now there are dozens of similar models in the US alone. You have the super angel phenomenon. For many companies, these kinds of investments might be enough to support the creation of a nice, small enterprise. It might not be a multibillion dollar business, but it is a reasonable business that provides great returns for

those early investors. One consequences of this that a lot of the VCs have gone into providing very late-stage investment in proven concepts. That is not what VCs were built to do.

Secondly, when things get cheaper, you just naturally have more competition and excess returns get bid away. There will always be the Mark Zuckerbergs and Andrew Masons and the young kids who come in and become billionaires quickly. But I think a lot of people who are going to start businesses don’t recognize that really at any given time there’s only going to be a handful of these success stories. And if everybody is starting something up, the odds that they have a lottery ticket are low.

This again goes to a point I made earlier, that this could potentially be a great opportunity for big companies. Big companies have what many entrepreneurs wish they could have. If big companies can become the partners of choice for some of the companies that quickly get started and sorted out in the market place, they can do some very interesting things.

And the thing I’ve been focused on is to make their pursuit of change and innovation a purpose-driven activity for large companies. Right now it’s sexy to go to a start-up but is it really exciting to create the 73rd picture application for the iPhone? I don’t know. Some of problems of the world need big solutions and only big companies can do some of these things.

Maguire: SAP and Intel have had their own ventures. Would it make sense for companies that may not necessarily be in technology to actually diversify into making a lot more early-stage investments?

Anthony: Yeah, it’s interesting, I’ve observed even in the middle of Singapore, over the last 12 months or so, Singtel formed a big venture-investing arm. MediaCorp, which is a media company here, formed an investing arm. It’s just a sensible thing for just about everyone to do. Corporate venturing has gone through boom bust cycles in the past, but just in terms of learning, being exposed to the entrepreneurial ecosystem and participating in startups, it’s just a critical thing. Part of it is just helping your leaders understand what it is like to start a business and how the cycles go. Most leaders don’t know that and they need to because of the pace of change in today’s markets.



Maguire: As you look out at inhibitors for the next three to five years, what do you see as the big hurdles or salient issues that the companies may not have had to not think about - but with the rise of litigation, what do you see as some of the implications of this increase in litigious activity?

Anthony: To me at least, and I’m not an expert in patent law or anything close to it, but that strikes me as a pretty big risk. The government could screw it all up by making it cost prohibitive to even try to start something. Like in healthcare, doctors are afraid to do things in the US healthcare system because of malpractice. So what if you have the same sort of thing where entrepreneurs are afraid to start something up because they had to get insurance against patent law suits? That would be a horrible thing.

To me that is the only thing that would strain the innovation energy that exists in the world today. The innovation genie is out of the bottle. It’s not going to get more expensive to innovate unless there was that kind of external shock. It would have very negative repercussions for consumers and for really everyone in the world. I don’t think that’ll happen, to be honest. But that’s the only thing I could see. But other than that in large companies, it’s just a matter of choice. Do the right things, embrace the energy, channel the energy and do great things with it. Those that do will have glowing stories written about them. Those that don’t will have stories describing how they had great opportunities and blew it. So it really is up to the decisions of today’s leaders.



Eva Chen, Trend Micro Since its inception in 1988, Eva Chen has spearheaded Trend Micro’s emergence as one of the world’s most innovative internet content security companies.

Before becoming CEO, Eva served as executive vice president from 1988-1996 and CTO from 1996-2004. Under her direction, Trend Micro has produced a chronology of industry firsts, from unique products to security management approaches. As a result of her innovative leadership, she was appointed CEO in late 2004.

Of her many accolades and accomplishments, a few of the most prominent:

Named one of the 50 most powerful people in networking, Network World, 2004

Named one of the top five ‘Women of Vision,’ Information Security, 2003

Received the Lifetime Achievement Award, Secure Computing, 2001

Eva holds a Master's degree in Business Administration as well as a Master's degree in Management Information Systems from the University of Texas. She earned a degree in Philosophy from Chen Chi University in Taipei.

Key points from conference call As a company grows, the most important thing is the type of people you

want to attract - the key is putting things together, not revolutionizing the whole thing.

A global organization with management, research, marketing and sales all over the world is able to identify trends in certain regions then translate this elsewhere around the globe. This truly leverages the global nature of the business.

Innovation usually comes from a group of people having fun together and then they are all very relaxed. There’s no need to wear a mask.

Trend holds a “pajama meeting,” which is a global meeting where everyone wears pajamas. This is designed to break down traditional communication barriers between marketing and R&D by leveling the differences between people. When everybody looks funny, everyone becomes very equal and presentations with pajamas are less intimidating.

Cloud computing is a great platform for innovation, like the invention of printing technology. The distribution of knowledge, sharing of knowledge and value you can get from the knowledge are unprecedented.

Trend Micro has produced a chronology of industry

firsts under Eva’s leadership

The type of people you want to attract is

most important

Innovation usually comes from a group of people

having fun together



Eva Chen transcriptMaguire: What I’d love to have you share with us is the philosophy, the integration of innovation at Trend. What your background of innovation has been, but also maybe talk about some of the processes, the catalysts for you internally.

The first thing is the very differentiated approach to innovation compared to your major competitors in the anti-malware markets. They’ve been much more focused on M&A. Going back to the origins of the company, just talk about your views of innovation and how you focus your efforts to innovate your products, your portfolio and to stay ahead of where the market goes.

Chen: A lot of how a company grows has a lot to do with culture or characteristics of the company. I’ll go back to how Trend Micro was born. There were actually three co-founders. Me, my sister and my brother-in-law. The three of us co-founded this company. From the beginning, we coined the culture as being about “Communication, Change, and Creativity.”

Actually, these three represent our co-founders or should I say our passions. My sister, Jenny Chung, loves people, very people oriented; she talks with a lot of people; she has great communication skills. Steve Chung is an explorer; he likes to explore new things. Whatever is new gets him excited. He likes change. He’s never afraid of change. And myself, since I was little I liked to put things together, create things and make things. So those are the three things put together that became Trend Micro’s philosophy.

We like to by talking, observe what’s going on and then anticipate what’s going to be the next change. And then we put together the plans for solving the problem or the change we see coming. That is why Trend Micro’s approach is different.

Trend Micro from the start was very small; it was just the three of us. So we had to differentiate ourselves from the bigger competitors. And therefore, we chose to focus. Sometimes I call it the Starbucks strategy. All we sell is coffee and we sell very good coffee.

And so we’re very focused on security. And that is how we always are able to anticipate the next wave of security problems that will impact customers. That’s why we were the first ones to come out with server-based anti-virus in the local area network. That was a long time ago.

We were the first ones to come up with internet gateway anti-virus. Email just came out, the internet just came out in 1995 or 1996. The web browser also started to come out. So this is why I think we were much focused. We anticipated change to come.

The impact of change will be for our customers and therefore we can put together the vision to address the customer’s needs in the future. I think that companies need to change. The key of our innovation is anticipating the future. Of course, you cannot know why. Because I think the change is not even there yet.

We anticipated the local area network. That will be where the virus will get spread. We were seeing that people were starting to send email attachments and people were starting to exchange information. This is why we were anticipating whenever there is an infrastructure change we see the change and then we see how that change will affect security. We see how it will affect our customer and then we come out with a solution. We fix the infrastructure problem, that’s what security is about. It’s not like we’ve invented something. But we need to put together the solution. We identify where the problems are, and therefore we can patch those problems that generated from the infrastructure or the network.

Maguire: As the company grows, the scope of threats continues to increase. How do you balance the growing scope of the extent of change that tends to accelerate with the fact that your roots are closely bound to three people who have a strong culture. How do you ensure that your culture remains intact as you have a company that needs to scale to meet thousands of customers or millions of consumer customers and of course this accelerating threat landscape?

Chen: First, from the culture side, as our company grows the most important thing is what type of people you want to attract. The first thing is to get the right people on to the bus. And when you say the right people, the term I quote is not just that you are super in sales or you are a super engineer but are you the person that can work with this existing team as a collaboration to harness potential of this existing technology. We are talking about putting things together, not revolutionizing the whole thing.

So that’s how we keep our culture intact. We do put a lot of emphasis on our HR process. How do we recruit? How do we groom people and how do we



screen and say these are the right people we want to keep? For instance, in our training program, which we call the training circle, rather than just focus on technical training, we put a lot of emphasis on how to think, how do you collaborate. We invite outside speakers. In Japan there’s a person who emphasizes the philosophy of creating an environment where people can feel free to communicate - that’s the way innovation will come. We always say innovation is not something that comes 1,2,3.

You can’t say from now to 12pm you’re to going to think and give me innovation. You need to create an environment. Innovation usually comes from a group of people having fun together and then they are all very relaxed. There’s no need to wear a mask and therefore they can freely communicate. And they are not afraid to change. Because if people are afraid and wear a mask and they become defensive and don’t want to change. They want to defend their territory. So that is how we create and emphasize by recruiting the right people and creating the right environment so that people can come here freely. And that’s how we deal with the emerging and growing threat landscape.

You can say our company is a real growth-oriented company. We have 15 executives in our executive team. We speak nine different languages. The thing about this is that we are located in parts of world so meeting is very difficult. We are very conference call and email oriented. We have to spend a lot of time doing time doing this type of communication. But the good thing about this real global team is that our reach is onto different places. For instance, it’s hard to attach.

Nowadays, you see people in the US starting to talk about this threat or that but long time ago because of our China region, we’ve already seen that happen in the China region a lot no matter what the reason or how it started. We’ve already developed a solution for that type of problem. And now we’re seeing that kind of precise threat, we’ve already seen that so we already have the solution with that in the US.

Our CTO is in Germany. The people, how do I say it, are paranoid about privacy. And so long time ago he kept on talking about encryption and identity theft. And therefore we invested in identity theft encryption a long time ago. When we acquire companies, we were not acquiring companies for market share; we were acquiring technology that could address future problems. One example is we acquired a company located in the UK. It was just

six or seven people. Cambridge University is very famous for PKI encryption technology. This group of people is almost like a small lab that specializes in identity theft encryption.

And based on that technology that group of people that we acquired about four or five years ago, now we have a very unique technology hat can insert an encryption layer in between the hypervisor and the virtual machine. And therefore when the virtual machine stores the data onto a virtualized store the key can be controlled by the company.

Even though your virtual machine server is running on say Amazon and the computing power workload is operated by somebody else, the data can be encrypted and controlled by the customer. So this is an example of anticipating change, acquiring the right technology, and this group of people - we let them focus on the security and they work with our product group in Asia. And come up with a confined solution that can work in this kind of environment. So I think with the right people on board, group culture should be a culture that is not enclosed instead expandable.

Maguire: You discussed the trend in many respects is one of the most international of the firms in security. I recall you have people in the US, Japan, Germany, Philippines. You talked about some of the advantages that allow you to foresee some of the threats. What are some of the challenges to managing people across time zones and culture? And you mention that you are careful who does join the company and selecting and hiring the right people but also just managing across different cultures and work styles. How have you addressed some of the challenges there?

Chen: I must say time zones are not just time zones. It’s a major thing. Sometimes we just need to do things in a fun way in terms of communication. Annually, we have a meeting I call the “pajama meeting”. Because most of our project managers are in the US and Europe, because it’s closer to the market. And most of our developers, we call project managers - they are in the development center in China and Japan so everyone’s in different time zones.

So we have this meeting, called the pajama meeting, which is a global meeting where we get everyone together in a hotel and we just go crazy. We all walk around the meeting room wearing pajamas. Why is that? Because the tradition of the



biggest problem of any company whether you’re international or not is the marketing and the R&D - they don’t communicate well. And they become very defensive. The marketing people say every time you develop a new product, it sucks; it doesn’t compete well. And the engineers say you marketing people don’t know how to sell; you don’t know how to write or know anything about demand.

When they can take off their mask or their position then everybody looks very funny; nobody looks very professional. When everybody looks very funny; everyone becomes very equal. It’s like a vacation, very fun. When people are doing presentations with pajamas on they are less intimidating. You can just freely talk. Sometimes we just make it fun; something ridiculous.

When we have those groups offsites there is a program that we do, we go to the Philippines to build houses for poor areas in the slums. We put in the money to buy materials and then we have our employees volunteer and go to the site and build houses. One important thing that we do differently in being socially responsible is that our people actually live in those houses. All those houses we build, we live and then we build the next wave of houses.

This has nothing to do with security or innovation. Through this process, I think the important thing is that the people who live in these houses are people who originally lived in the slum. And the people who built these houses are from all over the world. It shows that we are all equal. It feels like you haven’t come to help but you are a part of me. I always remember when I was doing that one day when I was living in the house, I was missing tissue paper. They brought me the tissue paper, they helped me clean the room. I felt ashamed later. At the time, I felt like, well I wanted to give them something. But they were like “no, you cannot give me any money.” These are very poor people but they rejected any money. So this type of activity, we created this company outlet, instead of going to a big hotel and having an event. We created this outlet to let people know everyone is equal and no matter what we need to do, you need to understand and respect them and appreciate them. That is the most important thing for running a global company.

Maguire: That’s really unique. That’s the first I’ve heard of what you’re doing and it seems like being able to break those barriers down in a large company sounds like a very effective way to strip that away.

Chen: For global companies, the most important thing is that you understand that underneath everybody is the same. I was talking about the Germans before and how they are paranoid about privacy but underneath they are the same. It’s important that you understand them and that you respect that kind of culture. Don’t isolate them and say they are paranoid or crazy. And that is why as a global company we are not just sales offices in different locations. We actually have all types of people like marketing people in all types of functions in different countries. And we can work together because you need to be able to understand, appreciate and respect.

Maguire: So you’re really sourcing ideas and input globally. I think that’s reflective in that when I look at where the executives in the company are located and where the company is headquartered. That’s pretty unique. How do you feel about if you were starting up a company today. You’ve, over the last two decades founded Trend Micro, when there were just fax machines and telephones. And now you have all these social-networking tools, and video conferencing and Skype. How would you, with all this technological change, do it or would you differently given all the types of technologies available to startups.

Chen: Today, with cloud computing, is actually a great platform for innovation. We had to use fax machines to communicate, but now you’re instant messaging and video conferencing. It’s much easier. If you would, information technology is like pen and paper; the invention of pen and paper.

Cloud computing is like the invention of printing technology. That distribution of knowledge and sharing of knowledge and the things you can get from the knowledge. If we were to start another startup - and actually we are - I would say and utilize all this cloud computing technology and I should be able to go much faster and be even more effective as a global company. The pace of innovation is going to be much faster. Look at Netflix. It took 13 years for Barnes and Noble and Borders and Blockbuster to scale. Now it takes five years for all these companies to come to this scale.

Maguire: Well, if you look at Groupon, in a year it’s exploded. What Ray Kurzweil has talked about in some of his research where you have change and it accelerates and it’s just an aspect of the environment where you have more logarithmic than linear growth.



Chen: It’s like freeing technology, it allows knowledge to be spread and from that knowledge you can create and have new intelligence.

Maguire: I thought it was really interesting to watch how you had created your cloud and data center business unit which was really a startup within the company which was a unique approach. This conversation has helped me understand a little bit more of how your culture has been a factor in your strategic decisions.

Maguire: Did you notice that Google has discontinued or is no longer going to sell the old Postini service?

Chen: Yes, I noticed. We kind of predicted that. It’s not their core business and it’s not their focus. And security is something that. . . even when I’m so laser-focused on security, I still have so many challenges.

Maguire: Security is interesting because it’s created by human beings, it’s not like storage.

Chen: I say, whenever you have one person sitting in front of the computer and doing something then that is a totally different dynamic of just building a wall. We are not just anti-malware; we are anti-stability of the human being.



Michael Docherty, Venture2 Mike Docherty has a deep passion for collaborative innovation from diverse experiences in general management, marketing and innovation. He is currently president of Spencer Trask & Co, a unique private-investor network that has been an early investor in many big ideas including Innocentive, Health Dialog and Ciena. He is also president of Third Screen Marketplace, a co-creation network for mobile innovation, and founder of Venture2, a leading open innovation professional services firm.

Mike possesses over 25 years of broad-based leadership experience in general management, marketing and new product development. Prior to Venture2, he was a vice president and general manager for Sunbeam Products (now Jarden) in the successful turnaround of the company. His previous career includes consulting as well as corporate positions in marketing and planning leadership at Ford, General Electric and Rohm & Haas. Mike holds an MBA degree from Northwestern University’s Kellogg Graduate School and BSME degree from Drexel University

Key points from conference call In the wake of “Chainsaw Al” Dunlap’s damage to the company, Sunbeam

opened up innovation to partners. That year saw 10 new products launched - small appliances, durable products and health products. By the end of the second year, Sunbeam launched 150 new products without increasing the R&D budget.

Companies are very, very good at incremental innovation; they’re not very good at disruptive innovation. What stands in the way of true innovation are reward systems and processes that do not reward risk; they reward incremental optimization. Creating a crisis and setting big audacious goals can force people to think bigger and take more risks.

Competitive advantage in the future is not about who owns the best technology, but who has the best relationships.

Companies need to get beyond the transactional mindset where they define a problem and look for the solution in a linear prescriptive way. Innovation is never that linear. Companies must move beyond a prescriptive approach and into co-creation, which involves building networks and relationships.

R&D spend is not really tied to innovation performance, it is about more-targeted innovation. True consumer engagement and open models of innovation leveraging external resources are very efficient ways to get more bang for your buck.

Companies are very, very good at incremental

innovation

Competitive advantage in the future is about who

has the best relationships

Mike Docherty has a deep passion for collaborative

innovation



Michael Docherty transcriptDocherty: My background and experience has been about 30 years. I started as an engineer. I never stayed in one industry - I moved around a quite a bit. I would not have planned a career path, but I would not have changed a thing because it’s really given me a pretty unique perspective having worked in large companies like Ford and GE as well as startups and venture capital.

My career progression was from the technical side and then after business school, into marketing and new product development and then into general management. Ford and GE were large players and even there though I was focused on new product development, innovation and marketing in those roles. I’ve developed a real interest, passion and a good understanding of what it takes to innovate within large companies, having lived through this for 30 years.

I believe strongly that large companies talk a good game in terms of innovation, but everything in their culture, in their DNA, and their success measures and their rewards systems work against real innovation. And so in my previous life in the corporate side, I always found myself being one of those change agents that was going against the grain trying to make companies try new things that were not in their comfort zone.

Being on the outside, having done startups, I have a lot of respect and admiration for the entrepreneurial side of things. But then you see the fallacy and the mistakes being made in terms of not having enough business discipline. They need large companies and their brands for scale. And so for me, I’m in a really great spot where I’m excited and happy and I think I can add value, which is having a good understanding of the corporate side and what companies need to create future growth and innovation. And how there are so many opportunities in terms of external capabilities, partners in technologies on the outside and being a matchmaker if you will, is a valuable role that I love playing. And even the venture-capital role, it’s similar. Just a segue in the “open innovation” business - how I got into this was out of my last corporate role with Sunbeam Products. I don’t know if you guys have ever heard of “Chainsaw” Al Dunlap?

Maguire: Absolutely, sure.

Docherty: Well, so I was part of the clean-up team after “Chainsaw” Al Dunlap at Sunbeam.

I was part of the team that came in about three months after he was fired. Initially, I was the VP of new products, then I was the general manager of the Health Division. Just to make the point, here we were the Mr. Coffee brand, but we didn’t have a single engineer left who had ever made a coffee maker. The company was just destroyed.

We needed to just basically reinvent it and we really didn’t have a choice given where we were taking it through bankruptcy and fixing the problems. We didn’t have a choice, but to find ways to partner and innovate in a non-traditional way. So we actually welcomed inventors, we partnered with our suppliers. We outsourced more to China; we did everything we could to get more done with less.

Just one statistic: in our first year, we launched 10 new products and this is small appliances and small durable products and health products. By the end of the second year, we launched 150 and we did it without increasing the R&D budget. And it was because, basically, we learned to leverage capabilities elsewhere and that really got me passionate about this whole arena.

And it was around the same time P&G was launching their Connect+ Develop initiative, which included a mandate that 50% of their innovation was to come from the outside - it’s really making a strategic move into finding the best ideas wherever they are, versus feeling like you need to invent them all from the inside.

So my focus in the innovation practices has always been innovation generally, but more specifically collaboration, or collaborative innovation, or open innovation. There’s a bunch of different labels for it. The common sense definition is just that knowing a good idea can come from anywhere and I’m all about helping companies connect to those best ideas wherever they are.

Maguire: I think what you describe is endemic to companies really in any industry where you may have an ingrained culture, but you’ve also described how what forced to change at Sunbeam was being forced by the catalyst of going through a painful restructuring. How do you get companies that are doing okay to step out of their comfort zone? It’s sort of the classic innovator’s dilemma - you’re focused on taking care of your existing clients and things may be working okay. What have you found is



an effective approach to ensure that companies stay ahead of the curve?

Docherty: Well, you’re absolutely right, it is the innovator’s dilemma. And one of the reasons that companies have trouble innovating - in the speeches I give I often talk about basically creating a crisis. The senior leadership team needs to create that crisis mentality. And what that does is, if you look at the mechanisms behind that, is that it changes the risk profile; it changes the willingness of people to take risk.

What really stand in the way of true innovation are all the reward systems and all of the processes in the companies do not reward risk. They reward incremental optimization and so creating a crisis and setting big audacious goals at least to some extent can force people to think bigger and force people to take more risks than they normally would.

The other thing that I would think in terms of how do you get companies to innovate more. I always go back to the point that companies should do what they do well - using the innovator’s dilemma example - companies are very, very good at incremental innovation; they’re not very good at disruptive innovation and that’s where I tend to promote that companies look to do all the next generation and extensions internally but to look for disruptions on the outside. P&G - one person there once said ‘We’re great at growing and basically scaling the businesses; we’re not good at creating them.’

Maguire: Right.

Docherty: So it’s really those externally driven opportunities to which companies can provide their brands and their scale. In terms of process capability, I work with companies on either developing the capability to do this or doing it better. Ultimately designing your systems to develop things on the inside, but developing a skill set that you know how to partner on the outside and scout for the best ideas. And it really is a different kind of skill set to be able to have people in your company who can bridge the entrepreneurial world and the more traditional corporate culture where things have to be implemented.

Maguire: It’s like the conflict between the private company - sort of taking a big swing at a big idea - sort of the custodial approach to maintaining shareholder value that big public companies have to deal with is a very different animal. One of the

questions that I’m very interested in or one of the themes I’m interested in is in ‘how?’.

Maguire: With Eric von Hippel’s work, the idea that open-source software, web services, all these collaborative tools, essentially a lot of technology, has evolved and now we think about Facebook, Twitter and social networking and even a basic extent going back 15-20 years ago such as email - how has technology helped/been a catalyst for improving innovation and from your perspective, if it also has presented challenges?

Docherty: First of all, I’m a big believer in the collective intelligence approach, if you will, that you hear a lot from what others talk about. And Eric von Hippel’s idea of co-creation and your consumers innovating for you. I think those are all part of this whole notion of, in the broader sense, creating innovation ecosystems. If you come at this from the corporate viewpoint, these companies need to be part of the innovation ecosystems versus seeing themselves as the center and having a dedicated group of suppliers.

So they basically need to plug into the ecosystems that are going to operate with or without them and try to engage to the point where those people who are innovating in their direction as much as they can. But ultimately, just like social media, if you put your brand on social media - you lose control, there’s an analogy in innovation which is you can’t really control innovation ecosystems, but you need to be involved with them. The quote I use a lot is ‘competitive advantage in the future is going to come from not about who owns the best technology, but about who has the best relationships.’ Companies need to be more explicit about that. We’re big believers that this democratization of innovation is just at the beginning of where it’s all going.

Spencer Trask, the venture-capital firm that I’m also associated with, we’re big believers in that we’re investors in the space and we’ve invested in InnoCentive, which is one of the big platforms for open innovation. We also have a platform called VenCorp, which is a cloud-source platform for connecting entrepreneurs and venture capital where the crowd determines the best ideas for investment. We’re experimenting a lot in all these models around how do you leverage intelligent crowds. Instead of three guys sitting in a room saying, ‘here is the best idea’, how do you leverage the intelligence of domains of experts and non-traditional players to



find the best ideas wherever they are. And where we’re going next is how do you help corporations plug into that.

On the venture-capital side, we funded a company called the Inno360, which is a innovation ecosystem engine that helps companies search the deep web for best technologies and resources and then build an ecosystem via a technology platform. And finally another business that I’m involved in is called Third Screen Marketplace, where we’re building a consortium of brands all interested in mobile technology world related to brand building. Having those companies come together and identify strategic areas of common interest in mobile marketing and then co-creating new ventures to support ecosystems solutions or cross-company solutions. We’re experimenting with a lot of different ways in the space, but all of those are aims around the same idea of innovation ecosystems and leveraging technology platforms to accelerate connecting the best ideas to the best users.

Maguire: From your perspective as an investor in innovation, how much more capital efficient has technology made innovation now that we have much greater access to global resources where you don’t necessarily have to be somebody within a corporation in their physical location. You could be somebody in Russia, Brazil or Kenya or really anywhere. What implications does that have for, number one, your view of how the venture-capital model can sustain going forward with making a little less investment, and also some of the challenges to remaining competitive with some of the traditional barriers that were not necessarily intentional but some of the competitive barriers are falling away.

And when you talk about the competitive barriers. . .

Docherty: I would say more of organizational barriers, people who control the processes and can bring ideas to life and who have the resources to start a software company when it’s no longer the company who needs US$50m of dollars in funding to buy a bunch of servers and a data center. If you got a couple of folks in a garage with a credit card and Amazon Web Services, who could program Angry Birds, which can be sold for millions of dollars.

There is no doubt that technology has lowered the barrier to entry and startups - it’s a great thing. I’ve always been a big believer in failing early and experimentation. The globalization of all these

capabilities has really allowed garage startups to get scaled much faster and need a lot less funding. This is probably a different discussion. But yes, there is a lot of implication for the venture-capital model. It’s funny you used the word value creation early on because in my role, we really positioned ourselves not as traditional venture capitalists, but really as a group of super angels. We have a network of high net-worth people. When we fund programs we’re putting money into a business, we’re building a network of resources for value creation.

So we’re looking to bring in mentors and coaches, boards of advisors, and chairmen who can create and help accelerate value creation for the startups. And that’s really our model, if you marry that concept of leveraging a network for value creation with web2.0 tools and collaborative innovation tools. You’ve got something pretty unbeatable. In fact what we’re doing is, we’re actually running innovational challenges in a sense that some of our platforms to solve the problems of our portfolio companies to help create value more quickly and accelerate their growth. That’s where we’re headed. We are using these open innovation tools in venture capital.

Maquire: I think it’s really fascinating, so I’m going to have to dig in a little bit deeper into what you guys are doing in incentives. I look at what the TechStars or YCombinators are doing. Is it creating a far more capital-efficient way of having ideas go through the lifecycle? If they can fail more quickly and certainly generate a few successes.

Docherty: To be clear, InnoCentive is primarily a corporate model where problems and solvers get connected. On the venture-capital side, the other one that I mention is Vencorps, which is another startup that we’re funding that is a using the crowd to select the best startups for investments.

Maguire: Over the next five to 10 years, what do you see as maybe some of the most promising ideas? I know this is a very broad question. Some of the most promising ideas or approaches towards accelerating innovation and what do you see as potentially some of the biggest obstacles? We’ll just start for large corporations, number one and secondly for startups and venture capital.

Docherty: For large corporations, it is a good question. I would build on the idea I brought up earlier, which is this innovation ecosystem model where I think companies are going and need to go is



to get beyond transactional models for finding external innovation - even companies that are experimenting with getting ideas on the outside use what I would call a transactional mindset that they define a problem and they look for the solution in a linear prescriptive way. Innovation is never that linear. So what companies need to do is move beyond this prescriptive approach to innovation, and into one where it’s more about co-creation as Eric talks about. And in order to do that you need to build networks and have these relationships. Think of all the systems and processes that companies have in place.

Earlier in my career, I use to do a lot of consulting and help companies put in place stage gate processes to manage new product development and it serves a lot of value. But what you find is that companies want to apply that prescriptive process to the fuzzy front end of product development and to their relationships externally. So now imagine 10 years from now, we’re in a different world and we’re more like Cisco where we’re connected and managing relationships as part of our innovation process. You can’t work through one company’s very prescriptive process.

So what companies need to do is to move beyond the process into frameworks and mechanisms, if you will, more of a balance between discipline and creativity. They need process, but they need processes that are guard rails on the road versus step-by-step instructions because ultimately it’s all about how your system works with your suppliers and how yours works with other companies you’re collaborating with in your innovation approach. And then I guess, on the venture capital and startup world, as I hit on these main points earlier, the one thing I always tell entrepreneurs is they need to not think about going to traditional venture capitalist firms, but going to

corporations first, or finding ways to prove your model with lean approaches. And to design your exit as you’re building your company. Similarly, counseling corporations to get more tied into the venture-capital world because what you really need to be doing is guiding startups to design things that you’re the exit plan for. Let them take the risk, but ultimately have them design it for your long-term need and then buy it when it makes sense.

Maguire: A topic for another discussion is the efficiency of research and development spend. When you look at what Apple spends in R&D (2-3% of revenue) and IBM and Microsoft (11-13%), there’s an imbalance in the number of patents they have. But certainly, this is no better example that value creation is not as tied directly to financial outlays.

Docherty: Just a quick answer to that is Booz Allen and others have done some pretty good studies that show that R&D spend is not that tied to innovation performance. It really is about more targeted innovation. I’d go back to two points there. One is more consumer-driven innovation and I don’t mean just go out there and do focus groups, but really involving the consumer in the entire innovation process. True consumer engagement in the innovation process is one. The other is open models of innovation where you’re leveraging external resources, which is a very, very efficient way to get more bang for your buck as well. You can apply the notion of leveraging external ideas in one of two ways: you can do more with the same spend or you can spend less on R&D and get the same amount done. But ultimately, all the statistics tell you that most of the patents and real innovation is not being developed in IBM and Microsoft these days. And hence the very healthy M&A market for startups and bankers.



John Hagel III, Deloitte Center for the Edge John Hagel III has nearly 30 years experience as a management consultant, author, speaker and entrepreneur, and has helped companies improve their performance by effectively applying information technology to reshape business strategies. John currently serves as co-chairman of the Silicon Valley-based Deloitte Center for the Edge, which conducts original research and develops substantive points of view for new corporate growth.

Before joining Deloitte, John was an independent consultant and writer. Prior to that, he held significant positions at leading consulting firms and companies. From 1984 to 2000, he was a principal at McKinsey & Co, where he was a leader of the Strategy Practice. In addition, he founded and led McKinsey’s Electronic Commerce Practice from 1993 to 2000. John has also served as senior vice president of strategic planning at Atari, Inc, and earlier in his career, worked at Boston Consulting Group. He is the founder of two Silicon Valley startups.

John is the author of a series of best-selling business books, including Net Gain, Net Worth, Out of the Box and The Only Sustainable Edge. He has won two awards from Harvard Business Review for best articles in that publication and has been recognized as an industry thought leader by a variety of publications and professional service firms. Additionally, he and Center co-chairman John Seely Brown recently contributed a chapter to Business Network Transformation: Strategies to Reconfigure Your Business Relationships for Competitive Advantage (2009) and they recently published The Power of Pull (April 2010).

Key points from conference call There are two forces that are core catalysts for fundamental change. One

is the emergence of digital technology infrastructures. In prior technological shifts, the technology stabilized, then one could figure out what kind of infrastructure to build around the technology. This would stabilize core technology components and businesses could figure out what to do with the infrastructures. In this case, we’re going on 40-plus years and there is no stabilization at the core technology level.

The second force is a long-term public policy shift, since the end of World War II, towards global economic liberalization - removing barriers to products, money, people, ideas on a global scale.

The first stage is the playing out of these forces, manifesting in increasing pressure and deteriorating performance for companies. Companies are having a harder and harder time earning a return on their assets; one of the things documented was a 40-plus-year erosion in return on assets for all public companies in the USA.

There is a “pincer squeeze” on companies because, on the one hand, more and more powerful customers are getting more value at lower cost, while inside the company, creative talent is getting more and more bargaining power.

The second phase has to do with tapping into knowledge flows rather than protecting knowledge stocks.

The third wave is about the notion of shifting from a diminishing returns performance environment to an increasing returns performance environment through harnessing not just knowledge flows, but the learning processes of platforms that are available when you get scalable knowledge flows.

John has nearly 30 years experience as a mgt consultant, author,

speaker and entrepreneur

Two forces that are core catalysts for fundamental

change . . .

. . . Digital technology infrastructures and a shift in long-term public policy

Companies are experiencing a pincer

squeeze



Pull platforms can be very large scale. The Chinese apparel company Li & Fung has 15,000 business partners in the global network where they can pull out very specialized expertise to support customized supply chains for apparel designers on demand. They’ve figured out how to scale it very rapidly and it’s giving them a degree of flexibility and access to specialization that is unparalleled relative to more traditional western supply-chain operations.

Chinese and Indian companies pioneering pull-based approaches use minimal technology by focusing on a different set of management practices.

Open innovation is another example of where pull is starting to operate, but most of the instances of open innovation are relatively short-term transactions. The opportunity is to move open innovations into more of a relational context, where partners can actually learn more rapidly from each other because of trust-based relationships.

There tends to be a predominant view among senior executives that the winning strategy is adaptation, but it’s a reactive kind of strategy with a lot of risks. A different approach is a shaping strategy that you can bet the company on, that motivates a lot of other companies to invest in and supports spreading the risk around.

The temptation of a lot of senior executives is to go directly at the core of the business and try to transform it. That’s often a losing battle because the core has powerful defense mechanisms that resist that kind of change. From our experience, the most productive way to get change is to identify edges of the business that have major potential to scale rapidly.

The real opportunity is to scale at the edge and pull more people and resources from the core business out to the more promising edges over time. Then over time these edges become the new core of the business.

Pull platforms can be very large scale

Adaptation strategy is a reactive kind of strategy

with a lot of risks

Real opportunity is to scale at the edge and pull

people and resources from the core business



John Hagel transcriptMaguire: We would like to have you outline a few of the points from your book The Power of Pull as they relate to the state of innovation, largely from a US perspective. And as we look forward a few years, ultimately what the impact this “Big Shift” will have in accelerating innovation in specific sectors, hopefully reaccelerating some growth in our economy.

How do you view the three waves of the “Big Shift”, the fundamental disruption to the old “push” model of the economy with “push” programs of innovation?

Hagel: It’s based on a lot of research that we’ve been doing at the Center for the Edge at Deloitte. Essentially what we focused on is the core catalyst for fundamental change. There are two forces. One is the emergence of digital technology infrastructures, so you can think of going back to the development of the microprocessor and packet switch networks back in the 70s as kind of the opening salvo. What’s interesting is, relative to Carlota Perez’s study of historical disruptions at an infrastructure level, in all the previous cases - steam engine, electricity, telephone - you had a major burst of innovation and then a rapid tailing off or modest incremental improvements to the technology.

But basically it stabilized so that you could then figure out what kind of infrastructure to build around the technology and then that would stabilize because the core technology components are stable and then business could figure out what to do with the infrastructures.

In this case, we’re now going on 40-plus years and there is no stabilization at the core technology level. In fact, it’s exponential price performance improvement that continues. And so it’s a huge source of instability at one level. We’re now talking about cloud computing as the new infrastructure while 40 years later we’re now coming up with yet another infrastructure in these technologies and I’m sure that it’s not the end. It’s not only the final infrastructure, but it just reflects a continuing dramatic shift in performance at the core level. So you’ve got that playing out, digital technology infrastructures more and more accessible on a global scale.

The second force is this long-term public policy shift that we’ve seen basically since the end of World War II towards global economic liberalization - removing barriers to products, money, people, ideas on a global scale. Now it’s clearly uneven, some countries

moving faster than others, some industries moving faster than others, but it’s remarkable when you step back since World War II at how much the barriers have come down on a global scale. And so what you have are these two fundamental forces that have been playing out for decades, actually reinforcing each other and amplifying in the sense that from an economic viewpoint what they are doing is reducing barriers to entry and barriers to movement, which from an economic viewpoint means intensifying competition.

So that’s, we believe, the core fundamental forces that dominate the first stage, which is the playing out of these forces. And that initially manifests itself in increasing pressure and deteriorating performance for companies that at one level it’s a great development. We certainly would never advocate rolling these things back because as customers we’re all benefiting enormously. We’re getting much more value at lower cost and so from a consumer viewpoint it’s a great social benefit.

But the challenge is companies are having a harder and harder time earning a return on their assets, and one of the things we documented was a 40-plus-year erosion in return on assets for all public companies in the US. You can think about it at one level as a “pincer squeeze” on the company because you’ve got, on the one hand, more and more powerful customers getting more value at lower cost.

And then inside the company you’ve got creative talent who are getting more and more bargaining power because they are more central to dealing with this pressure. They know that they have options. If they don’t get paid better, there’s a better offer down the road. And there’s more visibility around the alternatives, again, because of the internet you can get a better sense of what options are available.

So they’re getting one of the things again that we’ve documented in our research, that creative talent is getting higher and higher cash compensation over time, which again puts a squeeze on the company on both ends - channel and customers.

So that’s the pressure story, which leads to the second phase, which is much more around starting to think about the opportunities that are created, which at the second stage has much more to do with tapping into knowledge flows rather than protecting knowledge stocks. And so our focus there is on the



challenge that in a more rapidly changing environment you’ve got a situation where the knowledge stocks that you are so jealously protecting are depreciating at an accelerating rate and the only way you can continue to create economic value is by refreshing those knowledge stocks and learning faster and driving performance to new levels, which requires participation and knowledge flows.

And so the whole game at that point is how do you start to develop the practices and the platforms that help you to do that in a scalable way? We’re not talking about 10 strategic partners. We’re talking about 10,000 or 100,000 - in some cases even millions of participants that come together.

And then finally the third - the third way is around the notion of shifting from a diminishing returns performance environment to an increasing returns performance environment through harnessing not just knowledge flows, but the learning processes of platforms that are available when you get scalable knowledge flows. And this goes back to my early days at BCG where the experience curve was kind of the dominant way to describe performance improvement and this was remarkably accurate across many industries, but it had a significant common element which was that it was a diminishing returns curve. The more experience you gain the harder and harder it was to get to that next increment of performance improvement.

And what we’re seeing now for the first time, and admittedly I think this is the most speculative part of our work, but we see the potential in an increasing returns environment where you can create learning platforms where people actually learn faster and get to higher levels of performance more rapidly as more and more people join in and participate in these platforms.

Maguire: The idea of pull platforms is one that you’ve articulated as this paradigm shift that’s being enabled by technologies and how you look at pull platforms. It would be helpful to just define or provide a couple of examples of a pull platform, but also how that ties into new models of innovation you know such as open innovation.

Hagel: Pull platforms - when we talk about “pull” in a business environment, often people immediately go to pull-inventory systems and lead manufacturing and certainly that’s an important initial element, but

the challenge or limitation of those approaches so far have only worked when you have a very limited number of partners in the supply chain - five, 10 at most kinds of partners to develop very deep relationships with.

The kinds of pull platforms we’re talking about are very, very large scale. One of the examples that we’ve written a lot about is this Chinese company in the apparel industry by the name of Li & Fung, who has 15,000 business partners in the global network where essentially they can pull out very specialized expertise to support customized supply chains for apparel designers on demand. And they’ve figured out how to scale it very rapidly. They’re continuing to add more and more partners. They haven’t maxed out yet, but it’s giving them a degree of flexibility and access to specialization that is unparalleled relative to more traditional western supply-chain operations.

So it’s an interesting example of the ability to get that kind of scale. I think what’s important - and this is a distinction with open innovation - there are lots of elements that are manifestations of this move towards “pull”. Certainly open innovation is another example of where pull is starting to operate, but most of the instances of open innovation are relatively short-term transactions: You create a platform. You pose a problem. You see if anybody’s got a solution or an idea and it’s an exchange - ‘OK, I’ve got the idea now we’re moving on’ as opposed to sustained kind of collaboration across again a very large number of participants.

The opportunity we see is to take a lot of early open-innovation initiatives that have been very transactional and move them into more of a relational context where you can actually learn more rapidly from each other because you have the trust-based relationships as opposed to ‘I’m just getting an idea and moving on.’ These are sustained collaborations that take on very challenging business opportunities. And working together, you learn from each other over again an extended period of time.

Maguire: It would seem that the evolution of particularly some of the peer-to-peer and social-networking technologies, internet connectivity, the rise of cheap and accessible processing power and mobile access would be a facilitator for a lot of these - creating connections and enabling networks. What do you see as primary obstacles and potential catalysts for existing organizations to harness these technologies and adopt models that really drive



incremental value - to the point of incremental or accelerating returns? It would seem that this would be a real cultural challenge and a shift for companies that have built their businesses on fundamentally different models.

Hagel: That’s a great point and it highlights one of our core views. As a result of the research we’ve done, when you look at that deteriorating return on assets over four-plus decades. . .I’m a huge believer in markets and their innovative power and ability to address new challenges and overcome them - and yet we haven’t seen that happen in this case over multiple decades.

It’s not just that competition is intensifying. It’s that it’s shifting at a fundamental level - this notion of moving from knowledge stocks to knowledge flows and the corollary of moving from push-based models or ways of organizing your resources to pull-based approaches requires a huge mindset shift.

There are basic assumptions about what drives success. Part of the problem is that very large companies became hugely successful around a very different mindset. That’s particularly hard to dislodge and get people to even make explicit the assumptions, much less challenge them. They contributed to their success. So it’s a big deal - it starts with basic assumptions. It goes into culture and the kinds of values you have in your business and then it gets down to basic practices required to harness the potential of these technologies. It’s not just the technology itself.

I think one of the interesting things about many of the Chinese and Indian companies we’ve looked at, who are pioneering many of the pull-based approaches, actually do it with minimal technology, but they’ve focused on a different set of management practices. How do you take an extended business process that engages many different participants and make it very modular so that you don’t have to tightly specify all the activities? That’s a key shift in terms of getting scalable pull platforms. Otherwise you would get overwhelmed by the complexity of coordinating at a detailed activity level. So there are a lot of changes needed.

Maguire: Well, it would seem that the new model in many respects does favor startups or new initiatives. It reminds me of a comment that Sam Palmisano made earlier this year - he has repeatedly tried to move IBM in the direction of adopting or

benchmarking themselves against their Indian competition, which must work with fewer resources.

Certainly in the US, you have established companies that are in the classic “innovators dilemma” where they’re focused on doing what they’ve done to make themselves successful. Now that we have found ourselves in an economic situation where resources are challenged, growth is certainly challenged, particularly in the US where there’s maybe more intellectual capital than investment capital than there had been in the recent past. How do you think that this plays out impacting the pace of change and the emergence of more innovative business models among established and startup companies?

Hagel: I think you’re on to an important issue, which is that one of the values of markets is that you are exposed to different approaches to doing business, and there is a set of new competitors emerging on a global scale adopting these new practices and approaches at a much more rapid rate. So it does apply pressure on companies to change their approaches. I think I would certainly acknowledge that it’s much easier for a startup with a clean sheet of paper to develop the pull approaches, but at the same time, large enterprises have incredible relationships and brands they can leverage to develop pull approaches very rapidly, if they choose to do so.

The big question again is motivation and mindset, but that’s really going to be the gating item here. But threat-based challenges do focus the mind, and in my experience at least most of the successful large change-management initiatives in large enterprises tend to be threat-based, where there’s a clear and present danger as opposed to opportunity-based, where you just have a vision of a different way of doing things.

Maguire: Right. One of the key ideas that you articulated in The Power of Pull is the idea of a “shaping strategy”, which I was intrigued that you had applied it to the example of Salesforce.com in the SaaS world - and Microsoft in the 80s. Could you discuss the characteristics of a successful shaping strategy and the importance for driving value creation?

Hagel: Much of our research takes on a contrarian view relative to a lot of management wisdom. Right now, in a world of increasing uncertainty, there tends to be a predominant view among senior executives that the winning strategy is adaptation -



just “sense and respond more quickly than anybody else to what’s going on in the environment and that’s the winning strategy.” But it’s a very reactive kind of strategy, and it has a lot of risks.

One of the key risks is that it spreads you way too thin. There are an infinite number of things to respond to and if you try to respond to everything, you end up getting consumed by the exercise. So I think that what we focus on is that in times of high uncertainty and rapid change, you actually have more degrees of freedom to shape your market or industry than you ever did when it was more stable. The key question is, well, how do you do that?

Our focus is on a particular kind of shaping strategy that is not the kind of classic disruptive innovation, like Southwest Airlines, where it was just one company that kind of changed the game. This is a different approach that says, ‘How could you shape not just betting your own company on it, but motivating a whole lot of other companies to invest to support your strategy so you’re spreading the risk around the strategy?’ And to do that you really need three elements to come together and this is based on looking at successful shapers throughout business history. We started back in the 50s with a guy by the name of Malcolm McLean, who reshaped the global shipping industry around containerized shipping.

One of the core elements is a shaping view. This is very challenging for most executives because it requires you to have a compelling view, long-term view of your market or industry. What’s it going to look like 10 to 20 years from now and what are the implications for where and how value will get created?

Since you mentioned Salesforce.com - if you went to hear Mark Benioff in the early days when Salesforce.com was just getting off the ground, when he spoke at a conference he spent nine-tenths of the talk talking about the way the software industry is changing, moving from product to service and with the implications and all of that - and then, ‘Oh, by the way, I have a company that’s developing software as a service.’

His focus was on getting that shaping view out in the marketplace. What it does is it slips in the minds of other executives the risk and reward equation. What you find in times of high uncertainty is that most people naturally, psychologically, magnify the risk and discount the return. They see all the risks that could happen and ‘yes, there might be return but

there are so many risks, why would I do it?’ So it pushes you either into paralysis or very modest incremental moves. The opportunity for a shaper is to flip that through this shaping view - magnify the sense of reward and discount the perception of risk so that you’re motivating people to move aggressively and to invest aggressively to support a shaping strategy - there’s huge opportunity here.

The other thing about a shaping strategy is it’s not - it’s fatal if you just talk about the opportunity for your company as a shaper. You have to be articulate about how it creates opportunity for a whole lot of other companies in the process, so it’s not just one company winning.

Maguire: It’s interesting that you bring up the asymmetrical risk equation between established companies and startup companies. That was exactly the point that Joichi Ito made at the Web 2.0 conference. This ties into the way he’s designed the MIT Media Lab, which is to find people that are, if not polymaths, are at least experts in multiple fields. You’ve argued for value creation at the edge. Looking forward, we live in a society where we’re constantly fighting and science is constantly fighting the need for deep specialization needed to become expert in a specific field - which is the baseline to then achieve breakthroughs. However the ability to connect dots across different domains - existing at the edge - seems to be an area with great opportunity for value creation and “out of the box” insights.

Some other people that have been thinking about this. I think about Daniel Pink’s A Whole New Mind where you’ve got the combination of creative/right brain and logical left-brain abilities. How do you look at the idea of edge-based thinking, structuring organizations to finding opportunity as we seek innovative, value-creating directions for the coming century?

Hagel: Yes, it’s a great question. Obviously since we are the Center for the Edge, we place a lot of emphasis on edges as being - at one level - very productive areas for innovation. An edge - and we mean edges in many contexts, so it could be geographic edges, in terms of emerging economies coming into the global marketplace. It could be demographic edges, new generations of customers coming into the marketplace or technology edges - new technologies. Or it could be the edge of a company where you confront customers and partners and engage with them and often see unmet needs most quickly.



But those unmet needs become the catalyst for innovation. I think it’s again a bit of a contrarian view when you think about how to get organizational change to occur. You know we talked about the dramatic shift companies are going to have to go through to move from a world of push to a world of pull. The question is how you do that? The temptation of a lot of senior executives is to go directly at the core of the business and try to transform it. From my experience, that’s often a losing battle. The core has very powerful defense mechanisms that resist that kind of change.

From our experience, the most productive way to get change is to identify edges of the business that have major potential to scale rapidly. It could be new product initiatives, new customer segments, new business models, but target and edge that has the potential to scale rapidly, bring people who are passionate to those edges and we put a lot of emphasis on passion as a way to drive performance improvement and creativity, and focus them on very aggressive performance goals and scale those edges as rapidly as possible.

A lot of the conventional wisdom is that, yes, you go out to the edge. You try something in a pilot and then you pull it back into the core. Our experience is those pull backs tend to again have very disappointing outcomes. The real opportunity is to scale that edge and pull more and more people and

resources from the core business out to these more promising edges over time. So over time these edges become the new core as well of the business.

Maguire: That makes a huge amount of sense, but it’s as you said, it’s a fairly contrarian way of thinking and requires some courage and a bit of a leap of faith. Certainly the component of passion can’t be underestimated as well.

Hagel: Well, and one of the things I would emphasize is that it may be a leap of faith, but one of the great things about these new technologies that we’ve talked about is that they can be implemented incrementally without significant investments. In the past, you know when you talked about enterprise applications, it was a “bet the company” thing.

Maguire: Yes.

Hagel: Massive investment, five, 10 years and maybe you got the results at the end of that. With these new technologies you can edge into them - forgive the pun - in ways that reduce significantly the investment and risk at the outset. And particularly if you can mobilize these third parties through shaping strategies, you can share the risk even more. So I think what’s exciting about it, is that if you do it right there’s actually relatively modest risk and a lot of reward.



Kamal Hassan, Innovation 360 Institute Kamal Hassan is president and CEO of Innovation 360 Institute, an innovation management and operation advisory group that works with private and public organizations throughout the world.

Kamal advises, mentors and trains clients on their business and innovation transformation efforts, innovation strategy to execution and sustaining the gains. He also educates clients on how to become more competitive using business model innovation. Kamal’s expertise includes:

Innovation deployment to solve business challenges and business model innovation to enhance value creation.

Innovation management training and executive coaching, having delivered more than 75 workshops in the areas of innovation strategy development, idea generation and management, innovation project execution, change leadership, operational innovation and Lean Six Sigma, and strategic planning.

Change management leadership, particularly in the areas of organizational, human resources and process assessments, dealing with resistance, resource management, project prioritization and on-boarding.

Startup mentor and business model innovator, as a 20-year veteran of the business world and a Lego Serious Play® Facilitator, trained to apply a unique method for creative business models to help entrepreneurs succeed.

Key points from conference call The most innovative people are kids and criminals. Why? Because they try

alternative ways for solving problems and there are no inhibitors for thinking outside the box.

In the USA, it’s the “laundromat syndrome.” In the Middle East, it’s “falafel shop syndrome.” Everyone starting a business sees their neighbor opening up a falafel shop or a laundromat and so they start something similar thinking, ‘So this is how it’s done. This is how business should go.’ In Silicon Valley in the 1990s, everybody wanted to start a falafel shop called a dotcom.

Innovation is key to creating value for the economy and society. To create jobs, you have to promote innovation. To create social change, you also have to promote social innovation. As an entrepreneur, starting a business that creates value requires you to be different.

The CEO needs be chief innovation officer for the first two or three years, in charge of innovation - starting, launching, implementing - before hiring somebody from outside or within to lead the innovation efforts.

Companies who have practiced innovation in a real way know how to reward innovation. This is not always rewarding success, but also rewarding trying, taking risk and even failure. So companies that don’t have that type of culture and that type of policies and procedures, they might fail in their effort.

There is a lot of talk about the free business model. Start free and then think of how to make money later on. The real innovation that needs to take place in these types of companies is how they can wrap up all these creative ideas into an innovative business model. They need something that creates value, a very innovative business model that disrupts the market and breaks through the status quo.

Kamal is a startup mentor and business model

innovator

The most innovative people are kids and

criminals

Innovation is key to creating value for the economy and society



There are many tools that allow you design a creative business model. Lego Serious Play® is a tool using Lego blocks to simulate a strategic plan. Using Lego in building shared models, you can build business models that are completely different. It’s the whole concept of using your brain and hands; they always go together, and this approach allows you to use both sides of your brain.

The culture in the Middle East needs to become more innovation and entrepreneurship focused. In the rich countries in that part of the world, the parents say ‘Why would you want to starve and struggle? The government pays really, really well.’ My advice to some of the executive counsels in the government was, ‘You pay too high for jobs. That's what’s preventing people from becoming entrepreneurs.’

Many tools to allow you to design a creative

business model

The culture in the Middle East needs to become more innovation and

entrepreneurship focused



Kamal Hassan transcriptMaguire: From looking at your background, I thought it might be really useful and interesting to hear your perspective on working with companies both in the US and also the Middle East and internationally. It would be great if you could share some of your experiences in terms of what brought you to the focus on innovation.

Hassan: Basically, how I got into entrepreneurship is I have a very strong entrepreneurial background and I had the interest in starting businesses, which I’ve done back in the 90s and even the early 80s when I was still at college. What I found was starting a business, and the ability to have the entrepreneurial spirit, also required that you have to be different. I coined a term that now a lot of people use, which is “falafel shop syndrome.” Are you familiar with falafel?

Maguire: Absolutely.

Hassan: I lived in the US and I called it the “laundromat syndrome.” In the Middle East, I call it the falafel shop syndrome. Every entrepreneur opens up a falafel shop; it’s very easy and it doesn’t require any effort or creativity. You see your neighbor opening up a falafel shop or a laundromat and you start something similar. And you’re thinking, ‘So this is how it’s done. This is how business should go.’

I lived in Silicon Valley back in the days, and everybody wanted to become a dotcom. Everybody wanted to start a falafel shop called a dotcom. Everybody copied the success of somebody else and wanted to start a dotcom regardless of whether it was going to work, it was unique or not, or innovative or not. I had a trouble with that.

I basically thought that entrepreneurship and innovation should go hand in hand. They shouldn’t be separate, which a lot of people disagree with. In many cases of entrepreneurship, people think they just have to start something, it doesn’t have to be innovative. But my thought was innovation is the creation of new and unique businesses, products and services. We should be starting new businesses that can last and create value for the economy, for the entrepreneur, for society. It could be any sort of business that basically adds value to all of us.

So that’s where, in my mind, innovation is key to creating value for the economy and society. To create jobs, you have to promote innovation. To create social change, you also have to promote

social innovation. The best way for me to promote this is to work in a consultancy and that was my transition. I wanted to see how innovation works in companies, the different types of innovation, and the way different companies are innovating. I started considering working for a firm that specializes in this. But, being an entrepreneur, I decided to start my own. So that’s how I transitioned into this space of innovation management or consultancy.

I’ve seen how the big boys in the big companies are innovating. I spent a lot of time in that space. How these companies are creating new value by implementing innovation systems and understanding the different catalysts, carriers and barriers of innovation. And understanding exactly how companies innovate, which is the innovation management process in general. How they sustain innovation in their company, how they keep doing this for a long time and what are the components and aspects of companies like this.

Going back to one of your questions - what are the catalysts? I call them the success factors of making innovation work in any company. One is definitely leadership commitment and involvement. That’s a must. And I’m not saying just by giving money and nodding their heads and saying yes, we’re committed to innovation, but they’re also involved in the innovation process.

Some of my recommendations have been that the CEO be the chief innovation officer for the first two or three years. And so he is in charge of innovation - starting, launching, implementing - before he hires somebody from outside or within to lead the innovation effort. This way, the executive team and the CEO unfold the innovation process.

My other recommendation is that the management team as a whole should be part of what I call the “innovation management office.” Just like the project management office, it’s a team, a committee, a group of people that meets regularly to review every single thing that relates to innovation practice in the company - including the ideas and the number of ideas, the selection of ideas, the conversion of ideas from concepts to innovative products and services, and so on. They also set the rules and directions and the motivational forces for the entire company to keep the innovation momentum going. So that’s the first success factor - the executive management team’s commitment and involvement. They don’t just give money and support, but they get involved.



The second success factor is having a robust infrastructure for the innovation initiative to be sustainable and for it to build momentum. What is a robust infrastructure? When you launch any initiative in a company or an organization, it will bring some change to the processes, to the culture, to the way you conduct business. With this comes resistance to the change, and also the need to communicate the change properly. So this is not only a soft component of the innovation implementation, but it also has to have concrete change in policies and procedures.

I’ll give you an example. Companies who have practiced innovation in a real way know how to reward innovation. Rewarding innovation is not always rewarding success, but also rewarding trying and taking risk and even rewarding failure. So companies that don’t have that type of culture and that type of policies and procedures, they might fail in their effort. Because all they’re focusing on are the results of the innovation, but not the change in the culture. So what we do is sit with management and say let’s change some of your HR policies. Let’s change some of your rewards and incentives policies. Let’s change some of your financial recognition of results and so forth. We look at many different elements in the company that need to be changed in order to make the innovation happen and make it sustainable.

Another part of that robust infrastructure is technology that is a physical enabler for that innovation process. The front end of innovation needs some technology in order to monitor, to listen to the customers, to the market needs, to the industry changes, to the forces that are around you. And that’s not an easy thing if you don’t have some sort of enabler that monitors these things. So, basically, we recommend that organizations set up some sort of customer assistance to gather data from the customer about the current experiences with the business. We also recommend that they set up some sort of trendspotting, and the ability to spot opportunities that are outside the organization by monitoring all the trends in their industry and their adjacent industries as well.

We also recommend that they set up some sort of crowdsourcing application where they can monitor and engage the ecosystem with the ideation process. Also that they set up some ideation systems internally where they collect ideas from all their employees, partners, suppliers and so on. That’s building the direct funnel for their ideas. So in

the front end, there are a lot of enablers in addition to the training, the change of policies and things like that they need to set up.

The third success factor that I believe is critical to the innovation process is you need both a dedicated champion for innovation and dedicated practitioners who are actually dedicating their time to push the innovation methodology, the practice learning and also the conversion of innovation into real-life products and services. You cannot do this if you are starting an innovation initiative in a company. You cannot do this with part-time work. You have to have some dedication and some roles in the system that will actually manage the problem. I’m not saying that you should single out people and you say ‘you are Mr. Innovation today.’ I’m saying you have to put in some dedicated effort to select a few people to promote innovation and to remove barriers to innovation. These are your innovation champions.

Innovation champions are senior managers that can change the behavior and the culture in their area - let’s say, in their own region or in their own function. They actually remove barriers if there are obstacles in the system or in the process; they have the authority to remove these barriers. They actually encourage people to participate; they spend money on training, on skill building and capabilities. So the champion’s role in the innovation process is very important.

Then there’s another role, which are the innovation experts. These are the ones who know the methodologies and the tools. There doesn’t need to be many of them, but they are the reference point, they are the ones that people go to if they get stuck and they know what to do. Now, once the innovation thinking and innovation practices have become part of the company’s DNA, you don’t these experts to be fully dedicated, because now everybody is participating, everybody knows the methodology, everybody knows the tools you need to use in the infrastructure.

I’ll give you a very simple infrastructure. Let’s say a group of engineers want to run a brainstorming session to generate ideas about a specific problem in the department and they want to contribute to the innovation process. They might not know that there are 20, 30 different tools they can use in the brainstorming session to generate ideas. They might think that the only tool they can use is to sit down at the table and put on the problem and then they generate ideas by talking.



There are actually several tools they could use to produce better results. I teach my clients 20 different tools that they use to enhance their brainstorming sessions - and they are able to generate more ideas, and better ideas. So if we bring in the innovation expert who can teach these tools to facilitate the session, these engineers can learn all the different methods or tools they can use in their sessions. In the beginning, that type of expertise is very important, but over time it’s not necessarily needed.

Maguire: As you allude to this, I think a lot of the structure is appropriate to established companies. But when you were talking about startups, it sounds like innovation really needs to be effectively embedded in the DNA of a startup. If I’m hearing you correctly, it’s almost the whole reason for existence is to have a differentiated and innovative approach. Do you think that this is well understood by the venture community? What about more broadly among entrepreneurs? How does this message or type of thinking address the people who have a technology idea or who may seeking funding for the first time?

Hassan: Yeah, I agree with you. It could be suited to the large companies; it could be suited to the venture-capital community. I see two types of entrepreneurs. I see some who want to start. They don’t care whether it’s different - they just want to start. I’m not saying that’s wrong, it’s absolutely right.

Big universities like Stanford have fellowship centers, and MIT and everybody has their own approach to entrepreneurship, and they teach these concepts. I’m not disagreeing with them. They’re teaching, really, how to start, how to build a business, how to put together a business plan that would convince VCs. They talk about differentiators in a very incremental way. They talk about how to be different from just your neighbor, the one right next to you. And they talk about entrepreneurship as a way of just starting things. We need that. Actually, I think one way out of the economic problems we have is just to let people start.

The US, especially, is very good at this, It’s very easy to start a business there. For US$50, you can start a business. You just register a company, you get the tax ID and you can start. You don’t need offices; you don’t need a lot of people to work for you. But at the same time, 80 percent plus of these startups fail. And a lot of money is being put into

these startups, especially technology startups, that is going to waste, which is fine. You’re taking the risk and you want to do this. But I have yet to see a serious focus on innovative startups.

I’ll give you a very simple example. If you search the patent database, you will find millions of patents that are not being used. There is so much innovation around us not being used. And so when I go to startupweek.org or these big startup entrepreneurship conferences where they're helping young entrepreneurs, they’re not injecting the innovation component into this. They’re not injecting business model innovation, product innovation, and new service innovation. They’re saying ‘if you have an idea you can prototype it very quickly, then that will work’ - which is fine. I don’t think at this moment, unless you’re into space technology or pharmaceuticals, I don’t think there are innovations coming out, in the way it used to be, that are completely different and unique.

For a startup, what they need to do is to combine what exists, innovations that existed, the patents, the ideas that exist with new business models, very innovative business models, and then launch from there. It’s not just about having an idea and then getting funded. What I’m promoting is that venture capitalists should insist on an innovative business model - with a combination, not just products and services, but an innovative business model. I’m sick and tired of seeing the free business model. Everybody is talking about the free business model. Start free and then think of how to make money later on after you’ve spent US$30-40m of someone else’s money.

We need new and innovative business models in the entrepreneurship space because that’s the area that is very fluid and flexible. A successful startup can get funded and sold quickly, making the founders and investors a lot of money. But in order to do this, the business model needs to be something completely different, and something that creates value.

So my focus with entrepreneurs is not incremental innovation. You can’t just copy someone else and change a few things. So, going back to the falafel shop syndrome, you can’t just say my neighbors downstairs just started a falafel shop and I have a few other ideas of how it could be done. This is a person who will open a falafel shop, too, but paint it a little differently, or maybe make it a little bit bigger or maybe make the pita bread a little bit different. And they think that’s a differentiator.



Maguire: I experienced that in Hoboken when I lived there. At least every block for 15 blocks there was at least one pizza place and then I remember seeing another pizza place open up, it was the second one on the block and I was scratching my head. It’s exactly the same syndrome.

Hassan: Yeah, it’s just an analogy that people understand. We’re starting another Facebook. We’re starting another Ebay.

Maguire: It’s whatever that’s working, it’s the flavor of the day.

Hassan: And it gets a lot of funding unfortunately. It's not differentiated and it still gets a lot of funding. And that’s a different dilemma that I have with the VC community. The VC community is driven by innovation, which I absolutely agree with and admire. You have to spend money to make money anyway, right? So as a management team you have to spend the money. But they’re becoming very careful these days.

So let’s start off with how you have to have a very different and innovative business model. The sky’s the limit. A lot of people argue with me about saying it’s very hard to come up with a new business model. I understand it’s hard but you have to come up with something. And there are so many tools out there. There are so many tools that allow you to be very creative with the business model. I recently got certified as a Lego Serious Play® facilitator. Lego Serious Play is a tool that they put out a few years ago and there’s a success story about this. Lego was about to go bankrupt, and they came out with a tool using Lego blocks to simulate their strategic plan.

I see so many powerful tools, and I got certified in this one because it’s incredible that just using Legos you can build all types of shared models. You can build business models with these Legos that are completely different. It’s the whole concept of using your brain and hands; they always go together and this approach allows you to use both sides of your brain. You show people your idea, instead of sitting at a meeting and saying what’s our next business model, and brainstorming by talking or using sticky notes or by looking around and finding other business models and tweaking them, or using excel spreadsheets. Lego allows me, in just a few days, to come up with an extremely unique and innovative business model for a client. And there are a lot of

other tools out there that you can use to create a unique business model.

I think that there are a lot of barriers to innovation. They’re specific to industries, regions and even different types of cultures, so the barriers to innovation in many different parts of the world are different. The education system is a barrier to innovation in many ways - this whole thing about education being about getting good grades and going to the next big schools versus learning real-life experience.

Maguire: The criticism of, say Asian-style rote learning versus a more Socratic method of sorts. Which is partly out of culture, but one would look at the Japanese education system versus the US/western education system. But then you do see so many successful Asian entrepreneurs that are doing very well in the US.

Hassan: Absolutely, there are many. But the more we are professionals, the more we become barriers to innovation. When we grow into our companies or into our profession, we box ourselves into what we know. We resist different things and stick to what we learned is right. Basically, they think they know everything. They’re not open for challenges. They box themselves away. They think in a way that doesn’t solve problems. They use the same tools over and over. They don’t experiment as much.

The most innovative people are kids and criminals. Why? Because they try alternative ways for solving problems and there are no inhibitors for thinking outside the box. That’s what they do, they think outside the box. They think outside the box to solve a problem. And so I think being so professional in what we do becomes an issue. Your doctor, all that he tries to do is solve things by the book because it’s too risky to try something new other than the things he learned in school. And the ones who take risk in the medical profession, they don’t become doctors, they become researchers and they move into a different profession.

So that’s one of the things I think, especially in the US, is a barrier to innovation. Also, our beliefs or our culture tell us that chaos is not a good thing, even in companies. But if you want to create everything by the book, you’re really limiting everyone to processes and procedures that typically wouldn’t allow you to innovate and think outside the box.



If you look at some of the most innovative companies, they try to create some storms inside the company by creating a chaotic environment that allows innovation to flourish. Like Google and Apple. They challenge and they create a chaotic environment, what I call storms inside the company. These storms shake things up very quickly and put forth some heavy challenges that make people come up with something unique and different. I don’t know if you’ve heard of formulas in Google and Apple. They have formulas like 70 percent focus on the core and stability, and the other 30 percent focus on destruction and the chaotic environment. So people are encouraged to create chaos and a little bit of destruction. But most companies are not like that. That’s why I like entrepreneurship, because it’s all chaotic anyway at the beginning.

Maguire: What do you see having worked in Dubai and the Middle East? Are there aspects of some of the emerging countries you'd say some of the countries in the Middle East are maybe not as developed economies. What do you see are some of the potential accelerators and inhibitors about some of the different countries you've worked in?

Hassan: I've been at this for a long time. I’ve worked in Europe, Asia and Latin America. And now I'm working in the Middle East. What drives me is this change and these different challenges. I think the Middle East is one of the lowest on the innovation index, when it comes to innovation capabilities. They spend very little on R&D. The output of their innovation efforts is very low when it comes to patents and the number of new companies. We don't hear of a Google coming out of the Middle East. We don't hear of Alibaba coming out of the Middle East, like China. We don't hear of these things. So that was a big challenge that I wanted to tap into and wanted to address. But that's what drives me, I wanted to go to areas where there was huge resistance to change and promote innovation. So that was my thought of the Middle East almost four years ago.

What prompted me was a report in the Economist. There was one about five or six years ago, that reported the amount of spending in different regions on innovation - the output of each country in terms of innovation. So the number of patents, the number of new businesses, the number of global businesses, and so on. And the Middle East ranked the lowest. The minute I see those kinds of things, I get excited. I say it's a green field for me. I can go there and make a change. And actually that's why I went.

So the Middle East is the lowest, has very little output, but there are catalysts for innovation there. One of the catalysts that no other country has is that the leadership - especially in UAE and Qatar and a few others - they want to make a change. They want to be extremely global and innovative. However, their execution has room for improvement. So, literally, if you look at the Prime Minister of the Emirates, all he talks about is how we need to be different, how we need to build global companies, how we need to be innovative, and they invest. They put money in innovation centers and all. But again there is room for improvement in execution.

So that was a business opportunity for me. That was my business model - finding a really challenging environment, a challenging area, and differentiating myself by taking on these challenges. And bringing in tools and methods in that area that you can actually sell at the same time you make a big change and a big impact. So to be honest with you, when I moved to Dubai, there was maybe one competitor, maybe now two or three, but I'm in the top as an innovation management consultancy in the region.

I also found an opportunity in the fact that entrepreneurship levels are low, but it is a priority in the strategic plans for many countries. If you look at the UAE 2020 or 2030 strategic plan, they are saying that they want to diversify their economy by creating an environment for entrepreneurs. They want entrepreneurs to start in these countries by the hundreds of thousands and millions, but they don't know how.

Why would you move to Dubai to start a business? Some people say because it's tax free. But if you're an innovator, it doesn't make any sense. You need the infrastructure, you need the support system, you need the ease of starting, the venture capital community, and you need all of this together. So that's what I'm working on right now. As part of my practice in entrepreneurship and business model design, my goal is to bring all these elements into that environment and help entrepreneurs start.

The government wants to set up these free zones for entrepreneurs to come in, but they don't enable them. They're just saying ‘okay, you can start tax free’ but there are no enablers involved. There are a small number of VCs there. It's a very fragmented industry, so I am playing a role and trying to put all of



this together and link all these different elements to help innovative entrepreneurs.

Maguire: A lot of these economies have benefited from natural resources in countries like the UAE and when the natural resources have run out, it's the human resources that are going to sustain them. The culture of entrepreneurship needs fostering by a push by planting some seeds.

Hassan: Absolutely. Do you know which country has the lowest number of natural resources in the world?

Maguire: Japan?

Hassan: Yes, Japan has the lowest natural resources. It doesn't have any natural resources to support the economy. What it does have is people. It only has its people. And that's what they built in the 40s and 50s. And also the World War. That's what they wanted to do. To empower their people. To create an education system. To create an environment for a very innovative and creative society that produces things.

I'm working with funds and I'm working with VCs. They are looking for differentiation and very innovative entrepreneurs. They don't want to invest in falafel shops because they've invested in enough of that. They're looking for something completely innovating like Google. And a few things are coming up. And so

that's the challenge and theme for me. The bigger the problem, the bigger the opportunity for me.

Maguire: It seems like there's no limit.

Hassan: Exactly. The barrier for me is culture,. The entrepreneurship level especially in the rich countries in that part of the world, the parents say ‘why would you want to starve and struggle? Just, go work in the government. They pay really well.’

That's the other problem, the government pays really, really well. A job that pays US$5,000 in the US, there you can get US$15,000. That was my advice to some of the executive counsels in the government. You pay too high for jobs. That's what’s preventing people from becoming entrepreneurs.

Maguire: People are smart. They take the path of least resistance.

Hassan: Exactly, there's no struggle. And that's why you see entrepreneurship and innovation picking up in countries like Egypt and Lebanon. When there is a poorer economy and the government is corrupt, people will try alternatives to support themselves. And so that's one of biggest problems I'm facing there. It's in addition to the education system. It's more difficult to enter the startup business. It's more expensive than the US. The biggest challenge is the culture.



Saul Kaplan, Business Innovation Factory Saul Kaplan is the founder and Chief Catalyst of the Business Innovation Factory (BIF).

Saul started BIF in 2005 with a mission to enable collaborative innovation. The non-profit is creating a real-world laboratory for innovators to explore and test new business models and system-level solutions in areas of high social importance including healthcare, education, entrepreneurship and energy independence.

Prior to focusing on business-model and system-level innovation at the Business Innovation Factory, Saul served as the executive director of the Rhode Island Economic Development Corporation and as the executive counselor to the Governor on Economic and Community Development. Saul created Rhode Island’s unique innovation @ scale economic development strategy aimed at increasing the state’s capacity to grow and support an innovation economy, including an effort to turn the state’s compact geography and close-knit public and private-sector networks into a competitive advantage.

Prior to his state leadership role in economic development, Saul served as a senior strategy partner in Accenture's Health & Life-Science practice and worked broadly throughout the pharmaceutical, medical products and biotechnology industry. Saul also spent eight years working for the Pharmaceutical Division of Eli Lilly and Company. As a marketing plans manager, Saul assisted in developing the launch strategy and successful introduction of Prozac into the US market.

Saul shares his innovation musings on Twitter (@skap5), his blog (It’s Saul Connected) and as a regular contributor to the Harvard Business Review and Bloomberg Business Week.

Kaplan holds an MBA from Rensselaer Polytechnic Institute, focusing on the strategic management of technology, and a BS in Pharmacy from the University of Rhode Island.

Key points from conference call Innovation is a better way to deliver value; it’s not an innovation until it

actually solves a problem and delivers value in the real world. This is very different from invention.

We became very good at creating deep silos in both the public and private sector during the Industrial Era. Now we need to get better at working horizontally across them.

Successful innovators and investors play at the edge where they can find the greatest knowledge flows and see what’s going on in the gray areas between silos. They are positioned best to take advantage of new combinations that can only be found at the edges.

Most of the big challenges we face are systems-level challenges in healthcare, education, energy and the economy. These are systems comprised of public and private sector entities that are well intentioned, but built for an industrial era that is gone. Many people think we can fix these systems challenges with incremental change, but we need transformational change.

Saul started BIF in 2005 with a mission to enable collaborative innovation

Innovation is a better way to deliver value

Most big challenges are systems-level challenges in healthcare, education, energy and the economy



The same way we design, prototype and test new systems for products and technology, we need to do the same for business models and systems. Nobody knows how to do that today. They don’t teach how to experiment with a new business model in business school, but in the 21st century the half-life of a business model has declined significantly.

This is the innovator’s day. In very difficult economic times and conditions, there is more responsiveness and receptivity to transformational ideas.

This is the innovator’s day

The half-life of a business model has declined

significantly



Saul Kaplan transcriptKaplan: My name is Saul Kaplan. I’m the founder and Chief Catalyst of a group called Business Innovations Factory. We focus on real-world experimentation with new business models and systems-level change. I’m really an innovation junkie. I eat, sleep and breathe this stuff. And I define innovation simply as a better way to deliver value.

Innovation is a better way to deliver value. To me, it’s not an innovation until it actually solves a problem and delivers value in the real world. And so it’s very different from invention. Invention is very important and I’m glad that there’s a steady flow of new inventions and new technologies, but the challenge we face is not about needing more inventions or new technology.

The truth is that we have more technology available to us today than ever before in history. It’s amazing. We have more technology than we know how to absorb as humans. So the challenge is, with us humans, we’re stubbornly resistant to change. I’m very focused on the human aspects of innovation and how we can create new approaches to solve problems that deliver value. How do we use today’s technology as an enabler for solving real world problems.

I’ve done that throughout my career in several different settings. I started in the pharmaceutical industry with a background in pharmaceutical science and a Master’s in the Strategic Management of Technology. I worked directly in the pharma industry for a number of years. My big claim to fame during my pharma career was working for Eli Lilly & Company, where I worked on the US introduction of a product called Prozac. Which I usually say, despite our efforts, was pretty successful in the marketplace!

I then went into the “road warrior” consulting period of my career first with Arthur D Little and then as a partner in what was Andersen Consulting, which became Accenture. I spent a lot of years as a road warrior, travelling around the world working with senior executives across the pharmaceutical and healthcare industry, working on large scale change initiatives. How do you change your business model, what kinds of capabilities do you need, and how do you leverage technology to enable them?

I then went into another phase of my career which I call my “accidental bureaucrat” period when I worked in the public sector. I had the opportunity to work for the then-governor of the State of Rhode Island. I became the

executive director of the state’s economic development agency and served as a member of the cabinet. For the first time in my career I thought about innovation not through the lens of a corporation, but through the lens of a community.

Thinking about innovation through the lens of the community is a very different perspective. I began to shape some views about how we could transform social systems including healthcare, energy, entrepreneurship and education. I spent about six years in the public sector and during that time I created the non-profit Business Innovation Factory that I now run. We are all about creating real world labs to mobilize large scale transformational change.

We have established an impressive global network of innovators that are trying to go up on a learning curve together with us on what those transformational changes mean and how you enable them. Key questions we are addressing include: What types of platforms and tools do we need to enable transformation system change? How do we experiment in the real world? How can technology help enable system level change?

Maguire: Given your unique perspective on having worked on both the public and private side, what do you see as key enabling factors to promote the type of innovation that’s going to be the most effective in delivering returns both to the innovators and also to the broader society at large?

Kaplan: It’s a good question and the first thing we need to do is to break down silos. We became very good at creating deep silos in both the public and private sector during the Industrial Era. We need to get better at working horizontally across them. How do you connect capabilities across sectors, disciplines, and functions?

If we’re ever going to make real progress, on changing and transforming our important social systems, we’re going to have to learn how to work more effectively across silos. At the Business Innovation Factory we call it collaborative innovation and we believe it is the key for solutions to the big challenges we face. The best opportunities to solve problems and create value will be found in the gray areas between silos.

Successful innovators and investors play at the edge where they can find the greatest knowledge flows and see what’s going on in the gray areas



between silos. They are positioned best to take advantage of new combinations that can only be found at the edges.

I wish I had dollar for every time someone talked about a public/private partnership. When you really get underneath that and scratch below the buzzwords, we really haven’t figured out how to operationalize public private partnerships. How do we work effectively across those two sectors to solve new problems and create new value for citizens as well as creating new opportunities for private sector companies positioned to commercialize new products and services?

Maguire: That’s an interesting point that you raised - the idea of operationalizing a public/private partnership. When I think about public/private partnership or innovation partnerships, I think about things like economic empowerment zones, policies, R&D tax credits and that sort of thing that can be used to incent investors and businesses. Are there other characteristics or have there been successful examples of public/private partnerships that could be transferred across different types of problems? Or might you need a different blueprint for each type of problem that you’re looking to solve?

Kaplan: Most of the big challenges we face are what I call systems-level challenges. You take healthcare, education, energy and the economy, these are all system comprised of both public and private sector entities. They are systems that are well intentioned, but they were built for an industrial era that has gone. And many people still think we can fix these systems challenges with incremental change.

I don’t believe that. I think we need transformational change. I think we need to design, prototype, and test new systems, to do R&D for new business models and systems. The same way we think about R&D, for products and technology, we need to learn how to do R&D for business models and systems. Nobody knows how to do that today. We need to build that capacity.

Most of innovation has been “how do we work within the constructs of the current system?” Or if we’re a company, “how do we improve the performance of our existing business model?” And most executives have never had to really change their business model. They’ve worked one business model their

entire career. And all of their peers have worked one business model.

They don’t teach in business school how to experiment with a new business model. But here we are in the 21st century where the half-life of a business model has declined significantly. I often use the example of Blockbuster and Netflix.

Maguire: Right.

Kaplan: You’re never going to convince me that the executives at Blockbuster that were fully vested in their bricks and mortar model to distribute movies didn’t see DVD and then online technologies evolving and that they didn’t recognize there were opportunities to deliver value to the end user in transformative ways.

They saw the disruptive technology coming but couldn’t get out of the way of their own business model. It’s very hard to experiment with business models that might disrupt your core, especially when you are focused on making the earnings numbers for the next quarter. In the 21st century, all leaders will need to learn how to do R&D for new business models or risk getting NetFlix-ed.

Leaders must experiment with new business models, even disruptive ones while they’re pedaling the bicycle of the current business model. Those experiments at the systems level is what will need to do - if we’re ever going to transform healthcare, energy, education and our economy. Systems experiments must work fluidly across the public and private sectors trying new approaches to the way we deliver value.

Maguire: One of the most interesting books I’ve read that touches on that is Clay Christiansen’s Innovator’s Prescription where he had laid out how healthcare is really a lot of systems in plural with incentives, where different parties have interests that are if not completely diametrically opposed at least very incongruent with one another. He had done a terrific job just breaking down the complexities of the systems. You also touched on the idea of disrupting yourself, cannibalizing your own business. The analyses have identified that this is what needs to happen, but what does it take to implement some of that transformative change in an incremental fashion?



Kaplan: First of all, Clay is fantastic and a friend. He’s an advisor to the Business Innovation Factory. I love his work. I think he’s right on the money. He’s written two recent books: one you just mentioned in the healthcare space and one in the education space, where he’s trying to apply the theory of disruptive innovation at the system’s level.

I believe that we have to learn how to do real-world experimentation of new systems because just introducing new technologies into the current system is not going to work. We’ve tried that right?

We’ve thrown US$60bn worth of technology into US classrooms and we’re still getting incredibly poor outcomes and the reason for that as Clay would teach us is they’re using technology in a sustaining way. They’re trying to use it in the construct of the current system as opposed to how could we redesign the system and use technology in a more disruptive way to change the way we deliver value to the student.

The same exact thing is true in healthcare, where we’re throwing huge amounts of technology into our current healthcare system, but again in a sustaining way not in a disruptive way. And what Clay’s books teach us is that we just can’t deploy disruptive technologies into the market, we have to deploy disruptive business models and systems. So I think we need to carve out real-world laboratories or the conditions in the real world where we have enough freedom to be able to reconfigure the way the system works to be able to demonstrate that we can deliver value in a different way and that we can use technology to enable real systems change. The Business Innovation Factory is organizing the real-world conditions that will allow us to do systems-level experiments in areas like healthcare and education.

Maguire: What you’re touching on has such profound societal implications. It’s so difficult, but I just think back to the way Clay had laid out the idea how he organized his prescriptions for the healthcare industry where you have outcome-based wellness and then you have team-based approaches to chronic illness and then being able to have competition for things like flu shots and the way he laid all these issues out and then I read that in summer of ’09 before this healthcare debate was going on, it seemed like you’re watching this train coming down this track and with all these healthcare legislation, there are going to be all these sustaining innovations that are just going to worsen things.

Kaplan: Yes, that’s human nature, we don’t like to disrupt things. And these systems that have evolved over a long period of time - everyone is pedaling the bicycle of this system so incredibly hard, so the thing to think about is how are we going to transform it. I believe this requires some parallel conditions, so how could we put some of those principles in place in the real world.

Let’s demonstrate in the real world that it’s possible, that it’s safe to live in that environment, that there are important roles for doctors, nurses and all the players in the current system. But if we try to get there incrementally through the current system, it’s going to take an awfully long time for the disruption to happen and we need it to happen faster. So we need to create the conditions that will allow that to happen. The investors that aggregate capital and sit on the edge of this kind of work are going to have enormous investment opportunities and be on the front lines of helping to catalyze and move the set of disruptive models and systems forward.

Maguire: That’s an interesting point because I think you touched on how investors can think about positioning themselves and for capitalists certainly a catalyst for some of these parallel systems.

Kaplan: Yes, I think you’re going to see new financial products and investment vehicles build around disruptive innovation. Clearly, the venture-capital model that worked so well over the last period of time is really challenged and I think you’re going to see capital start to form, again, at the edge around how we invest in new disruptive business models. How do we invest and support creating the conditions for system level experimentation in the real world? I think you’re going to see both public and private sector capital start to migrate towards those opportunities.

Maguire: The other idea about the edge, I’m not sure how familiar you are about some of the stuff by John Hagel or John Seely Brown, who worked at Deloitte. And Vinnie Mirchandani’s work on PolyMaths, which is also pretty fascinating. It seems like there are these conflicts between the move towards deep specialization that’s an outcome of having so much information, but then the ability to tie these things together. How do organizations/investors that are stuck in these silos find ways to get more of the edge?



Kaplan: John Hagel and JSB are also friends and advisors. Their book, The Power of Pull, is brilliant and a must read for anyone who wants to understand the transition from the industrial push model to a 21st century pull model. It’s absolutely fantastic. Executives need to proactively get out into the marketplace and out of their silos. Leaders need to collide more frequently with unusual suspects.’

Leaders go to the same meetings every year, with the same group of people talking about the same set of ideas over and over again, Get out and immerse yourself at the edge with ideas that may not seem directly relevant to your business but force yourself into the gray area.

We run a conference every year we call the Collaborative Innovation Summit. This is our seventh year. It’s an annual celebration of the unusual suspects. And creating an environment where you can collide with unusual suspects. Get yourself out of the silos that you live and work in and expose yourself at the edge to these new ideas. It is incredibly inspiring and important for executives to do that. The second thing you have to do is you have to act on it. So you’ve got to start building your innovation agenda that includes experimenting with new business models. Not just projects that will make your current business model stronger, although you have to do that, but some portion of your time and resource should focus on the next business model. The challenge is to avoid being Net-flixed.

Maguire: The last question is what do you see as obstacles going beyond just inertia going forward, what you’ve articulated is going uphill? This is very hard to accomplish - this disruptive, out-of-the-box, edge-based thinking. This goes beyond the natural inertia. What do you see as being big obstacles to being able achieve this going forward?

Kaplan: I actually believe this is our day. This is the innovator’s day. Because in very difficult economic times and conditions, there is more responsiveness and receptivity to transformational ideas. So it’s really incumbent on those of us in this space to take advantage of this opportunity. I stopped trying to convince people that they should be more innovative. I find proselytizing doesn’t work.

What I try to do is find people that are oriented to be innovators, and want to innovate and help them connect with each other in purposeful ways. So we’re not trying to convince people that don’t want to change to change, we’re trying to find people that do want to change and then to help them to be more effective at it.

When you do that, you’re surrounded by people that are positive in nature, know that there is incredible opportunity in the 21st century and they’re wanting to get on with it and to do it. I think we live in a period where self-organization is becoming more possible. It used to be we had to wait for the big institutions to move whether they’re in public or the private sector. And I think we’re starting to get confident that we don’t have to wait.

Social media platforms and other ways to connect and exchange information and ideas are now everywhere. We can start experimenting and we can bring the institutions along that want to play. But we don’t have to wait for intransigent institutions that don’t want to move. There’s a very positive feeling among the innovation community and we have a sense of urgency to do this work and to get more innovators to become part of the movement.

Maguire: It fits nicely. The whole concept of the power of pull as well, I appreciate your thoughts and it’s really refreshing and quite optimistic.



Braden Kelley, Innovation Excellence Braden Kelley is a dynamic, engaging innovation speaker with experience consulting to some of the world’s leading organizations and talks at conferences and corporate events around the globe.

Braden has a passion for innovation and social business and has spoken at events in a range of countries including the United States, Belgium, Mexico, Canada and Chile. He has also led workshops for groups including PDMA Mexico and the Open Innovation Summit and has been a special guest for Seattle Pacific University MBA courses.

Rowan Gibson, Innovation Excellence Rowan Gibson is widely recognized as one of the world’s foremost thought leaders on business innovation. He is the internationally bestselling author of two major books on innovation and strategy - Rethinking The Future (1996) and Innovation to the Core (2008) - which have been published to date in 25 languages. His latest book, Innovation to the Core (Harvard Business School Press), explains how to build and sustain a deep, company-wide innovation capability that drives continual growth and strategic renewal.

Over the last two decades, Rowan’s international clients have included some of the world’s largest and most successful organizations. He teaches them how to seize new growth opportunities, create new markets and even transform entire industries by recalibrating their whole organizational system around the paradigm of innovation.

Rowan is one of the world’s most in-demand public speakers. In just the last four years alone, he has delivered his keynote speeches, innovation masterclasses and public seminars in 51 countries around the world. He has addressed a long list of major organizations, including Accenture, Bayer, Coca-Cola, Dow Chemicals, Haier, Heineken, Henkel, IBM, Mars, Microsoft, Motorola, NOKIA, Philips, P&G, Roche, Siemens, Steelcase and Volkswagen.

Rowan is co-founder of www.innovationexcellence.com, the online home of the global innovation community. The portal, which builds on an international group of around 5,000 members from over 150 countries, offers an arsenal of resources from innovation thought leaders and practitioners that is aimed at helping companies achieve innovation excellence.

Key points from conference call Innovation is all about value and value creation. People tend to get

enamored with ideas when it comes to innovation and think the ideas or how well they execute is the key to innovation. Organizations need to make sure that they do not only a good job of value creation, but also value access and value translation.

The field of customer insights has become nearly a holy grail of innovation. We have tools available to us today that we never had available in the past, much more sophisticated data mining.

Procter & Gamble used to be the sort of company where marketing was a one-way street. With PG.com, it really started to interface with consumers, ask people what they want and talk to them, using their feedback to drive development.

Innovation is all about value and value creation

We have tools available to us today that we never

had available in the past

Braden and Rowan specialize in business

innovation



BestBuy’s Consumer-Centric Cycle uses data mining to quickly see if there’s a spike in sales of a particular product in a particular place sold in a particular way so they can then roll it out. But they also encourage the human connection, with every single employee at Best Buy encouraged to think of ways to improve the consumer experience.

Open innovation is a fabulous tool, but it needs to be integrated with the entire innovation system and done properly. Open innovation works brilliantly; however, if companies do not build the backend of innovation inside their companies, they can quickly generate a huge volume of new ideas they don’t know what to do with. Open innovation is almost like the software “glove,” where companies think by putting in ERP or CRM they’re going to solve all of their problems.

Life is Good is an idea based on nothing more than a psychological benefit. A lot of people want to hear that life is good. Two guys built an empire with the simple concept that life is good, using a quirky little logo they put on t-shirts. They decided they weren’t going to spend money on advertising, and instead decided to have parties and musical events and invite people to come; there’s no technology there.

Open innovation is a fabulous tool, but it needs

to be integrated with the entire innovation system

Life is Good is an idea based on nothing more

than a psychological benefit



Braden Kelley/Rowan Gibson transcript Maguire: You spent a quite a bit of time on open innovation. I think the disciplines around crowd-sourcing and open innovation are an exciting area. What do you see as catalysts/accelerators and inhibitors in the innovation process in the US?

Kelley: I am Braden Kelley, author of a book called Stoking Your Innovation Bonfire from John Wiley and Sons. I am also the author of a chapter in a new book called The Guide to Open Innovation and CrowdSourcing from Cook and Page. It was put together by Paul Sloan from the UK. And I’m also a co-founder of Innovation Excellence as you know.

I spend my time split between speaking, writing, consulting and running the website. My primary focus when it comes to innovation is really working to try to identify what it takes to making innovation a deep capability in the organization. Within that capability, the area that’s probably most interesting to me and where I think people don’t focus enough attention is on uncovering key customer insights or key stakeholder insights that people can use to drive the ideation process and ultimately the solution discovering and development process.

Too often, when it comes to innovation, people tend to get enamored with ideas; they think that ideas are the keys to innovation or that how well you execute is the key to innovation. But in my mind, innovation is all about value and value creation, but not just value creation. I think value creation is only one component of the importance of value when it comes to innovation.

I talk about three things when it comes to innovation as being the major success factor and that’s value creation, value access and value translation. Value creation is the component that most people think of when they think about innovation, which is when you are enabling somebody to do that they couldn’t do before or how are you enabling somebody to be more efficient or more effective. Do you have certain psychological benefits or emotional benefits they didn’t have before? Those are some of the key ways that value gets created.

It’s also important to make sure it’s not only for the customer, but it’s in the process itself. You make it as easy as possible for people to access that value. That’s an ongoing process, not a “one and done” process. It comes through for the customer and how easy you make it to extract the value from the solution that you’ve made.

Then are you making it easier and easier to create that value over time? And then the value translation piece is really all about how well are you helping people understand how the value that you’re creating fits into their lives and why it should displace the existing solution that one is using.

People like to say ‘I’ve come up with something that solves a problem that nobody’s ever solved before’ and I think that that’s not true and I think that’s misleading when people say ‘We’re solving a problem that’s never been solved before.’ Because people are solving every single problem in their life; they may solving it with the do-nothing solution, but they have a solution. And so when it comes to creating a true innovation, you’re always displacing something.

When Quicken came on the market, it wasn’t just competing against Microsoft Money and other financial software packages. When Mint came on the market, it wasn’t just competing against other online solutions, but was competing against Quicken and Quicken trying to displace the pen and paper or just ignoring it completely.

So those are some of the key success factors. Organizations need to make sure that they do not only a good job of value creation, but also value access and value translation. Because if you do a good job at two and do a poor job at one, you can still have a negative outcome.

Maguire: Braden, you had just finished highlighting value creation, value access and value translation as key points. What jumped out at me is how to drive key customer insights to drive the ideation process. When I think about companies that are very successful at innovation, they really know how to anticipate what their customers need.

When you think about uses of social technology, being able to tap tweet streams or social media, even just more basic analog processes like having customer accounts and listening to the customer, what are the ways that you see companies really missing the ball in listening to their customers? And how have certain companies managed to really break new ground by effectively anticipating and listening to what their customers need?

Kelley: I think a lot of companies do a really poor job in this area and that’s why their product launches tend to be very meager. There are very few



companies that I would say do a great job in this particular area. I think that there’s a lot of opportunity in the insight area for organizations to get better.

I think that one of the ways that organizations can get better is not thinking of insight creation as the purview of just the marketing research department, but really starting to open up the creation of insights and making information more freely available to the broader employee base; recognizing the broader employee base has insights to share and information to add to the pot to stir around to help make the organization’s innovation effort stronger.

One of the ideas that I’m trying to pull together and communicate is the idea of building a global network, taking things we do in isolation and trying to build them into a more cohesive collection of tools that people can access and use to stir around in their own brains to contribute to the conversation. So if you think about that, people do take a look at graphs or people do take a look at what’s going on in a particular geography, sometimes people will go out and do focus groups or demographic research or surveys. They’ll offer these tools to try to gather customer information or they’ll do customer listening through social media or other networks such as oral or electronic.

Most companies don’t collect information and make it available to a broad range of people to spur their own innovation juices. And then if you look at other tools like Rowan’s or Lenses, a lot of organizations really don’t make tools available to the broader employee base to give them the ability to make stronger contributions to the overall innovation success. If you’re lucky, you might get a CEO saying ‘Hey, let’s go innovate,’ but there’s not a lot of training of employees on how they can make stronger contributions to the overall innovation success of the organization and there’s not a lot of formal attempts to gather some of the information that’s out there and share it in a way that can spark conversation and spark connections between some of these isolated dots.

Maguire: Do you think that’s a legacy of just how difficult information sharing has been in the past, where you’d have to either print something or speak something or share something before the advent of some of these new electronic or software tools?

Kelley: When it comes to sharing information, it has definitely been more difficult in the past, but it’s still very difficult to share information because we don’t really do a good job of context-sensitive sharing. We don’t really do a good job of making information available to people when they need it; when they’re actually trying to do thought work. We might have a corporate portal and there might be information on the portal or we might have a knowledge management system and there might be information in there.

We might have an expert location system and there might be some information about who knows things there. But we have all of these isolated systems and then we tell people to go innovate and maybe we might have an idea management system. And there might be some interesting information in there, but we don’t really pull information together in a thoughtful way in terms of the context of people and the jobs they’re trying to get done - trying to service information at the right time to the right people. We create software solutions to address a particular information storage challenge as opposed to or trying to organize information around how people try to get work done.

Gibson Maybe I can just add something - I think the whole field of customer insights has become almost a holy grail of innovation today. So a lot of companies are investing a lot of time and money in that. And we do have some tools available to us today that we never had available in the past; much more sophisticated data mining.

Amazon.com is really an outstanding company in many ways, but really one of the ways that Amazon really stands out is in being completely consumer-centric. So Amazon has proved that you can use today’s technology brilliantly to figure out what customers want, anticipate needs, figure out what they bought last time, so we can recommend products to them next time and so on. So Amazon is using that stuff; companies are, I would say, slowly getting around to using the Twitters and the Facebooks and whatever else to interface with customers. There are gaming companies that go out and ask their customer base what they want in the next game via Twitter. Best Buy actually answers technical questions in real-time on Twitter, so they’re the examples of using the new social media tools to create a link to consumers.



And also Facebook, there are companies out there, just to give examples: Coca-cola now has 33 million Facebook fans. I know just a few months ago it was 8.5 million; it went 15 and now it’s 33. So there’s a company that traditionally had very little interaction with the customer. If you’re Coca-Cola, or Mars or Heinz or whatever, you’re a manufacturer that sells through to the retailers and the retailers have interaction with the consumer. And so now, via things like Facebook, a company like Coca-Cola can very quickly generate up to 33 million fans, and use Facebook to interact with customers to ask people what they want; introduce new products and get a lot of feedback.

Procter & Gamble has also jumped on the internet bandwagon in a big way. Procter & Gamble used to be sort of a company where the marketing was a one-way street. We would produce a new product, we market it, advertise it and sell it out to people. But with PG.com, they really started to interface with consumers, ask people what they want, talk to them about skin and hair, and all of the needs that people have. And try to build communities around those product categories, whether it’s shampoo or face cream or whatever else. I think they’re very good examples of using the new technologies and so on. But I would still add that we’ve really got to remember that we’re talking about human beings. And what P&G also does really well is go out and actually observe the way people use products, figure out needs. They saw, for example, that people were trying to clean their showers with a broom stick with a cloth or whatever else, so they produced a product that answered that need.

When I was advising Mars, the chocolate company, about consumer insights, we encouraged everyone to go out and actually do home visits including the CEO. So this was actually going out and going to people’s homes and talking to them about Mars products. For example, say to mothers, ‘Would you serve up a Mars chocolate bar for a dessert if you cooked a meal?’ And the mothers would say, ‘No, I’d feel ashamed if I gave my kids a chocolate bar on a plate - it just would feel like I was a bad mother and I didn’t make them something.’ And then we said, ‘Would you give them a Mars cake?’ I mean exactly the same product basically. It’s exactly the same product but the form of the product would be changed - more like cake than a chocolate bar. Would you give your kids a slice of that cake and they said yes. And so actually going out and interfacing one-to-one with consumers whether you’re a CEO or anyone else in the organization really revolutionized the way they see things at Mars in terms of consumer insight.

Maguire: It seems like such a simple change in philosophy that can have an impact on how successful a company can be.

Gibson: Absolutely. Best Buy is another example where they have a thing called the Consumer-Centric Cycle and this is again where they do two things: on the one hand, they use data mining so they can see very quickly if there’s a spike in sales of a particular product in a particular place sold in a particular way so they can they can then roll it out. But they also encourage, again, that human connection, so every single person at BestBuy is encouraged to think about ways to improve the consumer experience.

And one example that I often use in my speeches is that somebody in one of the Manhattan branches of BestBuy realized that there’s a big Brazilian community living in the neighborhood and somebody there said why don’t we reach out to the Brazilian community. So they hired a couple of people that could speak Portuguese and they reached out to this Brazilian community and they found that not only the store traffic increased but in the process they found out that there was a cruise ship coming in every Sunday from Brazil with people who wanted to go see things in New York. And they said, ‘Why don’t you include our Manhattan branch on the tour?’ because there wasn’t a lot open on a Sunday afternoon. So now they had busloads of Brazilians coming every Sunday to that particular branch of BestBuy. And that’s coming from front-line innovator. Somebody that understood a customer need and reacted to it. And that‘s the kind of thing you’re never going to get from headquarters. You’re only going to get it from the frontline who are interfacing with consumers every day.

Maguire: I know both of you have alluded to data mining and analytics as a real key for particularly for consumer goods or consumer-facing companies to gain a better understanding of how to drive innovation. Using analytics can be very powerful, but what are some of the challenges involved with analytics and conversely what are some of the competitive disadvantages if companies are not employing the same level of data analysis as their competition?

Kelley: When it comes to technology, we too easily get enamored with the technology and forget that why technology is powerful is because it can be an enabling factor for humans to do things they couldn’t



do before. The machine and the software do the things that humans did. So if you think about data, data we can turn into information and computers can do that to some extent. But from information and knowledge often requires humans and from knowledge to insight definitely requires humans.

When we talk about going all the way to insight from data, too often if you keep this data too narrowly released, you can fail to find the insights and there’s a great example that lots people talk about - Goldcorp, this gold company in Canada where they made all of their data available publicly on the web. And by doing that and inviting people to use their data to help try to find their gold, they did find the gold and they found billions of dollars of gold. And the people inside the company didn’t do that, it was the people outside the company.

Gibson: There was company in Australia that actually did that. So there was a geology that created this challenge - the GoldCorp Challenge. And so that was a great example.

Maguire: There are ideas of allowing open innovation or open-sourcing the data and allowing these innovators to extend beyond the organization itself. Who’s doing that well and what are the challenges in really being able to embrace that model?

Gibson: I don’t want to say that everyone’s doing it, but it seems like everyone is going in that direction. GE recently made a couple of hundred million available for new ideas on green grid technology; so this is like an open innovation thing. And IBM is doing it, Netflix is doing it, Tupperware is doing it. It seems like everywhere you look, everyone seems to be doing it. And the whole open innovation thing is working brilliantly except that if companies are not building the backend of innovation inside their companies, they could very quickly generate huge volume of new ideas which they really don’t know what to do with. Because they don’t have the mechanisms in place to screen and evaluate those new ideas to align them with the corporate strategy to quickly reallocate resources behind them so they can actually start pushing them forward.

To manage a portfolio of strategic options that have come out of that ideation process, so then turn that portfolio into individual projects with an experimentation phase and pushing them through the innovation pipeline all the way to commercialization. What I find in most companies is

that all of that backend is just not there. It doesn’t matter who you talk to, the biggest companies on earth, a lot of them say, ‘Well, we’re very good at kicking off innovation through internal ideation programs or open innovation programs externally. But we really don’t have the corporate innovation system in place on the inside - the backend of innovation to take those ideas from mind to market.’

Kelley: And if you don’t do that you’ll fail and I think that the open innovation thing is almost like the software glove that people often have, where they think by putting in ERP or CRM they’re going to solve all of their problems. When you really start looking at open innovation, not only does it really not solve all of your problems if you don’t have the backend in place, but you’re also putting your brand at risk; you’re creating brand exposure that may not necessarily be positive.

So if you look at Starbucks, which gets used as an innovation example sometimes positively, sometimes negatively. In being completely open, Starbucks has exposed itself to a huge amount of potentially negative brand risk from people getting disillusioned with the whole thing and feeling like ‘Hey, why don’t you use my idea; what’s wrong with my idea?’ Or ‘Why haven’t I heard anything about my idea?’

Others have put up open innovation that basically says, ‘You can submit your idea but we don’t guarantee we’re ever going to get back to you and by the way, now it’s ours.’ And then there are other issues too that people don’t always think about which is that, is it okay you can bring ideas in from the outside?

What is the psychological impact on the employees inside your organization going to be? Are they going to feel like are we not good enough or are we not smart enough? Why are you going outside? If you don’t manage that and help people understand that even if you do go outside for ideas, the ideas don’t come in from the outside fully formed or ready for market and that there’s still a huge amount of work to be done. Even if an idea is good to help get it ready for market and that the people inside the organization don’t have a lot of skills to help with that then you can also fail as well.

Gibson: So I think what you’re seeing here is open innovation is a fabulous tool, but it needs to be integrated with the entire innovation system and done properly, otherwise there is a tendency of a lot



of companies to think of innovation as this hoopla thing where ‘We’re just going to add and open innovation program or something and we’re going to become a hugely innovative company’ Or ‘We’re going to buy an idea management software program or software platform and that’ll make us a highly innovative company.’ And those things are important; they’re pieces of the puzzle but they’re not the whole puzzle.

And like we’re trying to emphasize, if you don’t get the backend of innovation in place and you don’t build that deep and sustainable enterprise capability for innovation, then all of that frontend stuff is going to fail. The analogy I’ve used for years is total quality movement. Think about what it took to turn quality from a sort of department into an enterprise capability back in the 80s. It wasn’t about going out and asking the world, ‘How do we improve our quality? Give us ideas about improving our quality.’ That wasn’t the answer.

The answer was really revolutionizing the way we organize things inside the company; making it something that involves everyone everywhere, all the time. It was about new management processes, new values, new cultural mechanisms, new tools, new processes, new systems and whatever else all of that integrated as a system. That’s what it took to make quality happen and the message here is that it’s going to take exactly the same set of components integrated in a similar way to make innovation all the time everywhere a sustainable capability.

Maguire: I’d like to just frame our discussion in terms of the economic environment where we are now and I think a lot of what we’ve been discussing is examples of larger companies. How do you guys see the current environment - particularly the difficulty of getting capital for startups and new regulatory pressures in the US - impacting the ability for new companies and entrepreneurs to really create value? Obviously, there are a lot of great companies that have been started in recessions and even depressions. How do you see some of these lessons applying to the smaller companies or the startups with this type of macroeconomic back drop?

Gibson: Well, Braden is in a place where a lot of startups have done well right up in Seattle. Starbucks and you think about a bunch of others.

Kelley: I think when it comes to entrepreneurs and successful companies, they’re successful because they find a way to become successful regardless of what the times are. I think it’s always about finding that thing you’re starting your company around that is creating so much value that people will be crazy not to adopt it. If you’re doing that, then no matter what the times and if you do a good enough job of translating the value for people, then people are going to become just as passionate about your ideas as you are and to line up to help you make it happen. If you don’t, then it’s going to be that much harder during the tough times. There’s always going to be money to fund really good business propositions; the thing that changes are during hard times is that fewer get funded and so more and more of the best ones get funded. Some of the marginal ones don’t get funded because there’s just not enough money to go around.

In the boom times, all these crazy businesses get funded because the venture capital firms have money that they want to put somewhere. And then if they have enough strong possibilities, they’ll bet on some long shots. But during the tough times, they have less money to invest, so they’re really careful about which ones they invest in. That means as an entrepreneur you have to make sure and communicate really clearly and really push your idea really hard to make sure that the value you’re creating is worthy of outside funding or whether you just to need to bootstrap it.

What we’re seeing is that more and more startups are going the bootstrap method, and then some that were forced to go the bootstrap method in other times might have gone the VC route. Now the VCs wish they could get in because they’ve built up things that are usually valuable.

Gibson: And let’s not forget a lot of companies have started up in bootstrapped operations in the first place - Steve Jobs and Steve Wozniak in a garage. That’s sort of a classic example. Today, one thing that’s interesting is that there’s a misconception about innovation that it’s all about products and technologies and that’s not necessarily true because if you talk to government, well if we’re going to encourage innovation we need to build science parks like Silicon Valley; so you find this all around the world with various government programs. But one of the things I keep emphasizing to people is that innovation is so many different things.



With innovation, it’s not necessarily about products and services or technologies, it’s about business models, it’s about customer experiences, it’s about all that stuff. And those things don’t necessarily require big budgets. Clearly, if you’re going to split the atom, you need a huge budget, but there are great innovations that have nothing to do with science.

A quick example is a guy in Australia, Jim Penman, who started a company called Jim’s Group. Basically the idea was to take a lot of groggy burdensome jobs we have to do around the house off your hands - so whether it’s washing the car, cleaning the windows, cutting the grass, walking the dog, cleaning the drains, whatever else, who do you turn to do those things? So Jim’s Group was set up to take over all of those tasks. It is now a huge company with thousands of franchisees in several countries.

Again, innovation has nothing really to do with science or anything like that. That’s something minor. The other thing is if you do start a company today and you are small, you get to be able to do a lot of things that in the past only big companies could do. For example if I were to start a shoe company, I could get the shoes produced in China, I could get the designs done in Spain, or California, I could get the marketing done online on the internet, or whatever else - viral.

There are ways for you to be “big” without you being big today, now that actually includes science and it might surprise you to find out that Skype was invented in Estonia. Most people couldn’t even find Estonia on the map. So these days, there are ways for you to be big without actually being big. So you can scale up relatively quickly by integrating a whole bunch of things.

Maguire: The amazing thing is as well, I just had a conversation today with some venture capitalists in a conference. The advent of public cloud technology means that if you’re starting an internet company, website or any kind of company where you had to spend a lot of money on IT systems or even record-keeping systems, you can get all that stuff with a credit card and Amazon Web Services or Software as a Service. All that backend that you’d have to replicate is there for an operating expense not a capital expenditure.

Gibson: So if you don’t make it as startup, it’s your fault.

Maguire: It’s got to be a good idea, but it’s got to be well executed as well.

Kelley: I think another good example is the company Life is Good. Here’s an idea that’s based on nothing more than a psychological benefit that things aren’t as bad as we keep hearing. A lot of people want to hear that life is good. And here are two guys that start selling t-shirts out of the back of their truck and they built this empire with the simple concept that life is good with a quirky little logo and they put on t-shirts and decided that they weren’t going to spend money on advertising. And instead decided that they would have parties and musical events and things and invite people to come and try to help Life is Good and do things differently and there’s no technology there. There’s nothing other than a psychological benefit that wasn’t being met by somebody else before and they’ve identified that and filled that need for people.



Dr John E Kelly III, IBM Dr John E Kelly III is IBM’s senior vice president and director of research. In this position, he directs the worldwide operations of IBM Research, with approximately 3,000 technical employees at nine laboratories in seven countries around the world, and helps guide IBM’s overall technical strategy. Dr Kelly’s top priority as head of IBM Research is to stimulate innovation in key areas of information technology and quickly bring those innovations into the marketplace, to sustain and grow IBM’s existing business, to create the new businesses of IBM’s future, and to apply these innovations to help its clients succeed. Dr Kelly also leads IBM’s worldwide intellectual property efforts. IBM has led the world in US patents for 18 consecutive years, generating nearly 6,000 patents in 2010 and delivering more than US$1bn per year in income from its intellectual property.

Dr Kelly received a Bachelor of Science degree in Physics from Union College in 1976. He received a Master of Science degree in Physics from the Rensselaer Polytechnic Institute (RPI) in 1978 and his Doctorate in Materials Engineering from RPI in 1980. In 2004, he received an Honorary Doctorate of Science from The Graduate School at Union College. Dr Kelly has received numerous technical and business leadership awards, including the Semiconductor Industry’s highest honor, the Robert E Noyce Award.

Key points from conference call IBM firmly believes that it will only survive if the company innovates. It’s

not a side strategy, it’s in the fiber of the corporate strategy, from the Board on down.

R and D are different. Managing a development effort, pipeline, investments, schedules and portfolios is different than managing research. IBM’s connected, but independent research division is a core differentiator.

The research effort allows IBM to have a portfolio of technologies that provide pipelines for product development. So new products are never starting from scratch.

Innovation is the fiber of IBM’s corporate strategy, from the Board on down. The company believes it will only survive if it innovates. It’s the reason why the company continues to spend US$6bn a year and a portion of that on core research. Even in down times that number is not questioned.

IBM recognizes that R and D are different. IBM has retained a connected but somewhat independent research division for many decades. A connected but somewhat independent research organization is highly unique and a huge advantage that allows constant innovation ahead of what business units and sometimes the market can see.

Beyond the current product roadmaps, IBM is innovating in and finding spaces in technologies that are disruptive. The whole field of analytics is not something anybody was focused on. But years ago, IBM looked at trends and said the world will be awash in data. It’s going to go from storing bits to analytics in a sense - there will be a need to extract business value. IBM has upped its own investment research to a couple hundred mathematicians.

IBM firmly believes that it will only survive if the

company innovates

IBM recognizes that R and D are different

IBM is innovating in and finding spaces in technologies that

are disruptive

Dr Kelly heads the worldwide operations of

IBM Research



One of the advantages of a research division and a company with IBM’s resources is that resources can be shifted behind projects quickly and the company is not dependent on M&A for new technology. When Ferucci and the team reached a point with Watson where it was clear they could do it, IBM was able to say ‘Whatever you need, you tell us because you’re going to do it.’

IBM puts together a global technology outlook, a process that runs nearly nine months, which involves surveying the competitive technology landscape, talking to universities and faculty, startups and VCs, scouring every source possible to find out what’s going on in technology and business. IBM develops a set of views around usually five or six topics that could be hugely important or hugely disruptive to IBM. That process runs until mid December. Then the entire team will take a whole day chewing on that, figuring out what to do with it and how to respond to it.

IBM, as the leading patent holder in the USA, needs to have an enormous high-quality portfolio for freedom of action or reasonable balance of power wherever the company wants to go. It then has to decide whether to hoard it all or license some of it, for either tactical or strategic reasons. IBM prefers to cross-license as much as possible to litigation with partners and entities.

Dr Kelly thinks analytics is big. ‘It’s bigger than I even thought. I always believed in it and was here when we did a GTO on it. But it’s a big deal.’

Big data and fast data are also a place that is ripe for innovation. We need whole new software/data systems, new hardware because the amount of data and the rate that it’s coming in is far beyond what we can deal with. The challenge is a lot of the data is messy or noisy.

IBM spends a lot of time focused on how to make services more productive with tools, technologies and process that increase productivity and return.

Cognitive computing is the next big project that IBM Research is focused on along with DARPA. Dr Kelly believes the progress made in cognitive computing is analogous to Watson five years ago, and the company has committed similar resources.

IBM needs to have an enormous high-quality

portfolio for freedom of action

Big data and fast data are also a place that is ripe

for innovation

Cognitive computing is the next big project



John Kelly transcriptMaguire: How does research drive innovation? The crux of our thesis is that innovation is the key engine for value creation for technology companies and non-technology companies. It’s finding way better ways to solve problems or give different experiences to users.

You have 3,000 people in research, 6,000 patents per year, a huge amount of patents from basic materials to chemicals to chips to software and hardware. I’d like to know how you’re organized from a strategic level; what’s the guiding philosophy that makes IBM’s research tick?

Kelly: I would start with one of the core differentiators, but before how we get into how we do it is the fact that the corporate strategy is fundamentally around innovation and differentiation. SanDisk described it as sort of the high road versus chasing commoditization.

We firmly believe that we will only survive if we innovate. It’s not a side strategy, it’s in the fiber of the corporate strategy; from the Board on down. So that’s a tremendous help because it gives corporate research or R&D saying power. It’s the reason why we continue to spend US$6bn a year and a portion of that on core research. Even in down times that number is not questioned. There’s just huge support for it. Because we believe that, not only historically but in the future, we’ll struggle if we don’t innovate or our margins won’t continue to expand; it’ll start to contract. So that’s the highest level.

So then I say the second differentiator is the recognition that R and D are different things. I’ve managed both and they’re really different; to manage a development effort, a development pipeline, and develop investments and schedules, and portfolios is different than managing research. And there’s recognition that those things are different and therefore IBM has retained a connected but somewhat independent research division, at least in the past many decades. I think that’s a core differentiator.

Lots of companies in earnest don’t do that. Some are trying to form research divisions, some are getting rid of their research divisions, or at least dramatically contracting them. Outside of Microsoft, I can’t think of another technology company that has a prominent research division. How much of their stuff has made it through the product is somewhat questionable. Google has research-like things, but I

wouldn’t really say they have a division of 3,000 people. Intel does not have one. Their different strategy is networking with different universities. HP has one, but they turned it into a development lab a few years ago and contracted it. With networking, which is Cisco, really doesn’t have one.

So we fundamentally invest in it; every Board CEO that I’ve been associated with has been an enormous supporter of research. I think Lou’s first or one of his very first site visits was to Yorktown when he came to the company. Sam comes continually over to research multiple times personally. We run a global technology outlook for the company, which is part of our headlights, so which we’ll talk more about. But the net of it is, a connected but somewhat independent research organization is highly unique at least in our industry. And that I think is a huge advantage because it allows us to constantly innovate ahead of what the business units and sometimes the market can see because we have the freedom, skills and wherewithal to do it. And that’s a huge advantage and what we do with that is we feed technologies into the unit roadmaps on a constant basis.

So when IBM’s systems group gets done with Power 7 and then they say now we’ve got to do Power 8. We’ve got a pipeline of things that they can grab off the shelves, innovate into Power 8 and they’re off to the races. They don’t have to start at ground zero. The same is true in software and now in services. So we have this pipeline.

And then the second thing is beyond the current product roadmaps. We’re innovating in spaces and finding spaces in technologies that are really disruptive. Watson, of course, could be a poster child for that. But I would even say that the whole field of analytics is not something anybody was focused on. But years ago, in this global technology outlook, we looked at trends of where we think things are going. We said we’re going to be awash in data. It’s going to go from storing bits to analytics in a sense and we’ve got to extract business value from this. And we really got people focused on it. We upped our own investment research to a couple hundred mathematicians. We’re off to the races and the next thing you know we’re defining a new space, we’re buying companies, SPSS, etc in that space, and now it’s one of the four growth strategies of IBM. So now we can not only innovate core technologies, but we can see new spaces emerging, create some assets and help pull IBM to those spaces.



Maguire: I think one of the most difficult challenges for technology companies is to understand, and I think IBM has the luxury of being able to follow directions that may not necessarily be easily folded into a near-term business case. I’m guessing you have a lot of people who are very imaginative, who do a lot of work on all types of demographics or technology trends.

How do you balance this type of thinking so that you can determine or assess what from this portfolio of alternatives would most justify focus? How do you prioritize, very simply?

Kelly: The way we manage the question, or is we have to cover many dimensions. We have to cover the dimensions of the different business units. So in a sense, we’re responsible for feeding their road maps. We have to have some allocation of our resources over hardware and software and services. That’s one dimension.

The second dimension is, as IBM globalizes, We need to globalize with or ahead of IBM in order to help develop the technical resources in those regions. And also, because I believe and we’ve demonstrated in several cases that we can get insights in these markets we can’t get from Yorktown or Zurich. By being in Beijing or Shanghai, we can insights that you can’t here or in Rio, Brazil. So I have the geographic dimension.

And then we have underneath that, what I call strategy areas which are analytics that crosscuts all types of services, but I have a senior person who’s responsible for our analytics strategy portfolio that will work across all divisions, across all geographies. So it’s a fairly matrixed organization, but not all really matrixed. And then there’s how much is short-term versus long-term dimension and that we just sort of watch the balance; we don’t try to over manage that. We just sort of let it ebb and flow. But by seeing the amount of work and the quality of the work in core sciences decline, then I’ll sit down and talk to the person who’s in Sciences and the rest of the team and say, ‘Look, we got to goose this up or we got to do some math or we got to do something long-term.’ So there’s not a formula.

We have moved from almost all hardware to roughly two-thirds software and services - that was a big shift. We’re moving more and more - higher into the emerging markets. We’ve opened two labs this year in Brazil and Australia. Recently we opened second labs are in China and India. So we’ve got a lot of moving parts.

And I guess the last dimension is and probably the most important is Watson. We spend a lot of time keeping our eye on some of these exploratory projects for something that could be really disruptive. And when we get a sense that something is on that path, we really start to double down resources, skills and machines. So when Ferrucci and the team reached a point with Watson where, it was clear to me that, they could do it, I basically told them ‘Whatever you need, you tell me because you’re going to do it.’

And one of the advantages of having a research division and having a company with IBM’s resources is we didn’t have to go get five companies and we didn’t have to go beg, borrow and steal. I can make that decision in my conference room in three picoseconds. And we have enough resources that I can shift them and make a substantial difference in minutes versus weeks. That’s a huge advantage.

Maguire: When you think of ideas, how much of would you say your pipeline of ideas is individually sourced versus generated through a process? I know the whole idea of creativity and inspiration is often when people think of an apple falling on your head. That’s not necessarily a lot of innovation just happens from a few people coming together and synthesizing ideas. How much structure do you have versus how much is having a really talented individual?

Kelly: So, there are three processes that we would use. One is where we know generally the roadmaps, again, take the Power Systems example: So we really have focused teams - we know we’re going to be hitting power consumption limits and power certain generations, so we need innovations to break through that power performance wall. So we’ll organize teams around breaking through those walls with really innovative ideas and they’ll go off and work for months on those kinds of problems. That’s one set of processes. Or the data is getting so big, we need a new thing to replace those relational databases. So that’s sort of directed along breaking through barriers and that’s a really important process.

The second important process is this thing called a global technology outlook. This thing is proven to be really important. It’s a process that runs nearly nine months out of the year, which may sound crazy - we do it every year. But it starts with surveying the competitive technology landscape. We talk to universities and faculty. We talk to startups and VCs.



We scour every source possible to find out what’s going on in technology and business. And through the course of the Spring through December, when we hit the pavement.

We develop a set of views around usually five or six topics that could be hugely important or hugely disruptive to IBM. That process is really important. It starts out very messy. I don’t tell the team the topics. They usually come forward with 15 or 20. And it isn’t till August or September, right now that we’re really starting to sort down to what are the five or six things out of this six months of work that could be really important. And we’re at that stage right now. We’ll take that until about the middle of December. We’ll all take a whole day chewing on that, figuring out what to do with it and how to respond to it.

And the third is purely individual - no process thing. And this is really betting on people. It could be somebody brand new that comes in. We have some people that are already winning rewards out there. It could be people that are sort of mid-career; the believers of the world that have done a sequence of things and now they’re really hitting a home run and they have a track record of doing good things.

Or it could be late career guys who are - Stuart Parkin who invented GMR and disk drives. He almost won a Nobel Prize for that. He’s got new theories on room temperature super-conductivity. He’s the kind of guy you bet on. When he says, ‘I think I can do this,’ you say, ‘What do you need Stuart?’ ‘Well I need X amount of capital. I need three post-docs.’ I say ‘Okay, you got it. Go do it.’ Because he’s just liable to hit something that could change the whole industry or the world. So those are the people I place bets on or place more chips on those people.

And sometimes things just come out of left field, something we don’t even spot but they come up with a good idea. We don’t use the Google philosophy of ‘Look, I tried to ask you to do innovation.’ - It’s not that simple, we create an environment.

We also create an environment by the way where there’s a mix of skills so guys who cooked up this DNA transistor. They were going to lunch; the biologist and the guy who was working on drilling all the holes on the devices. They started shooting the breeze on the way to lunch and the next thing you know they designed this thing on a napkin in the cafeteria. So it’s just having the environment that you have the mixed people skills and it’s a

non-threatening environment. So this isn’t a simple answer.

Maguire: No, I certainly wouldn’t expect it. There’s never one way to come up with a game-changing idea. One of the questions that we’ve been asking of people is what you see as innovation catalysts or enablers broadly in terms of your use of technology to further and accelerate the productivity of your teams.

One of the themes that constantly comes up is, that with the advent of cloud computing, it’s gotten so cheap for someone to start up a business.

I was at the New York Tech Meetup last night and there were about 700 people there and people demonstrating their startup ideas on a shoestring. It seems that, it’s lowered a lot of barriers to innovation as well as open-source. I’d love to hear your perspective on how your own technologies/use of technologies have helped you be more productive/effective, and bridge the gaps between cultures and geographies.

Kelly: We use all of our technologies. We can have three labs around the world working on the same set of code, co-designing code or semiconductor chips simultaneously globally. We do that routinely. I’ve introduced high-definition video conferencing to all my labs for two reasons.

One is at this level of work, I think it’s really important that these people know each other and since I can’t fly them all over the world everyday they have to get a feel for each other. It has to get personal and so we’ve installed high-definition video conferencing. Also, that allows sales people to bring clients into the lab and we can put together a three-, four-, five-way meeting with world experts from any place on the planet in all of my labs. And again, my observation is, it’s different when clients can see the person who’s an expert. They’re not always well dressed. They might be in shorts, but they are the world’s expert so that helps.

And then we try to eat our own cooking. Two examples would be within IBM we’ve stood up our first cloud and we’ve used it ourselves. And we’ve made great inventions, we’ve made lots of mistakes around that dealing with multiple tenants, cyber security issues, but we really try to eat our own cooking.

Another example would be high-performance computers. I always feel like I have to give my team access to a really world-class high-performance



super computer. So for years, we’ve had a big one in Yorktown; it still sits there and guys have modeled materials, guys have done DNA modeling, guys have done pharmaceutical drug modeling on those tools and what’s good is we can not only do work on those fields, but we’re learning next-generational system design.

Because by working with pharmas, we say, ‘Okay, these are the classes of problems that need to be solved on next-generation systems.’ So making those kinds of tools available to our own researchers, you always want to have the best drills, the best timers to build things. It’s not cheap, but world-class people won’t come to use second-class tools.

Maguire: How about the input from the field? What’s the structure that you have for feeding, assessing, collecting and using field feedback from sales, or implementation of people to determine needs or drive ideas?

Kelly: I have lots of ways. I have a separate group that reports to me that is industry client facing. So these people are experts somewhat in IT, but less in IT and more in industry. I have a team in healthcare: five medical doctors, practitioners. They have an IT bent, but they’re MDs. And so they can translate usability, they can call up any doctor at any healthcare center in the world and have access to them. And they can help the IT folks understand the requirements better.

The same is true in energy and utilities. Smarter Cities, we have experts in municipalities, etc. We have a specific group that is that conduit. I don’t make everything go through that. I encourage all of the researchers to interact with clients. They’re either on client advisory boards, the client’s home. Sometimes they’re at work with partnership executives with the clients. In any means I can. I want them exposed to the clients, client problems. Initially, by the way, they are reluctant. But the more they do it, the more they want to do it. And the better they get.

Maguire: What about the issues around patents? As I look at IBM, IBM is historically a classic research and development-driven technology firm where filing patents is just an outgrowth of the work that you do on a proprietary basis. Sort of the way I think patents are supposed to be used. But now there’s clearly a lot more activity - trolls. The Intellectual Ventures and certainly around what’s happening around Android. How do you view the dynamics of the industry

changing with this far more active litigious stance among people that are NPEs (non-practicing entities). IBM as a company clearly has an enormous storehouse of IP. How do you view that?

Does it become more important now for you to be even more active in filing more patents? One final aspect of this is the criticism of the quality of the software patents beginning in the 90s around processes that has created these low-quality issues that has opened up a lot of this litigation in the Eastern District of Texas.

Kelly: First of all, we need to have an enormous high-quality portfolio so that we have freedom of action. Because of the size of our business and the areas that we go into, we can’t want to go into a business but not be protected from an IP standpoint or at least have enough patents that we can have a reasonable balance of power wherever we want to go. So job No.1 is freedom of action.

It would be bad for me if IBM wants to go and do something and I say, ‘We don’t have any patent protection.’ We’re going to be paying people and that would be a bad day for me. So that causes us to generate large numbers of patents in a pretty sophisticated process for what fields do we generate demand, how many, what geography, US versus China, versus Europe, etc. So that’s job No.1.

Job No.2 is then to decide now that we have it, do we want to hoard it all, do we want to license some of it, for either tactical or strategic reasons. We do a lot of licensing, which generates a billion dollars or so in IP income per year. But we don’t just really license anything to anybody - there’s a set of rationales behind everything that we do there. We would possibly prefer to cross-license as much as possible, so we avoid litigation with partners and entities. And lastly, the trolls - we saw this coming five or six years ago in a big way.

The problem is that it’s an asymmetric threat. If somebody is a practicing entity comes through that front door then . . . when they’re not practicing, it’s asymmetric, so there our strategy is nine times out of 10, it’s a poor quality patent just prior to ours and so we do our damndest to have that thing validated or dismissed as the lawsuit proceeds.

In the end, there are a few that do stand up and we’ll have to reach a settlement on that, but most of the time it’s poor quality. The strategy to deal with



these things has been through legislation and through briefings to the Supreme Court. A lot of IP cases have reached the Supreme Court in the last two to three years.

And so we’ve done a lot of work with the Senate and Congress at reform and we have done countless briefs to the Supreme Court to try to get to higher-quality patents from the beginning; trying to get uniformity in patent laws, trying to get them more up to date with the way the world is today. And then ultimately, when patent disputes reach the Supreme Court, make sure the Supreme Court has a proper view of where they should land on this. And so we send in pretty extensive briefings. They tend to listen to us, which by the way is because we have the largest number of patents and we are the largest cross-licensing entity in the world. When we suggest something to them, they tend to read it very carefully. And again most of the time, they pull the way we want them to pull. So we have this closed loop system, but in the end occasionally there will be a troll that comes in with something that I can’t invalidate, but we’ll have to settle. But it’s not a lot. That would be another bad for me.

Maguire: I’d like to switch gears a little bit. What are some of the most disruptive technologies or what you think may be the most impactful innovations, even directions you’re focused on over the next five to 10 years - areas where IBM has a unique set of advantages that will allow you to define the development of either technologies in the markets.

Kelly: I’ll start with the top and work my way down.

This analytics thing - it’s big. It’s bigger than I even thought. I always believed in it and was here when we did a GTO on it. But it’s a big deal. My research team is basically sold out between the work they’re doing, part of the work they’re doing with clients and business units and I’m just basically hiring every great mathematician I can find around the world that wants to work in this field. And I believe we’re just scratching the surface. We’ve gone beyond optimizing supply chains to much deeper work. But every place we look, the value to the clients is enormous. And it’s because there’s just so much room to improve. So I think we’ve not only defined the big space, I think it’s bigger than we think and we’re excited to think we really have better skills, better capacity than anybody in this field.

Maguire: I have used this analogy that Business Intelligence/reporting is sort of like a hammer and a screw driver, you can hit it a lot of different ways - but analytics is like a socket wrench where you get incredible amount of torque; however, you need to have the appropriate gauge. But it’s specialized so you need to have people who understand the data of this problem and then the higher mathematics, all of those skills sort of a trifecta of the three. I would admit looking at the i2 and Algorithmics acquisitions, it seems that in different business units and Smarter Planet - all of this ties together with concept of the Internet of Things and the data that comes from sensors. What do you see as challenges going forward?

Kelly: There’s a couple of areas where we need breakthroughs in algorithms; you know mathematics where problems are just so big it just takes so long to run it and we don’t have time. But I think most of the challenges going forward is. . . what we’re trying to do is look for patterns for problems where we can create fields of mathematics and algorithms that can solve multiple types of problems. So looking across industries, for these patterns and solutions and then we can make advancements to the technology roadmaps of SPSS or ILOG. So that’s the next sort of big thing that we’re trying to work on.

A second big thing, a lot of people are now starting to worry about big data and fast data, but this is also a place that is ripe for innovation. We just need whole new software/data systems to do this. We also need new hardware systems to deal with this because, as you predicted, the amount of data and the rate that it’s coming in is far beyond what we can deal with. And so as we look at this, it could be a really big deal. The challenge, as an answer to your second question, is a lot of the data is messy or noisy or sort of what we call dirty data. And it comes in all forms; it can be noisy deal data, it could be noisy GPS data - we were working in Dublin, Ireland, on traffic management. They have GPS there on all their buses. When you look at their screen they may show 200 buses out there; two or three of them will be placed in the river. If you build all your algorithms assuming all of your data is clean there’s some pretty funky stuff right? They may send those buses into the river. And in India, some of the data is really a mess.

Maguire: You guys talked about some of your Smarter Traffic solutions actually had to use street noise rather than using video sensors?



Kelly: Yeah, so we’re actually trying to do that in cities in China. You have to tease out of it at certain frequencies what data is important and what isn’t relative to density of traffic. So this area, I think, we’re just beginning to scratch the surface again in big, fast, noisy data. And whole new technologies are going to be required, so someplace out there is something that has capability as big as relational databases and analytics perhaps put together. But it’s enormous, I don’t see anything that’s going to stop the generation of data from exploding.

Maguire: I mean it seems that open-source development around Hadoop has created some interesting ways to organize data. I guess emerging skill sets are pretty fragmented right now. I understand that Netezza gave you some really good capabilities to work with that. I guess what you’re saying is there needs to be a certain level of maturity, once technology reaches a certain level of maturity, it can eclipse in scope what we’ve seen right now for traditional systems.

Kelly: And even now Hadoop is just a data layer that allows you parallelize the data operations. But we’ve had to build an incredible amount of code and tools above it in order to apply it to real problems. Hadoop by itself can’t do much, but we build the right tools on top of it - all of a sudden you can start dealing with enormous amounts of data. You can put data cleansers ahead of it, so it’s not dealing with the bus in the river. And the techniques to cleanse the data are sort of the breakthrough technologies that we’re working on, so you’re not wasting half of the computer’s time onjunk.

Maguire: I’d love to get your perspective on what we may see in terms of evolutions of purely vertically integrated solutions.

Kelly: We’re at a point and it starts with what’s happening at the chip/circuit level. Moore’s Law is changing. Some say it’s slowing down, but the net result is in silicon. As we shrink we’re getting more density, but we’re not getting more performance at constant power. And that’s a problem, that’s a real problem. And that’s why the growth in chip frequencies stopped. It hit a wall at 3GHz or so.

We’ve been able to achieve north of 5GHz with our mainframe processors through a lot of tricks, a lot of technology, but it’s not as simple as just doubling the densities and jacking up the frequency because of leakage currents and a whole bunch of things.

And so going forward, but really for the last couple of generations, this ability to vertically integrate has been really critical because we still need to get chip-level densities, but we all necessarily have to drive clock frequencies.

And it’s more than just doing more cores, and more threads. We were the first to put dual-cores on and multiple threads and everybody else followed. But tight linkages with the software, so knowing exactly in the software, when a database or a middleware has to make a call on silicon, knowing exactly what it’s going to do is really important because you can get huge acceleration of those functions. You saw us pull together our systems and software groups under Steve Mills. More and more, we’re going to have to use those levers to get those advantages going, going forward. And as we get a deeper understanding of those workloads, we can then say, ‘Okay, does this work or does this analytics work or I can leave this portion of it in high-level software, this piece has to drop down in the O/S and this piece has to drop down and run on the metal because that function is dominant in the overall system performance so it better be in silicon.’ And we find ourselves now with every generation of system making those trade-offs. Parallel software, O/S, hardware and that’s a lever that we have that nobody else has. You can’t lever that between a Microsoft and an Intel. HP can’t pull those levers anymore.

Maguire: Do you see over time the evolution of client computing becoming “dumber” endpoints of sorts - that this becomes a predominant paradigm in computing for running data centers?

Kelly: For many workloads, not all. There will still be a class of workloads which are the searches of today and whatever is next. They’re easily run on large clusters and we don’t have to worry about the state of the machine. And when one server goes down, we’ll just plug it or kill it. And the person doesn’t know it took three seconds to get that search answered versus 5 milliseconds. There will always be a class of those things.

I think there will always be a class of servers and datacenters that’s just rack and stack. But anything that’s mission critical or any missed transaction or anything that’s state sensitive - I think those things are going to go more on these vertical integrated systems. The performance benefits, the cost benefits not only the hardware and software level but the people level, is going to be enormous. We see it today, the Ps and Zs can just handle hundreds if not



thousands of distributed servers. So I think the trend is there but it won’t gobble up everything.

Maguire: We’ll touch a little on people. How do you improve people? Where does research drive innovation in services?

Kelly: This is still an emerging field. Services are by and large still people-oriented labor. There is direct correlation between revenue output and the number of people on it. It still has to go through, in mind, the equivalent of mechanization or factories in the early 1900s where you have reproducible processes; it’s highly engineering controlled, etc.

And part of that is it’s got to move to more asset intensive whether it’s software assets or combinations of software/hardware and the cloud. And things like cloud could be an enormous asset in the service business. We’ve got one out of the gate with the server. So this is a huge opportunity.

I’ve got an enormous number of people in research working on this. We’ve demonstrated where we can do this and where we can get assets and where we can productivity tools and the services to pay off is big. We can see immediate pricing differentiation, maybe competitive differentiation, maybe margin expansion when we can get it in there; we just need to do more.

Our services business is so enormous that it looks like there’s so much opportunity. So we have to look for sweet spots where we can attack this thing. We’ve done it in some of our corporate factories and services. We’re going to concentrate on that and put tools in them. Certain portions of GBS consulting, we’ve provided tool kits for use of assets, libraries of assets, things like that. But this is a huge opportunity. But the good news is it’s stuff we’re good at. We know engineering, we know tools, we’re good at software, whereas the other services firms don’t even know how to spell those things.

Maguire: I’ve seen the coverage on the human brain like computing. So when are you guys selling the singularity machine?

Kelly: This is one of those things that started from a number of different angles. We connected the dots. But fundamentally we had a bunch of individuals basically studying everything that’s ever been written about how the brain functions. And as electrical engineers, they were studying everything

from cat and monkey brains to human brains. How are these things patterned; trying to figure it out.

And originally what we were trying to figure out was how does this thing do it with 20 watts. Obviously, it’s not programmable but somehow learned and so they were looking at it from that standpoint. And as they started to look at it, they started to say there’s no reason why we couldn’t. We don’t understand how it works, but there’s no reason why we couldn’t build a replica of the brain in silicon or something that resembles silicon.

And in parallel, we could build models of this thing in a supercomputer say Blue Gene and every node is basically a synapse or a neuron and so they simultaneously went out to Livermore and were able to build the same number of nodes or synapses in the Livermore supercomputer as in a cat’s brain. So we can start to do some playing around with how this thing behaves. And several days later, we started to build chips of a few hundred equivalent to those synapses and we’re working back and forth from the models and the silicon.

And had actually built small silicon-based systems that can learn, but the shape of something it should be. So it learns that that picture is square and if you show the machine three quarters of it, it will figure out that that’s a square or a rectangle based on previous patterns of seeing. So we never programmed the damned thing, it just learns that I see that much, it must be this. And so it’s starting to extrapolate based on what it’s seeing.

It’s a project we’re very interested in. It’s a project we’ve been getting DARPA’s type of funding; and you might not be surprised that DARPA’s interested in such a thing. But one of our long-term provisions is that the system will not be programmable - they will be learning machines. A few years ago, I do what I usually do, “You guys are crazy, get the hell out of here,” but I never stop them. And then they come back with a little bit more data, so these guys are now at the point where Ferrucci was five years ago. Where they’re demonstrating some stuff which is pretty impressive and pretty scary. And I’m saying, ‘Whatever you want - you get.’

Maguire: I have been to the Singularity Summit the past two years. It’s a fairly eclectic group of folks. There are some people working on re-engineering the brain.



Kelly: The first thing that we’re interested in is not trying to build a brain, not even a cat’s brain, but a lot of the inputs from the centers from the environment are going to be signals that we’re going to want intelligent learning - microcomputers - close to it. So if you’re looking at patterns, you want something there that can just look at the patterns

and start to make sense of it before you ever shift it to another computer. And so probably the first application of these simple and unique systems will be learning out at the endpoints of these smarter planet applications. And the guys have done some modeling of prototypes of different things and it’s pretty impressive.



Nathan Oostendorp, Ingenuitas Nathan Oostendorp is an open-source entrepreneur, co-founder of Slashdot, architect of SourceForge.net and founder of Ingenuitas.

He has developed multiple successful online communities, including Everything2.com and PerlMonks.org. His areas of expertise include software architecture, information economics, incentive design and large-scale information system operation.

Ingenuitas is Nathan's new company with the mission of developing an ecosystem of open-source hardware and software industrial controls products. The company focuses on creating an online space for industrial engineering collaboration and prototyping ultra-low-cost solutions in machine vision, robotics, wireless sensors, and control systems. Open-source software has been a tremendous catalyst for technology development on the Web in the last decade, and open innovation in manufacturing will accelerate innovation in the next.

He holds an MS in Information Science from the University of Michigan and a BS in Computer Science from Hope College.

Key points from conference call The cloud has been a game-changer in terms of how open-source

companies can effectively run a business because they don’t need to invest 70% of their resources in enterprise sales and locking down a few big deals.

More companies are releasing open-sourced software that their business relies upon but isn’t necessarily a profit center for them.

Open source has more advantages because everyone has the ability to adapt each tool as they need to.

There are obstacles. Manufacturing is one of the most risk-averse technology sectors; it’s probably not quite as bad as banking or healthcare, but it’s definitely up there.

Open-source hardware is an open-source mentality moving beyond software engineering into electrical and mechanical engineering, realizing this because of technologies like CAD and cheap means of fabricating and assembling circuit boards.

Manufacturing is a lot like enterprise software in that it’s a very follower kind of culture - not about what products offer the most features or the best interface. It’s about “we want to use what everyone else is using.”

Nathan is an open-source entrepreneur, developer

of multiple successful online communities

The cloud has been a game-changer

Manufacturing is about “we want to use what

everyone else is using”

Open source has more advantages



Nathan Oostendorp transcriptMaguire: We’d like to cover your experience and views with the open-source model as it relates directly towards encouraging and enabling innovation.

What would be most helpful would be to provide a view philosophically about the emergence of the open-source world. I saw that you had actually been at the VA Linux and been through their product transitions, but discuss from your perspective this open-source, crowd-sourced model or the emergence of different business models, the implications and ramifications for innovation broadly across technology and other industries.

Oostendorp: As far as my background goes, I got involved in the open-source movement in college with founding Slashdot. At the time, we were computer science students, so we had some familiarity with Unix and installing Unix on a machine. It was all very novel, this new thing where you could take your lab assignments and do them in your dorm room.

Slashdot went from my roommate Rob Malda’s home page and turned into this proto-blog for tech news and it was one of the first big websites that used what is now called a LAMP stack. It was a MySQL, Perl backend and my role was primarily as the technical guy. I wrote all the software around the blog and the discussion system and then later the ad server, which was our revenue model.

Then we had an exit to Andover.net, which bought the site, I want to say, in 98 or 99. And I spent the next couple of years doing an open-source content management system company called “The everything engine” and it was very similar to the modern platforms like Drupal. But we, unfortunately, did a lot of consulting for other people trying to build Slashdot-like websites. Then in 2001, we ended up with several hundred thousand dollars in accounts receivable that we knew was not going to be paid and we closed our doors.

That’s when I joined VA Linux, which had purchased the company that bought Slashdot from us. And I started working first as the sole engineer for SourceForge and then a variety of different roles in the organization, usually centered on SourceForge. And SourceForge went from its initial stage of “we give you a few really distinct tools - source-code management, a kind of an index; a place to upload your files; a place to organize your work.

As SourceForge developed over that decade, it became a lot more oriented towards giving open-source projects tools to organize their community. I would say the actual nuts and bolts of the code and the uploading and downloading fell more to the background, and so it became a lot more where people wanted content management systems. People wanted things they could effectively harness the power their community for. It really gave me a lot of insight, especially looking at which projects did well, which projects did poorly as to how important it was as an open-source project to be effective at marketing. A lot of projects get to this place where they have reasonable tech, but if they didn’t actually reach out to their potential user base, it would just sit in a file directory somewhere.

And then I left SourceForge late last year. I was very interested in what was going on with the open-source hardware community - that is the community around companies like Makerbot and the Arduino platform - just because I was starting to see a lot of similarities to what was happening there with what had happened in the prior decades with Linux and open-source databases.

Then this spring, I founded Ingenuitas - which is our company - with the purpose of building an open-source automation stack and our first product is an open source called a “Machine vision appliance,” which is a system that does a visual inspection in automation process and usually talks to some backend and gives some sort of pass/fail test or logs data about products as they go under a camera.

Maguire: That’s really interesting that you bring up, as well as the open-source hardware. From your perspective going back to the SourceForge experience, the idea of community seems critical for getting involvement, participation and contributions to broader collective input in open-source code, but it seems to be that your role evolved to be something of a curator at SourceForge.

What was your experience in finding the best way to manage that? It would seem that it’s of a completely unstructured process in a public community, where there’s a lot of chaos; it gets very difficult to sort out what’s good from what may not be quite as good.

Oostendorp: Our primary role was just making sure that at SourceForge, people could store assets there and be very assured they weren’t going anywhere. I would say SourceForge has a single community that



didn’t really exist for the most part. It was more of these little ecosystems or projects that have their own community and they were using us as a service provider to do that.

When it came to actually dealing with the open-source ecosystem as a whole . . . since we weren’t a very big team, usually what we did was just borrow very liberally from what was from the very hot social-networking types of MAMES. Putting together a more flexible search feature, doing some activity feeds for users, doing ways where people can kind of give each other signals of gratitude and the donation system we put together.

Maguire: What’s your feeling, having been around a couple of companies with somewhat different business models? I guess the jaundiced view on open source is when you’re giving software away for free, can it generate enough revenue to really sustain the business?

As you’ve looked at software that’s been developed by open source, I see this LAMP stack enabling a tremendous amount of innovation on top for application developers, organizations and people looking to solve a problem. In your experience, what has been the most viable approach to creating a sustainable enterprise based on open source? In your experience, what’s been the process of how you experiment with various business models? What are some of the things that have worked and may not have worked so well?

Oostendorp: I think that RedHat has been the most successful in what I would consider the very traditional open-source and enterprise model where you have an open-source technology - where you are building a product on top of that, typically has something like a community version and an enterprise version. You sell the enterprise version, you sell support for the enterprise version and it’s really about being able to arbitrage innovations in the community version into your enterprise version, while at the same time having enough value added in your enterprise version that you have a viable business. For a lot of years, I think this was the template that all open-source companies tried to do. I think there’s only a few that were very successful and it tended to work better in software that was a significant cost center for large organizations.

Nowadays, there’s a lot more potential in offering things that are tied to cloud-based services. So, for

example, you get companies that haven’t been proven yet and have generated a lot of excitement like Cloud 9, which is doing an interactive web-based code development environment. They’re releasing their software as open source, but they don’t have to market to large organizations because people can individually say I want to use this as an editor and I want to pay X dollars per month.

So I think the cloud has definitely been a game-changer in terms of how open-source companies can effectively run a business because they don’t need to invest 70% of their resources in enterprise sales and locking down a few big deals.

The other thing I’ve seen a lot more is companies releasing open-sourced software that their business relies upon but isn’t necessarily a profit center for them. An example of this would be both Facebook and VMWare publishing open-source projects: Facebook with Cassandra storage engines and VMWare with Reddis. Both are open cloud Platform-as-a-Service projects. So these are critical pieces of infrastructure for their own businesses.

Their primary interest in publishing it in open source is that it gets as robust and as useful as it can be. And they may not put a lot of energy into it, proportionally to their main business. But it does provide a commercial-grade open-source offering that is backed by a company even if it doesn’t have the traditional open-source sales and service model.

Maguire: The open-sourced hardware model as you’ve mentioned - we’ve just been looking at Makerbot and a few other companies like Bug Labs in this area - what do you find most compelling about these companies? Where do you think the ultimate impact might be of open-sourced hardware beyond the initial do-it-yourselfers or the folks that go to Maker Faire? Do you think this could have broader implications for innovation across different industries and different types of organizations?

Oostendorp: Yeah, this is one of the things I’m definitely betting on with my own venture. The interesting thing for me with open-sourced hardware was just that open-sourced mentality moving beyond the field of software engineering into electrical engineering and mechanical engineering. And realizing that because of things like CAD and these pretty cheap means of fabricating circuit boards and assembling them.



You can have an entire physical product, which has all the pieces of it published that anyone with really not much substantial resources, just a few thousand dollars, could source the parts for and start producing. And Makerbot is definitely the most sophisticated version of this and there are some fast followers I’ve seen. There’s a company called Lasersaur that’s doing an open-sourced laser cutter. And a number of people have done these one-off C & C mills. Before I actually did web stuff, I was an industrial programmer, so when I saw the Arduino come out. We used to have a data acquisition board that did a lot of the same things Arduino did, but that cost US$3,000 and this costs US$50.

When I saw the Makerbot, and as a 3D printer, I viewed it as an open-source C&C machine that has a Gcode interpreter on it and that is the core technology that is in a lot of machines. You’re starting in the hobbyist community because they can take a lot of risks; they’re doing it for fun. Not everyone who’s involved has profitable ventures, but we’re not far away from the community and the technologies they’ve developed being applicable in real-world manufacturing cases.

It seems similar to what happened with Linux, when in the space of a relatively few years it went from what you installed on PCs for fun and something you play around with, to something that . . . Linux is in every computer you don’t see. Similarly now with MySQL. It went from something that was a toy database to a really robust and powerful data storage platform over a few years. There are some different barriers to not being a pure software solution, but it seems like the same thing can definitely happen with these open-source machines that are coming out.

Maguire: You mentioned you had some experience in industrial production. When I think about some of these industrial systems SCADA/manufacturing systems, these historically have been a bastion of proprietary systems and software, not a lot of standards in integration. What do you see as either opportunities or the obstacles for open-source systems to really gain meaningful adoption and potentially become disruptive in industrial systems? It’s kind of what you’re doing with your company right now.

Oostendorp: I think one of the opportunities is that manufacturing is a lot like enterprise software in that it’s a very follower kind of culture. It’s not necessarily about the products that offer the most

features or the best interface or anything. It’s about “we want to use what everyone else is using”. It would be very hard for a traditional proprietary software strategy to disrupt the entrenched incumbent.

To a certain extent where open source has had some of its biggest successes in taking these fields. . . where 15 years ago, it was unthinkable anyone would be using anything but Oracle or DB2 for extremely large dataset manipulation. Now you have a variety of robust, scaleable open-source data storage systems and they’ve been able to build on top of each other.

The other opportunity is what tends to be very black-boxed; they tend to be sold through a very end-tier distribution network, and simply moving them to a more of a direct-sales sort of framework where they use off-the-shelf components. Nobody right now orders an automation system like they do at Dell Computers. That’s something which I’m interested in pushing towards, something where a lot of this technology has the potential to be very commoditized. And so it’s going to be how well we can lower barriers to entry for especially small- to mid-sized manufacturers that don’t have the economies to scale to spend the US$1-2m on an automation unit - a system of machines that are integrated and work together.

The proprietary thing as a third pillar for opportunity is that open-source stuff tends to be able to work together, rather than closed, proprietary black-box stuff because you have access to everything at all levels.

If you really need to fix a bug in a machine that you’re interfacing with, you can go and do it. If you really want to update this controller to talk this new protocol, you can go do it. And that doesn’t currently exist right now. Especially for integrators who are contractors and who develop on older systems, this is a major part of their workload, getting all of these different black-box systems to talk to each other and to play nice.

As it gets more and more complex. I think open source has more advantages because everyone has the ability to go in and adapt each tool as they need to. There are definitely a lot of obstacles. I think one of them is definitely that manufacturing is one of the most risk-averse technology sectors; it’s probably not quite as bad as banking or healthcare, but it’s definitely up there.



Just providing an open-source solution for download isn’t going to cut it. It really needs to be a product sold in the same framework in which they buy things today. I also think a big one is that a lot of the higher-end manufacturing systems use industrial protocols; they talk over industrial Ethernet. And there are only two that I know of that have open-source drivers, of say 15 protocols in total. These are the glue that ties these automation systems together; right now only a fraction is really there.

Most of the rest of it is owned by companies like Rockwell Automation and then specific customers to whom they have licensed that technology. So either you have to have a hybrid open-source commercial product that can interface with these systems or more likely your entire factory is running stuff from Rockwell and their proprietors; we’re not just going to be able to crack that because they’re talking something that can’t be unlocked.

Maguire: What you describe though is a potential opportunity for a new set of more open solutions for manufacturing companies that can be potentially a lot more cost effective and certainly improve. If it’s in the US, of course everything’s global, so being able to adopt it and being able to reduce costs and capital expenditure for automation could certainly help to improve competitiveness in the US.

Oostendorp: We, for instance, we are at this point, we’re dodging implementing traditional industrial

protocols although some we can’t avoid We’re using technologies like Http and J2EE, which are traditionally more for Web APIs.

Just because it’s a very easy way to talk between machines. And I think about your point about the US is good. One of the trends I think is going to emerge especially as prices for automation come down is that it’s going to matter much less that you have large-scale capabilities for production of a single part. That was a 20th century model, that if we can build X amount of widgets, they’re US$0.05 cheaper because we have all of these fancy machines to do them. And now it’s going to be much more about where your position is in the supply chain and how quickly you can adopt so that the people downstream from you can do more just-in-time, they can do shorter production runs, they can rely on the quality.

Microsoft had created this vision of having PCs in every home. My vision is an end to manual gauging. Most quality control is essentially when people measure parts with calipers and they do a sample of the entire batch and they use statistics to figure out if it’s likely to have an x% of defects. When you have an automated inspection, you can inspect every single part. You can inspect every single part at each stage in the assembly process. And the implications of that widely adopted at a very low cost mean really an end to assembly defects in manufacturing systems.



Patricia Seybold, Patricia Seybold Group With 30 years of experience consulting to customer-centric executives in technology-aggressive businesses across many industries, Patricia Seybold is a visionary thought leader with the unique ability to spot the impact that technology enablement and customer behavior will have on business trends very early. She assesses and predicts how new and evolving technologies will impact customers.

Patricia forecasts the ways in which both business and consumer customers will make new demands on companies in many different industries. She provides customer-centric executives within Fortune 1000 companies with strategic insights, technology guidance and best practices. Her hands-on experience, her discovery and chronicling of best practices, her deep understanding of information technology, her large, loyal client base and her ongoing case-study research enhances the thought leadership she provides.

Patricia Seybold is an internationally acclaimed best-selling author. Her groundbreaking book, Customers.com, published in late 1998, provides insight into how 16 still-thriving companies designed their ebusiness strategies to improve revenue, increase profitability and enhance customer loyalty.

Her latest book, Outside Innovation, was published by HarperCollins in October 2006. This book describes the “new” approach to the process of business innovation, customer co-design. Check out her Outside Innovation Blog for the latest on the best practices in customer innovation - customer co-design. It offers insights into how to make it easy for customers to do business with you and how to measure and monitor what matters most to a company’s fundamental source of value: its customers.

The Customer Revolution, published in 2001, describes how 13 global businesses in a variety of industries managed by and for customer value while they continuously improve the quality of the customer experience they deliver.

She is co-author of BRANDchild, published in 2003. Her books have been translated into over 10 languages.

Key points from conference call Very few companies actually observe and listen to their would-be

customers well or treat their customers very well.

Smart customization, is the application of technology to give customers tools to configure and design customized products, whether apparel or furniture or manufacturing equipment. Those kinds of tools are going to have a big impact in next five to 10 years.

Another important area is aggregation and curation, various forms of crowdsourcing as a form of innovation and or source of innovation. Allowing users of a common product to create and share intellectual property they’ve come up with and/or to gain insight across products and services and to share insights across a network creates real value.

Cocoa Fitness was one of the first to innovate in providing real-time interactive feedback. As their customers are exercising, they get interactive feedback, but this is part of a 360-degree ecosystem so that each consumer can see how they’re doing and compare to other

Customers are a company’s fundamental

source of value

Few companies listen to or treat their customers

very well

Crowdsourcing allows users to create and share intellectual property and

insights across a network

Patricia is an internationally acclaimed

best-selling author and thought leader



consumers. Then each franchisee or health club operator can see the specifics across customers, machines, physical trainers and therapists.

We are in a world of sensors. Everything gets sensed, and every business event can be. And the trick is to figure out what makes sense to sense, what you do with all that information and how to make sense of it.

There will be a lot of innovations in Life Science-related areas but the whole concern is about gene manipulation. On one hand, there’s a huge amount of opportunity but there’s also a lot of concern about negative repercussions.

There is strong consensus for next-generation nuclear technology. Industrial companies are talking about the fact that they’re investing in their own small-scale nuclear power plants.

There is a lot of action, innovation and development of physical data centers around the globe. With internet connectivity to enable the cloud-computing networking infrastructure, some are being built in very interesting places like under the ocean, in the middle of nowhere, and there is innovation in new types of power generation and cooling technologies.

We are in a world of sensors: the trick is to figure out what makes

sense to sense

There is innovation in new types of power

generation and cooling technologies



Patricia Seybold transcript Maguire: From a very high level, I’d be very interested in getting your view on what you’ve seen as enabling changes in the process and the pace of innovation in the US but even globally over the last 10 years. Could you provide us with a bit of your background and what has led you to the work on your focus on innovation now?

Seybold: My specialty in my career really has had to do with how technology transforms industries, work processes in different industries. And I inherited that interest from my father John Segal, who was the catalyst in the prototype setting.

Basically, I grew up apprenticing with somebody who had basically helped an industry transform itself through technology. So my practice is basically to work with companies to help them understand what it is their customers want to get done. I’m very specifically engaged in what I call customer-led innovation, which is just a piece of innovation. I don’t claim that that’s the only way innovation gets done. I think it’s 50% or less probably happens that way. But that’s where I focus - I happen to work with companies where technology changes are playing a big role. So it’s kind of that combination of companies, what their customers are trying to get done and how technology could enable them to do that better. And then helping them co-design better solutions.

Maguire: So you work on helping businesses that look outside the organization and facilitate. Could you discuss what you see as the challenges for organizations that led to the opportunity you’re finding? Clearly, there’s a pain point or maybe a lack of process.

Seybold: I think it’s the latter - that very few companies actually observe and listen to their would-be customers well or treat their customers very well. So obviously for any startup, that’s how they get into business right? They have to understand what customers might need for the products they come up with and how do they come up with the products by finding an unmet need. So as companies get bigger, they usually lose that capability. So instead of doing customer-centered design from the beginning, they tend to do design-work based on their core competencies and try to stay in sync with what their customers care about, but it doesn’t really fit.

I think Eric Von Hippel described it best in his book about user’s innovation when he said that your company has a core expertise or core competency

and your customers have core expertise and core competency in what they do. And customer-led innovation takes place when you marry those two and get those two domain expertises married.

Maguire: It’s interesting that you bring up Eric Von Hippel. I’ve read Democratizing Innovation. It seems as technology is involved, right now we’re in an environment where there are all of these tools that enable types of communication and sharing. How do you see the companies that do it right? How are they effectively incorporating technology to improve their. . .

Seybold: One whole category that I’m fascinated by and I wouldn’t claim to be an expert in that I certainly follow is mass customization versus smart customization, which is basically the application of technology to give the customers tools to configure and design customized products, whether it’s apparel or furniture or manufacturing equipment. And so the innovation there is to re-think your entire product line or portfolio and, by the way, these can be services as they often are. Like software services, financial services, or whatever. That in such a way it makes it really easy to mix and match and modularize and still keep a really good profit margin and still be able to do it very quickly. And in fact, sometimes more quickly in terms of being able to deliver customized shoes the next day or whatever. So those kind of tools I think are going to have a big, they are having, but I think they are going to have in the next five to 10 years a big impact.

Maguire: It would seem as you’re describing this. . . There is a company called BugLabs that creates prototype kits. I think you’re familiar with them?

Seybold: Yes, I am.

Maguire: So what you’re describing sounds like a set of tools or technologies that would be applied to either apparel or manufacturing, or potentially consumer goods or even. . .

Seybold: Right, but you then have to have the tools and this is where Von Hippel comes in. You have to be able to give those tools to the end customers.

Maguire: Right.

Seybold: As well so there are tool kits for end customers that tend to be very electronic. They’re usually some website or portal or something where you go and start designing stuff. Sometimes there



are physical capabilities as well like 3D printing or whatever. So that’s one angle that’s worth noting - and the modularization or mass customization and the tools that the manufacturer or producer needs and the tools the end customers need.

Another area, of course, is a whole kind of aggregation and curation, and social media is too vague; I’m really talking about various forms of crowdsourcing as a form of innovation and or source of innovation. And particularly when you talk about information content - digital media, software services, etc . . . the ability to enable your customers to create and share either intellectual property they’ve come up with and/or to gain insight across products and services.

So here is a very simple example and it’s very common and you’ve seen it many, many times. But it’s much more enabled now in just about any industry. Let’s just take automobiles for example. People who own cars, they want to keep track of the status of their car, the mileage, the mechanical state of it, etc. . .and aficionados are particularly interested in learning from each other, how is my performance compared to yours, what are the best practices and etc. Well that pattern, I use cars as an example but I find it in working with power plant managers, I find it in working with retailers, it could be Amazon; just about any place where I as a customer and or consumer or business customer is able to manage, what I call manage my stuff. I’ve got my own assets, my own stuff; it could be my financial portfolio. But by virtue of the fact that I have that information well-organized using technology and the provider of that technology has everybody else’s information, too, they can then start to point out patterns that show how I’m doing compared to others and etc . . . And I can also ask questions and get advice and get mentoring from not just the provider who’s presumably the expert in this area but also from other people like me who are doing things in a very similar context. So it’s kind of moving up the stack in the way we understand and use and organize the information about what we’re doing. That’s another whole area that seems to be another emerging pattern that I think has been around forever.

Maguire: It’s interesting that you’ve mentioned that. There’s a company called ServiceSource that you’re probably familiar with. They help their clients, which are typically technology companies or software companies, optimize their maintenance renewals. As they have gotten data on transactions, they have a

repository of over two million transactions and they’re able to help their customers, now through an analytical tool kit and this proprietary database, benchmark themselves and improve their own processes.

Seybold: Right, exactly.

Maguire: This is exactly the kind of thing you’re talking about.

Seybold: Yeah, and you can also see it being used in consumer veins in slightly different ways if you think about Netflix’s real value. If you talk to Reed Hastings about it, he’ll say well it’s the database. It’s the fact that everybody who’s ever seen a movie has rated it on our site and that gives us an incredible amount of information, which we can use to make us better and better. And it makes us more and more valuable for everybody.

Maguire: It’s really interesting because as you look at this sort of broader trend of . . . Kevin Kelly has talked about how in the future at least with things like media - Netflix is a good example and whether it’s a Spotify or Pandora on music and ZipCar for cars - this idea of being able to rent or borrow rather than own and use temporarily and having the value of these services be informed by the experience of the users to improve the overall experience.

Seybold: Right.

Maguire: And I guess what you’re saying is that has maybe much broader applicability than many of us have begun to imagine.

Seybold: Yeah, it’s a pattern that I see turning up over and over again. Another one that’s somewhat related I think, which is kind of a different spin on the same thing, is when you include a lot of metrics in what you’re doing and monitoring. So take for example physical fitness.

One of the companies that I’ve written about, keep following, is Cocoa Fitness. That was one of the first to really innovate in providing real-time interactive feedback as I’m exercising and doing it in a way that I can see what form I should have and where I’m missing the mark. And I get this real-time feedback of how I’m doing and so on.

What they did, which was really brilliant from the beginning, which was not only that interactive feedback with exercising, but they did it as an



ecosystem - a 360-degree ecosystem - so that each consumer can see how they’re doing and, of course, can be compared to other consumers. Then each franchisee or health club operator can see the specifics across all of their customers and machines and the physical trainers, the physical therapists.

They also can see these patterns, and the guys who are designing this per team can see this. You have this kind of ecosystem of each party with a different view of what’s going on, but each one is able to continuously improve and evolve the ecosystem by being able to see what’s happening real-time.

Maguire: So all of this is enabled by connectivity. . .

Seybold: And instrumentation. And the other thing that’s really important here is that we’re in a world of sensors. Everything gets sensed, and every business event can be. And part of the trick is to figure out what makes sense to sense. And what do you do with all that information and how do you make sense of it. But I think that is one of the things that has changed quite a bit and I see that in everything across the environment, world, people measuring CO2 intake of. . .

Maguire: Really smart grid stuff. . . you’ve got . . .

Seybold: Yeah exactly, you’ve got that, you’ve got people measuring oxygen intake in oysters, you’ve got stuff out in the field, and stuff that’s in very hard to access, in difficult, locations. And yet with mobile and wireless technology, it becomes more and more possible to basically wire up.

Maguire: And this in turn seems to be driving a lot of innovation in different types of solutions.

Seybold: Right, so then you have the geo-presence/geo-location information as well.

Maguire: I don’t know if you’re familiar with this trend of the “Quantified Self”? There was actually a Quantified Self conference recently.

Seybold: No, I’m not familiar with this.

Maguire: This includes people obsessively measuring everything they do. Like Tim Ferris, who wrote The 4-hour workweek and The 4-hour body. He compulsively measures every aspect of his health and his life and activities by taking that data and being able to create insights by applying analytics from it.

Going back to sort of a broader longer-term thesis that I’ve had about why analytics has become so important is that you’ve had this phase of transactional applications that has essentially evolved to automate processes and create data - in effect to “instrument” data about processes. Now in the next stage, how do you take that data and derive insight, analysis and value from that? It seems like what you’re observing is that similar phenomenon starting to manifest in other areas.

Seybold: Exactly, but I think that the key is again, the filter that I‘m using allows me to see in particular that the customers are the ones who are doing it. It’s not the case that people are scraping up all this data and then undoing it and giving it back to people. It’s more that customers themselves/the end users themselves are making observations and assessments and poking at it and then kind of going to the next level etc. And then if you have an ecosystem where you have multiple parties actually working off some of the shared data, then you’ve got everybody going at it in different ways. But it gets more and more value because everybody is contributing their insights.

Maguire: That’s fascinating. What do you see as real obstacles or hurdles - because technology has been a huge enabling force in allowing for these types of feedback and innovation ecosystems? What in your mind are some of the key challenges or hurdles or obstacles to broad adoption of these types of systems?

Seybold: Within a company there’s all the stuff that Clay Christiansen points out - the “innovator’s dilemma” problem. It’s hard to really be innovative within companies because you tend to have to incubate and isolate and insulate the people who are trying to do the innovations. Or just spin them off and let them do their own thing.

So there’s the NIH “Non invented here” syndrome: “We already know all this stuff so we don’t actually see what customers are trying to tell us or show us or what would be powerful for us to see if we looked”.

So there’s that and the kind of cultural impediment. I was interested that a lot of the kudos for Steve Jobs evolved around that. The ability of Apple to cannibalize itself and to meet those tech-y ends of being innovative and thinking out of the box over and over again.



I think there are the cultural issues, I think that from a business climate standpoint, of course people complain - from the economic standpoint, it’s hard to get investment now. There aren’t many countries where venture capital is as easily accessible as it is in the US. And even in the US, they tend to go in waves and herds. Whatever the current herd is, sometimes it’s hard to break that mold.

On the other hand, the positive is people will be able to bootstrap more, particularly because of the capital requirements, at least for software, are much lower than they have ever been. Right? So you don’t have to buy a computer, you don’t have to use a computer, except for maybe a laptop in order to do very sophisticated stuff using cloud computing and paying as you go.

That’s good news for innovation. I know lots of people who have done a lot of trial and error work that way. It just lets you move through so many iterations and try things without having to raise a lot of money.

Maguire: This topic has come up a couple of times where this has been benefiting entrepreneurs with good ideas, for sure; but, on the other hand, it creates a need for traditional VCs to change their business model because they need to spend on different things such as office space and servers.

What do you see over the next five to 10 years in innovation outside of the US?

Seybold: Not as much as I would like. I actually do work with African countries. I guess I’m assuming we’re going to see a lot of innovations in Life Science-related areas, and I think the inhibitors - one of them is the whole concern about gene manipulation. On one hand, there’s a huge amount of opportunity there, and great work being done there - in many parts of the world - and China is one of them. There’s a Life Sciences area and the plant sciences area but then there’s also a lot of concern about the negative repercussions.

I’ve also been involved with some clients in the energy business, so I’ve been looking at the traditional fossil-fuel-type energy systems, alternative energy. There seems to be a pretty strong consensus for the stuff that’s going to be for next-generation nuclear technology that will get applied and be actually very safe. So that’s another thing that I’m kind of bullish on. I’ve never been a

fan of nuclear. But I hear companies, particularly industrial companies, talking about the fact that they’re investing in their own small-scale nuclear power plants. I’m thinking this is a very different business model, we don’t need government support or regulation, just government permission. I think that’s going to change things.

Maguire: Lastly, I would like to get your view on patents. You’ve worked with software over the years, and you’ve probably seen the rise of or loosening of standards around software patents.

Seybold: Yeah, I see the biggest problem right now being, all of my clients have hot debates about this topic, and I think there’s still the general consensus that it’s still a good idea to patent your software. But there’s real concern about the patent troll and then there’s the open-source guys to not just do it all by keeping ahead of the pack by being smarter than everyone. I think software patents and other patents are going to remain problematic and I don’t have a magical elixir.

Maguire: I know there’s some proposed legislation that is reported to help add some clarity to the situation. I think about what Microsoft and Apple are doing with Google around Android and then all the litigation.

Seybold: And then the question is, is that just because of Oracle now and the patents and they’re not going to let Android be run on mobile platforms.

Maguire: What’s interesting is the determination of damages. Google is saying we give the software away but we’re not getting any economic benefit. And the Oracle argument is that you still make money in a different way and even if you’re not monetizing it, it’s the fact that there is still value.

That was the argument they used against SAP where they said just because SAP was only able to monetize US$50m from what they stole from Oracle that doesn’t mean they weren’t going and stealing all the Disney logos and selling it for US$10 on the street. If they’re bad salesmen, that doesn’t diminish the value of the asset and that argument prevailed, which is pretty interesting.

Seybold: Yeah, I thought so too. One other thing that’s a technology enabler, we talked a little about the cloud-computing piece, but underneath the cloud there are physical servers and physical data centers.



And I mentioned energy before. One of the other patterns I see is that there is a fair amount of action and some innovation and certainly a lot of development of physical data centers around the globe. And with internet connectivity to enable the cloud-computing networking infrastructure, some of these are being built in very interesting places like under the ocean, out in the middle of nowhere, and there’s been some interesting ways of power generation and cooling technologies and so on.

Then, of course, the fact that we used to think data centers were a place where we had a few big machines. And, then now, we discovered that maybe we should have lots and lots of little machines and should just consider them disposable and turn them on and provision them in real-time. So I think that’s

definitely an enabler of the cloud. But then there’s the infrastructure under the cloud. And the fact the cloud can be local, it doesn’t have to be distant or far away and the fact that you can connect all this stuff with fiber, it gives you incredible capability.

Maguire: There are a lot of agents that are accelerating change right now. Because of that hopefully there will be benefits to society at large as well.

Seybold: To me, that occurs with the mobile internet. It’s not just all the rich people in the world. It’s reaching the Third World. Anybody - even a kid in Kenya with a smartphone can pull up the same data anybody in a research university in the West would have access to just as a research function. That’s pretty powerful.



Gary Shapiro, CEA Gary Shapiro is president and CEO of the Consumer Electronics Association (CEA), the US trade association representing more than 2,000 consumer electronics companies and owning and producing the continent’s largest annual tradeshow, the International CES.

Gary led the industry in its successful transition to HDTV. He co-founded and chaired the HDTV Model Station and served as a leader of the Advanced Television Test Center (ATTC). He is a charter inductee to the Academy of Digital Television Pioneers, and received its highest award as the industry leader most influential in advancing HDTV. He focused on the need for and led the effort to obtain the 2009 cut-off date of analog broadcasting.

As chairman of the Home Recording Rights Coalition (HRRC), Gary led the manufacturers’ battle to preserve the legality of recording technology and consumer fair-use rights. Gary has held many exhibition industry leadership posts, and received the exhibition industry’s highest honor, the Pinnacle Award. He is a member of the Board of Directors of the Northern Virginia Technology Council, the State Department's Advisory Committee on International Communications and Information Policy, and the Board of Directors of the Washington Economic Club. He has served as a member of the Commonwealth of Virginia's Commission on Information Technology and on the Board of Visitors of George Mason University. Shapiro also has been recognized by the US Environmental Protection Agency as a “mastermind” for his initiative in helping to create the Industry Cooperative for Ozone Layer Protection (ICOLP).

Gary leads a staff of 140 employees and thousands of industry volunteers and has testified before Congress on technology and business issues more than 20 times. He has received annual recognition from The Hill since 2006 as a "top lobbyist" in Washington. Also, Washington Life magazine has named him one of the 100 most influential people in Washington, DC. CEA has won many awards as a family-friendly employer and one of the best places in Virginia to work.

Gary authored the 2011 bestselling book The Comeback: How Innovation Will Restore the American Dream (Beaufort).

Prior to joining the association, Gary was an associate at the law firm of Squire Sanders. He also has worked on Capitol Hill, as an assistant to a member of Congress. He received his law degree from Georgetown University Law Center and is a Phi Beta Kappa graduate with a double major in economics and psychology from Binghamton University. He is married to Dr Susan Malinowski, a retina surgeon.

Key points from the conference call The US strategy in the last century has been focused on innovation. It’s

part because it’s what we’re good at. The USA welcomes different viewpoints; pushes back against the status quo. We have a first amendment, which protects new ideas. We have a questioning society. We’re the only developed country in the world where failure in business is actually a plus.

Since 9/11, the USA has shifted strategies to discourage high-quality immigration, forcing companies to go overseas. The USA has the highest corporate tax rate in the developed world. The deficit is a huge threat.

US strategy in the last century has been focused

on innovation, but this has changed

Gary is president and CEO of the Consumer

Electronics Association

Since 9/11, the USA has shifted strategies to

discourage high-quality immigration



The USA is a great leader in finance, investment and entrepreneurship, but there are a lot of things working against us. And the object is to focus on the good things and remove the barriers whether it be litigation, trade, deficit and taxes.

The USA needs an innovation policy as a national bipartisan strategy that requires immigration of the best and the brightest, entrepreneurs, free trade, tax structure and spectrum.

There is anti-business sentiment, the anti-employer sentiment, the fact that taxes are biased against business startups and an anti-business attitude that comes from the top. Sarbanes-Oxley makes it very difficult to go public.

The USA has a surplus of lawyers that are litigation-happy. For a public company, litigation is not a question of if, it’s a certainty. A common frustration is that patent litigation is an absolute certainty; it’s expensive, it’s unclear, and that’s not a healthy system.

Thirty years ago, all of venture capital was in the United States. Now it’s less than 50%. Major merchant banks and investors are looking abroad more, going to China, going elsewhere in terms of investment.

Never before have we had this opportunity where with a computer and an internet connection you can be an entrepreneur. And that’s a lot of the growth now in what we’re seeing in Silicon Valley and in a lot of the social-media startups - in LinkedIn and even Pandora and others recently going public.

The CEA has created an Innovation Movement, which has attracted well over a hundred thousand people. Business leaders have a big shot at standing up and speaking out about these issues to put innovation on the national agenda.

What is our biggest threat? The bottom line was the health of the US economy. The US economy, our board agreed unanimously, is in danger in the next five- to 10-year period. And the big reason we’re in danger is the policies of our government.

A common frustration is that patent litigation is an

absolute certainty

The big reason we’re in danger is the policies of

our government

The USA needs an innovation policy as a

national bipartisan strategy



Gary Shapiro transcriptMaguire: Hi Gary, I’d like you to address the key themes in your book The Comeback. One is the issues or aspects of innovation in the US, and what are the threats to competitiveness from competition overseas, and some of the prescriptions in innovation, regulation and spectrum, which are aspects we’ve not covered in our report. What are the value and threats to innovation?

Shapiro: Well, we start with the premise that every nation, every company, every individual, every entity should have a strategy. And the US strategy in the last century has been focused on innovation. It’s part because it’s what we’re good at; genetically, most people came here directly, or through their parents or grandparents or other generations for a better life. We are a heterogeneous society. We welcome different viewpoints; we push back against the status quo. We have a first amendment, which protects new ideas.

We have a questioning society. Our kids, as President Obama said in the State of the Union address, they are taught to ask questions. We’re the only developed country in the world where failure in business is actually a plus. Because you learn from your failures much more than you learn from your successes. So we have the basic ingredients for innovation. And innovation is something which requires great mind power and requires the ability to think differently. When I deal with Asian cultures, there’s tremendous groupthink. It’s very difficult to get new ideas through. You’re rewarded for going along rather than thinking differently.

So that is who we are - and because of that, we have virtually every major internet company in the world based here - or is what other companies are based on. We have companies like Apple and Intel and Qualcomm; they are great leaders. And we also have leaders in Biotech and in other creative fields, whether it be the motion industry or in publishing or writing, in so many other areas. Even like Dreamworks, where you have great amounts of creativity combined with computing, we’re clearly leading the world. That’s all good and we’re positioned right, but what has made us good is we’ve attracted the best and the brightest, who want to come here.

But since 11 September, we seem to have shifted strategies rather radically so we seem to have discouraged high-quality immigration, forcing companies to go overseas. We have the highest

corporate tax rate in the developed world. If our companies were to hire the best and the brightest, therefore, they’re encouraged in a sense to go overseas and invest overseas to get at those bright people, based on our tax structure and immigration policy. Plus our deficit, to me, is a huge threat that obviously Congress and the president have now recognized as something that deserves action in the long term because with the deficit comes inflation and higher taxes and come many things, which discourage innovation.

So what we need for an innovation policy is one that focuses on innovation as a national bipartisan strategy; it requires immigration of the best and the brightest and entrepreneurs. It requires free trade; we haven’t entered into a trade agreement in five years. We’re the only developed country not to have signed a trade agreement. And so we’re paying higher tariffs than our competitors and exports in almost everything. We also have to address our tax structure and, of course, a lot of innovation is tied around spectrum.

Spectrum is the mother’s milk for a lot of innovation, especially recently. If you look at a lot of our companies, whether they be in social media or content or different platforms, it is all about where we are in innovation and creating new jobs - the growth area of the economy. I just came from a lengthy meeting this morning with Chairman of the FCC and he was talking about the need for additional spectrum - wireless broadband. The fact that we are soon hitting a challenging time, especially in certain areas of the country, where we simply just don’t have enough spectrum to make our devices work. A smartphone, which is now used by half of the population, uses 25 times the data that a phone did just five years ago. A tablet PC, like the iPad, uses up to over a 120 times the data stream of a regular phone.

So we don’t have enough spectrum right now to serve this burgeoning area. And there are two types of spectrum; there’s spectrum which can be bought and sold and licensed spectrum and unlicensed spectrum. Both of those are very important for our future. In the short term, all eyes are looking at the Super Committee with the December deadline. We’re hoping that they will make the auction of spectrum - incentive auctions, voluntary incentive auctions, as part of the deal. We’ll know by December. If not, I am sure that Congress will turn to spectrum to survive for some short-term funding need, whether it’s helping refund FEMA for the billion of dollars they



need, which isn’t funded because they’re out of money and we have lots of disasters. Or for something else that comes up where they need an offset. Republicans in the House definitely need an offset. So, additional spectrum will be auctioned off in the next several years and be implemented several years after that. Broadcasters are seeking protections with a bunch of deceptive ads, but that spectrum is very important for our future and for innovation to use our products.

Maguire: What do you see as the primary obstacles towards adopting more innovation-friendly national policies? It seems there are a lot of entrenched interests that have to be addressed, particularly around tax policy and labor laws. But also this idea of companies being too big to fail or not allowing businesses to fail seems to be another issue.

Shapiro: Well, we have a lot working against business in the country at the moment, and never before in my lifetime has there been more anti-business attitude that comes from the top. President Obama always talks about green business and he clearly has an anti-employer bias. Take what the NLRB has just done. Not only with Boeing, but what they did last week; where now every employer in the country, with some minor exceptions, has to post a notice that their workers have a right to unionize.

The fact is that we have Sarbanes-Oxley out there, which makes it very difficult to go public. If it’s very difficult to go public, and expensive to go public, you’re less likely to raise money to start a company. The fact that we have a surplus of lawyers here that are litigation-happy, too; so, if you are a public company, you are certain to face a lawsuit. It’s not a question of if, it’s a certainty. We have a litigation atmosphere. We have a million-surplus lawyers, and the law schools keep churning them out because, as a recent series of articles in the New York Times has pointed out, it’s profitable for universities to do so.

Our phenomenal economic growth for the last century has basically allowed us to become fat and lazy and paper over a lot of luxuries we can no longer afford. We can’t afford the lawyers we have in this litigious environment. The anti-business sentiment, the anti-employer sentiment, the fact that our taxes are biased against business startups - we need a new approach that recognizes what our strategies are and which works around an innovation strategy.

So right now, it’s a very challenging time for this country. We started talking about these things a couple years ago in our Innovation Movement. There’s been a national shift and a lot of the themes that we raised two years ago are now part of the national discussion whether it’s the deficit, or what I call strategic immigration or even trade policy - President Obama claims to want to pass these three free trade agreements. He wants to double exports or even how we’re treating tax policy and other things; it’s positive signs.

So at the same time we have an administration machine, which is full of people that just seem to be on a mission to destroy the business environment. For some reason, they say they want jobs but hate employers. So it’s a very challenging time and it’s a time for Americans to focus on what kind of future they want for their children. Do we want to look like Europe and have slow growth with guaranteed social programs? A lack of innovation frankly; there’s not a lot coming out of Europe. Or do we want to look like the US we know we can be, leading the world in innovation?

Maguire: You’ve mentioned some fundamental points about the role innovation plays in fueling economic growth. I guess as a counterweight to some of the regulatory headwinds, we also have a lot of technological accelerators; the rise of open-source software and web services.

From where you sit, there seem to be fewer barriers to entry for startups right now, leaving aside sort of capital and regulatory issues. As someone who’s watched the consumer electronics industry evolve over the last 20 years, what do you see over the next five years to potential growth for the industry if something doesn’t happen to really change some of these arduous regulations? Do you think we’ll start to see a replication of venture capital in other countries to a similar extent?

Shapiro: Well, first of all, we’ve seen it. Thirty years ago, all of venture capital was in the United States. Now it’s less than 50%. We’re seeing the major merchant banks and investors looking abroad more, going to China, going elsewhere in terms of investment, which is natural in a sense: you follow the money. This is a difficult psychology thing. We are the slower-growth country now. We’re looking at 1% growth even though Congress and the president assume in their budgeting phenomenally higher growth, double or triple or what the real rate is in all their budgeting.



The situation is much worse than it appears in the US. So, which is why there should be even more. In a way, I am sympathetic with the Tea Party in that they understand the ramifications of the deficit. They have some sense of the fact that state pension liabilities - all of the state pensions are assuming an 8% return now, which is an unrealistic assumption. They’re basing them on historical averages, but I think it’s safe to ask whether the historical averages will be around.

You have 50 states, which are heading towards fiscal instability in the next 10-30 years. You have the federal government, which if interest rates increase, we’d just be paying our interest payments. You have unsustainable entitlement programs, which have to be addressed, and this will play out a little bit in the next few months. So you start out by saying - I should have started with - we have three choices now with our deficit: we can cut spending, we can grow revenue (raise taxes), or we can grow the economy.

Economic growth comes from higher efficiencies through innovation, it comes from exports and it comes from innovation. All three of those are about innovation except arguably about exports - you could not be innovative, but just by getting rid of tariffs, therefore, we can increase. So you can talk about cutting spending and about raising taxes and those are all necessarily entitled, but the third point, which is very important to economic growth, is higher percentage growth, and that’s the goal here. That’s what innovation is about - higher economic growth - because growth covers a lot of the other sins. And if you go to a higher growth, you achieve 4 or 5% growth for the next five to 10 years, some of the tax and other cutting-spending problems actually become radically diminished.

So, economic growth requires innovation, and innovation is coming in largely from biotech, tech and nanotechnology. I guess they all have the word tech. Of course, governments can be innovative, Starbucks is innovative. There are all sorts of ways of exporting innovation or creating innovation. And my definition is: it is innovative if someone’s willing to pay for it. Governments can obviously be innovative in how they deal with their constituencies. But putting government aside, what has to happen in business is to create an environment for startups. Now, we have done that in a sense that we still have at the higher incomes lower tax rates, so people want to emigrate and invest here.

We still have a phenomenal university system, which we are exporting in a sense - graduate level education. We are getting the best and the brightest from some level to come to the United States; we have to get them to stay here. And we have to keep our university system up; and not necessarily by throwing more money at them, but we have to recognize that is part of our strategy. But we also have pockets of innovation around the country believe it or not: Omaha, Nebraska, has a pocket of internet innovators; and obviously New York, Silicon Valley, Northern Virginia, Maryland for Biotech. We have pockets, which kind of feed on themselves and they grow.

And we have a society and infrastructure, even Wall Street, that still is positive towards innovation and entrepreneurship. At CEA, we have a wireless fund - an ETF essentially. We have the ability to actually start funds for these things. The US is a great leader in finance and investment and entrepreneurship. It’s a good thing. There are a lot of good things that are happening. I don’t want to downplay everything, but we have a lot of things working against us. And the object is to focus on the good things and remove the barriers whether it be litigation, trade, deficit and taxes.

Maguire: I want to quickly switch gears. You made a point in your book about the constitution providing the basis for monetizing intellectual property and the patent system that we’ve had, which has been really critical. You talked about the VCR wars and changes in the music business. But recently, patent litigation has become quite top of mind, particularly around the mobile O/S world. I would love to get your perspective on what the strengths are of our current system, but also with an increased emphasis on litigation, which frankly may be as much a reflection of a slower-growth environment as anything else. What implications may this have for fostering innovation going forward?

Shapiro: Well, the patent issue is very difficult. The strength is, obviously, we have a good patent system, and we have smart patent examiners for the most part. We have an infrastructure. You know obviously it’d be nice if we harmonized with the rest of the world whether it is first to file or first to invent. We have a runaway district in Texas where all the patent litigation occurs.

And we have differences depending on what kind of technology you’re talking about. If you’re talking about biotechnology, the patent laws are pretty



much okay. You talk about a drug for example. One patent covers it. You talk about the smartphone though, the concept could be a thousand patents embedded in that phone. And part of a country that’s built up on rule of law is in the fundamental rights you should have as an individual or corporation is to know when you are breaking the law - when you are interfering on someone else’s property. In some way, the patent system has gotten a little complex in the technology - where you don’t know if you are violating existing patents. We know it with drugs and biotech - you don’t know it in electronics. There’s an absence of certainty, which has been crippling, especially for smaller companies.

The larger companies - some would argue that Motorola is being acquired largely because of patents. The Microsoft-Nortel patent purchase. You’re starting to buy companies for their patent pools and you’re doing this defensively - not even offensively. You need something to negotiate with. It used to be that you had a lot of patents, but every technology company as a matter of course cross-licensed.

And then you have the issue of trolls. And, obviously, to me trolls are not a good thing because you’re basically buying patents that are not being exploited with products. And the answer is an easy one: you should have products that unless the patent is being used and put into production, the level of responsibility should go up, the damages should go up. The damages should not be high. And there are huge issues there where you’re blocking production of a product that may have a thousand different patents potentially that it’s covering because one patent is claimed. It could be devastating.

So a common frustration in our companies that I hear about all the time is that patent litigation is an absolute certainty; it’s expensive, it’s unclear and that’s not a healthy system. So we definitely have to do something to change that. Now, the troll world has put on a vigorous fight, saying they’re hiding behind the small inventor, they’ve got the traction of Congress, legislation is moving along. And the legislation is kind of like “we’ll do some good” but by no account does it solve the patent issues that we face. And those issues are harmful to the extent that they don’t allow new entrants to a market.

Do I lose sleep over the fact that Intel, Nokia or Qualcomm, or Apple or others are facing patent litigation? No, I don’t lose sleep because they’re big boys and they have big patent pools. When patents

become unknown or unknowable or unclear, patents become a barrier to entry, we’ve reached a problem point in society. So you should know what it costs to get into business. And you don’t want to limit opportunity.

Our whole association of 2,000 companies including the big boys is based upon the premise that we need the small entrepreneurs to come on. We do it how we run our trade show the International CES® - anyone with an idea can expose it for a few thousand dollars. Potential investors, retailers, media, people like that can see their ideas - that’s how we run our events and how we do what we do. Eighty percent of our companies are small business and that’s very important to us. And the patent system is now working against entrepreneurs being able to do things. Certainly you can do things on the online world.

After the internet world we have new opportunities. Never before - with a computer and an internet connection you can be an entrepreneur. And that’s a lot of the growth now in what we’re seeing in Silicon Valley and in a lot of the social-media startups - in LinkedIn and even Pandora and others recently going public. Even going back to the young life of Facebook, it just doesn’t take a lot to start a fast-growth international company, which is unprecedented in the history of the world. You can have an international company almost overnight for a very small investment. But what we do have, once you get out of the software realm, even though there are patents affecting software and shopping carts and things like that, you do have an issue that patents are starting to restrict the level of innovation.

Maguire: With the issue of process rather than a widget for an instance. Patenting a process is, I think, behind a lot of the issues with some of these weak software products and weak software patents. What I hear as well from startups that have been approached by patent trolls early on and that can sink startups.

Shapiro: Right, startups can’t afford lawyers to fight these things. It’s just a fact. And also funders run away when they hear there’s potential litigation. So it’s not in the national interest to have this; patents are totally essential, but they should be clear. You should understand if you’re violating them or not. And right now, it’s gotten beyond anyone’s level of comprehending whether to know you’re violating the patent.



I don’t know the answer - you talk about loser pays. You definitely have to get out of that Texas district. Definitely, the Patent and Trademark Office needs more money; they should be allowed to keep it, which is, believe it or not, a political issue in Congress. Because Congress is used to saying who gets what money and they don’t want to give it up. It’s an unhealthy system right now - it’s not in the strategic long-term interest of the nation to put a chokehold on companies where they don’t know whether they’re violating the law. Companies have a right to know if they’re violating the law.

Maguire: One final point we’d like to wrap up on relates to the Innovation Movement you’ve alluded to, which at least has been raising a lot of awareness on exactly the obstacles you’ve described. Could you just provide a bit of color at least in terms of some of the progress you’re seeing in raising awareness and addressing some of these challenges head on?

Shapiro: Well, what I don’t say in the book, but what I started to say publicly in speeches, is that the truth is that our board (the leaders of the technology industry) agreed on the most important thing for the success of the technology industry in the United States. This is my mandate as head of the Consumer Electronics Association in the US market, although our trade show is definitely international with 30,000 people from abroad.

Our industry in the United States, when I was asked a question at a board meeting a few years ago: What is our biggest threat? The bottom line was the health of the US economy. The US economy, our board agreed unanimously, is in danger in the next five- to 10-year period. And the big reason we’re in danger is the policies of our government - it’s as simple as that. So, we basically agreed that that was what we’d focus on. We didn’t support the stimulus plan, we didn’t support the bailouts. We didn’t support Cash for Clunkers, or first-time home buyers. We’re the only

association I’m aware of that supported the bipartisan deficit commission’s recommendations. And we have never asked for a penny from the government. So our focus has been on getting the US economy back in a healthy way through government policy that makes sense for entrepreneurs in innovation.

We created an Innovation Movement, which has attracted over a hundred thousand people. And get other Americans focused on it. Basically, that’s what we’re doing. In my view, business leaders have a big shot at standing up now and speaking out about these issues and putting innovation on the national agenda. And they have. In fact when President Obama gave his state of the union address, 80% of it was the things I was talking about and it could have been called innovation and the American Dream. But then, of course, he prescribed the whole ways of new government spending, which is something we would not support.

But the bottom line is: innovation has now become bipartisan. The Republican internet task force has embraced innovation as a major item including all of the things I’m talking about. And Democrats have definitely given lip service to some of these things whether it be free trade, strategic immigration and cutting the deficit and spectrum. So, we saw a bill come out of the Senate that helps on the spectrum issue in a bipartisan way; we expect something in the House in the next month or two. And the budget committee, we’re hoping will be part of it. So virtually every major plank that we’ve raised is now being addressed as part of the national agenda. But I think from a business-leader perspective, which I assume is your audience, business leaders have to step up.

Maguire: Absolutely. We’re starting to see some of it now, but that’s absolutely a lot of hard road ahead. But I think the message is certainly beginning to resonate.



Dane Stangler, Kauffman Foundation Dane Stangler is a director at the Ewing Marion Kauffman Foundation. In this capacity, he provides research and writing on a wide variety of subjects, including entrepreneurship, expeditionary economics and cities. He initiated and manages the Kauffman Foundation Research Series on Firm Formation and Economic Growth and contributes to the blog, Growthology. He also advises the Foundation’s president on matters relating to strategy and programming, and represents the Foundation at meetings and conferences around the country. Dane earned a Bachelor’s degree in English from Truman State University and a JD from the University of Wisconsin-Madison.

The Kauffman Foundation has proposed The Startup Act, a set of proposals that are intended to improve the environment for entrepreneurs. Specific policy changes the Startup Act proposes include:

Lowering barriers for immigrants capable of building high-growth companies by providing “Entrepreneurs’ visas” and green cards for potential immigrants with science, technology, engineering and math (STEM) degrees.

Providing fiscal reforms that would benefit financing for growing companies, including capital-gains tax exemptions for long-held startup investments, tax incentives for startup operating capital and an optional exemption for Sarbanes-Oxley compliance for companies under US$1bn in market cap.

The creation of differential patent fees to reduce patent backlog and provide academic innovators more licensing freedom.

Introduce an automatic 10-year sunset for all major rules, establish standards for regulations and provide periodic assessments of state and local business policies.

Key points from conference call Some universities are very good at commercializing and helping bring

innovations into the market place, but most are not. Commercializing university innovations is a key area for improvement.

There's no such thing as a free lunch in economics, except for immigrant entrepreneurs. One of the focuses of the Startup Act is to lower barriers for immigrant entrepreneurs.

One area that deserves a lot more attention that has an invisible effect on innovation and commercialization of innovation is state and local (particularly local) regulations, not necessarily taxes but rules on zoning and land use law.

The real issue for startups and growing companies is capital gains - this tends to get blurred in a lot of tax policy and risk.

Dane is a director at the Ewing Marion Kauffman

Foundation

The Startup Act: A set of proposals intended to

improve the environment for entrepreneurs

Commercializing university innovations is a key area for improvement

Capital gains are a real issue for startups and

growing companies



Dane Stangler transcriptMaguire: I’ve been intrigued by what Kauffman has been doing around innovation, in particular some of your proposals to stimulate innovation, what you have identified as some of the obstacles in innovation and some of the prescriptive measures that we can take in the US to try to restore some of the vibrancy to our startups and our entrepreneurial culture.

Stangler: My specific role here is working in the Research and Policy department - half of the foundation is devoted to education and the other half is devoted to entrepreneurship and there's a lot of integration across those. Basically our Research and Policy department falls into two broad modes of operating. One is because we're a foundation, we do lots of research and to varying degrees and we work closely or not closely with researchers; sometimes we publish their stuff, sometimes they publish it elsewhere. So, we've learned a lot in that stuff, keeping abreast in their research. We also have a semi-large but growing in-house research capacity. We own and operate a longitudinal database of firms; the Kauffman firm survey that's been going since 2004 and it was a database of about 5,000 firms, now down to about 2,700, but that database is a platform that Kauffman has that any other researchers can use.

We also increasingly do, as you probably have seen more and more, a lot of research and publishing ourselves. So a lot of policy recommendations, a lot of research trying to figure out how to better measure entrepreneurship because it’s a floating target, and then to better quantify and understand the link between entrepreneurship and innovation and economic growth. That's a very broad overview.

Maguire: So you are looking to quantify the impact of startup culture and entrepreneurial culture on driving innovation and from our conversation it's imperative that entrepreneurship is really an outgrowth of or it's closely related with innovation. That's usually the reason they come up with an idea for a new company because they can do something better, more efficiently and faster. In quantifying the impact on the broader economy, how would you characterize how easy it is in the US for an innovator or someone with an innovative idea to realizing and bringing an idea into fruition?

Stangler: We do a lot of work and have a substantial amount of energy devoted to the personalization of innovation at the university. And we've worked on this for a number of years. We first identified it as a choke point in the system where

you get lots of research that's being done at universities off of innovation being developed.

Some universities are very good at commercializing and putting them out in the market place; most universities are not. And one of the choke points we identified and did a lot of research and work on was both how research and innovation are treated in the universities, but also the technology transfer or the technology licensees process was really a blocking point, a blockage.

We've done a ton of work on the importance of university innovations, on how they do or don't get out into the marketplace. That would be one place where it's not exactly easy for an innovator should they want to pursue it in a commercial sense, to actually do it whether it's licensing it or starting a company around it. In a broader sense, in a comparative way, I think the US is probably easier than a lot of other countries to develop an idea and incorporate a company or whatever. I think, again, there's sort of that venture depending where you are

Maguire: Some of the work you've done has been focused on legal reform and around the rules for growth and publications that has a lot of ideas there. Could you walk us through the primary areas of focus where your research has led you to believe we could get the most beneficial impact from making changes in legal reform?

Stangler: One of the chapters that has been devoted to university technology transfer and another big thing that we have focused on is immigration of entrepreneurs. As you know, there's no such thing as a free lunch in economics, except for immigrant entrepreneurs and this is it. The US has always been welcoming, but there have been lots of hurdles put up and so we focus a lot of attention on that. One of the things that I was surprised at in the Rules for Growth, that deserves a lot more attention and has an invisible affect on innovation and commercialization of innovation are state and local (particularly local) regulations, not necessarily taxes but rules on zoning and land use law.

It's not the first thing you would think of in terms of innovation, because it would seem like there's no direct correlation. But when you talk to people who are actually in research and innovation and trying to start a company, this is a real issue for them. The rules are so valuable in calling attention to that something we wouldn't normally think of, but there's a lot more research to be done there.



Maguire: So, the message is state and local governments may have instituted restrictive zoning laws or use cases that unintentionally make it difficult for startups to operate and find the places to do business - and that's more out of a lack of awareness than a deliberate strategy?

Stangler: I don't think any land use restrictions are put in place to deliberately quash innovation, but I could be wrong. Usually, it's the general story of people trying to protect the existing assets of their existing value but having the unintended effect of squashing new entries.

Maguire: Following on with that, the Startup Act is intriguing because I think you've distilled, or the Kauffman Foundation has distilled, a number of key points floating around there. After speaking with Gary Shapiro about his book, the Comeback, I would appreciate if you could walk through some key points and recommendations of the Startup Act because it really goes to the heart of the obstacles that are standing in front of capital and value creation in the US.

Stangler: This is getting a lot more attention now from both sides of the political aisle, which is good news. This tends to get wrapped in emotional debates over illegal immigration, which is unfortunate, but that was one of our leading recommendations.

Maguire: Another would be the idea of improving access to early-stage financing and creating capital gains tax exemptions for startup investments as well as the exemptions for market caps on Sarbanes-Oxley. Have you been able to quantify how much of a drag that's been on value creation for entrepreneurs? And what do you believe the benefits might be of some more favorable tax treatment for long-term capital gains for startups?

Stangler: Right, when you're talking about taxes . . . here's another instance in which issues around startups get wrapped in broader debates. But when we talk about taxes in the US, most people talk about income taxes.

I'm not convinced that income taxes are much of a concern to someone who’s just starting a business. First of all, they're all different and second of all they don't have much income. Their goal is to get to higher tax brackets. But the fact that someday they may face 35% of their income taxes is not going dissuade someone from not starting a company.

The real issue for startups and growing companies is capital gains, so this tends to get blurred in a lot of tax policy and risk; that's why we specifically called that out. Especially for investors, this is when you're seeing the rewards being raised for founders and investors. Because it's the primary form of your payout or cash-out; that's why we typically called out capital gains taxes and put a lot of attention to income taxes.

On the regulatory front, again, I'm not convinced Sarbanes-Oxley is a barrier to someone when they are deciding to start a company. It's probably not a barrier - definitely. But the issue here is not just new companies, but the growth of those companies. You'll increasingly find that startups are important for all sorts of quantitative and qualitative reasons.

We're talking about job creation, we're talking about innovation, we're talking about growing companies, and not exclusively high-growth companies because there's not a lot we know yet about high-growth companies. But firms add jobs and grow revenue and for those that we want more of, regulations and taxes could be hugely important. It's simultaneously trying to make those policy recommendations and also trying to recognize the distinction between the types of companies. A lot of that stuff gets swirled up in either just one word, “startups,” or one word, “small business or high-growth,” without people knowing what types of companies are high-growth.

Maguire: One other interesting point of this proposal is the idea of having an automatic tenure sunset for legislation, which as I think about certain laws of the US like the AMT that require and automatic re-certification. This sounds pretty simple, but it could be potentially a highly consequential change to our legal system.

Stangler: Yes, that’s true. Part of the motivation behind the Startup Act was motivated by everything that is going on or has not been going on at the federal level in Washington. No one has been able to come to an agreement on anything and has been coming to a budget impasse every few months. When you're in an environment like that, that's not really conducive to either smart policy making and regulatory oversight in the first place, and also totally not conducive to revisiting any regulations that may have become a burden or may be just irrelevant to the entire motivations behind the startup - what can we do to boost innovation and entrepreneurship without adding to the deficit at low cost?



But specific to the sunset recommendation, there's definitely the sense a lot of people share that now we have to build in these mechanisms to force ourselves to revisit things. With an economy that's changing a million times faster than anyone in Washington can keep up with, this is one way to automatically force ourselves to revisit these issues. And yes, you're right it could be a huge change, but do we want to continue with the current way of doing things? It just seems kind of ridiculous.

Maguire: There's no one on the planet who can memorize much less comprehend hundreds of thousands of pages of federal code. It's gotten so

overwhelming. Clearly, the motivation of government is to create laws and that's their reason for being.

Stangler: I don't have to tell you that in a lot of cases, not all, but in my mind, the impetus for a certain law - a lot of the times you find the motivation to protect their position. It's absolutely not the case that all businesses are opposed to all regulations. There are a lot of businesses that want regulations that prevent them from having to face new competitors, so it's another motivation forcing ourselves to revisit these things. Let's make room for new entrants.



Stephen Trilling, Symantec Stephen Trilling is the chief technology officer at Symantec. In this role, Stephen, a 16-year veteran at the company, is responsible for developing the overall technology vision for the company, driving cross-company engineering initiatives and collaboration, and overseeing Symantec’s shared engineering organizations. The CTO organization includes Security Technology and Response, Symantec Research Labs, Product Security, Standards as well as the Shared Engineering Services division that comprises product localization, user experience, product certification and shared engineering tools.

Prior to transitioning to the CTO role, Stephen served as senior vice president of Symantec’s Security Technology and Response (STAR) division. STAR is a worldwide team of security engineers, threat analysts and researchers that provides the underlying functionality, threat expertise and security content for all of Symantec’s enterprise and consumer-security products. Under Stephen’s leadership, Symantec’s security products consistently achieved top protection ratings in independent reviews, winning such awards as the AV-Comparatives Product of the Year Award and the Wall Street Journal’s Technology Innovation Award. Stephen also oversaw the development by the STAR team of Symantec’s award-winning Insight technology, a transformational protection capability that leverages the wisdom of hundreds of millions of Symantec users to automatically compute security ratings for virtually every software file on the planet. Insight, now incorporated in all of the company’s endpoint security products, enables Symantec to identify and block even the most complex malware and targeted attacks without traditional virus fingerprints.

Prior to his role leading STAR, Stephen was the founder and vice president of Symantec Research Labs, the company’s advanced research division. During his tenure at Symantec Research Labs, the team researched, prototyped and collaborated to commercialize numerous new technologies across all of Symantec’s security and availability business areas. These innovations have collectively impacted hundreds of millions of Symantec customers.

Stephen has represented Symantec publicly on numerous national television and radio programs, including “Good Morning America”, “The Today Show,” and “60 Minutes.” He has published a number of papers on security-related issues and has also testified before the United States Congress. He is also a member of the Dean’s Advisory Council for the UCLA Henry Samueli School of Engineering and Applied Science.

Stephen holds a BS in Computer Science and Mathematics from Yale University and an MS in Computer Science from the Massachusetts Institute of Technology.

As CTO, Stephen is responsible for the overall

technology vision of Symantec

Innovation from Symantec Research Labs

has impacted hundreds of millions of customers

Stephen has represented Symantec on numerous national television and

radio programs



Summary of call with Stephen Trilling Perspectives on innovation Compared to Microsoft and IBM, Symantec is focused on innovation that is going to have impact. The company doesn’t conduct purely academic research, rather R&D with a high likelihood of impacting products and ultimately customers. Microsoft or IBM research puts a lot of effort into blue sky or academic-style research. Symantec tends to do open innovation and has strong ties to universities.

The company has direct sponsorships and a fellowship program, making data and other assets available to universities and other partners for open-collaborative research to help with a balanced portfolio. Its internal R&D tends to be focused on how it is going to have market impact. The company does not always focus on what’s being requested, but what is expected to be actually needed.

Customers, if asked what the biggest problem is, actually won’t tell the problem, they’ll tell what they think the solution is. In the data-protection space, if you talked to customers five or six years ago, they’d say they wanted bigger tape units, faster tape drives and bigger robots for managing their tape arrays. Symantec realized that the real answer wasn’t making better tape solutions, it was moving to disk-based data protection. At the time when customers would look at this, the economics weren’t there yet. But looking at where the trajectories were going for storage costs and tape costs, all the new data that were being created made it practical over time.

How Symantec determines what to prioritize Disruptive innovation gets probably 90% of the mind share when talking about innovation and it’s actually a very small part of the true innovation that gets done by the industry. But that’s what you hear about, but almost by definition disruptive innovations are few and far between.

Symantec’s bread and butter is not disruptive innovation. It’s core innovation that makes products better on a day-by-day basis, things that make products faster, things that make security products that much more secure in finding and remediating more malware.

When Stephen Trilling ran the research labs four or five years ago, he started a project with key researchers called reputation-based security, which is hugely disruptive, not only in a sense that it turns the table on the attackers, but is disruptive to competitors. Symantec stopped playing the game the way that everybody was playing it, and built an infrastructure, set of technologies and operations that would allow us to do things in a completely new way. So that’s really a major innovation.

Symantec has to do both - but that type of innovation, scale, scope and something like reputation, frankly there are fewer of those and they’re riskier. The company had a really good feeling about reputation, but the difference between having the “a-ha” moment - “hey, there’s a great idea!” - and taking that to something that operates on the scale that it does today (eg, hundreds of millions of machines and billions of pieces of data in a very large data environment), it is a risky endeavor. It’s not something that Symantec takes on lightly, but in this case the company recognized the value that it would bring as a competitive lever and to customers.

Focusing on innovation that is going to

have impact

Disruptive innovation gets probably 90% of

the mind share

Reputation-based security is hugely disruptive



How Symantec prioritizes projects Symantec has some activities that are top-down driven, a corporate strategy that translates to a technology strategy supporting the corporation, and vision that has direct implications on existing and new products. Some of it is very top-down driven and of course the corporate strategy comes from competitive analysis and market research (primary and secondary research in terms of where the markets are going).

An example is Symantec’s Ozone (O3) project, which follows that exact top-down-driven model. It’s driven from analysis of where the world is going in terms of the cloud and inhibitors for the adoption of cloud technology. What Symantec can do to secure and enhance the adoptability of the cloud will make it possible for companies to really feel safe in moving to a cloud-based world.

Symantec is also more tactical on a product-by-product basis. Market-leading products like the Data Loss Prevention product are doing very well and something the company wants to continue investing in, creating an even bigger margin from the competition. Symantec puts significant resources into enhancing the way the product works and the way that it detects sensitive information to keep it from leaving the company.

The company also has core innovation investments that are always continuing with every product release in every cycle. As part of his CTO office, Stephen is responsible for another organization, the Security Technology and Response organization (STAR) that creates all of the technologies that go into our security products. Consumer and enterprise products are creating core technologies.

Because Symantec is expected to have the best products and the best technology, there is a baseline innovation investment where the company is always innovating regardless of incremental activities or new areas. It is a mix of top-down, strategy-driven, tactical product focus.

Deciding whether to build or buy Vontu was a great example of whether to build or buy. That’s the case where the company really needed to be in that business protecting customers from data loss. Independent of Vontu, Symantec put together a program to develop in-house technology for data loss prevention. At the same time, in parallel with that project, M&A and business development looked at what was going on in the marketplace, what it would take to be competitive, who the players were, what the penetration was, the uptake and so on. The decision was to acquire Vontu to accelerate the growth curve, even though there was some great technology in house.

The CTO office and the research labs are often involved in acquisition decisions, both in helping to understand from a base level where the company ought to be looking and in the due diligence process to understand all the real players out there. To do that, Symantec has to have a knowledge base of our own in order to evaluate properly and actually built up some expertise that helped in that evaluation. Once Vontu was in house, it turns out the internal technology was very good and complementary and was rolled into the Vontu technology. Build and buy don’t always end up being mutually exclusive.

Top-down driven activities

Symantec is also more tactical on a product-by-

product basis

Vontu was a great example of whether

to build or buy



How Symantec managed the very large merger with Veritas Any merger of such a large scale is always hard and that’s true in R&D and every other aspect. One of the keys for the integration was really coming to an understanding of both cultures, and understanding where it made sense to merge and harmonize on one approach versus the areas where it really made sense. At an extremely high level, the legacy of Veritas business and its R&D culture was akin to NASA; they’re building things that cannot fail. They’re building technology that’s going to go out into the world, or in NASA’s case out into space. They have to operate it on a phone and people’s businesses are dependent. If it goes down, they’re in serious trouble. Symantec was more like the FBI. Those are the folks who will go to any lengths and take any and all measures to keep people safe. And when you think about it that way, there are core things that are very common between the organizations. And there are some things where they are just different.

Within the research organization, which serves all of the different business areas, Symantec has to keep that in mind in terms of the kinds of research projects to undertake and the primary benefits in those projects. Ultimately, in finding the areas of synergy, a big part was figuring out the drivers for each of these organizations and the areas where they will naturally overlap.

Symantec went through a number of things that sounded good on paper in terms of synergies and overlaps where, frankly, they weren’t the right things to do. It took a while to figure out the areas where Symantec really got tremendous benefit from having both R&D organizations in the same company and areas where they had different goals.

Smaller acquisitions are much more typical Symantec recently acquired Clearwell. This was more a traditional type of acquisition where the company has a natural home in existing businesses. Symantec has a whole integration checklist that isn’t just R&D; it’s all of the things the company needs to do to integrate a new business including R&D components. One of the first things that happens is Stephen Trilling gets on the phone to the CTO of the new business to start setting up technology exchanges.

Symantec starts learning much more in detail about the technologies, underlying products and services, letting them know more about the technologies available in the rest of Symantec. When Symantec buys companies, newly acquired firms think, ‘We’ve got access to this big sales force, we can finally go global, they have all of the reach.’ For technologists who come in, it usually takes them a while, but then they realize the treasure trove of technology that’s part of Symantec - all of that is available for them to use either in products or to integrate within products. In the smaller acquisitions, that’s much easier than it was in the Veritas case.

How Symantec uses cloud computing and virtualization Two innovations that have been important are large-scale internal clouds and formulated very closely is big data tools including machine learning. The second is machine-learning technologies. Reputation work would not have been possible without the advent of large-scale clustered computing, private cloud computing and big data technology. It’s beyond the scale that Symantec would’ve considered doing a few years back.

Any merger of a large scale is always hard, and

that’s true in the R&D and every other aspect

Symantec recently acquired Clearwell,

a more traditional type of acquisition

Important innovations are internal clouds and

machine-learning technologies



Symantec has had such good success with this big data model that the security, technology and response organization built a framework. The Symantec data analytics platform is not only for reputation-based technology, but now for a number of other new technologies that will also be based off a big data cloud analytics model.

This is a game-changer because it means that not all the computation has to happen on the end computing device. When thinking about adding iPhones, iPads and other tablets to the mix, it is helpful to offload heavy compute into the cloud.

The other key technology is machine learning. Eighty percent of the portfolio of research projects within Symantec’s research labs has a machine-learning component. It’s becoming extremely important to a lot of the businesses Symantec is in; there are obvious uses in the security space, detecting patterns, being able to make decisions automatically.

It’s important in computing or security, but also really important in storage as well. For example, big storage systems need to optimize performance of the system based on patterns of usage, how hot certain pieces of information are. Machine learning ends up being a fundamental color for that. Symantec built a lot of expertise; the research labs across the STAR organization are applying approaches to machine learning across technologies.

Customers looking at public and private clouds In terms of the cloud from a security perspective, Symantec is talking with people moving to public clouds and out to private clouds. When the company started looking at how to leverage a back-end service for security, it was really an advance of a big migration seen over the last few years.

Symantec was solving a slightly different problem. There are billions of files on the internet. Most threats are only on a couple of people’s machines in the world because they are created by a server. You go to a website, you might get infected with one threat and your colleague might go to the same website later and get infected with a different threat. Somebody else can go to the same site five minutes later and get infected with a third threat.

Each of those threats requires a different signature - the model simply can’t keep up. So it’s a realization of the idea that a security company would have some sort of cloud-based service. Another happy benefit is that people are migrating to mobile devices; there is a much smaller footprint. Having a service that runs entirely on the backend is a much more efficient way to solve problems on those devices.

Even on a PC, the model of shipping down tens of megabytes of data files every month wasn’t working. The industry/enterprises have generally moved towards a more cloud-based model. For Symantec, it’s really been a game-changer in terms of simply being able to solve the problem given the new threat landscape. It’s one thing to cloud-enable products, but another to actually do something with all that data. It’s been a big data problem requiring a lot of custom technologies. It’s the only way to keep up with the problem, driven by a changing world where the old model simply was not going to work.

Not all the computation has to happen on the end

computing device

A realization of the idea that a security company would have some sort of

cloud-based service

Machine learning is important in computing, security and particularly

storage



Security as a data analytics problem Even beyond the use of cloud and big data for malware prevention, the whole security world is moving more towards ‘how do you find that needle in a haystack,’ rather than ‘how do you analyze those 20 viruses that customers send in a month.’ In the beginning, viruses from customers would come in paper envelopes on floppy disks that would arrive in the mailroom. So that was the world - viruses on Saturdays; no viruses after four o’clock.

Symantec is shipping out 20 to 50 thousand traditional signatures in a day, in addition to one billion rows added to the database for cloud-based security. Data analytics is going to come into play in every part of security one can imagine; forensics, for analyzing logs post-attack to try to find that needle in a haystack that might suggest a breach or figure out which machine was breached or where it came from.

More and more security will be dependent on big data problems; certainly malware protection, but more will come across as targeted attacks. It’s all about taking in massive amounts of data and pinpointing the one thing that tells what happened, when it happened, who it happened to and potentially where the attack came from. That’s a data problem.

IT security requires big scale Symantec can tell you how many attacks per day each of its technologies and security stack stop. It can tell you how many attacks each of our different product sets have, different versions of our consumer product and different versions of our corporate products stop. This is a fine-grained approach. If the number of detections Symantec is seeing from customers on a daily basis changes wildly, there is an immediate feedback loop to figure out what’s going on. Symantec is getting truly real-time data. The volume of threats on a daily basis is astounding. Last year, Symantec detected more than 3 billion attacks in customer machines. Keeping track and knowing how to adjust is a data-mining problem.

Is the signature-based approach just completely outdated? The signatures will never completely go away. In the past, the signature-based approach was a good example of why security companies were really scalable because of massive worms like Melissa and Loveletter. Symantec would write a signature once that would protect millions of customers from millions of threats, which were all the same - they weren’t distinct threats. Millions of emails all had exactly the same Melissa infected document in them - and one signature that one guy created would protect millions of people from millions of infected emails. That’s a really efficient and scalable business.

Now it’s just the opposite. Now there are millions and millions of threats that are each on one machine, so one can never see all of them. Writing millions and millions of signatures just isn’t practical. Signatures will always be there, but the vision is over time that more and more of the intelligence and the security operation will be on the backend.

On integrating hardware and software in a unified solution There is no question the vast majority of threats seen today cannot be handled at the silicon layer because there is needed context only in the operating system. Inside the hardware, one can’t know what the format of a PDF file is, so one can’t look for a PDF buffer overflow through a PDF. Based on all the

Data analytics comes into play in every

part of security

Symantec practices a fine-grained approach

Signatures will never completely go away

Over time more and more of the intelligence and the

security operation will be on the backend



attacks seen today, can expect to see and the kind one can imagine, the bad actors are targeting confidential information/proprietary information.

With the overwhelming majority, one needs the context of operating inside the traditional OS, which means the solution like the one Intel and McAfee have discussed. There’s a security partition that is completely separate from the operating system. Symantec believes the challenge that most customers are having is with the targeted attacks, the attacks on the database, the attacks on intellectual property. And it’s hard to see the direct benefit today of protecting from that on hardware.

Hardware has some benefits. But with software, you’re outside the main operating system; there are certain rootkits and low-level threats to get visibility into. Symantec has tamper resistance to handle all the same rootkits that have been seen. It feels that the vast benefit to customers is still around the attacks where there is some operating system context. Hardware, over time, may give some performance benefits or some function able to embed into the silicon. The security industry and big corporations are most worried about attacks that are caught inside the operating system.

There are a few things that can be done at the silicon level that have more to do with hardware rooted trust, enabling secure identity and adaptation. Those types of things are interesting and will be useful to the industry.

If Symantec is building a product that runs on an appliance, it’s a much more efficient process in a sense - not testing 27 different drivers, different IO cards and massive sets of inner configuration issues. It greatly simplifies things from a development perspective, which means Symantec has more cycles to focus on innovation. From a customer perspective, it’s a similar kind of story. They get the appliance, it does one thing and it does it really well. The administration of it, the feeding of it is a lot similar, so we think the appliances can be really attractive in certain areas and that’s why Symantec is pursuing those as well.

Customers are having most problems with

targeted attacks

With software, you’re outside the main operating system

Building a product that runs on an appliance

is a much more efficient process



Notes

Company profiles US strategy


Company profiles

Amex.............................................................................................. 185

Apple.............................................................................................. 189

Applied Materials............................................................................ 193

BlackRock....................................................................................... 199

Bristol-Myers.................................................................................. 203

Coca-Cola ....................................................................................... 207

Gap................................................................................................. 209

Google............................................................................................ 213

Heinz.............................................................................................. 217

IBM ................................................................................................ 221

Illumina ......................................................................................... 225

Intel ............................................................................................... 229

McDonald’s..................................................................................... 233

Microsoft ........................................................................................ 237

Schlumberger................................................................................. 241

US chemicals .................................................................................. 245

All prices quoted herein are as at close of business 27 October 2011, unless otherwise stated

Company profiles US strategy


Notes

Amex Produced byProduced byProduced by

US$51.81 - BUY

Financials Year to 31 Dec 09A 10A 11CL 12CL 13CLRevenue (US$m) 24,523 27,582 29,290 32,778 34,931Net income (US$m) 2,009 4,081 4,657 4,938 5,535EPS (US$) 1.72 3.36 4.02 4.30 5.00CL/consensus (15) (EPS%) - - 101 101 105EPS growth (% YoY) (30.6) 95.4 19.5 7.0 16.2PE (x) 30.1 15.4 12.9 12.0 10.4Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate

The group of companies that comprise CLSA are affiliates of Credit Agricole Securities (USA) Inc.

Craig Maurer [email protected] (1) 212 408 5923

Matthew O'Neill (1) 212 408 5827

2 November 2011

USA Financial services Reuters AXP.N Bloomberg AXP US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$53.80/38.88 12M price target US$60.00 ±% potential +16% Target set on 6 Jul 11 Shares in issue 1,199.0m Free float (est.) 99.7% Market cap US$61,849m 3M average daily volume US$133.3m Major shareholders

Berkshire Hathaway, Inc. Investment Management 12.7%

Stock performance (%) 1M 3M 12M

Absolute 7.5 (4.4) 27.9 Relative (2.6) 1.9 20.9

34

39

44

49

54

59

64

Oct 09 Jun 10 Feb 11 Oct 11

96

101

106

111

116

121

126

131

Amex (LHS)Rel to 500

(US$) (%)

Source: Bloomberg

www.clsa.com

Horse-drawn wagons to Facebook American Express’ “Link, Like, Love” initiative with Facebook is the most surprising and most innovative cardmember program to emerge from a major player during this period of investment by card issuers and the payments industry. The company is leading its more mainstream network and issuing competitors in embracing social media. The program takes advantage of the unique capabilities of a closed-loop network, while introducing the brand to younger generations who have integrated social networking into their everyday lives.

Truly unique American Express might seem like an unusual choice to include in a report on innovation, but this 160-year-old-plus company has truly stepped up its game as it emerged from the recession - refocused and flush with capital. Its new platform is the first highly developed one that we’ve seen, delivering deals and access based on cardholder’s “Likes” and interests, and represents a significant step ahead of the competition for American Express. Launching this product is indicative of its strategy to go where its customers already are (ie, Facebook) as opposed to building its own destination within the American Express ecosystem, a smart strategy, which we’ve seen MasterCard pursue with its partnership with Google. The platform takes advantage of the company’s closed-loop network, and given the seamless nature of the offers (they are delivered directly via statement credits, avoiding coupons and tedious merchant training), they are highly attractive to American Express cardmembers and merchants. We signed up for the program and immediately took advantage of two offers, Dunkin’ Donuts and the US Open tennis tournament, both strong examples of successful target marketing. Additionally, we believe that this move will help American Express grow its cardmember base, particularly attracting a younger demographic, as existing cardmembers use this program and share their experiences. The company has already amassed more than 2.2m “Likes” on its Facebook page.

How “Link, Like, Love” works A cardmember, upon signing up for the program, will be connected to a personalized dashboard through which American Express can deliver deals, content and experiences based on their Facebook “Likes” and interests, as well as the “Likes” and interests of their friends. Cardmembers will then be able to choose deals that are attractive to them and continue to use their card as they usually do. When cardmembers visit the associated merchant and swipe their card, the offer will be seamlessly delivered to them in the form of a statement credit. To be clear, there will be no coupons to carry or download, and no printout associated with redeeming a deal. Simply swipe the card and receive a statement credit. The company’s capability to deliver real-time statement credits to its proprietary cardholders is an enormous competitive advantage of the closed-loop network, as American Express sees transactional data in real-time as opposed to the delayed reconciliation that takes place with 4-party systems like Visa and MasterCard.

Amex - BUY US strategy


This program is also associated with Foursquare, and when a cardmember checks in at a location with an existing offer, they will receive the value of that offer as if they had selected it through Facebook.

“Go Social” merchant tool Continuing the theme of leveraging social networking, American Express has developed “Go Social.” The tool facilitates a merchant’s ability to easily establish official merchant locations on social networks with just a few clicks, create and manage coupon-less offers that can be redeemed without the need to train staff, and to track campaign results across multiple social networks and locations. It is this sort of seamless integration that merchants seek, and the fact that these offers require no training at the point of sale or physical coupon redemption, is a boon to marketing departments who can develop and deploy offers on the fly.

Figure 1

American Express driver in front of the company’s NYC stables in 1854

Source: Becoming American Express

“Go Social” continues the theme of leveraging

social networking

American Express progresses from horse-

drawn wagons . . .



Figure 2

American Express Facebook page with more than 2m “Likes”

Source: Facebook.com

At launch this past summer, supporting merchants included: 20th Century Fox, Dunkin’ Donuts, Whole Foods Market, Lord & Taylor, Outback Steakhouse, Fleming’s Prime Steakhouse & Wine Bar, Virgin America, Bonefish Grill, H&M, Roy’s Hawaiian Fusion Cuisine, Westin Hotels & Resorts, Carrabba's Italian Grill, Sheraton Hotels & Resorts, Celebrity Cruises, Lenovo, Sports Authority, 1-800-FLOWERS and Travelocity.

. . . to Facebook

Supporting merchants included at launch



Figure 3

American Express’ Link, Like, Love

Source: Facebook.com

“Link, Like, Love” initiative

Apple Produced byProduced byProduced by

US$404.69 - BUY

Financials Year to 30 Sep 09A 10A 11A 12CL 13CLRevenue (US$m) 42,905 65,225 108,249 137,012 153,292Net income (US$m) 8,235 14,013 25,922 33,766 37,870EPS (US$) 9.08 15.15 27.68 35.70 39.62CL/consensus (54) (EPS%) - - 99 108 105EPS growth (% YoY) 33.8 66.9 82.6 29.0 11.0PE (x) 44.6 26.7 14.6 11.3 10.2Dividend yield (%) 0.0 0.0 0.0 0.0 0.0FCF yield (%) 2.3 4.2 8.7 8.8 10.1PB (x) 11.6 7.8 4.9 3.5 2.6ROE (%) 30.5 35.3 41.7 36.1 29.3Net debt/equity (%) (16.6) (23.6) (12.8) (39.8) (56.1)Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate


Avi Silver [email protected] (1) 212 261 3859

2 November 2011

USA Technology Reuters AAPL.OQ Bloomberg AAPL US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$426.69/297.76 12M price target US$505.00 ±% potential +25% Target set on 21 Jul 11 Shares in issue 900.7m Free float (est.) 99.2% Market cap US$346,388m 3M average daily volume US$1,999.5m Major shareholders

Fidelity Management & Research 5.3%


Absolute (4.4) 2.2 27.3 Relative (8.2) 13.0 23.6

180

230

280

330

380

430

480


90

110

130

150

170

190

210

Apple (LHS)Rel to 500

(US$) (%)

Source: Bloomberg

www.clsa.com

Consumerization of IT Apple drove the consumerization of IT through its deep vertical integration of software, hardware and digital media. The company has led the innovation cycle in computing, mobility and multimedia in recent years. While its R&D budget more than doubled over the past five years from US$712m (FY06) to US$2.4bn (FY11), it still represents only 2.0% of sales, underscoring the company’s efficiencies.

Innovation is the foundation for leading market share The iOS operating system is the No.1 mobile operating system in the smart mobile device ecosystem, accounting for 43% of the total mobile installed base. Apple’s focus on developers and its App Store has unlocked a new wave of innovation that has led to 500,000 apps, including 140,000 dedicated to the iPad tablet. Looking ahead, Apple’s recently introduced Siri speech-recognition application should provide an early mover advantage in artificial intelligence (AI) technology, which could be one of the next key applications driving increased smartphone adoption and replacement. We expect Apple to evolve its TV offering as the battle for the digital living room is just around the corner.

Artificial intelligence - The next smartphone killer app Apple launched Siri with iPhone 4S, an artificial intelligence voice-recognition technology that it acquired for US$200m in April 2010. While voice recognition has been around for some time, the personal assistant’s ability to apply intelligence to a query and understand which applications are used to address different types of queries is particularly compelling. Siri can set up calendar appointments, send messages to contacts, place phone calls, conduct searches, and is likely to evolve further as the technology is only in beta today. We believe Siri one-ups Android with voice-recognition features and it gives us a direction of where mobile integrated AI is headed.

Outsourced innovation Apple’s creativity with its App Store has unleashed a whole new wave of innovation by developers that has led to the development of 500,000 apps, including 140,000 dedicated to the iPad. A total of 18bn apps have been downloaded from the App Store. Apple has so far paid over US$3bn to innovative developers in its ecosystem. We believe the company understands the balance between its own development and integration and the capabilities that third-party developers bring to the table. Striking this balance has been remarkably successful in building the most comprehensive ecosystem for end users.

Apple - BUY US strategy


Apple in the clouds iCloud is a cloud-based initiative that stores content, music, documents, photos, contacts and applications that wirelessly push to all iOS devices. It offers users 5GB of free storage space, users will be able to sync and back up their digital content anywhere, and all Apple devices can automatically update any such changes. Additionally, the company launched iTunes Match service for US$24.99/year, by which it can help users locate the content in their library and download instantly without having to upload the entire library to the cloud. Apple is not the first mover in consumer cloud services. When it officially previewed iCloud in June 2011, competition in cloud services was already heating up, including Google, Amazon, Dropbox, Box.net, etc. However, we believe Apple should be able to rapidly increase the penetration of its cloud services by leveraging its 250m iOS devices sold, in turn creating stickiness that will drive higher customer retention and market share.

Figure 1

Figure 2

Apple’s R&D spending over time

OS market share by mobile installed base

0

500

1,000

1,500

2,000

2,500

3,000

3,500

F2006 F2007 F2008 F2009 F2010 F2011 F12CL F13CL

0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0 R&D% of sales (RHS)

(%)(US$m)

RIM17%

Other7%

Android33%

iOS43%

Source: Company, Credit Agricole Securities (USA)

Source: Company, comScore

Figure 3

Figure 4

iPhone and iPad units of shipments

Global tablet market share, 2Q11

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

Dec

10

Mar

11

Jun 1

1

Sep

11

Dec

11CL

Mar

12CL

Jun 1

2CL

Sep

12CL

Dec

12CL

Mar

13CL

iPhone units iPad units('000 units)

Others26%

Apple74%


Source: Company, IDC, Credit Agricole Securities (USA)

Apple should be able to rapidly increase the

penetration of its cloud services



Summary financials Year to 30 September 2009A 2010A 2011A 2012CL 2013CL

Summary P&L forecast (US$m) Revenue 42,905 65,225 108,249 137,012 153,292Op Ebitda 12,474 19,412 35,604 46,732 52,761Op Ebit 11,740 18,385 33,790 44,129 49,480Interest income 326 155 415 300 348Interest expense 0 0 0 0 0Other items 0 0 0 0 0Profit before tax 12,066 18,540 34,205 44,429 49,828Taxation (3,831) (4,527) (8,283) (10,663) (11,959)Minorities/pref divs/affils 0 0 0 0 0Net income 8,235 14,013 25,922 33,766 37,870

Summary cashflow forecast (US$m) Net income 8,235 14,013 25,922 33,766 37,870Operating adjustments 0 0 0 0 0Depreciation/amortisation 734 1,027 1,814 2,603 3,280Working capital changes 0 0 0 0 0Non-operating adjustments 1,190 3,555 9,793 2,305 2,642Net operating cashflow 10,159 18,595 37,529 38,673 43,792Capital expenditure (1,144) (2,005) (4,260) (4,521) (4,599)Free cashflow 9,015 16,590 33,269 34,152 39,193Acq/inv/disposals (16,290) (11,849) (36,159) 0 0Net investing cashflow (17,434) (13,854) (40,419) (4,521) (4,599)Increase in loans 0 0 0 0 0Dividends 0 0 0 0 0Net equity raised/other 663 1,257 1,444 0 0Net financing cashflow 663 1,257 1,444 0 0Incr/(decr) in net cash (6,612) 5,998 (1,446) 34,152 39,193Exch rate movements 0 0 0 0 0Opening cash 11,875 5,263 11,261 9,815 43,967Closing cash 5,263 11,261 9,815 43,967 83,160

Summary balance sheet forecast (US$m) Cash & equivalents 5,263 11,261 9,815 43,967 83,160Debtors 3,361 5,510 5,369 7,953 9,238Inventories 455 1,051 776 1,067 1,166Other current assets 4,275 9,497 12,891 15,784 17,247Fixed assets 2,954 4,768 7,777 10,296 12,214Intangible assets 453 1,083 4,432 4,432 4,432Other term assets 20,212 16,622 19,693 19,693 19,693Total assets 47,501 75,183 116,371 158,811 202,768Short-term debt 0 0 0 0 0Creditors 5,601 12,015 14,632 18,970 20,721Other current liabs 5,905 8,707 13,338 13,338 13,338Long-term debt/CBs 0 0 0 0 0Provisions/other LT liabs 4,355 6,670 11,786 16,122 20,458Minorities/other equity 0 0 0 0 0Shareholder funds 31,640 47,791 76,615 110,381 148,251Total liabs & equity 47,501 75,183 116,371 158,811 202,768

Ratio analysis Revenue growth (% YoY) 14.4 52.0 66.0 26.6 11.9Ebitda growth (% YoY) 41.4 55.6 83.4 31.3 12.9Ebitda margin (%) 29.1 29.8 32.9 34.1 34.4Net income margin (%) 19.2 21.5 23.9 24.6 24.7Dividend payout (%) 0.0 0.0 0.0 0.0 0.0Effective tax rate (%) 31.8 24.4 24.2 24.0 24.0Ebitda/net int exp (x) 0.0 0.0 0.0 0.0 0.0Net debt/equity (%) (16.6) (23.6) (12.8) (39.8) (56.1)ROE (%) 30.5 35.3 41.7 36.1 29.3ROIC (%) 52.1 73.1 125.6 134.5 132.3EVA®/IC (%) 41.4 62.4 114.9 123.7 121.6Source: Company, Credit Agricole Securities (USA)

Ebitda margins to expand by 120bps in FY12CL

Net income to grow 30% YoY in FY12CL

Revenue to grow 27% YoY in FY12CL



Notes

Applied Materials Produced byProduced byProduced by

US$12.54 - OUTPERFORM

Financials Year to 31 Oct 09A 10A 11CL 12CL 13CLRevenue (US$m) 5,014 9,549 10,495 8,650 10,355Net income (US$m) (305) 938 1,715 1,142 1,714EPS (US$) (0.05) 0.88 1.28 0.90 1.33CL/consensus (21) (EPS%) - - 100 100 107EPS growth (% YoY) (105.9) nm 46.7 (30.2) 48.5PE (x) nm 14.3 9.8 13.9 9.4Dividend yield (%) 1.9 2.1 2.4 2.6 2.6FCF yield (%) 0.8 10.3 15.3 8.7 11.5PB (x) 2.4 2.2 1.9 1.7 1.5ROE (%) (4.2) 12.8 21.1 12.5 16.6Net debt/equity (%) (19.4) (21.9) (42.7) (47.3) (52.5)Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate


Mark Heller, CFA [email protected] (1) 415 434 6143

2 November 2011

USA Technology Reuters AMAT.O Bloomberg AMAT US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$16.93/9.70 12M price target US$12.50 ±% potential +0% Target set on 9 Sep 11 Shares in issue 1,330.0m Free float (est.) 100.0% Market cap US$16,522m 3M average daily volume US$205.5m Major shareholders Fidelity 6.2%


Absolute 10.4 (11.1) (3.6) Relative 1.3 (3.4) (7.9)

9

10

11

12

13

14

15

16

17

18


73

78

83

88

93

98

103

108

113

Applied MaterialsRel to 500 (RHS)

(US$) (%)

Source: Bloomberg

www.clsa.com

Semicap innovator Applied Materials is a key enabler of next-generation semiconductor, solar and LCD display manufacturing technologies. In the semiconductor market, the move to tri-gate/FinFET transistors and 3D packaging is likely to introduce new challenges for IC manufacturers. These transitions will increase capital intensity and grow Applied’s dollar opportunity. In solar, the company is a key enabler of higher-efficiency solar technology. LTPS and touch are key technology transitions in its Display business.

Enabling Moore’s Law The key to increasing the performance and lowering the cost of an integrated circuit is to reduce the circuit geometry on a chip to allow more transistors to fit in a given area. This is often referred to as Moore’s Law. As the world’s largest and broadest supplier of semiconductor manufacturing equipment, Applied Materials is a key enabler of next-generation IC manufacturing technologies, such as tri-gate transistors and 3D packaging (TSV). Generally speaking, these transitions require more manufacturing steps (ie, more CVD, ALD, PVD, etch, doping, etc), which means more dollar content for capital equipment companies, such as Applied Materials.

Emphasizing efficiency in solar The company is also a leading supplier of equipment into the crystalline silicon (c-Si) solar market. Its products include automated metallization and test systems for c-Si cell manufacturing (Baccini) and systems for slicing and squaring wafers from silicon ingots (HCT). Applied’s Baccini business is a key enabler of higher efficiency Gen 1.5 solar cell technologies, such as selective emitter and double printing.

Touch and LTPS driving Display Applied Materials’ Display business sells equipment to fabricate thin-film transistor (TFT) LCDs for televisions, computer displays and other consumer electronic applications. While we view the overall LCD business as a maturing market, touch and high resolution displays (LTPS) for tablets and smartphones are a growing opportunity. The main advantage of LTPS is that polycrystalline silicon has 100-300x the “mobility” of a-Si. This enables higher resolution and higher speed displays, such as iPhone’s “retina display”. LTPS has also been proven to be a compatible backplane technology for OLED.

Applied Materials - O-PF US strategy


Enabling Moore’s Law As the world’s largest and broadest supplier of semiconductor manufacturing equipment, Applied Materials is a key enabler of next-generation IC manufacturing technology. As shown below, technology innovation within IC manufacturing generally occurs in a few key areas: transistor design, interconnect, photolithography and packaging. We discuss two of these key IC manufacturing innovations (3D transistors and 3D packaging).

Figure 1

Technology transitions in semiconductor manufacturing

Source: Applied Materials

3D (tri-gate/FinFET) transistors The move to tri-gate/FinFET transistors is perhaps the biggest evolution in transistor design since the introduction of high-k metal gate (HKMG) in 2007 as it represents a fundamental shift in transistor architecture. Traditional 2D planar transistors form a conducting channel in the silicon region under the gate electrode when in the “on” state, while 3D transistors form conducting channels on three sides of a vertical fin structure. In other words, the conducting channel is “above” the wafer surface versus “in” the wafer surface for planar/2D. Intel will be the first to launch tri-gate transistor technology in 2H11 on its 22nm logic technology (Ivy Bridge). We believe that the foundries are likely to introduce FinFET transistors at the 14nm node.

Figure 2 Figure 3

Traditional planar transistor

3D (tri-gate) transistor

Source: Intel

The move to FinFET/tri-gate transistors creates some new challenges for equipment and IC manufacturers. While FinFETs appear to be able to use most of the same materials as planar transistors, including high-k metal-gate and strained silicon, the change in geometry means that process changes will be needed. According to Intel, more double patterning is required for the

Technology innovation generally occurs in

transistor, interconnect, patterning and packaging

Plenty of technology transitions

Tri-gate moves the conducting channel above

the wafer surface

Intel is moving to tri-gate transistors on its

22nm process

FinFET uses most of the same materials, but

process step changes are needed



critical layers, but the company is still able to use immersion 193nm lithography. Applied Materials notes that there are a number of challenges and/or additional steps for doping, deposition (epi, CVD, ALD, PVD), etch and CMP given the nature of the 3D architecture. Much of this activity needs to be done conformally and creates new control requirements. The number of new process steps depends on the flow chosen; however, Applied estimates that between 45nm and 14nm there are over 30 incremental transistor formation steps, with most being in CVD, PVD and ion implantation.

Figure 4 Figure 5

Applied’s equipment opportunity for FinFET transistors

Incremental transistor steps between 45nm and 14nm


3D packaging technology Not to be confused with 3D transistors, packaging is also moving into the third dimension. 3D packages contain two or more ICs that are vertically stacked with the benefit being that the ICs occupy less space and have greater connectivity. The technology is called “through-silicon via” or TSV. TSV replaces traditional edge wiring bonding that is used in bump and redistribution layer (RDL) packages with vertical connections made of copper through the body of the ICs.

Figure 6 Figure 7

TSV Bump RDL (1st) at IC fab

TSV Bump RDL (2nd) at packaging fab


The process steps, depicted above, bear some resemblance to copper interconnect and are segmented into steps at an IC fab (front end) and packaging fab (back end). At the IC fab, the TSV is first created through a series of etch, CVD (oxide liner), PVD (barrier/seed), ECD (copper plating)

TSV replaces traditional edge wire bonding

TSV requires many steps including CVD, PVD, ECD,

CMP and others

Over 30 incremental transistor formation steps between 45nm and 14nm



and CMP steps, after which the first bump/RDL layer is created. On the back end, additional TSV steps such as bonding/thinning, CMP, CVD and etch are completed to expose the other side of the TSV. Lastly, the second bump/RDL layer is created. Thanks to Applied’s acquisition of Semitool in 2009, the company has nearly an end-to-end solution for TSV packaging, including etch (Silvia), CVD (Producer GT), PVD (Endura CuBS), ECD (Raider-S), wafer cleaning and CMP (Reflexion LK).

Emphasizing efficiency in solar Applied Materials is also a leading supplier of equipment into the crystalline silicon (c-Si) solar market. The company’s products include automated metallization and test systems for c-Si cell manufacturing (Baccini) and systems for slicing and squaring wafers from silicon ingots (HCT). Applied’s EES business was more or less built through acquisition: HCT in 2007, Baccini in January 2008 and Advent Solar in November 2009.

Figure 8

Applied’s PV solutions


Applied’s Baccini business is a key enabler of Gen 1.5 solar cell technologies, such as selective emitter and double printing. Double printing enables the formation of taller, narrower grid lines on the front side of a solar cell, which reduces the shadowing effect caused by wide grid lines while enhancing electrical conductivity. Applied claims that double printing enables the replacement of single 120um wide lines with two-layer, double-height lines that are <80um wide. This enables about a half a point of cell-efficiency gain and up to a 14% reduction in consumption of silver printing paste. Together, this helps reduce manufacturing costs by about US$0.03/W.

Applied’s Baccini business also offers tools that can implement selective emitter structures (versus homogenous emitters), enabling the creation of low-resistivity regions beneath the contacts. This is accomplished by depositing more phosphorus directly under the silver grid in order to facilitate contact to the silicon, enabling better electron migration. At the same time, selective emitter reduces the amount of phosphorus between the grid fingers in order to reduce recombination losses and improve the cell’s blue response. Selective emitter can add up to a two-point gain in cell efficiency.

Touch and LTPS driving Display Applied Materials’ Display business manufactures and sells equipment to fabricate TFT LCDs for televisions, computer displays and other consumer electronics applications. While we view the overall LCD business as a maturing market, touch and high resolution displays (LTPS) for tablets and smartphones are a growing opportunity.

EES accounts for c.19% of Applied’s total revenue

Applied focuses on the wafer and cell parts of the

solar supply chain

Double printing can add about a half a point of

cell-efficiency gain

Selective emitter can add up to a two-point gain

in cell efficiency

We expect traditional LCD equipment sales to

decline in FY11, but touch and LTPS will be up



LTPS seeing traction in smartphones, tablets and OLED displays LTPS backplane technology for LCD displays is a more advanced alternative to traditional amorphous silicon (a-Si) backplanes. The technology has already seen significant traction in the smartphone market and is likely to make its way into tablets as well. The main advantage of LTPS is that polycrystalline silicon has 100-300x the “mobility” of a-Si. The higher the mobility, the faster the electrons will travel and the smaller the TFT channel needed. This enables higher resolution and higher speed displays.

LTPS has also been proven to be a compatible backplane technology for OLED displays due to its higher mobility and the reliability of the TFT over time. The TFT arrays for OLED and LCD modules differ slightly: the driving circuit for OLEDs requires two TFTs, whereas that for LCDs requires only one. For OLEDs, the first TFT switches the sub-pixels on and off, as with LCD units, while the second TFT controls the current level.

Figure 9 Figure 10

a-Si versus LTPS TFT (1/2)

a-Si versus LTPS TFT (2/2)


There are a few disadvantages of LTPS though. It is currently limited to Gen 6. Additionally, capex for LTPS is about double that of a-Si, though this is good for Applied. Yields are also lower for LTPS versus traditional a-Si technology and the process suffers from variations in polysilicon-grain size, which requires the addition of compensation circuits to reduce grayscale variations between pixels. That said, the transition to LTPS is a net positive for Applied Materials. LTPS has up to 2x mask steps, which means more CVD, litho and etch spending. For 2011, Applied estimates a US$250m serviceable market (SAM).

Touch, too Touch is another area of strength thanks to smartphone and tablet adoption. There are over a dozen touch technologies, though capacitive is the most common in multitouch applications. According to DisplaySearch, touch units are forecast to grow from 830m in 2010 to 1.9bn by 2015, an 18% Cagr, while touch panel revenue should grow from US$6.5bn to US$14.1bn over the same time period. Touch technology typically requires more PVD (four to five layers) and CVD steps, which means more equipment intensity for Applied. In CY11, Applied estimates a US$150m equipment SAM.

LTPS enables pixel densities of 200 dpi

and greater

LTPS is also the preferred backplane technology

for OLED

LTPS has a few disadvantages, but

it’s a net positive for Applied Materials



Summary financials Year to 31 October 2009A 2010A 2011CL 2012CL 2013CL

Summary P&L forecast (US$m) Revenue 5,014 9,549 10,495 8,650 10,355Op Ebitda (394) 1,384 2,392 1,629 2,379Op Ebit (394) 1,384 2,392 1,629 2,379Interest income 49 37 42 40 40Interest expense (21) (22) (60) (100) (100)Other items (119) (13) 0 0 0Profit before tax (486) 1,387 2,374 1,569 2,319Taxation 180 (449) (659) (427) (605)Minorities/pref divs/affils 0 0 0 0 0Net income (305) 938 1,715 1,142 1,714

Summary cashflow forecast (US$m) Net income (305) 938 1,715 1,142 1,714Operating adjustments 829 556 253 388 388Depreciation/amortisation 0 0 0 0 0Working capital changes (191) 229 553 (149) (281)Non-operating adjustments 0 0 0 0 0Net operating cashflow 333 1,723 2,521 1,381 1,821Capital expenditure (248) (169) (171) (140) (140)Free cashflow 85 1,554 2,350 1,241 1,681Acq/inv/disposals 361 (693) 354 0 0Net investing cashflow 113 (862) 183 (140) (140)Increase in loans (1) (6) 1,730 0 0Dividends (320) (349) (397) (424) (423)Net equity raised/other 39 (221) (229) 0 0Net financing cashflow (282) (576) 1,104 (424) (423)Incr/(decr) in net cash 164 285 3,807 816 1,258Exch rate movements 1 (4) 4 0 0Opening cash 1,412 1,576 1,858 5,669 6,486Closing cash 1,576 1,858 5,669 6,486 7,743

Summary balance sheet forecast (US$m) Cash & equivalents 1,576 1,858 5,669 6,486 7,743Debtors 1,041 1,831 1,405 1,539 1,793Inventories 1,627 1,547 1,433 1,570 1,829Other current assets 805 802 855 855 855Fixed assets 1,090 963 830 734 638Intangible assets 1,477 1,623 1,558 1,558 1,558Other term assets 904 1,011 1,105 1,105 1,105Total assets 9,574 10,943 13,907 14,899 16,574Short-term debt 1 1 0 0 0Creditors 1,062 1,766 1,281 1,404 1,636Other current liabs 877 1,121 1,625 1,625 1,625Long-term debt/CBs 201 204 1,947 1,947 1,947Provisions/other LT liabs 340 315 327 327 327Minorities/other equity 0 0 0 0 0Shareholder funds 7,095 7,536 8,727 9,596 11,039Total liabs & equity 9,574 10,943 13,907 14,899 16,574

Ratio analysis Revenue growth (% YoY) (38.3) 90.5 9.9 (17.6) 19.7Ebitda growth (% YoY) (129.0) nm 72.9 (31.9) 46.1Ebitda margin (%) (7.9) 14.5 22.8 18.8 23.0Net income margin (%) (6.1) 9.8 16.3 13.2 16.6Dividend payout (%) 0.0 29.5 23.2 35.7 24.0Effective tax rate (%) 37.2 32.4 27.8 27.2 26.1Ebitda/net int exp (x) 0.0 0.0 132.9 27.1 39.7Net debt/equity (%) (19.4) (21.9) (42.7) (47.3) (52.5)ROE (%) (4.2) 12.8 21.1 12.5 16.6ROIC (%) (4.8) 18.9 37.7 27.5 39.7EVA®/IC (%) (16.7) 7.0 25.8 15.6 27.8Source: Company, Credit Agricole Securities (USA)

Over US$5bn in cash

US$2.5bn in operating cashflow in FY11

Modeling an 18% sales decline in FY12

BlackRock Produced byProduced byProduced by


Financials Year to 31 Dec 09A 10A 11CL 12CL 13CLOperating income (US$m) 4,700 8,612 9,184 9,396 10,575Net income (US$m) 875 2,063 2,354 2,246 2,611EPS (US$) 7.13 10.94 12.01 12.70 14.75CL/consensus (17) (EPS%) - - 101 100 100EPS growth (% YoY) 13.2 53.4 9.7 5.8 16.1PE (x) 23.7 15.5 14.1 13.3 11.5Adjusted EPS (US$) 7.13 10.94 12.01 12.70 14.75Adjusted PE (x) 23.7 15.5 14.1 13.3 11.5Dividend yield (%) 1.8 2.4 3.3 3.7 4.3Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate


Chris Spahr [email protected] (1) 212 261 4005

2 November 2011

USA Financial services Reuters BLK.N Bloomberg BLK US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$207.44/137.03 12M price target US$181.00 ±% potential +11% Target set on 20 Oct 11 Shares in issue 62.7m Free float (est.) 94.3% Market cap US$22,104m 3M average daily volume US$40.0m Major shareholders PNC Bank National NA 35.7%


Absolute 1.9 (19.2) (10.7) Relative (7.7) (13.8) (15.6)

130

150

170

190

210

230

250


58

63

68

73

78

83

88

93

98

103

108

BlackRock (LHS)Rel to 500

(US$) (%)

Source: Bloomberg

www.clsa.com

One BlackRock “One BlackRock” is the company’s core philosophy to serve clients by maintaining a globally integrated platform that ensures consistency, allows for the tailoring of products, promotes teamwork and improves corporate efficiency. Leveraging technology is a core competency of the firm that goes back to its foundation in 1988, and differentiates BlackRock from most of its peers today.

A foundation on technology BlackRock was founded in 1988 as a technology-driven unit that helped financial companies manage their fixed-income portfolios. Today, it is the world’s largest asset manager, but its focus on technology and how it can help clients and shareholders remains.

Maintaining a globally integrated platform BlackRock believes that the best way to provide client solutions and leverage intellectual capital is to operate on a common platform across asset classes and geographies. BlackRock spends over US$300m in technology, services and communications annually to maintain this edge.

A leader in outsourcing risk management BlackRock Solutions represents 5% of revenue and differentiates the company from its peers. It includes management and advisory outsourcing tools that can be used by other financial institutions for asset/liability management, operational risk management and regulatory requirements. BRS is the combination of the company’s intellectual capital, risk-management analytics and the operating systems that support BlackRock’s asset management business.

Leveraging scale to maintain superior margins Almost two-thirds of BlackRock’s AUM are in businesses that benefit from scale (institutional index funds, ETFs, cash management/advisory), and the company is one of the largest in the world in many of these categories (including a 43% share in ETFs globally). This gives the firm a highly variable expense base that keeps pretax operating margins well above its peers through the cycle, including 40% during 1H11 versus 35% at large peers.

BlackRock - O-PF US strategy


Innovation summary BlackRock was founded in 1988 as a small, technology-oriented group that

focused on providing customized risk-management solutions.

Today, it is the world’s largest asset manager with US$3.3tn in AUM, and it’s one of the most diversified in terms of product mix and geography.

Yet, its core focus on technology has been unchanged - to be a globally integrated investment and risk-management firm, operating on a unified platform with a common brand and a shared vision.

To that end, the company spends over US$150m annually on technology alone and another US$150m on professional services and communications.

Yet, these investments help keep overall costs well below its peers, resulting in a 40.1% core pretax margin during the volatile 3Q11, above the peer average of 31%.

Figure 1 Figure 2

AUM by product type

AUM by client domicile

AUM mix by asset (US$3.3tn)

Advisory4%

Cash mgmt7%

Alternative3%

Multi-asset6%

Index fixed inc

17%

Active fixed inc

19%

Index equity36%

Active equity8%

AUM mix by region (US$3.3tn)

US61%

EMEA29%

Asia10%


Providing financial solutions BlackRock’s mission is to solve clients’ problems by offering a platform that has attributes of an asset manager, investment bank, financial systems vendor and strategic consultant. First, BlackRock is an asset manager because it provides an investment process that maximizes returns while minimizing risks, yet is still mindful of the fiduciary nature of the business. Second, the company is an investment bank because it has deep capital-markets expertise, extensive risk-management capabilities, time-tested operating processes and broad advisory skills on behalf of its clients. Third, it’s a financial systems vendor that provides clients a compliance framework that incorporates multidisciplinary checks and balances. Fourth, BlackRock is a strategic consultant because it provides independent and objective advice that combines its asset management, investment banking and operational capabilities.

Investing in technology BlackRock is a functionally integrated investment and risk-management firm, operating on a globally unified platform with a common brand and a shared vision. These systems and processes require extensive in-house expertise, and BlackRock spends over US$150m per year on technology alone and another US$150m on consulting services and communications (a combined 5% of total estimated 2011 operating expenses and over 10% of G&A costs). The company believes its focus and unified operating platform strongly differentiate it from other vertically integrated financial services companies and many of its asset management peers.

BlackRock spends over US$150m per year on

technology alone

Using a globally integrated platform to

provide financial solutions for clients

BlackRock was founded as a technology-driven firm that provided risk-management solutions



Leveraging intellectual capital Representing around 5% of consolidated revenue, BlackRock Solutions (BRS) differentiates BlackRock the most from other pure-play asset managers. A product that was first offered in 2000, BRS essentially offers risk management and advisory outsourcing tools that can be used by institutions for asset/liability management, operational risk management and regulatory requirements. BRS is the combination of the company’s intellectual capital, risk-management analytics and the operating systems that support BlackRock’s asset management business. Many of the tools used in BRS are the same used by the firm’s asset management businesses, such as Aladdin (an enterprise investment system). The company notes that institutional demand is strong and growing across the globe, especially from insurance companies and banks. As of 30 June 2011, BRS provided services for approximately US$10tn in securities and derivatives across more than 150 clients, many of whom are among the largest and most sophisticated financial institutions in the world.

Exploiting scale in scale businesses BlackRock is one of the most efficient asset managers with an operating pretax margin of 40%, which is well above the industry average of 36% (core). This strong performance is helped by BlackRock’s superior scale in scale businesses such as index funds and related ETFs, which comprise 64% of the firm’s asset base. Indeed, BlackRock is the largest ETF provider with 43% market share of the US$1.6tn global industry. This scale gives the firm a relatively high variable expense base compared to traditional asset managers. During turbulent markets, BlackRock can adjust expenses more easily than others. For example, during 3Q11, BlackRock had flattish operating leverage (revenue and expenses down 7%), while the majority of asset managers had negative operating leverage and declining margins during the quarter.

Figure 3

Core pretax margins at BlackRock and large peer asset managers

37% 37%

39%38%

39%40%

33%

36%

33%

29%

35%35%

2006 2007 2008 2009 2010 1H01

BlackRock Asset managers

Note: Peers include AllianceBernstein, Franklin Resources, Invesco, Legg Mason and T Rowe Price; pretax margins are adjusted for one-time items and distribution costs. Source: Company reports, Credit Agricole Securities (USA)

BlackRock possesses superior scale in scale

businesses such as index funds and related ETFs

BlackRock is one of the most efficient asset

managers with an operating pretax

margin of 40%

BRS is a combination of intellectual capital, risk-

management analytics and operating systems



Summary financials Year to 31 December 2009A 2010A 2011CL 2012CL 2013CL

Summary P&L forecast (US$m) Interest income 4,700 8,612 9,184 9,396 10,575Interest expense 0 0 0 0 0Net interest income 4,700 8,612 9,184 9,396 10,575Fee income 0 0 0 0 0Other operating income 0 0 0 0 0Non-interest income 0 0 0 0 0Total op income 4,700 8,612 9,184 9,396 10,575Staff & related costs (1,802) (3,097) (3,240) (3,286) (3,698)Other operating expenses (1,620) (2,517) (2,629) (2,699) (2,954)Total operating expenses (3,422) (5,614) (5,870) (5,985) (6,652)Preprovision OP 1,278 2,998 3,314 3,411 3,923Loan-loss provisions 0 0 0 0 0Other income/expenses (28) 66 (132) (46) (11)Profit before tax 1,250 3,064 3,182 3,365 3,912Taxation (375) (971) (854) (1,119) (1,301)Minorities and other 0 (30) 26 0 0Net income 875 2,063 2,354 2,246 2,611

Summary balance sheet forecast (US$m) Placements to other banks 0 0 0 0 0Cash & equivalents 4,708 3,367 4,482 5,122 5,834Other int-earning assets 0 0 0 0 0Total int-earning assets 0 0 0 0 0Fixed assets 443 428 385 259 133Intangible assets 30,304 30,317 30,258 30,234 30,210Other assets 159,957 160,519 161,855 162,350 162,965Total assets 178,066 178,459 179,693 180,039 180,503Customer deposits 0 0 0 0 0Other int-bearing liabs 8,490 6,004 6,063 5,817 5,569Total int-bearing liabs 8,490 6,004 6,063 5,817 5,569Other non-int-bearing liabs 144,974 146,121 145,269 145,221 145,221Total liabilities 153,464 152,125 151,332 151,038 150,790Shareholder funds 24,377 26,099 28,127 28,767 29,479Minorities/other equity 225 235 234 234 234Total liabs & equity 178,066 178,459 179,693 180,039 180,503

Ratio analysis Gross NPLs/total loans (%) 0.0 0.0 0.0 0.0 0.0Loan provisions/NPLs (%) 0.0 0.0 0.0 0.0 0.0Provision exp/loans (%) 0.0 0.0 0.0 0.0 0.0Fee income growth (%) 0.0 0.0 0.0 0.0 0.0Operating inc growth (%) (7.2) 83.2 6.6 2.3 12.5Risk-wtd assets growth (%) - - - - -Net profit growth (% YoY) 11.6 135.8 14.1 (4.6) 16.2Cost/income (%) 72.8 65.2 63.9 63.7 62.9Staff costs/op costs (%) 52.7 55.2 55.2 54.9 55.6Effective tax rate (%) 30.0 31.7 26.8 33.3 33.3RWA/total assets (%) 0.0 0.0 0.0 0.0 0.0Equity/total assets (%) 13.8 14.8 15.8 16.1 16.5Tier 1 CAR (%) 0.0 0.0 0.0 0.0 0.0Tier 2 CAR (%) 0.0 0.0 0.0 0.0 0.0CAR (%) 0.0 0.0 0.0 0.0 0.0Loans/deposits (%) 100.0 100.0 100.0 100.0 100.0Reported Loans/deposits (%) 0.0 0.0 0.0 0.0 0.0Source: Company, Credit Agricole Securities (USA)

Revenue comes from advisory and

performance fees and risk-management

consulting

BlackRock’s assets include co-investments

with its investing clients

Equity to assets is expected to be

in the mid-teens over time

Bristol-Myers Produced byProduced byProduced by

US$32.62 - UNDERPERFORM

Financials Year to 31 Dec 09A 10A 11CL 12CL 13CLRevenue (US$m) 20,919 19,484 21,313 18,493 18,415Net income (US$m) 4,041 3,735 3,965 3,440 3,363EPS (US$) 2.04 2.16 2.31 2.03 2.03CL/consensus (20) (EPS%) - - 100 97 99EPS growth (% YoY) 17.2 5.8 7.2 (12.1) 0.4PE (x) 15.9 15.1 14.1 16.0 16.1Dividend yield (%) 0.0 0.0 4.1 4.1 4.1FCF yield (%) 5.0 7.1 8.8 7.3 6.5Net debt/equity (%) 11.0 9.7 (7.4) (13.3) (16.7)Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate


Kim Vukhac [email protected] (1) 212 261 7148

Milind Parate (1) 212 408 5828

2 November 2011

USA Healthcare Reuters BMY.N Bloomberg BMY US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$33.19/24.97 12M price target US$35.00 ±% potential +7% Target set on 27 Oct 11 Shares in issue 1,706.0m Free float (est.) 99.9% Market cap US$55,639m 3M average daily volume US$118.6m Major shareholders Capital World 8.0%


Absolute 6.3 12.0 19.3 Relative 7.6 21.7 17.7

21

23

25

27

29

31

33

35


89

94

99

104

109

114

119

124

129

134

139

BristolMyers Rel to 500 (RHS)

(US$) (%)

Source: Bloomberg

www.clsa.com

A focus on innovation Several years ago, Bristol-Myers was like many of its large pharma peers - a “conglomapharma” with several businesses helping to diversify revenue streams but also dragging on profitability. Since 2007, the company has shed its non-core businesses and is now leaner, focused purely on innovative therapeutics. In early 2010, management laid out five novel pipeline programs to focus on. Two have since been approved, with the others slated to be approved or filed by the end of 2012.

A transformation paying off Since 2007, Bristol-Myers has transformed itself from a “conglomapharma” into a pure-play biopharmaceutical company. The spinoff of non-core businesses, including ConvaTec (May 08), ImClone (Sep 08) and then Mead Johnson Nutrition (Nov 09), has left the company resembling less like a traditional large pharma company and more like a specialty company.

Yervoy approval represents a first-in-class drug The FDA approval of Yervoy in March 2011 is a reflection of Bristol-Myers’ newly focused biopharma strategy on innovative therapeutics. Doctors have called Yervoy a significant breakthrough in fighting metastatic melanomas in that it works to boost the patient’s own immune system to fight off the cancer. This mechanism potentially allows Yervoy to be used in combination with other therapies that attack the cancer more directly. Yervoy sales in its first quarter far exceeded Street expectations.

Eliquis to change the afib/stroke prevention landscape The company’s biggest opportunity lies with Eliquis, its twice-daily oral drug for atrial fibrillation/stroke prevention. Partnered with Pfizer, it will be one of three new oral anti-coagulants that is trying to unseat warfarin as the standard of care. With a best-in-class safety and efficacy profile established in the ARISTOTLE study, we believe Eliquis will emerge as a clear leader.

Near-term hits backed with a fully loaded pipeline Bristol-Myers is also targeting two other pipeline drugs for approval by the end of 2012: dapagliflozin for diabetes, another first-in-class drug that lowers glucose outside of the insulin pathway (28 January PDUFA); and Brivanib in hepatocellular carcinoma. In addition, Bristol-Myers has a number of Phase II drug candidates that covers a wide range of therapeutic areas, with one-third of the drugs focused on oncology.

Bristol-Myers - U-PF US strategy


Targeting another three drugs by 2012 Since early 2010, Bristol-Myers has been focused on the development of five key pipeline drugs, two of which have been approved by the US FDA in 2011.

1. Yervoy is leading the way for Bristol-Myers’ immuno-oncology pipeline. It is a first-in-class drug for the treatment of patients with inoperable or metastatic melanoma that was launched in the USA in spring 2011 and received European approval in July. Yervoy stimulates the patient’s own immune system to fight cancer cells, leading to a cascade of immune-related events, with studies having shown the potential for long-term remission in some patients.

2. Nulojix for the treatment of organ rejection during kidney transplant was approved in both the USA and EU in June 2011. Nulojix is the first intravenous biologic therapy to prevent transplant rejections on a maintenance basis in a market that has traditionally been treated with oral therapies. Nulojix’s benefit over oral therapies is that it can extend the life of the transplanted kidney as it is not nephrotoxic.

Bristol-Myers is targeting another three new compounds for approval by the end of 2012.

Figure 1

Key Phase III drugs (in alphabetical order)

Drug Notes Est peak potential

- Treatment for liver cancer (hepatocellular - HCC) US$1.0-1.5bn

- Oral small molecule that is dual selective kinase inhibitor of FGF and VEGF

- A number of Phase III studies ongoing in HCC; data expected at end of 2011 Brivanib

- Plays into EM strategy given the high prevalence in the AsiaPac region, particularly China

- Treatment for type 2 diabetes US$1.5-2.0bn

- Potential first-in-class SGLT2 inhibitor

- Completed submissions in USA and EU in December 2010; PDUFA date set for 28 Jan 11

- Negative FDA panel in July 2011 led us to push out our expectations for approval

Dapagliflozin

- Partnered with AstraZeneca

- Treatment for atrial fibrillation (AF) US$3.0-4.0bn

- Potential alternative to warfarin (standard of care)

- NDA filing for Eliquis for atrial fibrillation/stroke prevention in 4Q11

- US submission for VTE (venous thromboembolism) prevention in 2011

- ARISTOTLE reveals that Eliquis has a best-in-class safety and efficacy profile

Eliquis (apixaban)

- Partnered with Pfizer


Two of Bristol-Myers’ five key pipeline drugs,

Yervoy and Nulojix, were approved in 1H11

Bristol-Myers is targeting three new compounds

for approval by the end of 2012



A fully-loaded pipeline through Phase II Bristol-Myers has a number of drugs candidates through Phase II that covers a wide range of therapeutic areas, with one-third of the drugs focused on oncology.

Figure 2

Drug pipeline - Post discovery through Phase II

Cardiovascular Metabolics Oncology Virology

CCR2 / 5 antagonists 11βHSD inhibitors Anti-CD137 HIV attachment inhibitor

IKACh inhibitor FGF21-PKE Adnectin Anti-CD19 NRT Inhibitor

IKur antagonist Glucokinase activator Anti-CD70 ADC NS3 inhibitor

LXR modulators GPR119 agonist Anti-CXCR4 NS5A inhibitors

PCSK9 Adnectin MCHR1 antagonist Anti-PD1 NS5B inhibitor

Immunology TGR5 agonist Anti-PD-L1 NS5B Primer Grip inhibitor

Anti-CD28 Neuroscience EGFR/IGFR Tandem Adnectin PEG Interferon λ

Anti-IL6 Aβ modulator Elotuzumab (Anti-CS1)

Anti-IP10 CGRP antagonist IGF-1R antagonist

BTK inhibitor GABA/Nicotinic modulator IL-21

CCR1 antagonists Gamma Secretase inhibitor JAK2 inhibitor

Dual-acting p38 Kinase inhibitor Microtubule stabilizer Notch inhibitor

IL-23 Adnectin Triple Reuptake inhibitors RAF Kinase inhibitor

α-7 Nicotinic agonist SMO antagonist

VEGF R-2 Adnectin

Source: Company (as of 31 December 2010)

Innovation strategy in the emerging markets (EM) Bristol-Myers has been slower in growing its EM business, choosing to focus on a longer-term innovative drug strategy rather than follow a strategy of mature branded generics, semi-generics or generic products, as many of its peers are doing. Areas of primary focus will include diabetes, oncology and liver diseases.

Baraclude, for the treatment of chronic hepatitis B, is a good example of an innovator product that has also become a main driver for the company’s China expansion.

Brivanib, for the treatment of liver cancer (hepatocellular carcinoma - HCC), is one of the key Phase III pipeline drugs expected to receive approval by end of 2012. Seventy percent of the 700k HCC cases each year occurs in the Asia-Pacific region.

One-third of Bristol-Myers’ Phase III drugs is

focused on oncology

EM focus is on a longer-term innovative drug strategy rather than

branded generics




Summary P&L forecast (US$m) Revenue 20,919 19,484 21,036 18,258 18,197Op Ebitda 6,923 7,012 7,672 5,800 5,195Op Ebit 6,216 6,268 6,912 5,040 4,435Interest income 0 0 0 0 0Interest expense 0 0 0 0 0Other items 57 155 147 116 116Profit before tax 6,273 6,423 7,059 5,156 4,551Taxation (1,546) (1,590) (1,942) (1,447) (1,287)Minorities/pref divs/affils (686) (1,098) (1,235) (332) 53Net income 4,041 3,735 3,883 3,377 3,317

Summary cashflow forecast (US$m) Net income 4,041 3,735 3,883 3,377 3,317Operating adjustments 6,571 (633) (12) 0 0Depreciation/amortisation 707 744 760 760 760Working capital changes 42 (166) 616 285 (114)Non-operating adjustments (7,296) 811 119 0 0Net operating cashflow 4,065 4,491 5,365 4,422 3,963Capital expenditure (730) (424) (346) (309) (308)Free cashflow 3,335 4,067 5,019 4,112 3,655Acq/inv/disposals (2,819) (1,120) 2,026 3,388 3,388Net investing cashflow (3,549) (1,544) 1,680 3,079 3,080Increase in loans 1,445 (963) (36) 0 0Dividends (2,483) (2,202) (2,264) (2,232) (2,193)Net equity raised/other 1,021 (178) (214) (833) (833)Net financing cashflow (17) (3,343) (2,514) (3,065) (3,026)Incr/(decr) in net cash 499 (396) 4,531 4,435 4,017Exch rate movements 39 14 20 0 0Opening cash 7,976 7,683 5,033 6,196 7,243Closing cash 8,514 7,301 9,584 10,631 11,260

Summary balance sheet forecast (US$m) Cash & equivalents 8,514 7,301 9,584 10,631 11,260Debtors 3,164 3,480 0 0 0Inventories 1,413 1,204 1,443 1,159 1,273Other current assets 867 1,288 1,594 1,594 1,594Fixed assets 5,055 4,664 4,524 4,365 4,206Intangible assets 8,083 8,603 8,313 8,021 7,729Other term assets 3,912 4,536 4,419 4,419 4,419Total assets 31,008 31,076 29,877 30,189 30,480Short-term debt 231 117 135 135 135Creditors 1,711 1,983 0 0 0Other current liabs 4,371 4,639 4,584 4,584 4,584Long-term debt/CBs 9,910 8,699 8,195 8,195 8,195Provisions/other LT liabs 0 0 0 0 0Minorities/other equity 0 0 0 0 0Shareholder funds 14,785 15,638 16,963 17,275 17,566Total liabs & equity 31,008 31,076 29,877 30,189 30,480

Ratio analysis Revenue growth (% YoY) 1.6 (6.9) 8.0 (13.2) (0.3)Ebitda growth (% YoY) 18.3 1.3 9.4 (24.4) (10.4)Ebitda margin (%) 33.1 36.0 36.5 31.8 28.5Net income margin (%) 19.3 19.2 18.5 18.5 18.2Dividend payout (%) 0.0 0.0 58.3 66.2 66.1Effective tax rate (%) 24.6 24.8 27.5 28.1 28.3Ebitda/net int exp (x) 0.0 0.0 0.0 0.0 0.0Net debt/equity (%) 11.0 9.7 (7.4) (13.3) (16.7)ROE (%) 35.0 31.8 31.4 21.7 18.7ROIC (%) 30.1 28.1 30.5 23.6 21.5EVA®/IC (%) 23.5 21.5 23.9 17.1 14.9Source: Company, Credit Agricole Securities (USA)

Strong net cash position for the foreseeable future

We expect FCF to reverse its declining trend beginning in 2014

New products expected to come on line will offset some of the upcoming

patent expirations

Coca-Cola Produced byProduced byProduced by


Financials Year to 31 Dec 09A 10A 11CL 12CL 13CLRevenue (US$m) 30,990 35,123 46,416 48,700 51,741Net income (US$m) 7,119 8,158 8,954 9,801 10,841EPS (US$) 3.06 3.49 3.86 4.29 4.83CL/consensus (16) (EPS%) - - 100 103 104EPS growth (% YoY) (2.7) 14.3 10.3 11.3 12.5PE (x) 22.4 19.6 17.8 16.0 14.2 Dividend yield (%) 2.4 2.6 2.7 3.0 3.3FCF yield (%) 3.8 4.5 5.1 5.7 6.5PB (x) 6.3 5.1 4.7 4.4 4.0ROE (%) 31.4 29.0 26.7 26.7 27.9Net debt/equity (%) 10.7 39.0 28.7 24.5 18.8Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate


Caroline Levy [email protected] (1) 212 261 3956

Michael Lavery (1) 212 261 3964

2 November 2011

USA Consumer Reuters KO.N Bloomberg KO US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$71.77/59.75 12M price target US$76.00 ±% potential +11% Target set on 28 Sep 11 Shares in issue 2,303.0m Free float (est.) 95.0% Market cap US$155,722m 3M average daily volume US$290.1m Major shareholders Berkshire Hathaway 8.6%


Absolute (4.7) 0.5 13.2 Relative (5.4) 8.0 8.7

50

55

60

65

70

75


88

93

98

103

108

113

118

123

Coca-Cola (LHS)Rel to 500

(US$) (%)

Source: Bloomberg

www.clsa.com

Innovation as branding Coke approaches innovation as a key part of its brand building and growth strategies. New product innovation is a key piece of its plans for sales growth, but the company also innovates in its fountain equipment, price/package strategies and packaging design. Coke’s brands are among the most valuable in the world, and innovation complements its marketing spending to maintain relevance and excitement for consumers.

Coke’s “Freestyle” fountain machine changes the game Coke’s Freestyle fountain machine, introduced in 2009, allows consumers to develop their own fountain sodas by mixing and matching varieties and flavors. By using micro-flavor cartridges that are mixed with soda on premise, the company is able to offer 125 different drink options, instead of the more typical half dozen or so in traditional fountain machines. Consumers use touch screens to create their drinks, and usage information is tracked and uploaded to Coke’s corporate headquarters nightly, allowing for timely re-stocking. These data also provide insights into consumer-usage preferences and patterns that can be applied to new product development.

Coke Zero, Minute Maid Pulpy typify ongoing innovation Coke is constantly engaged in ongoing product innovation, including several large recent successes. Coke Zero launched in the USA in 2005 as a better tasting zero-calorie drink and has since spread around the globe with over US$1bn in sales. Also in 2005, Coke launched Minute Maid Pulpy in China as a juice with enhanced pulp. It is now also a US$1bn brand in 18 countries.

Price/package architecture innovation Less tangibly, Coke has also innovated in its merchandising by re-thinking its price/package architecture. It reconsidered consumer and retailer need states to develop packaging and price points specific to various occasions and need states. As a result, it has been growing average price per volume unit by improving the selection of products and price appropriate to each channel.

Packaging design matters, too Coke’s soft drinks are relatively simple with fairly straight-forward packaging. However, Coke has innovated here, too, to differentiate its products and build its brands. One simple but impactful example was adapting the signature contour shape of its classic glass bottles to its larger two-liter packages. While it may seem a simple innovation, this change boosted volumes and reinforced the brand’s trademarked elements in ways that help support future growth.

Coca-Cola - O-PF US strategy



Summary P&L forecast (US$m) Revenue 30,990 35,123 46,416 48,700 51,741Op Ebitda 9,780 11,024 12,939 14,122 15,499Op Ebit 8,544 9,581 11,026 12,171 13,489Interest income 0 0 0 0 0Interest expense (106) (74) 18 (60) (60)Other items 890 1,107 790 835 886Profit before tax 9,328 10,614 11,834 12,946 14,315Taxation (2,127) (2,406) (2,840) (3,107) (3,436)Minorities/pref divs/affils (82) (50) (40) (38) (38)Net income 7,119 8,158 8,954 9,801 10,841

Summary cashflow forecast (US$m) Net income 7,119 8,158 8,954 9,801 10,841Operating adjustments 82 50 40 38 38Depreciation/amortisation 1,236 1,443 1,913 1,951 2,010Working capital changes (564) 370 94 225 56Non-operating adjustments 313 (489) 119 0 0Net operating cashflow 8,186 9,532 11,121 12,015 12,945Capital expenditure (1,993) (2,215) (2,940) (3,000) (2,850)Free cashflow 6,193 7,317 8,181 9,015 10,095Acq/inv/disposals (26) (1,638) (115) 0 0Net investing cashflow (2,019) (3,853) (3,055) (3,000) (2,850)Increase in loans 2,363 1,848 2,736 0 0Dividends (3,800) (4,068) (4,318) (4,721) (5,108)Net equity raised/other (856) (1,245) (2,131) (3,246) (3,274)Net financing cashflow (2,293) (3,465) (3,713) (7,967) (8,382)Incr/(decr) in net cash 3,874 2,214 4,353 1,048 1,713Exch rate movements 576 (166) 305 0 0Opening cash 4,701 9,151 11,199 15,857 16,906Closing cash 9,151 11,199 15,857 16,906 18,619

Summary balance sheet forecast (US$m) Cash & equivalents 9,151 11,199 15,857 16,906 18,619Debtors 3,758 4,430 4,045 4,161 4,420Inventories 2,354 2,650 2,442 2,541 2,699Other current assets 2,288 3,300 3,801 3,801 3,801Fixed assets 9,561 14,727 15,727 16,776 17,616Intangible assets 12,828 26,909 27,461 27,461 27,461Other term assets 1,976 2,121 2,701 2,701 2,701Total assets 48,671 72,921 80,490 82,802 85,773Short-term debt 6,800 9,376 14,812 14,812 14,812Creditors 6,657 8,859 8,873 9,313 9,785Other current liabs 264 273 396 396 396Long-term debt/CBs 5,059 14,041 11,373 11,373 11,373Provisions/other LT liabs 4,545 9,055 9,099 9,099 9,099Minorities/other equity 0 0 0 0 0Shareholder funds 25,346 31,317 35,938 37,810 40,307Total liabs & equity 48,671 72,921 80,490 82,802 85,773

Ratio analysis Revenue growth (% YoY) (3.0) 13.3 32.2 4.9 6.2Ebitda growth (% YoY) (2.4) 12.7 17.4 9.1 9.8Ebitda margin (%) 31.6 31.4 27.9 29.0 30.0Net income margin (%) 23.0 23.2 19.3 20.1 21.0Dividend payout (%) 53.7 50.4 48.8 48.2 47.1Effective tax rate (%) 22.8 22.7 24.0 24.0 24.0Ebitda/net int exp (x) 92.3 149.0 0.0 235.4 258.3Net debt/equity (%) 10.7 39.0 28.7 24.5 18.8ROE (%) 31.4 29.0 26.7 26.7 27.9ROIC (%) 26.7 20.9 18.2 19.5 21.3EVA®/IC (%) 17.8 12.0 9.3 10.6 12.4Source: Company, Credit Agricole Securities (USA)

Cash continues to build on Coke’s balance sheet

Capital expenditures are up on investments

in US bottling

We expect innovation to continue driving strong

revenue growth

Gap Produced byProduced byProduced by


Financials Year to 31 Jan 10A 11A 12CL 13CL 14CLRevenue (US$m) 14,197 14,664 14,681 15,585 16,432Net income (US$m) 1,102 1,204 835 928 1,049EPS (US$) 1.58 1.88 1.50 1.70 1.93CL/consensus (34) (EPS%) - - - - -EPS growth (% YoY) 17.6 19.1 (20.0) 13.3 13.1PE (x) 12.3 10.3 13.0 11.4 10.1Dividend yield (%) 1.9 2.1 2.3 2.3 2.3FCF yield (%) 11.9 9.7 6.9 9.0 12.1PB (x) 2.8 3.1 4.2 3.2 2.4ROE (%) 23.8 26.8 25.0 31.2 26.9Net debt/equity (%) (28.3) (16.4) 32.9 4.5 (20.9)Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate


Barbara Wyckoff [email protected] (1) 212 261 3852

2 November 2011

USA Consumer Reuters GPS.N Bloomberg GPS US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$23.72/15.15 12M price target US$19.00 ±% potential 0% Target set on 5 Oct 11 Shares in issue 550.4m Free float (est.) 63.7% Market cap US$9,888m 3M average daily volume US$38.9m Major shareholders ESL Investments 4.9% Alliance Bernstein 4.4%


Absolute 16.4 (3.4) (0.8) Relative 5.5 3.6 (6.5)

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23

25

27


63

68

73

78

83

88

93

98

103

108

Gap (LHS)Rel to 500

(US$) (%)

Source: Bloomberg

www.clsa.com

Industry innovator Gap has facilitated shopping on its website via smartphones, using iPhone and Android apps, and early results are encouraging. Mobile traffic has grown 10% per month and conversions to buyers on smartphones in August 2011 were triple those of August 2010. Gap attributes this success to higher smartphone penetration plus its smaller, easier-to-use platform. It plans to launch the mobile platform for Canada and Europe next year.

New technology helps retailers & suppliers Gap built its own website and made the adjustments to it and its mobile platform. Many other retailers are investing in mobile technology, but some have admitted that they don’t know when or whether their customer will respond to the technology. Our industry contacts tell us that there is a Word application from demandware that can be used to customize a website for mobile phone use. In addition, this company offers a seamless platform for a retailer or wholesaler to launch e-commerce in multiple countries and jurisdictions having different pricing and currencies.

Market intelligence Our industry sources also shared a broad range of new technologies that could be used effectively by both retailers and manufacturers/wholesalers. One especially interesting application comes from panjiva.com, which specializes in market intelligence - panjiva combines US customs data with other accessible data, enabling a supplier to search for production capabilities and capacity. It also helps ferret out fraud so a company can protect its brand, and it can be used to enhance competitive positioning as it shows details on brand production.

Manufacturers want to dive deeper into competitive selling tools SkyIT.com is a graphical user interface that enables a manufacturer to access weekly selling information so it can analyze that data to help understand product performance better – or, why performance may differ with two distinct retailers (ie, comparing the performance of their brand in Saks Fifth Avenue and Neiman Marcus in the same mall). This program helps the manufacturer to better understand product placement, store demographics and to isolate assortment and size issues that may be affecting the sell through of a collection versus the competition.

Gap - O-PF US strategy


Another new system is Predictix, a user-friendly forecasting and planning program compared to the JDA Arthur planning systems, which are widely used in retail. This ‘lightweight’ application is a flexible system designed by the founders of JDA and helps retailers improve their merchandising decisions.

A big push in the industry is the development of PLM systems - or Product Lifecycle Management. Lectra has these systems as do Tradestone and Optitex, among others. These systems manage the supply chain from the ideaization stage to in store, enabling the user to tap into historical information in order to revisit cad images, fabric information and selling results from prior successful (or unsuccessful seasons). These systems are different in that they are more fluid than the ERP or Enterprise Resource Planning systems that SAP offers.

Retailers and their suppliers have utilized technology for many years to help manage inventory. Analytics help retailers predict pricing and markdown strategies, customers’ shopping habits and to forecast the right classification mix, what colors and sizes to flow by store location based on historical results. Universal inventory systems between stores and direct/online channels help ensure that a potential sale is never lost. A wholesale brand can predict what styles might sell best in a key retail account, using that store’s historical selling results. These tools help retailers and manufacturers make better decisions in order to best utilize inventory dollars and avoid unplanned markdowns.

Predicting future style selling results is more difficult unless the style has some roots in history; thus, retailers typically have shied away from predictive tools for new styles and trends. Most merchants still rely on their “eye,” editing and predictive skills in order to determine future best-sellers from the flood of trends that appear each season. However, early sales from online channels can be studied to gauge better predictability of what will sell in the stores. New systems are starting to be utilized to help merchants predict styles, trends and outfit options as they appear on searches, blogs, viral videos and street clothes in real time online. This will enable a history to be built and more predictability as to which styles will be the season’s winners.

Company outline The business Competition & market franchise

The Gap, Inc., through its subsidiaries, operates as a specialty retailing and e-commerce company. The company offers clothing, accessories and personal care products for men, women, children and babies under the Gap, Old Navy, Banana Republic, Piperlime and Athleta brand names. The company has stores in the USA, Canada, Europe and Asia. It also has franchised stores in many countries with local retail partners who buy the product from Gap, Inc. on a wholesale basis, run the stores and pay them a royalty based on sales. The company also has e-commerce in the USA and overseas supporting the owned and franchise stores.

Gap, Inc.'s competitors include most specialty retailers and department stores in the USA that carry apparel, accessories and footwear for men, women, children and babies. Gap had first-mover advantage into the casual sportswear business but has lost market share as more nimble competitors and aggressive discounters have entered the US retail scene. Gap also competes with e-commerce retailers in every market in which it has stores and a web presence. Internationally, Gap competes in many markets with H&M, Inditex (Zara) and FAST Retailing (Uniqlo) as well as local retailers who offer casual unisex and children's sportswear at affordable prices.

Retail software has become more user friendly

Marrying history with predictive tools is tricky,

but these systems will be more widely used

Product lifecycle management systems are

becoming more widely used



Summary financials Year to 31 January 2010A 2011A 2012CL 2013CL 2014CL

Summary P&L forecast (US$m) Revenue 14,197 14,664 14,681 15,585 16,432Op Ebitda 2,388 2,530 1,948 2,080 2,292Op Ebit 1,815 1,968 1,398 1,519 1,720Interest income 0 0 0 0 0Interest expense 1 14 (27) 2 0Other items 0 0 0 0 0Profit before tax 1,816 1,982 1,371 1,521 1,720Taxation (714) (778) (536) (593) (671)Minorities/pref divs/affils 0 0 0 0 0Net income 1,102 1,204 835 928 1,049

Summary cashflow forecast (US$m) Net income 1,102 1,204 835 928 1,049Operating adjustments 0 0 0 0 0Depreciation/amortisation 573 562 550 561 572Working capital changes 229 (247) (68) 52 247Non-operating adjustments 24 225 0 0 0Net operating cashflow 1,928 1,744 1,317 1,541 1,868Capital expenditure (334) (557) (575) (600) (600)Free cashflow 1,594 1,187 742 941 1,268Acq/inv/disposals (203) 128 0 0 0Net investing cashflow (537) (429) (575) (600) (600)Increase in loans (50) 3 1,606 0 0Dividends (234) (252) (249) (245) (245)Net equity raised/other (487) (1,878) (2,031) 0 0Net financing cashflow (771) (2,127) (674) (245) (245)Incr/(decr) in net cash 620 (812) 68 696 1,023Exch rate movements 13 25 0 0 0Opening cash 1,715 2,348 1,561 1,629 2,325Closing cash 2,348 1,561 1,629 2,325 3,348

Summary balance sheet forecast (US$m) Cash & equivalents 2,348 1,561 1,629 2,325 3,348Debtors 0 0 0 0 0Inventories 1,477 1,620 1,696 1,801 1,903Other current assets 839 745 750 750 750Fixed assets 2,628 2,563 2,610 2,708 2,778Intangible assets 0 0 0 0 0Other term assets 693 576 500 490 470Total assets 7,985 7,065 7,185 8,074 9,249Short-term debt 0 0 0 0 0Creditors 1,027 1,049 1,060 1,134 1,201Other current liabs 1,104 1,046 1,038 1,111 1,176Long-term debt/CBs 963 890 2,486 2,476 2,416Provisions/other LT liabs 0 0 0 0 0Minorities/other equity 0 0 0 0 0Shareholder funds 4,891 4,080 2,601 3,353 4,456Total liabs & equity 7,985 7,065 7,185 8,074 9,249

Ratio analysis Revenue growth (% YoY) (2.3) 3.3 0.1 6.2 5.4Ebitda growth (% YoY) 12.9 5.9 (23.0) 6.8 10.2Ebitda margin (%) 16.8 17.3 13.3 13.3 13.9Net income margin (%) 7.8 8.2 5.7 6.0 6.4Dividend payout (%) 22.8 21.3 29.3 25.8 22.9Effective tax rate (%) 39.3 39.3 39.1 39.0 39.0Ebitda/net int exp (x) 0.0 0.0 72.1 0.0 0.0Net debt/equity (%) (28.3) (16.4) 32.9 4.5 (20.9)ROE (%) 23.8 26.8 25.0 31.2 26.9ROIC (%) 30.4 34.6 24.8 26.6 29.9EVA®/IC (%) 18.3 22.4 12.7 14.5 17.7Source: Company, Credit Agricole Securities (USA)

Gap and Banana Republic should show improved

sales trends as product improves early in FY13

Typically, Gap generates strong free cashflow even

if business is bad

No LT debt outside of leases until 2QFY12,

when it took on US$1.6bn at attractive rates



Notes

Google Produced byProduced byProduced by

US$598.67 - BUY

Financials Year to 31 Dec 09A 10A 11CL 12CL 13CLRevenue (US$m) 23,651 29,321 38,545 47,535 56,734Net income (US$m) 6,523 8,505 10,526 12,930 15,270EPS (US$) 20.42 26.31 32.19 39.18 46.00Adjusted EPS (US$) 23.22 29.61 37.10 44.27 51.06CL/consensus (36) (EPS%) - - 91 94 92EPS growth (% YoY) 53.4 28.8 22.4 21.7 17.4Adj EPS growth (% YoY) 19.1 27.5 25.3 19.3 15.3PE (x) 29.3 22.8 18.6 15.3 13.0Adjusted PE (x) 25.8 20.2 16.1 13.5 11.7PB (x) 5.3 4.2 3.3 2.7 2.2ROE (%) 20.3 20.7 20.0 19.3 18.3Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate


James Lee [email protected] (1) 646 596 2409

Wei Fang (1) 617 295 0128

2 November 2011

Global Media Reuters GOOG.O Bloomberg GOOG US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$642.96/473.02 12M price target US$775.00 ±% potential +29% Target set on 15 Oct 11 Shares in issue 326.0m Free float (est.) 100.0% Market cap US$193,303m 3M average daily volume US$2,634.3m Major shareholders Fidelity Management 5.9%


Absolute 6.2 (3.6) (4.5) Relative 5.5 5.6 (7.0)

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Google (LHS)Rel to 500

(US$) (%)

Source: Bloomberg

www.clsa.com

Moving up the funnel We like Google’s strategy of moving up the marketing funnel, capturing larger opportunities outside search, such as display, mobile, local and social. The company is creatively marrying science, technology and scale to offer better solutions to customers. We are excited about the display and mobile segments and believe that once Google’s investments start to bear fruit, the growth story will play out. We like its 80/20 philosophy that encourages employees to spend 20% of time on innovative projects.

Upper marketing funnel to drive growth Google has been successful in search, the discovery phase of the internet. As the internet becomes more of a connected medium, the next phase of growth is likely to come from the upper end of the marketing funnel, which generates demand from consumer emotion, impulse and engagement. With that in mind, Google’s strategy centers on platforms that enable the distribution of products to capitalize on a c.US$70bn opportunity in the upper funnel, leveraging its core search as an extension.

Marrying science, technology and scale For display, Google marries its user knowledge from search, reach from ad network and technology from ad exchange to effectively match inventory supply and demand. For mobile, it leverages its end-to-end presence to offer comprehensive ad solutions. For local, it brings together its search competency with a new payment technology and commerce platform to converge online and offline experiences.

Mobile display advertising We believe Google has a meaningful technology advantage with the experience of AdMob. The in-app ad represents a unique opportunity as it reaches scale, yet is targeted, making the proposition compelling for branded advertisers. The Android OS has also quickly become the leader in the USA and gained more than 40% market share. Nielsen data show about 70% of Android users’ time spent on phones is in apps. We believe the mobile ad opportunity can be substantial for Google - in both smartphones and tablets.

Valuation attractive Our US$775 target price is based on 15x 12CL non-GAAP EPS of US$44.27 plus net cash per share of US$119. Our target multiple is at a discount to two-year earnings Cagr of 22%. We reiterate our BUY rating.

Google - BUY US strategy


Figure 1

Google is moving up the funnel from demand fulfillment to demand generation

Social Display Mobile

Search

Demand generation

Demand fulfillment

Purchase intent

Favorability

Consideration

Awareness


Figure 2

Time spent vs ad spend in percentage terms among media in the USA

0

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10

15

20

25

30

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40

45

TV andvideo

Internet Radio Mobile Newspaper Magazines Other

Time spent Ad US$ spend(%)

Source: Nielsen, eMarketer, Credit Agricole Securities (USA)

Figure 3

How Google retargets search users

Search on Google

Landing site visit history and behavior likesite browsing, online purchasing

Retargeting database

New visit to sites


Targeted ads

Store consumer visit history and behavior

Search consumer prior behavior

Personalized ad based on consumer interest and behavior


Google is moving up the marketing funnel

Mismatch between time spent and ad spend

creates opportunities

Google integrates innovative tech to

retarget search users



Figure 4

Consumer behavior data on Youtube extremely valuable to advertisers

Watching video on Youtube


New visit to sites


Targeted ads

Store consumer visit history and behavior

Search consumer prior behavior

Personalized ad based on consumer interest and behavior


Figure 5

Google aggregates user data and behavior via Android OS, leading to opportunities in mobile search and display

(Use open source OS to partner with OEMs)

(Use open source OS to attract 3rd party app developers)

(Analyze behavioral data aggregated from end users)

(Offer better search and display services)

OEMs+

Mobile search(more relevant results)

Mobile display(more accurate targeting)


Figure 6

Android Market has more free apps in absolute number

(‘000 except for downloads) App Free apps

Paid apps

Total downloads

Android market 270 170 100 6bnApple app store for iPad 76 25 51 naApple app store for iPhone 333 113 220 10bnSource: Company (as of July 2011)

Google analyzes consumer behavior and

creates targeted ads

Apple Store vs Android Market





Summary cashflow forecast (US$m) Net income 6,523 8,505 10,526 12,930 15,270Operating adjustments (3) 0 0 0 0Depreciation/amortisation 1,524 1,396 2,018 2,420 2,420Working capital changes 486 (99) 518 (294) (296)Non-operating adjustments 785 1,279 2,021 2,100 2,100Net operating cashflow 9,316 11,081 15,083 17,156 19,494Capital expenditure (810) (4,018) (3,607) (3,200) (3,200)Free cashflow 8,506 7,063 11,476 13,956 16,294Acq/inv/disposals (7,209) (6,662) (8,222) 1,717 2,855Net investing cashflow (8,019) (10,680) (11,829) (1,483) (345)Increase in loans 0 3,463 (65) 0 0Dividends 0 0 0 0 0Net equity raised/other 233 (413) 250 250 250Net financing cashflow 233 3,050 185 250 250Incr/(decr) in net cash 1,530 3,451 3,439 15,923 19,399Exch rate movements 11 (19) 187 0 0Opening cash 8,657 10,198 13,630 17,256 33,178Closing cash 10,197 13,630 17,256 33,178 52,577

Summary balance sheet forecast (US$m) Cash & equivalents 10,198 13,630 17,256 33,178 52,577Debtors 3,178 4,252 5,280 6,512 7,772Inventories 0 0 0 0 0Other current assets 15,791 23,680 30,880 28,702 25,399Fixed assets 4,845 7,759 9,686 10,806 11,926Intangible assets 5,678 7,300 7,962 8,622 9,282Other term assets 679 707 578 713 851Total assets 40,497 57,851 72,165 89,056 108,330Short-term debt 0 3,465 400 400 400Creditors 216 483 327 410 500Other current liabs 2,532 6,048 6,526 7,497 8,491Long-term debt/CBs 0 0 3,000 3,000 3,000Provisions/other LT liabs 1,745 1,614 2,688 3,245 3,815Minorities/other equity 0 0 0 0 0Shareholder funds 36,004 46,241 59,225 74,504 92,125Total liabs & equity 40,497 57,851 72,165 89,056 108,331

Ratio analysis Revenue growth (% YoY) 8.5 24.0 31.5 23.3 19.4Ebitda growth (% YoY) 36.9 19.6 21.0 23.8 16.2Ebitda margin (%) 42.7 41.2 37.9 38.1 37.1Net income margin (%) 27.6 29.0 27.3 27.2 26.9Dividend payout (%) 0.0 0.0 0.0 0.0 0.0Effective tax rate (%) 24.6 23.4 22.1 22.0 21.7Ebitda/net int exp (x) 0.0 0.0 0.0 0.0 0.0Net debt/equity (%) (28.3) (22.0) (23.4) (40.0) (53.4)ROE (%) 20.3 20.7 20.0 19.3 18.3ROIC (%) 26.9 25.4 23.2 25.7 31.1EVA®/IC (%) 15.3 13.8 11.6 14.2 19.5Source: Company, Credit Agricole Securities (USA)

We expect Google’s free cashflow to remain strong

We expect Google to continue its robust

revenue growth

Google’s assets should continue to expand

Heinz Produced byProduced byProduced by


Financials Year to 30 Apr 10A 11A 12CL 13CL 14CLRevenue (US$m) 10,495 10,707 11,811 12,342 12,898Net income (US$m) 904 990 1,098 1,202 1,317EPS (US$) 2.84 3.06 3.38 3.70 4.05CL/consensus (17) (EPS%) - - 102 101 102EPS growth (% YoY) (2.7) 7.8 10.4 9.4 9.5PE (x) 19.0 17.7 16.0 14.6 13.3Dividend yield (%) 3.0 3.3 3.5 3.8 4.1FCF yield (%) 5.7 7.1 6.5 7.1 7.8PB (x) 9.1 5.6 5.0 4.5 4.1ROE (%) 59.2 40.2 33.9 33.1 32.2Net debt/equity (%) 218.6 125.1 107.0 82.4 60.2Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate


Diane Geissler, CFA [email protected] (1) 212 408 5649

Patty Kanada, CFA (1) 212 261 3238

2 November 2011

USA Consumer Reuters HNZ.N Bloomberg HNZ US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$54.99/47.05 12M price target US$59.00 ±% potential +9% Target set on 31 May 11 Shares in issue 316.2m Free float (est.) 99.3% Market cap US$17,346m 3M average daily volume US$52.4m Major shareholders Vanguard Group 3.8%


Absolute 7.3 (1.2) 7.7 Relative (1.6) 7.3 2.9

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Heinz (LHS)Rel to 500

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Source: Bloomberg

www.clsa.com

Keeping it fresh We believe Heinz showcases one of the more robust and consistent innovation pipelines supporting future growth. Recent cutting-edge breakthroughs include Dip & Squeeze - a transformational innovation to sachet foodservice - and a recyclable ketchup bottle made with Coca-Cola’s proprietary PlantBottle technology. More convenience and ease of transport/storage are also in place with other core products that leverage Heinz’s new technologies and innovations internally across core brands.

Dip & Squeeze transforms foodservice and heads into retail Following a highly successful commercial launch earlier this year, Heinz released the retail version this summer of a new ketchup package that represents the first ‘transformational’ packaging innovation in the sachet foodservice industry in over 40 years, according to Food & Beverage Packaging magazine, which named Heinz ‘Food Packager of the Year’ earlier this month.

PlantBottle partnership with Coca-Cola thriving Distribution of Heinz’s new earth-friendly PlantBottle is flourishing with about 70% of the company’s restaurant tabletop ketchup business taking up the product. The proprietary bottling technology being used in Heinz’s 20oz ketchup product promises to be a key point of differentiation as it satisfies consumers’ growing preference for sustainable (green) products.

King of ketchup Heinz’s strong innovation platform supports its preeminent position as the top ketchup brand in the world. According to Euromonitor data, Heinz ranks No.1 in six out of the world’s top 10 ketchup markets. Strong growth out of other key markets, such as France, Russia and Spain, bodes well for future share leadership in additional markets.

Leveraging innovation across brands Ketchup is not the only innovation pillar for Heinz. New packaging, sustainability and taste improvement technologies are being applied to its other products, as retailers and consumers search for greater convenience and ease of display, transport and storage. We believe the company’s expansion of TGI Friday’s into the single-serve frozen aisle promises to revitalize a category that is highly competitive, but has lacked significant innovation in recent years.

Heinz - O-PF US strategy


Keeping it fresh Despite a weak macro environment and a cautious consumer, Heinz’s product innovation pipeline remains robust, establishing important seeds for future growth and making the company a standout innovator among its packaged food peers. We believe Heinz’s recent introduction of the new Dip & Squeeze ketchup packaging format for use in foodservice and retail is a strong example of disruptive technology at work. Its partnership with Coca-Cola on a new and eco-friendly PlantBottle is an example of best-in-class collaboration that leverages world-class expertise across industries. Finally, we believe Heinz is effectively internalizing its new strengths across its core product portfolio as it improves innovation behind up-and-coming mega brands such as TGI Friday’s.

The enormous success of its recently launched ketchup packaging innovation is a clear example of what Heinz strives to do best: listen to consumers. After 16 months in development, the new Dip & Squeeze platform offers customers three times the amount of ketchup typically available in the standard foodservice packet and the option of either “dipping” or “squeezing” the condiment for use. Food & Beverage Packaging magazine lauds Dip & Squeeze as the first ‘transformational’ packaging innovation in the sachet foodservice industry in over 40 years.

Already available at Chick-fil-A and Smashburger, Heinz recently added Wendy’s to its customer roster. Foodservice reception was so great that Heinz followed up the commercial launch with a retail launch of 10-pack cartons last month, marking the first time a Heinz ketchup innovation meant for foodservice landed on retail shelves as well. We believe that Heinz was able to leverage its long experience in portion-pak, as well as its recent experience in emerging markets, where products often come in sachet format, to create an entirely new product offering.

The company has also shown its ability to connect with consumers in creating Simply Heinz tomato ketchup in response to consumer preferences for sugar versus high fructose corn syrup (HFCS). Heinz also introduced other ketchup varieties that exclude salt, reduce sugar or are made with organic ingredients. We believe its ability to adapt to changes in consumer taste preferences is key to continued success.

Sustainability is also a driving factor behind Heinz’s innovation initiatives and addresses customers’ desire for convenience and ease of display, transport and storage. The company’s new partnership with Coca-Cola to manufacture eco-friendly packaging for Heinz products, starting with its 20oz ketchup product, promises to be a key point of differentiation for Heinz and satisfies consumers’ growing preference for sustainable (green) products. Launched earlier this year, the new packaging is manufactured with Coca Cola’s proprietary PlantBottle technology that produces bottles that include 30% plant-based materials (working toward 100% renewable content) and are fully recyclable. So far, sale of the product is flourishing with distribution throughout participating restaurants (70% of Heinz’s tabletop ketchup business) and a target of 120m PlantBottle packages in 2011.

As a result of its strong innovation platform, Heinz has remained at the top of the global ketchup market with a No.1 position in six out of the world’s top 10 ketchup markets, including the USA (~60% share), Germany (26%), UK (~72%), Venezuela (~54%), Canada (85%) and France (~37%), according

Robust and innovative product pipeline supports a healthy growth outlook

The first transformational packaging innovation to

hit the sachet foodservice industry in over 40 years

Partnering with industry leaders to deliver

best-in-class technology

Innovation supports Heinz’s global leadership

in ketchup

Strong foodservice reception of Dip &

Squeeze led to retail launch

Delivering on consumer demands



to Euromonitor (2010). As of 1QFY12, France, Russia and Spain led Heinz’s ketchup growth in Europe with France growing at 13%, Russia at 11% and Spain at 7%.

Heinz has also applied new packaging, sustainability and taste improvement technologies to other core products, such as TGI Friday’s frozen entrees, Ore Ida and Smart Ones. In 4QFY11, for example, Heinz launched nine new frozen SKUs across bag and tray packaging formats, representing its biggest new product launch in the North American consumer division in more than five years. We believe the expansion of the TGI Friday’s line into the frozen category positions the line to become Heinz’s next mega brand in the USA and addresses retailers’ demand for new product innovation in this hyper-competitive, yet weakly innovative, category.

Figure 1 Figure 2

Heinz named ‘Food Packager of the Year’

Disrupting sachet foodservice packaging

Source: Company, Food & Beverage Packaging

Figure 3 Figure 4

PlantBottle partnership with Coca Cola

Listening to consumers: Sugar ‘yes’, HFCS ‘no’

Source: Company

Internalizing expertise



Summary financials Year to 30 April 2010A 2011A 2012CL 2013CL 2014CL

Summary P&L forecast (US$m) Revenue 10,495 10,707 11,811 12,342 12,898Op Ebitda 1,847 1,947 2,149 2,305 2,469Op Ebit 1,544 1,648 1,822 1,971 2,129Interest income 45 23 16 18 20Interest expense (296) (275) (285) (280) (280)Other items (18) (21) (22) (20) (20)Profit before tax 1,275 1,374 1,531 1,689 1,849Taxation (354) (368) (413) (464) (509)Minorities/pref divs/affils (17) (16) (20) (22) (24)Net income 904 990 1,098 1,202 1,317

Summary cashflow forecast (US$m) Net income 904 990 1,098 1,202 1,317Operating adjustments (22) 16 0 0 0Depreciation/amortisation 303 299 327 334 340Working capital changes 261 50 (35) (35) (35)Non-operating adjustments (184) 229 55 55 55Net operating cashflow 1,262 1,584 1,445 1,556 1,677Capital expenditure (278) (336) (300) (300) (300)Free cashflow 985 1,248 1,145 1,256 1,377Acq/inv/disposals 291 (614) (260) 15 15Net investing cashflow 13 (950) (560) (285) (285)Increase in loans (611) (9) (210) (310) (310)Dividends (534) (580) (623) (671) (721)Net equity raised/other (4) 106 (100) (100) (100)Net financing cashflow (1,148) (483) (933) (1,081) (1,131)Incr/(decr) in net cash 128 152 (49) 190 261Exch rate movements (18) 90 0 0 0Opening cash 373 483 724 676 866Closing cash 483 724 676 866 1,126

Summary balance sheet forecast (US$m) Cash & equivalents 483 724 676 866 1,126Debtors 1,045 1,265 1,275 1,285 1,295Inventories 1,249 1,452 1,477 1,502 1,527Other current assets 273 313 333 353 373Fixed assets 2,092 2,505 8,725 8,691 8,651Intangible assets 4,069 4,897 0 0 0Other term assets 864 1,075 0 0 0Total assets 10,076 12,231 12,485 12,696 12,972Short-term debt 59 1,535 1,525 1,515 1,505Creditors 1,130 1,500 1,510 1,520 1,530Other current liabs 987 1,127 1,152 1,177 1,202Long-term debt/CBs 4,559 3,078 2,878 2,578 2,278Provisions/other LT liabs 1,450 1,882 1,937 1,992 2,047Minorities/other equity 0 0 0 0 0Shareholder funds 1,891 3,109 3,483 3,915 4,410Total liabs & equity 10,076 12,231 12,485 12,696 12,972

Ratio analysis Revenue growth (% YoY) 4.8 2.0 10.3 4.5 4.5Ebitda growth (% YoY) 3.6 5.4 10.4 7.2 7.1Ebitda margin (%) 17.6 18.2 18.2 18.7 19.1Net income margin (%) 8.6 9.2 9.3 9.7 10.2Dividend payout (%) 59.1 58.8 56.8 55.8 54.8Effective tax rate (%) 27.8 26.8 27.0 27.5 27.5Ebitda/net int exp (x) 7.4 7.7 8.0 8.8 9.5Net debt/equity (%) 218.6 125.1 107.0 82.4 60.2ROE (%) 59.2 40.2 33.9 33.1 32.2ROIC (%) 15.1 14.8 14.8 15.6 16.9EVA®/IC (%) 7.3 6.9 6.9 7.8 9.1Source: Company, Credit Agricole Securities (USA)

We forecast revenue growth of 10.3% in FY12

and 4.5% in FY13

We expect Heinz to maintain healthy dividend

levels and strong free cashflow

We forecast debt levels to remain stable

through FY14

IBM Produced byProduced byProduced by


Financials Year to 31 Dec 09A 10A 11CL 12CL 13CLRevenue (US$m) 95,757 99,870 107,690 111,715 116,115Net income (US$m) 13,451 15,022 16,204 17,491 19,048EPS (US$) 10.03 11.67 13.39 14.71 16.39CL/consensus (24) (EPS%) - - - - -EPS growth (% YoY) 13.2 16.4 14.2 10.3 11.5PE (x) 16.9 14.5 13.9 12.7 11.4Dividend yield (%) 0.0 0.0 1.6 1.8 2.0FCF yield (%) 7.8 7.4 6.6 8.7 9.5Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate



David Kwon (1) 212 261 7586

2 November 2011

USA Technology Reuters IBM.N Bloomberg IBM US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$185.61/132.34 12M price target US$200.00 ±% potential +6% Target set on 18 Oct 11 Shares in issue 1,211.2m Free float (est.) 99.8% Market cap US$219,624m 3M average daily volume US$317.5m Major shareholders State Street 5.4%



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www.clsa.com

Innovation leader IBM approaches innovation as a core strategy for differentiation. The research division has unparalleled resources with the largest mathematics department, latest super-computers and unique independence. This allows IBM to innovate ahead of the curve, with disruptive innovations beyond the current roadmaps driven by the skills of its researchers. IBM’s innovation output is consistently unrivaled with 2010 representing the 18th straight year as the patent leader.

Analytics is a larger opportunity than imagined IBM continues to invest in its research team by hiring droves of high-quality mathematicians, which has resulted in the world's largest mathematics department of any public company. For IBM, analytics reaches beyond optimizing supply chains to finding patterns of all types of problems across industries. Big Data and Fast Data are ripe for innovation and IBM is developing new software and systems to deal with these areas.

Hardware innovation involves tighter integration Recently, clock frequency has not increased as Moore’s Law reaches its physical limits, thus the ability to vertically integrate chip density with more cores and threads has become increasingly important. With tight integration of software at the chip level, IBM has been able to achieve significant acceleration. This has been an underlying force in pulling together the systems and software business as a deeper understanding of workloads is required to optimize hardware.

Still room for improvement in Services Management believes the Services business still has to go through the process of mechanization, such as reproducible processes, more asset intensive combinations of hardware and software. Cloud computing can reduce the number of people in a data center, which is a huge opportunity. IBM has a lot of resources involved in working on tools and productivity to improve pricing and returns.

Astonishing advancements in human/cognitive computing IBM’s cognitive-computing project has accelerated more quickly than expected, which involves reverse-engineering the brain in order to replicate the architecture in a computer. The research team was able to construct silicon chips with a few hundred synapses and ultimately the same number of synapses as in a cat’s brain. These chips possess self-learning capabilities that do not need to be programmed. Along with heavy funding from DARPA, the long-term vision is that this project will deliver learning machines that can be deployed in a variety of uses.

IBM - O-PF US strategy


Innovation summary IBM’s core strategy and differentiation are fundamentally driven by

innovation. The company religiously spends about 6% of total revenue for R&D per year regardless of the macro environment.

IBM is consistently ranked among the most innovative companies given its unmatched output of patents with 5,896 patents awarded in 2010 - the 18th consecutive year IBM has been the patent leader.

IBM’s research department has unparalleled resources with the largest mathematics department of any company, latest super-computing technology and unique independence within the company.

Figure 1 Figure 2

R&D as % of sales and patent output

R&D focus across the portfolio

Source: Company

Business model revolves around innovation IBM's business model revolves around helping clients successfully deliver business value by becoming more innovative, efficient and competitive through the use of business insight and IT solutions. Innovation at IBM involves a balance of focused teams, betting on people fully dedicated to innovative breakthroughs as well as discovering disruptive technologies outside the company.

The company’s portfolio is built around networked, modularized and embedded technologies, as well as business intelligence and analytics. Analytics is a major focus with about 1,000 researchers globally including roughly 400 mathematicians. The company's R&D efforts continue to push the frontiers of science and technology - from analytics, to cloud, to Watson.

Figure 3

Four technologies of IBM’s innovation focus

Source: Company

IBM's business revolves around helping clients

become more innovative

IBM is consistently ranked among the most

innovative companies

IBM's R&D efforts continue to push the

frontiers of science and technology



Watson emerging onto the commercial arena IBM recently announced an agreement with WellPoint to create the first commercial applications of its Watson “Deep Q&A” technology, with the first solutions expected to come to market in early 2012. Watson’s Deep Q&A system seeks to provide intelligent answers to natural language questions. This has been a holy grail for computer science for decades. Natural language has nuances and structures that are far more complex than data in a database. The ability to translate a question into a query, survey massive quantities of data and return a probability-weighted answer is no small feat.

The Watson project incorporates a plethora of natural language, artificial intelligence and machine-learning technologies. Watson can sift through and analyze the equivalent of roughly 200m pages of data to deliver precise responses in less than three seconds. When applied to specific problem domains, the relevance and potential value creation is compelling. We would expect Watson applications to be offered through the cloud on a subscription basis at first - possibly in conjunction with publishers of proprietary data. We expect vertical applications to be a promising approach to monetize this technology.

Figure 4

Underlying technology of Watson

Source: Company

Patent moat is wide and deep IBM believes it needs to have an enormous high-quality patent portfolio to have freedom of action - either hoard certain patents or license some for tactical purposes (US$1bn in IP income). The company prefers to cross license as much as possible. It foresaw the patent troll issue with non-practicing entities (NPEs), which is considered an asymmetric threat. When litigated, nine times out of 10, it’s a poor-quality patent that ends up dismissed. There are a few that stand out that have been settled and even less that has gone through legislation. The courts tend to listen to IBM since the company has the largest technology-patent portfolio in the world.

Watson seeks to provide intelligent answers to

natural language questions

Watson can analyze roughly 200m pages of

data to deliver responses in less than 3 seconds

IBM possesses the largest technology-patent

portfolio in the world

The Watson project employs a vast array of

natural language and analytic technologies




Summary P&L forecast (US$m) Revenue 95,757 99,870 107,591 111,737 116,243Op Ebitda 23,182 24,135 25,842 27,290 29,421Op Ebit 18,188 19,304 20,932 22,197 24,135Interest income 351 787 668 1,117 1,162Interest expense (402) (368) (387) (391) (407)Other items 27 188 465 477 487Profit before tax 18,164 19,912 21,678 23,400 25,377Taxation (4,713) (4,890) (5,397) (5,850) (6,344)Minorities/pref divs/affils 0 0 0 0 0Net income 13,451 15,022 16,282 17,550 19,033

Summary cashflow forecast (US$m) Net income 13,451 15,022 16,282 17,550 19,033Operating adjustments (27) (188) (465) (477) (487)Depreciation/amortisation 4,994 4,831 4,910 5,094 5,287Working capital changes 0 0 0 0 0Non-operating adjustments 2,354 (115) (2,689) 2,575 2,807Net operating cashflow 20,772 19,550 18,038 24,742 26,640Capital expenditure (3,117) (3,415) (3,750) (3,770) (3,770)Free cashflow 17,655 16,135 14,288 20,972 22,870Acq/inv/disposals (3,612) (5,093) 1,343 (197) (203)Net investing cashflow (6,729) (8,508) (2,407) (3,967) (3,972)Increase in loans 0 0 0 0 0Dividends (2) (3) (3) (3) (4)Net equity raised/other (14,700) (12,428) (15,532) (17,900) (18,259)Net financing cashflow (14,702) (12,431) (15,535) (17,904) (18,263)Incr/(decr) in net cash (659) (1,389) 95 2,871 4,405Exch rate movements 101 (134) 130 3 4Opening cash 12,741 12,183 10,660 10,885 13,760Closing cash 12,183 10,661 10,885 13,760 18,168

Summary balance sheet forecast (US$m) Cash & equivalents 12,183 10,661 10,885 13,760 18,168Debtors 26,793 28,225 29,799 31,241 32,716Inventories 2,494 2,450 2,653 2,799 2,953Other current assets 7,467 6,780 6,184 6,185 6,185Fixed assets 14,165 14,096 14,415 14,553 14,499Intangible assets 37,542 42,392 42,162 42,168 42,168Other term assets 0 0 0 0 0Total assets 109,024 113,451 116,338 120,950 126,935Short-term debt 4,168 6,778 7,985 7,953 7,954Creditors 7,436 7,804 8,239 8,638 9,046Other current liabs 24,399 25,980 25,452 26,160 27,064Long-term debt/CBs 21,932 21,846 21,915 21,915 21,915Provisions/other LT liabs 28,334 27,871 28,298 28,301 28,300Minorities/other equity 0 0 0 0 0Shareholder funds 22,755 23,172 24,449 27,984 32,656Total liabs & equity 109,024 113,451 116,338 120,950 126,935

Ratio analysis Revenue growth (% YoY) (7.6) 4.3 7.7 3.9 4.0Ebitda growth (% YoY) 2.8 4.1 7.1 5.6 7.8Ebitda margin (%) 24.2 24.2 24.0 24.4 25.3Net income margin (%) 14.0 15.0 15.1 15.7 16.4Dividend payout (%) 0.2 0.2 0.2 0.2 0.2Effective tax rate (%) 25.9 24.6 24.9 25.0 25.0Ebitda/net int exp (x) 458.1 0.0 0.0 0.0 0.0Net debt/equity (%) 61.2 77.5 77.8 57.6 35.8ROE (%) 74.3 65.4 68.4 66.9 62.8ROIC (%) 23.3 24.9 25.8 26.9 29.1EVA®/IC (%) 14.4 16.0 16.9 18.0 20.2Source: Company, Credit Agricole Securities (USA)

We forecast revenue growth of 3.7% in FY12

and 3.9% in FY13

Our 2011 free cashflow assumes US$15bn in

share repurchase and US$4bn in capex

Margin improvement will be driven by software’s

increasing contribution to the revenue mix

Illumina Produced byProduced byProduced by


Financials Year to 31 Dec 09A 10A 11CL 12CL 13CLRevenue (US$m) 666 903 1,052 1,110 1,237Net income (US$m) 104 142 165 182 220EPS (US$) 0.80 1.06 1.19 1.30 1.55CL/consensus (21) (EPS%) - - 96 91 88EPS growth (% YoY) 17.5 32.7 12.8 9.2 18.7PE (x) 39.5 29.8 26.4 24.2 20.4Dividend yield (%) 0.0 0.0 0.0 0.0 0.0FCF yield (%) 3.3 6.0 5.8 5.7 7.0PB (x) 4.8 3.5 4.1 3.4 2.8ROE (%) 12.2 13.8 11.8 13.4 13.8Net debt/equity (%) 16.8 5.2 41.1 19.2 0.1Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate


Paul Knight [email protected] (1) 212 261 3967

Jonathan Palmer (1) 212 261 3827

Reggie Miller (1) 212 408 5883

2 November 2011

USA Healthcare Reuters ILMN.OQ Bloomberg ILMN US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$79.40/25.58 12M price target US$32.00 ±% potential +1% Target set on 25 Oct 11 Shares in issue 123.1m Free float (est.) 98.6% Market cap US$3,915m 3M average daily volume US$42.5m Major shareholders

Fidelity Mgmt & Research Co 7.6%


Absolute (44.7) (63.7) (47.4) Relative (45.1) (60.2) (48.8)

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Genomic revolution Illumina is leading the forefront of a genomic revolution more significant than the sequencing era of 1999-2001. We estimate that over 40,000 human genomes will be sequenced in 2011 versus only several hundred prior to 2010. Genomic work in plant, animal and diagnostics is transforming with gene validation and commercial products. Although Illumina’s end markets have slowed and our rating is Underperform, the company, along with downstream beneficiaries Thermo Fisher, Sigma Aldrich and Techne are poised to benefit from growth in sequencing.

A new genetic era The new second-generation sequencing devices by Illumina, Life and Roche 454 have made sequencing faster and have lowered cost. According to Michael Shatz, assistant professor at the premier molecular biology and genetics institute Cold Spring Harbor, sequencing has seen a step change from the common methods used as recently as 2000-05 when sequences were done one at a time. Now technology has changed to allow sequencing many individuals or organisms on a large scale at a rapid pace. There is an overflow of data being accumulated as a result of increased efficiency.

Hardware innovation Next-generation sequencing is the technology behind improved test efficiency. Longer read lengths resulting in more accurate analysis can be produced in a shorter time frame. Illumina is leading the industry, in our view, with its MiSeq system, which provides an efficient, low- to mid-throughput solution at a low cost that offers the best balance between cost, performance and accuracy. Competitors such as Life Technologies’ SOLiD franchise and Ion Torrent or Pacific Biosciences’ RS haven’t been able to provide the best methods, allowing analysis techniques to leverage the technology.

More significant advances today The immediate opportunity for growth is with animal and crop production as the advancement of technology, the need for efficiency and product development time is faster than human healthcare research. Innovation in seed technology and the resulting applications translate into commercial success as demonstrated by the Dicamba tolerant corn hybrid for Monsanto in 2012. From looking at the 2001-11 era of gene sequencing, we expect the first line of human health applications to be molecular diagnostics tests.

Illumina - U-PF US strategy


Innovation at work Acquiring Solexa in 2007 to leverage its presence in the genetic research laboratory market, Illumina has an estimated 60% of the next-generation sequencing market (NGS) and competes against Life Technologies, Roche and a variety of new entrants including Pacific Biosciences, Ion Torrent and Helicos. Illumina’s most recent product is the MiSeq, introduced in January 2011, initially priced to compete in the sub-US$125,000 price point, which followed the HiSeq 2000 introduced in January 2010 with a list price of US$690,000. Illumina covers a wide variety of price points and functionality with the Genome Analyzer IIx (US$390,000), Genome Analyzer IIe (US$250,000), HiScanSQ (previously called Harmonia and an add-on to the iScan array reader) and Avantome technology (low-price-point technology expected in 2010).

In addition, the company has participated in three rounds of equity investment with Oxford Nanopore Technologies (ONT) that included worldwide marketing rights. Utilizing ion detection of DNA sequences, ONT will eliminate tedious sample preparation and costly reagents, which represents another transformational step in sequencing.

Figure 1

Second-generation sequencers - Cold Spring Harbor Laboratory


Sequencing speed is increasing fivefold

per year

Illumina completed its third round of financing

in April 2011

MiSeq demand is a niche product driven by low

cost and rapid turnaround



Company outline The business Competition & market franchise

Illumina develops, manufactures and markets integrated systems for the large-scale analysis of genetic variation and biological function. The company provides a comprehensive line of products and services that currently serve the sequencing, genotype, gene expression and molecular diagnostics. Operating under two business lines, the Life Science segment services the research market while its Diagnostics unit concentrates on the emerging field of molecular diagnostics.

In a market that increases analytical speed faster than Moore's Law in technology markets, Illumina's primary competitor is Life Technologies and its portfolio of technology (Applied Biosystems, Agencourt, VisiGen), which sequenced the human genome in the late 1990s. Life Technologies' new technology, SOLiD, offers competitive prices and comparable sequencing speed. Illumina has about 60-70% of fast-sequencing installations; Life has c.20%, with Roche, Pacific Bio, Helicos and Complete Genomics as other competitors.

Source: Credit Agricole Securities (USA), Company

Figure 2

R&D as a percentage of sales

0

5

10

15

20

25

1Q

09

2Q

09

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09

4Q

09

1Q

10

2Q

10

3Q

10

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10

1Q

11

2Q

11

3Q

11CL

4Q

11CL

(%)

Source: Credit Agricole Securities (USA), Company

Figure 3

The promise of a US$1,000 genome

1

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10,000,000

Hum

anG

enom

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ics

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2000

Life

SO

LiD

5500 ??

??

(US$000)


Illumina was founded in 1998 and is based

in San Diego, CA

R&D as a percentage of revenue should remain

around 15%

The genome cost has gone from US$200m-plus to thousands of dollars in

less than 10 years




Summary P&L forecast (US$m) Revenue 666 903 1,050 1,100 1,198Op Ebitda 181 244 282 333 386Op Ebit 149 215 216 263 311Interest income 7 5 2 5 7Interest expense 0 0 0 0 0Other items 0 0 0 0 0Profit before tax 157 219 218 268 318Taxation (53) (77) (76) (88) (99)Minorities/pref divs/affils 0 0 0 0 0Net income 104 142 143 179 220

Summary cashflow forecast (US$m) Net income 104 142 143 179 220Operating adjustments (32) (17) (88) (60) (50)Depreciation/amortisation 32 29 65 70 75Working capital changes (11) (2) (30) (12) (12)Non-operating adjustments 82 121 136 110 110Net operating cashflow 174 273 226 287 342Capital expenditure (52) (50) (1) (65) (65)Free cashflow 123 223 224 222 277Acq/inv/disposals (204) (235) (454) 0 0Net investing cashflow (256) (285) (455) (65) (65)Increase in loans (10) 0 563 0 0Dividends 0 0 0 0 0Net equity raised/other (89) 116 (286) 0 0Net financing cashflow (99) 116 277 0 0Incr/(decr) in net cash (180) 104 47 222 277Exch rate movements (2) 0 0 0 0Opening cash 327 145 249 297 519Closing cash 145 249 297 519 797

Summary balance sheet forecast (US$m) Cash & equivalents 145 249 297 519 797Debtors 158 166 185 192 200Inventories 93 142 180 187 195Other current assets 586 702 1,026 1,026 1,026Fixed assets 117 130 127 122 112Intangible assets 257 348 435 435 435Other term assets 74 103 69 69 69Total assets 1,430 1,839 2,319 2,551 2,833Short-term debt 290 312 41 41 41Creditors 53 67 68 71 74Other current liabs 98 156 186 186 186Long-term debt/CBs 0 0 757 757 757Provisions/other LT liabs 124 107 47 47 47Minorities/other equity 0 0 0 0 0Shareholder funds 864 1,198 1,220 1,450 1,729Total liabs & equity 1,430 1,839 2,319 2,551 2,833

Ratio analysis Revenue growth (% YoY) 16.2 35.5 16.3 4.8 8.9Ebitda growth (% YoY) 21.6 34.7 15.5 18.1 16.2Ebitda margin (%) 27.2 27.0 26.8 30.2 32.3Net income margin (%) 15.6 15.8 13.6 16.3 18.3Dividend payout (%) 0.0 0.0 0.0 0.0 0.0Effective tax rate (%) 33.5 35.2 34.7 33.0 31.0Ebitda/net int exp (x) 0.0 0.0 0.0 0.0 0.0Net debt/equity (%) 16.8 5.2 41.1 19.2 0.1ROE (%) 12.2 13.8 11.8 13.4 13.8ROIC (%) 9.9 11.1 9.0 9.9 12.1EVA®/IC (%) 0.1 1.2 (0.9) 0.0 2.2Source: Company, Credit Agricole Securities (USA)

Gross margins have remained resilient despite

slowing revenue growth

We expect gearing to decrease in 2012

Illumina enjoys a healthy cash position versus

industry peers

Intel Produced byProduced byProduced by


Financials Year to 31 Dec 09A 10A 11CL 12CL 13CLRevenue (US$m) 35,127 43,623 54,821 57,807 61,369Net income (US$m) 4,369 11,464 13,347 13,934 14,196EPS (US$) 0.77 2.01 2.46 2.61 2.70CL/consensus (47) (EPS%) - - 104 105 101EPS growth (% YoY) (15.9) 160.0 22.1 6.2 3.6PE (x) 32.5 12.5 10.2 9.6 9.3Dividend yield (%) 2.2 2.5 3.1 3.3 3.3FCF yield (%) 4.7 8.1 7.1 11.1 11.7PB (x) 3.4 2.9 2.8 2.3 1.9ROE (%) 10.8 25.2 27.1 25.7 21.8Net debt/equity (%) (4.2) (6.8) (4.2) (21.1) (33.2)Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate


Srini Pajjuri [email protected] (1) 415 434 6142

Ryan Goodman, CFA (1) 415 434 6147

2 November 2011

USA Technology Reuters INTC.OQ Bloomberg INTC US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$24.78/19.16 12M price target US$26.00 ±% potential +3% Target set on 20 Oct 11 Shares in issue 5,340.0m Free float (est.) 99.9% Market cap US$131,958m 3M average daily volume US$408.0m Major shareholders BlackRock 4.9%



18

20

22

24

26

28


78

83

88

93

98

103

108

113

118

Intel (LHS)Rel to 500

(US$) (%)

Source: Bloomberg

www.clsa.com

Semiconductor innovation Intel has consistently helped pioneer geometry shrinks in the semiconductor sector. Its ‘tick-tock’ roadmap strategy of alternating between shrinks and new microarchitectures has remained a steadfast cadence for semiconductor technology for years. In 2011, the company also introduced an integrated CPU and GPU (Sandy Bridge). With the upcoming 22nm node (Ivy Bridge), Intel will introduce 3D tri-gate transistors, a fundamental shift from traditional 2D planar transistors.

‘Tick-tock’ cadence has defined the semiconductor industry The key to increasing the performance and lowering the cost of an integrated circuit is to reduce the circuit geometry on a chip to allow more transistors to fit in a given area. Intel’s tick-tock cadence of shrinking geometries (‘ticks’) and redesigning microarchitectures (‘tocks’) has done just that. Intel’s most recent microarchitecture redesign was the 32nm Sandy Bridge launch in early 2011, and the upcoming shrink (22nm Ivy Bridge) is shipping for revenue today and expected to launch in early 2012.

Sandy Bridge marked a change from traditional processors Intel’s 32nm Sandy Bridge processor, which launched in early 2011, integrated the GPU with the CPU in a single chip. This integrated solution enabled performance similar to that which previously had required a discrete GPU for most mainstream applications, all at a lower power envelope. AMD followed a similar path with its APU Fusion products, but lagged somewhat at the leading 32nm node and has still faced yield challenges into 2H11. Integrated CPU+GPUs appear to be the future for processor chips and pose a meaningful long-term threat to the discrete GPU market.

Ivy Bridge will mark a change from traditional transistors Intel will introduce tri-gate transistors on its 22nm logic technology (Ivy Bridge), which went to production in 2H11. Not only can transistors be packed more densely, but performance also improves as does power consumption. Intel claims a 37% performance increase at low voltage and >50% power reduction at constant performance. The move to tri-gate is a fundamental shift in transistor architecture, and competitors appear three years away from replicating this change. We believe foundries are likely to introduce FinFET transistors at the 14nm node.

Intel - U-PF US strategy


A leader in semiconductor technology Intel’s tick-tock roadmap strategy of alternating between shrinks and new

microarchitectures has remained a steadfast cadence for semiconductor technology for years.

Intel’s 32nm Sandy Bridge, which launched in early 2011, integrates a CPU and GPU in a single chip, both adding significant value to the processor market and creating a long-term headwind for the discrete GPU market.

Intel will introduce tri-gate transistors on its 22nm logic technology (Ivy Bridge), marking a fundamental shift in transistor technology that is likely to be replicated in the foundries at the 14nm node.

Figure 1

Intel’s tick-tock cadence of innovation

Sandy BridgeMicroarchitecture

Ivy BridgeMicroarchitecture

HaswellMicroarchitecture

WestmereMicroarchitecture

NehalemMicroarchitecture

PenrynMicroarchitecture

32nmProcess Technology



Nov 07 Nov 08 Jan 10 Jan 11 1H12F

TICKTICK TOCKTOCK TICKTICK TOCKTOCK TICKTICK TOCKTOCK

Sandy BridgeMicroarchitecture

Ivy BridgeMicroarchitecture

HaswellMicroarchitecture

WestmereMicroarchitecture

NehalemMicroarchitecture

PenrynMicroarchitecture




Nov 07 Nov 08 Jan 10 Jan 11 1H12F

TICKTICK TOCKTOCK TICKTICK TOCKTOCK TICKTICK TOCKTOCK

Source: Intel

Sandy Bridge marked a change from traditional processors Intel launched the Sandy Bridge 32nm processor in early 2011. Sandy Bridge represents the ‘tock’ of the 32nm node, but also marked a significant shift in technology as it integrated the GPU with the CPU in a single chip. The prior Westmere processor included GPU capabilities, but in a multichip package where the graphic capabilities resided on the Northbridge. The change enabled a user experience similar to that with a discrete GPU sufficient for most mainstream applications on a single chip solution. AMD followed suit with its APU Fusion products, but lagged at the leading 32nm node and has faced yield challenges into 2H11. The transition to integrated CPU+GPU processors presents a material threat to discrete GPUs, and we expect pricing pressure to increase for GPUs in the coming years.

Figure 2 Figure 3

Westmere 32nm microarchitecture

Sandy Bridge 32nm microarchitecture

Source: Intel

Sandy Bridge integrates the CPU and GPU on a

single chip

Intel’s last ‘tock’ and next ‘tick’ have fundamentally

changed the sector

Sandy Bridge has been well received by

the industry



Ivy Bridge will mark a change from traditional transistors Intel will introduce tri-gate transistors on its 22nm logic technology (Ivy Bridge), which is slated for production in 2H11. The company claims a 37% performance increase at low voltage and >50% power reduction at constant performance. We believe foundries are likely to introduce FinFET transistors at the 14nm node.

Figure 4 Figure 5


3D (tri-gate transistor)

Source: Intel

The move to tri-gate is a fundamental shift in transistor architecture. Traditional 2D planar transistors form a conducting channel in the silicon region under the gate electrode when in the “on” state, while 3D transistors form conducting channels on three sides of the vertical fin structure. In other words, the conducting channel is “above” the wafer surface for 3D versus “in” the wafer surface for planar/2D.

The advantages of moving to tri-gate are numerous. Not only can transistors be packed more densely, but performance also improves as does power consumption. This is largely related to tri-gate’s “fully depleted” operation. As shown below, the gate electrode controls silicon channel from three sides, thus providing a steeper sub-threshold slope (reduces leakage). The inversion layer (where source-drain current flows) is also increased for higher drive current and reduced gate delay. Intel estimates that the process cost adder for tri-gate is 2-3% versus 10% for SOI-based solutions.

Figure 6 Figure 7


3D (tri-gate transistor)

Source: Intel

Fully depleted tri-gate transistors mean

less leakage

Many advantages to 3D transistors

Intel will introduce 3D transistors at 22nm

While in the “on” state, 3D transistors form

conducting channels on three sides of the vertical

fin structure




Summary P&L forecast (US$m) Revenue 35,127 43,623 54,821 57,807 61,369Op Ebitda 10,763 20,226 24,268 26,550 26,918Op Ebit 5,711 15,588 18,137 19,526 19,894Interest income 163 109 83 100 100Interest expense 0 0 (55) 0 0Other items (170) 348 258 0 0Profit before tax 5,704 16,045 18,423 19,626 19,994Taxation (1,335) (4,581) (5,076) (5,692) (5,798)Minorities/pref divs/affils 0 0 0 0 0Net income 4,369 11,464 13,347 13,934 14,196

Summary cashflow forecast (US$m) Net income 4,369 11,464 13,347 13,934 14,196Operating adjustments 0 0 0 0 0Depreciation/amortisation 5,052 4,638 6,131 7,024 7,024Working capital changes 60 65 837 (67) (33)Non-operating adjustments 1,689 525 (171) 1,000 1,000Net operating cashflow 11,170 16,692 20,144 21,892 22,187Capital expenditure (4,515) (5,207) (10,520) (7,000) (7,000)Free cashflow 6,655 11,485 9,624 14,892 15,187Acq/inv/disposals (3,450) (5,332) 3,061 0 0Net investing cashflow (7,965) (10,539) (7,459) (7,000) (7,000)Increase in loans 1,893 (134) 5,014 0 0Dividends (3,108) (3,503) (4,151) (4,396) (4,349)Net equity raised/other (1,353) (1,005) (9,836) 0 0Net financing cashflow (2,568) (4,642) (8,973) (4,396) (4,349)Incr/(decr) in net cash 637 1,511 3,712 10,495 10,838Exch rate movements 0 0 13 0 0Opening cash 3,350 3,987 5,498 9,224 19,719Closing cash 3,987 5,498 9,224 19,719 30,557

Summary balance sheet forecast (US$m) Cash & equivalents 3,987 5,498 9,223 19,719 30,557Debtors 2,273 2,867 3,949 4,154 4,410Inventories 2,935 3,757 3,905 4,180 4,655Other current assets 2,029 3,102 3,720 3,720 3,720Fixed assets 17,225 17,899 23,357 24,357 25,357Intangible assets 4,421 4,531 8,882 7,858 6,834Other term assets 15,273 21,498 19,325 19,325 19,325Total assets 53,095 63,186 73,736 84,687 96,232Short-term debt 172 38 66 66 66Creditors 1,883 2,290 3,030 3,072 3,306Other current liabs 5,536 6,999 9,076 9,448 9,912Long-term debt/CBs 2,049 2,077 7,076 7,076 7,076Provisions/other LT liabs 1,751 2,352 5,449 5,449 5,449Minorities/other equity 0 0 0 0 0Shareholder funds 41,704 49,430 49,038 59,576 70,423Total liabs & equity 53,095 63,186 73,736 84,687 96,232

Ratio analysis Revenue growth (% YoY) (6.5) 24.2 25.7 5.4 6.2Ebitda growth (% YoY) (20.7) 87.9 20.0 9.4 1.4Ebitda margin (%) 30.6 46.4 44.3 45.9 43.9Net income margin (%) 12.4 26.3 24.3 24.1 23.1Dividend payout (%) 72.4 31.3 31.9 32.2 31.1Effective tax rate (%) 23.4 28.6 27.6 29.0 29.0Ebitda/net int exp (x) 0.0 0.0 0.0 0.0 0.0Net debt/equity (%) (4.2) (6.8) (4.2) (21.1) (33.2)ROE (%) 10.8 25.2 27.1 25.7 21.8ROIC (%) 12.0 27.5 27.5 27.2 27.7EVA®/IC (%) (0.4) 15.1 15.2 14.8 15.3Source: Company, Credit Agricole Securities (USA)

US$1.60 in net cash per share

Expecting 5% revenue growth in 2012

2011 capex tracking to US$10.5bn

McDonald's Produced byProduced byProduced by

US$93.51 - BUY

Financials Year to 31 Dec 09A 10A 11CL 12CL 13CLRevenue (US$m) 22,745 24,075 27,035 28,817 30,953Net income (US$m) 4,408 4,971 5,476 5,934 6,395EPS (US$) 3.98 4.60 5.24 5.81 6.42EPS growth (% YoY) 8.5 15.6 13.9 10.8 10.5ROE (%) 32.2 34.7 37.1 39.3 40.9Net debt/equity (%) 62.6 62.3 67.1 67.5 64.8FCF yield (%) 3.7 4.2 4.3 5.3 6.1Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate


Diane Geissler, CFA [email protected] (1) 212 408 5649

Jeremy Scott, CFA (1) 212 261 3385

2 November 2011

USA Consumer Reuters MCD.N Bloomberg MCD US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$93.84/72.14 12M price target US$109.00 ±% potential +17% Target set on 24 Oct 11 Shares in issue 1,044.7m Free float (est.) 99.9% Market cap US$96,479m 3M average daily volume US$215.5m Major shareholders Fidelity 4.4%


Absolute 4.2 7.4 20.7 Relative (6.6) 8.7 11.2

58

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99

104

109

114

119

124

129

134

139

144

149

McDonald's Rel to 500 (RHS)

(US$) (%)

Source: Bloomberg

www.clsa.com

The new gold standard While the majority of chained restaurants will engage in remodeling or a refresh of the brand once a decade (free cashflow permitting), McDonald’s reimaging efforts have been the most game-changing in the field. For one, the remodeling serves as the backdrop for the McCafe extension, a well-timed introduction during the global consumer crisis through which McDonald’s could leverage its value proposition against Starbucks. Secondly, the new look complements a brand evolution towards healthy, wholesome and premium.

Embracing the café culture The remodeling initiative is indeed a nod to the emerging café culture that was pioneered in the USA by Starbucks in the 90s; however, McDonald’s ramp-up was well timed amid a global consumer crisis in which the company could deliver value alternatives at faster service times. As Starbucks’ key customer base shrinks as its fringe consumers in the mid-to-upper middle class trade down, McDonald’s can create new recurring users with a consistent product at cheaper prices.

Growing off-peak occasions Menu innovation has focused on the incremental as opposed to substitutes of core items (Big Mac, etc), which have represented 70% of the comparable sales growth in the past five years. The company typically targets 25% incremental rate for new products. Snack wraps can be consumed between meals, while smoothies, lemonades and iced beverages are typically consumed mid-afternoon. By increasing daypart diversification, McDonald’s creates higher utilization with off-peak sales, which in turn increases margins.

Speeding up peak service As part of its reimaging and rebuilds, McDonald’s has implemented measures to smooth congestion and speed up service during peak hours, including a new point-of-sales system, self-order kiosks and dual drive-thrus. The McCafe extension, freestanding in most locations (see picture on next page), prevents incremental coffee traffic from becoming entangled in food lines. With every 1ppt in same-store sales (SSS) contributing US$0.03 to EPS, the company’s focus on order efficiency is a high ROI opportunity.

Rebranding healthy McDonald’s has made great strides in recent years to shift the brand image in developed markets away from convenient indulgence towards healthier and more wholesome. These rebranding efforts were in part a response to growing consumer concern over healthy eating as it relates to the ballooning obesity epidemic in the USA and abroad, but it is also an opportunity to enter higher-margin categories, such as beverages.

McDonald’s - BUY US strategy


The new gold standard Overall, McDonald’s innovation scheme has been cohesive, complementary and well orchestrated. In the USA, the new reimaged model is equipped with free Wi-fi and ample seating for individuals, while the atmosphere inspires a more relaxed and comfortable eating environment (see Figure 3). In terms of the consumer dining “experience,” it is clear where McDonald’s is reaching for market share.

Modernizing the brand and promoting the “experience” is imperative to drive sales of premium products. Customers are unlikely to pay up for a US$3 caramel latte or an incremental US$1 for an Angus burger if the environment suggests that the level of service and preparation involved in their premium order is on par with a dollar menu sale. McCafe machines automate preparation of even complex drinks; formulaic and impersonal, but fast, quite the contrast to the morning line at Starbucks. The McCafe product has been well reviewed, and with little manual input, the product should be consistent.

McDonald’s also faces obstacles in its campaign to provide more nutritious content and options. The company first introduced salads in 1985 and relaunched them in 2003 under its premium line. However, the unhealthy perception of the brand remained. Salads represented merely an outlet for weight-watching parents forced into a fast food trip by mini-van consensus. The rebranding initiatives in recent years have been far more game-changing, in our opinion. We anticipate the move into smoothies could bridge the perception gap more effectively, as the product is consumed as an indulgence and, for most, isn’t regarded as a meal replacement.

With the launch of oatmeal in December 2010 and the portion cutting and fruit and vegetable additions to the Happy Meal, McDonald’s appears to be taking more drastic measures to improve its nutritional profile than it has in the past. We believe these nutritional initiatives could enhance the value of the brand equity, even if few consumers opt for them. The halo effect is a concept that McDonald’s is learning to embrace.

Figure 1

Quarterly and trailing 12-month average unit volume (AUV) in USA

0.45

0.47

0.49

0.51

0.53

0.55

0.57

0.59

0.61

0.63

0.65

Q12008

Q2 Q3 Q4 Q12009

Q2 Q3 Q4 Q12010

Q2 Q3 Q4 Q12011

Q2 Q3

(US$m)

2

2.1

2.2

2.3

2.4

2.5

2.6

2.7

2.8

2.9(US$m)Qtrly AUV systemwideTTM AUV - Systemwide (RHS)TTM AUV - McOpCo (RHS)TTM AUV - Franchise (RHS)

Note: Systemwide includes both company-operated and franchised restaurants. Source: Company, Credit Agricole Securities (USA)

AUVs continue to trend upwards

McDonald’s innovation scheme has been well

orchestrated

The rebranding initiatives in recent years have been far more game-changing

McDonald's - BUY US strategy


Figure 2 Figure 3

The McCafe extension

A reimaged McDonald’s

Source: Company

Figure 4 Figure 5

Dual drive-thrus

Self-order kiosks

Source: Company

Figure 6 Figure 7

Menu innovation - Rebranding the Happy Meal

Menu additions - Rebranding with nutritional focus

Source: Company

McDonald’s - BUY US strategy



Summary P&L forecast (US$m) Revenue 22,745 24,075 27,035 28,817 30,953Op Ebitda 7,992 8,778 9,950 10,690 11,502Op Ebit 6,776 7,502 8,508 9,158 9,854Interest income 24 (22) (23) (25) (28)Interest expense (473) (451) (491) (471) (490)Other items 0 0 0 0 0Profit before tax 6,327 7,029 7,994 8,662 9,336Taxation (1,919) (2,059) (2,518) (2,729) (2,941)Minorities/pref divs/affils 0 0 0 0 0Net income 4,408 4,971 5,476 5,934 6,395

Summary cashflow forecast (US$m) Net income 4,408 4,971 5,476 5,934 6,395Operating adjustments 143 (25) 0 0 0Depreciation/amortisation 1,216 1,276 1,442 1,531 1,647Working capital changes 171 (129) (192) 7 35Non-operating adjustments (187) 248 92 99 106Net operating cashflow 5,751 6,342 6,818 7,571 8,184Capital expenditure (1,952) (2,136) (2,600) (2,500) (2,500)Free cashflow 3,799 4,206 4,218 5,071 5,684Acq/inv/disposals 297 80 200 200 200Net investing cashflow (1,655) (2,056) (2,400) (2,300) (2,300)Increase in loans 219 787 1,425 773 950Dividends (2,236) (2,408) (2,643) (2,945) (3,216)Net equity raised/other (2,405) (2,108) (2,668) (2,660) (2,660)Net financing cashflow (4,421) (3,729) (3,886) (4,832) (4,926)Incr/(decr) in net cash (325) 557 531 439 958Exch rate movements 58 34 0 0 0Opening cash 2,063 1,796 2,387 2,918 3,357Closing cash 1,796 2,387 2,918 3,357 4,315

Summary balance sheet forecast (US$m) Cash & equivalents 1,796 2,387 2,918 3,357 4,315Debtors 1,060 1,179 1,275 1,361 1,461Inventories 106 110 159 137 155Other current assets 454 693 693 693 693Fixed assets 21,532 22,061 23,019 23,787 24,440Intangible assets 2,425 2,586 2,586 2,586 2,586Other term assets 1,639 1,625 1,625 1,625 1,625Total assets 30,225 31,975 33,609 34,881 36,609Short-term debt 18 8 0 0 0Creditors 636 944 846 867 970Other current liabs 2,335 1,973 2,023 2,073 2,123Long-term debt/CBs 10,560 11,497 12,922 13,695 14,645Provisions/other LT liabs 2,642 2,919 2,919 2,919 2,919Minorities/other equity 0 0 0 0 0Shareholder funds 14,034 14,634 14,899 15,326 15,952Total liabs & equity 30,225 31,975 33,609 34,881 36,609

Ratio analysis Revenue growth (% YoY) (3.3) 5.8 12.3 6.6 7.4Ebitda growth (% YoY) 4.5 9.8 13.3 7.4 7.6Ebitda margin (%) 35.1 36.5 36.8 37.1 37.2Net income margin (%) 19.4 20.6 20.3 20.6 20.7Dividend payout (%) 51.5 49.1 48.3 49.6 50.3Effective tax rate (%) 30.3 29.3 31.5 31.5 31.5Ebitda/net int exp (x) 17.8 18.6 19.4 21.6 22.2Net debt/equity (%) 62.6 62.3 67.1 67.5 64.8ROE (%) 32.2 34.7 37.1 39.3 40.9ROIC (%) 20.1 21.4 22.5 23.3 24.5EVA®/IC (%) 12.6 13.9 15.0 15.8 17.0Source: Company, Credit Agricole Securities (USA)

Net debt/Ebitda has fallen below 1.0x

Roughly half of capex spend will be directed

towards existing restaurants through its

reimaging initiative

The company has returned 1.5x its FCF over

the past 5½ years

Microsoft Produced byProduced byProduced by

US$27.25 - BUY

Financials Year to 30 Jun 10A 11A 12CL 13CL 14CLRevenue (US$m) 62,484 69,943 75,190 80,685 85,612Net income (US$m) 18,804 23,150 23,930 26,544 28,665EPS (US$) 2.11 2.69 2.83 3.17 3.45CL/consensus (33) (EPS%) - - 99 102 100EPS growth (% YoY) 24.3 27.9 5.1 12.1 8.7PE (x) 13.0 10.1 9.6 8.5 7.8Dividend yield (%) 1.9 2.3 2.9 2.9 2.9FCF yield (%) 9.1 10.1 11.2 12.6 13.5Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate



David Kwon (1) 212 261 7586

2 November 2011

USA Technology Reuters MSFT.OQ Bloomberg MSFT US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$29.46/23.65 12M price target US$32.00 ±% potential +17% Target set on 29 Apr 11 Shares in issue 8,763.8m Free float (est.) 87.8% Market cap US$229,232m 3M average daily volume US$527.2m Foreign s'holding 7.3% Major shareholders Capital 4.2% BlackRock Global 3.8%


Absolute 0.7 2.7 5.8 Relative (1.0) 11.2 0.6

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Microsoft (LHS)Rel to 500

(US$) (%)

Source: Bloomberg

www.clsa.com

Big innovation In addition to its extensive R&D efforts, marketing and support, Microsoft is among the rare few technology companies with the resources and commitment to maintain a dedicated research initiative. Microsoft Research has 850-plus researchers studying over 55 areas of computing in eight locations worldwide. This unit contributes extensively to academic and scientific communities, while creating technologies that are licensed as well as incorporated into the company’s products.

Platforms provide the foundation Microsoft’s dominance in the Windows operating system provided a broad standard for PCs, which the company has been able to extend to servers and phones more recently. This has proven critical to attract application developers and technology partners, creating a virtuous cycle around the ecosystem. Microsoft’s development tools and technologies (eg, C++, .Net, SilverLight, Visual Studio, etc) foster innovation across its platforms.

Reaching for the cloud The company is transforming itself from a seller of traditional on-premise technologies to a provider of cloud services. Over 90% of developers are “all in” managing the transition to the cloud. The innovative Azure platform is unique as a cloud operating system that can power either public or private clouds by Microsoft or third parties. Microsoft’s Office, Lync, Sharepoint and DynamicsCRM offering are similarly making the transition to cloud-based offerings that ultimately target a larger total addressable market (TAM).

Gaming the living room Microsoft’s efforts in the consumer market continue to push the envelope. The Kinect motion capture and voice control interface for the Xbox360 is the first mass-market commercialization of gesture recognition, while Xbox Live provides a cloud-based platform and marketplace for collaborative gaming, content and digital goods, with partnerships driving expansion into IPTV.

Scientific research Microsoft Research maintains active efforts in cutting-edge technology, media and scientific research as well as collaboration with universities worldwide. The company is a leader in exploring technology issues related to data-intensive science. The vision of Jim Gray (the former head of research lost at sea in 2007) informed The Fourth Paradigm, a book that outlined the vision for a multitude of deep scientific uses for data-intensive computation, which Microsoft continues to explore today.

Microsoft - BUY US strategy


Big innovation Innovation is the foundation for Microsoft’s success. Delivering innovative, high-value solutions through integrated software and services platforms is the key to meeting customers’ needs and future growth.

In the past three years, Microsoft has invested 13-15% of total revenue in R&D, which is primarily focused on internally developed products and services. Its long-term focus is on smart connected devices, cloud computing, entertainment, search and productivity.

Figure 1 Figure 2

Bing visual search

Xbox360 and Kinect

Source: Microsoft

Microsoft currently has a portfolio of over 26,000 patents issued and 36,000 pending. The company has revamped its innovation pipeline from both a technology and process standpoint. It has made significant progress in its processes and organization over the last couple of years to launch innovations to the market more quickly.

Project groups are focused on innovations for technologies that are currently in the market or about to be introduced. Microsoft Labs works on technologies expected to be commercializable within two to four years, while Microsoft Research focuses on technologies and problems that may be five to 10 years, or more, in the future.

Figure 3 Figure 4

Windows Phone 7 - People Hub

Windows 8 - Developer Preview

Source: Microsoft

Microsoft has revamped its innovation pipeline

from both a technology and process standpoint

Innovation is the foundation for Microsoft’s

success

Its visual search and Kinect controller are

leading innovation for search and gaming



Licensing and product incubation Microsoft Research sometimes licenses technologies that are developed internally through the company’s IP Ventures program. The company views IP licensing as a way to provide business opportunities for venture capitalists, entrepreneurs and government economic development organizations.

Microsoft Research operates several product incubation teams to deliver technologies through applied research. Live Labs, Office Labs, DevLabs, SQL Labs, the adCenter Incubation Lab, the Internet Services Research Center and the Cloud Computing Futures group are teams that bring together researchers and product teams to incubate and rapidly prototype new technologies and services.

Figure 5

Microsoft Surface

Source: Microsoft

Microsoft continues to fine tune its research processes by involving multiple teams including research and product groups. In the case of offerings like Bing and Kinect, the company has been able to effectively bring to market new innovations. However, one example of a promising technology that was subject to inefficiencies while in product development is Surface, which was initially prototyped in 2003-04 but didn’t hit the market until 2007. Microsoft’s Surface went through a formalized process, rather than a product-focused group working with Microsoft Researchers from the beginning. Given the delayed introductions, research projects now often involve product groups early on, and the Kinect sensor is a prime example.

Microsoft Surface provides an intuitive,

touch-based user experience

Microsoft Research sometimes licenses

technologies

Microsoft continues to fine tune its research

processes



Summary financials Year to 30 June 2010A 2011A 2012CL 2013CL 2014CL


Summary cashflow forecast (US$m) Net income 18,804 23,150 24,873 26,796 29,095Operating adjustments (44) 0 0 0 0Depreciation/amortisation 4,519 4,915 4,944 4,944 4,944Working capital changes 661 (3,003) (118) (753) (934)Non-operating adjustments 133 1,932 2,465 2,782 2,120Net operating cashflow 24,073 26,994 32,163 33,769 35,225Capital expenditure (1,977) (2,355) (2,567) (2,729) (2,926)Free cashflow 22,096 24,639 29,596 31,040 32,299Acq/inv/disposals (9,337) (12,261) 0 0 0Net investing cashflow (11,314) (14,616) (2,567) (2,729) (2,926)Increase in loans 190 5,960 0 (1,250) (3,000)Dividends (4,578) (5,180) (5,417) (5,359) (5,326)Net equity raised/other (8,903) (9,156) (7,985) (7,985) (7,985)Net financing cashflow (13,291) (8,376) (13,402) (14,594) (16,311)Incr/(decr) in net cash (532) 4,002 16,195 16,446 15,988Exch rate movements (39) 103 80 80 80Opening cash 6,076 5,505 9,610 25,885 42,411Closing cash 5,505 9,610 25,885 42,411 58,479

Summary balance sheet forecast (US$m) Cash & equivalents 5,505 9,610 25,885 42,411 58,479Debtors 13,014 14,987 15,726 16,760 18,057Inventories 740 1,372 1,222 1,226 1,226Other current assets 36,417 48,949 48,558 48,567 48,567Fixed assets 7,630 8,162 7,946 7,892 8,035Intangible assets 13,552 12,581 12,581 12,581 12,581Other term assets 1,501 2,178 1,835 1,844 1,843Total assets 86,113 108,704 124,618 142,146 159,654Short-term debt 1,000 0 1,250 3,000 0Creditors 4,025 4,197 4,404 4,694 5,057Other current liabs 21,122 24,577 25,444 26,931 27,746Long-term debt/CBs 4,939 11,921 10,671 9,671 7,671Provisions/other LT liabs 8,852 10,926 10,776 10,780 10,779Minorities/other equity 0 0 0 0 0Shareholder funds 46,175 57,083 72,073 87,071 108,400Total liabs & equity 86,113 108,704 124,618 142,146 159,654

Ratio analysis Revenue growth (% YoY) 6.9 11.9 6.5 6.4 7.2Ebitda growth (% YoY) 12.5 11.9 10.4 6.6 7.5Ebitda margin (%) 45.9 45.9 47.6 47.7 47.8Net income margin (%) 30.1 33.1 33.4 33.8 34.3Dividend payout (%) 24.7 23.8 21.8 20.0 18.3Effective tax rate (%) 25.0 17.5 20.0 20.0 20.0Ebitda/net int exp (x) 0.0 0.0 0.0 0.0 0.0Net debt/equity (%) 0.9 4.0 (19.4) (34.2) (46.9)ROE (%) 43.9 44.8 38.5 33.7 29.8ROIC (%) 40.5 41.8 41.5 45.6 49.7EVA®/IC (%) 30.8 32.1 31.8 35.9 40.0Source: Company, Credit Agricole Securities (USA)

We forecast improved margin performance

through FY14

We expect Microsoft to continue to build on its

strong cash balance through FY13

Strong cashflow could leave door open for increased dividends

and/or buybacks

FY12 should benefit from Windows 7 and Office

2010 product cycles

Schlumberger Produced byProduced byProduced by

US$74.54 - BUY

Financials Year to 31 Dec 09A 10A 11CL 12CL 13CLRevenue (US$m) 22,702 27,446 39,458 48,045 53,767Net income (US$m) 3,156 4,279 4,921 6,988 8,136Core EPS (US$) 2.78 2.86 3.61 5.15 6.00CL/consensus (33) (EPS%) - - 96 98 91PE (x) 24.2 23.6 21.0 14.7 12.6Source: Credit Agricole Securities (USA); FactSet for consensus data. CL = estimate


Mark S. Urness [email protected] (1) 212 408 5683

Tate Sullivan, CFA (1) 212 261 3962

2 November 2011

USA Oil & Gas Reuters SLB.N Bloomberg SLB US

Priced on 27 October 2011 S&P 500 @ 1,284.6 12M hi/lo US$95.53/54.79 12M price target US$93.00 ±% potential +25% Target set on 24 Oct 11 Shares in issue 1,356.9m Free float (est.) 99.7% Market cap US$100,582m 3M average daily volume US$335.4m Major shareholders State Street 4.0%


Absolute (7.0) (22.5) 7.4 Relative (9.7) (15.4) 4.8

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Schlumberger Rel to 500 (RHS)

(US$) (%)

Source: Bloomberg

www.clsa.com

Oil service technology leader Schlumberger continues to develop new technologies to maximize oil and natural gas production and reserves based on rising demand for unconventional and deepwater drilling and services. This technology innovation can improve the efficiency of reservoir exploitation by reducing time spent exploring and costs. The company anticipates more demand for a workflow product that combines seismic and wireline services to help customers pick the best locations to drill wells.

Service intensity increasing demand for new technology An increasingly larger share of worldwide exploration and development in unconventional and deepwater fields continues to raise demand for new technology from the oil services sector. New technology from Schlumberger, such as HiWAY Flow Channel Fracturing, can reduce the environmental impact of drilling by developing methods that use less water and chemicals. Service intensity has doubled in the last five years as deepwater and unconventional drilling has become much more prevalent. Schlumberger expects service intensity to grow in the future, which will support demand for innovative technologies.

Demand for innovation in oil and gas industry Demand for new technology increases revenue opportunities for diversified oil service companies like Schlumberger, which has exposure to multiple exploration projects. This exposure has helped the company to develop specialized technologies to market to operators. Schlumberger has also actively acquired small companies with niche technologies. In general, deepwater drilling commands a higher level of technology and services. Instead of developing the technology internally, national oil companies are relying to a greater extent on more advanced technologies that they buy directly from suppliers.

Technology and size is a barrier to entry in the oil services sector Schlumberger is the largest company in the oil services sector, employing 108,000 people in 80 countries and supplying the widest range of products and services. The structure of the oil services industry continues to evolve as reservoirs are increasingly difficult to exploit and customers require new technology. Barriers to entry are growing for smaller oil service companies without a global infrastructure, based on more regulatory requirements after the April 2010 Deepwater Horizon drilling rig incident and higher costs from technology and infrastructure development.

Schlumberger - BUY US strategy


Schlumberger technology improves efficiency There are large variances in the performance of horizontal wells in shale developments, and the current approach to drilling is maximum coverage in the geographic area. Schlumberger’s workflow product combines seismic and logging measurements to help customers pick the best locations for new horizontal wells. We believe growth in pressure pumping, the largest and fastest-growing segment in the oilfield services, will continue to increase demand for new technologies and services. For instance, the Schlumberger HiWAY fracturing technique uses less water and proppant, and production improved 53% using HiWAY on 15 Eagle Ford wells.

Figure 1

Recent technology

Technology Description Results

HiWAY Flow Channel Fracturing

Uses a proprietary fiber to engineer stable flow channels in a proppant fracture

Saved more than 135,000 tons of proppant in 2,000 stages

Barnett shale job: Reduced water and proppant volumes by 40% each, reduced average horsepower by 25% and increased initial production

PowerDrive Archer rotary steerable system (RSS)

Combines push-the-bit and point-the-bit steering, can drill vertical, curve and lateral wellbore sections in one run

Reduced drilling time per well in Marcellus Shale wells from 18 days to eight days

Dual Coil Shooting Acquires ultra long offset marine seismic data using four vessels following a circular path

Began second Dual Coil Shooting Survey in Green Canyon area of the Central Gulf of Mexico

Dialetric Scanner Offers new petrophysical measurements for enhanced hydrocarbon saturation computation

Revealed a 150-foot section of moveable oil in a laminated reservoir in South America


Schlumberger focuses on technology Founded in 1926, Schlumberger is the world's leading supplier of technology, integrated project management and information solutions to the international oil and gas exploration and production industry. Having invented wireline logging as a technique for obtaining downhole data in oil and gas wells, the company provides the industry's widest range of products and services from exploration through production. Schlumberger forayed into information technology away from its oil and gas roots in 2001 when it bought Sema Group, an IT and technical services company that sold systems integration, consulting services and software products to various industries, including telecommunications, energy, transport, finance and outsourcing. In 2004 and 2005, Schlumberger actively divested its non-oilfield businesses, including Sema in 2004, and going forward will continue to focus on oil and gas technologies.

Schlumberger’s products help customers pick the

best locations for new horizontal wells

World's leading supplier of technology, integrated project management and

information solutions

HiWAY fracturing uses less water and proppant

to improve production efficiencies



Innovation is key to Schlumberger’s franchise Technological innovation, quality of service and price differentiation are the principal methods of competition in the oil services sector, and competition varies geographically with respect to the different services offered. While there are numerous competitors, both large and small, we view Schlumberger as an industry leader in providing wireline logging, well testing, measurement-while-drilling, logging-while-drilling and directional-drilling services, as well as fully computerized logging and geoscience software and computing services.

Figure 2

Sample of technology innovation

Year Technology innovation

1912 Conrad Schlumberger uses electrical measurements to map subsurface rock bodies

1932 Conrad and Marcel Schlumberger present a principles of well-logging paper: "Electric Coring: A Method of Determining Bottom-Hole Data by Electrical Measurements"

1948 Establishes a technology research center in Ridgefield, Connecticut - now located in Cambridge, Massachusetts

1951 Begins to experiment with a microneutron device to measure formation porosity by sensing the amount of hydrogen present

1961 Completes first computer processing of dipmeter logs

1970 Introduces the first computerized reservoir analysis product

1980 Completes first measurements-while-drilling job that combined wireline logging with real-time data transmission

1991 Uses geosteering to plan the drilling path in horizontal wells

2006 Wireline sampling delivers fluid samples from well


Leader in technological innovation, quality of

service and price differentiation

Schlumberger completed its first computer

processing of dipmeter logs in 1961




Summary P&L forecast (US$m) Revenue 22,702 27,446 39,505 48,316 54,128Op Ebitda 6,562 5,332 10,270 13,197 14,291Op Ebit 4,085 5,332 7,071 9,981 11,075Interest income 55 46 37 36 59Interest expense (207) (209) (305) (273) (203)Other items 0 0 0 0 0Profit before tax 3,933 5,170 6,804 9,744 10,931Taxation (770) (890) (1,704) (2,436) (2,733)Minorities/pref divs/affils (8) 0 (4) 0 0Net income 3,156 4,279 5,095 7,308 8,198

Summary cashflow forecast (US$m) Net income 3,156 4,279 5,095 7,308 8,198Operating adjustments (14) 2,746 0 0 0Depreciation/amortisation 2,476 0 3,199 3,216 3,216Working capital changes (218) (23) (1,918) 197 (231)Non-operating adjustments (89) (1,508) 22 (97) (109)Net operating cashflow 5,489 5,494 6,398 10,624 11,075Capital expenditure (2,395) (2,914) (4,220) (5,126) (5,334)Free cashflow 3,094 2,580 2,178 5,498 5,740Acq/inv/disposals (1,719) (24) 127 0 0Net investing cashflow (4,203) (2,938) (4,093) (5,126) (5,334)Increase in loans 219 1,001 1,324 0 (2,000)Dividends (1,006) (1,040) (1,314) (1,366) (1,366)Net equity raised/other (401) (1,370) (2,676) (2,000) 0Net financing cashflow (1,188) (1,409) (2,666) (3,366) (3,366)Incr/(decr) in net cash 98 1,147 (361) 2,132 2,374Exch rate movements (45) 0 8 0 0Opening cash 189 617 1,764 1,411 3,543Closing cash 242 1,764 1,411 3,543 5,917

Summary balance sheet forecast (US$m) Cash & equivalents 243 1,764 1,411 3,543 5,917Debtors 6,088 8,278 9,500 9,401 0Inventories 1,866 3,804 4,660 4,610 18,804Other current assets 1,080 1,026 1,065 1,065 0Fixed assets 9,660 12,071 13,303 15,213 17,332Intangible assets 6,379 19,459 19,431 19,581 19,731Other term assets 7,411 4,833 5,643 5,643 2,088Total assets 33,465 51,719 55,330 59,374 64,189Short-term debt 804 2,596 2,817 817 817Creditors 5,003 6,438 6,941 6,991 6,933Other current liabs 1,452 1,782 1,546 1,546 1,546Long-term debt/CBs 4,355 5,517 5,745 5,745 3,745Provisions/other LT liabs 2,622 3,942 3,619 3,619 3,619Minorities/other equity 109 218 217 217 217Shareholder funds 19,120 31,226 34,445 40,439 47,312Total liabs & equity 33,465 51,719 55,330 59,374 64,189

Ratio analysis Revenue growth (% YoY) - 20.9 43.9 22.3 12.0Ebitda growth (% YoY) - (18.7) 92.6 28.5 8.3Ebitda margin (%) 28.9 19.4 26.0 27.3 26.4Net income margin (%) 13.9 15.6 12.9 15.1 15.1Dividend payout (%) 30.2 29.4 26.9 18.7 16.7Effective tax rate (%) 19.6 17.2 25.1 25.0 25.0Ebitda/net int exp (x) 43.2 32.8 38.4 55.7 99.3Net debt/equity (%) 25.6 20.2 20.6 7.4 (2.9)ROE (%) 17.5 16.9 15.4 19.4 18.6ROIC (%) 13.0 13.1 12.3 16.3 17.2EVA®/IC (%) 0.9 0.9 0.1 4.1 5.1Source: Company, Credit Agricole Securities (USA)

Increasing complexity of worldwide oil and gas

development helps SLB sell more products

Schlumberger has the highest GAAP value of

intangible assets in the oil services sector

Operating cashflow funds significant R&D effort

We project a 27% EPS Cagr in the next

two years

US chemicals Produced byProduced byProduced by

Sector outlook


Nils-Bertil Wallin, CFA [email protected] (1) 212 261 3381

Mark Connelly (1) 212 261 3970

2 November 2011

USA Materials

Celanese CE Rec O-PF Price US$45.45 Target US$48 Up/downside +6%

DuPont DD Rec O-PF Price US$48.73 Target US$52 Up/downside +7%

www.clsa.com

Industry innovators Innovation isn’t a word often spoken in the same breath with chemical companies, even if most of them like to talk about their pipeline. But chemical companies are constantly innovating, whether to improve throughput or energy efficiency or to lower capital costs. Hence, the engineering aspect of innovation is constantly employed. But as the foundation of the industry tends to be based on relatively old technology compared to even a landline phone, disruptive technologies are limited.

Process rather than cutting edge Commercializing new production processes is the most common form of innovation. And companies with first-mover status can generally patent and license the enabling technology. Innovation usually takes the form of alternate routes to production either based on different feedstocks or modified conversion steps. While sometimes such technologies prove to be successful, they don’t always prove to be profitable. In 2005, Eastman Chemical set out to build a new PET resin plant based on its patented “Integrex” technology that had lower capital and conversion costs. But since the overall market was oversupplied, even though the technology was substantiated, its earnings power was not. Ultimately, the business was sold.

Raw materials first, conversion improvements second The Holy Grail of chemicals tends to be lowering raw material costs - that usually depends on the luck of one’s geological location rather than technology. Still, if one isn’t lucky enough to be born on an untapped oil or natural gas field, improving conversion costs are usually the next best thing. And that generally relies on improving throughput either by increasing plant scale or by eliminating process steps.

Ethanol as a disruptive technology DuPont and Celanese are two companies concurrently working on improving conversion costs to produce ethanol, but with very different tactics and end markets in mind. DuPont hopes to commercialize cost-effective fuel ethanol, based on cellulosic feedstocks, by 2012-13 as well as bio-butanol in the same time frame. On the other hand, Celanese has developed a proprietary technology to produce industrial ethanol on a much larger scale and with lower conversion costs than traditional corn-based ethanol. Fuel ethanol is used primarily as an additive to gasoline, while industrial is used in pharmaceuticals and coatings.

Both companies are clearly vying to create disruptive technologies that will circumvent the food versus fuel debate. And both technologies will depend on the magnitude of the improved conversion costs to succeed. In DuPont’s case, lower conversion costs are needed because alternative feedstock technologies aren’t currently commercially viable. For Celanese, a lower overall cost for commodity industrial ethanol is the only way to create a sustainable advantage. Moreover, although the technology could ultimately also produce ethanol for fuel use, it would need to have a lower cost to compete with the current subsidies and mandates afforded by bio-based ethanol.

US chemicals US strategy


DuPont already has a test plant in Vonore, Tennessee, that currently has a 250k gal/year capacity with a 100x scale up. Celanese does not currently have a plant for industrial ethanol, but claims its technology, known as TCX, can scale to 350m gal/year. An average corn-based ethanol plant in the USA is around 50-60m gal/year, while a world scale one is approximately 100m gal/year. DuPont’s technology is competitive with gasoline at US$70-80/bl of crude oil, while Celanese claims it is competitive at US$60/bl.

Figure 1 Figure 2

DuPont cellulosic ethanol plant size

Celanese ethanol conversion cost

0

5,000

10,000

15,000

20,000

25,000

30,000

Current Commercial

(m gal/yr)

0.0

0.5

1.0

1.5

2.0

2.5

Corn-based TCX

(US$/gal)


Of course, the two technologies are not precisely comparable as DuPont’s is meant to fit within the renewable fuels standard in the USA, while Celanese’s technology is geared more toward the industrial market in Asia. Nevertheless, if Celanese’s technology were to be employed to produce fuel ethanol, it would appear to enjoy a lower cost base than DuPont’s technology or corn-based ethanol. But it would not be considered a “sustainable” or “renewable” technology as it uses existing hydrocarbon feedstocks.

Will either of these technologies be disruptive? Perhaps, they both can. If DuPont’s cellulosic ethanol works it could reduce demand for corn-based ethanol, although scale is still an issue. Alternatively, DuPont is also working on a bio-butanol design that could prove better and doesn’t require additional infrastructure for blending with gasoline.

Celanese’s TCX technology has been validated by third-party engineering companies, so there isn’t as much concern about it not being commercialized. Nevertheless, apart from the much smaller industrial ethanol market, the technology is likely to face hurdles as an alternative energy given its traditional fossil fuel dependence. That may prove to be less of a hurdle if shale gas production in the USA fulfills the hopes of many in the industry in terms of lasting supply. Until then, the technology is likely to compete in the niche industrial market. On that basis alone, it could prove disruptive.

DuPont and Celanese are two companies working

on improving conversion costs to produce ethanol

Celanese’s TCX technology has been

validated by third-party engineering companies

Both are vying to create disruptive technologies to

circumvent the food vs fuel debate

Important disclosures US strategy


Analyst certification The analyst(s) of this report hereby certify that the views expressed in this research report accurately reflect my/our own personal views about the securities and/or the issuers and that no part of my/our compensation was, is, or will be directly or indirectly related to the specific recommendation or views contained in this research report.

Important disclosures CLSA (which for the purpose of this disclosure includes subsidiaries of CLSA B.V. and Credit Agricole Securities Asia B.V., Tokyo Branch)/Credit Agricole Securities (USA) Inc ("Credit Agricole Securities (USA)")'s policy is to only publish research that is impartial, independent, clear, fair, and not misleading. Analysts may not receive compensation from the companies they cover.

Regulations or market practice of some jurisdictions/markets prescribe certain disclosures to be made for certain actual, potential or perceived conflicts of interests relating to a research report as below. This research disclosure should be read in conjunction with the research disclaimer as set out at www.clsa.com/disclaimer.html and the applicable regulation of the concerned market where the analyst is stationed and hence subject to. This research disclosure is for your information only and does not constitute any recommendation, representation or warranty. Absence of a discloseable position should not be taken as endorsement on the validity or quality of the research report or recommendation.

Neither analysts nor their household members/associates may have a financial interest in, or be an officer, director or advisory board member of companies covered by the analyst unless disclosed herein. Unless specified otherwise, CLSA/Credit Agricole Securities (USA)'s did not receive investment banking/non-investment banking income from, and did not manage/co-manage public offering for, the listed company during the past 12 months, and it does not expect to receive investment banking relationship from the listed company within the coming 3 months. Unless mentioned otherwise, CLSA/Credit Agricole Securities (USA) does not own disclosable position, and does not make market, in the securities.

The analysts included herein hereby certify that the views expressed in this research report accurately reflect their own personal views about the securities and/or the issuers and that unless disclosure otherwise, no part of their compensation was, is, or will be directly or indirectly related to the specific recommendation or views contained in this research report or revenue from investment banking revenues. The analyst/s also states/s and confirm/s that he has/have not been placed under any undue influence, intervention or pressure by any person/s in compiling this research report. In addition, the analysts included herein attest that they were not in possession of any material, non-public information regarding the subject company at the time of publication of the report. Save from the disclosure below (if any), the analyst(s) is/are not aware of any material conflict of interest.

Key to CLSA/Credit Agricole Securities (USA) investment rankings: BUY = Expected to outperform the local market by >10%; O-PF = Expected to outperform the local market by 0-10%; U-PF = Expected to underperform the local market by 0-10%; SELL = Expected to underperform the local market by >10%. Performance is defined as 12-month total return (including dividends) for the stock relative to the 12-month forecasted return for the



local market where the stock is traded. For example, in the case of US stock, the recommendation is relative to the expected return for S&P of 11.3%. Exceptions may be made depending upon prevailing market condition.

Overall rating distribution for CLSA/Credit Agricole Securities Equity Universe: Buy / Outperform - CLSA: 69%; Credit Agricole Securities (USA): 65%, Underperform / Sell - CLSA: 31%; Credit Agricole Securities (USA): 35%, Restricted - CLSA: 0%; Credit Agricole Securities (USA): 0%. Data for 12-month period ending 30 June 2011 (CLSA) and 30 September 2011 (Credit Agricole Securities (USA)). INVESTMENT BANKING CLIENTS as a % of rating category: Buy / Outperform - CLSA: 95%; Credit Agricole Securities (USA): 65%, Underperform / Sell - CLSA: 5%; Credit Agricole Securities (USA): 35%, Restricted - CLSA: 0%; Credit Agricole Securities (USA): 0%. Data for 12-month period ending 30 June 2011 (CLSA) and 30 September 2011 (Credit Agricole Securities (USA)). Prior to 25 November 2008, Credit Agricole Securities (USA) Inc used an absolute system (based on anticipated returns over a 12-month period): Buy: above 20%; Add: 10%-20%; Neutral: +/-10%; Reduce: negative 10-20%; Sell, below 20% (including dividends). FOR A HISTORY of the recommendations and price targets for companies mentioned in this report, as well as company specific disclosures, please write to: (a) Credit Agricole Securities (USA), Compliance Department, 1301 Avenue of the Americas, 15th Floor, New York, New York 10019-6022; and/or (b) CLSA, Group Compliance, 18/F, One Pacific Place, 88 Queensway, Hong Kong.

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© 2011 CLSA Asia-Pacific Markets ("CLSA"). Key to CLSA investment rankings: BUY = Expected to outperform the local market by >10%; O-PF = Expected to outperform the local market by 0-10%; U-PF = Expected to underperform the local market by 0-10%; SELL = Expected to underperform the local market by >10%. Performance is defined as 12-month total return (including dividends). 12/10/2011

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