Amid the drama of 2018’s technology markets, one sector showed notable resilience: enterprise software. This was no accident, these companies are geared into a major shift in the way the corporate sector manages its technology needs. This ‘digital transformation’ (tackling traditional problems with digital technology) is dramatically changing industries from the healthcare to consumer sectors and beyond. In 2018, more companies woke up to the potential gains from a digital strategy.

What is digital transformation?

The definition of digital transformation strategies will be as disparate as the companies that employ them. However, at its heart, it involves rethinking existing business models and processes through the use of technology. As such, it may incorporate many aspects of technology, including artificial intelligence, the internet of things, cloud computing and software-as-a-service.

For example, moving to software as a service and cloud computing as part of a digital transformation lets companies circumvent a costly upgrade cycle. Rather than having to support expensive in-house technology capability, they can pick and mix their technology requirements to suit their business requirements. They can move data storage to the cloud and buy their software on a subscription basis. This means companies don’t have to anticipate years in advance or commit significant capital to technology infrastructure, bringing invaluable flexibility.

Why did digitisation fast-track in 2018?

Adoption of digital transformation strategies accelerated this year. Until relatively recently, mid-sized companies had been eager adopters of the cloud computing, but larger companies – possibly because of greater implementation challenges – had been more reluctant.

However, these companies are increasingly recognising that it is a major competitive disadvantage to lag on digital transformation. At the same time, companies had more cash to direct to these transformation programmes as a result of the US administration’s tax cuts. Many technology companies were able to repatriate capital held offshore at lower tax rates and reinvest it.

Cloud computing continues to get cheaper and its functionality is improving, notably with new artificial intelligence options. The most recent ‘LogicMonitor’s Cloud Vision 2020: The Future of the Cloud’ Study found that 50% of IT professionals believe artificial intelligence and machine learning are playing a role in cloud computing adoption today, growing to 67% by 2020.

Increasingly, enterprises cannot overlook the efficiency gains from a move to the cloud, particularly when compared to upgrading legacy hardware and software. Upgrading legacy systems may achieve a 10-15% productivity improvement, compared to 50% for switching to a new architecture. This makes it harder for companies to ignore. CEOs continue to be focused on transforming their businesses and making them more efficient. This is a necessity in many cases to stay responsive to their customers.

This transformation is still in its early stages and is unlikely to be derailed. In many cases, companies are transitioning from decades-old software and the new software they are adopting will be embedded in their technology infrastructure for decades to come. For investors, this means that the return from these companies is less cyclical and more like a long-term annuity.

Entering the mainstream

Digital transformation is going mainstream. Today it has widespread application across different industries. Companies of all stripes are discussing technology investment and the opportunities available.

In healthcare, for example, electronic health records, digital imaging and e-prescription services have been integrated into existing IT systems for large healthcare organisations across the globe. There is also the increasing use of ‘telemedicine’ – apps providing immediate consultations for minor health complaints, important for rural areas with poor access to medical facilities. At the consumer healthcare end, we are seeing the adoption of wearable health monitoring devices, which increasingly feed into health insurance assessments.

In retail, digital technologies are being used to improve the customer experience, to tailor and guide their preferences and to prevent ‘spamming’ them with products they are never likely to buy. PwC research shows that only 4% of UK consumers say they’ll keep interacting with a company that provides unsatisfactory experiences¹. Retailers need to get it right first time, or risk losing customers for good.

The beneficiaries

There are a number of different types of companies benefiting from this trend. There are the large cloud providers, where pricing benefits from economies of scale – Amazon, Google, Microsoft. They are taking share in the cloud market. At the same time, there are the smaller Software-as-a-Service providers. This would include names such as ServiceNow, whose offering includes enterprise platform-as-a-service management software for human resources, law, facilities management, finance, marketing, and field operations.

Salesforce.com is the largest of the SaaS companies, focused on customer relationship management software. Paycom and Workday are other holdings in this area. These companies are moving into horizontal applications in areas such as marketing management. The tools needed to build the infrastructure are generic and can be used for a wide range of different purposes. Now these companies have built the infrastructure, they can customise it to create a second level of SaaS.

At the same time, we are seeing SaaS infrastructure packaged up with industry knowledge to solve major problems. One of the companies in our portfolio, Veeva Systems, has built cloud-based systems specifically for the life sciences industry. They take on the administration process for drug approvals for healthcare companies. This means companies can focus on finding and making drugs.

Legacy technology

This transformation also has implications for legacy technology as well. Where it is coming to the end of its lifecycle, companies can no longer rely on renewals. Newer technology is constantly improving, delivering greater productivity improvements at lower and lower cost. With each upgrade cycle those companies not transforming are become less competitive. In a recent report McKinsey said: “Only 8% of companies we surveyed said their current business model would remain economically viable ‘if their industry keeps digitising at its current course and speed’. ¹

A solution to the productivity puzzle

Part of the reason companies need to embrace digitisation is for productivity enhancements. Another McKinsey report ‘Solving the productivity puzzle: the role of deman and the promise of digitisation’ noted that digitisation “promises significant productivity-boosting opportunities but the benefits have not yet materialised at scale. This is due to adoption barriers and lag effects as well as transition costs.” ²

In our view, enterprises will progressively be forced to overcome these barriers as the competitive environment demands it. This suggests that the digital transformation has a considerable way to run, which should continue to support those cloud computing and software-as-a-service companies that benefit from it.

1 Why Digital Strategies Fail; 2 Solving the Productivity Puzzle

Walter Price is portfolio manager at Allianz Technology Trust