Something in the Air

[In a blog earlier this year, I reprinted a speech that I had given on challenges which the electricity industry is facing due to technological change and evolving consumer preferences.  In this blog, I discuss business transformation in general, and in particular some of the ideas that I have personally found most helpful and enlightening in providing guidance on how to deal with it.  Much of the following content appeared in an article that I authored for Electricity Perspectives magazine entitled “The New and You”.]

Incumbent providers in many industries may have to reinvent themselves in the years ahead, or risk getting sidelined by innovative new competitors, and possibly even driven into oblivion.  The lyrics from a popular song in 1969, “Something in the Air”, come to mind:  “We’ve got to get together sooner or later, because the revolution’s here . . . We have got to get it together, we have got to get it together now.”  Change is definitely in the air, and it is bringing both challenges and opportunities for providers of products and services.  In order to successfully ride these waves of change, rather than be overrun by them, providers will have to have a superior strategic focus.  The risks of not doing so will be particularly pronounced for incumbents, who may be overly invested in business models that will become outmoded and irrelevant.  Unless their leaders “get it together”, then change could lead to very unhappy consequences: established business models could be upended, traditional revenue streams threatened, and entire customer segments put at risk.

How does one plan for change?  The very idea seems almost oxymoronic, like being prepared to be surprised.  If the innovations that may overturn a particular industry are still unknown, then how exactly can business models be developed to address them, and incorporate them?  Many business strategists have contended with this question, and have come up with some interesting insights. 

Jesse Berst, who has been observing and writing about business transformation in the electricity industry (he shares his views on his website, www.smargridnews.com), has attempted to draw lessons from previous industrial transformations.  He has noted that several industries underwent fundamental change as new entrants challenged existing providers, including transportation (i.e., the railroads), telecommunications, and retail sales.  The new market entrants – who in some cases virtually supplanted the previous incumbents in their respective industries – generally succeeded, according to Berst, by capitalizing on “disintermediation”, a process whereby the new entrant provided the product more efficiently (e.g., more quickly, more conveniently, at lower cost) than the existing supplier(s).  This was generally done by capitalizing on some recent technological innovation which had occurred: an innovation that was recognized by the new entrant (but not the incumbent – at least not at first) as a means of introducing new efficiencies into the market.  The classic example is Amazon.com, which introduced a more convenient and efficient way for persons to buy books through the use of the internet.  Amazon did not invent the internet; but Jeff Bezos, Amazon’s founder, recognized how the internet could be used to introduce disintermediation into the book-buying value chain (and he then later expanded this market model to a whole range of diverse products and services).  Similarly, Netflix used the internet as a tool for disintermediation in the video rental business, and in doing so upended the traditional “brick and mortar” stores that had been offering this service.

The Amazon and Netflix strategies have earlier historical precedents.  At the turn of the last century, Sears Roebuck – the “original Amazon”, says Berst – became the first company to create a virtual superstore using a new infrastructure (the expanding rail system) for ordering and fulfillment and for undercutting the generally more expensive mom-and-pop stores.  The store’s famous catalog initially was mailed to people in towns with railroad stops.

The railroads themselves found quick competition with the new interstate highway system started by President Eisenhower in the 1950s.  By the 1960s and 1970s, commuter rail had almost disappeared (going from 2,500 in the mid-1950s to fewer than 500 by the late 1960s) and trucking ate into freight profits.  The highly traditional, highly regulated, railroads failed to adapt.

But there is another process that has often played a role in industrial transformation, and that is “disruptive innovation”, a term introduced by Clayton M. Christensen in his book, The Innovator’s Solution (coauthored with Michael Raynor).  In this and his earlier work, The Innovator’s Dilemma, Christensen provides a number of examples where technological discoveries or advances completely overturned existing markets.  Whereas disintermediation is the application of an existing technology to improvements in the delivery chain (the process), disruptive innovation capitalizes on improvements in the underlying product.  And, based on his research, Christensen came to some very counterintuitive conclusions about how existing businesses succumb to the threat of disruptive innovation. He found, for example, that the technology adopted by the new competitor resulted in a product that was usually inferior, at least from the perspective of the incumbent providers’ existing business model.  If it was genuinely more highly prized by any particular class of customers, these customers generally comprised a small or low-margin segment of the business, whose loss was not perceived to be a significant threat to the incumbents.  In fact, the incumbent business model would suggest that an investment in this new product would be unprofitable, particularly if doing so would result in sales losses from the established product line.  Some examples illustrate disruptive innovation at work:

·       The 5.25-inch disk drive was vastly inferior to the 8-inch drive, which was the standard for minicomputers manufactured in 1981.  But makers of this smaller drive marketed it to manufacturers of the new desktop computer, where the size alone presented a distinct advantage for the more compact machines.  By the time the desktop market supplanted that of minicomputers, many of the sellers of the larger 8-inch drive failed to adapt quickly enough by creating their own versions of the smaller drive, and fell by the wayside.

·       Minicomputers themselves were originally marketed as an inexpensive alternative to mainframes, and were not perceived as a threat to mainframe manufacturers, until their sales exceeded that of mainframes – a fate which in turn befell the minicomputer market as personal computers grew in popularity in the 1980s.

·       When the steamship was invented, its more expensive design (relative to traditional sailing ships) seemed to only justify its applicability to inland water routes, where its greater manageability made it a profitable alternative.  But after conquering the inland water route market, steamships eventually supplanted sailing vessels for long distance hauling as well.

·       Western Union, the dominant provider of long-distance communication services in the 19^th century, rejected an offer to buy Alexander Graham Bell’s patent for the telephone (for $100,000).  While it was clear that telephones could serve the (at the time) relatively small market for short-distance electronic messaging, for communication at longer distances, it was not considered to be an economic alternative to Western Union’s existing nationwide network of telegraphs.

·       Manufacturers of music CDs abandoned the market for musical singles, concluding that it had become “extinct”, or at least had become a market that no longer presented a profitable way of being served.  The market was not extinct, however, and after the demand for singles was met through a new medium – downloadable MP3s – providers in this new medium went on to capture a sizable chunk of the market share that had been held by sellers of CDs.

The important point made by Mr. Christensen in his writings is that the decisions made by incumbent providers in the face of these innovations were generally – from their perspective, and based upon sound business principles and analysis – the logical and correct ones to make.  Their business models hadn’t failed them: they were merely caught in a paradigm that prevented them from seeing the transformational opportunities that were only visible from the perspective of an outside entrepreneur.  The actions of the incumbents were in fact usually guided by what they perceived to be the interests and desires of their existing customers – in other words, they were following what is generally touted as the hallmark of a successful business: they were customer-centric and customer-focused.  And, when they did begin to see some of their customer segments falling away (often those that were considered less vital or profitable to serve), they concentrated even more intently on their high-margin customer segments, and on specific strategies for retaining them, but often with less than successful – or even disastrous – consequences.

When presented with these cautionary tales, incumbent providers respond with the logical question: “What can I do to prevent a loss of sales to new market entrants, or, even better, how can I make sure that my company is on the right side of change and innovation?”  Unfortunately, it is easier to characterize the underlying threats than it is to map out distinct solutions, and in many cases consultants fall back on two clichéd recommendations: “Customers want choice, find ways to provide more of it to them,” and “Learn to be more competitive, because you will have to be in this approaching competitive environment.”  I would now like to kick these two particular sacred cows – at least a little bit – as I describe a third term that has been linked with very successful businesses: “creative monopoly”.

            In a New York Times article (“The Creative Monopoly”, April 23, 2012), columnist David Brooks described the life and philosophy of Peter Thiel, the founder of PayPal.  Having started his career in the very competitive field of law, Thiel had been following a very successful trajectory, getting into Stanford University, and then into Stanford Law School, and becoming a clerk for a federal judge, but his promising career had a setback when he failed in the particularly intense competition to obtain a Supreme Court clerkship.  He then changed course in his life, becoming an entrepreneur, investing in many technology startups that went on to success, and eventually starting his own hugely successful company.

Thiel’s experiences led him to some interesting conclusions, principal of which is that the benefits of competition are overrated, particularly in the business arena.  Rather than being a good competitor, he contends, it is often better to be a good monopolist.  Brooks sums up the Thiel philosophy this way:

Competition has trumped value-creation . . . the competitive arena undermines innovation.

You know somebody has been sucked into the competitive myopia when they start using sports or war metaphors. Sports and war are competitive enterprises. If somebody hits three home runs against you in the top of the inning, your job is to go hit four home runs in the bottom of the inning.

But business, politics, intellectual life and most other realms are not like that. In most realms, if somebody hits three home runs against you in one inning, you have the option of picking up your equipment and inventing a different game. You don’t have to compete; you can invent.

Thiel’s observations may sound like they fly in the face of basic economics, and even a little heretical.  After all, isn’t competition at the base of the free enterprise system – isn’t it the engine of capitalism, motivating individual businesses to provide superior products and services at the lowest price possible?

            Yes . . . and no.  In truly competitive markets, where there are many suppliers selling an identical product, profit margins are virtually nonexistent, and there are little or no interesting differences in the level of product quality or service between the competing suppliers.  Think of the market for agricultural commodities, or certain basic raw materials, such as cotton.  There is little profit to be made here.

            By contrast, think of some of the largest and most successful companies that have appeared on the landscape in recent years: Apple, Amazon, Netflix, Facebook, and Google.  These companies were successful, not because they rose to the top of a heap of companies selling identical products or services, but because each carved out a niche for itself – or in some cases created a market niche where none had even existed before.  Their success – and corresponding profitability – laid in their ability to become creative monopolists.

In strict economic parlance, a monopoly is a company with a dominant market share, generally obtained through exercising market power over potential rivals, but for Thiel, the term means something a little different, with a more positive connotation.  A monopoly is a company with a customer base loyal to its product.  The monopoly “owns” its market, not through nefarious means, but through some combination of branding, scale cost advantages, network effects, or proprietary technology.  Apple is an example of a company that has all four.

While it is true that customers love variety, and the ability to express themselves and their personal tastes through the selection of alternative product offerings, it does not follow that providing customers with more choices – including choices of alternative suppliers – is a panacea for customer satisfaction.  The creative monopolist succeeds, in fact, by doing the opposite:  by establishing a relationship with its customers in which choice becomes unnecessary, or even undesirable.

When I walk into the grocery store and buy cola, for example, I don’t have to – and don’t want to – think about choices.  I don’t have to compare the prices of all the competing brands.  I look for Coca Cola, and I buy it.  For customers like me, Coca Cola has succeeded in becoming a monopolist.  The other brands in the cola universe are invisible to me.  And to the extent that any cola brand (Pepsi, for example) can do the same thing, they also enjoy, among their sphere of committed customers, the benefits of a monopolist.  They can charge more for their product, compared to generic colas, and they can enjoy a fairly predictable earnings stream based upon customer loyalty.  It truly is a “relationship”, based upon the customer’s faith that they are receiving a quality product or service at a reasonable price.  It is only when the customer’s faith is shaken that this relationship becomes threatened

This can happen in many ways.  For Coke, in fact, it nearly happened in the 1980s, when it attempted to replace its long established formula with a new one, which had been developed based upon blind taste tests.  Many of its loyal customers were ready to abandon Coke, and would have, had Coca Cola not quickly corrected its misstep, by reintroducing the original brand as “Coke Classic”.  America Online – once a promising internet provider – suffered from a stampede of exiting customers when it was revealed that AOL was making it difficult for customers to leave its service.  This policy demonstrated a lack of faith in its own product and a lack of regard for its customer relationships.  Many cable or satellite TV providers, in their zeal to attract new customers with special rate offerings and product giveaways, have alienated some of their existing customers, who realize that they are paying much more and getting less for the same service.  When a creative monopolist fails in maintaining the faith and loyalty of its customers, it always learns too late that it is far less expensive to retain a satisfied customer than it is to bring on a new one – particularly a former customer who has been driven away.

Peter Thiel now teaches a course at Stanford, where he shares his ideas and theories on what make a successful creative monopolist, such as the following:

The best kind of business is thus one where you can tell a compelling story about the future.  The stories will all be different, but they take the same form: find a small target market, become the best in the world at serving it, take over immediately adjacent markets, widen the aperture of what you’re doing, and capture more and more.  Once the operation is quite large, some combination of network effects, technology, scale advantages, and even brand should make it very hard for others to follow.  This is the recipe for building valuable businesses.

. . . Of course, putting together a completely accurate narrative of your company’s future requires nothing less than figuring out the entire future of the world, which isn’t likely to happen.  But not being able to get the future exactly right doesn’t mean you don’t have to think about it.  And the more you think about it, the better your narrative and better your chances of building a valuable company.

Peter Thiel is cognizant of the fact that most of the successful creative monopolies that have come into existence have done so on the heels of innovation, disruptive or otherwise.  But he warns that it is dangerous to come into an industry that is currently undergoing technological change: come in too early and your particular innovations will be quickly superseded by others (as happened in the floppy disk market); come in too late, and there will be nothing new left to offer.  However, “if nothing has happened in an industry for a long time, and you come along and dramatically improve something important, chances are that no one will come and do that again, to you.”

            Many of Peter Thiel’s insights echo those of an earlier business strategist, Michael Porter.  In a seminal article published in the Harvard Business Review (Nov.-Dec. 1996) entitled “What is Strategy”, Porter identified two distinct means by which businesses attempt to gain and sustain a competitive edge.  The first, which he called “operational effectiveness”, comprises all of those activities that a business undertakes to outperform its rivals.  These are the classic “competitive” strategies that all companies rely upon in some form or another: benchmarking, total quality management, “six-sigma”, outsourcing, efficiency improvements, cost reductions, etc.  While Porter acknowledges that such activities are necessary, he contends that they are not sufficient to ensure a lasting competitive edge.  At worst, they consign a company to constantly running to stay in place with its competitors.  The key to a more endurable competitive edge, said Porter, is to engage in “strategic positioning”.  In essence, this means finding a means to establish a lasting, significant difference between oneself and one’s competitors, a way of doing things that is difficult to imitate.  Southwest is an example of an airline that has done exactly that.  The theme of establishing a difference, rather than simply engaging in competitive behavior, has also found expression in a book published in 2005 by W. Chan Kim and Renée Mauborgne entitled Blue Ocean Strategy, where a “blue ocean” is a metaphor for an uncontested market space (as opposed to a “red ocean”, where competitors are engaged in an ongoing struggle with each other to gain an edge through superior performance).  All of these theories share a common theme: that to find true, long-lasting success in any market, one must establish a niche: in the “brand” of the product itself and/or in the process by which the product or service is provided.

            But what if a company has a “niche” – a unique product or service that has provided a virtually uncontested market share – and finds that its market is no longer a growing one?  A common model illustrating this phenomenon is the “S-curve”.  A newly-introduced product or service might exhibit slow sales growth at first, as it is purchased only by that segment of the population that likes to risk trying new things (“early adopters”).  However, as more and more of these risk-takers buy it and express satisfaction with it, then its popularity expands into the general population, and sales growth increases dramatically – in fact, exponentially.  But there comes a day when this sales growth tapers off, just as dramatically.  This might simply be due to product saturation: everybody who could have bought it, already has.  On the other hand, sales could evaporate because something else has come along to replace the existing product or service – something that is seen as better, or trendier, in the eyes of consumers.  How does one contend with this dreaded “S-curve”?  Pamela Morgan, a consultant and former electric utility executive, has proposed one possible strategic solution.  In an article published in Electricity Policy magazine entitled “From VHS to DVD: Need for a New Business Model for the Electricity Industry in the 21^st Century” (September 21, 2010), Morgan suggests that what is needed is a broadening of strategic vision.  Companies, she argues, are often too wedded to the particular products or services that they are offering, and neglect to understand what the broader needs of their customers are which these products and services are answering.  She cites VHS player/recorders as a classic example.  These devices definitely exhibited an “S-curve”, with slow sales growth that eventually became phenomenal sales growth, but which was then followed by rapidly declining sales, as the VHS was superseded by the rise of the DVD.  This in turn, is also seeing its rapid growth undercut by the subsequent rise of video streaming services.  Morgan suggests that none of these transformations needed to be catastrophic for the business that had a sufficiently broad vision of what service it was providing: on-demand home video entertainment.  Such a business would have kept abreast of technological development and thereby found the means to envision what the next potential “S-curve” could be.  With this type of strategic focus, technological change presents an opportunity for continual rebirth and evolution, rather than a threat of catastrophic demise.

            These, then, are some of the most salient strategies, I think, for facing technological change and industry upheaval.  The greatest successes, both recently and in decades past, have found ways to use innovation to create niches for themselves – in the design of their product or service, or the channels that they have used to deliver it, or both – and in so doing have ensured their long-term survival and profitability.  Finding that niche requires strategic vision, of course.  At the very least, it requires the ability to spot means by which new innovations will improve existing products or services or enhance the methods of their delivery.  A broader vision will benefit from Pamela Morgan’s insight that there might be a next generation of products and services that will better serve the underlying needs of customers who are buying the current offerings.  But what of those innovators who seem to anticipate future needs and desires of consumers – those who offer things that consumers didn’t realize that they even wanted?  As I indicated in a previous blog (“Thoughts on the Future of the Electricity Industry", May 2014), I believe that the greatest innovations are those that have improved the quality of personal time, by eliminating drudgery, or by finding ways to inject pleasure or happiness into existing time.  It is the entrepreneur who is able to do this, and is able to do so in a way that is difficult to replicate or even emulate, who will enjoy the greatest success in the economy of tomorrow.