To calibrate the intensity of Power, I ask the question “What governs the leader’s profitability of the company with Power (S) when prices are such that the company with no Power (W) makes no profit at all?”
In the case of Process Power, I assume all costs are marginal, so the zero-challenger profit price equals marginal costs. I focus on the case where the leader costs are lower due to its Process Power (alternately, it might charge a higher price due to its Process Power, or both). As a consequence:
Profit ≡ π = [P – c] Q
with
P ≡ price
c ≡ marginal cost per unit
Q ≡ units produced per time period
To determine SLM, assess:
What are S’s margins if P is set Э Wπ = 0 ?
Industry economics define the function D(), which determines the potential magnitude and sustainability of leverage. D(t) is an increasing function of t, reflecting that Process Power requires action over time to be increased. The logistic function was chosen to reflect the reinforcing aspect of Process Power investment, while allowing diminishing marginal returns over time. The particular form specified above for D(t) ensures that D(t)=1 at t=0 by adjusting the location parameter as a function of F and Z. When F is larger, the logistic curve is steeper and the Process Power cycle time is shorter. When F is smaller, the logistic curve is shallower and the Process Power cycle time is longer.
Time t represents the competitive position that S has relative to W in developing Process Power, because it determines the ability of a competitor starting at time t = 0 to catch up to the strong firm at time t=t. Z and F (i.e., D[t]) determine industry position. As can be seen in Figure 7.6, the longer the life cycle, the farther behind the weak competitor, and so the harder it is to catch up to the strong firm. The sustainability of the process depends on the shape of the D(t) function relative to D(0) for all t in the case of the weakest competitor with no Process Power, and an alternative D’(t) function (i.e., an alternative F’) and alternative t for another competitor.
Figure 7.6: Process Power as a Function of Time
P A R T I I
STRATEGY DYNAMICS
C H A P T E R 8
THE PATH TO POWER
“ME TOO” WON’T DO
We have come a long way together on our journey to enable you to flexibly develop your company strategy. Each of the prior seven chapters detailed one Power type, and block by block I have constructed the 7 Powers. You now possess a potent strategy compass: it covers all attractive strategic positions for all businesses in all locations.77 Armed with one or more of these Power types, your business is ideally positioned to become a durable cash-generator, despite the best efforts of competitors. If you possess none of these, your business is at risk. Period.
The contribution of the 7 Powers does not stop there, however. You still need a guide for your journey, a roadmap for the creation of Power. You might anticipate the various routes being so idiosyncratic as to preclude meaningful generalization. But the 7 Powers enables us to penetrate through this tangle of details to the deeper core.
By now you know that your business must achieve Power, or else face ruin. So you are probably asking yourself two questions: “What must I do to establish Power?” and “When can I establish it?” Part II of this book reveals the answers to these questions. The question of “What?” serves as the subject of this chapter, and “When?” the subject of the next.
I will start with a single case: Netflix’s streaming business. From there, I will generalize on the “How?” question for all businesses. But let me offer a first insight right here up front: all Power starts with invention. Once we have explored this notion, I will then move on to the ways in which invention propels the other key element of the Fundamental Equation of Strategy—market size.
Out of the Frying Pan…
When I became an investor in Netflix in 2003, my investment hypothesis had two legs:
Netflix’s DVD-rental business had Power: Counter-Positioning to the brick-and-mortar incumbent, Blockbuster; Process Power, as well as modest spatial distribution Scale Economies relative to other DVD-by-mail wannabes.
This Power was not properly recognized by the investment community.
My hypothesis proved correct, as Netflix handily beat back other like competitors, while also winning a bruising battle against Blockbuster, with a finale as definitive as any strategist could hope for: on September 23, 2010, Blockbuster declared Chapter 11 bankruptcy. The dramatic demise of this previously high-flying competitor served as testimony to the potency of the Counter-Positioning I had hypothesized.
One might hope that such a victory would have provided a durable sinecure, but that was not in the cards for Netflix, at least not yet. My investment hypothesis carried a two-part caveat. First, I knew DVD rentals were transitory, destined to be supplanted by digital distribution over the Internet.
This was hardly news to Netflix management. Reed Hastings, their CEO and founder, wrote in 2005:
DVDs will continue to generate big profits in the near future. Netflix has at least another decade of dominance ahead of it. But movies over the Internet are coming, and at some point it will become big business…. That’s why the company is called Netflix, not DVD-By-Mail.78
The second part of my caveat was likewise cautionary: Netflix had no yet-evident sources of Power in this new modality—the technology to stream was accessible to many, and the powerful content owners were implacably committed to wringing every penny from their rights. I suspect Netflix management might have agreed with me on this assumption too.
The Netflix response to these predicaments? They tested the waters, investing 1–2% of revenue on streaming79—not a bet-the-company amount, sure, but hardly trivial. This effort culminated in the launch of the Watch Now feature on January 16, 2007. It was a modest beginning, and the initial offering comprised only about 1000 titles, small compared to their DVD library, which was 100 times larger, but significant still.
Customers responded positively, encouraging Netflix to fuel the fire. The company negotiated in turn with each hardware vendor to achieve device ubiquity; they upped their commitment on content, eventually reaching deals with CBS, Disney, Starz and MTV in 2008–2009, and they constantly refined the backend technology needed to make streaming a seamless customer experience.
By 2010, streaming had become a force for Netflix. At the beginning of 2011, TechCrunch headlined “Streaming Is Driving New Subscriber Growth At Netflix,”80 showing the graph below to document the company’s astonishing subscriber growth.
Figure 8.1: Accelerating Net Subscriber Additions (in millions)
This was good news, but the second part of my caveat still held—streaming had no apparent sources of Power. At last Netflix had come face-to-face with Professor Porter’s uncomfortable truth: operational excellence is not strategy.
Yes, operational excellence is essential and constantly challenging; it rightfully occupies the lion’s share of management’s time. Unfortunately, it does not by itself assure differential margins (a positive m in the Fundamental Equation of Strategy) combined with a steady or growing market share (s in the FES). Competitors can easily mimic the improvements yielded by operational excellence, eventually arbitraging out the value to the business.
Netflix suffered many acute operational challenges as it moved into streaming, and gradually addressed them. But even these efforts were insufficient to assure continuing differential returns. Consider some examples:
User Interface (UI) development. Netflix rightfully paid a great deal of attention to its UI. The company is a data smart one, and A/B testing of UI alternatives has led to many frequent refinements. Unfortunately, as Blockbuster showed in its mail-order rental competition with Netflix, it is easy to copy a UI.
Recommendation engine. Netflix was a world leader in recommendation engine development, even sponsoring the Netflix Prize, which yielded machine-learning insights still notable in that community. H
ere one might hypothesize some Scale Economies: as Netflix accumulates more data, the acuity of their recommendations increases. True, but not linear: these advantages paid only diminishing returns, meaning a smaller competitor of an attainable scale could realize most of the same benefit.
IT infrastructure. Video consumes a prodigious amount of bandwidth and storage: by 2011, for example, Netflix had become by far the largest user of peak bandwidth on the Internet. They took the view—perhaps unexpected for a technology company—that this was not their core competence and made the decision (correctly, in my view) to outsource their information technology (“IT”), eventually ending up as a large customer of Amazon Web Services. This relieved many of their IT expansion headaches and allowed them to focus on what they do best.
Each of these areas required relentless and expert focus, and yet solving this multiplicity of problems was not enough. All of the advances could be more or less mimicked by others in the longer term. The potential for Power remained elusive.
Netflix realized that content lay at the heart of the problem. After all, great content ultimately represents any streamer’s core value proposition, and for Netflix, it accounted for the bulk of their cost structure. Unfortunately, content holders could “variable cost price” the programming they licensed, charging Netflix according to usage. This put other licensors on an even footing with Netflix, regardless of scale, thus eliminating any chance of Power.
Ted Sarandos, the strategically acute Netflix content head, took the first step in addressing this challenge by pursuing exclusives. At first blush, exclusives seemed a poor choice for Netflix: their higher price meant less content for subscribers. Nevertheless, on August 10, 2010, Netflix and Epix agreed to an exclusive agreement:
“Adding EPIX to our growing library of streaming content, as the exclusive Internet-only distributor of this great content, marks the continued emergence of Netflix as a leader in entertainment delivered over the Web,” said Ted Sarandos.81
This changed the game. The price of an exclusive was fixed, which meant some content no longer carried a variable cost. All of a sudden Netflix’s substantial scale advantage over other streamers made a difference.
But the owners of potential exclusive properties could take note of Netflix’s success. Eventually they would resort to bargaining hard for an outsized share of those returns, even using other streaming competitors as stalking horses. In fact, Epix did exactly this, ending its deal with Netflix and signing up instead with Amazon on Sept 4, 2012.
So again, with Sarandos’ approbation, Netflix took the next logical step—originals. Here they took a page out of HBO’s playbook—that network’s transition to originals had secured their position as a premium cable juggernaut years before. First for Netflix was the modest Lilyhammer, but on March 16, 2011, Netflix dropped a bomb. Deadline Hollywood splashed:
Netflix To Enter Original Programming With Mega Deal For David Fincher-Kevin Spacey Series ‘House Of Cards’82
Netflix plunked down $100 million, beating out HBO, CBS and Showtime to lock up twenty-six episodes, two full seasons of the political thriller. It was a big bet, and despite modest assurance from their user stats, a large risk.
They were rewarded with increased subscriptions and numerous awards, including nine Primetime Emmy Nominations, a victory on the Benefit side, but also the beachhead for a victory on the Barrier side. Originals unequivocally rendered content a fixed cost, guaranteeing powerful Scale Economies, and they also permanently altered Netflix’s bargaining position with content owners. As Reed Hastings put it:
“…If the television networks stop selling shows… the company has a game plan. We just do more originals….”83
Fast forward to 2015. Originals have now become the centerpiece of Netflix’s strategy, as this Wikipedia chart shows.
Figure 8.2: Netflix Originals84
The value created by this robust strategy has been stunning, a nearly 100x gain in share price, culminating in a market cap of about $50B.
Figure 8.3: Netflix Stock Price85
The Rudder Only Works When the Ship Is Moving
Professor Henry Mintzberg’s canonical 1987 article86 rightly characterized such a process as “crafting,” rather than designing. The saga of Netflix’s ascent exemplifies intelligent adaptation over an extended period in the face of daunting uncertainty. The terrain of entrepreneurs, not planners.
The 100x increase in stock price noted above serves as a signal of the uncertainty that initially existed. Prior to Netflix’s success, the value potential was opaque to the investment community, not because investors were thoughtless or ill-informed, but because the “route to Power” was not just unknown, but unknowable—even to Netflix management.
Here’s the first important takeaway from our consideration of Dynamics: “getting there” (Dynamics) is completely different from “being there” (Statics). This is a distinction not only for academics but for practitioners as well. For example, in the early days of strategy consulting, the two were frequently conflated: a close study of Statics indicated that high relative market share led to attractive returns; this fed the instinct to gain market share (Dynamics), usually via aggressive pricing. Such policies usually did not create value, as competitors would push back until the cost of share gains typically outweighed their benefits.
This disconnect might tempt you to reject Statics as a means of understanding Dynamics, but that would be folly. In a prescient article of two decades ago, Professor Porter saw past this error to the underlying premise that inspired my approach:
A body of theory which links firm characteristics to market outcomes must provide the foundation for any fully dynamic theory of strategy. Otherwise dynamic processes that result in superior performance cannot be discriminated from those that create market positions or company skills that are worthless.87
In other words, to assess which journeys are worth taking, you must first understand which destinations are desirable. Fortunately the 7 Powers does exactly that: it maps the only seven worthwhile destinations.
Accordingly, we can look back to my previous discussion of Netflix’s streaming saga in Chapter 1, where we viewed it through the lens of Statics. This snaps into focus the crux moves that established the foundations of Power:
Competitive Position: an attractive new service. Netflix’s pioneering rollout excited customers, and their influx propelled Netflix to an early relative scale advantage that the company has never relinquished.
Industry Economics: originals and exclusives. This converted some content, the largest element of their cost structure, from variable cost to fixed cost, cementing Power by creating Scale Economies for the first time.88
These are the profound breakthroughs that forever changed streaming from an unattractive rat race commodity business to a bankable cash flow generator. This is what developing a “route to continuing Power in significant markets” looks like. Again, one is struck by Mintzberg’s perspicacity when he dubbed this “crafting.” Netflix adaptively found its way to streaming ascendancy via successive thoughtful experimentation, demonstrating once again that action is the first principle of strategy, just as it is in business. This is about as far removed from the orderly analytics of strategic planning as you can imagine.
Invention—the Mother of Power
Okay, that’s Netflix and their streaming business. An inspiring tale, no doubt, but one story alone won’t cut it. My objective in this chapter is far more ambitious: to help you figure out “What must I do to create Power in my business?”
With Netflix, we saw that creating the streaming business and then segueing to originals propelled their “route to continuing Power in significant markets.” With an eye toward deducing a more general understanding, let’s take a step back, reexamine all seven types of Power and ask the Dynamics question “What must you do to get there?”
Scale Economies. With this first Power type, you must simultaneously pursue a business model that promises Scale E
conomies (industry economics), while at the same time offering up a product differentially attractive enough to pull in customers and gain relative share (competitive position).
Network Economies. Here the needs are similar to Scale Economies, except that installed base, rather than sales share, is the goal.
Cornered Resource. You must secure the rights to a valuable resource on attractive terms. This often comes from having developed that resource in the first place and then gaining ownership of it, the most common avenue being a patent award for research developments.
Branding. Over an extensive period of time, you make the consistent creative choices which foster in the customer’s mind an affinity that goes beyond the product’s objective attributes.
Counter-Positioning. You pioneer a new, superior business model that promises collateral damage for incumbents if mimicked.
Switching Costs. With Switching Costs, you must first attain a customer base, meaning the same new-product requirements demanded of Scale and Network Economies factor in here as well.
Process Power. You evolve a new complex process which renders itself inimitable within a reasonable period and yet offers significant advantages over a longer period of time.
We are covering a lot of ground here, but you will notice a common thread: the first cause of every Power type is invention, be it the invention of a product, process, business model or brand. The adage “‘Me too’ won’t do” guides the creation of Power.
For any business person, “‘Me too’ won’t do” feels right intuitively. Action, creation, risk—these lie at the root of invention. Business value does not start with bloodless analytics. Passion, monomania and domain mastery fuel invention and so are central. The compelling continuing contribution of founders demonstrates this. Planning rarely creates Power. It may meaningfully boost Power once you have established it, but if Power does not yet exist, you can’t rely on planning. Instead you must create something new that produces substantial economic gain in the value chain. Not surprisingly, we have worked our way back to Schumpeter.
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