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Speed of Innovation and Fragmented Value Chains
Friday, May 31st, 2019
It was reported by Forbes this week that half of Americans aged 22 to 45 didn’t watch any cable TV in 2018, and that over the last decade, 35 million Americans have already quit cable.

Arguably, those people are migrating to streaming services like Netflix and Hulu.

For many years Netflix has been the perfect example of a disruptor: A company with humble beginnings entering the low-end of a market with an inferior product at a lower price, but that over time outpaces the incumbents and beats them out of the market.

That same dynamic explains how Netflix's mail-in subscription service disrupted video rental stores, how digital cameras disrupted film photography, and how smartphones disrupted digital cameras.

They all followed a similar pattern of disruption, and as I explained last week, this is due in part to an asymmetry of the entrant’s Value Chain with respect to incumbents’, meaning that the things that new entrants are good at are different from the things that incumbents are good at.

Another way to say this is that the new entrant's new product presents a solution to an existing problem that is so different from existing solutions that incumbents could not imitate it if they wanted to.

So if incumbents wanted to replicate what new entrants are doing, they would have to create a new Value Network and go through a steep Learning Curve, something that is super hard to do when you are running a successful business.

To make things worse, incumbents already have preconceived ideas about "what works" in their industry based on their current experience, but also because of their current experience they know little about what "could work", which is the universe entrepreneurs try to force users into.

What all this means is that, had Blockbuster actually acquired Netflix when it was a small game (and they did in fact have the chance to do it), they would most likely have not made any money with it.

Because what really made Netflix the monster it is today, was the introduction of its streaming business model, which was a big leap from their mail-in subscription service, which was by itself already a step ahead of Blockbuster’s in-store rentals.

Back then, Blockbuster, an established company with a strong balance sheet, just didn’t have what was needed to make Netflix’s value proposition the opener of a new industry, which among other things, included a combination of cash-starvation and a constant threat to its existence.

Blockbuster could not have made Netflix what it is today, in the same way that Yahoo!, had it had acquired Google back then, would not have made Google what it is today.

I mean, if Blockbuster couldn’t make the jump to mail-in rentals, do you think it could have jumped ahead two steps and parachute onto streaming?

No way. They were blinded by their knowledge about the industry.

And be careful challenging me on that point, because I'd be forced to remind you that Kodak invented digital cameras in the '70s and was later disrupted by them, just like Dr. Frankenstein’s own creation turned against the poor guy.

By the time Blockbuster realized they had to do something about Netflix they couldn’t, because now they didn’t have the balance sheet to build that value network quickly enough, and their executives "knew too much" about the film industry to start their way down a new learning curve.

All they could do was watching it all come to ashes, just like Toys r Us executives did. A painful movie to watch for incumbents, but a blast for the disruptors.

Fast forward a few years, and now Netflix is facing an existential threat once again as Disney, Comcast, ATT and even YouTube TV try to enter the streaming space, but this time they are not the upcomer but the one on the incumbent side of the table.

Companies like Comcast, HBO, and Disney that to some extent were collateral victims of the evolution of streaming as a business model, are now turning that same weapon back at Netflix, the pioneer in the space.

Streaming technologies have had significant advances over the last several years, and the consumer market for those technologies has exploded as a result of the deep penetration of mobile technologies, to a point that streaming content is ubiquitous, but nothing like a competitive advantage anymore.

A significant difference in this new landscape though, is that the competition Netflix is facing is not "disruptive" in nature, but good ol’, bloody rivalry, like in any mature industry.

The type of competition that fights with bare knuckles and doesn’t end but by knockout.

And just like in any other mature market, companies will try to craft their own space following predictable strategies: Some will compete on "better" while others will compete on "cheaper", something that we explain in detail in the book.

But Netflix may still have some time to decide where it wants to position itself along these axes. Basically, they must pick whether they will be the Apple (higher quality) or the Walmart (lower prices) of content streaming.

My guess is, judging by the quality of some of their recent productions, they will try to be the Walmart of content.

So, their current strategy where they spend $20 billion a year in new content and raise prices slowly but continually, is probably a way to get two things they need: Number one, they want to raise the "bottom" (aka the low price) of the market, and second, they want to increase the "number" of in-house productions, so that they have a large selection by the time Disney and Comcast start pulling their content out of Netflix to make it available through their own platforms.

By 2021 there will be no Disney movies, no Marvel Universe, no The Office, no Friends, and no Parks and Recreations on Netflix. 

A key to successful disruptive products is to price them lower than incumbents' solutions, and that's probably the reason why Netflix has tried to keep its prices as low as possible, as a way to prevent these "low-end disrupters" from germinating.

Now, the point I’m trying to make here is that Netflix, which was the disruptor one time, could now be put to sleep by some of the players that were almost disrupted by the emergence of streaming options, which Netflix originated.

That’s why a clean disruption to be truly successful should leave no survivors. That’s disruption 101: Unless the new product disrupts ALL incumbents, meaning that none of the existing players can exploit the opportunity that product creates, the innovation may not succeed as a disruption.

Why? because if any of the existing players can do it, when they see the need they will, and because some will normally have the motivation and resources to fight back, some will.

What makes this case even more interesting, is that while Netflix was a Low-end Disruption to the video rental stores, it was probably a linear innovation to cable companies.

Now cable companies, after many few years trying to find the bathroom in this new landscape, not only have access to streaming technologies of their own, but they also happen to own the content, a critical supply to Netflix’s success recipe, and now they are prepping up to challenge Netflix at their own game, and they actually have better chances.

Winter, is definitively coming for Netflix.

A moral of the story is that the "speed of innovation" is what actually enables a disruption to happen.

More precisely, it is the difference in the rates at which incumbents and upcomers can improve their products what "creates" disruptions.

When these disruptions initially show up, incumbents can’t keep up with the pace at which the upcomers improve their solutions’ performance and most run out of money and crash while trying to catch up.

Some disruptions can come and go by so fast that incumbents sometimes don’t even know what hit them*.

But once those disruptive businesses lose inertia, and they will eventually lose inertia, and when the pace of innovation slows down, then companies that have been left behind will have a chance to catch up.

And then, from that point forward, competition will happen as we know it: price wars, deceptive marketing, strategic positioning, etc.

That’s why companies like Amazon and Alibaba try to innovate as fast as they can in many directions, because they know that as soon as their pace of innovation slows down, serious competition will arrive in some of their markets, and with it a shrinkage of margins.

There's no breaking news here. We all know how disruptions work, but seen its entire propagation from beginning to end helps us appreciate how the speed of innovation, specifically, plays a different role at both sides of the disruption cycle, and why disruptors eventually become disruptees.

Let me know what you think about this.

* In some cases, incumbents may have enough time to do something about it, like its happening right now with the oil industry.

A Case of Fragmented Value Chains
Ben Thompson published a fascinating story this week about how Intel has lost competitiveness in the chip processor market because they have stuck for too long to an integrated design-and-manufacture Value Chain.

Thompson explains how players like AMD have focused their business models around design-only, and have opened the door to a chip "manufacturing-only" business model that companies like Taiwan Semiconductor Manufacturing Company (TSMC) and GlobalFoundries have come to own.

This is another fascinating case on innovation that’s currently brewing and probably the perfect flip side to our comments above about disruption, because as we explained before, specialized value chains operating within competitive markets will in most cases "fragment" as a result of competition, which creates important tradeoffs between performance and economies of scale.

To make a simple example, think about a computer maker who manufactures all of the computer’s components.

As long as the company manufactures and integrates all the components in-house, the company will be able to achieve the higher levels of performance in the computers it makes, as they control the entire operation from design to manufacturing.

Alan Kay’s quote captures the essence of this problem: People who are really serious about software should make their own hardware.

So, if you want to create great software, then you have to make the hardware as well. And something similar happens in other types of integrated operations.

What happens is that as third parties get good at manufacturing components of the computer, let’s say memory or hard drives, the computer maker will be tempted to outsource those components as a way to keep its costs down, but by doing that, its computer could lose some performance.

But third parties eventually get so good at manufacturing these components, that at some point there will be no difference in the performance of the computer as a whole than if you were making those in-house, and by outsourcing the components you get to sell your products at lower prices and/or higher margins.

So, that implies that there’s a point in between where executives must realize that it is time to let go of a key part of the value chain, and outsource it.

The general rule we provided in the book was to retain control of any combination of activities that drive performance along dimensions that matter to customers and outsource the rest.

In plain English, that means that you should keep in-house the activities that are important for your customers as long as you can make them better than third parties, and outsource other activities that are less critical that third parties can do cheaper than you.

But it looks like IBM violated that rule and tried to keep both design and manufacturing in the house for too long as the value chain of the chip manufacturing industry moved the other way and got fragmented.

As a result, Intel processors today can’t match the performance and manufacturing speed of its competitors.

Now, don’t get me wrong here, that same strategy is what enabled Intel to be extremely profitable for more than a decade, but it looks like they held onto it longer than needed and didn’t let go on time, so now they are having some issues getting back on track.

The reason I’m bringing this up is to highlight the importance of understanding how a company’s strategic ability is the sum of its capabilities, and why the idea of a Value Network is so important.

When you see a new entrant competing with an incumbent or several incumbents competing with each other, that is, in essence, a fight of value networks, where those with the most effective Value Chain and networks of partners and vendors will in most cases win a particular market.

So for the next edition of the book I’m thinking about including the steps to do a full Value Network analysis since at the end, understanding a company's Value Network is a way to predicting its fate.

If you want to help me build this process for the next edition just let me know and I'll point you at a few resources to check.

Been getting a lot of good feedback about the newsletter. Please let me know what you think.

Remember you can just reply to this email or chat with me through google hangouts ([email protected]).

Checking out now. Talk to you next Friday.


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