The time to rethink three widely believed, but outdated management ideas is long overdue.
1. There are “good” and “bad” industries
In the late 1970s, Michael Porter’s seminal article on business strategy -- How Competitive Forces Shape Strategy -- established five industry characteristics to explain why some companies are inherently more profitable than others.
Porter advised managers to seek out businesses with strong bargaining power over buyers and suppliers, low threats of entry from similar or substitute products, and minimal competition, giving rise to the notion that there are “good” and “bad” industries, more or less conducive to attractive financial results.
Take airlines for example, plagued by intense price competition, high structural costs and fickle customers. Most airlines historically failed to earn their cost of capital, and every major legacy carrier has gone bankrupt -- at least once. Who would want to enter such a fraught industry?
But if structurally challenged industries are destined to suffer, how can one explain that Southwest Airlines’ market cap since 1980 has grown more than four times faster than the S&P 500 and more than 90 times faster than the airline sector as a whole?
If a company’s choice is either to enter a poorly performing industry, playing by the same rules as incumbent market leaders, or to stay out of the business entirely, Porter's advice is well taken. But there’s a third choice: recognizing opportunities to address poorly served customers by playing by a different set of rules.
Southwest Airlines initially focused on passengers who neither valued, nor were willing to pay for a broad range of amenities offered by legacy airlines, instead delivering no-frills, efficient and friendly one-class service.
Similarly, companies like Casper, Costco, Netflix and Warby-Parker have attacked sources of customer dissatisfaction and/or high costs to prove that there’s no such thing as a bad industry, except if you’re an incumbent mired in an outdated business model.
2. The objective of management is to maximize shareholder value.
Perhaps no management principle is preached more dogmatically than that management’s objective should be to maximize shareholder value.
But this belief has led too many executives to focus on boosting quarterly earnings and stock prices with actions that compromise long-term growth -- a serious problem that’s been getting worse.
For example, 80 percent of CFO’s recently reported that they would cut R&D spending if their company risked missing a quarterly earnings forecast. Moreover, S&P 500 companies have spent an unprecedented $3 trillion on stock buybacks over the past five years, partly at the expense of R&D, capital expenditures for expansion, workforce training and other value-creating activities. Share buybacks increase a company’s short-term EPS – that’s just math -- but there is growing evidence to suggest that excessive stock buybacks can undermine long-term value creation.
The real issue here is that maximizing shareholder value should be the outcome, not the driver of management priorities. Corporate strategy should be guided by a customer-centric corporate purpose, a clear articulation of the time horizon for planning, decision-making and capital allocation, and how tradeoffs between stakeholder interests should be resolved.
As an example, Jeff Bezos’ first letter to shareholders clearly articulated that Amazon would prioritize long-term market leadership over short-term profitability, and that the company would relentlessly focus on customers. By consistently putting customers at the center of Amazon’s strategy and new business development, the company’s market cap has increased almost 1,000X since its IPO. Customers and shareholders have been exceptionally well served by CEO Bezos’ overarching commitment to a long-term customer-centric corporate purpose.
3. Mature businesses inevitably decline
Recent research has found that less than 15 percent of Fortune global 100 companies have sustained above-market growth over multiple decades. Does this suggest a Darwinian form of corporate evolution where large corporations are destined to decline?
Those who question the feasibility of long-term growth point to three seemingly immutable marketplace constraints:
These “laws” are not only flawed, but they could become a self-fulfilling prophecy of corporate failure. After all, if managers truly believe that long-term growth is impossible, they will seek to protect and harvest current assets and customers for as long as possible. But such an approach—playing not to lose, rather than playing to win—only serves to hasten the decline of incumbent market leaders, as Kodak, Blockbuster, Sears and others have painfully discovered.
But there are counter-examples, where businesses have continued to prosper by maintaining the same core values, entrepreneurial spirit and adaptability that led to their success in the first place:
Amazon became the fastest company to exceed $100 billion in sales last year following this approach. Over an even longer term, Johnson & Johnson and 3M are still outpacing overall GDP growth more than a century after their founding.
Long-term profitable growth and shareholder value creation is possible in all industries – good or bad.
Amazon’s Q2 2014 earnings report brought a triple whammy of disappointment to impatient investors:
Three chronic concerns underscore growing investor unease with Amazon’s management priorities:
Jeff Bezos’ Guiding Principles
Bezos built Amazon on the foundation of being stubborn on vision, but flexible on details. And no CEO has ever been so clear in articulating his corporate vision as Jeff Bezos, who laid out the company’s guiding principles in his first letter to shareholders in 1997. In that document (which Amazon has included in its Annual Report every year since), Bezos signaled his intent to build a company focused on long-term growth, bold action, market leadership and customer satisfaction. As if anticipating the current criticism, in 1997, Bezos cautioned: “Because of our emphasis on the long term, we may make decisions and weigh tradeoffs differently than some companies.” He has been admirably, and to some, frustratingly true to that vision ever since.
In this context, let’s examine each of the sources of investor angst in turn.
The time is long overdue for the company to deliver profits
Echoing the concerns of many analysts, Michael Yoshikami, CEO of Destination Wealth Management (which sold its stake in Amazon last year) recently noted: “Most companies with the kind of gross revenue Amazon has are not posting these kind of losses.”
Well that’s an understatement!
To put Amazon’s recent financial performance in perspective, consider the figure below, which displays revenue and net income since the company’s inception. There should be little doubt that Amazon has been reinvesting operating profits to fuel future growth. And its growth rate has been extraordinary. From 1995 through 2013, Amazon has grown its topline at a compound annual growth rate of 94%.
Granted, growth rates have slowed as the company has bulked up, but Amazon is on track to be the fastest company in history to reach $100 billion in sales. With current revenues of >$75 billion, Amazon reported 23% topline growth on a year-on-year basis in its Q2 results. As noted below, comparing Amazon to companies that are within +/-10% of its current revenues, Amazon’s topline growth rate is in a class by itself – as is its lack of profitability!
In its relentless pursuit of growth, Amazon has become over-extended
Amazon’s profitability has undoubtedly been dragged down by its frenetic pace of investment in new businesses. As Jeff Bezos noted in his official statement accompanying the company’s Q2 earnings report:
We’ve recently introduced Sunday delivery coverage to 25% of the U.S. population, launched European cross-border Two-Day Delivery for Prime, launched Prime Music with over one million songs, created three original kids TV series, added world-class parental controls to Fire TV with FreeTime, and launched Kindle Unlimited, an eBook subscription service. For our AWS customers we launched Amazon Zocalo, T2 instances, an SSD-backed EBS volume, Amazon Cognito, Amazon Mobile Analytics, and the AWS Mobile SDK, and we substantially reduced prices. And today customers all over the U.S. will begin receiving their new Fire phones — including Firefly, Dynamic Perspective, and one full year of Prime — we can’t wait to get them in customers’ hands.
Each of these ventures requires startup capital that may take years (if ever) to recoup. As Amazon’s cash from operations has grown over time, it has accelerated its investment in new business development, venturing further afield from core ecommerce retailing to compete in the markets for tablets, smartphones, cloud computing, streaming media and original television content.
S&P Capital IQ analyst Tuna Amobi (who has a sell rating on Amazon) summed up the sentiment of many in noting: “There’s a lot of stuff they’re doing that’s questionable. There’s nothing wrong with spending to diversify your business, but it has to be in a focused manner as opposed to throwing spaghetti on the wall and seeing what sticks.”
The company’s obsessive secrecy manifests a blatant disregard for shareholders, which stands in stark contrast to its customer attentiveness
From the company’s founding, Jeff Bezos has been unwilling to divulge financial performance at the business unit level. This has set up a cat-and-mouse game between Amazon executives and industry analysts striving to learn more about company operations. For example, analysts have struggled for years to gain more insight into how many Prime customers Amazon has enrolled, or how many Kindles, Fires, hardcovers or ebooks it has sold, or how much AWS revenue it has booked or how much investment it has made in streaming video.
But Jeff Bezos doesn’t like to get specific with numbers.
For example, When Bezos took the stage in June to announce the launch of the Amazon Fire smartphone, during his 90-minute presentation, he took the opportunity to drop hints about the company’s broad-based business impact using the deliberately vague terminology: “tens of millions.”
Here’s a sampling from his presentation:
Bezos’ catchphrase is reminiscent of astrophysicist Carl Sagan, who popularized public awareness of astronomy with his frequent reference to the “billions and billions” of stars in the intergalactic universe. The difference of course is that the phenomenon Sagan was referring to is truly unknowable, whereas Jeff Bezos knows precisely how individual components of his business are doing. But that’s for Bezos to know and others to guess.
Care to speculate how many Kindles Amazon has actually sold? From Bezos’ opaque tease, the answer may be 20 million and growing or 220 million but declining. Granted, the SEC doesn’t require public companies to divulge such details to the investment community, but for a company whose market cap has been buoyed by shareholder trust, Amazon’s opacity has been testing investor patience.
Every quarter, buy- and sell-side analysts join in a conference call with Tom Szkutak, Amazon’s CFO, and pepper him with questions about company operations. But Szkutak doggedly dodges each query; as exemplified by his replies during Amazon’s Q4 2013 analyst call:
“I am sorry I can’t help you … you have to wait on that … In terms of the details, I can’t really give you a lot of color … you will have to stay tuned on that one … I can’t talk to the specifics of that … there is not a lot I can help you with there … I wouldn’t speculate what we would do or not do going forward … I wouldn’t speculate. We might or might not do in the future … if you look back at what we have done, you can’t expect that we might do [it] going forward … I wouldn’t want to speculate what they would or wouldn’t do related to pricing … it’s hard to tell, honestly. It’s hard to know … it’s very early … that’s really all I can say … I can’t comment.”
At Amazon, every obfuscating quarterly conference call feels like Groundhog Day.
What’s Next for Amazon?
So Amazon is arguably guilty as charged of disappointing earnings, worrisome increases in business complexity and investment, compounded by a stubborn unwillingness to share more information about business operations. The market has clearly lost confidence; Amazon is currently trading 25% off its 2014 peak.
Does the current market sentiment signal the need for a fundamental shift in Amazon’s overarching business vision, strategy or priorities? I don’t think so.
Taking the long view, it is somewhat puzzling that investors have seemingly become so unnerved by Amazon’s recent business performance. There is nothing particularly new or different in Amazon’s business priorities, or in its operating results through the first half of 2014. Jeff Bezos is managing Amazon today exactly as he said he would 17 years ago, making good on his longstanding commitment to prioritize long-term growth and market leadership over short-term financial returns. As such, it shouldn’t be surprising that Amazon has only beat quarterly earnings estimates half the time over the past 20 reporting quarters. So why have investors suddenly become impatient?
Admittedly, there are some headwinds of concern. To begin with, Amazon’s recent EPS misses have come in bunches – viz. 4 out of the last 5 quarters. Then too, some of Amazon’s current business development priorities – cloud computing and original video content development — have particularly high investment thresholds with inherently long paybacks. More generally, the law of large numbers is catching up with Amazon, making the required size of its investment bets and risks higher. Finally, as Amazon has moved farther afield into new business ventures, it has attracted new and stronger competitors. For example, AWS, Amazon’s industry-leading cloud computing business, is encountering fierce price competition from deep pocketed, committed players such as IBM, Microsoft and Google. So it shouldn’t be surprising that Amazon’s historically thin profit margins are under additional pressure.
But strategic, growth-oriented companies who are able and willing to sustain new business development activity through cyclical business swings are often rewarded over the long term. As a case in point, Amazon’s relentless focus on new business development and market leadership has propelled its unprecedented long-term growth.
Lest there be any doubt that Jeff Bezos is continuing to manage for long-term growth, consider the comparative business performance between Amazon and two of its major competitors: Walmart, the largest global retailer and IBM, a technology leader and fast follower in cloud computing.
Where Do The Profits Go?
As illustrated below, Amazon performed reasonably well in generating cash from business operations in 2013: 7.4% of revenues compared to 4.9% and 17.5% for Walmart and IBM respectively. What really distinguishes these three large enterprises is how each chooses to deploy their capital. Amazon spends far more of its cash from operations on R&D and Capex – the engines of growth – than Walmart or IBM. The payoff is in topline growth: 23% for Amazon vs. low single digit or negative for its competitors. In contrast, Walmart and IBM reward their shareholders with near term gratification in the form of dividends and stock buybacks (29% and 73% of cash from operations in 2013 for Walmart and IBM respectively).
To understand the reason for these stark differences, it is worth repeating Jeff Bezos’ prescient comments in his 1997 letter to shareholders:
“We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions…
Because of our emphasis on the long term, we may make decisions and weigh tradeoffs differently than some companies…
We aren’t so bold as to claim that [we have] the “right” investment philosophy, but it’s ours, and we would be remiss if we weren’t clear in the approach we have taken and will continue to take.”
Virtually every month, Amazon seems to announce yet another major new business venture. Recent examples include Amazon Fresh (groceries), Amazon Local (local services), Get It Now (same day delivery), Amazon Payments (online payments), streaming video and audio services, original content, Fire Smartphone, aggressive expansion in India, etc.
Critics who have grown impatient with Amazon’s lack of profits may be underestimating the long gestation period required for new-to-world ventures to yield attractive returns. This was certainly the case with Amazon’s initial ecommerce business, and subsequent third party marketplaces and Kindle platform, which took as long as a decade to go from concept to profitable returns.
This is not to suggest that Amazon hasn’t experienced its share of abject failures, including the following initiatives, which either were abandoned, written off or salvaged only via pricey, face-saving acquisitions:
It is also important to recognize that Amazon’s preference for long-term growth over short-term profits is a matter of strategic choice. Amazon could easily boost its EPS by throttling back Capex and R&D investments (at the expense of growth), whereas, it is unclear whether Walmart or IBM are capable of turbocharging their topline growth.
Investors who expect Amazon to deliberately scale back its growth initiatives and/or raise prices to achieve short-term profits either don’t understand the company or lack the appetite for Jeff Bezos’ long-term vision. Amazon is positioning itself at the epicenter of multiple businesses with exceptionally strong growth potential – global ecommerce, streaming media, electronic payments, cloud computing, same-day delivery services, the South-Asian continent etc. It is neither in Amazon’s DNA or long-term interest to slow its pursuit of these opportunities.
What could go wrong?
Is Amazon an indomitable force, bound for world domination? Of course not.
There are a number of factors that could sidetrack Amazon’s prodigious appetite for growth and market leadership.
The biggest challenge is management risk associated with the growing complexity of Amazon’s global business endeavors. As noted earlier, Amazon chooses to operate with razor thin margins across its business portfolio, and as such, will have to execute flawlessly to maintain torrid growth without jeopardizing their balance sheet. This will require a deep bench of committed executive talent across the enterprise.
As their Q3 2014 guidance perhaps presages, Amazon may hit a bad patch if a few of its strategic growth initiatives take longer to materialize, attract more vigorous competition and/or require considerably higher investment than anticipated. Such outcomes, as noted below, could set in motion a downward spiral in business performance that might require significant retrenchment. Amazon relies heavily on options-based compensation in its senior executive ranks, making the company vulnerable to prolonged softness in the stock market.
Given its dependence on public markets to fuel aggressive organic growth and acquisitions, Amazon’s reticence and repeated opacity in dealing with the investment community is another risk factor. A growing chorus of analysts and shareholders has lost patience with what they view as the company’s arrogant disregard of shareholders. True, the company can point to its unusual candor in initially articulating its management philosophy and to the shareholder-friendly returns achieved over the past decade (~500% stock price appreciation from mid-2004 to mid-2014). But the public has short a memory span, and Amazon risks needlessly squandering shareholder trust by doggedly refusing to respond to questions regarding business line results or to provide a credible case for the company’s path to profitability.
Another risk factor of course is Jeff Bezos himself. Few companies are as personified by their CEO as Amazon. Bezos’s eventual successor will obviously have some very big shoes to fill, with outsized management transition risk.
But for the foreseeable future, with respect to Jeff Bezos’ guiding vision, don’t expect new news from Amazon. If you’re looking for hints on Amazon’s strategic blueprint for the years ahead, look no further than Bezos’ 1997 letter to shareholders excerpted below.
We’ve all been inspired by stories of brilliant entrepreneurs whose game-changing ideas sparked in humble settings — e.g. a garage (Steve Jobs), dorm room (Mark Zuckerberg) or Milanese coffee bar (Howard Schultz) — blossomed into market-leading global enterprises. A new generation of entrepreneurs is now building companies that reached $10 billion in market value in record time (Uber, Airbnb, WhatsApp), posing grave threats to established industries. It would appear that the traditional bases of competitive advantage that used to protect incumbent market leaders – scale, operational experience, brand image, customer base, distribution, and financial depth –- can no longer withstand the onslaught of upstart entrepreneurs.
This was the theme of Malcolm Gladwell’s recent book, David and Goliath: Underdogs, Misfits and the Art of Battling Giants. In his retelling of the biblical tale of David and Goliath, Gladwell portrays David as a fearless, agile and resourceful fighter who defeats the dim-witted, over-confident and ponderous oaf, Goliath. Gladwell rebuts the common belief that David was an underdog. In this mismatch – and in a surprisingly large number of others – Gladwell asserts that leaders have liabilities that make them particularly vulnerable to brash upstarts.
This should come as no surprise to students of business. History is replete with examples of profitable, market-leading corporations who were felled by smaller but more nimble and effective competitors. For example, when AT&T — the largest company in the US for much of the 20th century– failed to adapt to deregulation and the emergence of wireless technologies, it was forced to sell its dwindling assets for a fraction of its historical peak value to one of its former regional divisions. AT&T’s vulnerability as a ponderous, customer-abusing monopoly was bitingly captured in one of Lily Tomlin’s signature parodies, with the tagline: “We don’t care. We don’t have to. We’re the phone company!”
GM, which also held the distinction of being the largest US corporation for decades declared bankruptcy in 2009, and only lives on today (in shrunken form) as the beneficiary of a taxpayer bailout. But GM’s management shortcomings are no laughing matter, as details of its willful disregard of fatal vehicle design flaws have recently come to light.
Kodak serves as yet another example of how the mighty have fallen. The firm, which enjoyed photographic film industry leadership for over a century, peaking at a 90+% market share in the mid-1970’s, declared bankruptcy in 2012. Kodak is a poster child of Clayton Christensen’sdisruptive technology theory, which explains why large enterprises struggle to adopt innovations such as digital imaging.
Are these isolated examples of bad management bringing down venerable institutions, or are market-leading corporations destined to be felled by disruptive upstarts, by aggressive attacks from traditional competitors, or by a combination of both? Conventional wisdom has increasingly tilted toward the latter: market leaders cannot sustain global competitive advantage over the long term.
Take Apple as a case in point. A gloomy outlook has been predicted for the post-Steve Jobs enterprise by no less than a Nobel Prize-winning economist (Paul Krugman), one of the most influential business theorists of the last 50 years[i] (Clayton Christensen), a Wall Street Journal reporter and best-selling author (Yukari Kane), an SAP board member writing for Der Spiegel (Stefan Schulz) and 71% of respondents to a recent Bloomberg global survey who say that Apple has lost its cachet as an industry innovator. The reasoning behind these arguments that the mighty must fall is not limited to Apple, but stem from a broader belief that large enterprises inevitably lose their competitive advantages over time.
But this viewpoint is not only flawed, but perversely could become a self-fulfilling prophecy of corporate failure. If management truly believes that long-term above-market profitable growthis impossible, the logical response is to protect and harvest current assets and customers for as long as possible. But such an approach — playing not to lose, as opposed to playing to win – only serves to hasten the decline of incumbent market leaders.
The biblical Goliath may have been a ponderous oaf, but large enterprise CEO’s don’t have to be. Business Goliaths can continue to prosper if they maintain the same entrepreneurial spirit and adaptability that led to their success in the first place.
Let’s explore the case of Apple as a case in point.
On September 29, 2012, Apple reported record earnings, capping a remarkable three-year run during which the company grew revenues by 266%, profits by 406% and market capitalization by 280%. Already the most highly valued company in the world, few expected that Apple could continue its torrid growth rate forever.
But as Apple’s margins and growth rate did begin to abate over the ensuing 18 months, many pundits declared this was a broader sign of the company’s expected erosion of competitive advantage, dooming Apple to average financial performance – or worse – going forward.
For example, one of my esteemed colleagues at Columbia Business School shared this provocative point of view with MBA students:
It’s very hard to dominate big global markets. Nobody has ever dominated electronic devices. Trust me, we’ve seen it in related industries for Sony, for Motorola and for Nokia. They’ve had nothing like the margins of Apple, and the margins of Apple have gone down by at least a third in the last 16 to 18 months. You can’t dominate a big market… Apple is going straight down the tubes! — Bruce Greenwald, Columbia Business School
Why would a company that has repeatedly demonstrated extraordinary customer insight, innovation, design expertise, marketing prowess, high quality manufacturing and retailing excellence be headed “straight down the tubes?”
I believe there are three fallacious arguments that underscore the belief that Apple, and indeed all market leaders, eventually must lose their competitive advantage and above-market financial performance over time:
This law posits the obvious mathematical property that as a company grows, the incremental revenue required to maintain above market growth becomes ever larger. For Apple, whose revenue is currently $175 billion, the challenge is indeed daunting.
For example, consider what would be required for Apple to grow it’s topline by 10% over the coming year, which while still above market average, is still only one-third of the compound annual growth rate the company achieved over the past five years. Growth of this magnitude would require the equivalent of adding the total revenue from companies such as Southwest Airlines or General Mills or US Steel to Apple’s current topline. No mean feat!
Or think of it another way. Apple-watchers have been keenly anticipating the launch of theiWatch, in the intriguing “wearable technology” category. Characteristically, Apple has not been the first-mover in this emerging technology (nor was it in portable music players, smartphones or tablets), as smartwatches from Samsung, Pebble and more recently Google have been on the market for a year or more.
But let’s give Apple the benefit of the doubt based on past success and assume that it achieves 10 times the industry sales of smartwatches achieved in 2013 ($712 million). At an assumed iWatch price of $299, this translates into annual sales of 24 million devices, generating just over $7 billion in revenue. As long as we’re being generous, let’s assume that each consumer also buys an average of $50 in apps each year for their slick new iWatch, of which Apple would claim a 30% revenue share. That would add a paltry $360 million in additional revenue (albeit at high margins). But the point here is that if Apple’s ability to continue to outgrow the market requires upwards of $17 billion of new revenue (and even more in the years ahead), it will take more than the vaunted iWatch to get the job done.[ii]
It will undoubtedly be difficult for Apple to outgrow the market over the long term. But is it impossible? Absolutely not!
The most definitive study on this issue was undertaken by the Corporate Executive Board in their landmark study of long-term growth rates. The CEB examined the performance of over 400 US companies that have been on the Fortune 100 list over the past 50 years, along with 90 non-US companies of a similar size. The authors concluded that approximately 13% of the nearly 500 large companies studied have been able to outgrow the market average for up to 50 years. So while outperforming the market over the long-term is a notably uncommon achievement, it is far from a mathematical impossibility.
So where might Apple find its next growth wave, if not from the iWatch? There are several large opportunities that Apple may exploit that could fuel another round of dramatic growth. Opportunities include:
Under any circumstances, the assertion that Apple cannot continue to outperform the market because of the “law” of large numbers is pure sophistry – a case of simple mathematics posing as strategic thinking.
The law of competition
A second argument for why Apple is destined to decline falls under the rubric, the law of competition. According to this “law,” Apple’s historically sky-high returns on invested capital (ROIC) must inevitably revert to average levels for the following reasons.
Many industry observers have also pointed to the loss of technological leadership in the smartphone/tablet market, and the four-year lag since the company introduced its last game-changing product (iPad) as further evidence of Apple’s inability to maintain the competitive advantage required to sustain high margins (see Exhibit 2).
But the inexorability of the law of competition applied to Apple and other highly profitable corporations is fundamentally flawed on two grounds:
In fact, the [current smartwatches] do the opposite: they re-enforce all our old assumptions about the form, which is that you take your phone screen, make it small and stick it on your wrist. All I can think when I see them is: “Beam me up, Scotty!” And where’s the joy — or the desire — in that?…
Admittedly, this has entirely to do with aesthetics, not functionality or engineering. But a smartwatch is an accessory, so aesthetics matters.
Tech writers have been largely negative as well, noting the lack of useful functionality and confusing user interface of the current genre[iv]. Given these reviews, it’s not surprising that early sales in the smartwatch category have been disappointing. But if history repeats itself, Apple will once again set a new standard for style, form factor, capability, usability and market leadership when it launches its new iWatch, as rumored this fall.
Critics who bemoan Apple’s late entry in this category as proof that Apple has lost its innovative edge in the post-Jobs era should remember that Apple’s unprecedented success with the iPod, iPhone and iPad came at least a decade after competitors pioneered product launches in these categories, as noted in Figure 3.
The law of competitive advantage
At the heart of the widespread conviction that large companies cannot sustain global leadership (marked by above-market growth and margins) is the underlying belief that the basis of a company’s competitive advantage inevitably erodes over time. A good starting point to examine the validity of this argument is to recall that all products and services experience aproduct life cycle. The familiar bell shaped curve shown in Figure 4 traces the trajectory of a new product through early adoption, rapid growth, maturity and eventual decline, driven by competitive technology advances and shifts in customer preferences. Schumpeter described this process as creative destruction over fifty years ago, and while the underlying dynamics are still compellingly true today, Downes and Nunes have argued that product life cycles have dramatically shortened due to a number of forces described in their recent book Big Bang Disruption[v].
Whatever one assumes about the duration of a product lifecycle – for example, in consumer electronics, successful products can come and go in less than a year – it is undeniably true that to sustain long-term market leadership, companies must consistently renew their product lineup with the “next new thing” in each of the categories in which they compete. This does not mean simply adding incremental improvements, which Christensen has noted propels most companies into a sustaining technology feature-function arms race. Rather, successful companies must rethink their consumer value proposition on an ongoing basis and be willing to consider entirely new product concepts aimed not only at current customers, but those poorly served by current offerings.
And herein lies the challenge. In most cases, established market leaders struggle to disrupt themselves and eventually get overtaken by newcomers who bring radically different approaches to market that are often better and cheaper than existing products. The list of disruptive technology examples stretches back centuries and cuts across every industry sector. For example, as noted in Figure 5, Western Union’s telegraph business was decimated by Bell Telephone, which in turn gave way to Motorola/Nokia’s leadership in mobile handsets, which in turn got toppled by Apple/Samsung’s dominance of the smartphone market. Figure 5 lists numerous other cases where incumbent market leaders got toppled by newcomers who attacked with better product technology and/or superior business models.
Christensen’s Innovator’s Dilemma explains that the reason why incumbents usually fail to disrupt themselves boils down to the strong tendency of large companies to:
This is precisely what Apple and Amazon have done over the past 15 years. For example, Apple has continuously created new growth opportunities through breakthrough product innovation, sometimes at the expense of cannibalizing its existing products. This is illustrated in Figure 6 below, where the top line reflects the sum of sales from each of Apple’s main product lines over time.
Similarly, Amazon’s exceptionally strong sustained topline growth (if not profitability) has been driven by relentless scope expansion and product innovation, often on initiatives with long-term payoffs and/or that have cannibalized existing product lines.
Summing It Up
The belief that business Goliaths will eventually lose their basis of competitive advantage stems from an implicit assumption that large enterprises suffer from strategic inertia. It is true that if a company (small or large) focuses more on defending current market positions than on renewing its basis of competitive advantage through meaningfully differentiated innovative new products and services, it will fail for all the reasons noted above:
Unlike scientific laws[vi], which describe intrinsic characteristics of our physical world, the business “laws” of large numbers, competition and competitive advantage can be broken by strong leadership.
As Rita McGrath notes in her insightful book, Transient Advantage, winning companies can (and indeed must) repeatedly renew their basis of competitive advantage to sustain long-term profitable growth. It is admittedly not easy, and there are often strong headwinds that challenge corporate entrepreneurship.
But exceptional CEO’s such as Jeff Bezos (Amazon), Howard Schultz (Starbucks), Marc Benioff (salesforce.com) and Fred Smith (FedEx) demonstrate that companies can continuously renew their bases of competitive advantage and achieve sustained profitable growth, notwithstanding the growing chorus of naysayers who assert that the mighty must fall.
Whither Apple in the years ahead? Tim Cook’s leadership rather than immutable laws of large numbers, competition or competitive advantage will determine Apple’s business performance going forward.
Time will tell.
After 40 years in management consulting and venture capital, I joined the faculty of Columbia Business School, teaching courses in business strategy and corporate entrepreneurship
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