Eric Button

7 Powers: Book Notes

H
amilton Helmer's 7 Powers is a masterpiece. It focuses on how strategy can directly impact business value and durability. These are my notes.

[Eric's note: expect some formatting and indentation issues; I've copied this over from a different note-taking format]

Introduction

The arc of any celebrated business is underpinned by decisive strategy choices that are few and typically made amidst the profound uncertainty of rapid change.

  • getting them right is a constant process
  • planning cycles won’t get you there

Strategy is best not as a process, but best when it’s embedded in a prepared mind of those executing

  • To achieve this, a strategy framework must be “simple but not simplistic”
  • This book’s focus on “Power” makes it simple enough to be learned/retained/used by any business person

If your business doesn’t have at least one of the 7 Power types, you lack a viable strategy and you’re vulnerable

Intel

Market cap of around $150B

Strategy: the study of the fundamental determinants of potential business value

Strategy can be divided into two topics:

  1. Statics: “Being there” — What makes Intel’s microprocessor business so durably valuable?
  2. Dynamics: “Getting there”—what yielded this state?

Intel didn’t start in microprocessors

  • started as “The Memory Company”
  • only got into microprocessors from a contract job done to provide cash for the memories business
  • eventually Intel dropped memories and went all-in on microprocessors

Why did Intel succeed in microprocessors but fail in memories?

  • both were:
  • first-mover items
  • large
  • fast-growing
  • in semiconductor space
  • same management, technical, financial backing
  • Competition wasn’t the factor either
  • microprocessors had intense competition

The answer must lie elsewhere

  • we can only assume microprocessors had some characteristics which:
  • improved cash flow while
  • inhibiting competitive arbitrage
  • This is what’s referred to as “Power”
  • Power: the set of conditions creating the potential for persistent differential returns
  • Power:
  • Notoriously difficult to reach
  • microprocessors had Power, memories didn’t

The Mantra

strategy [small “s”, and as in, a company’s strategy]: a route to continuing Power in significant markets

  • by narrowing definition of strategy this way, we gain clarity and usefulness
  • the Game Theory version of strategy ignores the business imperative of creating value
  • Game Theory version isn’t sufficiently constrained, therefore

Value

value: absolute fundamental shareholder value

  • the ongoing enterprise value shareholders attribute to the separete business of an individual firm
  • best proxy: NPV (net present value) of expected future FCF

Potential Value = [Market Scale] * [Power]

For:

  • Intel’s memories business:
  • competitive arb drove long-term differential margin negative
  • Intel’s microprocessors business:
  • Power enabled Intel to maintain high and positive long-term differential margins

Upcoming Topics

  • Persistence
  • Value comes from the years ahead
  • This is more accentuated with high-growth businesses
  • growth is only valuable if it’s here to stay for some time
  • Intel’s current market cap reflects high returns for a very long time
  • Dual Attributes
  • Persistence has 2 factors: magnitude and duration
  • Benefit (magnitude)
  • The conditions created by Power must increase cash flow
  • Can manifest as any combination of:
  • increased prices
  • reduced costs
  • lessened investment needs
  • Barrier (duration)
  • some aspect of the Power which prevents competitors from engaging in value-destroying arbitrage
  • Benefits are far more common than Barriers
  • Always look to the Barrier first
  • Industry Economics and Competitive Position
  • Power involve the interaction between these two
  • Will help with understanding role of “industry attractiveness” in creating value potential
  • Complex Competition
  • Power is entirely relative (to competitors or a specific one)
  • Good strategy involves assessing Power with each specific competitor
  • one arbitrageur is enough to drive down differential margins
  • Single Business Focus
  • each individual business within a business must be evaluated
  • The interplay of multiple businesses under one roof concerns Corporate Strategy, which is outside scope of book
  • Leadership
  • Power lends itself to Warren Buffet’s view:
  • “if you combine a poor business with a good manager, it’s not the business that loses its reputation”
  • Leadership remains important in creation of value

Conclusion

The ascent of great companies is not linear but more a step function.

  • there are critical moments when single decisions shape the co’s trajectory

Part 1: Strategy Statics

Chapter 1: Scale Economies: Size Matters

Netflix Cracks the Code

Author invested in Netflix in Spring, 2003.

  • Netflix was successfully disintermediating Blockbuster’s brick-and-mortar business model
  • Blockbuster faced unpleasant choice of losing market share or eliminating late fees, but late fees was half of their income
  • Investment hypothesis:
  • Blockbuster would drag their feet in facing up to these consequences
  • Netflix would continue this cannibalization
  • This hypothesis played out perfectly

A strategy must meet the high hurdle of “A route to continuing Power in a significant market.”

  • Netflix had this power

But there was a long-term time fuse to Netflix’s 2003-era mail-order distribution

  • DVD’s would inevitably be taken over by digital streaming
  • the timing was uncertain, but Netflix could see it
  • The problem: mail order and streaming have different sources of Power
  • streaming’s Power prospects weren’t as encouraging
  • Moore’s Law meant lower cost of cloud services, hence diminishing barriers
  • Netflix understood this, but also acknowledged that streaming was inevitable
  • So in 2007 Netflix slowly moved into streaming to test the waters
  • But smart tactics don’t constitute strategy, and the source of the new form of Power remained opaque at first
  • They could only remain vigilant for where they could establish that Power
  • The crucial insight didn’t come until 2011: original content
  • previously, they only distributed other’s content
  • launched their first original with House of Cards in 2012
  • At first glance, the push for original content looked risky/ambitious:
  • more expensive
  • Red Envelope Entertainment experiment in the past had flopped
  • But this push was game-changing
  • Exclusive rights were a fixed-cost item
  • Any new market entrants would have to match such fixed costs to compete on content, regardless of their subscriber base
  • Cost-per-customer was their advantage

Scale Economies—the First of the 7 Powers

Scale Economies: the quality of declining unit costs with increased business size

Why do Scale Economies result in Power?

  • Benefit: lower costs (straightforward)
  • Barrier: (more subtle): Incumbent would be able to lower costs in response to new entrants, thus destroying value for new entrants with inferior Scale Economies

In Intel’s case, Intel was able to fight off AMD by tapping into their Scale Economies

Benefit:

  • Cash flow is improved by:
  • Enhancing value (enabling higher pricing) and/or
  • lowering cost ceteris paribus

Barrier:

  • Competitor fails to arb out the Benefit because
  • They’re unable to, or
  • They can, but refrain due to unattractive economics

Scale Economies emerge from other sources:

  • Volume/area relationships
  • occur when production costs are closely tied to area, while their utility is tied to volume
  • examples: bulk milk tanks, warehouses
  • Distribution network density
  • As density of a distribution network increases, delivery costs decline as more economical route structures emerge
  • example: UPS
  • Learning economies
  • If learning leads to a benefit (reduced cost or improved deliverables) and is positively correlated with production levels, then a scale advantage accrues to leader
  • examples [Eric]: ScaleAI, Forward Health
  • Purchasing economies
  • A larger buyer can often command better pricing
  • example: Walmart

Value and Power

Netflix’s move to original content propelled them to immense market capitalization.

  • but the performance was a roller coaster
  • in situations of high flux, it often takes time for cash flow to reliably reflect Power, so investor expectations fluctuate
  • Netflix’s plummet in 2011 was the result of operational errors
  • after all, Power is the potential for value

Surplus Leader Margin (SLM):

  • The profit margin the business with Power can expect to achieve if pricing is such that competitor’s profits are zero
  • Surplus Leader Margin = [Scale Economy Intensity]*[Scale Advantage]
  • first term is tied to the intensity of scale economies in that industry, faced by all firms
  • second term is tied to position of leader relative to follower
  • for Power to exist, both these terms must be significantly positive
  • i.e. scale economies don’t help unless you actually have scale

Chapter 2: Network Economies: Group Value

BranchOut Takes on LinkedIn

BranchOut launched in 2010 as a professional networking Facebook app

  • $6M Series A
  • CEO knew: rapidly scale or die—this was a Network Economy

Catch-up is usually impossible if there are Network Economies

  • LinkedIn already had 70M members
  • But BO CEO wanted to build on Facebook’s base that was 10X of LinkedIn’s

BO quickly attracted 500k users, raised an $18M Series B in 2011

Users peaked at 14M in 2012 but then fell off a cliff

In 2014 Hearst acqui-hired BO, ending the company

Facebook and LinkedIn could co-exist because they served very different purposes

  • Users wanted to maintain a wall between personal and professional lives

The Benefit and the Barrier

Benefit:

  • A company in a leadership position with Network Economies can charge higher prices than its competitors bc of the higher value resulting from more users
  • Example: the value of LinkedIn’s HR tools comes from the number of LinkedIn users

Barrier:

  • The barrier for Network Economies is the unattractive cost/benefit of gaining share, and this can be extremely high.
  • The cost of offering something else to make up for the network size disparity can be unthinkably high
  • what would BO have had to offer users to make them use it rather than LinkedIn? probably money haha

Industries exhibiting Network Economies often exhibit:

  • Winner take all
  • Often once a single firm achieves a degree of leadership, then the other firms just give up
  • Even Google lost to FB with Google+
  • Boundedness
  • The boundaries of the network effects determine the boundaries of the business
  • Facebook: personal network
  • LinkedIn: professional network
  • Neither have much Power over each other
  • Decisive early product
  • Early relative scaling is critical in developing Power
  • who scales fastest is often determined by who gets the product most right early on
  • example: Facebook beating MySpace

Network Economies: Industry Economics and Competitive Position

Surplus Leader Margin used here again to measure Power

Not all networks are uniform

  • Not all nodes in the network are relevant to a given node

As the installed base difference gets large, the SLM balloons (to 100% at the limit)

Some comments on Network Economies:

  • There can be network effects but no potential for Power
  • The incremental benefit to each existing user when a new member joins the network needs to be large enough relative to the potential installed base and the cost structure for there to be even one profitable player.
  • if network effects are the only value source, then if [number of nodes]*[benefit to each existing user when a new member joins]<[variable cost per user], a firm can’t reach profitability
  • ex ante it’s often difficult to size potential network size and “incremental benefit to each existing user when a new member joins”
  • you’re left with a situation that can require significant up front capital but uncertain ability to monetize
  • example: Twitter
  • Demand side (or indirect) network effects:
  • If a business has important complements and these complements are somehow exclusive to each offering, then a leader will attract more and/or better complements
  • As a result the entire value prop to a customer is improved
  • example: smartphone apps
  • a new smartphone OS would start out with no good apps, and devs wouldn’t be incented to develop there due to a small market
  • [Eric] example: advertisers on Twitter, or HR orgs using LinkedIn

Chapter 3: Counter-Positioning: Scylla and Charybdis

Bogle’s Folly

Author’s own development

Avenue for defeating an incumbent who appears unassailable by conventional wisdom metrics of competitive strength

Vanguard’s assault on active equity management

  • 1975: John Bogle made an equity mutual fund that simply tracked the market, with no pretense of active management
  • Vanguard would operate “at cost”
  • all returns passed on to shareholders
  • later became a no-load fund (no sales commissions)
  • Lukewarm first years
  • depended on others for distribution
  • brokers didn’t like it for obvious reasons
  • Vanguard’s advantage by design:
  • average gross return of active funds must equal market return, and since their expenses are much higher than passive funds, their avg. net returns will always be less than those of passive funds
  • also for active investors, track record is only loosely tied to future performance
  • active funds are on average a loser’s game
  • Eventually Vanguard accelerated to $3T AUM by 2015

But: ETF’s flooded the market

Counter-Positioning: the Benefit and Barrier

3 characteristics to Vanguard’s rise:

  1. Upstart with a superior, heterodox business model
  2. that business model’s ability to challenge incumbents
  3. the steady accumulation of customers all while incumbents fail to respond

This pattern can be seen in:

  • Dell vs. Compaq
  • Nokia vs. Apple
  • Amazon vs. Borders
  • Netflix vs. Blockbuster

Common theme: the incumbent responds either not at all or too late

Benefit:

  • the new business model is superior to the incumbent’s model due to lower costs and/or the ability to charge higher prices
  • Vanguard:
  • much lower costs → higher avg. net returns
  • realized value from market share gains rather than differential profit margins

Barrier:

  • often, incumbent’s failure to respond results from thoughtful calculation
  • it’s when the question “am I better off staying the course, or adopting the new model?” is answered “No”
  • The barrier, simply put, is collateral damage
  • In Vanguard’s case, Fidelity concluded that the new passive funds’ more modest returns would likely fail to offset the damage done by a migration from their flagship products

The Varieties of Collateral Damage

Several possible reasons for an incumbent’s failure to mimic the upstart

Stand-Alone Unattractive is Not Counter-Positioning

  • If the business isn’t “stand-alone attractive” then collateral damage doesn’t account for the incumbent’s rejection of the challenger’s approach to the business.

Kodak:

  • Legendary business
  • Anyone could look at Moore’s Law and see that chemical film was doomed
  • Kodak was aware of its fate but digital photography simply was not an attractive business opportunity for the company
  • This situation can be characterized by 3 conditions:
  • A new superior approach is developed (lower costs and/or improved features)
  • The products from the new approach exhibit a high degree of substitutability for the products from the old approach
  • The incumbent has little prospect for Power in this new business
  • either the industry economics support no Power (a commodity) or:
  • the incumbent’s competitive position is such that attainment of Power is unlikely
  • Kodak had little relevance to semiconductor memory, and those new products were on an inevitable path to commoditization

Kodak’s failure to respond had nothing to do with collateral damage within their film business

  • it indicated only that digital photography as a stand-alone business failed to offer even the faintest promise of Power for Kodak
  • Even if Kodak had avoided “marketing myopia” and viewed themselves in the “image storage” business, this wouldn’t have fixed their lack of semiconductor capabilities

Milking: Negative Compined NPV

CEO is deciding to “milk” their current situation even though the new model is attractive

Fidelity:

  • Unlike Kodak with digital cameras, Fidelity could have easily made and distributed passive funds
  • However, the impact of entry into passive funds would have been subtractive
  • Fidelity assumed that any gains with passive funds would have been more than offset by their losses (reasonable)

This is a dynamic process:

  • as the upstart cannibalizes:
  • the incumbent’s original business shrinks
  • the uncertainty surrounding the viability of the challenger’s approach diminishes
  • the risk-adjusted size of expected collateral damage therefore declines
  • such delayed entry happens frequently
  • often characterized as foot-dragging, but often a rational response to the changing dynamic

History’s Slave: Cognitive Bias

Two reasons that an incumbent might choose to not counterposition, despite it seeming like the rational choice:

  1. The challenger’s approach is novel and at first unproven
  2. shrouded in uncertainty
  3. The incumbent has a successful business model
  4. this heritage is influential and deeply embedded
  5. comes with a certain view of how the world works
  6. CEO can’t help but view circumstances through this lens

These two items frequently cause incumbents to belittle and underestimate the new approach

  • Fidelity CEO on Vanguard: “Why would anyone settle for average returns?”

Job Security: Agency Issues

Differences between the objective of the firm (maximum value) and that of the CEO or other decision-makers

Counter-Positioning vs. Disruptive Technologies

They’re not fully intertwined:

  • Kodak vs. digital photography (DT but not CP)
  • In-N-Out vs. McDonald’s (CP but not DT (no new tech))
  • Netflix streaming vs. HBO cable (CP and DT)

Observations on Counter-Positioning

  • Power must be considered relative to each competitor, actual and implicit
  • With CP, this is especially important bc it relies on that specific firm making a decision
  • Remains only a partial strategy
  • to assure value creation it must be complemented by a route to Power respective to other similar competitors, as it is not a “blanket”
  • Cognitive Bias can be influenced by the challenger
  • avoid the temptation to trumpet superiority
  • adopt a tone of respect toward incumbent
  • this can delay objective cognition, giving a headstart
  • Counter-Positioning is not an exclusive source of Power
  • often dependent on many independent actors
  • Incumbents often follow these five stages of CP:
  • Denial
  • Ridicule
  • Fear
  • Anger
  • Capitulation (often too late)
  • An incumbent feels strong pressure to do something—while not upsetting the apple cart of the legacy business model
  • this results in “dabbling”—incumbent refuses to commit in a way that meaningfully answers the challenge
  • CP often underlies situations in which this is observed:
  • For the challenger:
  • Rapid share gains
  • Strong profitability (or promise of it)
  • For the incumbent:
  • Share loss
  • Inability to counter entran’s moves
  • Eventual management shakeups
  • Capitulation, often occuring too late

The Challenger’s Advantage

An entrenched incumbent with established Power is formidable, obv.

  • Unless incumbent is incompetent over a long period, challenging it is often a loser’s game
  • i.e. AMD challenging Intel
  • That said, there are fighting styles which work
  • The only bet worthwhile for a challenger is one in which even if the incumbent plays its best game, it can be defeated
  • A challenger must take advantage of the strengths of the incumbent, as it is this strength which creates the collateral damage

Counter-Positioning Leverage

It’s binary: you’ve adopted the new model, or you haven’t

Intensity of Power is determined by: What governs profitability of the company with Power when prices are such that the company with no Power makes no profit at all?

If the unit gains for an incumbent moving into the challenger’s space are more than offset by the losses in the “old” business:

  • CP is unlikely; for CP the margins would have to be attractive enough in the new business to offset both the lower prices and the volume loss

Irony of CP:

  • the higher the incumbent’s margins, the higher the SLM and the more the incumbent has to lose
  • CP can therefore present a potent challenge to an entrenched, highly successful incumbent
  • Incumbents will often exhibit a cognitive bias that raises their margin expectations, thus increasing challenger’s SLM

The potential for agency effects (Job Security) can be affected thus:

  • Example 1:
  • An important decision influencer is the division head for X
  • X has been the firm’s bread and butter, so this person’s voice carries a lot of weight
  • but the new challenger business results would be attributed to another division or group
  • This disincentivizes the decision influencer to push for adopting the new business model
  • Example 2:
  • A CEO may be incentivized financially in short-term increments
  • CEO will prioritize the near future at the expense of the distant future

Dynamic effects:

  • Over time, unit gains to be had by an incumbent counter-positioning, deplete and can disappear altogether
  • The risk to the incumbent is increasingly seen to come primarily from the challenger, vs. a self-immolatory action
  • The agency and cognitive biases toward avoiding “collateral damage” decrease as the threat of the challenger becomes more apparent and those who run the incumbent business or item lose credibility/influence

Chapter 4: Switching Costs: Addiction

Agony at HP

SAP is an ERP software company that has terrible customer satisfaction ratings, yet it has significant market share and retention

  • “No one ever got fired for sticking with SAP”

Example: Apple and iTunes

  • Apple customers forfeit their prior purchases

Back to the ERP model—high switching costs:

  • Integrated into business
  • employee training is extensive
  • relationships with service team established

In 2004 HP migrated their NA server sales divisions to SAP

  • despite major preparation, major hiccups for a month
  • HP lost $160M of business to Dell and IBM

SAP has every incentive to hike the price of their services, given that switching costs are so high

Switching Costs on the 7 Powers

Switching Costs arise when a consumer values compatibility across multiple purchases form a specific firm over time

  • can include repeat purchases of the same product or purchases of complementary goods

Benefit:

  • Co. with embedded SC’s for its current customers can charge higher prices than competitors for equivalent value
  • this benefit only accrues to Power holder in selling follow-on products to their current customers
  • no benefit w/ potential customers
  • no benefit if no follow-on products

Barrier:

  • To offer an equivalent product, competitors must compensate customers for SC’s

Types of Switching Costs

Financial

  • monetary outlays a customer must make when they switch
  • example: for ERP, would include purchase of both a new database and sum total of its complementary apps
  • [Eric] “Implementation Fees” from most enterprise SaaS’s

Procedural

  • Murkier, but just as persuasive
  • Stem from loss of familiarity w/ the product or from the risk/uncertainty associated with the adoption of the new product
  • Retraining
  • Switching could breed internal discontent
  • Switching could cause errors

Relational

  • the breakage of emotional bonds built up through use of the product
  • customer can identify as a user or enjoy the camaraderie which exists among the community of users

Switching Cost Multipliers

SC’s are a non-exclusive Powwer type

  • all players can enjoy their benefits

As a market matures, the benefit of SC’s becomes apparent to all players

  • this often leads to greater competition to grab new customers
  • this arbitrages out the Benefit for new customer acquisitions
  • therefore, the major value contribution comes from capturing customers before this process happens

SC’s offer no Benefit if no upsells/cross-sells are made

  • one tactic might be to develop more and more add-on products
  • another might be to acquire products
  • doing this both:
  • extends revenue coverage of the SC’s and
  • increases the intensity of the SC’s
  • increased retraining costs
  • deeper integrations
  • deeper emotional bonds

Switching Costs: Industry Economics and Competitive Position

Intensity of SC’s is derived from “Industry Economics”

  • competitive position is binary: you have the customer, or you don’t

the SC advantage can be swept away by major technology shifts

  • e.g. SAP and Oracle are working hard to make sure they’re not leapfrogged by cloud-based products

SC’s can pave the way for other Powers

  • connecting users and building a large supply of complementary goods may generate Network Effects
  • if the product preference of users tied down by SC’s spills over to a wider pool of potential customers, you can enjoy Branding Power

Chapter 5: Branding: Feeling Good

Tiffany & Co. diamonds are objectively 25% better than Costco rings, but are double the price

  • Tiffany can do this via Branding

Tiffany

  • Founded 1837
  • won awards starting in 1867
  • carefully crafted their image since

Branding

Branding is an asset that communicates information and evokes positive emotions in the customer, leading to an increased willingness to pay for the product

Benefit:

  • A business with Branding can charge a higher price due to one or both of these reasons:
  • Affective Valence
  • the built-up associations w/ the brand elicit good feelings about the offering, distinct from the objective value of the good
  • e.g. Coke: people will pay more for it than generic, despite indistinguishable taste
  • Uncertainty reduction
  • customer attains peace of mind knowing that the product will be just as expected
  • e.g. Bayer aspirin: people will pay more for the certainty
  • Unlike Switching Costs, Branding doesn’t require you to have the customer for it to work

Barrier:

  • a strong brand can only be created over a long time of reinforcing actions (hysteresis)
  • Tiffany has been around since the 1800’s
  • copycats face a long investment runway with uncertainty that it’ll work
  • efforts to mimic another brand can backfire legally

Branding—Challenges and Characteristics

Brand Dilution:

  • Firms require focus and diligence to guide Branding over time and ensure consistency
  • Biggest pitfall lies in hurting brand through shoddy products
  • Moving “down market” to achieve volume can reduce perceived exclusivity
  • e.g. Halston was a big high-end women’s designer brand in the 1970’s
  • but they accepted $1B from J.C. Penney to expand into mass production and destroyed the Halston brand

Counterfeiting:

  • can undermine a brand

Changing consumer preferences:

  • customer preferences can shift in a way that undermines brand value
  • e.g. Nintendo built a family-friendly video game, but the market shifted to primary adults
  • Nintendo’s Branding didn’t extend to this segment
  • The problem: Branding can’t shift quickly to accommodate these shifts

Geographic boundaries:

  • e.g. Sony had a Branding advantage in the US, but it didn’t extend to Japan, where rivals such as Panasonic thrived

Narrowness:

  • even if “brand recognition” is very high, there may not be Branding Power
  • Scale Economies could be creating this high brand awareness
  • e.g. a smaller soda brand can’t justify a Super Bowl commercial

Non-exclusivity:

  • Branding is a non-exclusive type of Power
  • a direct competitor may have an equally impactful brand targeting the same customers
  • e.g. Prada, Luis Vuitton, Hermès
  • however, all competitors with brand Power will earn superior returns to those without

Type of Good:

  • only certain types of goods have Branding potential, as they must clear two conditions
  • Magnitude:
  • the promise of eventually justifying a significant price premium
  • B2B goods can’t take advantage of affective valence effects as well as B2C, since purchases are made more objectively
  • Consumer goods are more associated with a sense of identity, and are more driven by affective valence
  • uncertainty reduction is most important for products associated with bad tail events
  • safety, medicine, food, transport, etc.
  • Duration:
  • a long enough duration to achieve such magnitude
  • [Eric] e.g. booths at a county fair

Chapter 6: Cornered Resource: Mine All Mine

To Infinity and Beyond

Pixar’s Toy Story:

  • Budget of $30M, box office of $350M

Pixar followed it with numerous major successful films that far exceeded industry averages in commercial succes

The Brain Trust

In 1986, George Lucas sold The Graphics Group to Steve Jobs for $5M and was renamed Pixar

  • brought together 3 exceptional people
  • John Lasseter, Ed Catmull, Steve Jobs

Cornered Resource: the Benefit and the Barrier

Benefit:

  • can emerge in varied forms
  • preferential access to a valuable patent
  • common in pharma
  • a required input
  • e.g. a cement producer’s ownership of a limestone source
  • cost-saving production manufacturing approach
  • e.g. Bausch and Lomb’s soft contact lens manufacturing technology

Barrier:

  • In Pixar’s case, it was a personal choice to stay as a team
  • Can also be fiat
  • e.g. patent law

The Five Tests of a Cornered Resource

  1. Idiosyncratic
  2. if a firm repeatedly acquires coveted assets at attractive terms, it begs the question, why are they able to do this?
  3. e.g. Exxon being able to consistently gain the rights to great hydrocarbon properties
  4. understanding their path to access is more critical
  5. Non-arbitraged
  6. If a firm gains preferential access to a coveted resource, but then pays a price that arbitrages out the worth of that resource, they fail to achieve Power
  7. e.g. if you get Brad Pitt to star in a movie, most if not all of resulting revenue is absorbed by Pitt’s price tag
  8. whereas, the Pixar Brain Trust was compensated far below their value, producing Power
  9. Transferable
  10. a coveted resource is only truly coveted if it is transferable
  11. e.g. Pixar’s team could transfer to Disney upon acquisition
  12. Ongoing
  13. do the differential returns suffer if you remove the source of Power?
  14. Sometimes the origin of the Power is separate from where it currently sits
  15. guy who invented the Post-It wasn’t the Power source; the Post-It patent was
  16. Sufficient
  17. for a resource to qualify as Power, it must be sufficient for continued differential returns, assuming operational excellence

Chapter 7: Process Power: Step by Step

It’s rare

Toyota Motor Corporation

  • Toyota Production System (TPS) allowed Toyota to steal major market share from American auto manufacturers by building superior cars
  • GM partnered with Toyota to adopt the TPS
  • but while Toyota offered full transparency, the system would not replicate
  • American manufacturers adopted the tech but failed to adopt the hidden underlying processes that formed the bedrock of TPS

Process Power

Benefit:

  • A company with Process Power is able to improve product attributes and/or lower costs as a result of process improvements embedded within the organization

Barrier:

  • it’s hysteresis: these process advances:
  • are difficult to replicate
  • can only be achieved over a long time of sustained evolution
  • this speed limit results from:
  • Complexity
  • Opacity
  • In Toyota’s cases, the process was developed over years and never formally codified

Process Power and the Discipline of Strategy

Strategy vs. Operational Excellence:

  • Operational excellence is not a strategy
  • improvements that can be readily mimicked are not strategic
  • heuristic: Process Power = operational excellence + hysteresis

The Experience Curve:

  • Experience often results in efficiency gains, but there is no edge gained relative to another firm, so this should be attributed to operational excellence, not Process Power

Routine:

  • “Routines,” or new processes added to an organization, are valuable, but don’t contribute to Power, as they don’t build a barrier

Part 2: Strategy Dynamics

Chapter 8: The Path to Power: “Me Too” Won’t Do

What must I do to establish Power?

When can I establish it?

Power starts with invention

Out of the Frying Pan…

When author invested in Netflix in 2003, investment hypothesis was:

  1. Netflix’s DVD-rental business had Power:
  2. Counter-Positioning to Blockbuster
  3. Process Power
  4. some modest Scale Economies relative to some copycats
  5. This Power was under-appreciated by other investors

Hypothesis had 2 caveats

  • DVD rentals had a time limit before replaced by the internet
  • Netflix had no yet-evident source of Power in the streaming iteration

Netflix’s streaming had solid demand, but no Power source yet

Operating Excellence is essential and rightly occupies most of management’s time

  • however, it doesn’t assure differential margins combined with a stead or growing market share, as competitors can easily mimic such excellence and arb out the difference

Examples of Netflix’s great operational excellence:

  • UI development
  • significant attention paid to this, very data driven, but can be ripped off
  • Recommendation engine
  • Some aspects of Scale Economies here, but with diminishing returns as a smaller competitor could achieve most of the same benefit
  • IT infra
  • understood this shouldn’t be their core competency and rightly outsourced it

All this was not enough; all of this could be mimicked by competitors

Netflix realized that exclusive or original content would dramatically raise the fixed cost requirements for market entrants

  • Netflix pursued exclusives in 2010
  • but early deals were subject to being poached to other services such as Amazon]
  • so Netflix invested in originals
  • invested $100M to create 26 episodes of Deadline Hollywood

The Rudder Only Works When the Ship Is Moving

Netflix’s rise exemplifies a long-term adaptation

  • “crafting” not desigining or planning
  • the route to Power initially wasn’t just unknown, but unknowable

Getting to Power (Dynamics) is completely different from being there

  • it’s a mistake to conflate the two
  • e.g. assuming that high relative market share alone leads to attractive returns
  • this feeds the instinct to gain market share via aggressive pricing, which doesn’t create value by itself

In other words, you must have the destination in mind, and the 7 Powers are the only worthwhile destinations

Netflix’s acquisition of Power can be broken into getting there and achieving Power:

  1. Competitive Position: an attractive new service:
  2. Netflix’s new streaming service excited customers and gave Netflix an early relative scale advantage
  3. Industry Economics: originals and exclusives:
  4. Netflix converted some content from a variable cost to a fixed cost, cementing Power by creating Scale Economies for the first time

Netflix demonstrated that action is the first principle of strategy

  • very far removed from orderly analytics of strategic planning

Invention—the Mother of Power

What must I do to get to Power?

  • Scale Economies:
  • you must simultaneously pursue a business model that promises Scale Economies, while at the same time offering a product that’s differentiated enough to gain market share
  • Network Economies:
  • similar to Scale Economies, but installed base, not sales share, is the goal
  • Cornered Resource:
  • you must secure rights to a valuable resource on attractive terms
  • often comes from having developed that resource in the first place
  • Branding:
  • over a long time, you make consistent creative choices which build an affinity that goes beyond the product’s objective attributes
  • Counter-Positioning:
  • you build a new, superior business model that ensures collateral damage for incumbents if mimicked
  • Switching Costs:
  • you must first attain a customer base
  • Scale and Network Economies factor in here too
  • Process Power
  • you evolve a new complex process which is not easily mimicked

Common theme above: the first cause of every Power type is invention

  • can be invention of a product, process, business model, or brand
  • “Me too won’t do”
  • Passion, monomania and domain mastery fuel invention and so are central
  • Planning rarely creates Power
  • it may boost Power if it exists, but if it doesn’t yet exist, you can’t rely on planning

The Topology of Invention and Power

Elements of this interplay of Power and invention:

  1. Flux in external conditions creates new threats and opportunities:
  2. e.g. Netflix: the eventual decline of their DVD business was the threat, streaming the opportunitiy
  3. The nature of flux demands that it happens in fits and starts
  4. any company wishing to take advantage must invent
  5. these tectonic shifts don’t occur frequently for a company, but they’re inevitable
  6. Amidst the chaos, you must find a route to Power
  7. Netflix didn’t win by fine-tuning their DVD-by-mail business

The Dynamics of Power, Netflix version:

  • Resources:
  • you must start with the resources on hand
  • Netflix had a recommendation engine, UI, customer data, relationships with content owners, platform
  • External conditions:
  • For Netflix, the exponential advances around streaming was the external condition
  • Invention:
  • For Netflix, the inventions were their new product directions
  • streaming, originals, and associated complements
  • Power:
  • For Netflix, it was the thrust into exclusives/originals
  • Most inventions don’t assure Power, but this one did

If you want to develop Power, the first step is invention, but it can’t be the last step

  • if Netflix had invented the streaming product without introducing originals, they’d have been a commodity business

In the midst of invention, you need to be ever watchful for Power openings

Invention: the One-Two Value Punch

Power only arrives on the heels of invention

But success requires Power and scale

Value = [Market Size]*[Power]

Compelling Value

Invention improves the company’s economics, but it’s the gain customers experience that will shape the market size

  • e.g. if Netflix customers had been lukewarm to the streaming pivot, no opportunities for Power would have helped

Product differences must be dramatic in order to achieve a “gotta have” response from customers

  • Andy grove suggests that it should be a “10X” improvement
  • but can be lower than 10x; even a 50% increase in battery efficiency can be sufficient

Capabilities-Led Compelling Value: Adobe Acrobat

3 paths to creating compelling value:

  1. Capabilities-led compelling value:
  2. When a company tries to translate some capability into a product with compelling value
  3. e.g. Adobe’s Acrobat
  4. Adobe used their expertise at the intersection of software and graphics
  5. but this type of initiative is risky, as the customer need is unknown
  6. therefore, should probably only be undertaken if an assured Barrier appears early on
  7. success requires that a company stay in the game for some time, morphing the product to suit customers
  8. Customer-led compelling value:
  9. when a company sees an unmet need that no one knows how to satisfy
  10. e.g. Corning’s fiber optics
  11. Corning was not a big player in fiber optics, but saw a need for enhanced glass clarity in the market
  12. uncertainty: can we invent it?
  13. Competitor-led compelling value:
  14. when a competitor has already released a successful product and the inventor must produce something so superior that it elicits a “gotta have” response
  15. e.g. Sony’s Playstation
  16. Nintendo and Sega were big rivals, but 3D graphics was the “gotta have” step change
  17. uncertainty:
  18. will the new features be differentiated enough?
  19. will competitors be sufficiently delayed in their response?
  20. often must make formal arrangements with exterior complements
  21. e.g. Sony having to make commitments with game developers
  22. e.g. iPhone having to make agreements with telecom giants

Equity INvesting and the 7 Powers as a Strategy Compass

The 7 Powers can result in alpha where there’s opacity in the market, but such opacity can be penetrated by the 7 Powers

  • most common in high-flux scenarios

Author’s investing track record shows how he’s been able to outperform the market for decades

Chapter 9: The Power Progression: Turn, Turn, Turn

When can you attain Power?

Intel Starts from Scratch

Intel’s route to power was long and arduous

Internally there was pushback

  • head of sales and marketing and the board tried to stop the semiconductors push

Intel pulled of a long-shot goal of landing IBM as a client for their first PC

  • was wildly successful

From Invention to Power

Intel’s rise to resulted from 3 of the 7 Powers

  1. Scale Economies:
  2. the IBM deal gave Intel a scale advantage that enabled lower per-unit costs:
  3. Fixed cost of chip design:
  4. design costs are high
  5. Fixed factory design costs:
  6. factory setup is expensive
  7. Early movers in lithography advances:
  8. Intel’s higher demand forecasts allowed them to justify upgrading their plants to newer tech sooner than competitors, enhancing their per-chip cost advantage
  9. Network Economies:
  10. IBM’s MS-DOS and the spreadsheet Lotus 123 was written specifically for the Intel processor
  11. when other PC makers came on line, they had to use IBM clones, which meant using Intel or Intel-compatible chips
  12. Switching Costs:
  13. PC consumers would be forced to stay with an Intel machine to keep using the same programs

Over time, OS’s and apps became chip-agnostic, eroding the Network Economy and Switching Cost advantages, but by then Intel had a massive scale advantage

“The one-sentence story of Intel is a single design win, then a decade and a half of very high Switching Costs,then Scale Economies."

How did Intel get there?

  • Scale Economies:
  • Intel rode the PC market wave
  • deal with IBM
  • Network Economies:
  • Intel was the PC standard
  • Switching Costs:
  • got there first

The Power Progression: Takeoff

All of Intel’s sources of Power were rooted in the takeoff period

  • this is when customer acquisition is done at favorable terms
  • Intel’s massive sales/marketing push made a crucial difference to Power only because it was early on
  • Intel pulled away from the pack just in time
  • if they hadn’t won the IBM contract, they would not have dominated

Takeoff period can be deceptive:

  • companies in the explosive growth stage will exhibit attractive financials, but if they haven’t attained Power, competitive arb will catch up to them as soon as growth slows
  • the concept that you should be pleased by a new and well-financed market entrant because it “validates the market”
  • you’re in a race for relative scale, and there can be only one winner

The Clock for the Power Progression

3 time windows for calibrating the acquisition of Power:

  1. Stage 1: Before—Origination:
  2. occurs before a company clears the “compelling value” bar at which time sales rapidly increase
  3. Stage 2: During—Takeoff:
  4. period of explosive growth
  5. Stage 3: After—Stability:
  6. business may still be growing considerably, but growth has slowed

Power must be established within a certain window; however the Power can extend well into the “stability” phase

  • e.g. Intel’s Power endured long into “stability” phase, hence Intel’s durability

The Power Progression: Origination

Two Power types typically become available during this period:

  1. Cornered Resource:
  2. In Intel’s case, it would be the invention rights to their microprocessor project they did for Busicom
  3. and also their cornered resource of Andy Grove et al
  4. pre-takeoff Cornered Resources underlie many important transforming successes
  5. e.g. drug patents often precede the company
  6. Counter-Positioning:
  7. Requires the invention of an attractive business model that presents a “damned if you do/damned if you don’t” quandary for incumbents
  8. therefore must occur during origination

These types of Power are great because the “route to Power” is locked in early—so long as you execute well.

The Power Progression: Stability

Two Power types typically become available during this period:

  1. Process Power:
  2. Only emerges when a company has scaled sufficiently and long enough to have evolved processes which are sufficiently complex or opaque to defy speedy emulation
  3. Branding:
  4. necessarily takes a long time
  5. it’s possible for branding to happen quickly in the origination stage, but unlikely

The Time Character of the Four Barriers

Each of the four generic Barriers (Collateral Damage, Share Gain Cost/Benefit, Hysteresis, Fiat) is specific to stage

  1. Hysteresis:
  2. Barrier: a structural time constant facing all players
  3. hysteresis requires sufficient build-up time that the Origination stage doesn’t afford
  4. Collateral Damage:
  5. must occur in origination, as it’s baked into the very business model of the challenger
  6. Fiat:
  7. critical issue is, is the Cornered Resource fully priced?
  8. As the resource’s value becomes more widely known, probability that it will be underpriced is reduced
  9. must be underpriced to qualify as a Cornered Resource
  10. [Eric] example: PayPal’s recruiting strategy of <30yo eccentric people
  11. therefore, generally occurs during takeoff period
  12. Cost of Gaining Share:
  13. by definition can’t occur in the origination stage, as sales haven’t yet materialized
  14. during the stability stage, customer acquisition strategy across the market shifts from “can I get it?” to “what’s the best deal?”
  15. all players grasp the value of share, thus arbitraging out its value
  16. therefore, share gains on attractive terms generally only occurs in the takeoff stage

The Power Progression—the Data (Frequency Histogram of Power Type)

When does each Power source occur?

  • Origination: Counter-Positioning and Cornered Resource
  • Takeoff: Scale Economies, Network Economies, Switching Costs
  • Stability: Process Power and Branding

The Dynamics Difference

Operational excellence alone is not strategic—it can be imitated

  • however, operational excellence via a concerted push during the takeoff phase can be highly strategic
  • e.g. Apple’s underwhelming Apple III launch cost them the lead to IBM’s PC and cost Apple a high Power position
  • conversely, Intel’s “Operation Crush” (sales and marketing blitz) landed them the IBM contract and gave them a route to Power

When you step back to consider how Power is established, there are numerous factors: leadership, timing, execution, cleverness, luck

Conclusion: The Strategy Compass and 7 Powers

Overall Power Dynamics is tied to 7 perspectives:

  1. The Value Axiom:
  2. Strategy has one and only one objective: maximizing potential fundamental business value
  3. this view improves the usefulness of the discipline
  4. still requires operational excellence
  5. The 3 S’s:
  6. Power is created if a business attribute is simultaneously:
  7. Superior—improves free cash flow
  8. Significant—the cash flow improvement must be material
  9. Sustainable—the improvement must be largely immune tocompetitive arbitrage
  10. The Fundamental Equation of Strategy:
  11. Value = Market Size * Power
  12. this thinking clarifies the value of Strategy by tying it to value
  13. The Mantra:
  14. A route to continuing Power in significant markets
  15. “continuing” is important here, as the process is ongoing
  16. The 7 Powers:
  17. There’s only 7
  18. If you do not have at least one of these for each competitor (current and potential, direct and functional), you cannot satisfy The Mantra and hence are lacking a viable strategy
  19. 2 additional characteristics of the 7 Powers enhance its usefulness:
  20. Small set:
  21. The key strategic questions:
  22. What Power types do i now have?
  23. What Power types do I need to worry about establishing now?
  24. at any given growth stage the max number of new Powers that are on the table is 3
  25. Observable ex ante:
  26. the potential for a Power type is usually evident long before detailed forecasting is possible
  27. “Me Too” Won’t Do:
  28. The first cause of a strategy is invention
  29. can be a product, business model, process or brand
  30. eventually such inventions lead to a Benefit:
  31. Benefit is sufficient if it delivers a “gotta have” response from customers
  32. The prospect of Power is a critical motivator of invention
  33. Silicon Valley exists because potential investors saw the possibility of Power
  34. The Power Progression:
  35. Knowing when a window opens for establishing a Barrier is useful for seizing the opportunity