7 Powers: Book Notes
7 Powers: Book Notes
How to build a business which can't be competed away
Hamilton Helmer's 7 Powers is a masterpiece. It focuses on how strategy can directly impact business value and durability. These are my notes.
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:
Statics: “Being there” — What makes Intel’s microprocessor business so durably valuable?
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:
Upstart with a superior, heterodox business model
that business model’s ability to challenge incumbents
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:
The challenger’s approach is novel and at first unproven
shrouded in uncertainty
The incumbent has a successful business model
this heritage is influential and deeply embedded
comes with a certain view of how the world works
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
Idiosyncratic
if a firm repeatedly acquires coveted assets at attractive terms, it begs the question, why are they able to do this?
e.g. Exxon being able to consistently gain the rights to great hydrocarbon properties
understanding their path to access is more critical
Non-arbitraged
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
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
whereas, the Pixar Brain Trust was compensated far below their value, producing Power
Transferable
a coveted resource is only truly coveted if it is transferable
e.g. Pixar’s team could transfer to Disney upon acquisition
Ongoing
do the differential returns suffer if you remove the source of Power?
Sometimes the origin of the Power is separate from where it currently sits
guy who invented the Post-It wasn’t the Power source; the Post-It patent was
Sufficient
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:
Netflix’s DVD-rental business had Power:
Counter-Positioning to Blockbuster
Process Power
some modest Scale Economies relative to some copycats
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:
Competitive Position: an attractive new service:
Netflix’s new streaming service excited customers and gave Netflix an early relative scale advantage
Industry Economics: originals and exclusives:
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:
Flux in external conditions creates new threats and opportunities:
e.g. Netflix: the eventual decline of their DVD business was the threat, streaming the opportunitiy
The nature of flux demands that it happens in fits and starts
any company wishing to take advantage must invent
these tectonic shifts don’t occur frequently for a company, but they’re inevitable
Amidst the chaos, you must find a route to Power
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:
Capabilities-led compelling value:
When a company tries to translate some capability into a product with compelling value
e.g. Adobe’s Acrobat
Adobe used their expertise at the intersection of software and graphics
but this type of initiative is risky, as the customer need is unknown
therefore, should probably only be undertaken if an assured Barrier appears early on
success requires that a company stay in the game for some time, morphing the product to suit customers
Customer-led compelling value:
when a company sees an unmet need that no one knows how to satisfy
e.g. Corning’s fiber optics
Corning was not a big player in fiber optics, but saw a need for enhanced glass clarity in the market
uncertainty: can we invent it?
Competitor-led compelling value:
when a competitor has already released a successful product and the inventor must produce something so superior that it elicits a “gotta have” response
e.g. Sony’s Playstation
Nintendo and Sega were big rivals, but 3D graphics was the “gotta have” step change
uncertainty:
will the new features be differentiated enough?
will competitors be sufficiently delayed in their response?
often must make formal arrangements with exterior complements
e.g. Sony having to make commitments with game developers
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
Scale Economies:
the IBM deal gave Intel a scale advantage that enabled lower per-unit costs:
Fixed cost of chip design:
design costs are high
Fixed factory design costs:
factory setup is expensive
Early movers in lithography advances:
Intel’s higher demand forecasts allowed them to justify upgrading their plants to newer tech sooner than competitors, enhancing their per-chip cost advantage
Network Economies:
IBM’s MS-DOS and the spreadsheet Lotus 123 was written specifically for the Intel processor
when other PC makers came on line, they had to use IBM clones, which meant using Intel or Intel-compatible chips
Switching Costs:
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:
Stage 1: Before—Origination:
occurs before a company clears the “compelling value” bar at which time sales rapidly increase
Stage 2: During—Takeoff:
period of explosive growth
Stage 3: After—Stability:
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:
Cornered Resource:
In Intel’s case, it would be the invention rights to their microprocessor project they did for Busicom
and also their cornered resource of Andy Grove et al
pre-takeoff Cornered Resources underlie many important transforming successes
e.g. drug patents often precede the company
Counter-Positioning:
Requires the invention of an attractive business model that presents a “damned if you do/damned if you don’t” quandary for incumbents
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:
Process Power:
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
Branding:
necessarily takes a long time
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
Hysteresis:
Barrier: a structural time constant facing all players
hysteresis requires sufficient build-up time that the Origination stage doesn’t afford
Collateral Damage:
must occur in origination, as it’s baked into the very business model of the challenger
Fiat:
critical issue is, is the Cornered Resource fully priced?
As the resource’s value becomes more widely known, probability that it will be underpriced is reduced
must be underpriced to qualify as a Cornered Resource
[Eric] example: PayPal’s recruiting strategy of <30yo eccentric people
therefore, generally occurs during takeoff period
Cost of Gaining Share:
by definition can’t occur in the origination stage, as sales haven’t yet materialized
during the stability stage, customer acquisition strategy across the market shifts from “can I get it?” to “what’s the best deal?”
all players grasp the value of share, thus arbitraging out its value
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:
The Value Axiom:
Strategy has one and only one objective: maximizing potential fundamental business value
this view improves the usefulness of the discipline
still requires operational excellence
The 3 S’s:
Power is created if a business attribute is simultaneously:
Superior—improves free cash flow
Significant—the cash flow improvement must be material
Sustainable—the improvement must be largely immune tocompetitive arbitrage
The Fundamental Equation of Strategy:
Value = Market Size * Power
this thinking clarifies the value of Strategy by tying it to value
The Mantra:
A route to continuing Power in significant markets
“continuing” is important here, as the process is ongoing
The 7 Powers:
There’s only 7
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
2 additional characteristics of the 7 Powers enhance its usefulness:
Small set:
The key strategic questions:
What Power types do i now have?
What Power types do I need to worry about establishing now?
at any given growth stage the max number of new Powers that are on the table is 3
Observable ex ante:
the potential for a Power type is usually evident long before detailed forecasting is possible
“Me Too” Won’t Do:
The first cause of a strategy is invention
can be a product, business model, process or brand
eventually such inventions lead to a Benefit:
Benefit is sufficient if it delivers a “gotta have” response from customers
The prospect of Power is a critical motivator of invention
Silicon Valley exists because potential investors saw the possibility of Power
The Power Progression:
Knowing when a window opens for establishing a Barrier is useful for seizing the opportunity