Retail Disruption

Brick-and-mortar retailers that only distribute and don't manufacture are being disrupted by convenient, low price online retailers with low cost structures. This is impacting a big swath of the retail industry.

Traditional retailers are protected -- to some extent -- when the distributed product is something consumers want to try on or touch before buying. Even then, however, sales of "try on" products are impacted by e-commerce: after a buyer makes the first purchase of a try on product at a physical store, he can make repeat purchases online.

Brick-and-mortar retailers trying to bolster sales through an online presence must compete with Amazon. And the difficulty here is that Amazon has the competitive advantages afforded by massive scale, a low cost structure, and a huge selection of products. By selling almost everything, Amazon provides one-stop convenience that other online retailers can't match. This convenience edge has been strengthened by Amazon Prime. So traditional retailers face daunting challenges when trying to compete online.

Retailers manufacturing unique products that they also sell -- like Apple -- are largely protected from Amazon. That's because these retailer-manufacturers can control distribution and/or distribute their products exclusively.

Looking beyond retail, other industries are experiencing widespread dislocation, often due to new technologies rather than Christensen-style low end or new market disruption. The oil industry is becoming less profitable due to EV's, abundant natural gas, and cheaper and cheaper solar/wind alternatives.

If a disruptive force doesn't swallow the entire industry market, then a disrupted company can try and adjust to reduced market share by downsizing. An unleveraged balance sheet makes downsizing easier and survival more likely. In the case of retail, many brick-and-mortar companies will survive -- particularly the companies that manufacture what they sell or sell products that people want to try on first -- but their sales may be lower. 

Growing Users Without Growing Profits

A number of popular companies with great products or services don't seem to make much money or are losing money; some of these are closely held, making it hard to determine the extent of losses. These companies include: Uber, Tesla, Amazon, Twitter, and Evernote.

I use Uber, Twitter, and Evernote regularly -- they're invaluable to me. Yet these companies apparently lack the pricing power needed to acquire users, grow sales, and generate/grow profits.

Investors satisfied with profitless sales growth seem to be banking on speculative, undemonstrated pricing power. Many investors believe these companies can turn a profit -- and generate healthy sales and sales growth -- once they stop focusing on the "land grab" effort of acquiring new users. When this kind of speculation doesn't pan out -- either user growth slows and/or profits never materialize -- the stock can really take a beating (a la Twitter). 

Absent aggressive, successful equity fundraising, a company that grows users without growing profits is going to have a hard time investing in its business and improving its product. Uber and Tesla have been very successful fundraisers, allowing them to continue releasing new, improved products/services. At some point though, investors want profits -- they want a return on their investment. Aggressive fundraising won't work forever. If the fundraising music stops and the profits aren't there, an unprofitable company faces major problems like paying its bills and improving its product/service at a rate sufficient to compete. Companies with profitable business models can invest in product/service improvements that unprofitable companies cannot.

If a stand-alone service can't increase its user base without losing money, what alternative business model could work? How could the service still drive profits? Possibly through tight integration with a product that does make money, like an iPhone or iPad or Apple Watch. Tight hardware/service integration creates a more unique, "magical" user experience by making things faster, simpler, and more convenient. As Michael Porter notes, companies should compete to be unique rather than competing to be the best.

It's worth noting that Apple doesn't try to compete within traditional, well-defined hardware or service categories -- they compete by trying to provide the best integrated hardware/software/service experience. This point was recently emphasized in John Gruber's podcast interview of Craig Federighi and Eddy Cue (on Gruber's "The Talk Show" podcast). When questioned about whether the quality of Apple's services was slipping, Federighi and Cue both emphasized that Apple focuses on the integrated, holistic user experience, not on the specific hardware or service component (consistent with Apple's functional organizational structure, its single P&L, and Steve Jobs's advice to focus on the user experience and work backward to the technology).

Apple's in a great position to cherry pick useful services and integrate them into their products, making their products more unique and "sticky." Apple can see how Evernote has become more and more valuable and can use this knowledge to make a more attractive, useful version of Notes. Apple can look at Uber's unprofitable transportation service and find ways to provide a more unique, magical user experience through an integrated hardware/service offering driven by profitable device sales (i.e., iPhone, Apple Watch, and Apple car). Apple can use the unprofitable stand-alone service to complement/strengthen its ecosystem and its profitable hardware.

This article has been amended since it was first posted. 

The author owns stock shares of Apple.

Blockbusters and Winner-Take-All Effects

In my last post I talked about Anita Elberse's Blockbusters, and how companies like Netflix seem to be moving away from "long tail" niche strategies toward strategies that focus on the creation/acquisition of premium content that drives blockbuster sales in the "head." Blockbusters, by Anita Elberse (Henry Holt and Company, 2013); see post titled Heads, Long Tails, and Light Consumers.

A couple stories came out right after this post: (1) Netflix announced it was giving up movies distributed by Epix -- including a few blockbusters -- to produce more original content, with Hulu picking up the Epix catalog; and (2) a rumor has developed that Apple is considering producing its own video/media content, possibly for a future Apple TV service. 

In Blockbusters Elberse talks about how premium content production can turn into a winner-take-all battle. As an example, she notes how major opera production outfits like the Met have started to dominate live-stream opera events, leading to an ever-growing, spiraling dominance. As the Met has expanded its live-stream efforts, its revenues and budget have grown larger, giving it the ability to sign better talent and create better productions than smaller opera houses trying to compete in the live-stream market. Smaller opera houses are being squeezed out of the market. Id. 

Elberse says one of the ironies of the opera house example is that cheap digital reproduction, distribution, and consumption don't actually democratize the opera house market (or any other media market). Instead, digital technology allows large production outfits like the Met to cheaply distribute the best opera product to markets formally served by smaller, less polished local players (the smaller, more regional opera houses). Id. Cheap digital distribution makes blockbuster strategies even more appealing, amplifying winner-take-all effects and increasing the importance of superstars and premium, big budget productions. Id.

In light of this, it seems like Netflix is making a mistake in giving up the Epix relationship, unless Netflix lacks the budget to simultaneously (1) acquire blockbuster content from Epix and (2) produce premium content in-house.

If you accept Elberse's theories, it also seems to make sense for Apple to try producing blockbuster content in-house. Apple has resources far greater than the other over-the-top providers/distributors -- Netflix and Amazon -- currently trying to produce premium content in-house. If content/media production is a winner-take-all (or most) market, then Apple's ample resources/budget could be a big competitive advantage/differentiator relative to alternative offerings from Netflix and Amazon.

Because it has a thriving device business, Apple is also well-positioned to distribute this content cheaply and conveniently to end users. Apple could make any content produced in-house exclusive to iTunes, possibly for a limited term, and then license this content to other distributors like Netflix and Amazon. Apple could leverage in-house content in a flexible way, maximizing the content's value.

The idea of Apple producing in-house content makes me a little nervous -- I've always appreciated Apple's focus on making the best hardware. At the same time, however, Apple's services business -- which includes Apple Music -- has always seemed to operate as a unique, separate entity (as noted by Horace Dediu at asymco.com). I think Apple can produce content through Apple services without interfering with its hardware business. It also doesn't seem like much of a stretch to go from the curated/produced content in Apple Music (like the Beats Radio shows) to movies and miniseries videos produced in-house by Apple. Premium movies and video could enhance the Apple brand and give Apple a more unique, differentiated ecosystem, which is consistent with Michael Porter's definition of effective strategy. See Concepts page and discussion of Michael Porter. 

It's interesting -- digital technology makes distribution cheap and easy, which opens movie and video production up to companies that formerly lacked the theaters or networks or other distribution vehicles needed to make content production financially appealing. Now that distribution is cheap, big budget, blockbuster productions are still strategically appropriate but are no longer the sole province of traditional content studios/networks like Disney or ABC.

Addendum (added 9/2/2015):

I should add that one other aspect I like about Apple producing movies and video is that art, whether it's a beautifully designed product, a movie, a miniseries video, or a piece of music, is always unique and differentiated and doesn't commoditize. And art doesn't have to improve over time the way most other products do -- it's timeless. As a result Christensen's concepts of overserving and "good enough" aren't really relevant. I like the idea of Apple adding ecosystem elements that are unique and don't commoditize. See post titled Art Doesn't Commoditize.

The author owns stock shares of Apple.

Focus, Functional Toys, Tradeoffs, and Following the River

I'm finishing up Becoming Steve Jobs and I wanted to summarize a few takeaways from the book, so here goes:

  1. Product focus was key to Apple's successful return in the late 1990's and early 2000's. Apple had way too many products prior to Jobs's return because the company was trying to cover every possible market segment/demographic. Renewed product focus under Jobs gave engineers and designers within Apple clear goals/priorities, allowing them to focus on making just a few great products.
  2. Apple makes functional toys -- its products are designed to produce the delight a toy gives (which is probably the reason Apple's products and marketing have always emphasized fun). The book quotes Woody's line from "Toy Story," when Woody tells Buzz that it's better to be a toy Space Ranger than a real Space Ranger because great toys are loved like nothing else. Beautiful, useful toys have a magical quality and check all the boxes when it comes to jobs-to-be-done. They satisfy functional, emotional, and social needs. See post titled Prioritize Great Products.
  3. Jobs under-designed the original Macintosh (no hard drive), over-designed the Apple III (fan-less, overheating, and too expensive), and over-designed the original NeXT computer (slow to ship, slow functioning,  and too expensive). For a functional toy to produce delight it first has to function well, and this means some pragmatic design/engineering tradeoffs are necessary, especially with early product versions. When Jobs returned to Apple in 1997 he was better at making these kinds of tradeoffs, focusing on the design of the entire product rather than becoming too focused on any one product element. Jobs's improved sense of appropriate/pragmatic tradeoffs is captured in his line that "real artists ship."
  4. Follow the river, or the natural flow, to determine what products to develop next. The development of iTunes naturally led to the iPod which naturally led to the iPhone. The iPhone naturally led to the Apple Watch and a computer on the wrist. Amazon's e-commerce business naturally led to the development and expansion of AWS. These are natural, inevitable seeming progressions. Basic intuition is all you need.

Becoming Steve Jobs, by Brent Schlender and Rick Tetzeli (Random House, 2015).

The author owns stock shares of Apple.

Prioritize Great Products

Marketing and even strategy are irrelevant without great product design and a great product. As noted in Becoming Steve Jobs, Apple was nearly bankrupted when Windows 95 was released and was better than the Macintosh OS -- a better competing product caused Macintosh sales to tank. Becoming Steve Jobs, by Brent Schlender and Rick Tetzeli (Random House, 2015). Pixar overcame early troubles through a great product -- "Toy Story" -- that led to a successful IPO. Id. NeXT succeeded because the company's great OS made it an attractive acquisition target (NeXT was acquired by Apple). Id. Conversely, NeXT struggled early on because it failed to create a great computer for its target market. Id. Google's success flows from a great search engine. Great products are core to a company's success.

Without a well-designed, well-engineered product, the best sales, marketing, and strategy have a muted or immaterial impact. You need a compelling product first. I think this is why Tim Cook is always emphasizing how Apple is focused on making "great products." Compelling products are the priority and drive a company's long term success or failure -- not marketing, sales, strategy, or financial measures of capital efficiency. A company that focuses too much on sales or marketing or capital efficiency has lost sight of what made it successful in the first place -- a compelling product.

So How Do You Make a Compelling Product?

Great products are designed around jobs-to-be-done. See Concepts page and discussion of Clayton Christensen. As noted in Horace Dediu's podcast with Bob Moesta, Critical Path #146, a company can think about jobs-to-be-done by looking at the functional, emotional, and social "energies" that surround a consumer's purchase decision. Functional energy refers to the physical effort expended in making the purchase. Emotional energy refers to any anxiety, fear, uncertainty, pleasure, security, or ease involved in the purchase. Social energy refers to concerns about what other people will think about the purchase.

In the podcast Dediu and Moesta also discuss the Kano Model of Quality, which says that products consist of the following attributes:

  1. Basic attributes: Attributes that must be present for the consumer to buy, like an affordable price, enough computer memory to store all the consumer's media, basic customer service, etc.
  2. Performance attributes: Measurable feeds and speeds like horsepower, engine size, zero to 60 acceleration time, battery life, number of pixels, etc.
  3. Excitement attributes: Subtle details that are often hard to quantify but that create delight or excitement, like the tactile qualities of sports car controls, the sound or smell of a car engine, the way a product is packaged, etc.

Looking at functional, emotional, and social energy, it's easy to see why the Google Glass hasn't sold well. It's expensive and has been difficult to try out, which raises the functional energy needed to purchase in addition to increasing negative emotional energies like buyer anxiety and uncertainty. And the social energy of the Google Glass seems tremendously negative -- potential buyers are obviously concerned about how people will react to someone who may be surreptitiously recording them.

With the Apple Watch, Apple's online and retail stores reduce the functional energy needed to make the purchase. Apple's retail stores reduce negative emotional energies like anxiety and uncertainty while increasing positive emotional energies like pleasure, security, comfort, and ease. Apple's brand strength conveys status, making the social energy of the Watch a positive. Excitement attributes -- subtle details -- also seem to work in favor of the Watch, whether it's product packaging or haptic feedback or clasps on the Watch bands.

In looking at products like the Google Glass and Apple Watch, the first order question is not whether the product is a logical part of a grand strategy, but whether the product itself is a great product. Is the Apple Watch a great product? Is Google Glass a great product? Is Google still coming up with innovative, great new products, or are its products more market/sales driven? Do recent European Commission filings -- regarding possible search engine bias in favor of Google sites -- suggest Google is too focused on sales and is losing its focus on a great search engine/product? Is Amazon coming up with great, innovative new products? Is the Fire Phone a great product? These are important questions in assessing a company's long term success or failure.

The Importance of People and Collaboration; Investing Issues 

Great products require lots of good ideas. These ideas come from teams of great people collaborating well together, not from just one person. With complex, cutting edge products, one person can't do it all. Hence the critical importance of: (1) hiring the best people; and (2) creating an environment that fosters candid, free-flowing communication/collaboration among these people. See post titled The Rational Management Checklist.

From an investing perspective, it's also worth noting that the typical retail investor probably can't assess whether an industrial/b2b product is "great" and well-targeted on a job-to-be-done. That's because a retail investor normally lacks hands-on experience or deep knowledge of b2b products. With b2b companies a retail investor has to rely more on portfolio diversification and financial ratios/metrics.

Conversely, retail investors can use and directly experience consumer products, allowing them to subjectively assess whether a company is making great products and/or whether a company's products are improving or deteriorating.

The author owns stock shares of Apple.

Riding Waves

I just listened to another excellent podcast from Asymco's Horace Dediu: Critical Path #145: "Arbitrage." Near the end of the podcast Dediu talks about how cord cutting and the demise of cable television is following a slow but predictable path. The downward trend in cable subscriptions may accelerate as over-the-top ("OTT") content distributors like Apple, Netflix, Google, and Amazon offer more and more unbundled alternatives to the current oversupply of bundled cable channels. Dediu's comments reminded me of how Steve Jobs compared taking advantage of technological change to picking and riding a giant wave:

"Things happen fairly slowly, you know. They do. These waves of technology, you can see them way before they happen, and you just have to choose wisely which ones you're going to surf. If you choose unwisely, then you can waste a lot of energy, but if you choose wisely it actually unfolds fairly slowly. It takes years."

The Cord Cutting Wave

You can really see Apple riding the cord cutting wave with Apple TV: years of overserving and price inflation in the cable TV business have created a huge wave for OTT providers. See post titled HBO, ESPN, and Jobs-to-be-DoneAnd Apple's closed ecosystem of hardware devices amplifies its ability to exploit this wave -- Apple will get more benefit from cord cutting hardware than companies without a closed ecosystem, since Apple TV will drive the sale of other Apple ecosystem products that work with the Apple TV (Apple Watch, iPhone, MacBook, etc.). OTT providers like Netflix, Google, and Amazon won't get these same benefits because they don't have a viable, prosperous range of closed ecosystem hardware all running a consistent operating system.

The Cloud Storage Wave

The other big wave Apple seems to be riding is the way people are moving their personal photos and videos (as well as all other content) from their computer hard drives to the cloud. With the release of Apple's latest Photos app, people are going to stop storing personal media on their hard drives and start storing it on iCloud. Because Apple's range of closed ecosystem devices makes the user experience the easiest and most convenient, Apple is going to be in a great position to charge for iCloud storage of this media (even if Google and Amazon are giving cloud storage away). iCloud storage of personal media is really going to lock customers into Apple's ecosystem, dramatically raising switching costs. This trend/wave is just starting, and Apple will be able to ride it indefinitely as data storage demands continue to rise.

The author owns stock shares of Apple.

Investing 101 and "Cheap is Good Enough"

The quote “cheap is good enough” comes from a very successful value investor named Walter Schloss. Schloss, along with Warren Buffett, formerly worked for Benjamin Graham, the father of value investing. Graham believed that if you always held low PE stocks with conservative balance sheets, ideally trading close to tangible book value (the balance sheet value of the hard assets, less total debt and preferred stock), then you would do pretty well as an investor. See Concepts page and discussion of Benjamin Graham. High PE stocks aren't cheap relative to trailing earnings. The danger of a high PE stock is that anticipated earnings growth won’t materialize and the stock will tank.

The danger of a low PE stock is that earnings will disappear, the company will go out of business, and the stock will tank (also known as a “falling knife”). Graham tried to address this risk by investing in low debt companies with strong working capital positions — i.e., companies with low credit risk and plenty of money to pay the bills. He also dealt with it by looking for companies trading at or below tangible book value, which gives some downside protection in the event of liquidation. Warren Buffett deals with downside risk by looking for companies with great brands, wide competitive moats or barriers, and highly predictable future cash flows, like Coca-Cola. See Concepts page and discussion of Benjamin Graham and Warren Buffett.

So which of these approaches makes more sense?

Scenario One

A company with a high trailing PE, say 30, is like a guy coming to you and saying, “my business earned $1,000,000 last year, but it’s growing like crazy and should continue to do so, so I’d like you to pay $30,000,000 for it.” As an investor, you should ask whether you’d really be interested in this kind of deal. The initial earnings yield in this scenario is 3.33% (1/30), slightly above the 2.47% yield currently available from risk free 30 year Treasury bonds.

Scenario Two

A company with a low trailing PE, say 10, is like someone coming to you and saying, “my business earned $1,000,000 last year and I’ll sell it to you for $10,000,000.” With an earnings yield of 10% (1/10), well above the risk free Treasury rate, you might be interested. But you’d also want to know if the company is going to be around for a while, so you’d look at whether earnings are growing, flat, or declining, whether earnings are steady and predictable, whether the company has plenty of cash to pay bills, whether there’s a lot of debt to pay down or very little, and what the hard assets of the company are worth after subtracting total debt.

You probably wouldn’t be interested in a company with declining earnings, unless you felt the situation was temporary or the company’s tangible book value was well above the asking price (suggesting you could make a profit by liquidating the hard assets and paying off the debt; this would have to be verified by estimating the fair market value of the hard assets, instead of just relying on the assets’ stated book value). If the company’s earnings were flat or growing, and relatively predictable, you might be interested, since your undiscounted payback period (the time it takes to recoup your initial $10,000,000 investment) would be around 10 years.

To summarize, a Scenario Two company typically has: (1) an unleveraged, low debt balance sheet; (2) a strong working capital position; (3) steady and hopefully growing earnings; and (4) a low price relative to earnings. Investors who are fans of Graham, Schloss, and Buffett generally prefer this type of investment. They’re unwilling to pay a big premium for earnings growth, because high growth rates frequently disappear (often unexpectedly) as competition increases and markets saturate. And it's better if a Scenario Two company isn't facing a low end or new market disruption, a la Clayton Christensen. See Concepts page and discussion of Benjamin Graham, Warren Buffett, and Clayton Christensen.

Low end or new market disruption is often the reason low PE companies go out of business. Amazon has disrupted thousands of brick and mortar retail businesses through new market disruption. Brick and mortar retailers have difficulty matching Amazon’s online, low cost business model. Leveraging its low cost model, Amazon has helped create a vast new market of online consumers who shop at their computer (the new context/situation) instead of shopping at a brick and mortar store. See Concepts page and discussion of Clayton Christensen.

Amazon currently has no meaningful trailing PE, because its EPS for the past 12 reported months is negative. Its forward PE based on estimated earnings for the next 12 reported months is 333, making it a Scenario One stock. Amazon investors seem to believe the company can deliver higher future earnings with no material, concurrent impact on its sales, growth, and ability to compete with other low margin retailers like Wal-Mart, Costco, Sam’s Club, eBay, Target, Alibaba, and Google Express. Applying Michael Porter's five forces, retail industry profits are constantly pressured by: (1) high rivalry (lots of competing retailers doing the same thing -- reselling goods made by others); (2) high buyer power (buyers with lots of information and the ability to comparison shop); and (3) a high threat of new entrants (it's easy to start an online store or brick and mortar store). See Concepts page and discussion of Michael Porter.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock.

What Motivates Employees

Apple has made a bunch of high profile hires recently, most notably:

(1) Paul Deneve, former CEO of Yves Saint Laurent

(2) Angela Ahrendts, former CEO of Burberry

(3) Marc Newson, designer

Ahrendts and Newson are almost iconic figures. Deneve and Ahrendts were prominent, well-respected CEO's of their respective companies. It seems unusual for two CEO's to give up positions of great power, pay, and prominence to accept vice president roles with Apple where they report to someone and where they operate in the background.

So what motivated these people to accept positions with Apple?

In One More Time, How Do You Motivate Employees?, by Frederick Herzberg (Harvard Business School Publishing Corporation, 2008; article originally published in the Harvard Business Review in January, 2003), Herzberg talks about intrinsic motivators like growth and learning, responsibility and personal achievement, and recognition and advancement, versus extrinsic incentives like pay, perks, and promotions.

Herzberg says the problem with extrinsic incentives is that employees must be regularly placated with promotions and pay to keep them performing and on the job. Id.

The more a company utilizes intrinsic motivators, the less it has to rely on extrinsic incentives to keep people performing. With intrinsic motivators, people perform and stay on the job because they're growing, learning, getting more authority and responsibility, and developing new and deeper expertise. Id.

Companies can proactively create an environment with robust intrinsic motivators by:

(1)  removing some controls while giving employees more accountability, responsibility, and authority for complete, natural units of  work;

(2)  making information directly available to employees, rather than indirectly providing this information through management;

(3)  giving employees new and more difficult types of work; and

(4)  giving employees specific or specialized work, allowing them to develop expertise and advance in a particular area. Id.

When Scott Forstall left Apple, Tim Cook noted the importance of greater collaboration within Apple. As noted by Ed Catmull in Creativity, Inc., candid, team-based, problem-focused collaboration is critical in generating the thousands of good ideas needed to create an innovative new product. Because great new products require lots of good ideas, good people and good teams are more important than any single great idea. See post titled "The Rational Management Checklist."

When you see Apple making hires like Newson, Ahrendts, and Deneve, it suggests these people see a work environment with rich intrinsic motivators, rich enough to make it worthwhile to leave prominent, challenging positions. Something about Apple's present state and future prospects must have really excited them. Was it a highly collaborative work environment, the challenge of working on great new products and services, the opportunity to develop new expertise?

This points to what may be a significant competitive advantage for Apple over the long term. Because Apple is so end user focused, and doesn't have to compromise its "great product" mission by trying to generate ad revenues (Google) or e-commerce (Amazon), it may have a real advantage in recruiting talent like Newson, Ahrendts, and Deneve. People who join Apple get the intrinsic motivation that comes from a tight focus on end users and on creating the best products in the world.

The author owns stock shares of Apple.

Reducing Rivalry by Staying Focused

One of Michael Porter's five forces is industry rivalry. Rising industry rivalry often leads to price-based competition and commoditization of competing products. Companies in an industry can reduce rivalry by: (1) pursuing a unique, hard-to-duplicate strategy;  (2) competing on non-price elements like quality, features, service, and brand image; (3) targeting different market segments with different mixes of product/price (thereby expanding the total market pie); and (4) forgoing the goal of market dominance or market leadership. See Concepts page and discussion of Michael Porter. Companies that compete based on the same product dimensions often end up engaged in price-based, zero sum competition. Companies that pursue sales growth and market dominance by broadening their product range increase the number of competitors they have to face, which increases long term rivalry and makes future corporate partnerships more difficult. In pursuing growth, these companies often compromise the unique strategies and product qualities that made them successful in the first place.

When you look at the technology and e-commerce industries, it's hard not to notice Amazon and Google's ambitious pursuit of market dominance. Google wants to dominate search and data collection to drive ad revenues. It tries to do this through proprietary Android, which is a combination of the Android Open Source Platform ("AOSP") and Google Mobile Services ("GMS" services include Google Play, Gmail, and Google Maps). OEM's that want to use the Android brand and GMS services must agree to limit any efforts to fork proprietary Android. Some major OEM's, like Samsung, sell phones with proprietary Android, which ensures Google gets the search/user data. Google also sells Nexus hardware, which runs proprietary Android, to ensure it gets search/user data.

In pursuing market dominance, however, Google has dramatically increased rivalry with other major tech players. Google's development of Android angered Steve Jobs and pushed Apple away from Google services: Eric Schmidt left Apple's board, Apple created Google Maps and started using Bing as the default search engine on iOS, and Apple has basically started trying to disengage itself from direct use of all Google services. And now bare-bones AOSP, which can function as a mobile operating system without GMS services, is coming back to bite Google: more and more low end OEM's are using AOSP alone, without GMS services, which prevents Google from gathering search/user data.

In pursuing market dominance of data collection and search -- through Android and the Nexus line -- Google has created a fragmented, intensely competitive smartphone market consisting of: (1) an openly hostile Apple, which is actively trying to move away from Google services; (2) a few major proprietary Android OEM's like Samsung (that seem to be exploring proprietary Android alternatives like AOSP and Tizen); and (3) lots of small AOSP-OEM's that provide Google with no search/user data.

While a highly competitive, fragmented market may ensure Google has access to at least some search/user data, the long term outcome of increased rivalry/fragmentation seems to be declining search/user data for Google, which indirectly depresses Google's ad prices. And over the long term, AOSP puts Google in a data collecting competition with every competing search engine (like Baidu), every competing email/mapping service, and every competing digital storefront that resides on an AOSP mobile phone.

Instead of creating a vehicle (AOSP) that increases OEM rivalry and makes it harder for Google to collect the data needed to drive ad revenues, Google could have reduced rivalry and increased data collection by partnering with major OEM's (Apple, Nokia, Blackberry, Samsung, etc.) at the outset. Google could have offered all smartphone OEM's integrated Google search and Google Maps. Apple integrated Twitter services into iOS -- maybe something similar could have been worked out with Google (I realize I'm speculating here). This approach still would have allowed Google to capture significant user/search data. Instead of working with major OEM's to reduce rivalry, however, Google increased rivalry through proprietary Android, the Nexus line, and AOSP.

Amazon also seems bent on market leadership/dominance, which is increasing rivalry and direct competition with companies like Apple and Google. With the help of AOSP, Amazon has started selling Kindle Fire tablets and phones to ensure it can sell profitable digital media and e-commerce (similar to how Google is using proprietary Android to ensure access to search/user data). In 2013 Google responded with Google Shopping Express. Apple has responded by bolstering its iBooks effort, and by partnering with streaming movie companies like Netflix.

Because Apple was already selling digital media/content through iTunes, Amazon's rivalry with Apple may have been unavoidable. What's clear, however, is that Amazon's ambition increases its rivalry with other tech players, often making it infeasible for them to partner with Amazon. Imagine if Amazon had successfully negotiated partnerships with Apple and Google. The Google Play store and Google Shopping Express may never have developed. Apple might have passed on iBooks altogether (along with other forms of digital media). Amazon could have stayed focused on profitable digital media and e-commerce rather than saddling itself with a subsidized/break-even hardware business.

Regardless of what might have been, there's no question that the blind pursuit of market dominance incentivizes competitors to defend themselves. These competitors often end up developing alternative offerings that increase industry rivalry. Rising industry rivalry increases price-based competition.

A company can reduce rivalry by staying focused, by competing to be unique, and by deepening integration around a job-to-be-done. See posts titled "Acquisitions, Rivalry, and Strategic Trade-Offs" and "Avoiding Disruption by Integrating Around a Job-to-be-Done." To date Apple has largely done this: with the possible exception of the iTunes store, Apple has stayed focused on creating integrated, easy to use computing tools. Apple moves up and down the value/supply chain only when it helps the company deliver a simpler, more seamless computing experience for end users. While the digital media on iTunes is arguably outside Apple's core hardware/software business, iTunes was necessary to create an integrated, seamless user experience for the original iPod. Interestingly, Apple may be moving away from downloaded/owned iTunes music, in favor of streaming through a Beats Music subscription, because it improves the end user experience.

Apple's focus on integrated computing tools has allowed it to avoid unnecessary rivalries, making it easy for Apple to partner with software developers, service providers, and music/media content providers. These partnerships have helped make iTunes, the App Store, and the iPhone a success. The challenge for Apple is to maintain this focus going forward.

The author owns stock shares of Apple.

Apple's Downmarket Moves, Privacy and Security, Amazon's Fire Phone, and Google's Nest

Apple's Downmarket Moves

Apple is blending modular and integrated approaches to keep costs down and avoid low end disruption; it's integrated around things that add meaningful differentiation (design, mobile chips, fingerprint security, battery design and engineering, software and hardware engineering, high-end aluminum milling equipment, etc.) and modular around things that don't add meaningful differentiation (Intel chips, flash memory, hard drives, laptop/desktop glass, assembly line manufacturing, etc.).

Apple's approach allows it to keep dropping price: the company has been lowering prices for the iMac, MacBook Air, MacBook Pro, and iPad Mini, and Apple is probably going to lower the price of the iPhone 5c or another iPhone model. Apple is making its entire product line more affordable and simplifying products where possible. Look out below.

Apple also isn't giving up on the low end education market -- it's giving iPads to schools. This is how Apple is dealing with Chromebook competition in the education field.

Privacy and Security

Apple has a no compromises ecosystem product/service: Apple makes an integrated hardware/software product with no strategy straddle. No straddle is needed because Apple relies on hardware profits rather than profits from data-driven ads (e.g., Google) or e-commerce (e.g., Amazon). And Apple doesn't have to collect data on behalf of Google -- like Samsung does -- because it doesn't need Google services or Android. As a result Apple can focus entirely on the end user experience. See post titled "Acquisitions, Rivalry, and Strategic Trade-Offs."

Apple's tight focus on the end user allows it to give end users greater privacy control -- users can "open the door" as much as they wish. Google, OEM's who rely on Google, and Amazon have to open the door wide to support profitable ads and e-commerce. 

Privacy, security, and trust are becoming a bigger issue as devices proliferate. Privacy and security are going to be valued more and more, especially with health monitoring and health records. Companies that don't need to gather user information to support their business model, and can instead prioritize privacy and security, are going to be rewarded: this is where the puck (the money) is going to be.

Amazon's Fire Phone and Google's Nest

Amazon is probably going to struggle. The Fire Phone is a high margin product and must compete with Apple and Samsung smartphones that rely on the same business model (a model based on high margin hardware profits), which is poor strategy. See Concepts page and discussion of Clayton Christensen and Michael PorterThe Fire Phone doesn't address any simple, low margin job to be done for new or low end markets, where incumbents lack motivation to respond. Instead, the Fire Phone addresses a high margin job that's already being satisfied by well-entrenched incumbents; these incumbents will be motivated to respond, making it more difficult for the Fire Phone to succeed. See Concepts page and discussion of Clayton Christensen.

Google is facing the same problem with Nest: Google is now selling hardware for a profit, competing head-to-head with a well-entrenched incumbent's business model (Apple's hardware-based profit model), at the same time it's trying to collect data-driven ad revenues. So Google will have two hurdles to overcome: (1) a motivated response from an incumbent (Apple); and (2) the inherent difficulty of straddling inconsistent strategies (with one strategy focused on hardware profits and the end user's needs and a second strategy focused on data-driven ad profits and the advertiser's needs). See Concepts page and discussion of Michael Porter; post titled "Acquisitions, Rivalry, and Strategic Trade-Offs."

The author owns stock shares of Apple. 

M&A, Apple and Beats, and the Downsides of Asymmetric Competition

Christensen's Thoughts on M&A Clayton Christensen says the main reasons to do an acquisition are: 

(1) acquiring resources that permit a company to meaningfully differentiate a product and thereby increase price; 

(2) acquiring resources to increase scale and efficiency, so that costs can be distributed over more customers or more resources (e.g., acquiring an adjacent oil field so that existing fixed assets/costs can be utilized with two fields instead of just one, or buying a company to acquire customers in the same geographic area so that fixed shipping assets/costs can be distributed over a larger customer base); and

(3) acquiring a simpler, more affordable business model, and then operating the new model as a separate company (with the expectation of significant future growth and future upmarket product moves). See Harvard Business Review, "The New M&A Playbook," by Clayton Christensen, Richard Alton, Curtis Rising, and Andrew Waldeck (March, 2011); also see Concepts page and list of sources and recommended reading.

With resource-based acquisitions (reasons one and two), the acquired company's resources are integrated into the acquiring company’s existing operations. In the course of integration the processes and priorities of the acquired company typically disappear. 

With a business model-based acquisition (reason three), Christensen says the acquired company should generally be operated as a separate entity from the acquiring company. Otherwise the acquiring company can end up destroying the processes and priorities that make the acquired company’s disruptive business model unique and profitable.

Christensen says the most compelling reason for an acquisition is the opportunity to pursue a new business model, which can often be a source of tremendous future growth for the acquiring company. Resource-based acquisitions can produce a one time bump in profitability, but are usually not long term sources of future growth. 

Christensen says that companies often overpay for resource-based acquisitions, but that companies should be looking for, and paying more for, opportunities to acquire new business models. Because of growth prospects, new business model acquisitions are worth far more than the typical resource-based acquisition. See Harvard Business Review, "The New M&A Playbook," by Clayton Christensen, Richard Alton, Curtis Rising, and Andrew Waldeck (March, 2011).

Apple and Beats

Apple’s prospective acquisition of Beats seems both resource-based and business model-based. This kind of acquisition would give Apple new resources in the form of Beats Music and Beats headphones, including algorithmic search, human curation, contracts and relationships with the music industry, headphone design/engineering/manufacturing, and the Beats brand. 

Beats Music would also give Apple a new business model very different from iTunes, in the form of profit-based music subscription/streaming services. Apple makes iTunes and its other services available at close to break-even so it can sell highly profitable hardware. If Apple acquires Beats — or more specifically Beats Music -- it’s acquiring a profit-based music subscription/services model. 

If you apply Christensen’s recommendations, Apple should run Beats Music as a separate company to insure the survival of the processes/priorities that make Beats Music a unique, profitable business model. If Apple tries to integrate Beats Music into iTunes and makes it a break-even service (kind of like iTunes Radio), then Apple may derail the innovation and unique processes/priorities that make Beats Music a profitable service.* (see Addendum below).

Conversely, it should be fairly easy for Apple to integrate profitable Beats headphones, and headphone resources, into its existing business, possibly as a sub-brand. Beats headphones are just profitable hardware, which is identical to Apple’s business model of selling profitable hardware.

The Downsides of Asymmetric Competition

The prospective Beats acquisition highlights one of the fundamental downsides of asymmetric competition, where a company gives away one product at break-even to generate profitable sales from a related product (e.g., Amazon selling Kindle Fires to sell profitable electronic content, Apple giving away services to sell profitable hardware, Google giving away hardware to drive data collection and sell profitable ads). At some point the product or service being given away becomes pretty crappy/mediocre, despite the indirect benefits of driving profitable sales of a related service/product. 

With the Beats acquisition, Apple is: (1) addressing the weaknesses in a break-even iTunes product and (2) taking advantage of technological improvements in music discovery, curation, and streaming (faster broadband, expert curation, the future possibility of high quality streaming audio, etc.). The Beats acquisition allows Apple to "catch up" in music services. But the underlying reason Apple has to catch up is because break-even, asymmetric products/services like iTunes often trend toward mediocrity over time, especially relative to products from motivated competitors who are trying to create simpler, profit-based alternatives (like Beats Music).

Some of Apple's services have become mediocre or overly complex/cumbersome — iTunes especially -- because profits aren’t needed for the service to survive. Apple’s hardware provides the profits needed to sustain iTunes. For Apple this is often a strength: Apple is famous for a functional structure rather than a product division structure, meaning the company has "one P&L" and can offer proprietary, break-even services to increase the profitability and "stickiness" of Apple's hardware and overall ecosystem. The downside is that there’s no direct incentive to make meaningful upmarket improvements to break-even services/products, since the whole point of an upmarket improvement is to improve profit margins. See Concepts page and discussion of Clayton Christensen. When the product or service is an asymmetric giveaway, profits aren’t critical and neither are improved profit margins.

Another downside of any asymmetric giveaway, regardless of enhanced ecosystem/product stickiness, is that the giveaway product tends to stagnate over time, since continued product innovation and improvement aren't needed for the product to survive. A company selling a profitable competing product is highly motivated to out-innovate a company giving its product away, and is also motivated to make upmarket product improvements that make the giveaway product an inferior or obsolete choice (as Beats Music is arguably doing to break-even iTunes, and as the iPad is arguably doing to the break-even Kindle Fire).

And this is what’s really interesting about Apple’s reported purchase of Beats and Beats Music. Beats Music is excellent — and improving -- because Beats must build a profitable user base to survive. If Apple successfully operates Beats Music as a separate, profitable service, it may start trying to generate profits from other Apple services. Apple may reduce the number of giveaways and start trying to create proprietary, profitable services that are really good and worthy of upmarket improvements. 

It makes sense for Apple to insist on a profitable service when a break-even service that was formerly good enough (like iTunes) becomes inferior or obsolete due to technological advances that permit a better solution to a job that needs done (in this case simple and convenient music discovery, curation, and streaming). 

When a break-even product/service is no longer good enough due to technological advances, a profit-based business model can help inspire the innovation and upmarket improvements needed to create a better, more competitive offering. By applying profit-based business models to hardware and services that have become inadequate, or aren't yet good enough, Apple can make its services as strong as its hardware.

* Addendum (added 5/21/2014): This article assumes Beats and Beats Music are profitable business models or will become profitable business models. Financial statements for Beats aren't publicly available, so there is no way of verifying this assumption.

The author owns stock shares of Apple.

How Successful Strategies Develop and When Subsidies Make Sense

Deliberate and Emergent Strategies

Christensen talks about how the best strategies develop through a mix of deliberate, intended creation and emergent, opportunistic, iterative adjustments. A strategy is initially deliberate and explicitly stated (at least normally). It then goes through an emergent fine-tuning process as a company discovers what does and doesn’t work, and as it discovers new opportunities it didn't initially think of. See Concepts page and discussion of Clayton Christensen and list of sources. 

In How Will You Measure Your Life?, Christensen notes that 93% of successful companies have had to abandon their original strategy. Companies need to be opportunistic and change strategies when appropriate. Once a strategic approach starts clicking, a company can shift from an emergent strategic approach to a deliberate approach, where the focus is on execution. See Concepts page and discussion of Clayton Christensen and list of sources.

Christensen says the best way to test a strategy's viability is to make a list of the assumptions which must prove true for the strategy to work. If key assumptions are unrealistic or unlikely to prove true, then the strategy probably isn't the right one.

Serendipity can also play a part. In How Will You Measure Your Life?, Christensen notes that in the 1970's Honda abandoned its original, unsuccessful strategy of selling large motorcycles (competing directly with companies like Harley-Davidson), and started selling smaller Honda Cub motorcycles when customers showed an unexpected interest in the Cub. 

When a strategy changes, resources should be reallocated as necessary. A company shouldn’t keep pouring resources into an initial deliberate strategy that isn’t working. It should look for mistakes and opportunities to adjust and improve the original strategy through an emergent, iterative process, and should adjust its resource allocation appropriately (as Honda finally did with the Honda Cub motorcycle). 

If the original strategy, and emergent adjustments to the strategy, don't have the necessary resources supporting them, then they'll never actually happen. Christensen notes that strategic actions are what's relevant, not strategic intent.

The end result of cycling back and forth between deliberate and emergent strategic approaches is a set of activities/processes that’s been fine-tuned over time, and that’s often difficult for competitors to duplicate. 

Resource scarcity and the need for early profits facilitate the development of a successful, unique strategy, because companies with limited resources are forced to promptly adjust their original strategy, as necessary, to generate the profits needed to continue funding the new product. That's why Christensen counsels new companies to be impatient for profit and patient for sales growth. 

Once a company develops a successful strategy, and achieves profitability sufficient to fund upmarket product improvements, it can shift its focus to growing sales and increasing the scale of manufacturing/distribution, all of which leads to growing bottom line profits.

Companies that don't face resource scarcity can pursue and fund an unprofitable deliberate strategy indefinitely, often growing sales but not profits. These companies aren't forced to cycle between deliberate and emergent strategies in search of life-blood profits. As a result they never develop a profitable, unique set of activities with great fit (although they may fully develop -- and find themselves mired in -- an unprofitable set of unique activities, making future strategic changes more difficult). See Concepts page and discussion of Michael Porter; also see post titled "Acquisitions, Rivalry, and Strategic Trade-Offs.

Product-specific strategies can be emergent until an attractive offering is developed/created, at which point product strategy should become deliberate and execution focused. Once a company hits on a successful product strategy through an emergent process, it should shift to a deliberate approach that aggressively executes the strategy. Successful product strategies are targeted on a job that customers need done. Products that don't accomplish a job well -- for a meaningful segment of the market -- struggle to succeed.

Blending the ideas of Porter and Christensen, Porter seems focused on the strategic target, which is a unique strategy that’s hard to duplicate. Christensen seems focused on how companies reach this strategic target, which is through deliberate and emergent strategic approaches.

Real World Applications and When Product Subsidies Make Sense

Apple seems to pursue product-specific, emergent strategies in-house, through its own employees. Apple keeps working on a product until it's something its own employees want, and then shifts to a deliberate strategy that brings the product to market. The one exception seems to be the Apple TV: in this case Apple seems to be following a very public emergent product strategy, slowly adding content and features and letting the product gradually gain market traction (in the classic, unthreatening style of a new market or low end disruptor). 

The concept of emergent strategy is helpful in examining how Apple might handle the slow-selling iPhone 5c. If sales of the 5c are profitable but small, then Apple can afford to be patient for sales growth (so long as sales are slowly trending up). If sales are not profitable, or if sales are profitable but remain flat over time, then Apple can adjust its product strategy by questioning the underlying assumptions that led to the 5c’s release. If any of these assumptions appear untrue or unrealistic, then Apple can modify its “low end” iPhone strategy accordingly. The overall goal is a product that does an important job for a significant/meaningful customer segment.

Christensen and Porter’s strategy concepts also impact when a company should subsidize unprofitable or break-even products or services. Apple runs iTunes, the App Store, iWork, iLife, and Apple TV hardware at anywhere from a loss to slightly above break-even. But these products also enhance and protect Apple's hardware margins and whole company profits, in addition to raising switching costs for anyone who wants to leave Apple’s ecosystem. So in total, Apple’s approach seems to make sense. 

Amazon subsidizes break-even — or close to break-even — Kindle Fire hardware to generate profitable e-commerce sales for Amazon.com. But Amazon’s margins have stayed razor thin, suggesting the Kindle Fire hasn't enhanced Amazon's pricing power, while whole company, bottom line profits have stayed small (both before and after introduction of the Kindle Fire). Given this kind of limited financial impact, do Kindle Fire subsidies make sense?

Product subsidies are more logical when they’re part of a unique, well-integrated set of carefully chosen activities that produce healthy margins and strong profits. Without this profitability test, product subsidies can burn through a company’s resources indefinitely, in addition to preventing the company from really working to develop a profitable product strategy.  

It's interesting how so many companies today -- Amazon and Twitter come to mind — have been rewarded by investors for being patient for profit and impatient for sales, which is exactly the opposite of what Christensen recommends. 

The author owns stock shares of Apple.

Business Models That Facilitate the Creation of New Products

A company with a business model that incentivizes and facilitates the creation of well-designed new products can avoid disruption indefinitely. Integrated Versus Modular Business Models

Apple's business model is based on hardware profits. To grow these profits -- and survive -- Apple has to create innovative new products. To create innovative new products, Apple makes sure it controls the key technologies and integrates the key functions of design, engineering, and manufacturing. As a vertically integrated company, Apple can create almost any piece of computing hardware it wants, creating new product categories, moving upmarket with sustaining improvements, or moving downmarket with simpler, more affordable versions of existing products. Companies that do this can avoid low end or new market disruption indefinitely -- they just keep creating new stuff, squarely addressing different jobs that need done.

Modular companies that assemble standardized components have to rely on component manufacturers to innovate. When a standardized component becomes good enough, additional improvements to the component won't drive additional sales for the company that uses it. HP and Dell's PC businesses have struggled, at least in part, because Windows 7 and existing Intel chips are good enough for many people. And because they aren't vertically integrated, HP and Dell lack the design, engineering, and manufacturing resources and processes needed to create attractive new computing devices. They're basically stuck in the low to middle end of the PC and tablet markets, selling standardized, modular devices based on different chipsets and different versions of Windows, Android, and Chrome OS.

Another drawback with modular assemblers like Dell, HP, Lenovo, Samsung, and others is that their reliance on standardized, modular components often leads to bad design. Because they're putting together modular components, their design options are limited -- they have to operate within the parameters of the standard components they're assembling. And if you're a modular assembler competing with other modular assemblers, you have to at least match your competitors' technical specifications. So to compete, modular manufacturers end up abandoning good design principles, often using components that overserve the job that needs done or putting too many features into the final assembled product. This ultimately results in: (1) poorly designed, undifferentiated products and price-based competition; (2) little to no meaningful new product innovation (just immaterial improvements to things like screen resolution or "speeds and feeds"); and (3) the kind of industry-wide overserving that developed in the Wintel PC market.

And that's exactly the kind of market that's ripe for disruption by an integrated competitor. An integrated company isn't stuck with standardized components and cut-throat, modular style competition, so it can design products based on the job that needs done and avoid overserving. The outcome is frequently a simple, beautiful product that happens to be more affordable than many overserving, modular alternatives (e.g., Apple designing the simpler iPad as an alternative to laptop PC's).

The Importance of Business Model Incentives and Resource Scarcity

Google and Facebook have ad-based profit models. With the acquisition of Nest, Google may be shifting toward a hardware-based profit model (as noted by Horace Dediu at asymco.com). To duplicate Apple's ability to efficiently create new hardware products, Google will probably have to vertically integrate thousands of design, engineering, and manufacturing activities. And that's not going to be easy. See post titled "Acquisitions, Rivalry, and Strategic Trade-Offs."

Some people see an ad-based profit model (Google or Facebook), or a business model based on tremendous scale and operational effectiveness (Amazon), and think the relevant company is a safe, monopoly-type business with predictable, growing earnings. But as Horace Dediu at asymco.com has noted, ad-based models may lose traction as Internet usage starts growing less in developed economies, which have higher personal incomes, and starts growing more in developing economies, which have lower personal incomes.

Additionally, when a company's business model doesn't really depend on the periodic creation of new products, it's not going to be as good at developing them. A company focused on collecting user data and churning out profitable ads, such as Google or Facebook, or trying to efficiently grow retail sales volume, such as Amazon, isn't really focused on creating entirely new product categories -- these companies are focused on improving the efficiency and performance of the dominant, profitable business models they've already established, whether it involves data collection, ad targeting, or operational effectiveness.

Clayton Christensen has noted that disruptive new products are generally developed in a context where resources are scarce. Most startup companies with a disruptive idea have scarce resources, so they have to be impatient for profit. That's because they need early profits to fund ongoing product sales and development. Early profits also test whether the product is truly disruptive, appealing to new and low end markets. Without resource scarcity, and the need for early profits, a company can keep wasting time, talent, and money on a product that lacks the market appeal to sustain itself. See Concepts page and discussion of Clayton Christensen.

You can see Google and Amazon doing this, at least to a degree, with: the subsidized/break-even Kindle Fire; the break-even Nexus products; Google's lackadaisical approach to the Motorola acquisition and to Motorola's hardware; and the high end Google Pixel (which doesn't even qualify as a low end or new market disruption). Because Google has a dominant, highly profitable ad business, while Amazon has a dominant, profitable retail business, neither company has to deal with resource scarcity. As a result, both companies are willing and able to continue subsidizing break-even hardware. Analysts looking at Google justify this by saying that Google uses subsidized hardware to collect data for its profitable ad business. Analysts looking at Amazon justify it by comparing the Kindle Fire to a storefront (which may arguably be true, although Amazon's customers already have an optional Amazon app storefront on most tablets and smartphones). The bottom line is that neither Amazon nor Google is strongly motivated to focus on disruptive new hardware that performs a specific job well, because their business models don't depend on profitable hardware sales.

Apple shares at least some of this motivation problem, since past product successes have provided it with abundant resources, especially cash. Apple doesn't have to deal with resource scarcity, so it must be vigilant in saying "no" to unfocused product ideas that don't squarely address jobs that need done; unfocused products waste time, talent, and money that could be productively used elsewhere. The big difference between Apple and companies like Google and Amazon, however, is that Apple depends on profitable new hardware to survive. Hardware isn't a side-game, so despite its resources Apple is still strongly motivated to design any new device around a job that needs done, which increases the odds of market success, prevents overserving, and often results in more affordable products that appeal to new and low end markets.

Maybe that's what Steve Jobs meant when he counseled others to "stay hungry, stay foolish" -- namely, to avoid complacency, and to keep creating well-designed products that squarely address important jobs. A good business model facilitates and incentivizes this effort.

The author owns stock shares of Apple.

Acquisitions, Rivalry, and Strategic Trade-Offs

There have been a lot of acquisitions lately. Facebook is acquiring WhatsApp for $19 billion, and WhatsApp apparently received a multibillion dollar competitive offer from Google. Google is acquiring Nest for $3.2 billion.  In 2012 Facebook acquired Instagram for $1 billion and Google acquired Motorola for $12.5 billion; Google is now selling Motorola to Lenovo for $2.9 billion.  In 2010 Amazon acquired Diapers.com for $540 million, and in 2009 Amazon acquired Zappos for over $900 million.

The Facebook/WhatsApp acquisition seems motivated by Facebook's desire to: (1) grow its user base and market share; (2) eliminate WhatsApp as a potential rival and as a buying opportunity for competitors like Google; and (3) possibly experiment with WhatsApp's paid subscription business model. In one of his recent Critical Path podcasts (Critical Path #112), Horace Dediu at asymco.com noted that Facebook and Google may both be experimenting with different business models, trying to move away from reliance on ad revenues. This motivation may be behind Google's recent acquisition of Nest. Similar to the WhatsApp acquisition, many of Amazon's acquisitions appear motivated by the desire to grow market share and eliminate potential rivals.

So the question is, do these acquisitions make good business sense, at least based on the strategic writings of Clayton Christensen and Michael Porter? See Concepts page for discussion of Clayton Christensen and Michael Porter and list of sources.

What is Strategy?

Porter defines a strategy as a unique set of activities that fit well together, making it hard for competitors to duplicate. Duplication becomes more difficult as the number of activities increase -- matching one activity is obviously easier than matching several. See Concepts page for discussion of Michael Porter and list of Michael Porter sources.

Southwest Airlines, for example, tailors its activities around delivering low cost, quick turnaround, on-time flights to budget-conscious consumers, so it doesn't serve meals on planes, doesn't take advance seat reservations (thereby permitting quicker boarding), and tries to fly in and out of more cost-competitive secondary airports (such as Midway in Chicago). Southwest's activities are carefully chosen based on the target audience (the budget-conscious traveler), and these activities are all designed to fit well together and complement each other. As a result competitors have not been able to effectively match Southwest's strategy.

Southwest competitors that try to offer low cost flights while also offering premium, full service flights typically fail because they haven't crafted a unique set of activities aimed at one target audience. When a competing airline targets the high end traveler and the budget traveler, it ends up splitting the difference in terms of activities and fit. Porter calls these companies "straddlers." A straddler tries to address more than one target market at a time, often through inconsistent activities that don't fit well together. Companies like this are unwilling to make the trade-offs needed to create a tailored set of activities that squarely address the needs of a specific target market; straddlers often try to address the entire market, leading to a haphazard, unintegrated set of activities, poor fit, and no real strategy. For these reasons it's easier for new entrants to compete with a straddler than with a company that has a unique, hard to duplicate strategy comprised of many well-integrated activities.

So an airline straddler targeting budget travelers and high end business travelers might give up reserved seating, going for quicker boarding and faster turnarounds, but be unwilling to give up service to primary airports like Chicago O'Hare. The problem is that this kind of middling product/service often appeals to neither the budget traveler nor the high end traveler. And straddlers generally lack the focused execution of a company that's made meaningful trade-offs based on its target market and the activities it's crafted around that target market.

Porter's point is that a company needs to try and move toward a unique strategy, with carefully chosen, integrated activities that fit well together. And a unique strategy generally targets a specific market segment rather than trying to be all things to all people -- untargeted strategies usually result in poorly chosen activities and poor fit. This point dovetails with the following quote from Steve Jobs, from October, 2008:

"There are some customers we choose not to serve. We don’t know how to make a $500 computer that’s not a piece of junk, and our DNA will not let us ship that. But we can continue to deliver greater and greater value to those customers that we choose to serve. And there’s a lot of them. We’ve seen great success by focusing on certain segments of the market and not trying to be everything to everybody. So I think you can expect us to stick with that winning strategy and continue to try to add more and more value to those products in those customer bases we choose to serve."

Porter believes companies should compete to be unique rather than competing to be the best.  Competing to be the best generally leads to product one-upsmanship and head-to-head comparisons (often based on technical specifications), which ultimately leads to homogenous products and price-based competition (all of which hurts industry profitability). If companies in an industry instead compete to be unique, then more than one company can prosper and destructive rivalry can be avoided. And a unique, hard to duplicate strategy is the best protection against price-based competition.

Lastly, Porter believes organic growth is best achieved by deepening and strengthening a unique strategy over time. Acquisitions that strengthen a successful, unique strategy make sense. Acquisitions for the sake of market share growth do not, and often lead to unfocused straddling.

Porter's concepts of activity and fit are very similar to Christensen's idea of avoiding disruption (i.e., building a strong competitive barrier) by integrating to do a job perfectly. See post titled "Avoiding Disruption by Integrating Around a Job-to-be-Done." Apple has integrated around the job of technology that's always available and that anyone can use, and is always striving to do this job more perfectly. Southwest has integrated around the job of providing cheap, reliable air travel to budget-conscious consumers. IKEA has integrated around the idea of providing cheap, easy to assemble furniture to budget-conscious consumers. All these jobs are accomplished through carefully chosen, integrated activities that fit well together.

So when you see an acquisition, or you see a company trying to grow rapidly, a relevant question is whether the company is trying to integrate activities to more perfectly accomplish a job that needs done.

Integrating Around a Job that Needs Done and Shifts in the Basis of Competition

Christensen says that over time the basis of competition for a product or service tends to shift from making functionality and reliability "good enough," to making convenience, accessibility, ease of use, customization, and affordability good enough. See Concepts page and discussion of Clayton Christensen. This shift may occur quite rapidly for companies without a unique, integrated strategy designed around a job that needs done. Companies without a unique strategy can quickly find themselves forced to: (1) compete on price; and (2) make expensive acquisitions to eliminate rivals, expand market share, and hopefully achieve sustainable network effects.

Incumbent companies with a unique, integrated strategy that squarely addresses a job that needs done may be able to avoid the final shift to low end, price-based competition. That's because it's very hard for new entrants to duplicate (let alone surpass) the tightly integrated activities of a well-entrenched incumbent with a unique strategy. New entrants may also be unwilling to make the trade-offs needed to pursue a unique strategy that targets a specific market segment (e.g., Apple giving up the low end market, Southwest giving up first class business flyers, and IKEA giving up consumers who don't want to assemble their own furniture). A new entrant's unwillingness to make strategic trade-offs gives focused, integrated incumbents a competitive advantage/barrier.

When you don't have a unique, trade-off based strategy, you're effectively forced to compete based on market share, network effects, operational effectiveness, and price. And when a company competes for the entire market, and doesn't have an integrated set of activities that's hard to duplicate, every industry competitor looks like a threat. Price and operational effectiveness can be competitively matched over time (Porter notes that cost efficiency and economy of scale benefits go to zero past a certain point), so your only competitive defense ends up being a dominant market share and network effects. The pursuit of market share and network effects leads to expensive acquisitions, new and often unrelated product/service lines, and new business models, all designed to grow revenues and eliminate competitive threats. In this scenario, a company's revenues may grow dramatically while its profits stay small. That's because a company with rapidly growing revenues or a "dominant" market share, but no unique strategy, lacks pricing power and can still lose sales to: (1) other large, price-based competitors with roughly equivalent scale and operational effectiveness; and (2) more focused, specialized competitors that are tightly integrated around the perfect solution to a job that needs done.

Large companies with dominant market share -- but no unique set of activities integrated around a job that needs done -- can be "unbundled" by one or more focused competitors with a unique set of well-integrated activities that squarely address a job that needs done (usually for a specific market segment, such as the budget-conscious Southwest traveler). Consumers in the target market segment will prefer the unbundled product that perfectly addresses the job they need done (often in a more affordable way). And as Christensen notes, focused companies that are integrated around the perfect solution to a job that needs done can avoid low end or new market disruption. See post titled "Avoiding Disruption by Integrating Around a Job-to-be-Done." 

Acquisition Fever

Google's unique strategy is effectively the algorithm for Google search, which has led to a successful advertising-based profit model. Google may now be moving away from this unique strategy, trying to match Apple's hardware-based profit model. To the extent Google tried to do this with Motorola, it clearly failed, selling Motorola to Lenovo at a substantial loss. Google appears to be making a second effort with Nest. The difficulty here is that Google has to duplicate (and probably surpass) the activities and fit of well-entrenched incumbents in order to succeed. If Google pursues a business model based on profitable computing hardware, it will have to match thousands of well-integrated activities already in place at hardware companies like Apple and Samsung. And as the number of activities increases, the likelihood of successful duplication decreases. The hardware business is also capital intensive, meaning that mistakes in this area are costly.

A hardware-based profit model also presents Google with a straddling problem. On one hand Google probably wants to use its hardware to collect user data, permitting better ad targeting on behalf of Google's advertising customers. On the other hand Google probably wants to preserve user privacy and minimize ads to enhance the hardware purchaser's experience, thereby boosting profitable hardware sales. If Google tries to sell ads at the same time it sells profitable hardware, it will be forced to serve two target markets at once (advertisers and hardware purchasers), resulting in compromised activity choices and poor fit across activities.

Facebook also depends on an ad-based revenue model, but it lacks Google's unique search algorithm. Facebook's acquisitions of WhatsApp and Instagram seem motivated by the quest for market share, network effects, and the elimination of potential rivals (including rival purchases by competitors like Google and Yahoo). These acquisitions don't seem to enhance or deepen a unique set of hard to match activities. Customers already have multiple messaging alternatives to WhatsApp, including Line, WeChat, iMessage, and traditional SMS services. And it's easy to switch among free messaging services -- users just give the service their contact information and then tap the correct app icon. Photo app alternatives to Instagram are also abundant.

To the extent Facebook is trying to move away from an ad-based model toward a subscription model (like the one used by WhatsApp), it has the same straddling problem as Google. On one hand Facebook wants to collect data and target ads for its advertising customers, which degrades user privacy and the user experience. On the other hand it wants to experiment with and possibly use subscriptions. Subscriptions enhance user privacy and the user experience but may antagonize Facebook's advertising customers.

And lastly, Amazon's acquisitions and rapid revenue growth seem driven by a quest for market domination and the elimination of potential rivals, hence the deals with Zappos and Diapers.com. Amazon is extremely cost efficient, and operates at tremendous scale, but as Porter notes the benefits of scale and operational effectiveness go to zero past a certain point. Operational effectiveness, massive scale, and the apparent pursuit of monopoly power don't constitute a unique strategy, and it's hard to discern what Amazon's unique set of well-integrated activities is. There don't seem to be any trade-offs based on a target market and the integrated activities needed to do a perfect job for this market. That's probably because Amazon is pursuing the entire retail market. The problem is that e-commerce has few barriers to entry, and Amazon still has a number of very large competitors, including: Wal-Mart, Sam's Club, Costco, Target, eBay, and Alibaba. All these companies offer a high quality e-commerce experience. Amazon's online experience may be a little better in certain cases, but this just comes down to operational effectiveness, and competitors typically catch up in this area. Amazon must also deal with more focused, integrated retail competitors who are trying to perfectly address a job that needs done for a specific target market.

Amazon's large competitors, as well as more focused, integrated competitors, limit Amazon's pricing power. Amazon can continue growing top-line revenues through acquisitions and new product/service lines, but bottom-line profit growth may be another matter.

Organic Growth and the Right Kind of Acquisition

So what kind of growth, and what kind of acquisition, makes sense? Blending the views of Porter and Christensen, a company should strive for organic growth by deepening integration and fit across carefully chosen activities, resulting in a more perfect solution to a job that needs done. Apple, for example, is focused on integrated activities to perfectly accomplish the job of always available technology that anyone can use. So good acquisitions enhance an integrated, perfect solution to this job. Apple's acquisitions of FingerWorks (multitouch control), AuthenTec (fingerprint security), and Embark (public transit mapping), all enhance product integration and make the technology easier to use. Good talent "acquisitions" for Apple might be people who can help it create and fashion new, integrated devices that are always available and easy to use. Every time Apple creates a new device that integrates into its existing device ecosystem, it strengthens the benefits of its unique, integrated strategy.

And when a market saturates, what should a company with a unique, robust strategy do? Porter says it should try and implement its strategy on a global basis. See Concepts page for discussion of Michael Porter and list of Michael Porter sources. Looking again at Apple, that's exactly what it's doing: (1) expanding into China, Brazil, and other large population areas with the necessary broadband infrastructure; (2) avoiding the low end and price-based competition; and (3) continuing to make technology that's always available and that anyone can use.

The author owns stock shares of Apple.

The Battle for Talent

When you're in an industry where the success of your efforts depends on the talent, intelligence, and effort of key people, you better have the money or resources needed to attract and retain those people.  With a publicly traded company, money or resources to attract and retain key people generally come from a rising stock price or a profitable business. When a company can make predictable, consistent sales of its product with little significant product innovation -- think Coca-Cola or Altria -- talent attraction and retention is probably less critical because new product innovation isn't as important.  Companies like Coca-Cola and Altria have well-established and slow-changing resources, processes, and priorities, and process execution is the focus.  See Concepts page and discussion of Clayton Christensen.

For companies in the tech industry, however, talent attraction and retention are critical, and that requires either a rising stock price (to create effective stock incentives) or the profitability needed to attract and pay the most talented designers and computer engineers.  Because in tech, the company with the most talented key people often has the best chance of creating new product innovations that consumers will value.

So over the long haul, which tech-related companies are best positioned to attract the most talented people?  The ideal combination is probably strong and rising earnings combined with a rising stock price.  That way if a company's stock price drops -- often due to slower earnings growth, or due to previously unrealistic expectations of future growth -- then strong underlying profits should still allow the company to attract and retain talented people.  

A rising stock price unsupported by growing earnings -- and supported only by expectations of future earnings growth which may not materialize -- is fine up until expectations change and a market correction occurs. When this type of correction occurs, stock options, stock awards, or delayed stock vesting may not be enough to attract and retain the most talented people (especially in the hyper-competitive tech industry). And without strong underlying profitability, a company in this situation has no other way to attract and pay for top talent (other than the intangible, psychic benefits of the work itself).

Based on this discussion, which of the following tech companies look most attractive? The reader will ultimately have to make this assessment.

PE (trailing 12 months, diluted and continuing, as of January 31, 2014 closing)

Amazon          607.9

Apple              12.4

Google            32.8

 

The author owns stock shares of Apple.