Learning to Survive and When to Move Up and Down the Value Chain

Relevant Concepts from Christensen and Porter 

Clayton Christensen says incumbents can normally address sustaining product improvements, even product breakthroughs by new entrants, by simply co-opting or acquiring the entrant's business. See The Innovator’s Solution, by Clayton Christensen and Michael Raynor (Harvard Business School Publishing Corporation, 2003). If a company is acquired only for its resources (people, products, technology, or market position) then it can be safely integrated into the acquiring company's business. Id. If a company is also acquired for its processes and values -- its ways of making decisions, getting things done in a timely and cost effective way, and company culture/priorities -- then it should be operated as a separate entity since integration may destroy the processes and priorities that make the company successful. Id.

Christensen also says it makes sense for a company to move to adjacent links of the value chain when the company's link becomes too commoditized or unprofitable. Christensen says companies should try and skate to where the money will be, or those chain links that aren't yet good enough and therefore aren't yet commoditized and low margin. Id.

Blending a little of Christensen with Michael Porter, Porter says companies should compete to be unique. See Concepts page and discussion of Michael Porter and post titled Acquisitions, Rivalry, and Strategic Trade-Offs. So Porter might say it makes sense to acquire an adjacent link of the value chain when the acquisition gives the company a more unique set of activities and improves activity fit, making the company's value chain link(s) more defensible and harder to duplicate.

Costs and Benefits of Value Chain Moves

It's important to consider the costs and benefits of any move to an adjacent value chain link. When a component manufacturer, for example, moves up the value chain and also starts assembling final products that incorporate the component, it may lose component business from the final assemblers who were previously its customers. This outcome is less likely if the component is priced attractively, but it's still a risk -- companies don't like helping or giving business to competitors. This is why Samsung has started losing some of Apple's semiconductor business. Samsung went from making smartphone semiconductors to also making smartphones, competing more and more directly with Apple, one of Samsung's semiconductor customers. Apple is now ordering more chip components from TSMC, which is a pure chip foundry. TSMC's willingness to stay squarely in place, in its component manufacturing value chain link, has become one of its key competitive advantages.

There's also the risk of a final assembler moving down the value chain and entering the component manufacturing business. This outcome is unlikely so long as the component business is lower margin -- and therefore less attractive -- than the final assembly business.

As this discussion illustrates, any time a company moves into new parts of the value chain it creates new rivals and new competitive pressures. This can make partnerships more difficult. It's easy for companies in different parts of the value chain to partner (e.g., Apple and TSMC). Partnering is more difficult when companies share one or more value chain links (e.g., Apple and Samsung).

When a company moves to an adjacent value chain link, it must consider the competitive response of companies in that adjacent link, and whether damage from this response outweighs the benefit of higher margins, more unique activities, and/or better activity fit.

I'd argue that component makers with low cost business structures are usually well-positioned to move up the value chain, even if it means they might lose business from final assemblers that buy their products. That's because a component maker moving up the chain, operating with a low cost business structure, has already experienced intense competition at the component level and is well-prepared to deal with competition from final assemblers, even if it means losing some component orders.

A component maker moving into a higher margin assembly business can also profitably sell the final product to end users at a lower price than unintegrated final assemblers. That's because the component maker can get the relevant part at cost, while the unintegrated final assembler must buy the part at a marked up price from a separate supplier. This phenomenon gives component makers moving into final assembly a pricing advantage -- their cost of goods sold is lower, meaning they can sell the final assembled product at a lower, more competitive price.

Acquiring at an Attractive Price

From an investing perspective, one powerful rationale for making an investment (or acquisition) is when the upside is large and the downside is small, or what investor Mohnish Pabrai calls "heads I win, tails I don't lose very much." See The Dhando Investor, by Mohnish Pabrai (John Wiley & Sons, Inc., 2007). Pabrai believes the markets often undervalue businesses with uncertain future outcomes. For this reason he looks for businesses with:

(1) high uncertainty in terms of possible future outcomes (which often creates an undervalued situation);

(2) high returns if things go well; and

(3) minimal losses if things go poorly.

Id. Pabrai especially likes businesses with low cost operating models, which is consistent with Porter's comments on generic strategies. Porter believes there are four viable generic strategies: differentiated and targeting a broad market; differentiated and targeting a niche market; low cost and targeting a broad market; and low cost and targeting a niche market. See Concepts page and discussion of Michael Porter. Competitors typically don't want to get stuck in the middle, selling an undifferentiated product that's not low cost to the middle of the market. That's because they lose business to: (1) low cost, undifferentiated competitors who can beat them on price; and (2) high end, differentiated competitors who can beat them on quality, service, and product features.

If you accept Pabrai's reasoning, it makes a lot of sense for large incumbents to acquire threatening new entrants as early as possible, before the entrant grows prohibitively expensive. Uncertainty over a new entrant's future can help keep the acquisition price down.

Acquisition Criteria

In light of the principles above, acquisitions can be evaluated in terms of the following criteria:

(1) Does the acquisition move the company into an adjacent part of the value chain that isn't yet good enough and therefore isn't yet commoditized and low margin? Do the margin benefits outweigh any damage to the company's existing business?

(2) Is the acquisition needed to defend/strengthen the company's existing link(s) in the value chain because:

(a) the entrant has a breakthrough, sustaining technical improvement/innovation (which might only require a resource acquisition followed by integration of the acquired company); or

(b) the entrant has a breakthrough, disruptive business model (which might require acquisition of the company's resources, processes, and values and operation of the company as a separate entity).

(3) Does the acquisition strengthen the company's existing link(s) in the value chain by leading to a more unique set of activities with better fit across activities? See post titled Acquisitions, Rivalry, and Strategic Trade-Offs.

(4) Can the company be acquired cheaply enough -- due to future uncertainty -- that the financial upside is large while the financial downside is small?

Western Digital

Looking at a real world example, Western Digital ("WD") seems to satisfy a lot of the criteria discussed above:

(1) WD acquired Hitachi Global Storage Technologies ("HGST") to get a better foothold in a sustaining technology, enterprise flash storage. HGST subsequently acquired sTec, another enterprise flash storage company. These moves strengthened and defended WD's existing value chain link, hard drive manufacturing/storage.

(2) HGST recently acquired Skyera, which makes all-flash arrays and accompanying software systems for enterprise storage, effectively moving into an adjacent value chain link. All-flash arrays and related software should provide WD/HGST with a higher margin business than the manufacture of hard drives and flash memory. This acquisition also seems to give WD/HGST a more unique set of activities with the possibility of good fit between Skyera's activities, assembling all-flash arrays, and WD/HGST's activities, manufacturing flash memory and hard drives.

The caveat here is that WD is now in direct competition with some of its former customers, companies like Dell and EMC. Hopefully WD has weighed the costs and benefits of this kind of competition, ultimately concluding that the benefits of higher margins and more unique, tightly integrated activities outweigh lost partnerships and component business.

Because WD/HGST makes one of the key components -- flash memory -- used in Skyera (now HGST) all-flash arrays, its cost of goods sold for all-flash arrays will probably be lower than the cost of goods sold for incumbents like Dell and EMC, giving WD/HGST an all-flash array pricing advantage and putting them in a good competitive position.

(3) WD/HGST has positioned itself as a low cost manufacturer of tiered storage for a broad market, selling low cost hard drives and flash memory to consumers and enterprises. This is one of Michael Porter's four viable generic strategies.

How Competition Teaches

There's a great blog post by Professor Bill Barnett, who teaches at Stanford University's graduate business school. In a post titled The Red Queen Barnett argues that competition teaches and "causes organizations to learn." Barnett says that over time an organization facing rivalry will outperform and out-innovate a monopolist, because an organization with strong rivals must continue improving and innovating to survive.

In this sense, rivalry should make at least a few industry competitors stronger over time (i.e., the ones that survive). This, in turn, may make it more difficult for new entrants to upend the industry with a sustaining technological improvement or disruptive low end or new market product/service. Western Digital and Seagate, for example, have engaged in years of brutal competition in the hard drive industry -- they're now the only companies left making hard drives (a very attractive duopoly). Intense competition has taught them how to survive, both through low cost business structures and through strategic acquisitions of threatening new entrants. Industry rivalry has sharpened Western Digital and Seagate's strategic knowledge and operational skills.

The caveat to Barnett's article would be that industry rivalry isn't good if a company lacks the knowledge and ability needed to adapt and survive (consistent with Porter's comments on the destructive impact of too much industry rivalry).

The author owns stock shares of Apple and Western Digital.

Surviving Competitive Attrition

There seems to be a repeating cycle in the life of successful breakthrough products. These are: Phase One: The introduction of the breakthrough product followed by a "headstart" growth period with little industry rivalry/competition (e.g., the iPhone or Apple Watch).

Phase Two: As competitors catch up with the technology contained in the breakthrough product, and try to participate in the growing market created by the breakthrough product, industry rivalry increases. Industry growth is sufficient to sustain competitors even if their products lack sustained differentiation or a low cost competitive advantage (e.g., Samsung smartphones). See Concepts page and discussion of Michael Porter.

Phase Three: As industry growth slows competitors with sustained differentiation try and grow sales by moving downmarket (through market segmentation), while companies with a low cost competitive advantage try and grow sales by moving upmarket. Companies without sustained differentiation or a low cost competitive advantage are eventually forced out of the market (e.g., Samsung). As competitors drop out rivalry decreases.

When a company introduces a new product it must make sure the product has either: (1) some element of sustained differentiation (like Apple's iOS and the Apple ecosystem); or (2) is produced through a low cost, trade-off based approach that's difficult for competitors to match. See post titled "Acquisitions, Rivalry, and Strategic Trade-Offs."

Without sustained differentation or a low cost advantage, a competitor will get squeezed out of the market during phase three. This happened to Samsung and Sony in the PC business and is currently happening to Samsung in the smartphone business. With smartphones, Samsung probably made a mistake trying to compete in the mid to high end market with an undifferentiated Android product instead of making a strong, early commitment to a low cost approach. During phase two this strategy works (when the industry is rapidly growing), but it stops working during phase three.

One downside of pursuing a low cost advantage is that many low cost approaches seem to get matched by at least a few hyper-efficient competitors. Dell originally had a low cost advantage in PC's, but this advantage has been largely matched by Lenovo, HP, Asus, and Acer, leaving these companies stuck in a price-driven modular battle that makes it difficult for them to invest in meaningful product innovation (which makes them vulnerable to technological breakthroughs by integrated companies like Apple). See posts titled "Business Models That Facilitate the Creation of New Products" and "How Outsourcing Can Destroy a Company."

Michael Porter notes that operational effectiveness ("OE") is typically matched over time, and does not constitute a unique long term strategy. For this reason, any company pursuing a low cost strategy should focus on trade-off based activities that competitors can't or won't match (regardless of OE improvements these competitors eventually make). See Concepts page and discussion of Michael Porter; post titled "Acquisitions, Rivalry, and Strategic Trade-Offs."

The author owns stock shares of Apple.

How Outsourcing Can Destroy a Company

In making outsourcing decisions, Clayton Christensen recommends that companies focus on: (1) what capabilities (resources, processes, and priorities) they need to keep in-house in order to succeed in the future; and (2) the type of work subcontracting suppliers will try to do later on. See "How Will You Measure Your Life?" and list of Christensen sources on Concepts page. Subcontractors making cheap, outsourced components don't want to stay at the low end of the market -- they want more sophisticated, profitable product work as they move upstream in search of better margins. As a low end subcontractor moves upstream and acquires new capabilities, it often displaces the company it formerly worked for. The original outsourcing company creates its own demise at the hands of a more cost efficient low end competitor (that formerly served as a subcontracting supplier).

Christensen notes that Dell outsourced its way to mediocrity by subcontracting more and more work to component suppliers like Asus. As a result Dell gradually lost its capabilities, while Asus gained new capabilities and eventually started making Asus-branded computers. Dell ended up just stamping its brand name on computers designed and made by its subcontractors, losing its ability to create innovative new products. Outsourcing: (1) retarded Dell’s ability to create compelling new products; and (2) hampered meaningful sustaining improvements to Dell’s existing products.

Consistent with Christensen's recommendations, Apple seems aware of the need to protect its future by keeping key technologies and capabilities in-house. The following quote from Steve Jobs is revealing: "One of our biggest insights [years ago] was that we didn't want to get into any business where we didn't own or control the primary technology because you'll get your head handed to you." Tim Cook has said the same thing. And Cook's expertise in supply chain management gives him the ability to create a unique supply chain where Apple avoids outsourcing too much. Apple keeps the following key technologies or capabilities in-house: industrial design, hardware and software engineering, mobile chip design and engineering, fingerprint authentication, Siri, and retail sales and service. Apple also maintains ownership or exclusive control of certain key manufacturing equipment/processes (through agreements with companies like GT Advanced, which is producing sapphire for Apple). 

Outsourcing is great for a company’s return on net assets, since it reduces the net assets denominator, but it can destroy the capabilities needed to make: (1) meaningful product improvements; and (2) innovative new products. The outsourcing company gives up control of its destiny: lacking in-house capabilities, an outsourcing final assembler is at the mercy of the supplier's ability to continue making meaningful innovations at the component level. 

If component suppliers can't continue making meaningful improvements, the outsourcing company’s business is vulnerable to more integrated companies with strong in-house capabilities. These integrated companies are better positioned to improve existing products and come up with new products. And that's exactly what’s happening right now with Apple taking more and more business from traditional PC makers. Intel and Microsoft are no longer making meaningful improvements to key PC components, leaving PC makers like HP and Dell vulnerable to integrated companies like Apple. 

Integrated companies are well-positioned to create innovative, affordable new products that disrupt overserving modular products. The conventional wisdom is that modular companies sell more affordable products. Dell, HP, and Asus sell standardized, modular PC's at very affordable prices. Outsourcing has caused a modular, price-focused "race to the bottom" in the PC market. Yet an integrated company — Apple — created the iPad. And the simpler, more affordable iPad has disrupted modular PC's, which overserve many users. 

Somewhat ironically, integrated companies may be best at creating disruptive, affordable products for new and low end markets, since outsourcing causes modular manufacturers to lose the capabilities needed to create this type of offering. When a modular, snap-together product starts to overserve, the final assembler/manufacturer lacks the capabilities needed to do anything about it. In this situation, an integrated company can swoop in and design, engineer, and manufacture an affordable alternative that isn’t overserving, and that squarely addresses the job that needs done.

And this is a big, long term problem for modular assemblers/manufacturers. At some point meaningful innovation at the outsourced component level dries up. Component suppliers start making improvements that aren’t meaningful, resulting in a final product with overserving product attributes. This leaves the modular final assembler vulnerable to integrated competitors with strong in-house capabilities. These integrated competitors are well-positioned to create affordable new products that: (1) don’t overserve; (2) squarely address a job that needs done; and (3) appeal to new and low end markets, thereby disrupting modular, overserving alternatives.

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.