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.

Sustaining Innovations Based on Different Capabilities

Clayton Christensen recently described Uber as a sustaining innovation -- rather than a new market or low end disruption -- since its service is generally better than existing taxicab options. "One More Time: What is Disruptive Innovation?", by Clayton M. Christensen, Michael Raynor, and Rory McDonald (Harvard Business Review, December, 2015). In his books Christensen counsels entrants to avoid competing with incumbents through a sustaining innovation. See Concepts page and discussion of Clayton Christensen. That's because incumbents will aggressively respond to companies that try to enter their markets with a better product. You can currently see this happening in the auto industry, with incumbent luxury car companies offering more electric vehicles to compete with entrants like Tesla.

Christensen believes Uber is an "outlier," and that its success may be due to the regulated nature of the taxi industry. "One More Time," by Clayton Christensen, et al. These regulations make it difficult for incumbent taxi companies to compete with Uber. This seems logical. I think, however, that the biggest problem facing traditional taxi companies is that they lack Uber's (1) resources (infrastructure, employees, capital access, etc.), (2) processes (manufacturing processes, logistical processes, software development processes, etc.), and (3) values (margin goals, priorities/culture, etc.), which together make up a company's capabilities.

Christensen discusses resources, processes, and values ("RPV") in The Innovator's Solution. In this book Christensen says entrants with a sustaining innovation usually lose to incumbents because incumbents have the RPV -- the capabilities -- needed to match the entrant's improvement. The Innovator’s Solution, by Clayton Christensen and Michael Raynor (Harvard Business School Publishing Corporation, 2003). He also says that incumbents normally lack the RPV needed to match a product or service that's a new market or low end disruption. Id. 

Looking at examples like the taxi industry -- and contrary to what Christensen theorizes -- incumbents may not always have the RPV/capabilities needed to match an entrant's sustaining innovation. Regional taxi companies lack the equity capital resources and the refined logistical and software processes needed to effectively compete with a global company like Uber. Uber offers a better service based on fundamentally different capabilities that are constantly refined on a massive scale. These different capabilities -- and their steady improvement -- allow Uber to effectively challenge incumbents despite the sustaining nature of Uber's service. The lesson here is that Christensen's RPV framework is relevant in both a disruption context and a sustaining innovation context.

So an entrant with a sustaining innovation can effectively compete with incumbents when the sustaining, better product/service is based on RPV/capabilities that are non-traditional relative to the pertinent industry. In this situation incumbents will be hamstrung by capabilities tailored around traditional/existing industry offerings, whether it's (1) a taxi company with employee-drivers and a cab fleet (competing with Uber's logistics/software and thousands of independent contractors driving their own cars) or (2) a hotel company with service-related employees and hotel-related infrastructure (competing with Airbnb's logistics/software and thousands of owners renting out their homes). In both these examples you have entrants -- Uber and Airbnb -- offering a different/better service and competing directly against incumbents for existing industry customers (what Christensen calls competing against consumption). Christensen would predict failure because of a vigorous and effective incumbent response, yet both Uber and Airbnb are succeeding because their RPV/capabilities are different from those of incumbents, making it difficult for incumbents to respond.

Applying these ideas to Apple, the original iPhone could be viewed as either a new market disruption (a personal computer for a new context/situation -- your hand or pocket) or a sustaining innovation relative to competing cell phone products from Nokia and Blackberry. See post titled The iPhone Conundrum and New Market Disruption. Regardless of how you class the original iPhone, it was built based on software and hardware capabilities that Nokia and Blackberry seemed to lack, which allowed it to gain a market foothold without a meaningful incumbent response.

One other point: a company that sells a mediocre service/product -- particularly a product that's become a monopoly either through market dominance and network effects or through regulatory protection -- leaves itself open to not only new market and low end disruption, but also sustaining innovations based on different capabilities. An uncompetitive industry environment leads to complacency and deteriorating products and services. 

This article has been amended since it was first posted.

The author owns stock shares of Apple.