The Innovator's Dilemma

With internet valuations back to the dizzying days of 1997, Huffington Post's sale to AOL this week for $315M actually seems reasonable. In justifying the deal to its audience, Arianna Huffington pointed to the "Innovators Dilemma" theory which states that large companies, no matter how successful, generally fail to adapt to the ever-changing business landscape and market trends. The primary reason stems from the fact that incumbents tend to focus on defensive tactics as they do not want to cannibalize existing sales by investing in areas that threaten their market position. In this case, AOL and HuffPost seek to change the face of news distribution by aggressively growing a free, open network-based media model where established players like WSJ or NYT, who are aggressively charging for access, will not.

In the internet age, its easy to see the Innovators Dilemma in play. Blockbuster filed for bankruptcy given the rise of Netflix and Redbox. Newspapers and magazines faced a quick, violent death. Bookstores and CD shops are no more thanks to e-commerce. Do you think all of these big companies failed to see the rise of the internet ? Its one thing for mom and pops to fail to adapt to the new Walmart in their locale given their limited resources, but how could Blockbuster not become the first streaming movie company? Did the handsomely paid executives miss what everyone else in the world saw ? Not at all. Their myopia handcuffed them from changing their distribution model, pricing, and cost structure. With quarterly pressure to prop up earnings, they failed to react to the bigger picture at hand. Instead of embracing change, they tried and failed to put up artificial borders around their existing business models. As they ultimately tried to cope, they were too little too late.

Long before the internet, this trend existed. American car companies almost went belly up (well 2 of the 3 did) with the Japanese invasion in the 1980s. Rather than focusing on fixing their business model, American Airlines tried to prevent Southwest from entering Dallas (but the Wright Amendment failed to stop Southwest from becoming the largest market-cap airliner). Macy's and other department stores, comfortable with their fat profit margins, failed to adapt to consumer's desire for lower priced apparel. Target was happy to oblige.

Its hard to blame the large companies from doing this. The emerging trend may not pan out. They might not execute as effectively as their competition. They are making good money, so why rock the boat? Thousands of reasons to look the other way and most of them justify it to themselves. This is why most innovation and true breakthroughs come from new players who have nothing to lose. So who's next? Cable television? PC companies like Dell ? Microsoft? Oil companies ? It's definitely an interesting question - one that will be answered by disruptive ideas and successful entrepreneurs.

What's ironic about HuffPost's argument for the deal is that AOL itself failed to adapt to the death of dial-up. It's easy to "reinvent" your business when its already in a downward spiral. I would have loved it if she was just honest and said "would you say no to $315M ?"

Goldman's Heart

It's easy and perhaps popular to deride Goldman Sachs for its role in the financial crisis, excessive employee compensation, and its overall Gordon Gecko style of arrogance. Besides peddling M&A advice and Facebook stock, however, they do some pretty noble things that most don't see. Their program, 10,000 Small Businesses, is a commendable effort that just completed its first year anniversary. It's part microfinance, part philanthropy, part business consulting; all methods that I passionately believe capitalism should be deployed to make the world a better place. Sure, there's a PR element to this that Goldman stands to gain, but for $500 million, there are better ways to attain that if that was their only endgame.

I've written about Endevour's VC- style approach and the limited microfinance efforts in the US; Goldman's 10,000 Small Businesses addresses both of these areas in a much bigger way. The goal of the program is to grow small business ($150k - $4M in revenue) into sustainable concerns with the ultimate goal of growing employee bases. They look at scalability, ability to gain from the program (ie. people with limited business background), desire to hire, and difficulty in capital raising. They're committing $200M to education and supporting community colleges and other institutions and $300M in capital through loans and grants.

Through partnerhips, they've built a whole ecosystem to do this. Entrepreneurs go through a 20 week crash MBA course designed by schools such as Wharton at their local community colleges. Grants and micro loans come primarily through non-profit local institutions. They partner with local nonprofits to provide support throughout the process. Their advisory panel, led by Warren Buffett, reads like a Who's Who in business, provides unrivaled guidance to small businesses. Goldman has built an infrastructure that leverages its national reach while customizing each effort to the local community affected. They target areas where they can make the most impact as evidenced by their recently announced $20M effort in the New Orleans area. Where else can the owner of Mel's Chicken Shack get access to capital, a Wall Street education, and local support to grow their business?

So the first year has yielded modest results. According to a recent Fortune article, they've invested in 50 businesses and educated 100 business owners, and spent $60M so far. They've kept their eligibility standards high to ensure yielding the desired results (scalable companies that grow employee bases). It will be interesting to see how the program matures and how successful these small businesses ultimately become.

I love to see capitalistic-based companies deploy their know-how into the non-profit space. Let's hope 10,000 Small Businesses is a wild success and dramatically strengthens the small business community in the US. And who knows, perhaps they may see a good opportunity to invest in a small opinion-based business blog (just need $150k more revenue to qualify).

the new new walmart

Everyone knows about the impact of Walmart on our daily lives. They've built the worlds' largest retailer by cutting out middlemen, building the smartest logistics system on the planet, and giving people what they want in a one-stop shop. They're the largest private employer in the US, and have lowered the cost of living for everyone. Certainly there have been many small businesses adversely impacted along the way, and there's probably an "atma-esque" debate on whether the net impact on society has been positive. I do have an opinion, but perhaps for another day.

For the first time, I feel the Walton clan faces a strong threat to its business model. It's not from anyone obvious; rather I see true competition from the company that I love to write about, Amazon.com. They're positioned for growth at the expense of traditional retailers like Walmart; but more importantly, they've built up their operations to take advantage of moving consumer trends while leveraging retailer best practices.

For one, e-commerce is booming. While only representing 5% of total consumer spend today, its growing at 15% per year. Walmart's only growth options is to build stores and take share away from competitors; Amazon doesn't necessarily have to do that to grow. But they are. Amazon's growth rates have been around 30%, which means they are not only taking their fair share from the Walmarts of the world, but from other ecommerce companies as well.

Walmart grew their business by increasing categories and products. Their fledgling grocery business now represents more than half of their US revenue. Similarly, Amazon continues to expand their product base every day (through acquisitions and on its own) to capture more share points. In the last couple of weeks alone, I bought diapers, high-end electronics, and air filters -- all delivered within 2 days, and all priced below every online and offline competitor i could find. Low cost, numerous offerings. Definitely the walmart way. What's even more remarkable is that they are not limited by shelf space like Walmart is; they already offer thousands of more products that Sam Walton does.

Third, and probably most important, is they've build a world class distribution system that rivals (and in some cases beats) Walmart. They've devised a clever hybrid distribution model that allows them to stock the most sold products and tightly control their third party delivered products to ensure delivery times and good in-stock ratios. Their server farms are so good that they lease space to smaller tech companies. At one point, Toys R Us and other retailers used Amazon to process and deliver their ecommerce sales (i'm not sure if they still do). They're better at brick-and-mortar style operations than most people give them credit for. This will help as they continue to scale.

Amazon has built a Walmart type back end, a front-end platform worthy of the #1 e-tailer status, world-class customer service, and prices that competitors can't match. They continue to grow fast without having to invest in traditional retail infrastructure and are taking a greater share of household purchases much like Walmart did during their growth years. And in the coming years, as ecommerce growth rates slow, don't be surprised to see Amazon.com stores in a city near you. While e-tailing is still in its infancy, there is no need to. But to me, this is a long-term growth strategy. It's easy to move into bricks and mortar when you have Amazon's infrastructure. It's more difficult to become a real e-commerce player if its not in your company DNA.

It's hard to crack into mass merchandising. I applaud Jeff Bezos for looking ahead many years out when building Amazon. He didn't want to just succeed in e-commerce; he wanted to build the next world-class retailer. Even though Amazon's $25B pales in comparison to Walmart's $400B of revenue, Mr. Bezos' company is poised to make a stronger and stronger noise in retailing, one that will eventually be heard in the tiny town of Bentonville Arkansas.

is Netflix sustainable ?

Several people have recently asked me if I thought Netflix had a viable business model. To be honest, I never thought much about that question until this month when Fortune magazine annointed Reid Hastings CEO of the year. The stock has been on a tear in 2010 – so it got me thinking, is Netfix sustainable?

Netflix is type of company I love to root for. It’s the nimble smart company that takes market share from slow incumbents despite all the odds stacked against them. Blockbuster, Walmart, and Amazon all went after the fledgling company. Coinstar’s Redbox inked deals with all of the chain stores to put their DVD kiosks in their establishments. Netflix was no match for these industry insiders and deep pockets. But they all pulled back or lost the battle to the startup (blockbuster = ch. 11). Kudos Mr. Hastings.

Now they are at it again. They are completely revamping their business model to lead the charge to real-time streaming content. 2/3 of Netflix subscribers already use streaming - a figure expected to rise rapidly. It’s a risky bet to gamble their entire DVD business, but probably a smart one. Like DVD’s in the mail, they are moving aggressively hoping to gain a critical mass of content and subscribers to give them a sustainable first mover advantage. So the question is can they beat the odds again ?

At first blush, it seems like they can. They inked deals with many of the movie and TV studios such as Disney. They cornered the hardware providers like blue-ray, smart phone, and the numerous media center offerings with “Netflix inside”. Like they did with DVDs, they no doubt have the widest array of streaming content compared to their competitors like Apple TV. Unlike the first time around however, the price to play has gone up considerably.

Netflix claims that they only need $9 / subscriber to make a profit. In a world of cheap or free content, I tend to agree. But that’s not the case anymore. They paid $1B over 5 years to MGM and other movie studios for their content. Sure they are padding their libraries with cheap second tier content online such as ABC family, but the good stuff costs a lot more now. The “28 day” delay rule is still in effect in which they can’t offer premium content from the top movie studios. HBO and the other premium providers still refuse to work with them. Bottom line, content costs are going up not down. $9 per subscriber works great in a cheap acquisition cost model but not when the big boys start charging real dollars.

It all comes down to bargaining power (remember Porter’s 5 forces?). Netflix has distribution and a growing customer base. Warner Brothers and NBC have the content that people want. Disney embraces Netflix. Warner despises them. How much is an “entourage” show or “harry potter” movie worth? That’s the million dollar question. How much can a distributor command versus the manufacturer (studios)?

How much would you pay for entertainment content? That’s the key to Netflix. In a $9/month world, Netflix wins. That means the content is more commodity priced which tips the scale to Netflix who has established strong distribution. If it’s more along the lines of your $50/month traditional cable bill, then the content guys win.

Times are different now. Back when music was free (Napster), Apple was successful in convincing all the studios to allow them to charge 99c per song in its Itunes store. They all feel robbed now – they will never get to the levels of sales as they did during the peak of compact discs. Bestselling Ebooks go for $20; not much cheaper than their hardback predecessors. The NY times and WSJ charge monthly subscription fees now to access their website. Content providers are no longer timid to charge as they once were in the net infancy days.

There are many parallels going on right now in business, particularly with this week's net neutrality ruling. How will YouTube and Pandora fare in negotiations with Comcast and AT&T? What about mobile content providers as they wrestle for airtime on Verizon and AT&T's networks (surprisingly the net neutrality compromise excluded wireless networks since that't the wave of the future)?

I'm still rooting for the boys in red. As respectful as I am of what Netflix has accomplished over the years, I think that online content distribution becomes ubiquitous over time (much like the movie houses which all filed for bankruptcy in the 90s while the studios thrived). Netflix will definitely survive; I just don’t think their $9 nut will net them as much as they think it will in the future.

The upcoming tax hike no one is talking about

There's heated debate going on right now about the compromise bill on what taxes are fair and what groups should (or should not) be subject to tax hikes if the Bush cuts are rolled back. There's another tax creeping up on us that will hit each of our pocketbooks more directly since it's tied to consumption.... the internet commerce tax. As much I hate giving more money to the government, I think its fair, especially if you take into consideration the hidden economic costs of the status quo. And get ready for it folks, its coming soon to a computer near you.

Consider this situation - Atmabus is looking to buy a Dyson vacuum for $399. It's the same price at both Best Buy and Amazon. At a 9% sales tax rate, my purchase is roughly $36 higher if i patron my local Best Buy - a no brainer for me. The way the tax rules work - internet commerce is not taxed, historically because its been difficult to establish jurisdiction. These sales have been viewed as interstate commerce; sales tax is governed by state and local authorities. Advantage: Amazon. Just today, Best Buy announced terrible earnings citing market share losses. Certainly their offline and online competitors are running faster than them; but the tax arbitrage situation has added fuel to the fire.

All things being equal, we're dissuading people from shopping at their local stores - a big economic cost to cities. It's one less sale to justify a new employee for Best Buy, and one less sale that circulates money locally (real estate, restaraunts, etc...). Also - the likes of Best Buy create more jobs than Amazon since their retail model is more labor intensive than ecommerce companies. So what is the cost ?

Amazon had sales of $25B last fiscal year (and growing), much of which had no sales tax applied to it. Assuming 90% of their sales were untaxed a 9% average sales tax rate, that would have generated $2B for state economies. Not enough to plug the CA budget hole, but not pocket change either. And this is just one ecommerce company, imagine applying this logic to all online sales.

Best Buy generated $50B last year. They employeed 180,000 full time employees. Amazon, which had half of Best Buy's revenue, employed a meager 25,000. For every dollar of revenue created by Amazon, it translated into 1/4 of the jobs than it did at Best Buy. Applying this ratio to Amazon's sales, this means 65,000 less jobs created. 65,000 less people with disposable income, paying payroll taxes, and circulating money locally. I know this is a bit of a generalization, but you get the point. Again, this is one example, imagine if you apply it more broadly.

I'm not saying that we should end ecommerce and source everything locally, but it doesn't make sense to give Amazon a competitive advantage when they clearly do not need one. Why should i have to pay $36 to my local Best Buy who employs people versus Amazon which does not ? Given the pressure on local government agencies to find new sources of revenue, they will no doubt jump at ecommerce. Many states have already done so and many are planning on it.

So as i blogged about earlier, i told everyone to take advantage of the short-lived free services the net currently affords due to its nascency. I'd now also load up on all your christmas gifts for the next several years to save another 9% that will hit in the years to come.

Endeavor - update to microfinance

A quick update to my MicroFinance in Marco Economies article -- I read an article in the WSJ this weekend that chronicled 13 year old non-profit Endeavor, which provides VC-like services to entrepreneurs in poor countries and communities. They leverage their Ivy league educations, business connections, and savvy to incubate successful businesses. They focus on building larger, scalable entities (as opposed to microfinance which focuses on the $1/day market) such as the "Latin America etrade" and a Turkish version of Cisco. They've had IPOs, and their entrepreneurs accounted for 135,000 jobs and $3.5B in sales last year (the bulk in Argentina).

Kudos to Linda Rottenberg and her team. This is a great effort that leverages capitalistic methods to complex societal problems. It also illustrates that free market philanthropy doesn't only work on the "bottom of the pyramid", but can work to build large startups and could even work in mature economies like the US.

America the Oligopoly

One of the things most concerning in the business landscape is the rise of big business and the fall of choice in America. I’m the biggest free market capitalist out there, but I don’t like the trend of the fat getting fatter and barriers to entry rising. We're inundated with chain restaurants, box retailers, and product differentiation based only on price. While conglomerates give us some advantage in terms of reach, they tend to focus on defending their market positions instead of creating value and providing customers what they want. Defense is not a great offense.

Every industry you look at is primarily dominated by one or two players. Consumer staples like diapers and razors – Kimberly Clark and P&G; Our services at home – one electric provider, 1 cable, 1 telephone, 1 gas company. Banking has become Chase or B of A. Even the next generation tech industries are now ruled by the chosen few – Oracle and Microsoft with enterprise software, Cisco with networking, Google and Facebook rule online eyeballs. America has done a great job of building scalability, consolidating industries, and homogenizing society. You can't blame Cisco for their aggressive acquisition strategy and monopolistic-like market share. But is this good for the US in the long run?

Not in my opinion. Big business creates fewer jobs than smaller companies (in aggregate), capture less of people’s talents, and reduce the workforce to merely caretakers versus innovators. I also think there is a societal cost of less worth to individuals who merely punch in and punch out. So how do we buck this trend? Not through regulation which creates artificial winners and losers (and unintended consequences). But there are ways that I see we can bring local business back.

-VCs: I gave them a hard time in an earlier post for not being innovation centers, but they have the deep pockets and smarts to level the playing field against the oligarchs. They can give new businesses scale, bring new ideas to market, and love to find “white space” opportunities that displace incumbents. Groupon (a huge payday as Google reportedly is paying $6B for them) is competing head on with NBC and Mint.com provides an alternative to high priced financial advisors.

-Keep our borders open for business: Toyota and Honda brought true value to consumers by giving quality at a better price. We should force the oligarchs to compete not only with the small businesses at home, but the big businesses abroad. Open markets force big business to remain honest and focus on consumer needs. This also opens market opportunity for small business (with the rise of the internet) in which entrepreneurs will find a niche. Four Hands has proven to be a formidable competitor against the big North Carolina boys by leveraging open markets.

-End government tax breaks: The richest companies hire the best tax firms to get them out of paying taxes. There’s a reason why Singapore is becoming a business hub – 5% corporate tax rate. Multinationals can park profits there. We need to simplify the tax code and end tax breaks. Small business is at a disadvantage in this area.

-Teach business in Schools: We need to teach students basic finance, marketing, and accounting just as we do basic science and English. Last week I heard a terrible stat – 70% of doctors ten years ago were non-employees (ie. entrepreneurs in their own private practice), now its 30%. It’s gotten so complicated to open a business now that doctors, auto repair shops, and other generally local business providers are falling to prey to becoming franchise employees. There would be no Monarch Dental or NTB if local experts were better educated in business.

-Make the patent process more accessible: I love the James Dyson story of how he tried to sell his unique designs to the large vacuum companies. They basically said no and tried to copy him. Dyson spent all of his life savings in the courts against the big guns (experienced personal bankruptcy, but eventually won). Most people don’t have the will, money or time to fight the battle that Dyson did. And let’s face it – nothing beats the suction and ball technology of a Dyson vacuum.

I like that Walmart has added more dollars to everyone's pocketbook by passing their significant cost advantages to the masses. There is certainly a place for this level of efficiency (and I'm glad walmart actually passes their cost savings to the public versus other big boys), but I don't think that should be the face of US business. Small businesses create better jobs, more choice, and a level of diversity that equals the US population. I think if small businesses get can better organized, tap into resources that create efficiencies, they will be well poised to give us the next bagless vaccum.