Can Best Buy Be Fixed? Reply To @vitaliyk

A value investor by the name of Vitaliy Katsenelson, whose blog I subscribe to, just posted his ideas on How to Fix Best Buy:

Best Buy cannot have lower prices than its online competitors, and its stores lack the breadth of selection of Amazon.com, putting it at a permanent competitive cost disadvantage.

The new strategy Dunn announced a few weeks before his resignation — of closing big stores and opening a lot of smaller stores — made little sense. It was basically turning Best Buy into RadioShack Corp. It would have been great if this approach had worked for RadioShack, but it hadn’t.

Katsenelson is correct. Best Buy’s business model is cooked. It provides a service that is increasingly out of touch with how consumers of its products shop, and it does it within a cost structure that is not price competitive with the other participants in its market.

So, Katsenelson proposes a solution for Best Buy:

Best Buy’s strategy for the brave new world requires thinking that cannot be delivered by somebody who spent 28 years in the Best Buy box. It requires the strategy of an Amazon or Netflix, where management was willing to bring forward and execute a disruptive new approach that undermined its current cash-cow business. Amazon did this by bringing electronic readers to the masses. Netflix did it by streaming movies and TV shows.

The rest of Katsenelson’s proposal, while creative and worth pondering on its own from a strategic value point of view, is unimportant for the purposes of our present discussion, which is actually to highlight the role of innovation.

According to our reading of The Innovator’s Dilemma, Katsenelson is suffering from two confusions in his analysis:

  1. He is confused about the difference between sustaining and disruptive technologies
  2. He is confused about the likelihood of success in a firm disrupting its own business model

Let’s tackle each confusion separately before reaching a new conclusion.

Confusion #1 – sustaining vs. disruptive technology

In building his analysis of Best Buy’s current predicament, Katsenelson cites the examples of Amazon’s Kindle and Netflix’s digital streaming technologies as examples of “disruptive” technology.

It might be useful at this point to revisit the definition of sustaining versus disruptive technology provided to us by The Innovator’s Dilemma before proceeding:

  • sustaining, which are new technologies that improve a product or service in a way that is valuable to existing customers or markets
  • disruptive, which are new technologies that are uncompetitive along traditional performance metrics, which are unusable or undesirable to existing customers or markets but which nonetheless can eventually come to replace the traditional market over time

(A disclosure here, as well– I have not studied Amazon nor Netflix in depth, so I am making some conjectures here about margins and pricing which may be incorrect, and I realize they are central to the point I am making so it could weaken my argument slightly if I am speaking out of turn here.)

Now, judging by the definitions above, I’d say both Amazon’s Kindle and Netflix’s digital streaming service are actually sustaining technologies, not disruptive. A good clue to the truth of this might come in the fact that these technologies each were developed and implemented from within the firms in question, rather than being produced by an entrant, competitor firm.

But even if that is not the give away, sure both of these technologies improved their existing products and services (books and movie rentals, respectively) and both were appealing to existing customers. It is not my understanding that there were a bunch of people who were not buying books and not renting movies until Amazon and Netflix released their new services, at which point they jumped on board. In fact, it is my understanding that many customers who now use the Kindle or digital streaming were previously physical book readers or mail-order movie renters.

Additionally, my understanding is that these new businesses are either similar margin or better margin businesses than what came before. I understand Netflix has had issues with the cost of acquiring distribution rights to film properties but that seems a separate issue from the actual question of the cost of distribution– digital streaming seems far more cost effective than sending things through the mail. Same with e-readership; the question of acquiring separate rights for digital distribution is a different one than the cost of distribution, of which digital book distribution seems to be a far higher margin business than the one involving costs of inventorying and mailing physical copies of books.

This is another aspect of the sustaining vs. disruptive technology debate– firms on sustaining technological pathways look for higher margin business that satisfies their existing customers and provides them with improved, but similar service to what they had before. Disruptive technological pathways involve different (usually lower) cost structures and different products or services which are competitive on metrics or feature sets that were previously not an issue in the pre-existing competitive paradigm.

Best Buy was, in its heyday, an electronics and appliance retailer where customers not only shopped but transacted. Nobody wants to transact with Best Buy anymore. That truly is a disruption as now people just want to shop. Any proposal that involves Best Buy no longer being a retailer (shopping AND buying) is a proposal for disruptive innovation within Best Buy’s existing business model, and a change in cost structure that would go along with it.

Confusion #2 – the likelihood of success in self-disruption

The other thing that’s clear from reading The Innovator’s Dilemma is that responding to a disruptive threat from an entrant firm is hard enough, but successfully disrupting one’s own business model is nearly impossible.

There are myriad reasons why this is so but what it essentially boils down to is that, as Geoff Gannon says, businesses have DNA and part of their DNA is their cost structure. Asking a business to change its cost structure is like asking it to change its DNA; it’s akin to expecting a megalodon to transform itself into a tick.

Another part of a business’s DNA is its management culture and accumulated experience. Just as certain animal species seem to have integrated various memory experiences into their DNA which are expressed as subconscious, instinctive behavior that comes naturally and effortlessly to the animal, a business develops a management culture (tightly interwoven with and often times predicated on the business’s cost and incentive structures) that possesses a kind of collective memory, or instinct. Management culture is “evolutionary”– it’s highly specialized and adaptive, designed to excel in the conditions unique to that business’s industry but which may prove maladaptive in conditions dominating outside of the industry.

Expecting a company’s management to successfully adapt its culture, its DNA, to new competitive circumstances is like expecting a polar bear to hunt successfully after air dropping it into the African savannah, or a jungle on the Indian subcontinent.

Getting rid of the top executive is not enough. CEO Brian Dunn might be gone, but all his lieutenants remain. They’re like mini-Brian Dunns, the children of Brian Dunn, they might not be exact replicas but they’ve undoubtedly learned a lot and probably “grown up” believing in his authority and vision the way children have trouble question their parents. They bring all that along with them. (David Merkel discussed this phenomenon in his bond manager series where he talked about the way a corporate debt team will come to be subtlety but surely influenced by the PM, and it applies in other business organizations outside the world of corporate bond management.)

Everyone who works at Best Buy is used to succeeding (and failing) a particular way. It is unlikely they’ll find themselves succeeding in a new paradigm that’s completely foreign to them when they are failing to sustain their business in a paradigm they’re intimately familiar with and once dominated.

A third way? Dissolution, sub-disruption, liquidation?

Katsenelson’s two examples don’t shed much light on what Best Buy should do because they’re examples of successful adoption of sustaining, not disruptive technologies. Best Buy is facing disruptive competition, it is beyond the point where its business could be improved by a sustaining technology.

And self-disruption doesn’t appear to be a viable strategy because Best Buy has built-in business DNA which can not be easily mutated, if it can be changed at all.

So, what should Best Buy do?

One perfectly reasonable strategy could be dissolution (aka liquidation by change in ownership)– Best Buy could sell itself to a strategic buyer who values Best Buy more as a sum-of-parts than as its currently operating whole. The new owner could salvage and re-orient what it can and then re-sell the rest as “scrap”. Just because the Pinto explodes when it gets rear-ended doesn’t mean the metal and upholstery in the vehicle couldn’t be used elsewhere. This is an option.

Another strategy is for the company to liquidate itself– managed, slow-motion suicide. The company could cut cap-ex to zero, start winding down its inventory buying and other business activities in line with the maturation of its existing facilities leases and then close out the stores one by one (selling property, plant and equipment when possible as this process continues). The proceeds could be distributed as periodic dividends to shareholders or be distributed as a lump-sum cash payment in exchange for shares at the end of the process several years from now.

But there is a third way and it actually does involve self-disruption: Best Buy could set in motion the slow-motion suicide or not, and at the same time use some of its capital to set up a small subsidiary to either compete in the world of Amazon, or work at discovering another disruptive technology which could re-jigger the industry even more and prove a disruptive threat to Amazon. This subsidiary would have completely separate managementcompletely separate capital and a completely separate cost structure which would be appropriate to the new market it is attempting to compete in.

That’s one way Best Buy could successfully respond to innovation in its industry. But it’s most likely far too late for that.

Which is why I think it’s pretty clear Best Buy is a value trap outside a strategic buyer coming into the picture (Schulze might be a little slow to the draw, but at least he’s got the good sense to go for his revolver before his opponent six-shoots him into a shallow grave), or the current management dedicating itself to a program of self-liquidation over the next several years.

Would You Buy This Business? A Bargain In The Videogame Industry

The Nintendo investment thesis in one paragraph

At Y9020/share (June 1, 2012), you are buying a strong global entertainment franchise for Y1278T which has earned Y126B on average over the last ten years and generated Y120B in average FCF, with Y1191B in book value, Y958B in cash and investments and no debt. Global financial market pessimism coupled with hyperventilating technology futurist forecasting and a recent misstep by management that is now behind the company can be used to your advantage to buy this good business at a fair price.

The Nintendo investment thesis in several paragraphs, with links and charts

Nintendo ($NTDOY – ADR, JP:7974), the cherished childhood video game icon and global IP behemoth behind such hit game franchises and characters as Super Mario Bros., Pokemon, The Legend of Zelda and more, has stumbled recently. The company rolled out its new 3D handheld video game system, the Nintendo 3DS, around the world in the spring of 2011 at a price point that proved out of reach to many consumers.

To sale initial sales were disappointing would be an understatement– the system was a flop and with little software support from Nintendo out the gate, gamers had even less reasons to purchase this pricey new system. Realizing their mistake, the company quickly slashed the retail price of the system and offered retroactive credits and concessions to select customers who had purchased the system prior to the price drop.

With a new slate of software titles by Nintendo and premium 3rd party developers released in the 2011 Holiday season and thereafter, and the new price point, the system has finally caught momentum and software and hardware sales are both impressive. As of March 2012, worldwide sales of the Nintendo 3DS reached 17 million units and sales of related software amounted to over 45 million units. Consider this in comparison to the 151 million hardware units and 900 million software units sold over the last 7 years with the predecessor system Nintendo DS and its generations, and the 95 million hardware units and 818 million software units sold over the last 5 years with the smash hit Wii home game console (data source PDF).

Game console hardware and software sales tend to grow and then peak 3-4 years after release (software especially, as its dependent upon a hardware install base for growth, while hardware is in turn dependent on hit software releases to coax gamers to purchase the system to play their favorite games). Even with the poor initial release, the Nintendo 3DS has already outsold the wildly popular Nintendo DS over a comparable time period.

The world’s biggest game expo, E3, starts the first week of June and Nintendo will make a new announcement about their 2nd generation Wii system, currently named Wii U. Sales of the predecessor, revolutionary motion-controlled system have continued to show strength as the company has strategically discounted the system over its lifecycle to maintain sales and the hardware install base, thus driving software transactions as well, although they are slowing as any game system will after long enough after its introduction into the market.

The pessimism about the initial 3DS rollout and the uncertainty about the potential success of the new Wii U system mean that the market is not looking forward to anything good for Nintendo. The stock has been left for dead as the company trades near book value of Y1,191B with a current market cap of Y1,278B.

The fear and pessimism about this company is not just related to the hardware issues (which appear to be solved). Nintendo’s fortunes have been swept up in the whirlwind Tech Bubble 2.0, where everyone insists that all old things will be torn down and ruined and new, cloud-based (and primarily Apple owned and operated) variants will rise in their place. Analyst opinions, professional and amateur alike, have revolved around an obsession with the idea of Nintendo giving up its hardware business completely and selling itself to Apple and focusing on its software franchises. The company’s stated disinterest in following any course resembling this option has left many to conclude it is an absurd dinosaur, cluelessly waiting for the asteroid apocalypse to arrive and destroy its once powerful and profitable franchise in a massive thermonuclear explosion.

That’s what’s being imputed into the stock price, which has continued to plummet like a rock. But, the reality is quite different. Nintendo’s hardware is not being abandoned en masse by former fans. Nor is the world moving to a permanent, entrenched and exclusive model of casual gaming via cell phone apps. The value of the “casual gamer” is likely severely overblown to begin with (which, by the way, calls into question the value of Nintendo’s strategy of “games for everybody” and expansion of the gaming population, as noble as it may be and as successful as it may appear with the blockbuster sales numbers of the Wii). And Nintendo, while initially hesitant and reluctant to jump into the online transaction and gaming space, is by now doing much more than just dipping a toe in.

A few choice quotes from the latest President’s address by Nintendo head honcho Satoru Iwata are below.

On digital downloads and digital game delivery:

it is true that downloading software with 10 gigabytes of memory cannot be done in an instant today, even with broadband connections. So, compared with the situation of portable gaming devices, where comparatively compact-sized software can be downloaded, we have to ask our consumers to wait for a longer time before the download process is completed. However, consumers will be able to use the Wii U effectively by finding convenient times to download software such as when they are sleeping at night. Some consumers prefer to download digital software so that they can play with them on their system anytime without the need to exchange the games’ storage media. Some other consumers find it easier to purchase the medium at a retailer and play it as soon as they insert it into the game hardware. These consumers think it advantageous that they can exchange games with their friends. In order to offer consumers options to choose from, it is important for the company to first make the situation (where digital downloads of packaged software are offered to our consumers in addition to the existing packaged software sales) a reality, and we are ready to offer these options now.

Nintendo is taking a flexible approach, trying to allow gamers a variety of options for receiving games and game content ranging from traditional retail distribution to digital distribution, all with respect for the current limitations of average broadband connections.

On digital versus retail pricing:

we are proposing the two formats of sales mechanisms from which our consumers can make their own choices. The needs of society shall be determined by the choices to be made by the consumers. We do not hold such a premise that digitally distributed software has less value. In fact, as we have discussed this with a number of software publishers around the world, we have found that their opinions are completely divided on the topic of the price points of the digital distribution of packaged software. Some publishers believe that the digital versions should be cheaper while others insist that both versions must be set at exactly the same price. So, it is not only Nintendo’s idea. Each publisher has various ideas on this point and, among them, Nintendo is now offering both versions at the same price point (the same suggested retail price).

Again, the focus is on flexibility– not wedding the company to one model but taking a wait-and-see approach that alienates neither consumers nor distribution partners and allows the market consensus to finally guide the company to the best process over time.

On management’s responsibility for the flop:

with the financial results that we have announced, it is natural that I am being criticized. I do not feel that I have been experiencing something unreasonable. I am making efforts so that the situation can change as soon as possible.

How often do you see the president of a public company accept responsibility for a problem, and, better yet, still feel like there’s hope for a resolution?

On the lessons learned from the failed 3DS launch that will be applied to the Wii U launch:

As we look back, when we launched the Nintendo 3DS, we failed to prepare a software lineup which could satisfy our consumers in addition to other factors, and the Nintendo 3DS could not initially increase the sales as we had originally expected. This is why the company needed to carry out such a drastic markdown measure by sacrificing the profitability. As a result, and supported by a strong software lineup, the Nintendo 3DS was able to regain momentum during the year-end sales season of 2011. We laid out such a drastic measure by understanding that regaining the momentum which had been once lost, is much harder than trying to create momentum from scratch. Without it, the Nintendo 3DS could not have realized positive results at the end of last year or the current sales pace in Japan. It did hurt our financial results, but it was a necessary measure. So, how will we be able to use this lesson for the Wii U? There is always a limit to our internal resources. The company now has to develop software for the Nintendo 3DS, has to prepare for the Wii U launch and has to finalize the hardware functionalities. With these circumstances in mind, if I said that an overwhelmingly rich software lineup would be prepared from day one, it would be too much of a promise to make. On the other hand, we are making efforts so that we will be able to make several proposals even from the launch period that can eventually become evergreen titles for the Wii U. We have learned the lesson that we have to make that kind of preparation for the Wii U, or the Wii U will not gain enough momentum to expand its sales.

On the role of their 3rd party software publishing partners in the success of their systems:

It is imperative for Nintendo that our new hardware offers new proposals and potentially new play experiences so that developers will be interested in this hardware and be motivated to make attractive software. At the E3 show this June, you will be able to experience not only Nintendo’s Wii U software but also the titles being prepared by the third-party publishers. As a result, I think you will be able to notice that a number of developers are creating software (for the Wii U) even today. As for the Nintendo 3DS, there may appear to be fewer commitments from the U.S. and the European software publishers than those of their Japanese counterparts. This is due to the different timing (between Japan and overseas) when they noticed that the Nintendo 3DS would surely expand widely into their markets and, thus, the different timing when they started the actual development of the Nintendo 3DS software. You will also notice a change in this situation when a richer Nintendo 3DS software lineup in the overseas markets is announced around the time of the E3 show.

The first bold part is critical– this is one of Nintendo’s competitive advantages. The company has a purposeful policy of creating new play experiences that will provide incentive for software publishers to publish for their hardware and not others.

The second part is an explanation for why it appears that non-Japanese publishers have not been excited to produce software for the 3DS after the failed launch. They were last to see the sales momentum for the system turn in their markets so they’re behind on the development schedule as a result.

On the “gaming population expansion” philosophy:

Without making efforts to increase the number of new consumers and make video games accepted positively by society, we cannot expect a brighter future than now, so we will continue to make these efforts.

Once consumers have a notion that “this system is not for us,” we have learned that it is extremely difficult to change their perceptions later. Therefore, in promoting the Nintendo 3DS and the Wii U, we have announced that we would like “width” and “depth” to coexist. With the Nintendo DS and the Wii, the approach of “width” was well accepted by many people; however, what we did in terms of “depth” was not satisfactory for some consumers. This time, we would like consumers to be satisfied in both aspects. In order to do so, we started to work on the “depth” aspect first, and the current and existing software you can see for the Nintendo 3DS is based on that idea. In the future, the approach will evolve. By exploring the development both from width and depth standpoints, it is our intention to satisfy a wider audience with one gaming platform. Our approach for the Wii U is basically the same. By doing so continuously, we are expecting that the number of game users per household will increase and as the gaming population increases, we believe we can create a sustainable video game market.

Nintendo is not going away. It’s not a clueless dinosaur. It made some mistakes with the 3DS launch that it has learned from. The industry may have some challenges, headwinds and uncertainties as the distribution model transitions to digital over time, but none of this changes the integral value of this business drastically, which is that it is a premium provider of desired game IP on innovative 1st party hardware platforms that a growing audience of gamers enjoy using.

It might be a different story if Nintendo were in a different financial position than the one it actually occupies but the reality is as of Q4 FY2012 (Mar 2012), the company had Y958B of cash and short-term investments against TOTAL LIABILITIES of Y177B. The company has no debt. According to this link on the Nintendo IR website, at a current share price of Y9020 the company actually is selling below book (NAV) of Y9313/share.

If you’re not yet getting an idea of how cheap this company is, consider the following table:

Nintendo Trading Multiples
10yr 5yr Pre-Wii
Market cap 1277863 (millions Yen)
EV 319541 (millions Yen)
P/S 1.3 1.0 2.5
EV/EBIT 1.5 1.2 2.7
P/E 10.2 8.0 17.9

I created three periods to consider– 10 year average (full system cycle from 2003-2012), 5 year average (since the global recession started, 2007-2012) and the pre-Wii era (these are average earnings generated by the company prior to release of the hit Wii console, 2003-2006).

As you can clearly see, the company is trading for abnormally low multiples of sales, operating and net earnings. The future for Nintendo will probably be better than the pre-Wii era (it is a larger company with an even more expansive market and fan base than then) but may not be as successful as it was with the Wii. That remains to be seen.

Here is the company’s historical margins over the last 10 years:

  • Gross – 40%
  • Operating – 22%
  • Net – 13%
  • FCF – 12%

I think these margins demonstrate Nintendo is a good business with stable earnings power and strong ability to generate FCF from sales.

Relative to its average earnings power and franchise potential, the company seems to be unreasonably priced. Businesses like Nintendo do not deserve to trade below book or anywhere close to 1.5-2x sales. The stumble on the 3DS was temporary and the company is moving on. It’d be nice if the company was even cheaper, and with all the pessimism in global financial markets it might still be. But at these prices, it’s “cheap enough” for a business like this.

David Friedman’s The Machinery Of Freedom, Illustrated

 

 

David Friedman narrates an illustrated look at the world of the private property society, where law and security are provided by voluntary contract and the legal system is pluralistic with trends/incentives toward monolithic standards in areas of major social importance. The source of the material is his book, The Machinery of Freedom.

Review – The Pixar Touch

The Pixar Touch

by David A. Price, published 2008

It starts with Disney

The story of Pixar is interesting because it starts and ends with Disney, but under very different circumstances in each case. The two primary characters in the company’s founding and subsequent rise to glory, Ed Catmull and John Lasseter, were both Disney aficionados and aspiring animators from the get-go. At the time each was coming of age and establishing their careers, Disney was not only the premiere animation studio to work for, it was essentially the ONLY major animation studio to work for. But Catmull almost missed playing a pivotal role in the development of computer-animation when he decided, in high school, that he was not artistically cut out to be an animator. Lasseter, by contrast, found his high school experience to be an affirming one and it was during this period of his life that he knew for sure that an animator was what he wanted to become.

The two luminaries: Ed Catmull and John Lasseter

Though they had similar aspirations (with Catmull’s muted initially), Catmull and Lasseter took quite different paths to their eventual rendezvous at LucasFilm where they would come to create a Pixar Animation-in-the-womb.

Catmull went from the computer science department at the University of Utah, which was not only the scene of huge amounts of R&D spending by the Department of Defense’s ARPA project, but was also the unwitting locus of a number of individuals who would come to be highly influential innovators in the space of computer graphic design. It was here at the university where Catmull had a second awakening and decided that while he may not have a future as a traditional animator, he might become one yet by pioneering animation in the computer-generated space.

He eventually was scooped up by an “eccentric millionaire”, Alexander Schure, who drafted Catmull as well as a number of his computer science comrades from the University of Utah computer science department to come to his mansion-turned-technical institute (the nascent New York Institute of Technology on Long Island) and essentially tinker away at computer graphic design on his dollar. Catmull and company obligingly did so until personal and family pressures drove him to seek other employment, eventually finding his way to George Lucas’s design outfit in northern California where he and a number of other defectors worked on various technology-related odd jobs for Lucas’s studio.

Meanwhile, John Lasseter graduated from high school and went into the animation program at CalArts, an art school that was partially meant to be a recruiting ground for future Disney animation talent. He was subsequently hired into Disney’s animation studios only to be later fired in a political scuffle. He, too, wound up at Lucasfilm, where he teamed up with Catmull and the other NYIT veterans to develop the proprietary Pixar Image Computer. On the side, the ambitious would-be animators continued teaching themselves the craft of computer-generated animation, a technology they were largely innovating into existence on their own. Each year they attended the SIGGRAPH convention and showed off their latest minutes-long computer-animated film clips to an awe-struck and excited audience.

Even early on, Lasseter was showing a knack for story-telling beyond his years and experience.

Exit Lucasfilm, enter Steve Jobs

Having tired of losing money on the Pixar Image Computer and the Pixar company itself for long enough, Lucas looked for a buyer at an asking price of $15M plus an additional $15M to capitalize the spun-off business. Initially, there were no takers. At one point, an executive at Disney considered purchasing the entire company at $15M to subsume it into Disney’s animation facilities, but a young Jeffrey Katzenberg felt pursuing it was a waste of time.

Another series of failed deals followed (including one in which GM almost acquired the company before board member Ross Perot shot the idea down) when Steve Jobs’s offer of $5M for the company was finally accepted.

For the next several years, Jobs stuck $5M at a time into Pixar to keep in afloat, but he, too, had trouble finding anything to do with it. Initially imagined as a hardware design company, everyone ended up being frustrated as Catmull, Lasseter and their team were truly animators at heart (and certainly not businessmen) and Jobs was impatient and still reeling from the ego-blow of being booted out of his own company at Apple. He was looking for vengeance.

Jobs almost abandoned Pixar but at the last minute he decided to hold on to the company, realizing what he controlled was an outstanding group of talented individuals, not a failing hardware business. Soon after, Pixar inked its first deal with Disney animation (under Katzenberg, who had come to see the error of his earlier ways) to create what would become the smash, breakout computer-animation genre hit, Toy Story.

Jobs, always the savvy financier just as much as he was an outstanding technologist and businessman, took the company public on November 29, 1995, one week after the premiere of Toy Story. Still hot off the success of the film, Jobs brilliantly managed to hype the IPO by placing it so close to the release of their first major film even though he was technically supposed to be observing an SEC-enforced quiet period leading up to the IPO event. Jobs 80% stake in the company was valued at around $1.1B.

The story ends with Disney

Just over a decade after going public, Disney, the long-time partner of Pixar (and the long-time dependent, as Pixar’s computer-animated films essentially had become Disney animation, not the mention a substantial part of Disney’s total film and company-wide earnings) announced its offer to acquire Pixar on January 24, 2006, for 287.5M shares of Disney valued at about $7.4B.

Pixar’s fortunes, and the fortunes of its two central figures, Catmull and Lasseter, had now come full circle. What started with inspiration, dreams and ambitions based on the world of Disney had ended as a massive payoff from that very same studio. And along the way, these gentlemen and their co-creators not only revolutionized the world of animation, they created and popularized a genre, all while maintaining a nearly uninterrupted stream of critically-acclaimed, highly profitable film franchise hits.

The moral of the story

The Pixar story carries with it many morals: Always have the courage to follow your dreams; Don’t let the absence of something stand as proof of its impossibility; A lot of life’s magic and human progress is due to lucky happenstance.

But the most enduring lesson of all from the Pixar story is most likely the fact that greatness is hard to forecast, and the future is always full of uncertainty. Before Pixar was sold to Disney for $7.4B in stock, it was first nearly kicked to the curb by Lucasfilm for a song ($5M on the original asking price of $15M) and thought to be hopeless. And this was the view of it from a highly successful film studio whose chief architect was a successful technological innovator himself! From there, the group went on to suck millions of dollars out of Steve Jobs nearly to the point of exasperation before it finally had its first major breakthrough. How many failed deals came and went before Pixar turned out to be a multi-billion dollar enterprise?

Would the Pixar we know today even have existed if no one had ever thought to drop the frustrating hardware side of the business and let these technological entrepreneurs follow their true passion in story-telling and computer-animation?

The world could always be a different place than it is. It’s easy to see how obvious everything looks when you’re at the end of the story and not the beginning.

What kind of value would you have put on Pixar in the early 1980s?

Review – The Innovator’s Dilemma

The Innovator’s Dilemma: The Revolutionary Book That Will Change the Way You Do Business

by Clayton M. Christensen, published 1997

Technological innovation always means change, but which kind?

In the world of business technology, innovation can be thought of as coming in two distinct flavors:

  • sustaining, which are new technologies that improve a product or service in a way that is valuable to existing customers or markets
  • disruptive, which are new technologies that are uncompetitive along traditional performance metrics, which are unusable or undesirable to existing customers or markets but which nonetheless can eventually come to replace the traditional market over time

Throughout history, it is the best-in-class businesses which have the most difficult time with disruptive technologies to the point that disruptive technologies are usually the death knell for the leading businesses at the time. But this raises a question: if they’re such good businesses and they’re so well-managed, how come they can’t manage their way around disruptive technology in their industry?

The answer lies at the heart of what the author refers to as the “innovator’s dilemma”:

the logical, competent decisions of management that are critical to the success of their companies are also the reasons why they lose their positions of leadership

Why do good management teams and competent decision-making processes miss disruptive technologies? Disruptive technologies:

  1. are normally simpler and cheaper, promising lower margins, not greater profits
  2. typically are first commercialized in emerging or insignificant markets
  3. are usually unwanted and unusable to leading firms’ most profitable customers

But good management teams with excellent decision-making processes are fine-tuned to search out:

  1. higher margin opportunities at best, and opportunities with minimum margin requirements based upon their existing cost structure
  2. opportunities that market research and querying of leading customers show there is a present demand for
  3. markets and growth opportunities which can have a significant impact on their business relative to their current scale

In short, every successful firm has a unique “value network” DNA that allows them to be especially dominant within a certain set of competitive circumstances.

the value network — the context within which a firm identifies and responds to customers’ needs, solves problems, procures inputs, reacts to competitors, and strives for profit

But disruptive technologies present a paradigm shift of a market into a completely different “value network” that the firm has not been evolved to survive in which results in, similar to biology, an extinction event for firms with the wrong type of value network DNA.

Crafting a response to disruptive technology

But the reality of disruptive technology is not entirely depressing for successful firms, and they can develop successful strategies for coping with disruptive technologies if they first make themselves aware of the five principles of disruptive innovation:

  1. Companies depend on customers and investors for resources
  2. Small markets don’t solve the growth needs of large companies
  3. Markets that don’t exist can’t be analyzed
  4. An organizations capabilities define its disabilities
  5. Technology supply may not equal market demand

Each of these principles holds within it a potential misstep for successful firms within their traditional value networks trying to respond to a disruptive technology. Because firms depend on their customers (primarily their leading, most profitable customers) and investors for their resources, they are often incentivized to ignore the low margin disruptive technology because their customers initially don’t want it. And because disruptive technologies start in emerging or insignificant markets, successful firms often ignore them in favor of better growth opportunities. Meanwhile, firms that DO try to take disruptive technologies seriously often commit themselves to particular investment and marketing patterns based off of market research for a market that is dynamic and prone to sudden and rapid change. At the same time, that which makes a company excellent at doing A simultaneously makes the company horrible at doing B (where B is the opposite of A), and often disruptive technologies require B responses when successful firms are honed to operate at A. The final frustration for these successful firms occurs when they attempt to enter a disruptive market with a solution that technologically exceeds the needs of its current users, causing them to withdraw in defeat only to watch the market then take off anyway!

An ironic twist

As hinted at above, it is ironic that the very strengths of leading firms in adapting their business to sustaining technologies (improvements in performance in relevant metrics that their best customers demand) are the exact things that cause them to fail to respond to disruptive technologies in a profitable, dominant way. And to make a bad story worse, it is these strengths-as-weaknesses that allow entrants in disruptive technological markets to capture important first-mover advantages for themselves, constructing barriers to entry which are later often insurmountable for established firms.

To a dominant firm, disruptive technology looks like low-margin, small market business that neither their customers nor anyone else seems to be interested in. But for entrants in the disruptive market, with radically different cost structures than dominant firms and with organizational sizes and resources better matched to the opportunities presented, disruptive markets are a wild playground full of unchallenged opportunity.

And while the dominant firms look down at lower-margin, smaller market business and shake their heads dismissively, entrant firms look up above at higher-margin, huge market opportunity and lick their chops. Every business ultimately looks upstream for higher-margin opportunities than the ones they have at present.

Is it any wonder why dominant firms are continually defeated by surprise attacks from below?

How dominant firms can successfully respond to disruptive technology

The position of the dominant firm in the face of disruptive emerging technology is not hopeless. For every yin, there is a yang. By inverting the five principles of disruptive innovation outlined earlier, dominant firms can find five guidelines for successfully responding to disruptive technology:

  1. Give responsibility for disruptive technologies to organizations whose customers need them
  2. Match the size of the organization to the size of the market
  3. Discover new and emerging markets through a flexible commitment to “plans for learning” rather than plans for implementation
  4. Create organizational capabilities and strengths which are complementary to the unique demands of the disruptive market place
  5. Resist the temptation to approach the disruptive technology with the goal of turning it into something existing customers can use, rather than serving the customers unique to the market and searching out new markets entirely

Conclusion

This book was published 15 years ago. The subtitle is, “The revolutionary book that will change the way you do business.” I don’t know if 15 years is long enough in the business world for the ideas of a book like this to be fully adapted into the mainstream but I would guess it is not. I am no business expert but this material was completely uncharted territory for me.

Frankly, I never thought I’d enjoy reading something written by a Harvard business school professor as much as I did with this book. Whereas case studies, quirky charts and statistical evidence usually bore me to the point that I often skip over them, this book was something of a page-turner for me and I found myself eager to find out “what happens next” in each subsequent chapter.

As faddish as it has become as of late to hype the increasingly rapid change of markets and business practices in general, the reality is that most markets don’t change that quickly and most business practices are timeless themselves. But for those unlucky enough to find themselves, suddenly or otherwise, in a market or business that is changing due to disruptive technology, this book could be a lifesaver at a minimum and a handbook for profiting immensely from that change at best.

You can get the essential points of the book entirely from reading my review, or skim-reading the introduction and final chapters of the book (which present a comprehensive summary of the ideas outlined above). But the case studies are invaluable in driving the point home and there are numerous nuances to Christensen’s argument that are worth savoring and considering on their own. Because of this, I unequivocally recommend that every interested reader purchase their own copy and read it in full, and thereby grant themselves an invaluable competitive advantage in the market place, whichever value network they might happen to be competing within.