7 Powers Read online

  My jumping-off point will be a brief look at Intel, one of the most important companies to come out of Silicon Valley, my home turf. Intel is an especially telling case because, as we will see, it is one of those rare instances of dramatic success mirrored by an equally dramatic failure. This uncommon intersection allows us to isolate success drivers. I will use this to define Power, the central concept of this book, as well as Strategy (the intellectual discipline) and strategy (the specific approach of a single business).

  Intel Hits the Mother Lode

  To grasp the phenomenal success of Intel, let’s first rewind nearly five decades to Silicon Valley’s inceptive moment. There, in 1968, Robert Noyce and Gordon Moore, fed up with the strictures of corporate parent Fairchild Camera and Instrument, cut ties with Fairchild Semiconductor to found Intel1 in Santa Clara, California. Intel went on to develop the first microprocessor, a seminal moment for personal computers and servers, as well as the numerous ubiquitous technologies they now sustain: the Internet, search, social media and digital entertainment. Without Intel, we would have no Google, Facebook, Netflix, Uber, Alibaba, Oracle or Microsoft. Modern society, in short, would not exist.

  To our modern ears, the very name—Intel—rings with success. Over nearly half a century, Noyce and Moore’s humble startup has ascended to become the undisputed leader in microprocessors, boasting some $50B in revenues and a market cap of around $150B—a phenomenal success by any measure.

  But how and why do successes like this take wing? The field of Strategy examines precisely that question. To define it more formally:

  Strategy: the study of the fundamental determinants of potential business value

  The objective here is both positive—to reveal the foundations of business value—and normative—to guide businesspeople in their own value-creation efforts.

  Following a line of reasoning common in Economics, Strategy can be usefully separated into two topics:

  Statics—i.e. “Being There”: what makes Intel’s microprocessor business so durably valuable?

  Dynamics—i.e. “Getting There”: what developments yielded this attractive state of affairs in the first place?

  These two form the core of the discipline of Strategy, and though interwoven, they lead to quite different, although highly complementary, lines of inquiry. As such, they will comprise the subject matter of Part I and Part II of this book.

  For now, though, let’s return to our case study of Intel. Their defining success came in microprocessors—the brains of today’s computers. But, perhaps surprisingly, Intel did not start out in that business. Their initial thrust was into computer memories, and indeed they styled themselves “The Memory Company.” The invention of microprocessors came about only as an offshoot of a development job for Busicom, a Japanese calculator company. Their motivation in taking this on was simply to generate much needed cash for their memories business. After a long gestation period, though, microprocessors gained traction, and the paths of their two businesses diverged, leading to wildly different value outcomes: $0 for memories and $150B for microprocessors.

  All of this begs the question, “Why did Intel succeed in microprocessors but fail in memories?” Both enjoyed numerous shared advantages. Intel was first mover in each market, for instance, and both were large, fast-growth semiconductor businesses, each enjoying the considerable benefits of Intel’s managerial, technical and financial prowess. Without question, then, the explanation must lie outside the bounds of all common ground shared between memories and microprocessors. So what’s the answer? Why did one succeed and the other fail?

  I am an economist, and with that comes a healthy respect for the arbitraging force of competition. Intel’s retreat and eventual exit from memories reflects this force perfectly. Intel’s great leadership, their superb business practices—none of it could offer any refuge. Yet somehow microprocessors escaped this fate—there was something different about this business. It eluded such arbitrage, enabling Intel to continue earning the very attractive returns that underlie their stock price today. It wasn’t for lack of competition, either. The competitive assault in microprocessors has, over the decades, been at least as intense as that in memories: IBM, Motorola, AMD, Zilog, National Semiconductor, ARM, NEC, TI and countless others have poured billions into this business.

  We can only assume microprocessors possessed some sort of rare characteristics which materially improved cash flow, while simultaneously inhibiting competitive arbitrage. I refer to these as Power.2

  Power: the set of conditions creating the potential for persistent differential returns

  Power is the core concept of Strategy and of this book, too. It is the Holy Grail of business—notoriously difficult to reach, but well worth your attention and study. And so it is the task of this book to detail the specific conditions that result in Power (Part I: Statics) and how to attain them (Part II: Dynamics).

  The Mantra3

  For Intel, microprocessors had Power and memories did not, and this made all the difference. Intel’s enduring triple-digit billion market cap reflects this Power applied across a large revenue stream. Such an outcome is the goal of any business and this allows me to define strategy (a company’s strategy) in the following way:

  strategy: a route to continuing Power in significant markets

  I refer to this as The Mantra, since it provides an exhaustive characterization of the requirements of a strategy.

  But despite the comprehensive nature of The Mantra, I have also considerably narrowed the definition of strategy. The term, in business, has become ubiquitous. Searching Google Scholar for articles about “strategy” yields a mind-numbing 5,150,000 hits. Over the last several decades business thinkers and corporate problem-solvers have developed an inclination to elevate nearly any problem to higher status by affixing “strategy” or “strategic,” hence “strategic suppliers,” “customer strategy,” “organizational strategy” and even “strategic planning.” There is nothing intrinsically incorrect about these uses, but my thinking cuts a different way. Decades of teaching and practice have convinced me that by adopting a heterodox, narrower view of Strategy and strategy, we gain considerable conceptual clarity and substantially enhance the usefulness of the concepts. In this instance, less is more.

  Two additional clarifications are needed to narrow our discussion of “Strategy” and “strategy.” First, though Game Theory has important intersections with Strategy—the whole notion of arbitrage, for example, can be likened to the process of players playing their best games over time—Game Theory’s definition of strategy simply refers to the set of actions available to a player and thus proves far more inclusive than my definition. Even an optimal strategy in Game Theory, such as a Nash Equilibrium, implies no assurance of value creation. Intel’s retreat and exit from memories would have appeared optimal through a Game Theory lens—but no route to Power resulted. If we hold the ultimate normative benchmark in business to be value creation, then Game Theory alone is not sufficiently constrained to provide a normative framework for Strategy.4

  Second, my definitions are distanced from the school of thought which centers on cleverness in choices—the idea that if you read Sun Tzu or hire a prestigious consulting firm, you can somehow make lemonade out of lemons. I have ignored this mindset on purpose. Businesspeople are usually smart, motivated, well-informed; with established businesses, this sort of cleverness typically figures into the perpetual to and fro of arbitrage—it’s necessary for value creation, sure, but relatively common and hardly sufficient.

  Value

  So far in this chapter I have separately defined “Strategy” and “strategy.” The first tied back to value, the second to Power.

  As an Economist it is my habit to use some light math to bring clarity to such definitions. In what follows, I establish the link between “Strategy” and “strategy” by mapping value to my definition of strategy.

  For the purposes of this book, “value” refers to absolute fun
damental shareholder value5—the ongoing enterprise value shareholders attribute to the strategically separate business of an individual firm. The best proxy for this is the net present value (NPV) of expected future free cash flow (FCF) of that activity.6

  NPV = Σ(CFi/[1+d]i)

  Where:

  CFi ≡ expected free cash flow in period i

  d ≡ discount rate

  A mathematically equivalent7 but more felicitous formula for the NPV of free cash flow is:

  NPV = M0 g s m

  Where:

  M0 ≡ current market size

  g ≡ discounted market growth factor

  s ≡ long-term market share

  m ≡ long-term differential margin (net profit margin in excess of that needed to cover the cost of capital)

  I refer to this as the Fundamental Equation of Strategy. Recall my definition of strategy:

  strategy: a route to continuing Power in significant markets

  The product of M0 and g reflect market scale over time; hence they capture the “significant markets” component of this definition. The impact of competitive arbitrage is expressed in margins and market share simultaneously, so the maintenance or increase of s market share,8 while maintaining a positive and material long-term differential margin, provides the numerical expression of Power. In other words, put another way:

  Potential Value = [Market Scale] * [Power]

  This is potential value and operational excellence is required to achieve that potential. Examining Intel through this lens, we can identify a large-scale market (M0g) for both memories and microprocessors. So what accounted for the utterly different value outcome? Under Andy Grove, operational excellence was the norm, so it was Power that made the difference: over time competitive arbitrage drove m in memories negative, whereas Power enabled Intel to maintain a high and positive m in microprocessors.9

  Upcoming Topics

  This simple math confirms my strategy definition as an exhaustive statement of value. Moreover, it’s normative as well. Fulfill the imperatives of “The Mantra” and you will create business value. Importantly, too, it is inclusive of both Statics and Dynamics.

  That said, you may not yet find my strategy definition satisfying, because it tells you nothing beyond the math of the Fundamental Equation; so far it is completely agnostic as to exactly what sorts of conditions have a high probability of fostering durable differential returns. That is the objective of the 7 Powers framework and the chapters to follow, the meat and potatoes of this book. Before I can make The Mantra operationally meaningful, I must identify and detail the specific types of Power and how they come to be.

  To conclude, let me debut some themes that will recur in the chapters to come:

  Persistence. The Fundamental Formula of Strategy specifies unchanging m—differential margins. Anyone who has done valuation work, M&A or value investing knows well that the bulk of a business’ value comes in the out years. For faster-growing companies, this reality becomes more accentuated. You won’t yield much from a few good years of positive m which then tapers off or disappears altogether. For example, let’s use a common valuation model: if a company were growing at 10% per year, the next three years would account for only about 15% of its value. Remember, we’ve reserved the term “Power” for those conditions that create durable differential returns. In other words, we are trying to discern long-term competitive equilibria, not just next year’s results. Intel’s current $150B market cap reflects not only investors’ expectations of high returns but also those which continue for a very long time. Thus persistence proves a key feature in this value focus, and such persistence requires that any theory of Strategy is a dynamic equilibrium theory—it’s all about establishing and maintaining an unassailable perch. Strategy requires you identify and develop those rare conditions which produce a value sinecure immune to competitive onslaught. Intel eventually achieved this in microprocessors but could never get there in memories.

  Briefly: a digression, but a vital one. Let me comment on the popular misperception that the stock market cares only about this quarter’s results. It is especially pertinent to our discussion of persistence, because if this assumption were true, then we could discount any talk of persistence altogether. However, over the longer term—that is, ignoring speculative perturbations—investors are aware of the 10%/15% calculation I mentioned above, and this is what drives analysts’ value models—they are attuned to their expectation of free cash-generation over the longer term. Of course, changes in current performance may result in significant recalibrations of their expectations, but this is not because they only care about the short-term; rather it is because current performance is a significant indicator of future performance and hence shapes long-term expectations. For those long-term expectations to bear out, though, persistence remains key.

  Dual Attributes. Power is as hard to achieve as it is important. As stated above, its defining feature ex post is persistent differential returns. Accordingly, we must associate it with both magnitude and duration. Benefit. The conditions created by Power must materially augment cash flow, and this is the magnitude aspect of our dual attributes. It can manifest as any combination of increased prices, reduced costs and/or lessened investment needs.

  Barrier. The Benefit must not only augment cash flow, but it must persist, too. There must be some aspect of the Power conditions which prevents existing and potential competitors, both direct and functional, from engaging in the sort of value-destroying arbitrage Intel experienced with its memory business. This is the duration aspect of Power

  As I delineate the seven types of Power in the chapters to come, I will similarly describe their unique Benefit/Barrier combination. The Benefit conditions probably won’t sound all too rare—they are met often in business. Indeed, every major cost-cutting initiative qualifies. The Barrier conditions, on the other hand, prove far rarer, a reality that merely proves the ubiquity of competitive arbitrage. As a strategist, then, my advice is, “Always look to the Barrier first.” In Intel’s case, the heart of its microprocessors strategy can be best understood not by sorting through the multiplicity of Intel’s value improvements, but by deducing why decades of capable and committed competition failed to emulate or undermine those improvements.

  Industry Economics and Competitive Position. The conditions of Power involve the interaction between the underlying industry’s economics and the specific business’ competitive position. In Part I, I will parse these two drivers for each of the seven types of Power analyzed. This adds an explicitness that is useful in understanding and applying the concepts developed, while also shedding light on the role of “industry attractiveness” in creating value potential.

  Complex Competition. Power, unlike strength, is an explicitly relative concept: it is about your strength in relation to that of a specific competitor. Good strategy involves assessing Power with respect to each competitor, which includes potential as well as existing competitors, and functional as well as direct competitors. Any such players could be the source of the arbitrage you are trying to circumvent, and any one arbitrageur is enough to drive down differential margins.10

  Single Business Focus. The protagonist of Strategy and of a strategy is each strategically separate business by itself, even if they exist within the same corporation, a common occurrence. In the case of Intel, memories and microprocessors were essentially separate businesses, posing two unique orthogonal Strategy problems. The concept of Power also takes into account this separation. The special considerations arising from the interplay of multiple businesses under a single corporate roof is the subject matter of Corporate Strategy. This is beyond the scope of the current edition of this book.11 I hope to address that in later editions, as the tools of Power Dynamics yield useful insights.

  Leadership. The notion of Power (and the impact of its lack) is what underlies Warren Buffett’s view that if you combine a poor business with a good manager, it is not the business that loses its reputation. On the
other hand, always the domain of Economists, I am a strong believer in the importance of leadership in the creation of value. Intel’s experience is again instructive. I have little doubt that the managerial acuity of Bob Noyce, Gordon Moore and Andy Grove would be remembered quite differently had they stuck with memories. True, but it is also true that their combined leadership was decisive in backing microprocessors in the first place and in a variety of choices that assured “a route to continuing Power.” These contrasting assessments of the contribution of leadership hint at the differences between Dynamics and Statics, a difference I will address explicitly in chapters to come.

  Conclusion

  My many years of advising companies and making value-driven equity bets has made it crystal clear to me that the ascent of great companies is not linear but more a step function. There are critical moments when decisions are made that inexorably shape the company’s future trajectory. To get these crux moves right, you must flexibly adapt your strategy to emerging circumstances. The goal of this book is ambitious: to enable such flexibility by making the discipline of Strategy relevant to you in those high-flux formative moments. But standing in the way is a daunting challenge: the core concepts of Strategy must be distilled into a framework that is simple but not simplistic. Only then can it serve you as such a real-time cognitive guide.

  This Introduction formally deduces definitions of Power, strategy and Strategy from the determinants of business value. This one-to-one mapping assures that major business objectives are not overlooked. This is what “not simplistic” means.12