7 Powers Read online

  This then creates a firm foundation for the seven following chapters, each devoted to one of the 7 Powers. Having worked your way through those and digested the mnemonics developed, you can then judge for yourself whether “simple,” the other side of this phrase, has been achieved. I can say this: many business people have used and are using the 7 Powers and have found it sufficiently memorable to be easily referenced day-to-day. I hope you have the same experience and that this book can assist you in building a great company.

  Appendix to Introduction: Derivation of the Fundamental Equation of Strategy

  13

  P A R T I

  STRATEGY STATICS

  C H A P T E R 1

  SCALE ECONOMIES

  SIZE MATTERS

  Netflix Cracks the Code

  This chapter begins our journey together to construct the 7 Powers. It and the six that follow will each cover one of the seven Power types. I start with Scale Economies and illustrate this Power with Netflix.

  In the spring of 2003 I took a leap by investing in a small early-stage company based in Los Gatos, California. Today you may recognize the name: Netflix. Most of my investments have been in large caps, but I made this bet on Netflix due to their impressive mail-order DVD-rental business which was successfully disintermediating Blockbuster’s brick-and-mortar business model. Blockbuster faced the unpleasant choice of losing market share or eliminating late fees, which accounted for about half of their income. The investment hypothesis was grounded in this dilemma: Blockbuster would drag their feet facing up to the painful existential imperatives that confronted them and Netflix would continue to cannibalize their customers.14

  This hypothesis was borne out by Blockbuster’s subsequent behavior and their eventual demise.

  Figure 1.1: Blockbuster and Netflix Revenue15

  As discussed in my Introduction, a strategy must meet the high hurdle of “A route to continuing Power in a significant market.” Netflix’s DVD-by-mail business made the grade, and it was their Power over Blockbuster that sealed the deal.

  But there was a long-term time fuse to this mail distribution business. Why? The physical DVD business would eventually be supplanted by digital streaming distribution. The timing was uncertain, but Moore’s Law, coupled with the meteoric advances in Internet bandwidth and capability, guaranteed this outcome. The digital future was rising over the horizon, and Netflix could see it. There’s a reason, after all, they hadn’t dubbed their company Warehouse-Flix.

  Streaming is a strategically separate business from DVDs by mail. By that I mean that the drivers of Power in each are largely orthogonal: different industry economics and different potential competitors. And streaming’s Power prospects were not that encouraging: plummeting IT costs and rapid advances of cloud services suggested diminishing barriers. Anyone, it seemed, could set up a streaming business.

  Netflix understood this but remained undaunted. First of all, they realized they had no choice but to embrace streaming; as astute strategists, they knew that if they didn’t obsolete themselves, someone else would do it to them. And they were tactically smart. Given the uncertainty inherent in this emerging field, they took their time, demurring on high-testosterone bet-the-company antics. Instead, they modestly eased into streaming in 2007, hoping to test the waters and gain the needed experience. They accompanied this with much painstaking legwork, partnering with a dizzying array of electronic hardware streaming platform makers.

  But deploying smart tactics, though complex and demanding, is not itself a strategy, and indeed any potential for Power remained opaque in those early days. For the time, Netflix could only stay alert and hope that Pasteur’s dictum would eventually bear fruit and chance would favor their prepared minds.

  For Netflix, the crucial insight didn’t snap into focus until 2011, fully four years after they started streaming. Up till then, Netflix had negotiated with content owners (film studios being the chief example) for streaming rights. But these content owners were very savvy about monetizing their properties—they sliced and diced these rights by geographical region, release date, duration of the agreement, and so on. Ted Sarandos, Netflix’s Chief Content Officer, came to believe that it was vital the company secure exclusive streaming rights to certain properties. Here now Netflix finally made a radical move: a major resource commitment to originals, starting with House of Cards in 2012.

  On the face of it, Netflix’s moves looked risky, overly ambitious. Creating originals, and thus tying up all the rights to that content, was more expensive. Further, Netflix had previously been down the road of original content with its Red Envelope Entertainment, and the results weren’t pretty. So too did it seem now that such forward integration might prove “a bridge too far.”

  But these bold, counter-intuitive moves proved game-changing. Exclusive rights and originals made content, a major component of Netflix’s cost structure, a fixed-cost item. Any potential streamer would now have to ante up the same number of dollars, regardless of how many subscribers they had. If, say, Netflix paid $100M for House of Cards and their streaming business had 30M customers, then the cost per customer was three dollars and change. In this scenario, a competitor with only one million subscribers would have to ante up $100 per subscriber. This was a radical change in industry economics, and it put to rest the specter of a value-destroying commodity rat race.16

  Scale Economies—the First of the 7 Powers

  The quality of declining unit costs with increased business size is referred to as Scale Economies. It is the first of the 7 Powers I will examine, and its conceptual lineage begins with Adam Smith’s Wealth of Nations and indeed the beginnings of Economics itself.

  Why do Scale Economies result in Power? Let’s recall the conditions for Power laid out in the Introduction. Power is a configuration that creates the potential for persistent significant differential returns, even in the face of fully committed and competent competition. To fulfill this, two components must be simultaneously present:

  A Benefit: some condition which yields material improvement in the cash flow of the Power wielder via reduced cost, enhanced pricing and/or decreased investment requirements.

  A Barrier: some obstacle which engenders in competitors an inability and/or unwillingness to engage in behaviors that might, over time, arbitrage out this benefit.

  For Scale Economies, the Benefit is straightforward: lowered costs. In the case of Netflix, their lead in subscribers translated directly in lower content costs per subscriber for originals and exclusives.

  The Barrier, however, is subtler. What prevents other firms from competing this away? The answer lies in the likely interplay of well-managed competitors. Suppose a company has a significant scale advantage in a Scale Economies business. Smaller firms would spot this advantage, and their first impulse might be to pick up market share, thus improving their relative cost position and erasing some of this disadvantage while improving their bottom line. To get there, however, they would have to offer up better value to customers, such as lower prices.

  In an established market, such tactics are visible to the leader, who would realize the threat of reducing their relative scale advantage; they would retaliate by using their superior cost position as a defensive redoubt (matching price cuts for example). After several bouts of this, a follower will come to expect such retaliation and build it into their financial models for the impact of gain-share moves. For them, such moves would inevitably destroy value, rather than create it.

  Intel’s microprocessor business that I discussed in the Introduction is a good example of how this plays out. Intel developed Scale Economies in the microprocessor business. Over a very long period, they were doggedly challenged by Advanced Micro Devices in this space. The outcome: a continuingly great business for Intel and persistent pain for AMD—at every turn Intel could fight off AMD relying on the economics rooted in its Scale Economies.

  This unattractive cost/benefit is itself the Barrier for Scale Economies. Of course
, it goes without saying: the Barrier must be thoughtfully maintained by the incumbent leader, but to bet on anything else would be foolish. So we see that Scale Economies satisfy the sufficient and necessary conditions for Power.

  Scale Economies: Benefit: Reduced Cost

  Barrier: Prohibitive Costs of Share Gains

  This situation creates a very difficult position for Netflix’s smaller-scale streaming competitors. If they offer the same deliverable as Netflix, similar amounts of content for the same price, their P&L will suffer. If they try to remediate this by offering less content or raising prices, customers will abandon their service and they will lose market share. Such a competitive cul-de-sac is the hallmark of Power.

  The 7 Powers Chart

  Scale Economies is only the first of seven Power types I will cover. To make it easier for you to track and compare them, let me now introduce the 7 Powers Chart. Chapter by chapter, as we move along, I will populate it with each additional Power type.

  As noted above, Power requires a Benefit and a Barrier.

  Figure 1.2

  I can now build up the chart by providing granularity surrounding both the Benefit and the Barrier. With regard to the Benefit, cash flow is improved by (1) enhancing value (enabling higher pricing) and/or (2) lowering cost ceteris paribus.17 With regard to the Barrier, a competitor fails to arbitrage out the Benefit because (1) they are unable to, or (2) they can, but refrain from so doing because they expect the outcome to be economically unattractive.

  Figure 1.3

  With this in hand, I can now populate the chart with our first Power type, Scale Economies:

  Figure 1.4: Scale Economies in the 7 Powers

  Here let’s define Scale Economies:

  A business in which per unit cost declines as production volume increases.

  In the Netflix example we see a feature of Scale Economies that recurs in many technology firms: a single fixed cost which declines per unit as it is prorated over higher and higher volumes.

  Beyond fixed costs, Scale Economies emerge from other sources as well. To name a few:

  Volume/area relationships. These occur when production costs are closely tied to area, while their utility is tied to volume, resulting in lower per-volume costs with increasing scale. Bulk milk tanks and warehouses would serve as examples.

  Distribution network density. As the density of a distribution network increases to accommodate more customers per area, delivery costs decline as more economical route structures can be accommodated. A new entrant competitor to UPS would face this difficulty.

  Learning economies. If learning leads to a benefit (reduced cost or improved deliverables) and is positively correlated with production levels, then a scale advantage accrues to the leader.

  Purchasing economies. A larger scale buyer can often elicit better pricing for inputs. For example, this has helped Wal-Mart.

  Value and Power

  The sole objective of a strategy is to increase the potential value of the business. The chart below shows how Netflix fared after creating Power in their streaming business.

  Netflix’s share price trajectory is instructive. First, the payoff for their successful strategy was enormous. Over the above six years, Netflix’s stock price increased six-fold compared to a doubling of the market. Second, we can observe that this outperformance was not monotonic—2010 to 2013 was a roller coaster, and later years were no walk in the park. Regarding this volatility:

  In situations of high flux, it often takes time for cash flow to reliably reflect Power, so investor expectations may move up and down.

  In our discussion of Power, I have been careful to characterize it as creating a potential for value, but this potential can only be realized when coupled with operational excellence. Netflix’s plummet in 2011 was the result of operational errors.19 Though the period proved painful, their strategy still remained valid, and their Power intact, so these missteps were not fatal.

  Figure 1.5: Netflix Stock Price vs. S&P 500 TR (8/2010 = 100%)18

  Parsing Power Intensity: Industry Economics + Competitive Position

  Before leaving this chapter and moving on to the next type of Power, I would like to add a bit more structure to the characterization of Power itself.

  Part of the tradecraft of economists consists of teasing out the essential nature of a problem by more formally modeling it. The art lies in selecting the simplifying assumptions: they must be chosen in a way that isolates the salient features of a problem, while not assuming away core characteristics.

  As I noted earlier, the Barrier in Scale Economies comes from a follower’s rational economic calculation (often learned) that, despite the attractive returns being earned by the leader, attack carries an unattractive payoff.

  A productive way to more formally calibrate the intensity of the scale leader’s Power is to assess the economic leeway they have in balancing attractive returns with appropriate retaliatory behavior to maintain share. The greater this leeway, the more attractive the longer-term equilibrium is likely to be for the leader.

  To do this, let me introduce the notion of Surplus Leader Margin (SLM). This is the profit margin the business with Power can expect to achieve if pricing is such that its competitor’s profits are zero. We derive the SLM for Netflix-like fixed cost Scale Economies in the appendix to this chapter. If the fixed cost = C, then:

  Surplus Leader Margin = [C/(Leader Sales)] * [(Leader Sales)/(Follower Sales) – 1]

  The first term of this equation20 indicates the relative significance of fixed cost in the company’s overall financials, while the second term shows the degree of scale advantage. Put another way:

  Surplus Leader Margin = [Scale Economy Intensity] * [Scale Advantage]

  Namely, the first term is tied to the economic structure of that industry (the intensity of the scale economy), a condition faced by all firms. The second term reflects the position of the leader relative to the follower. For Power to exist, both of these terms must be significantly positive. For example, even if there exists strong potential scale economies (C is large, relative to sales), the leader margin will still be zero (no Power) without any scale differential, because that second term was still zero, too.

  This parsing of Power intensity into the separate strata of industry economics and competitive position is critical for a practitioner as it applies to most types of Power. In any assessment of Power, both need to be understood independently, and both are fair game for strategy initiatives.21 Here, with their streaming business, Netflix launched a two-pronged assault. Their thrust into exclusives and originals changed the economic structure of the industry, while their early-in and thoughtful rollout gave them a scale advantage. If Netflix had accepted the existing industry economic structure as an unalterable given, then no route to Power would have been available in streaming, and their value prospects would have remained quite dim, dependent on a declining DVD rental business.

  So as we discuss each type of Power in the coming chapters, in addition to the 7 Powers Chart, I will roll up another table summarizing the nature of these two dimensions, which together govern the intensity of Power. Here is our first addition:

  Figure 1.6: Power Intensity Determinants

  Scale Economies: Summing Up

  Netflix’s streaming business is the driver of its remarkable rise to its double-digit billion market capitalization. Getting there has required the relentless pursuit of excellence in every corner of the company. Such dedication and focus is essential for creating value, but it is not sufficient. In addition, Netflix’s success could only emerge once they had crafted a route to continuing Power in significant markets—in other words, a strategy. The cornerstone of this strategy was moving to exclusives and originals which enabled them to wield their scale as a source of profound leverage. Such Scale Economies fully satisfy our definition of Power: the Benefit flowing from the reduction in content cost enabled by their vast pool of subscribers, and the Barrier resulting from the unattractive cos
t/benefit of market share onslaughts.

  Appendix 1.1: Derivation of Surplus Leader Margin for Scale Economies

  To calibrate the intensity of Power, I ask the question “What governs profitability of the company with Power (S) when prices are such that the company with no Power (W) makes no profit at all?”

  This appendix explores Scale Economies from a fixed cost. There are sources of Scale Economies other than a fixed cost but this is a common one.

  Total cost = c Q + C

  Where

  c ≡ variable cost per unit

  Q ≡ units produced

  C ≡ fixed cost (during each production period as opposed to start-up)

  ∴ Profits (π) = (P – c) Q – C

  Where P ≡ price faced by all sellers

  There are two businesses: S, the strong company, and W, the weak company

  As an indication of leader leverage, assess:

  Surplus Leader Margin: What governs S’s margins if P is set Э Wπ = 0?

  C H A P T E R 2

  NETWORK ECONOMIES

  GROUP VALUE

  BranchOut Takes on LinkedIn

  In June of 2010 Rick Marini had a problem. He needed to track down a contact at a particular company—he was certain he knew someone there but just couldn’t recall the name. To most people this would constitute a soon forgotten frustration. But Marini was not most people. He was a Harvard Business School trained serial entrepreneur with significant recruiting industry experience—he had founded both SuperFan and Tickle.com, selling the latter to Monster Worldwide for nearly $100M.