Larry Ellison, the CEO of Oracle, the Redwood Shores, California-based enterprise software giant, stunned Silicon Valley in 2003 by launching a hostile takeover bid for rival PeopleSoft. Many business analysts consider hostile takeovers to be a tool wielded by mature, old-world industriesa last-resort effort hardly worth contemplating in an innovative, nimble, high-growth industry such as software, in which alliances and pure competition are more the norm.
But Ellison correctly realized that the situation within his industry had fundamentally changed, that the circumstances on the software playing field were beginning to signal a dawning maturity, and that those impending events demanded a commensurate shift in Oracle's strategy. Whether Ellison can manage the shift successfully remains to be seen, but by finally nabbing PeopleSoft in December 2004, he at least has one key piece of the puzzle.
Although analysts and investors remain mixed in their verdict on Ellison's approach, if anything, Oracle should be faulted for waiting too long to shift its strategy; chinks in the company's armor began appearing several years ago as its growth slowed and disruptive attackers emerged, establishing footholds in adjacent markets.
Anticipating the need to make bold strategic shifts is one of the most pressing tasks facing CEOs and investors. And missing the appropriate window for an effective strategic shift can be dire: A generation ago, Digital Equipment Corporationthen a leader in the minicomputer businessmissed the personal computer era, fell into decline, and was acquired by Compaq in 1998. Currently, telecommunications giants such as Verizon are trying desperately to ensure they don't miss similar shifts toward new technologies such as wireless data and voice over Internet protocol (VoIP).
Managing this transition requires solving a two-part equation. First, a company must spot the early warning signals from the market that indicate it needs to shift strategies. Second, it must react appropriately to those signals. Companies that accomplish this can weather industry transitions while creating strong competitive advantages. Similarly, individuals who can discern which companies in their investment portfolios understand this and which do not can manage their assets more prudently.
Spotting the need to shift strategies
Conclusive, concrete evidence pointing to the need for a strategy shift rarely arrives early enough for the information to be acted on effectively. Why is that? Too often, the data and evidence trickling into a market reflects what has already happened or, sometimes, what occurred in the distant past. Market-share reports, for example, typically provide insight into a series of decisions reached years earlier, meaning they contribute precious little guidance into the choices being made today, decisions that will end up shaping future market-share reports.
Therefore, companies need to take action before the signs are readily apparent, when faint signals are just a glimmer in and around their market. Specifically, companies should pay close attention to three things: a looming growth gap, signs of overshooting, and the emergence of disruption in adjacent markets.
Sign 1: A looming growth gap.
At its simplest, a growth gap is a chasm between where a company is actually headed and where that company would like to go. To best visualize a growth gap, imagine you are a strategic planner in a large corporation. Take your current businesses and the new products or services you have in your development pipeline. Project the revenues and profits that you can reasonably expect to get from those businesses three, five, and ten years into the future. Now, look at your company's strategic targets. Is there a gap between the targets and the projections?
One large consumer products company that conducted this analysis was shocked by the results. Even in its most optimistic scenarios, the company had to come up with almost $1 billion in new growth to meet its ten-year strategic plan. Whenever this kind of analysis results in a chart that resembles a large bar consisting of unspecified "new-growth businesses," start thinking about a strategic shift.
The good news for the consumer products company was that its pipeline would provide adequate performance over the next three years, giving the business ample runway to begin considering alternative paths to growth.
Of course, doing this analysis is easy when you're inside a company and have full access to product plans, projections, and other forms of detailed financial information. The task is infinitely more difficult for an outsider.
Conclusive, concrete evidence pointing to the need for a strategy shift rarely arrives early enough for the information to be acted on effectively. Why is that? |
One way to begin is to see what growth rate is built into a company's stock price. To do this, look at the multiple of the current stock price attached to the company's most recent earnings (commonly called a price/earnings ratio, or P/E, and easily available at financial Web sites such as MarketWatch.com). The higher the multiple, the greater the growth rate the market attributes to the company. For instance, a high-growth company such as Google can have P/E ratios above 130, while low-growth companies such as General Motors have P/E ratios in the single digits.
With these numbers in hand, make your own assessment of whether it is reasonable to assume that the company's current product portfolio can carry it to where it needs to go. (This is especially powerful when combined with the following two signals discussed below.)
Watch carefully for changes in the rate of revenue growth as well. A decrease in the rate of growth can presage a looming growth gap. Oracle's experience provides a good example. The company's revenues grew at a compound annual rate of more than 30 percent between 1995 and 1999. Then, in 2000, its annual growth rate dipped to 15 percent. Although that rate is still relatively robust, the slowdown was a leading indicator of a shift in the marketplace. Oracle's growth dropped again to 7 percent the following year, after which sales declined for two years. Revenues in its most recently completed fiscal year, 2004, have finally returned to 2000 levels.
There are also more sophisticated ways to identify a gap between what a company has and what it needs. Chapter 1 of The Innovator's Solution: Creating and Sustaining Successful Growth, by Clayton M. Christensen and Michael E. Raynor (Harvard Business School Press, 2003), describes a methodology used by a company called HOLT Value Associates (now part of Credit Suisse First Boston) that measures the percent of a company's stock price accounted for by new growth businesses. For example, only 40 percent of General Electric's market capitalization in August 2002 came from existing businesses. (HOLT's analysis does not include in-development new products, only the expected returns as existing businesses slowly wind down over time.)
Sign 2: Overshooting is setting in.
The second indicator that a strategy shift is in order is signs that a company has overshot ever larger segments of its core business. This is often a root cause of industry change, since companies can innovate much faster than people can transition to benefit from those innovations. So companies ultimately give customers products and services whose performance is just too good (and whose price tag is too expensive) for the problems customers are trying to solve.
There are numerous signs that overshooting has occurred. Particular ones to watch for are:
- The market greeting a feature or improvement that a company worked on for years with a collective yawn.
- The company's sales force complaining to headquarters that "customers are just beating us up on price."
- The company ceding an "undesirable" market to a low-cost competitor.
- Declining prices or gross margins in a given market tier.
Such signals indicate one thing: Customers aren't valuing an industry's innovations the way they once did.
Conducting an analysis of whether a company has entered overshot terrain can be difficult because it is tough to secure definitive information showing that overshooting has set in. Typically, companies will find that the signals are mixed, so that interpretation requires management's judgment and intuition.
Given such ambiguity, the goal should always be to spot overarching trends and to look for a preponderance of evidence. Zero in on a specific market tier or group of customers to help bring the analysis into sharper focus. Finally, look at the problem from a variety of angles. Specific analyses that companies can run include:
- Analyzing market data to see if prices or margins in a given segment are trending down or whether companies are able to maintain price premiums for new products.
- Constructing substitution curves to measure the pace with which competitors with relatively cheap, simple solutions are gaining traction.
- Interviewing customers to see the dimensions along which they no longer need performance enhancements.
- Reading product reviews in industry journals to watch for indications that previously important features are growing increasingly irrelevant.
In Oracle's case, signs of overshooting had been apparent for years. Burned by the expense and difficulty of large-scale upgrades at a time when economic indicators wouldn't support those improvements, companies were growing increasingly unwilling to upgrade their software, stretching their existing products to last as long as possible. Some customers had even turned to simple, cheap solutions offered by companies such as San Francisco-based Salesforce.com.
Sign 3: Disruption taking root.
The third sign that a company might need to shift its strategy is when a business takes root with a disruptive strategy that could prove to be a future threat. Disruptive attackers often seem inoffensive at first, since they make their name by providing relatively simple, low-priced, convenient alternatives that are not good enough for the bulk of the market but are good enough for customers in the low end or entirely new markets. As those disruptive attackers grow and improve, however, they often emerge as serious competitive threats.
Once again, Oracle's recent experience provides a good example: In its case there clearly were (and are) disruptive players swirling around its market. For example, MySQL (Uppsala, Sweden) has established a base in a new market with its Linux-based database product. Although MySQL's product can't do everything that Oracle's product can, its flexibility and low price has made it very attractive for Web applications such as Web logs and financial Web sites. MySQL is still too small to have a meaningful impact on Oracle, but it has established a foothold from which it can grow to become a legitimate threat to Oracle.
Perhaps the biggest hazard in trying to spot disruptive developments is that disruptive companies that create new markets can grow for a long time before they materially affect existing companies. So looking at traditional data such as industry growth rates and market-share reports can lull incumbent companies into a false sense of complacency.
Consider the way mobile telephones disrupted the landline telephone. For about 25 years, the minutes of use for mobile calls had no impact on the minutes of use for landline calls. People made mobile calls in contexts where no landline phone was available. Today, however, customers are beginning to cut the landline cord, using their stationary phone significantly less often.
The search for disruption, therefore, has to be broadly conducted. For example, Microsoft recognized years ago that handheld devices such as the cell phone and the Palm Pilot and gaming systems such as the Sony PlayStation could eventually disrupt the personal computer. That would be devastating, Microsoft reasoned, for a company whose primary source of revenue came from selling the operating system that powers almost all personal computers.
So Microsoft set out to become a player in the handheld device market (through its Windows CE operating system) and in the gaming market (through its Xbox product). Though Microsoft has had difficulties gaining traction in both markets, identifying long-term disruptive threats and attempting to react proactively will always be in its strategic best interest.
Companies that need to pay particularly close attention to disruption are those that operate in markets where having particular skills, a degree of wealth, or access to a centralized setting limits consumption. Competitors with disruptive intentions will inevitably find a way to tackle one of those constraints, setting the framework for an entirely new market. Although it may take a while, you can predict that the company that has democratized a limited market will improve its solution to the point where it can materially affect existingand even adjacentproviders.
Reacting to the signals
This article has, up to now, primarily used the software industry to illustrate all three of the signs discussed above. The telecommunications service provider market also manifests these signs. The core business for most telecommunications providers (such as Verizon and AT&T) is in inexorable decline, portending future growth gaps. Customers are demonstrating that they would rather have convenient adaptable solutions as they switch from highly reliable landlines to somewhat less reliable but infinitely more flexible mobile solutions. And disruptive companies such as Skype, Vonage, and Clearwire are emerging in multiple markets.
Recognizing the signs is not enough. Nor is it sufficient to spot the signs and respond aggressively. AT&T, long one of the most well regarded U.S. companies, identified the need to shift strategies more than twenty years ago. As recounted in chapter 1 of The Innovator's Solution, AT&T's multiple efforts to create new growth platforms have all floundered. Similarly, Kodak identified the need to create a digital imaging platform in the late 1970s, but it took twenty years and a huge amount of investment before the company stumbled onto the right digital-imaging strategy.
Companies can chart one of three paths as they try to react to shifting signals:
1. Consolidate.
Companies can consolidate the industry by snatching up leading competitors and attempting to emerge as the dominant player in a dwindling marketplace. Citibank emerged as a banking powerhouse by following this strategy as companies used credit scoring techniques to hollow out the commercial banking industry. Ellison clearly intends for Oracle to follow this path as well.
It always is hard to grow to greatness by acquisition, but it is more prudent to play the game than to sit back and hope that the growth that existed in the past can be sustained in the future.
2. Create.
An alternative course is to begin creating new growth platforms. This is the approach Microsoft is trying as it attempts to kick-start its growth engine while the core business is still robust.
It is critically important that companies attempting to go down this path start to do so before it becomes a necessity. It is tough for new growth businesses to get very big very fast, so companies that start investing in this route only when the need is obvious oftentimes doom themselves to failure. In all likelihood, Microsoft probably started its efforts a bit too late, since it has had to spend hundreds of millions of dollars to play catch-up in established markets.
3. Acquire.
The third strategy borrows elements from the previous two strategies. It involves acquiring new growth platforms that are emerging and riding the resultant wave of growth. Johnson & Johnson's Medical Device and Diagnostics division famously did this throughout the 1990s, with several small acquisitions powering the growth of the entire division. Cisco Systems hopes its acquisition of low-cost networking provider Linksys in 2003 will prove similarly successful.
There are two components to getting this strategy right. First, companies need to make their strategic acquisition before the market recognizes the disruptive potential of the emerging growth company. Cisco had to pay only $500 million for Linksys. If it had waited until Linksys's disruptive potential was clear, the price tag would have been significantly higher.
Companies also need to ensure they avoid the temptation to integrate the new-growth platforms too tightly. Oftentimes, the very reason an acquisition looks tempting is because the company being acquired is different than the core organization in some meaningful way. Pushing for tight integration could destroy the very asset companies are seeking to obtain.
The cost of waiting
Most executives are loath to shift strategies unless they have conclusive proof that they have to. Their hesitation is understandable because changing directions and charting new trails is a daunting task. But the convincing proof executives desperately hope will confirm the necessity of a strategy change will materialize only after the industry shift has occurred and it is too late to initiate meaningful protective measures. After all, by the time the writing is on the wall, everyone else can read it, too.