SHAREHOLDER VALUE CREATION is the outcome—not the driver—of effective business strategy, which should be aimed at profitably creating and retaining satisfied customers. But how can a business best do this? In this chapter, I will show how the actions of a firm at all levels can create value for shareholders and other stakeholders.
Drivers of Shareholder Value
Let’s start with some definitions of key terms. Market value in a publicly traded firm is best measured by total shareholder return (TSR). This is the return on a shareholder’s investment in a company, including accumulated dividend reinvestments, usually over three to five years. For example, if you had invested $1,000 in J&J stock on January 2, 2009, immediately reinvested all dividends in additional J&J shares, and liquidated your J&J stock on December 31, 2013, your initial investment would then be worth $1,810, yielding a five-year TSR of 81 percent.
What determines how and why some firms achieve higher TSRs than others? In simplest terms, TSR largely reflects a firm’s performance over time on two key metrics: revenue growth and profitability.1 Just as shareholder value maximization as a desired outcome is too broad to guide the formulation of specific winning strategies and tactics, so too are revenue growth and profitability. Therefore, we need to further deconstruct the drivers of these high-level business-performance metrics.
Let’s start with profit margins. To be more precise, we are examining a firm’s return on invested capital (ROIC) relative to its weighted average cost of capital (WACC). Think about it this way: if a company can raise capital by issuing stock or bonds or arranging a bank credit line at a net cost of 7 percent and achieve a return of 15 percent by investing those funds in the business, the profit spread creates considerable value for the owners of the firm. Firms with a consistently positive profit spread can easily attract more capital to generate even more growth.
Under such circumstances, the next logical question is, how can a firm improve its ROIC? Figure 4.1 suggests that the drivers of ROIC include actions that either increase the numerator (by improving operating margins) or decrease the denominator (by reducing the amount of investment required for a given level of business output). These measures themselves can be further deconstructed into a set of management actions that drive higher-level business results.
Figure 4.1 Drivers of shareholder value
For example, higher operating margins result from higher prices or lower costs, which can be influenced by product design, advertising, and channel management for price realization, and manufacturing and distribution efficiency for cost control.
Firms can also improve their ROIC through a variety of actions that enhance the use of capital—e.g., more efficient deployment of capital expenditures and working capital. Examples of this type of specific action include manufacturing and distribution efficiencies of all types that reduce the need for plant investments and inventories throughout the supply chain.
As for topline growth, shown in the bottom half of figure 4.1, the primary levers to increase revenue are organic growth (through innovative product development, market expansion, or marketing effectiveness) and mergers and acquisitions. The point of this decomposition exercise is to demonstrate that it is the direct result of management actions throughout the firm to improve revenue growth and profitability that ultimately drives the creation of shareholder value.
In this regard, Peter Drucker may be guilty of hyperbole by asserting that “business has two—and only two—basic functions: innovation and marketing. Marketing and innovation produce results; all the rest are costs.”2 As figure 4.1 demonstrates, every business function can and should contribute to shareholder value enhancement. Business functions can do this by improving revenue growth, which is the primary domain of marketing and innovation, or through operational and capital efficiency, which is a shared responsibility throughout the organization.
As such, every employee within an organization should clearly understand how the creation and retention of satisfied customers drives overall profits, revenue growth, and shareholder value, and how their actions contribute to this. If employees do not understand the value of their daily activities, they are probably working ineffectively, working for a company with a poorly communicated management strategy, or both.
Is it realistic to expect that every employee should understand and care about how their efforts contribute to overall corporate performance? Consider how JetBlue, a $6 billion airline, communicates the company’s strategic intent to over eighteen thousand employees. Every two weeks, all newly hired employees, including baggage handlers, gate agents, pilots, administrative personnel, and senior executives, are required to attend a two-day orientation session at the company’s corporate training facility in Orlando, Florida. The first day of this training is devoted to presentations and Q&A sessions conducted by JetBlue’s executive leadership team, starting with the CEO. They cover the history and heritage of the airline, the economics of running the company, and the core values that every employee needs to embrace. The CFO provides a candid and eye-opening explanation of the razor-thin margins that airlines run on, driving home the point that every employee needs to be on top of their game for the company as a whole to prosper.
While the customer-centric values of JetBlue are easy to translate into the expected daily behaviors of employees in customer-facing positions, the executive team also stresses the importance of employees in administrative positions. For example, as a JetBlue senior operations executive explained at a recent employee orientation session,
If you are in accounts payable and one of our inflight crewmembers gets frustrated with the difficulty of getting properly reimbursed for travel expenses, he or she may not be in the right frame [of mind] on their next flight. For those of you in administrative positions, your colleagues are your customers. So every employee of JetBlue has a role in delivering outstanding customer service.3
After these orientation sessions, senior JetBlue executives communicate directly with employees at regularly scheduled company meetings in all their international operational hubs. JetBlue’s management practice represents a significant commitment of senior executive time, but it builds business alignment around the airline’s founding corporate mission to “bring humanity back to air travel.”4 Therefore, it is no coincidence that JetBlue has ranked first in customer satisfaction for eleven straight years and has outperformed the U.S. airline industry on profit growth and TSR in 2015.5
The Relentless Pressure for Profitable Growth
To show the pivotal importance of profitable growth, consider its impact on enterprise value, a broad economic measure of the overall value of a business. In simplified terms, enterprise value (EV) represents the net capital invested in a firm, defined as the market value of all stock plus total debt, minus cash.6 In essence, EV reflects the theoretical amount of capital that would be required to acquire a company at its current market value. To illustrate, consider how EV would be calculated for the Coca-Cola Company, using the following formula:
EV = (Number of Shares × Stock Price) + Total Debt – Cash
At the end of 2013, Coca-Cola had around 4.3 billion shares outstanding, selling at $41.60 per share, yielding a market cap of $179 billion. Adding in the company’s total debt of $37 billion and subtracting the $10.4 billion in cash on its balance sheet yields an EV of approximately $205 billion.
During 2013, Coca-Cola generated approximately $8 billion in free cash flow (FCF)7 that theoretically could be extracted by shareholders and debt providers. If the company continued to operate at this level of profitability in perpetuity, the value of Coca-Cola would be $121 billion (as shown in figure 4.2), based on the formula for valuing a fixed annuity of FCF. But investors were willing to commit capital to the company at a value of $205 billion, nearly 70 percent more than Coca-Cola’s current profitability alone would warrant. The reason for this is, of course, market expectations for further growth.
Figure 4.2 Enterprise value for Coca-Cola, 2013
Enterprise value = (Number of shares (4.3) × Price/share ($41.60*)) + Total debt ($38) – Cash ($10.4)
Value of current operations = Free cash flow ($8)/WACC (6.6%*)
Value of expected future growth = EV ($206) – Value of current operations ($121)
*Figures in billions unless marked with an asterisk.
Analyzing all companies in this fashion yields a wide range of market expectations for future growth. For example, at the end of fiscal year 2013, the EV of Staples was 18 percent less than its value based on current FCF, signaling a market expectation for declines in future profitability. In the same year, Starbucks showed an EV 112 percent higher than its value based on current profitability, indicating market expectations for strong future growth.
The common denominator in each of these cases is that the market value of an enterprise is largely determined by its expected future growth. Profitable growth is not only a key determinant of shareholder value, but it also enhances the welfare of other corporate stakeholders:
• Employees Growing corporations provide upward mobility and career opportunities at all levels of an enterprise, and possibly, additional profit-sharing rewards.
• Executives Equity-based compensation packages richly reward senior executives in profitably growing corporations.
• Consumers Companies that consistently do well in the marketplace can reinvest in innovative new products and in delivering superior customer service.
• Suppliers Successful corporations provide growth opportunities for suppliers and business partners.
• Communities Growing corporations provide jobs, tax revenue, and philanthropic contributions to the communities in which they operate.
No one feels the pressure for sustaining profitable growth more than the CEO, since the consequence of falling short of market expectations is often termination. Over the past few years, approximately one-fourth of all CEO transitions have been involuntary, usually precipitated by disappointing growth or profits. Recent high-profile examples include Bob McDonald (Procter & Gamble), Don Thompson (McDonald’s), John Riccitiello (Electronic Arts), Ron Johnson (JCPenney), Tony Vernon (Kraft Foods), and Gregg Steinhafel (Target).8
How Well Have Companies Performed in Sustaining Long-Term Growth?
Given the paramount importance of growth—the sine qua non of corporate performance and CEO job security—it behooves us to ask how well companies have sustained growth over the long term. The short answer is, not very well.
The most definitive study on this question was undertaken by the Corporate Executive Board (CEB), analyzing the long-term revenue growth of approximately five hundred Fortune 100 and comparable international companies over the past half-century.9 The study defined a revenue “stall” as being a point in time when a company could no longer sustain a real annual revenue growth rate of at least 2 percent over a ten-year period. (In many cases, companies actually experienced a decade or more of declines in revenue.)10 It should be stressed that the CEB study was explicitly designed to examine long-term performance trends, not the vicissitudes of annual growth rates, which every company experiences from time to time as a result of business cycles or temporary setbacks. Stalled companies identified in the CEB study clearly manifested a serious and sustained decline in business performance, which resulted from structural shifts in business circumstances that management was unable to overcome for at least a decade.
For example, consider the business performance of BFGoodrich (BFG), the first automotive tire maker in the United States. After over a century as a leading industry player, BFG experienced a revenue stall in 1979 (figure 4.3). In the three years prior to stalling, BF Goodrich enjoyed strong growth, with revenues increasing at a compound annual growth rate (CAGR) of over 12 percent. But when Michelin introduced a new, superior product technology—radial-ply tires—BFG’s sales stalled, suffering a CAGR of –6.5 percent over the ensuing decade. BFGoodrich never recovered and ultimately sold its tire business at a distressed valuation to a private equity firm in 1989.
Figure 4.3 Stall point definition: BFGoodrich example
Definition of a revenue stall:
CAGR in real revenues ten years prior to stall > 2 percent.
CAGR in real revenues ten years after stall ≤ 6 percent.
Stall point has > 4 percent “kink” in ten-year revenue growth.
BFGoodrich’s revenue stall is the norm rather than the exception. The CEB found that 87 percent of the companies in its study hit a stall point at least once over the past half-century. Some, like Apple and 3M, were able to recover. Most others, like RCA, Motorola, and Kodak, however, continued to struggle in ensuing decades, usually ending in bankruptcy or forced sale at extremely low valuations relative to their historical peak valuation (figure 4.4).
Figure 4.4 Long-term revenue growth among Fortune/Global 100 companies, 1955–2006
Additional evidence of the difficulty of sustaining long-term growth can be found in a study that discovered the tenure of companies on the S&P 500 has declined from sixty-one years in 1958 to eighteen years in 2012. Looking forward, this suggests that fifteen years from now, 75 percent of the current S&P 500 will no longer exist, at least as stand-alone entities.11 This phenomenon is also captured by observing topple rates—the speed with which firms lose their market-share leadership positions. According to a recent study by Deloitte’s Center for the Edge, the corporate topple rate has increased by 39 percent since 1965.12 Clearly, by any measure, it has become increasingly difficult for companies to sustain long-term profitable growth and industry leadership.
The authors of the CEB study went on to characterize the reasons for stalled growth. In 87 percent of the cases, the cause could be traced to factors under management control, like management complacency, failure to maintain product innovation, premature abandonment of a viable core business, or a failed major acquisition. In only 13 percent of the cases was management believed to be the unfortunate victim of external factors outside of its control, like major regulatory reform or geopolitical asset seizure.
There is some degree of subjectivity in the CEB analysis of the root causes of stalled growth. For example, there is a fine line between management complacency and failure to continuously innovate, which in turn might explain an ill-conceived acquisition. Nonetheless, the CEB findings are sobering. Despite the importance of sustained profitable growth, less than one in six large companies in the study were able to achieve it, and most failed for reasons under management control.
Is Sustained Growth Impossible?
Of course, there is the possibility that large corporations are destined to stagnate, decline, or fail in some Darwinian form of the evolution of corporations. In this view, the CEB study simply confirms the inevitable nature of business progress. This warrants further exploration.
We’ve all been inspired by stories of brilliant entrepreneurs whose game-changing ideas conceived in humble settings—e.g., a garage (Steve Jobs), dorm room (Mark Zuckerberg), or Milanese coffee bar (Howard Schultz)—blossomed into market-leading global enterprises. A new generation of entrepreneurs is building companies that have reached $10 billion in market value in record time (Uber, Airbnb, SnapChat, Xiaomi), posing grave threats to established market leaders. These success stories suggest that the traditional bases of competitive advantage that used to protect incumbent market leaders—scale, operational experience, brand image, customer base, distribution, and financial depth—may no longer be able to withstand the onslaught of upstart entrepreneurs.
This was the theme of Malcolm Gladwell’s recent book, David and Goliath: Underdogs, Misfits and the Art of Battling Giants.13 In his retelling of the biblical tale of David and Goliath, Gladwell portrays David as a fearless, agile, and resourceful fighter who defeats the dim-witted, overconfident, and ponderous oaf, Goliath. Gladwell rebuts conventional wisdom that David was an underdog. In this mismatch—and in a surprisingly large number of other situations within business and sports—Gladwell asserts that leaders have liabilities that make them particularly vulnerable to brash upstarts.
As we have seen, history is replete with examples of profitable, market-leading corporations who were felled by smaller, nimbler competitors. For example, when AT&T—the largest company in the United States for much of the twentieth century—failed to adapt to deregulation and the emergence of wireless technologies, it was forced to sell its dwindling assets for a fraction of their historical peak value to one of its former regional divisions. The vulnerability of AT&T as a ponderous, customer-unfriendly monopoly recalls the punch line in a Lily Tomlin skit: “We don’t care. We don’t have to. We’re the phone company!”14
General Motors, which held the distinction of being the largest U.S. corporation for decades, declared bankruptcy in 2009 and lives on today in shrunken form as the beneficiary of a taxpayer bailout. The management shortcomings of GM are well documented,15 becoming fodder for business school case studies on ineffective governance, insular and shortsighted management, and corrosive labor relations.16
Or take Kodak. The firm—which enjoyed film industry dominance for over a century, peaking at 90 percent market share in film and cameras in the mid-1970s—declared bankruptcy in 2012. Kodak is a poster child for Clayton Christensen’s disruptive technology theory, which explains why large enterprises struggle to adopt innovations like, in Kodak’s case, digital imaging.17
Are these isolated examples of bad management bringing down venerable institutions? Or are market-leading corporations destined to die by the hands of disruptive upstarts or from aggressive attacks by traditional competitors? Conventional wisdom has increasingly tilted toward the latter belief: market leaders cannot sustain global competitive advantage in the long term.
Apple is a case in point. A gloomy outlook has been predicted for Apple in the post–Steve Jobs era by a Nobel Prize–winning economist (Paul Krugman18), an esteemed academic business theorist (Clayton Christensen19), a Wall Street Journal technology reporter and best-selling author (Yukari Kane20), an SAP board member writing for Der Spiegel (Stefan Schultz21), and the 71 percent of respondents in a 2013 Bloomberg global survey who believe that Apple has lost its way as an industry innovator.22 The reasoning behind arguments that the mighty must fall is not limited to Apple. This belief stems from a broader conviction that large enterprises inevitably lose their competitive advantages over time.
But this viewpoint is not just flawed; it could even be a self-fulfilling prophecy. If management truly believes that long-term above-market profitable growth is impossible, a logical response would be to harvest and protect current assets and customers for as long as possible. Such an approach only hastens the decline of incumbent market leaders. Business Goliaths can continue to prosper, but only if they maintain the same entrepreneurial spirit and adaptability that led to their success in the first place.
Let’s examine Apple.
On September 29, 2012, Apple reported record earnings, capping a remarkable three-year run during which the company increased revenues by 266 percent, profits by 406 percent, and market capitalization by 280 percent. It was implausible that Apple, already the most highly valued company in the world, could continue such a torrid growth rate forever. And indeed, Apple’s margins and growth rate began to abate over the next eighteen months. Many pundits declared this was a sign of the erosion of Apple’s competitive advantage, dooming them to average financial performance or worse in the future.
For example, one of my esteemed colleagues at the Columbia Business School shared this provocative point of view with MBA students in a schoolwide lecture:
It’s very hard to dominate big, global markets. Nobody has ever dominated electronic devices. Trust me; we’ve seen it in related industries for Sony, for Motorola, and for Nokia. They’ve had nothing like the margins of Apple, and the margins of Apple have gone down by at least a third in the last sixteen to eighteen months. You can’t dominate a big market…. Apple is going straight down the tubes!23
Why would a company that has repeatedly demonstrated extraordinary customer insight, innovation, design excellence, marketing prowess, high-quality manufacturing, and trendsetting retail practices be so assuredly headed “straight down the tubes”?
I believe there are three misleading arguments that underscore the widespread belief that Apple—or any market leader—must eventually lose its competitive advantage and above-market financial performance over time:
1. The Law of Large Numbers
2. The Law of Competition
3. The Law of Competitive Advantage
The Law of Large Numbers
This law concerns the obvious fact that, as a company grows, the incremental revenue required to maintain above-market growth becomes larger. For Apple, whose annual revenue is currently over $200 billion, the challenge is daunting.
For example, consider what would be required for Apple to grow its topline by 10 percent over the coming year. (While this is above market average, it’s only one-third of the CAGR the company has achieved over the past five years.) Growth of this magnitude in a single year is equivalent to adding the total revenue from companies like Southwest Airlines, General Mills, or U.S. Steel to Apple’s current topline.
Another way to grasp the difficulty of Apple’s challenge is to consider how much revenue its new product launches must generate to sustain strong sales growth. Apple-watchers eagerly anticipated the April 2015 launch of the Apple Watch, a product in the intriguing “wearable technology” category.24 Characteristically, Apple was not the first mover in this emerging technology (as was also the case with portable music players, smartphones, and tablets). Smart watches from Samsung, Pebble, and Sony had already been on the market for a year or more.
While Apple does not release official sales figures, industry analysts reported that Apple shipped nearly seven million smart watches in the first six months (more than the combined shipments of all other vendors over the previous five quarters).25 With strong holiday sales, Apple is believed to have closed 2015 with sales of 12 million units. Assuming an average selling price of $530, this translates into Apple Watch revenues of approximately $6.4 billion in 2015.26 While we’re being generous, let’s assume that each consumer also spends an average of $50 on apps each year for their slick, new Apple Watch, of which Apple would claim a 30 percent revenue share. That would add a paltry $180 million in additional revenue, albeit at high margins. The point here is that if Apple’s ability to continue to outgrow the market this year requires upward of $20 billion of new revenue (and even more in the years ahead), it will take far more than the hyped Apple Watch to get the job done.
Undoubtedly, it will be difficult for Apple to outgrow the market in the long term. But is it impossible? After all, 13 percent of the five hundred companies in the CEB study cited earlier accomplished this feat for fifty years or longer. Exemplars of long-term growth performance include Johnson & Johnson (130-year-old healthcare products company) and the Ball Corporation (136-year-old provider of food packaging and aerospace products), who have admirably continued to outgrow the overall economy over the past two decades (figure 4.5). While outperforming the market long-term is a notably uncommon achievement, it is far from being a mathematical impossibility.
Figure 4.5 Long-term growth stars: J&J and Ball Corporation
So where might Apple find its next growth wave, if not from their smart watch? There are several major opportunities that Apple could exploit to fuel another round of dramatic growth.
Gaming
The next generation of Apple’s iPad is reputed to have processing speeds and video refresh rates equivalent to or better than any high-end gaming console. Combined with further inroads into the television market with streaming technologies, Apple can potentially disrupt the global gaming industry, which currently generates over $90 billion in revenue.27
Home Entertainment
Walter Isaacson’s 2011biography quoted Steve Jobs as saying “I finally cracked it”—the it being a uniquely easy-to-use television. Since then, Apple-watchers have been expecting a transformative technology that would put Apple in the forefront of the more than $120 billion global market in home entertainment.
With a worldwide installed base of over 800 million iTunes customers that have credit cards on file, and a market-leading share of mobile shopping on its iOS devices, Apple is ideally suited to transform the payment-processing industry. With over $4 trillion in credit card transactions in the United States alone, the Apple Pay product built into the iPhone 6 could be a game changer for Apple. Early market reaction from consumers and retailers has been positive.
Retail Services
In the same vein, Apple has been researching a range of in-store retail applications that would enable brick-and-mortar retailers to offer personalized shopping services to customers. Building on an in-store tracking technology called iBeacon, Apple could enable retailers to provide personalized shopping recommendations and cross-sell promotions, loyalty discounts, and automated checkout, all of which would generate transaction fees for Apple.
Mobile Wellness and Health-Care Solutions
Apple is investing heavily in health-and-fitness monitoring applications, to be incorporated in all its mobile computing devices. Industry analysts have forecast that the market for individual and enterprise solutions for mobile wellness is likely to grow to more than $40 billion over the next decade,28 with Apple expected to be a major provider in its own right and in partnership with IBM.
Enterprise IT Solutions
Following its recently announced partnership with IBM, Apple is poised to significantly expand its presence in the enterprise market. Both partners have complementary objectives to sell integrated mobile business solutions in the iOS environment to IT executives. These solutions include internal management processes (accounts receivable, time-and-expense reporting) and customer-facing apps (customer relationship management, mHealth, order-to-fulfillment processes). To date, Apple’s inroads in the enterprise market has largely been confined to selling smartphones and tablets, sanctioned by IT departments, at corporate discounts. Partnering to move up the value chain to enterprise solutions gives Apple (and IBM) the opportunity to deepen enterprise penetration at attractive value-based margins.
Automotive
Perhaps most intriguingly, Apple is reportedly accelerating efforts to build an electric car, designating it internally as a “committed project” and aiming to deliver by 202029 While it’s still uncertain how aggressively Apple wants to penetrate the car market, given its past track record and the fact that global automotive industry revenues exceed $1.5 trillion per year, there is obviously considerable growth potential for Apple in this arena.
Over the past two decades, Apple has repeatedly demonstrated an ability to launch market-expanding innovations, offsetting the inevitable sales declines of aging products. Moreover, Apple has been willing to cannibalize its own sales to seek new growth, as shown with the iPhone versus the iPod, and the iPad versus the MacBook. Looking forward, Apple’s greatest growth opportunities may now lie in exploiting ecosystem services, supplementing its hardware wizardry with a wide range of solutions in entertainment, mobility, health, finance, and commerce.
Under any circumstances, the assertion that Apple cannot continue to outperform the market because of the law of large numbers is sophistry—a case of simple mathematics posing as immutable business law.
The Law of Competition
A second argument that suggests Apple and other market leaders are destined to decline falls under the rubric of the law of competition. According to this “law,” a company’s historically sky-high ROIC must inevitably revert to average levels for a number of generalizable reasons:
• The higher a company’s ROIC, the more competition it will attract.
• New competitors are attracted to attack the market leader even if their cash returns are slightly lower than the market leaders. As long as the opportunity to generate above-average returns by attacking the market leader is deemed higher than alternative uses of capital, direct competitors will flood the market.
• As more competitors enter the market, the market leader’s product differentiation will weaken, pricing pressures will mount, and ROIC for all players will inevitably decline.
• This process will continue until profit spreads (ROIC less the cost of capital) approach zero, at which point a new industry equilibrium will be established with market leaders reduced to operating at or near industry-average net returns.
This theory is elegant and underlying data appear to be supportive. For example, figure 4.6 displays the distribution of ROIC versus market cap for all publicly traded U.S. companies in 2013. Adherents of the law of competition would claim their theory is validated by the observed decline in Apple’s ROIC and market cap between 2012 and 2013. Presumably, this is a timid first step toward Apple “going down the tubes” in the wake of growing competition.
Figure 4.6 Financial performance of U.S. companies, 2013. Source: Osiris Financial Database
Many industry observers have also pointed to Apple’s loss of technological leadership in the smartphone and tablet market30 and the four-year lag since its last game-changing product (the iPad) as further evidence of its inability to maintain the competitive advantage required to sustain high margins.
The inexorability of this interpretation of the law of competition as applied to Apple and other highly profitable corporations is fundamentally flawed on two grounds.
First, this “law” applies only if the market leader stands pat, opening opportunities for competitors to catch up with or surpass the technical merits of current product offerings. If the market leader continuously adapts its strategy, renewing its bases of competitive advantage, competitors may be put in a position of perennially playing catch-up. Take Amazon, for example. If Amazon had been content to sit on and defend its market-leading e-commerce book business, it would be a declining business worth no more than $3 billion today. Instead, Amazon, currently a $100 billion company growing at more than 20 percent per year, chose to disrupt itself in the book market and dramatically expand the scale and scope of its enterprise. It put competitors on the run, rather than exposing itself to the law of competition. True, most companies struggle to maintain a perennial industry-leading pace of product innovation, but there is no immutable law preventing such an achievement. Apple’s track record over the past two decades in this regard has been extraordinary. As noted earlier, Apple faces no shortage of future growth opportunities. In 2015, Apple reversed its temporary decline in financial performance in 2013, achieving a market cap of over $700 million and an ROIC in excess of 48 percent.
Second, as applied to Apple, many critics of its current products apparently misunderstand the basis of the company’s competitive advantage. Apple has never billed itself as a first mover or laid claim to leadership on technical specifications, such as the “speeds and feeds” of its products. Rather, Apple has created competitive advantage by consistently providing a superior customer experience across an expanding array of hardware devices and consumer services. This source of competitive advantage has as much to do with Apple’s integrated software-development prowess as with its hardware wizardry. Apple’s product-design superiority is another intangible but highly significant differentiator. Lest one doubt that these sources of Apple’s competitive advantage can continue to nullify the law of competition, consider the latest consumer electronics battlefield: smart watches. More than three dozen manufacturers have rushed products to market in this space, led by Samsung, Pebble, and Sony. But as New York Times fashion writer Vanessa Friedman noted in her “On the Runway” column, reviewing Samsung’s initial smart watch entries,
Neither [smart watch model] does what the best design does, which is make you rethink all your old assumptions about the form…In fact, the watches do the opposite: they re-enforce all our old assumptions about the form, which is that you take your phone screen, make it small and stick it on your wrist. All I can think when I see them is “Beam me up, Scotty!” And where’s the joy—or the desire—in that?…Admittedly, this has entirely to do with aesthetics, not functionality or engineering. But a smart watch is an accessory, so aesthetics matters.31
Tech writers have been largely negative as well, noting the lack of useful functionality and confusing user interfaces of the current offerings.32 Given these reviews, it’s not surprising that early sales in the smart watch category have been disappointing. But after the Apple Watch’s first six months on the market, history appears to be repeating itself. Apple is expanding the size of the category and selling more than twice as many smart watches as the rest of the industry combined, once again setting a new standard for style, form factor, capability, usability, and market leadership.
Critics who bemoan Apple’s late entry in this category as proof that Apple has lost its innovative edge in the post-Jobs era should remember that Apple’s unprecedented success with the iPod, iPhone, and iPad came at least a decade after competitors pioneered products in these categories, as noted in figure 4.7.
Figure 4.7 Time between first mover and Apple’s first entry
The few times Apple has stumbled in launching a new product is when it has rushed a new product to market without taking the time to refine the user experience. Examples of this include the Newton personal digital assistant and the Rokr, Apple’s first mobile phone (in a joint venture with Motorola). More recently, and characteristically, Apple waited to launch its electronic wallet service, Apple Pay, in conjunction with the introduction of the iPhone 6 product line. In doing so, Apple took the time to learn from the earlier unsuccessful mobile wallet entries from Google, PayPal, and others to perfect its industry-leading user experience.33
The bottom line is that companies can overcome the law of competition, provided they continue to innovate with superior—if not first-to-market—product technologies.
The Law of Competitive Advantage
At the heart of the notion that large companies cannot sustain long-term profitable growth is the belief that the basis of a company’s competitive advantage inevitably erodes over time. This argument rightfully recognizes that all products and services experience a life cycle. The familiar bell-shaped curve shown in figure 4.8 traces the typical sales trajectory of a new product through early adoption, rapid growth, maturity, and eventual decline, all driven by advances in competing technologies and shifts in customer preferences.34 Joseph Schumpeter described this process as “creative destruction” over fifty years ago.35 While the underlying dynamics are still true today, Downes and Nunes have argued that product life cycles have dramatically shortened due to a number of emerging information technologies.36
Figure 4.8 Typical product life cycle
Whatever one assumes about the duration of a product lifecycle, it is undeniable that to sustain long-term market leadership, companies must consistently renew their product lineup with the next new thing in each of the categories in which they compete. This does not mean simply adding incremental improvements, which, notes Christensen, propels most companies into a no-win, feature–function arms race. Instead, successful companies must rethink their consumer value proposition and consider entirely new product concepts aimed at not only current customers but also at those poorly served by current offerings.
Herein lies the challenge. Most established market leaders are extremely reluctant to disrupt themselves and, as a result, are eventually overtaken by newcomers bringing radically different solutions to market that are better and/or cheaper than existing products.
The reason incumbents usually fail to disrupt themselves often boils down to the strong tendency of large companies to focus on their bigger, more demanding customers, who typically push for incremental improvements in current products, and on traditional competitors, who behave similarly. They tend to dismiss non-traditional entrants, whose initial product entries may be relatively crude and unsophisticated, and lack interest in nascent or underserved segments that seem to offer limited short-term revenue opportunities. Incumbents often lack internal processes and management mindsets that promote corporate entrepreneurship, and establish incentives that reinforce short-term profit-taking while dissuading risky or long-term business development. As a result, most companies wind up riding the tail end of their product life cycles to stalled growth or worse.
Is it possible to overcome these barriers to innovation, allowing a company to renew its basis of competitive advantage and sustain market leadership?
The answer is yes, provided that a company faithfully executes the three pillars of the strategy for long-term growth that I identified earlier: continuous innovation to generate an ongoing stream of meaningfully differentiated products and services valued by consumers, enabled by business alignment of all corporate capabilities, resources, incentives, and business culture and processes to support a company’s strategic intent.
Such an approach yields a succession of new product launches whose growth trajectories more than offset declining sales of aging products. This is shown in figure 4.9, where total company sales at any given time is equal to the sum of sales from each product at the respective stage of its product life cycle.
Figure 4.9 Long-term growth over successive product life cycles
This is precisely what two of the most rapidly growing large companies—Apple and Amazon—have done over the past two decades. For example, Apple has sustained rapid growth by repeatedly launching innovative and meaningfully differentiated products, sometimes at the expense of cannibalizing its older product lines (figure 4.10). Similarly, Amazon’s exceptionally strong sustained topline growth (if not profitability) has been driven by relentless scope expansion and product innovation. This also often comes from initiatives with long-term payoffs that cannibalize existing product lines (as was the case with Kindle e-books versus print books and Amazon’s new streaming music service versus CD sales).
Figure 4.10 Apple sales by product line
Summing It Up
In summary, the belief that business Goliaths will eventually lose their basis of competitive advantage and suffer declining business performance stems from an implicit assumption that large enterprises exhibit strategic inertia. It is true that if a company, whether small or large, focuses more on defending current market positions than on renewing its basis of competitive advantage with meaningfully differentiated innovative products and services, it will fail, for a number of reasons.
First, the law of large numbers will catch up with the company as its products saturate maturing markets. For example, Apple’s iPhone sales are already more reliant on repeat purchases than new-to-category customers.
Second, competitors will relentlessly attack current products with comparable (or better) features, often at lower cost, eroding margins and enterprise value. For example, Xiaomi became the top-selling smartphone in China after only three years on the market by aggressively matching iPhone functionality at half the price but has since lost ground itself to other low-cost smartphone competitors.
Third, the historical basis of a company’s competitive advantage will be weakened or possibly destroyed by emerging disruptive technologies. For example, Apple’s industry-leading music download business (iTunes) has already stalled as a result of aggressive expansion by streaming music services from Spotify, Pandora, and Amazon.37
While inevitable, product life cycle effects are not inescapable. Unlike scientific laws, which describe intrinsic, immutable characteristics of our physical world, supposed business laws like the law of large numbers can be broken by strong leaders that continuously adapt their business strategy to sustain long-term profitable growth. As I pointed out earlier in this chapter, 13 percent of large corporations have been able to sustain above-market growth for a half-century or more despite relentless external competition and internal barriers to corporate entrepreneurship. Exceptional CEOs such as Howard Schultz (Starbucks), Craig Jelinek (Costco), Fred Smith (FedEx), and Tim Cook (Apple) are able to achieve long-term profitable growth, defying the chorus of naysayers who insist that the mighty must eventually fall.
