What makes modern business different? Simply put, speed plus disruption. Wave after wave of next-generation technology is continually transforming the landscape of business, both inside the tech sector, where the new offers are germinated, and everywhere else outside it, where they are largely consumed. This results in two imperatives for any established enterprise. In markets where you want to be the disruptor, where you want to play offense, you must catch the next wave. At the same time, in those markets where your current franchise is the incumbent and is itself under a disruptive attack, you have to play defense in order to prevent the next wave from catching you.
Either way, you are about to experience a crisis of prioritization, one that has stumped all but the very best of our top companies.
If you are in high tech, or for that matter in any other sector characterized by recurrent disruption, you can’t sit still. You simply have to be a growth company. If your enterprise is not in a growth category, if all you are doing is optimizing your current market positions, you are a sitting duck. Operationally, that means that at any given point in time you must find a way to participate meaningfully in one or more emerging high-growth categories. You need to find a rising tide to float your boat. You need to catch the next wave to propel you forward.
Rapid category growth is directly linked to disruptive innovation because it only occurs at the front end of a new adoption life cycle. That is, when an emerging technology reaches its tipping point, when it goes inside the tornado—be that in digital marketing, electric cars, cloud computing, or the like—the market, heretofore having been playing a wait-and-see game, now rushes to take it up. This results in a massive wave of net new spending, initiating a secular expansion with growth rates typically well north of 20 percent for a period of typically five to seven years. Such secular shifts in spending are one-time affairs. That means you either catch these waves when they crest or wait around for the next one.
To be sure, growth does not stop once the secular surge subsides, but it does moderate. From here on out for the life of the category, growth will be a function of cyclical, not secular, forces—tracking primarily to overall growth in the GDP, modulated by new product introductions and expansion into new market segments. As the category continues to mature, ecosystems will consolidate around the market leaders that will in turn get the lion’s share of future returns. Thus, category power gets converted into company power. This is how Fortune 500 franchises are made.
All these dynamics are captured in stock price and market valuation. During the secular growth phase, investors price up the stocks of first movers dramatically, often to ten times next year’s projected revenues or more. They see the rising tide that floats all boats, and they know that the companies that catch this new wave will substantially outperform those that don’t. By contrast, once the category transitions into cyclical growth, valuations will moderate to around one to two times the current revenue, the focus shifting to price-to-earnings ratio instead, a metric that better reflects competitive advantage in a mature category. In this context, valuations for all the companies in the sector become less volatile and begin to oscillate around a mean. As a result, even the best-performing enterprises in mature categories struggle mightily to budge their market caps—not because their deeds are not admirable, but because they have been anticipated and already priced into their stock. Investors who see no reason to expect either risks or returns to be substantially different in the future see no basis for bidding up or down the value of the equity.
What does change stock price dramatically, on the other hand, is entry into an emerging growth category at a meaningful scale. When a company’s participation in such a category exceeds, say, 10 percent of its total enterprise revenue, and moreover is on a growth trajectory to reach 15 to 20 percent in the foreseeable future, then investors take out a fresh sheet of paper to evaluate the potential returns from this new earnings engine. At minimum they will add these returns to their established models, but more often, particularly if the synergies look compelling, they will also top things off with an additional price premium.
Consider some examples from the technology sector, the epicenter of category disruptions. At the time of this writing, over the past ten years the Nasdaq has increased 148% in value. During this time the valuation of Oracle increased 229%, EMC 92%, Microsoft 88%, SAP 70%, Cisco 53%, and HP 42%, while IBM’s valuation dropped 39%. This is the kind of oscillation around the mean we see in the valuation of established enterprises in mature categories, even when many delivered superior earnings throughout this period. By contrast, in that same period, Apple’s valuation increased 2,378%, Salesforce’s 1,320%, and Amazon’s 1,197%. None of these increases had much to do with their performance in their established mature franchises in, respectively, personal computers, CRM, and e-commerce. Instead, investors were rewarding Apple for catching three new category waves (digital music, smartphones, and tablets), Salesforce for catching two (cloud platform as a service and cloud marketing automation), and Amazon for catching a single whopper (cloud computing as a service).
The key takeaway here from a growth investor’s perspective is that when it comes to generating serious upside returns, catching the next wave is all that really matters. This perspective has not been lost on executives and boards of directors in established enterprises. They all have equity-based compensation systems that incentivize them to pursue these opportunities aggressively. They all pay close attention to growth opportunities. They all seek surpluses on their balance sheets and free cash flow from their operating income to invest in emerging categories. They all employ super-smart strategy experts to analyze their current portfolios of businesses, to assess their landscape of opportunities, and to identify the best ones to target. They all have annual plans that set aside considerable resources to pursue these targets both organically and through acquisitions. The CEO and the board are completely aligned in the understanding that this is their highest overall long-term priority. What could possibly go wrong?
Well, perhaps we should ask the CEOs of any of the following companies that question:
COMPANIES THAT MISSED THE NEXT WAVE
Burroughs • Sperry Univac • Honeywell • Control Data • MSA • McCormack & Dodge • Cullinet • Cincom • ADR • CA • DEC • Data General • Wang • Prime • Tandem • Daisy • Calma • Valid • Apollo • Silicon Graphics • Sun • Atari • Osborne • Commodore • Casio • Palm • Sega • WordPerfect • Lotus • Ashton Tate • Borland • Informix • Ingres • Sybase • BEA • Seibel • PowerSoft • Nortel • Lucent • 3Com • Banyan • Novell • Pacific Bell • Qwest • America West • Nynex • Bell South • Netscape • MySpace • Inktomi • Ask Jeeves • AOL • Blackberry • Motorola • Nokia • Sony
I have spent the entirety of my business career working in the technology sector, and I can assure you, if you are looking for next waves to catch, there is no better place to hang out. Nevertheless, there are fifty-six companies on this list of companies that failed to do so. Look at the names. These were not the losers; these were the winners! These were not our worst management teams; these were our best! And yet every single one of them missed every single one of their efforts to catch the next big wave—hundreds and hundreds of misses with nary a single hit. Why is this so hard?
It turns out, to disrupt someone else’s business, you have to add a net new line of business to your own portfolio. This is, in effect, a form of elective surgery, one that can be scheduled at will. Because it is voluntary, because we get to choose the time and place of engagement, we are led to believe we have things under control. Unfortunately, nothing could be further from the truth. The real truth is most companies take run after run at this hurdle, but each time, at the critical juncture, that moment when you have to either go big or go home, they shy away. Normally it is not until their own legacy business comes under attack that they can summon the will to change, but by then it is usually too late.
Why? What’s going on?
Adding a new line of business to an existing portfolio creates a crisis of prioritization. Such efforts are easy to get started, but as momentum begins to build it becomes increasingly clear that there are not going to be enough resources to go around, so how are they going to get allocated? Partially this is a question of quantity—how much of your resources should you continue to deploy into your established lines of business versus how much to divert into the emerging new one? Partially it is a question of quality—how much value should you assign to achieving additional gains from your established lines of business versus new gains from your emerging new one? And partially it is a question of politics and power—how much are you willing to challenge the entrenched interests that demand and reward short-term returns versus how much you are willing to risk on a bet that requires immediate sacrifices in hopes of achieving exceptional long-term gains?
At the core of this crisis of prioritization is a battle for resources in the go-to-market functions—sales, marketing, professional services, and partner development. To add a net new line of business to the portfolio, the enterprise has to stretch its go-to-market capacity dramatically to meet the needs of both its established businesses and its next-generation initiatives. It turns out, however, not only are there not enough resources to go around, there is no efficient way to expand them. Here’s why. Marketing, selling, servicing, and partnering in any emerging category are radically inefficient processes, especially when compared to established lines of business. For starters, prospective customers have no budget allocated for the new category of offering—it is simply too new. So you have to work with the line-of-business executives in those companies to show them the possibilities and persuade them to take the risk. This takes time. It also requires relationships your salespeople are not likely to have (theirs are with the other side of the customer house, the side that is perfectly happy with the status quo, the one that has budget already allocated for your offers, and the one that is not likely to be very happy about you engaging elsewhere in their company). This makes developing the market for an emerging category both challenging and risky—you might not succeed in getting budget approved, or you might get budget approved only to lose the deal to a competitor. And to make matters worse, this is not a go-to-market motion your existing team is good at—they are much better suited to selling more of the old stuff via their established relationships.
Now, the standard way to address these problems is to overlay a sales force that does specialize in this sort of market development and is able to focus solely on the new initiative. At the outset, this approach is promising—it actually does work—but as the business begins to scale, it gets more and more expensive to operate. Moreover, as it seeks to engage with more and more of your installed base, your account managers with established customer relationships become increasingly reluctant to bring in the new team because their presence can destabilize a deal in the works or damage a long-standing relationship by going over the head of your traditional buyer. Because of this kind of inherent friction, scaling a single disruptive innovation can easily absorb 10 percent or more of your total go-to-market envelope before adoption reaches the tipping point.
And that raises a host of other problems. Increased expense with less revenue means your profit margins will take a hit. This can deflate your stock price and alienate your investor base, potentially to the extent that it could put your company in play. Meanwhile, your current ecosystem of partners is getting restless. They make their living supporting your established lines of business and are feeling threatened by this new disruptive innovation. And inside your own company the leaders of your established lines of business are feeling increasingly squeezed themselves and are signaling that they cannot make their numbers without getting a bigger share of the go-to-market pie. Of course they can spare a modest amount of their go-to-market resources, but 10 percent?
The net result of all this is painful but clear. It is just barely possible that an established enterprise, through intense commitment, clear prioritization, and laser focus, can grow a single net new line of business to scale while still maintaining its commitment to its existing franchises. That said, it is absolute lunacy to think it can do two or more at the same time. Unfortunately, that is precisely what the standard playbook for strategic portfolio management calls for you to do—don’t put all your eggs in one basket! That may sound like good advice until you realize it brought all fifty-six of the companies we listed to their knees.
When a go-to-market organization is charged to scale two or more new franchises while at the same time being expected to make the numbers in the established lines of business, anyone with experience knows this is simply not going to happen. This triggers a cascade of passive-aggressive behaviors in which the new lines of business are given lots of showcase attention, but everyone who wants to make quota focuses the bulk of their time on the tried and true. Sooner or later the sponsors of the new category have no choice but to fold their tents, allowing the “wiser” sort to give each other I-told-you-so looks. It is hard to imagine a more useless waste of human capital.
So, first things first: When it comes to making a big bet on your next big thing, pick one. Not two, not three—one. This is the single most important job a CEO has. Choose one thing to be your enterprise’s next big thing, and then deliver on that future—to customers, to shareholders, to partners, to employees, and to your industry as a whole. If someone questions you putting all your eggs in one basket, just tell them, “In our company we like to lay eggs one at a time. By the way, we find most chickens do too.”
If your company could catch a new wave just once in a decade, it would be world-class. IBM did. Digital Equipment Corporation did not. Microsoft did. Lotus and Novell did not. That said, as we already noted, Steve Jobs did it three times in one decade. What is the single most important lesson executive teams can learn from his performance? All of Apple’s new lines of business were brought to scale one at a time! Steve was a challenging person to work with, but there was never any question as to what his priorities were. His core principle was: “We have one team working on one thing.” He might whiff—the Lisa comes to mind here—but he would not waffle.
Fifty-six other CEOs played their hands differently. In effect, they did waffle. They were torn between funding the current business and backing the next big thing, and they did not want to put all their eggs in one basket. So they peanut-buttered their resource allocations, making sure every credible disruptive innovation got its fair share of support, but always with a tilt toward making the number on the back of the established lines of business. That by default is a kind of prioritization in its own right, but it is a painfully wasteful one, since it absolutely guarantees you will never catch the next wave, even as you spend all your scarce discretionary resources under the pretense that you can.
This brings us to the heart of the crisis of prioritization: At the core you must deliver on two conflicting objectives. On the one hand, you must maintain your established franchises for the life of their respective business models, adjusting to declining revenue growth by optimizing for increasing earnings growth. This objective most of the fifty-six CEOs did indeed deliver on. At the same time, every decade or so you must get your company into one net new line of business that has exceptionally high revenue growth. This they did not.
To stay relevant in any sector characterized by frequent disruptive innovations, you have to do both. That’s the problem facing every CEO in high tech. That’s why high tech needs a new playbook. But what about everybody else?
Unless you are Rip Van Winkle, you are now well aware that waves of disruptive innovation are no longer confined just to high tech. They have now been unleashed on whole swaths of the world’s economy. In media, in advertising, in travel and hospitality, in retail, in automotive, and in transportation, companies like Netflix, Google, Airbnb, Amazon, Tesla, and Uber have put companies like CBS, Omnicom, Hilton, Walmart, General Motors, and Hertz back on their heels.
And this is only just the beginning. What industry can possibly be exempt from massive reengineering now that every person on the planet is carrying the equivalent of a 1990 supercomputer in his or her pocket or purse? What legacy business process can possibly remain intact given the digitization of all information and universal availability of wireless communication? Even if disruption has not touched your sector directly as yet, how can you possibly imagine that your company will not get caught up in one or more of these maelstroms sooner or later—and more likely than not, sooner?
This is not about you catching the next wave. This is about the next wave catching you. In situations like this, you aren’t playing offense. You are playing defense. This too will create a crisis of prioritization, albeit one that will appear to unfold in slow motion. Take Kodak, for example. It hired George Fisher out of Motorola in 1993 to deal with the disruption of digital photography. It went bankrupt almost twenty years later because of that disruption. There was not one of those years when management and the board ignored this problem. But still they could not solve it. Why should things be different for you?
Well, first of all, not every disruption is of the Kodak variety. When the next wave catches you, its disruptive impact can be felt at different levels in your enterprise depending on how close to your core business it lands. The question you want to answer at the outset, therefore, is whether you are being disrupted at the level of your infrastructure model, your operating model, or your business model.
Take the disruptive impact of mobile smartphones as an example. If you are in the real estate business, smartphones don’t actually disrupt your business model or even your operating model to any great extent. You are still going to make your living earning a commission on real estate sales, and you are still going to operate as a network of agents. That means you can absorb the disruption of smartphones at the infrastructure model level, incorporating them into your marketing and communication systems, improving both the agent’s productivity and the customer’s service experience without changing anything more material. This is something like buying a new car. Yes, it will take some investment, and yes, it will take some getting used to as well, but the changes are reasonably straightforward to manage, and it is not an earth-shaking event.
Suppose, however, you are in the airline business, and you are competing for high-margin business travelers. These are people who live on their smartphones. They want to use them to book flights, secure their boarding passes, get flight statuses, check frequent flyer points, and the like. If you don’t offer them a powerful modern mobile app, they are going to take their business elsewhere. This means you have to change your operating model. Yes, you need new infrastructure, but it goes way beyond that. Over time you will redirect your investments in personnel and equipment for travel agents, check-in counters and kiosks, lounge services, in-flight services, boarding processes, and the like, all to adapt them to the new mobile landscape. This is much more disruptive than simply swapping out infrastructure. There are major process changes that must be accompanied by and coordinated with your infrastructure modernization. Whole budgets and job descriptions will get rewritten or even eliminated. Not only is this going to be expensive to undertake but also the ROI will not come until the out years, making a highly unattractive dent in the current year’s performance, not to mention the performance-based compensation of the executive team.
You are not just buying a new car here; it is more like you are moving to a new city and undertaking a new commute. For sure, this will generate enough inertial resistance to create a challenge of prioritization, but not, I would argue, a crisis. That’s because, when you step back and take the long view, the changes required are not truly life-threatening. You typically have a reasonable amount of time to manage them provided you hop to it, and overall you can be fairly optimistic about getting through an operating model disruption, perhaps after a couple of dodgy years.
But now let us suppose you are in the advertising business. You are best known for your creative ads, but you make the bulk of your revenues placing those ads in media buys, be that with TV, radio, print media, or billboards. Media consumption, however, has shifted dramatically to online digital properties, initially to desktops and laptops, now increasingly to tablets and even more so to smartphones. Here media buying has been completely disrupted by the likes of Google, Yahoo!, Appnexus, and their ilk, not to mention newer players like RocketFuel and AudienceScience—it’s all done by computer algorithms. All your buying expertise, your whole network of ecosystem relationships, has been rendered irrelevant. Not only can you not charge a premium for placing ads, you’re not really in a position to perform the task at all. Sure, you can still charge for creative, but that is a time-and-materials business model that has nothing like the scalability of your traditional commission model. Of course, you can still charge for “old media” in the old ways, but the tide is going out on this book of business, and you are going to have to replace it with something. In short, you have no option but to change your business model. This isn’t about buying a new car or even moving to a new town and learning a new commute. This about getting fired and having to find a whole new job!
Business model disruptions are where all the train wrecks happen. They are the “Kodak moments” that the press is compelled to write about and that executives in other companies read with such schadenfreude. They are the ultimate consequence of the next wave catching you. People say, when this happens, that you should have learned to disrupt yourself. You should have realized that if somebody is going to eat your lunch, it might as well be you. Well, in the interests of public safety and managerial sanity, let me share a secret with you: No established enterprise can reasonably expect to change its core business model, ever. All that stuff about how you have to learn to disrupt yourself—it’s baloney. It can’t be done. There is simply too much inertial momentum tied up in your internal systems, your customer relationships, your company culture, your supply chain processes, your ecosystem of partners, and your investors’ expectations. By the time you dismantled all of these, there would be nothing left for you to repurpose. All you would have done is chased away the remainder of the business that was yours to have.
So what must you do instead to prevent the next wave from catching you? Two things, actually. First, on an emergency basis, you must race to modernize your existing operating model as best you can, incorporating enough of the next-generation technology to at least blunt the impact of the disruptor in the short term. Thus, for example, all the major advertising agencies have developed digital ad-buying desks to offer as an in-house service. This buys you time by helping maintain and even extend the inertial momentum of your existing business relationships. It is not, however, a permanent fix, as you are competing on the other guy’s turf, and he plays the game much better than you do. So second, in parallel, you must turn to your own portfolio of next-generation opportunities to accelerate your own progress toward catching some other wave of disruption emerging in some other category. In the case of advertising, it turns out that digital marketing is a tough nut to crack. There is a lot of creative energy concentrated inside these agencies to apply to this problem and a lot of trapped value out in the world that would pay back the effort to do so. The challenge is to find new ways to express and monetize their talent. Hard as this may be to execute, it is the only thing that can provide the growth burst needed to get back in the game. The difference is that here agencies will be disrupting someone else’s legacy business model, not their own.
Of course, this begs the question: Why weren’t they doing this second step all along—isn’t that the whole point of portfolio management? Yes it is, and yes they should have been. But here, let me say, they have a lot of company, and once again the culprit is a crisis of prioritization. The legacy business model in advertising, like the ones in mainframe computing, enterprise software maintenance agreements, OEM licenses for operating systems, inkjet cartridges, automobile dealerships, taxi medallions, luxury retail, patented pharmaceuticals, investment banking, venture capital, and premier cru Bordeaux wines, is based on profit margins that have been locked in for a very long time and have subsequently lost correlation with the value received.
Now, from an investor’s point of view, this is great: you guys are investing low and selling high—it’s like printing money! Don’t stop! But, of course, stop is precisely what you have to do. Or rather, “transition.” You have to get your company off the drug. Unfortunately, in the short term you have no incentive to do so, and every incentive not to. As we have already discussed, your mature franchise is valued very differently from growth ones. For you the market focuses on your P/E ratio (price to earnings) rather than your P/S ratio (price to sales). As long as those earnings keep growing nicely, investors are happy. But when disruption enters your industry sector, new business models dramatically reset the pricing for traditional services, either by offering a whole lot more for the same price or by offering the same thing for a whole lot less. Either way, your margins are going to take a big hit. Moreover, if you are going to modernize your operating model and then invest in a next-generation disruption of your own, you’re going to have to spend working capital to do so, and your margins are going to take an even bigger hit. But here’s the thing.
It doesn’t have to happen this quarter!
You can postpone it for a while. You still have a lot of legacy customers who would rather pay you a price premium than switch to an unknown entity. You can still squeeze a bit more juice out of the old fruit. To be sure, every quarter a little bit more of your installed base will erode away never to return, and for sure you will not be winning a lot of new customers, but this quarter you can scrape by, defer the reckoning, and collect your current performance bonuses. How about it?
Welcome to your crisis of prioritization. If you go for renewal and reinvention, you are likely to alienate your current investors, trash your stock price, and potentially put your company in play. If you opt instead for a path of suppression and denial—what Thoreau once called a “life of quiet desperation”—you are effectively liquidating your company one quarter at a time, all the while keeping up the pretense that you have a viable future. Who do you want to be, Tweedledum or Tweedledumber? Ugh and ugh! There’s one thing for sure: you too are in great need of a new playbook.
To sum up the foregoing, whether you have been playing offense and trying to catch the next wave or playing defense and trying to defend yourself against a current wave, when it comes to strategic portfolio management, you are likely to need some help. In times of disruption, the current playbook just doesn’t work. It does not help us protect our current franchises, nor does it succeed in getting us into new ones. To be frank, we have spent the last several decades acting out Einstein’s famous definition of insanity: doing the same thing over and over again and expecting a different result.
At present the situation is so dire that conventional wisdom says established franchises under threat of disruption live on borrowed time. But here is the irony—it should be just the opposite! The advantages that established enterprises have over disruptive startups far outweigh the disadvantages. Global distribution, worldwide support systems, brand recognition, extensive ecosystems, strong balance sheets, predictable cash flow—all these can and should be massively impactful assets. All that is needed is a playbook to focus these resources and leverage them properly. And that is what the chapters that follow intend to provide.
We call this playbook zone management. It is based on dividing enterprise management into four zones. Each zone has its own distinctive dynamics—one for revenue performance in the current year, one for productivity initiatives to foster and fuel that performance, one for incubating future innovations, and one for taking such innovations to scale. Each zone follows its own local playbook, each of which will be summarized in the chapters that follow. All four interoperate to enable an established enterprise either to onboard a net new line of business while still maintaining its established franchises or to fend off a disruptive attack on of these same franchises.
None of these four local playbooks is likely to be unfamiliar to you. There are no radical prescriptions in zone management. Rather, what is radical is, first, for executive management to explicitly distribute operations across the four zones and to seek different outcomes within each one, and second, for operational leaders to play within their assigned zones, following the playbook appropriate to each one and collaborating respectfully with other members of the enterprise who are executing different playbooks in other zones.
When you step back from it, it’s not all that unlike youth soccer. Like our overenthusiastic children, we all tend to run to the ball, and we all hope to score the goal. But business, like soccer, is a team sport, and success depends on understanding formation and playing position. That is what zone offense and zone defense are all about, in business as in sports.
The foundation for this kind of zone discipline is established in the annual plan. That’s where the portfolio decisions are made that determine under which of the four zones’ various charters any given initiative is being funded. Once an initiative is “zoned,” that establishes the nature of its activity and the metrics upon which it will be evaluated; it is then the responsibility of the operating staff to execute to those metrics within that zone. The role of the CEO and the executive staff is to allocate resources across the four zones, supervising competition for funding within each one, and orchestrating the interactions across all four. That is, they must explicitly declare first how much will be spent in pursuit of performance, productivity, incubation, and transformation, respectively, then which initiatives should get prioritized within which zones, and finally which inter-zone dependencies need to be monitored most carefully. These ideas are not complicated. But they are powerful.
Specifically, what zone management ensures is that resource allocation, return on investment, organizational structure, operating cadence, success metrics, and management compensation all get aligned with the priorities and deliverables unique to each of the four zones. These are exceptionally powerful levers. In most corporations, unfortunately, they operate at such cross-purposes to one another that it is a wonder the enterprise can perform at all. By contrast, when you disentangle them from conflicting priorities and give each one its own space, the release of creative energy can be breathtaking. You really do hold the keys to the kingdom in your hands. You just have to get them into the right locks.
That’s what this playbook is all about.