January 2022 - Seven Powers by Hamilton Helmer

This month we dove into a classic technology strategy book. The book covers seven major Powers a company can have that offer both a benefit and a barrier to competition. Helmer covers the majority of the book through the lens of different case studies including his favorite company, Netflix.

Tech Themes

Power. After years as a consultant at BCG and decades investing in the public market, Helmer distilled all successful business strategies to seven individual Powers. A Power offers a company a re-inforcing benefit while also providing a barrier to potential competition. This is the epitome of an enduring business model in Helmer's mind. Power describes a company's strength relative to a specific competitor, and Powers focus on a single business unit rather than throughout a business. This makes sense: Apple may have a scale economies Power from its iPhone install base relative to Samsung, but it may not have Power in its AppleTV originals segment relative to Netflix. The seven types of Powers are: Scale Economies, Network Economies, Counter-Positioning, Switching Costs, Branding, Cornered Resources, and Process Power.
Invention. While Powers are somewhat easy to spot (scale economies of Google's search algorithm), creating them is anything but easy. So what underlies every one of the seven Powers? Invention. Helmer pulls invention through the lens of industry Dynamics - external competitive conditions and the forward march of technology create opportunities to pursue new business models, processes, brands, and products. Companies must leverage their resources to craft Powers through trial and error, rather than an upfront conscious decision to pursue something by design. I view this almost as an extension of Clayton Christensen's Resource-Processes-Values (RPV) framework we discussed in July 2020. Companies can find a route to Power through these resources and the crafting process. For Netflix, the route was streaming, but the actual Power came from a strong push into exclusive and original content. The streaming business opened up Netflix's subscriber base, and the content decision provided the ability to amortize great content across its growing subscriber base.
Power Progressions. Powers become available at different points in business progression. This makes sense - what drives a company forward in an unpenetrated market is different from what keeps it going during steady-state - Snowflake's competitive dynamics are different than Nestle's. Helmer defines three stages to a company: Origination, Takeoff, and Stability. These stages mirror the dynamics of S-Curves, which we discussed in our July 2021 book. During the Origination stage, companies can benefit from Cornered Resources and Counter-Positioning. Helmer uses the Pixar management team as an example of Cornered Resources during the Origination phase of 3D animated movies. The company had Steve Jobs (product visionary), John Lasseter (story-teller creative), and Ed Catmull (operations and technology leader). During the early days of the industry, these were the only people that knew how to operate a digital film studio. Another Cornered Resource example might be a company finding a new oil well. Before the company starts drilling, it is the only one that can own that asset. An example of Origination Counter-Positioning might be TSMC when they first launched. At that time, it was standard industry perception that semiconductor companies had to be integrated design manufacturers (IDM) - they had to do everything in-house. TSMC was launched as solely a fabrication facility that companies could use to gain extra manufacturing capacity or try out new designs. This gave them great Counter-Positioning relative to the IDM's and they were dismissed as a non-threat. The Takeoff period offers Network Economies, Scale Economies, and Switching Cost Powers. This phase is the growth phase of businesses. Snowflake currently benefits from Switching Cost dynamics - once you use Snowflake, it's unlikely you'll want to use other data warehouse providers because that process involves data replication and additional costs. Scale economies can be seen in businesses that amortize high costs over their user base, like Amazon. Amazon invests in distribution centers at a significant scale, which improves customer experience, which helps them get more customers - the flywheel repeats, allowing Amazon to continually invest in more distribution centers, further building its scale. Network economies show in social media businesses like Bytedance/TikTok. Users make content that attracts more users; incremental users join the platform because there is so much content to "gain" by joining the platform. Like scale economies, it's almost impossible to go build a competitor because a new company would have to recruit all users from the other platform, which would cost tons of money. The Stability phase offers Branding and Process Power. Branding is hard to generate, but the advantage grows with time. Consider luxury goods providers like LVMH; the older, the more exclusive the brand, the more it's desired, and every day it gets older and becomes more desired. A business can create Process Power by refining and improving operations to such a high degree that it becomes difficult to replicate. Classic examples of Process Power are TSMC's innovative 3-5nm processes today and Toyota's Production System. Toyota has even allowed competitors to tour its factory, but no competitor has replicated its operational efficiency.

Business Themes

Sneak Attack. I've always been surprised by businesses that seemingly "come out of nowhere." In Helmer's eyes, this stems from Counter-Positioning. He tells the story of Vanguard, which was started by Jack Bogle in 1976. "You could charitably describe the reception as enthusiastic: only $11M trickled in from investors. Soon after the launch, [Noble Laureate Paul] Samuelson himself lauded the effort in his column for Newsweek, but with little result: the fund had only reached $17M by mid-1977. Vanguard's operating model depended on others for distribution, and brokers, in particular, were put off by a product that predicated on the notion that they provided no value in helping their clients choose which active funds to select." But Vanguard had something that active managers didn't: low fees and consistency. Vanguard's funds performed like the indices and cost much less than active funds. No longer were individuals underperforming the market and paying advisors to pick actively managed funds. Furthermore, Vanguard continually invested all profits back into its funds, so it looked like it wasn't making money while it grew its assets under management. It's so hard to spot these sneak attacks while they are happening. But one that might be happening right now is Cloudflare relative to AWS. Cloudflare launched its low-cost R2 service (a play on Amazon's famous S3 storage technology). Cloudflare is offering a cheaper product at a much lower cost and is leveraging its large installed base with its CDN product to get people in the door. It's unclear whether this will offer Power over AWS because it's confusing what the barrier might be other than some relating to switching costs. However, there will likely be reluctance on AWS's part to cut prices because of its scale and public company growth targets.
A New Valuation Formula. Helmer offers a very unique take on the traditional DCF valuation approach. Investors have long suggested the value of any business was equal to the present value of its future discounted cash flows. In contrast to the traditional approach of summing up a firm's cash flows and discounting it, Helmer takes a look at all of the cash flows subject to the industry in which firms compete. In this formula (shown above), M0 represents the current market size, g the discounted market growth factor, s the long-term market share of the company, and m the long-term differential margin (net profit margin over that needed to cover the cost of capital). More simply, a company is worth it's Market Scale (Mo x g) x its Power (s x m). This implies that a company is worth the portion of the industry's profits it collects over time. This formula helps consider Power progression relative to industry dynamics and company stage. In the Origination stage, an industry's profits may be small but growing very quickly. If we think that a competitor in the industry can achieve an actual Power, it will likely gain a large portion of the long-term market. Thus, watching market share dynamics unfold can tell us about the potential for a route to Power and the ability for a company to achieve a superior value to its near-term cash flows.
Collateral Damage. If companies are aware of these Powers and how other companies can achieve them, how can companies not take proactive action to avoid being on the losing end of a Power struggle? Helmer lays out what he calls Collateral Damage, or the unwillingness of a competitor to find the right path to navigating the damage caused by a competitor's Power. His point is actually very nuanced - it's not the incumbent's unwillingness to invest in the same type of solution as the competitor (although that happens). The incumbent's business gets trashed as collateral damage by the new entrant. The incumbent can respond to the challenger by investing in the new innovation. But where counter-positioning really takes hold is if the incumbent recognizes the attractiveness of the business model/innovation but is stymied from investing. Why would a business leader choose not to invest in something attractive? In the case of Vanguard competitor Fidelity, any move into passive funds could cause steep cannibalization of their revenue. So in response, a CEO might decide to just keep their existing business and "milk" all of its cash flow. In addition, how could Fidelity invest in a business that completely undermined their actively managed mutual fund business? Often CEOs will have a negative bias toward the competing business model despite the positive NPV of an investment in the new business. Just think how long it took SAP to start selling Cloud subscriptions compared to its on-premise license/maintenance model. Lastly, a CEO might not invest in the promising new business model if they are worried about job security. This is the classic example of the principal-agent problem we discussed in June. Would you invest in a new, unproven business model if you faced a declining stock price and calls for your resignation? In addition, annual CEO compensation is frequently tagged to stock price performance and growth targets. The easiest way to achieve near-term stock price appreciation and growth targets is staying with what has worked in the past (and M&A!). Its the path of least resistance! Counter-positioning and collateral damage are nuanced and difficult to spot, but the complex emotions and issues become obvious over time.

Dig Deeper

June 2021 - Letters to the Nomad Partnership 2001-2013 (Nick Sleep's and Qais Zakaria's Investor Letters)

This month we review a unique source of information - mysterious fund manager Nick Sleep’s investment letters. Sleep had an extremely successful run and identified several very interesting companies and characteristics of those companies which made for great investments. He was early to uncover Amazon, Costco, and others - riding their stocks into the stratosphere over the last 20 years. These letters cover the internet bubble, the 08/09 crisis, and all types of interesting businesses across the world.

Tech Themes

Scale Benefits Shared. Nick Sleep’s favored business model is what he calls Scale Benefits Shared. The idea is straight forward and appears across industries. Geico, Amazon, and Costco all have this business model. Its simple - companies start with low prices and spend only on the most important things. Over time as the company scales (more insured drivers, more online orders, more stores) they pass on the benefits of scale to the customer with even further lower prices. The consumer then buys more with the low-cost provider. This has a devastating effect on competition - it forces companies to exit the industry because the one sharing the scale benefits has to become hyper-efficient to continue to make the business model work. “In the case of Costco scale efficiency gains are passed back to the consumer in order to drive further revenue growth. That way customers at one of the first Costco stores (outside Seattle) benefit from the firm’s expansion (into say Ohio) as they also gain from the decline in supplier prices. This keeps the old stores growing too. The point is that having shared the cost savings, the customer reciprocates, with the result that revenues per foot of retailing space at Costco exceed that at the next highest rival (WalMart’s Sam’s Club) by about fifty percent.” Jeff Bezos was also very focused on this, his 2006 annual letter highlighted as much: “Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long-term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com. We have made similar judgments around Free Super Saver Shipping and Amazon Prime, both of which are expensive in the short term and – we believe – important and valuable in the long term.” So what companies today are returning scale efficiencies with customers? One recent example is Snowflake - which is a super expensive solution but is at least posturing correctly in favor of this model - the recent earnings call highlighted that they had figured out a better way to store data, resulting in a storage price decrease for customers. Fivetran’s recent cloud data warehouse comparison showed Snowflake was both cheaper and faster than competitors Redshift and Bigquery - a good spot to be in! Another example of this might be Cloudflare - they are lower cost than any other CDN in the market and have millions of free customers. Improvements made to the core security+CDN engine, threat graph, and POP locations result in better performance for all of their free users, which leads to more free users, more threats, vulnerabilities, and location/network demands - a very virtuous cycle!
The Miracle of Compound Growth & Its Obviousness. While appreciated in some circles, compounding is revered by Warren Buffett and Nick Sleep - it’s a miracle worth celebrating every day. Sleep takes this idea one step further, after discussing how the average hold period of stocks has fallen significantly over the past few decades: “The fund management industry has it that owning shares for a long time is futile as the future is unknowable and what is known is discounted. We respectfully disagree. Indeed, the evidence may suggest that investors rarely appropriately value truly great companies.” This is quite a natural phenomenon as well - when Google IPO’d in 2004 for a whopping $23bn, were investors really valuing the company appropriately? Were Visa ($18Bn valuation, largest US IPO in history) and Mastercard ($5.3Bn valuation) being valued appropriately? Even big companies like Apple in 2016 valued at $600Bn were arguably not valued appropriately. Hindsight is obvious, but the durability of compounding in great businesses is truly a myth to behold. That’s why Sleep and Zakaria wound down the partnership in 2014, opting to return LP money and only own Berkshire, Costco, and Amazon for the next decade (so far that’s been a great decision!). While frequently cited as a key investing principle, compounding in technology, experiences, art, and life are rarely discussed, maybe because they are too obvious. Examples of compounding (re-investing interest/dividends and waiting) abound: Moore’s Law, Picasso’s art training, Satya Nadella’s experience running Bing and Azure before becoming CEO, and Beatles playing clubs for years before breaking on the scene. Compounding is a universal law that applies to so much!
Information Overload. Sleep makes a very important but subtle point toward the end of his letters about the importance of reflective thinking:
BBC Interviewer: “David Attenborough, you visited the North and South Poles, you witnessed all of life in-between from the canopies of the tropical rainforest to giant earthworms in Australia, it must be true, must it not, and it is a quite staggering thought, that you have seen more of the world than anybody else who has ever lived?”
David Attenborough: “Well…I suppose so…but then on the other hand it is fairly salutary to remember that perhaps the greatest naturalist that ever lived and had more effect on our thinking than anybody, Charles Darwin, only spent four years travelling and the rest of the time thinking.”
Sleep: “Oh! David Attenborough’s modesty is delightful but notice also, if you will, the model of behaviour he observed in Charles Darwin: study intensely, go away, and really think.”
There is no doubt that the information age has ushered in a new normal for daily data flow and news. New information is constant and people have the ability to be up to date on everything, all the time. While there are benefits to an always-on world, the pace of information flow can be overwhelming and cause companies and individuals to lose sight of important strategic decisions. Bill Gates famously took a “think week” each year where he would lock himself in a cabin with no internet connection and scan over hundreds of investment proposals from Microsoft employees. A Harvard study showed that reflection can even improve job performance. Sometimes the constant data flow can be a distraction from what might be a very obvious decision given a set of circumstances. Remember to take some time to think!

Business Themes

Psychological Mistakes. Sleep touches on several different psychological problems and challenges within investing and business, including the role of Social Proof in decision making. Social proof occurs when individuals look to others to determine how to behave in a given situation. A classic example of Social Proof comes from an experiment done by Psychologist, Stanley Milgram, in which he had groups of people stare up at the sky on a crowded street corner in New York City. When five people were standing and looking up (as opposed to a single person), many more people also stopped to look up, driven by the group behavior. This principle shows up all the time in business and is a major proponent in financial bubbles. People see others making successful investments at high valuations and that drives them to do the same. It can also drive product and strategic decisions - companies launching dot-com names in the 90’s to drive their stock price up, companies launching corporate venture arms in rising markets, companies today deciding they need a down-market “product-led growth” engine. As famed investor Stan Druckenmiller notes, its hard to sit idly by while others (who may be less informed) crush certain types of investments: “I bought $6 billion worth of tech stocks, and in six weeks I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basketcase and I couldn’t help myself. So maybe I learned not to do it again, but I already knew that.”
Incentives, Psychology, and Ownership Mindset. Incentives are incredibly powerful in business and its surprisingly difficult to get people to do the right thing. Sleep spends a lot of time on incentives and the so-called Principal-Agent Conflict. Often times the Principal (Owner, Boss, Purchaser, etc.) may employ an Agent (Employee, Contractor, Service) to accomplish something. However the goals and priorities of the principal may not align with that agent. As an example, when your car breaks down and you need to go to a local mechanic to fix it, you (the principal) want to find someone to fix the car as well and as cheaply as possible. However, the agent (the mechanic) may be incentivized to create the biggest bill possible to drive business for their garage. Here we see the potential for misaligned incentives. After 5 years of really strong investment results, Sleep and Zakaria noticed a misaligned incentive of their own: “Which brings me to the subject of the existing performance fee. Eagle-eyed investors will not have failed but notice the near 200 basis point difference between gross and net performance this year, reflecting the performance fee earned. We are in this position because performance for all investors is in excess of 6% per annum compounded. But given historic performance, that may be the case for a very long time. Indeed, we are so far ahead of the hurdle that if the Partnership now earned pass-book rates of return, say 5% per annum, we would continue to “earn” 20% performance fees (1% of assets) for thirty years, that is, until the hurdle caught up with actual results. During those thirty years, which would see me through to retirement, we would have added no value over the money market rates you can earn yourself, but we would still have been paid a “performance fee”. We are only in this position because we have done so well, and one could argue that contractually we have earned the right by dint of performance, but just look at the conflicts!” They could have invested in treasury bonds and collected a performance fee for years to come but they knew that was unfair to limited partners. So the duo created a resetting fee structure, that allowed LPs to claw back performance fees if Nomad did not exceed the 6% hurdle rate for a given year. This kept the pair focused on driving continued strong results through the life of the partnership.
Discovery & Pace. Nick Sleep and Qais Zakaria looked for interesting companies in interesting situations. Their pace is simply astounding: “When Zak and I trawled through the detritus of the stock market these last eighteen months (around a thousand annual reports read and three hundred companies interviewed)…” Sleep and Zakaria put up numbers: 55 annual reports per month (~2 per day), 17 companies interviewed per month (meeting every other day)! That is so much reading. Its partially unsurprising that after a while they started to be able to find things in the annual reports that piqued their interest. Not only did they find retrospectively obvious gems like Amazon and Costco, they also looked all around the world for mispricings and interesting opportunities. One of their successful international investments took place in Zimbabwe, where they noticed significant mispricing involving the Harare Stock Exchange, which opened in 1896 but only started allowing foreign investment in 1993. While Nomad certainly made its name on the Scaled efficiencies shared investment model, Zimbabwe offered Sleep and Zakaria to prioritize their second model: “We have little more than a handful of distinct investment models, which overlap to some extent, and Zimcem is a good example of a second model namely, ‘deep discount to replacement cost with latent pricing power.’” Zimcem was the country’s second-largest cement producer, which traded at a massive discount to replacement cost due to terrible business conditions (inflation growing faster than the price of cement). Not only did Sleep find a weird, mispriced asset, he also employed a unique way of acquiring shares to further increase his margin of safety. “The official exchange rate at the time of writing is Z$9,100 to the U$1. The unofficial, street rate is around Z$17,000 to the U$1. In other words, the Central Bank values its own currency at over twice the price set by the public with the effect that money entering the country via the Central Bank buys approximately half as much as at the street rate. Fortunately, there is an alternative to the Central Bank for foreign investors, which is to purchase Old Mutual shares in Johannesburg, re-register the same shares in Harare and then sell the shares in Harare. This we have done.“ By doing this, Nomad was able to purchase shares at a discounted exchange rate (they would also face the exchange rate on sale, so not entirely increasing the margin of safety). The weird and off the beaten path investments and companies can offer rich rewards to those who are patient. This was the approach Warren Buffett employed early on in his career, until he started focusing on “wonderful businesses” at Charlie Munger’s recommendation.

Dig Deeper

April 2020 - Good To Great by Jim Collins

Collins’ book attempts to answer the question - Why do good companies continue to be good companies? His analysis across several different industries provides meaningful insights into strong management and strategic practices.

Tech Themes

Packard’s Law. We’ve discussed Packard’s law before when analyzing the troubling acquisition history of AOL-Time Warner and Yahoo. As a reminder, Packard’s law states: “No company can consistently grow revenues faster than its ability to get enough of the right people to implement that growth and still become a great company. [And] If a company consistently grows revenue faster than its ability to get enough of the right people to implement that growth, it will not simply stagnate; it will fall.” Given Good To Great is a management focused book, I wanted to explore an example of this law manifesting itself in a recent management dilemma. Look no further than ride-sharing giant, Uber. Uber’s culture and management problems have been highly publicized. Susan Fowler’s famous blog post kicked off a series of blows that would ultimately lead to a board dispute, the departure of its CEO, and a full-on criminal investigation. Uber’s problems as a company, however, can be traced to its insistence to be the only ride-sharing service throughout the world. Uber launched several incredibly unprofitable ventures, not only a price-war with its local competitor Lyft, but also a concerted effort to get into China, India, and other locations that ultimately proved incredibly unprofitable. Uber tried to be all things transportation to every location in the world, an over-indulgence that led to the Company raising a casual $20B prior to going public. Dara Khosrowshahi, Uber’s replacement for Travis Kalanick, has concertedly sold off several business lines and shuttered other unprofitable ventures to regain financial control of this formerly money burning “logistics” pit. This unwinding has clearly benefited the business, but also limited growth, prompting the stock to drop significantly from IPO price. Dara is no stranger to facing travel challenges, he architected the spin-out of Expedia with Barry Diller, right before 9/11. Only time will tell if he can refocus the Company as it looks to run profitably. Uber pushed too far in unprofitable locations, and ran head on into Packard’s law, now having to pay the price for its brash push into unprofitable markets.
Technology Accelerators. In Collins’ Good to Great framework (pictured below), technology accelerators act as a catalyst to momentum built up from disciplined people and disciplined thought. By adapting a “Pause, think, crawl, walk, run” approach to technology, meaning a slow and thoughtful transition to new technologies, companies can establish best practices for the long-term, instead of short term gains from technology faux-feature marketing. Technology faux-feature marketing, which is decoupled from actual technology has become increasingly popular in the past few years, whereby companies adopt a marketing position that is actually complete separate from their technological sophistication. Look no further than the blockchain / crypto faux-feature marketing around 2018, when Long Island iced-tea changed its name to Long Island Blockchain, which is reminiscent of companies adding “.com” to their name in the early 2000’s. Collins makes several important distinctions about technology accelerators: technology should only be a focus if it fits into a company’s hedgehog concept, technology accelerators cannot make up for poor people choices, and technology is never a primary root cause of either greatness or decline. The first two axioms make sense, just think of how many failed, custom software projects have begun and never finished; there is literally an entire wikipedia page dedicated to exactly that. The government has also reportedly been a famous dabbler in homegrown, highly customized technology. As Collins notes, technology accelerators cannot make up for bad people choices, an aspect of venture capital that is overlooked by so many. Enron is a great example of an interesting idea turned sour by terrible leadership. Beyond the accounting scandals that are discussed frequently, the culture was utterly toxic, with employees subjected to a “Performance Review Committee” whereby they were rated on a scale of 1-5 by their peers. Employees rated a 5 were fired, which meant roughly 15% of the workforce turned over every year. The New York Times reckoned Enron is still viewed as a trailblazer for the way it combined technology and energy services, but it clearly suffered from terrible leadership that even great technology couldn’t surmount. Collins’ most controversial point is arguably that technology cannot cause greatness or decline. Some would argue that technology is the primary cause of greatness for some companies like Amazon, Apple, Google, and Microsoft. The “it was just a better search engine” argument abounds discussions of early internet search engines. I think what Collins’ is getting at is that technology is malleable and can be built several different ways. Zoom and Cloudflare are great examples of this. As we’ve discussed, Zoom started over 100 years after the idea for video calling was first conceived, and several years after Cisco had purchased Webex, which begs the question, is technology the cause of greatness for Zoom? No! Zoom’s ultimate success the elegance of its simple video chat, something which had been locked up in corporate feature complexity for years. Cloudflare presents another great example. CDN businesses had existed for years when Cloudflare launched, and Cloudflare famously embedded security within the CDN, building on a trend which Akamai tried to address via M&A. Was technology the cause of greatness for Cloudflare? No! It’s way cheaper and easier to use than Akamai. Its cost structure enabled it to compete for customers that would be unprofitable to Akamai, a classic example of a sustaining technology innovation, Clayton Christensen’s Innovator’s Dilemma. This is not to say these are not technologically sophisticated companies, Zoom’s cloud ops team has kept an amazing service running 24/7 despite a massive increase in users, and Cloudflare’s Workers technology is probably the best bet to disrupt the traditional cloud providers today. But to place technology as the sole cause for greatness would be understating the companies achievements in several other areas.
Build up, Breakthrough Flywheel. Jeff Bezos loves this book. Its listed in the continued reading section of prior TBOTM, The Everything Store. The build up, breakthrough flywheel is the culmination of disciplined people, disciplined thought and disciplined action. Collins’ points out that several great companies frequently appear like overnight successes; all of a sudden, the Company has created something great. But that’s rarely the case. Amazon is a great example of this; it had several detractors in the early days, and was dismissed as simply an online bookseller. Little did the world know that Jeff Bezos had ideas to pursue every product line and slowly launched one after the other in a concerted fashion. In addition, what is a better technology accelerator than AWS! AWS resulted from an internal problem of scaling compute fast enough to meet growing consumer demand for their online products. The company’s tech helped it scale so well that they thought, “Hey! Other companies would probably like this!” Apple is another classic example of a build-up, breakthrough flywheel. The Company had a massive success with the iPod, it was 40% of revenues in 2007. But what did it do? It cannablized itself and pursued the iPhone, with several different teams within the company pursuing it individually. Not only that, it created a terrible first version of an Apple phone with the Rokr, realizing that design was massively important to the phone’s success. The phone’s technology is taken for granted today, but at the time the touch screen was simply magical!

Business Themes

Slides-Character-And-Concrete-Actions-Shape-A-Culture.005.png

Level 5 Leader. The first part and probably the most important part of the buildup, breakthrough, flywheel is disciplined people. One aspect of Good to Great that inspired Collins’ other book Built to Last, is the idea that leadership, people, and culture determine the long-term future of a business, even after current leadership has moved on from the business. To set an organization up for long-term success, executives need to display level five leadership, which is a mix of personal humility and professional will. Collins’ leans in on Lee Iacocca as an example of a poor leader, who focused more on personal celebrity and left Chrysler to fail, when he departed. Level 5 leadership has something that you don’t frequently see in technology business leaders, humility. The technology industry seems littered with far more Larry Ellison and Elon Musk’s than any other industry, or maybe its just that tech CEOs tend to shout the loudest from their pedestals. One CEO that has done a great job of representing level five leadership is Shantanu Narayen, who took the reigns of Adobe in December 2007, right on the cusp of the financial crisis. Narayen, who’s been described as more of a doer than a talker, has dramatically changed Adobe’s revenue model, moving the business from a single sale license software business focused on lower ACV numbers, to an enterprise focused SaaS business. This march has been slow and pragmatic but the business has done incredibly well, 10xing since he took over. Adobe CFO, Mark Garrett, summarized it best in a 2015 McKinsey interview: “We instituted open dialogue with employees—here’s what we’re going through, here’s what it might look like—and we encouraged debate. Not everyone stayed, but those who did were committed to the cloud model.”
Hedgehog Concept. The Hedgehog concept (in the picture wheel to the right) is the overlap of three questions: What are you passionate about?, What are you the best in the world at?, and What drives your economic engine? This overlap is the conclusion of Collins’ memo to Confront the Brutal Facts, something that Ben Horowitz emphasizes in March’s TBOTM. Once teams have dug into their business, they should come up with a simple way to center their focus. When companies reach outside their hedgehog concept, they get hurt. The first question, about organizational passion, manifests itself in mission and value statements. The best in the world question manifests itself through value network exercises, SWOT analyses and competitive analyses. The economic engine is typically shown as a single metric to define success in the organization. As an example, let’s walk through an example with a less well-known SaaS company: Avalara. Avalara is a provider of tax compliance software for SMBs and enterprises, allowing those businesses to outsource complex and changing tax rules to software that integrates with financial management systems to provide an accurate view of corporate taxes. Avalara’s hedgehog concept is right on their website: “We live and breathe tax compliance so you don't have to.” Its simple and effective. The also list a slightly different version in their 10-K, “Avalara’s motto is ‘Tax compliance done right.’” Avalara is the best at tax compliance software, and that is their passion; they “live and breath” tax compliance software. What drives Avalara’s economic engine? They list two metrics right at the top of their SEC filings, number of core customers and net revenue retention. Core customers are customers who have been billed more than $3,000 in the last twelve months. The growth in core customers allows Avalara to understand their base of revenue. Tax compliance software is likely low churn because filing taxes is such an onerous process, and most people don’t have the expertise to do it for their corporate taxes. They will however suffer from some tax seasonality and some customers may churn and come back after the tax period has ended for a given year. Total billings allows Avalara to account for this possibility. Avalara’s core customers have grown 32% in the last twelve months, meaning its revenue should be following a similar trajectory. Net retention allows the company to understand how customer purchasing behavior changes over time and at 113% net retention, Avalara’s overall base is buying more software from Avalara than is churning, which is a positive trend for the company. What is the company the best in the world at? Tax compliance software for SMBs. Avalara views their core customer as greater than $3,000 of trailing twelve months revenue, which means they are targeting small customers. The Company’s integrations also speak to this - Shopify, Magento, NetSuite, and Stripe are all focused on SMB and mid-market customers. Notice that neither SAP nor Oracle ERP is in that list of integrations, which are the financial management software providers that target large enterprises. This means Avalara has set up its product and cost structure to ensure long-term profitability in the SMB segment; the enterprise segment is on the horizon, but today they are focused on SMBs.
Culture of Discipline. Collins describes a culture of discipline as an ability of managers to have open and honest, often confrontational conversation. The culture of discipline has to fit within a culture of freedom, allowing individuals to feel responsible for their division of the business. This culture of discipline is one of the first things to break down when a CEO leaves. Collins points on this issue with Lee Iaccoca, the former CEO of Chrysler. Lee built an intense culture of corporate favoritism, which completely unraveled after he left the business. This is also the focus of Collins’ other book, Built to Last. Companies don’t die overnight, yet it seems that way when problems begin to abound company-wide. We’ve analyzed HP’s 20 year downfall and a similar story can be shown with IBM. In 1993, IBM elected Lou Gerstner as CEO of the company. Gerstner was an outsider to technology businesses, having previously led the highly controversial RJR Nabisco, after KKR completed its buyout in 1989. He has also been credited with enacting wholesale changes to the company’s culture during his tenure. Despite the stock price increasing significantly over Gerstner’s tenure, the business lost significant market share to Microsoft, Apple and Dell. Gerstner was also the first IBM CEO to make significant income, having personally been paid hundreds of millions over his tenure. Following Gerstner, IBM elected insider Sam Palmisano to lead the Company. Sam pushed IBM into several new business lines, acquired 25 software companies, and famously sold off IBM’s PC division, which turned out to be an excellent strategic decision as PC sales and margins declined over the following ten years. Interestingly, Sam’s goal was to “leave [IBM] better than when I got there.” Sam presided over a strong run up in the stock, but yet again, severely missed the broad strategic shift toward public cloud. In 2012, Ginni Rometty was elected as new CEO. Ginni had championed IBM’s large purchase of PwC’s technology consulting business, turning IBM more into a full service organization than a technology company. Palmisano has an interesting quote in an interview with a wharton business school professor where he discusses IBM’s strategy: “The thing I learned about Lou is that other than his phenomenal analytical capability, which is almost unmatched, Lou always had the ability to put the market or the client first. So the analysis always started from the outside in. You could say that goes back to connecting with the marketplace or the customer, but the point of it was to get the company and the analysis focused on outside in, not inside out. I think when you miss these shifts, you’re inside out. If you’re outside in, you don’t miss the shifts. They’re going to hit you. Now acting on them is a different characteristic. But you can’t miss the shift if you’re outside in. If you’re inside out, it’s easy to delude yourself. So he taught me the importance of always taking the view of outside in.” Palmisano’s period of leadership introduced a myriad of organizational changes, 110+ acquisitions, and a centralization of IBM processes globally. Ginni learned from Sam that acquisitions were key toward growth, but IBM was buying into markets they didn’t fully understand, and when Ginni layered on 25 new acquisitions in her first two years, the Company had to shift from an outside-in perspective to an inside-out perspective. The way IBM had historically handled the outside-in perspective, to recognize shifts and get ahead of them, was through acquisition. But when the acquisitions occured at such a rapid pace, and in new markets, the organization got bogged down in a process of digestion. Furthermore, the centralization of processes and acquired businesses is the exact opposite of what Clayton Christensen recommends when pursuing disruptive technology. This makes it obvious why IBM was so late to the cloud game. This was a mainframe and services company, that had acquired hundreds of software businesses they didn’t really understand. Instead of building on these software platforms, they wasted years trying to put them all together into a digestible package for their customers. IBM launched their public cloud offering in June 2014, a full seven years after Microsoft, Amazon, and Google launched their services, despite providing the underlying databases and computing power for all of their enterprise customers. Gerstner established the high-pay, glamorous CEO role at IBM, which Palmisano and Ginni stepped into, with corporate jets and great expense policies. The company favored increasing revenues and profits (as a result of acquisitions) over the recognition and focus on a strategic market shift, which led to a downfall in the stock price and a declining mindshare in enterprises. Collins’ understands the importance of long term cultural leadership. “Does Palmisano think he could have done anything differently to set IBM up for success once he left? Not really. What has happened since falls to a new coach, a new team, he says.”