DI

The Importance of Innovation

Joe Dwyer

Joe DwyerPartner at DI and Founder Equity. Kellogg professor. Investor, technologist, serial entrepreneur.

We have mentioned previously that corporations often view innovation as a useless buzzword. So often the word has little or no substance. But if you believe that innovation really is important—at least the kind that has substance—then you’re not alone:

“Business only has two functions: marketing and innovation.”
—Peter Drucker

And for good measure (and from the person who developed the theory of “creative destruction”):

“Carrying out innovations is the only function which is fundamental in history.”
—Joseph Schumpeter

Yet it’s worth exploring, both to assess whether we’re right, and if so to understand why. Knowing why will power our conversation about what to do about it.

Maybe we can set a threshold by finding some industries where innovation is not particularly important. And if we have trouble identifying any, that might go a long way towards establishing that innovation is broadly important.

Is innovation important in government?

Governments tend to be slow and stable. Significant change can take decades. After all, stability is one of the key demands we tend to make of government. Without a stable government it is difficult to maintain a stable currency, assured property rights, reliable market transactions, and public safety.

Perhaps governments should avoid innovation, which can be risky and destabilizing.

Sometimes it’s not that easy. The Arab Spring of 2011 resulted in very rapid change in at least seven governments. And it’s nothing new; history is replete with revolutions and other forms of civil unrest. That sort of existential risk seems like a good reason for innovation in government—whether to crack down on it, or avoid it. So there’s likely a tension between stability and innovation when it comes to government.

Even long-term stable governments such as the US seem to be constantly evolving. The US federal government typically enacts between 200-500 laws per two-year Congress. Some involve commemorative coins, but others such as the JOBS Act or Dodd-Frank are more far-reaching.

So, while we’ve only changed the US Constitution 27 times in 200+ years, we’re still actively evolving some pretty important parts of our government. Stable governments frequently evolve in the face of changes in technology, society, and international affairs.

If that’s not a form of innovation, I don’t know what to call it. And given that it’s one of the key activities of government, innovation seems awfully important even for government.

What about highly regulated industries?

Maybe innovation isn’t particularly important in highly regulated industries. After all, they’re likely protected from most threats by regulatory moats.

Taxis

Most major cities strictly limit the number of cabs out on the streets, as well as their appearance, tools / technology, and pricing. Those constraints tend to work in favor of incumbents. That’s probably why Yellow Cab Company, which formed in Chicago in 1907, flourished for almost 100 years. But it succumbed to ride sharing services, filing for bankruptcy in 2015.

Banks

US banks are highly regulated. And the government effectively erected a defensive moat by only issuing one new bank charter between 2010 and 2017.

That, combined with heavy regulation after the 2008 financial crisis is why in 2007 the top three US banks held 20% of the country’s deposits, but as of the end of 2017 they held 32%. In the meantime they have allocated capital to technology improvements, but little to innovation.

Apparently, business as usual is working pretty well for them.

Yet digital disruption is a looming threat to even the largest banks. CB Insights writes eloquently on the topic, explaining that “emerging companies generally don’t attack incumbent players head-on, but rather focus on tackling specific verticals.” They go on to show an image of “Unbundling The Bank,” which demonstrates the multitude of smaller players eating away at the various components of traditional banking.

My friend Tom Loverro at IVP wrote a great post in 2014 pointing out the existential threat to the banking industry posed by startups:

“Non-bank actors are attacking just about every valuable and revenue-generating activity that traditional players engage in”
— Tom Loverro

The government is speeding things up with its new fintech special purpose bank charters, which will make it easier for new players to displace traditional banking. These fintech innovators often focus on underserved markets to rapidly establish meaningful market share. For example, the 20%+ of US households that are underbanked. And capital partners are ready and willing to finance this disruption: $31 billion alone went towards fintech investing in the US in 2017.

Electric utilities

Electric utilities in the US are typically monopolies whose profits are effectively set by regulations. Surely they aren’t threatened by disruptive innovation. Their maximum profitability is determined by what’s called a “rate base” calculation derived from a percentage return on assets, with a US average of 14.5% as of 2015 (read this blog post by Coley Girouard on Advanced Energy Perspects for more information).

But as Coley points out, changes in dynamics in the energy industry are putting significant pressure on electric utilities. Aging and outdated infrastructure combined with improvements in energy efficiency at the edges of the grid—for example residential solar—are threatening the stability of the entire industry.

At DI we have engaged with a number of major utilities in the US. It’s clear they are very aware of the need for innovation even in this regulated monopoly industry. Apparently even a government mandated monopoly and preset profitability model aren’t enough to protect an industry from disruption.

What about intellectual property monopolies?

Government regulation can create effective barriers in other ways. For example, intellectual property rules might protect some industries or organizations from disruption.

Pharmaceutical companies

Drug discovery can be extraordinarily expensive—it costs on average over $2 billion to bring a drug to market. But successful new drugs are typically protected by patents that create effective monopolies for up to 20 years (usually less due to patenting process).

Health care rules and procedures often ingrain effective treatments into “standard of care” rules that generate guaranteed revenue streams for many drugs. Distribution, insurance coverage, and channel partnerships favor incumbents, too.

But it’s not all unicorns and rainbows for the pharma industry.

Regulatory and market dynamics are putting drug companies in a tough spot as health care costs rise, and pharma costs are put in the spotlight. The solutions that promise to lower discovery costs—such as AI or “in silico” drug testing— or to improve overall efficiency—such as the rise of PBMs (Pharmacy Benefits Managers) and digital patient engagement systems—are alien to pharma companies.

Other new technologies such as CRISPR and 3D drug printing and trends such as personalized medicine present increased chances for leapfrog innovation. Meanwhile, companies such as Amazon are more comfortable with disruption, and have increasingly powerful positions in the consumer and health care markets.

As a result, they’re edging into important parts of the drug market, and putting pharma companies at increasing risk. Even normally conservative hospitals are banding together to enter the drug business. It’s definitely a brave new world for pharmaceutical companies.

Consumer Packaged Goods

CPG companies enjoy intellectual property protections that can create competitive barriers to entry. Their trademarks and trade dress rights combined with marketing expertise and massive manufacturing and distribution reach can lead to significant long-term profitability.

Proctor & Gamble (P&G) was founded as a soap and candle company in 1837. P&G is known as one of the most innovation CPGs in the market. In 2013 they did almost $83 billion in revenue. By 2017 they had dropped to $65.7 billion—an almost 21% decline.

Much of this is due to dropping about 100 underperforming brands to focus on their big money makers. That strategy resulted in a much smaller drop in EBITDA during the period: $17.5 billion in 2013 down to $16.8 billion in 2017. Meanwhile their market value during the period grew from almost $200 billion to almost $240 billion.

Yet some argue that P&G’s recent success is unsustainable without significant change. Per a 2016 NY Times article, P&G’s CEO suggested that the “rise of e-commerce and social media has reduced the cost of entry for new competitors.”

One key element of that is the increasing importance of direct-to-consumer sales, for which large CPGs were not built and are not well suited. But it’s probably much more than the rise of e-commerce that presents a threat to major CPGs.

An article from BCG presents it in stark terms: “[s]cale was once all important. On its own, however, it no longer guarantees competitive advantage… FMCG companies… need a new playbook.” Niche products and brands are taking market share away from the large incumbents. They point out a number of factors including: asset-light production, expanded distribution options, variable-cost marketing, and ease of coordination as underlying factors enabling the small players to beat the big ones at their own game.

How about network effects businesses?

Network effects can create substantial competitive barriers to entry. From railroads to faxes, network effects have been instrumental in the formation of sustained value creation. Are businesses that benefit from network efforts largely insulated from disruption?

Microsoft built an empire based in part on network effects. As described in a 2008 NY Times article:

“Microsoft attracted consumers and software developers to use its technology, the software that controls the basic operations of a personal computer. The more that people used Microsoft’s operating system (DOS and later Windows), the more that third-party developers built products to run on Windows, which attracted more users.”

That same article points to Google as the new king of network effects, suggesting that the Internet and open standards have eroded Microsoft’s competitive advantage.

Despite that, Microsoft’s share of the PC operating system market was over 90% in 2013, and remains almost 83% today. So while their desktop market share is declining, it remains dominant. Their profits during the period have remained strong with the exception of a significant dip in 2015. In mid 2018 Microsoft reported their best fiscal year ever both in terms of revenues and profitability.

It certainly appears that something is working for Microsoft. But they have run into some significant challenges as well—challenges which might persist for the long term.

Their business has been built around a partnership model rather than a direct-to-consumer model. While they have had some success in gaming, their pursuit of mobile and music have largely failed. Their enterprise business is thriving, but given the rising power and importance of direct-to-consumer models, it’s probably not safe to say they’re not out of the woods yet.

Businesses such as Facebook have also leveraged network effects to build powerful competitive barriers to entry. Once most of your friends are connected to you on a social platform, it’s probably hard for another platform to convince you to switch until they have both a persuasive reason and enough of your friends to create a critical mass. Given the cost of building a mass market social network, that probably makes it hard to fund competitors, on top of the difficulties challenging a network effects incumbent.

But it’s not impossible.

Instagram and WhatsApp both came at the market from a different angle, and Facebook ended up buying both of them. If their competitive power were unassailable, Facebook probably would not have had to make those acquisitions.

Snapchat has also made a good run at Facebook. That is part of a larger—and potentially existential—threat to Facebook from the changing dynamics of young consumers.

Many see Facebook as the product their parents use, and therefore less desirable. At the same time, the fundamental structure of Facebook may not weather well as consumers continue to explore new modes of social interaction and engagement.

Facebook obviously isn’t going away any time soon, but that doesn’t mean that they don’t need to continue to focus on continued innovation.

Local businesses?

So far, we have not done a great job of identifying industries where innovation isn’t important. There’s another type of business that might do the trick for us: local businesses.

Think hair salons, private schools, or independent retailers. They tend to be driven by geography, personal relationships, and brand intimacy. Most of these sorts of business models haven’t changed considerably in the past several decades. Are they mostly immune to disruption?

For decades, independent retailers were a key part of the fabric of our economy. They have long benefitted from personal relationships and geographic ties.

At first they were pressured by big box retailers such as Wal-Mart. Many went out of business. And then e-commerce and delivery systems combined to create an increasingly viable solution to bypass small and large retailers alike.

Big retailers have by-and-large adapted with their own e-commerce offerings. Independent retailers, despite their competitive advantages of geography and personal relationships are increasingly falling down in the face of market (and social) evolutions.

Hair salons are a good example of a local business. They, too, tend to be built on personal relationships and geographic ties. On top of that they are a service-oriented offering, and thus should be harder to disrupt via e-commerce. Their fundamental business model hasn’t changed for over 50 years.

Are they at risk of disruption? They are at least at risk of losing meaningful business.

Take for example the brands offering a direct-to-consumer e-commerce solution for hair coloring and related products. The same article mentions a hybrid solution where a salon professional applies a direct-to-consumer formula and teaches consumers how to do it. Or what about Salon64 and its hybrid salon, workspace, and coffee bar?

Even service oriented local businesses probably aren’t safe from disruption.

What about private primary and secondary schools? In most bigger US cities private schools occupy an elite niche, commanding their market due to a persistent supply demand imbalance—in favor of the schools. Parents fret about getting their kids into the right school. It has been happening for decades, and is only getting worse (for parents).

But there are warning signs for schools. New entrants with innovative technology and learning experiences are making a push for market share. Even WeWork is launching its own school called WeGrow.

Parents are understandably reluctant to try new things on their kids. These new schools are made possible in part by the exclusivity of the schools, and the increasing cost of private education. It’s likely that many private schools in the US will be faced with a need to consider more aggressive (e.g., higher level) innovation.

Innovation is broadly important

If you think your industry is mostly immune from the forces of disruption, you’re probably wrong. Virtually every industry is facing real threats—and in many cases existential threats—from disruptive innovation. There are many potential responses:

  • Stick your head in the sand (perhaps the most common)
  • Improve your ability to innovate internally
  • Engage with an outside firm to enhance your innovation capabilities and to create new value creation models / products
  • Invest in and / or acquire promising startups
  • Utilize a hybrid approach (probably the best approach)

All of this brings up an interesting question… have things changed? Is innovation increasingly important? Those are the questions I will address in the next post.

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