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Disruption and the Risks It Poses:

A Lesson for CEOs and Boards

July 18, 2017 - By Paul Fenaroli
Independent Strategy and Business Consultant

Article: LinkedIn | Download PDF

Recently I was asked to give a talk on disruption to a regional chapter of the NACD (National Association of Corporate Directors). I’ve had some experience firsthand in spearheading disruptive efforts as a consultant for clients in both the music and metals industries, as well as defending against disruptors as a C-suite executive responsible for strategy and e-commerce in the retail industry. To ensure I also addressed emerging disruptors and disruptions, I conducted further research on the subject. In doing so, the following quote by Bill Gates — one of the greatest disruptors of his, or any, time — really caught my attention:

"We tend to overestimate the speed but underestimate the ultimate impact of disruptive technologies."

As I penned my talk, and in the weeks that followed, I found myself dwelling on the profoundness of Gates’ insight and its implications to incumbent companies and their leadership. Ultimately, I think it’s important that today’s CEOs and board members recognize the following three common approaches companies use to address disruption, and three steps they can take to determine which is appropriate for mitigating and managing risk.

Examining risk or, more generally, uncertainty

Throughout the years, conversation and concern about risk in companies has steadily increased. Many 10-Ks lay out a litany of risks a company faces, often ranging from the mundane to the absurd. There are thought-provoking books on the subject including Nassim Taleb’s “The Black Swan” and Peter Bernstein’s “Against the Gods.” And while we can all wrap our minds around individual risks conceptually, we have a hard time bounding their potential impact at the extremes and an even harder time assessing the probability of such an outcome occurring.

Why is this a problem? As the saying goes, “That which gets measured gets done.” The inability for the vast majority of businesses to quantify risk means it’s nearly impossible for them to manage it. In particular, it becomes difficult to trade off current earnings for investments in disruptive opportunities that won’t materialize for many years … if at all. I recall presenting findings in 1998 to the Chairman of the world’s largest music company, laying out the likely future of music downloads. Among his challenges was that a startup — with no business model whatsoever — had just received $100 million of funding, with an implied valuation of $1B. Had his company spent $50 million per year trying to compete, its market capitalization would have declined by at least $600 million. Instead, his company spent about $5 million per year, being outspent 10:1. In fact, this competitor did NOT prove successful. Rather, three years later, in 2001, Apple released iTunes while the iPod followed eight months later. It’s not a perfect comparison, but Bloomberg reported that the iPhone took three to five years and $2.6B to develop. My experience tells me very few companies would have the stomach to expend $500 million to $1B per year for such an extensive period of time to create a new disruptive technology.

Exploring your options

So, what is an economically rational company to do in the face of this conundrum? There are three options:

  1. Ignore it. In other words, don’t try to innovate or disrupt the status quo. If you do this, you must assume no one else will disrupt it either. This option clearly has its risks.

    For more than two decades, retailers bemoaned their business model: elongated supply chains, large up-front merchandise commitments, excessive markdowns and increased promotions, the pull-up of selling seasons, the need for a storefront in every new mall that was developed, and competing with vendors’ own boutiques. Despite their complaints, few made meaningful changes to their business models. In turn, a plethora of new, disruptive models came about to take away their customers, including fast fashion houses, off-price retailers and online competitors. The result is that the traditional powerhouses of retail — Macy’s, Neiman Marcus, JCPenney, Sears, Gap, J.Crew, The Limited and many others — struggle mightily against the industry’s disruptors.

    The problem with ignoring disruption is that it’s most often a question of when you get disrupted, not if. Beyond retail, we’ve witnessed this in music companies, taxi firms, retail banking, network television, travel agents and myriad other brokers/middlemen.

  2. Commit to R&D budgets. Some businesses have explicit research and development budgets that are critical to their business model, with pharmaceuticals being perhaps the best example. Given product lives dictated by patent expiration, pharma companies must consistently maintain a pipeline of new drugs coming to market. As such, they commit a percentage of their annual revenues to researching new drugs or patent-extending variants of their existing drugs. The percentage they spend, and the effectiveness and efficiency of that spend, is subject to much scrutiny — both internally by management and externally by the investment community.

    Other industries don’t make such explicit R&D commitments and don’t have the processes in place to manage R&D productivity. An example might be casual dining companies that may invest in incremental improvements to menus and décor, but don’t explore fundamentally new concepts. Perhaps a good example of this is TGI Fridays, which extended its legendary 1st Avenue Manhattan location into roughly 1,000 locations worldwide. Meanwhile, they were slow to change menu items or décor, let alone try to develop additional concepts. On the opposite end of the spectrum is Bloomin’ Brands, Inc., which developed its Bonefish Grill, Fleming’s Prime Steakhouse & Wine Bar, Carrabba’s Italian Grill and Cheeseburger in Paradise concepts following the success of its Outback Steakhouse concept. Continually adding to your portfolio of market-facing offerings is one means of not being disrupted by changing consumer preferences, economics or demographics.

    As my music industry client attempted, R&D spending can be applied toward disruptive technologies as well. Perhaps the biggest challenge to this strategy, however, is funding. Until a company can demonstrate success in R&D, it will face skepticism in the Boardroom and on the Street. Allocating existing earnings to new R&D expenditures will lower the company’s earnings. Yet until the markets anticipate value to be derived from the spending, there will be no rise in the price/earnings ratio, resulting in a drag on stock price. Of course investments in potentially disruptive ideas can garner outsized (or even incalculable) P/Es. For example, WeWork has a $20B valuation with $14 million of earnings. (Note: At the end of the day, WeWork may prove to be less a disruptor worthy of a stratospheric P/E and more an interesting real estate company.) While P/E degradation may be inevitable, companies should review all aspects of their pricing and operations to find opportunities to self-fund sustainable R&D investment to mitigate the impact on share price.

  3. Invest in potential disruptors. An alternative way to invest in R&D is to effectively outsource it. If a company doesn’t have R&D capabilities and doesn’t want to (or can’t) sufficiently build them, making investments in potential disruptors may be a viable option. Startups and early stage companies are often advantaged over incumbents in R&D: they are less bureaucratic and faster to make decisions; they can make better use of equity to motivate staff; they often have less organizational silos and instead team together better; and their investors are more patient and value them based on potential rather than current earnings.

    Executing this strategy requires a company to develop venture capital investing skills. It may also require a company to help facilitate its own demise by sharing industry knowledge with the startup. A good example of this today is General Motors and its 9% investment in Lyft (it has tried to buy more). The more successful Lyft (and its competitor Uber) is, the less demand there will be for individual car ownership. GM has a valuation of about $50B today, while Uber is valued at close to $70B (Lyft is valued at about $8B).

    From a financial standpoint, while investment in disruptors does consume free cash flow, it does not affect current profitability, so perhaps Wall Street may be more lenient. It again means development of some new capabilities — those more like a venture capitalist. You have to be in a position to see deal flow, and in evaluating deals, you can’t rely on the typical merger and acquisition criteria. Most investments you encounter will be pre-profitability and many will be pre-revenue. Success in ventures and in finding disruptors means investing in a portfolio of opportunities, not falling in love with a single one. Most VC firms have one home run in a given fund that drives their total return, while a few provide some return and most simply try to preserve capital.

Keep in mind the last two strategies are not mutually exclusive. Pharmaceutical companies often invest via joint ventures or minority stakes in biotech companies to augment their own internal R&D.

Addressing incumbent disadvantages

The median tenure of CEOs of S&P 500 firms is six years. Many of those firms have three-year vesting periods for restricted stock and long-term incentive compensation plans. Bonuses are based on annual financial performance. Many investors are short-term investors evaluating quarterly performance; some are in and out of the stock in days (or minutes).

Contrast that with a startup disruptor, which on average spends eight years from angel investment to IPO and six years from VC investment to IPO, both typically with no interim rewards. Investors, executives and staff are all looking down the road six to eight years, rather than focusing on annual bonuses or three-year restricted stock or LTIPs.

Recalling the words of Bill Gates, it is hard for management and many shareholders to be as patient as they need to be to effectively disrupt an industry. Those public companies that do are often led by a founding CEO who directed a major disruption themselves (think Microsoft, Apple, Google and Amazon).

So how do Boards and CEOs respond? I suggest three steps:

  1. Get the lay of the land. What potential disruptors are in or adjacent to your industry? What are they doing? What stage are they in? How can they impact you? Are there analogs in different industries? Where are the profit pools in your business that are vulnerable? What are the pain points for consumers or inefficiencies that a disruptor could rectify?
  2. Identify your constraints. What are the reasons you are not as innovative as you could be? Are they economic? Do you have the right people and capabilities? Are there organizational structure issues? Who owns innovation within the company? Who sets the agenda? How is it managed?
  3. Map your strategy. Which of the strategies should you adopt? Should they be used in combination? How will you organize to execute the strategy? How will you resource it?

Disruption is not a new phenomenon. Marx and Engels wrote about it in 1848. Rather, technology makes the pace of disruption quicker and its scope wider. For many businesses it is an ever present threat. Despite the challenges of not having complete visibility into the risks posed by disruption and a means to quantify that risk, companies can, and must, implement economically rationale strategies to manage it.

As managing director at Verus Strategic Advisors, Paul Fenaroli leverages 30+ years of senior management, consulting and leadership experience to help businesses address an array of strategic issues and achieve sustainable growth. He pairs analytical insights with the vision and guidance that bring everyone from the C-suite to the frontlines together in support of a common goal. Satisfied clients range in size, industry and sales, but all have experienced the meaningful difference Paul has made in their business.

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