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a crash course in the evolution of business models
find the bottleneck, and own it
 

page two of four | previous page 

short circuiting circuit city: consumers take charge

          What's happening now in the Internet revolution is very simple¾IT is being introduced at the customer level and, in particular, at the consumer level.

          Why is the Internet interesting?  Because it's the first time we've ever had a technological revolution playing out at the consumer interface first.  Technology, because of its price and such, has always played out in government, industry or defense, never at the consumer level first.  That’s why we have unprecedented growth rates and an unprecedented source of innovation and models.  And let's not restrict this just to the Internet.  However fast the Internet’s growing, we also have mCommerce and mobile technology, set-top box technology and more.  PlayStation 2, by the way, could be the killer technology for Europe.  In the US, PC penetration is fantastic, so it makes sense if that's the way the Internet plays out here, but in Europe it is very small¾10-15% in some countries¾so game consoles like PlayStation 2 may become the dominant platform for Internet access there, not the PC.  If you look at projections for how quickly that market will grow in the fourth quarter of this year with the holidays, it’s a very intriguing business model.

          Technology has been introduced bringing economies of scale and scope.  Before, it was all about the intermediary and distribution, the supply chain games we've been playing for the last decade¾find a way to pile it high, sell it cheap and squeeze the margins, then we rock and roll.

          Today, this world is all about search economies.  That's really what the economies of scale and scope are.  By search economies I mean access to information and decision-making.  Increasingly, the Internet lets us have access not just to unfiltered data, but incredibly insightful opinions as well.  What does this mean?  It’s an abstract idea that I’ll try to put in simple terms, but the contrast is very, very powerful.

          Let's talk about some pragmatic examples of it to make it real.

          What's the average price of a new car in the US today?  You folks know this better than I because I've been out of the country too long.

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Audience Member:  $25,000.

That's a reasonable number.  What's the profit margin for a dealer, on average, selling a $25,000 asset?  Maybe 5-6%, so that’s $1,200 -$2,500, right?  Actually, for cars,  the range seems to be between $14 and $40, so let’s say about $20 for selling a $25,000 asset. For the quantitative people in the room, we call that low profit margin.  The decimal point's in the wrong place, and that's not good.  We all know what's happening.  Web sites have come up where you can buy cars, get information and more.  All of a sudden, two Web sites are responsible for over a billion dollars in car sales every month.

          Two years ago, when we wrote the Fortune article, one-third of all Americans knew what price they would pay for a car before they set foot in the dealer showroom.  Last year, it was 67%.  It doubled in one year.  Two-thirds of Americans now use the Internet to determine that.

          How did you become a millionaire before Regis came along?  You opened a car dealership.  That was the easy way to become a millionaire in America.  They all made a fortune, yet, in less than a decade, we see a reversal in that industry.  We see consolidation.  We see them getting killed.  A decade ago, 80% of their profits were in selling new cars.  Today, it's less than 20%.  All the profitability, today, is in selling used cars and service.  Why?  Because of the Internet; because car dealers have become a secured parking lot.  They’re not a part of the decision-making channel.  The guys in the cheap suits, whom we all love, are not winning.  Why?  There's no trust; there's no reliability of information.  The dealer showroom is no longer a decision-making point, it's a car collection point. Basically, you have a secured parking lot, and, if you have a secured parking lot, you basically get a fee similar to a parking garage for your services. That's what's happened.

          Here’s the general phenomena every one of you needs to think about in your own business or in the industry you're attacking.  What happens as the decision point moves outside the channel?  Your profit margins go to near zero.  You have to ask yourself a question, whether it’s about the intermediary channel that you're attacking, your own information channel, or the intermediary channel that you're creating¾is it a value adding source of decision-making or is it a necessary evil that people must go through to acquire your product or service?  If it falls into the latter camp, assume somebody's going to toast you.  Assume they're going to find a way to attack and eliminate you.  It's just going to happen.  It's a fundamental trend we have to watch.

          More importantly, I would only give a decade to anybody playing this intermediary game in the center of the chart.  If they don't do something, they're going to the cemetery.  I mean banks and businesses like that.  When's the last time anybody in this room went to a bank?  Since I don’t see any hands raised, I'll assume you're either asleep or that you haven’t been to one recently.  Banks are just going to become mausoleums.  They have these nice shiny marble lobbies, so make them mausoleums.  That's the only thing they're good for.  Who's going to go there?  They don't have a future.  I can give you very hard data about banking, but let me just summarize it this way: banks are dead.  Okay?  We need their services, but their business model is dead.

          Like I said, I could give you a lot of data, but, basically, it seems to be that banks are going through the elephant walk.  I don't know if you've ever watched the nature shows, but when elephants want to die they walk around forever in herds and look for a place to die. That's what banks are doing.  They're merging; they’re getting bigger and dumber, and they’ll die.  I have yet to convince banks that intelligence is not cumulative in that way.  They just get bigger, dumber and slower.  That's what they're doing.  They're squeezing out cost, but not innovating.

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          It's very simple.  Eighty percent of all financial dollar movement in the US occurs outside the commercial banking sector.  Eighty percent!  Only one out of five dollars goes through the commercial banking sector.  Banks are not a product leader in any category they offer.  If 80% of the funds flow outside the channel, what does that mean?  That's the market telling you that you are irrelevant.

          Alan Greenspan figured that out about 18 months ago.  He made a very simple statement which, to me, was the death of banking.  He couldn't say it that way because he has to worry about politics and market reactions, but I don't care.  The simple statement he made is that the Federal Reserve discount rate is no longer an effective means of controlling the money supply.  Why?  Because he only has access to one out of five dollars since 80% of the funds are flowing outside that channel.  They still talk about Federal Reserve discount rates and all that because it's an understood measure, but how do they implement it?  By the amount of short term T-bills they issue at auction.  If the government issues more T-bills, it takes money out of the economy and drives up interest rates.  If they issue less, it leaves money in the economy.  Well, if the market doesn't need you, and government regulators don't need you, that's the kiss of death, man.  It's just a matter of time.

          I also don’t see how the big retail channels that have been playing this game are going to work.  I know this because I go to them, right?  As a European, I have discovered something very simple¾good things cost less in the US than Europe.  I'm the classic European.  I come to the US with empty suitcases and fill them up.  That's what I do every trip.  I'm an academic, so I’m incredibly cheap.  They’re the same thing.  “Academic” means cheap.  They go hand-in-hand.  My wife gives me a shopping list any time I'm in the US for more than 24 hours.  I'm not a lecturer, not an academic, not a researcher; I am a personal global goods allocator.  I am a shopping assistant.  I do this because I don't want the look, right?  I do as I'm told.  I understand that I have these duties.  I perform and life is good, so I execute.

          Since I'm incredibly cheap, I understand Wal-Mart’s strategy of everyday low pricing, right? “We've consolidated the channel,” yeah, yeah, yeah, got it.  So I look up the address of a Wal-Mart, get in my rental car, cruise there and park in the parking lot.  The first thing I see is a parking lot about the size of England.  Why doesn’t Rhode Island have any Wal-Marts?  The state's not big enough for the parking lot.

          I get there, park and, two time zones later, I get to the front door where there's some senior citizen greeter saying, “Have a nice day!” and giving me a shopping cart.  I just want to slap his dentures out.  I'm already a little ticked off.  After I've done that¾I usually don't but occasionally it happens¾I take out my shopping list, study it carefully, see five items, then I look up to see a store of 50,000 products spread over 30,000 square feet.  I want five. It's the Marquis de Sade’s Easter egg hunt.  There's nothing friendly about this process.  You go up soulless aisle after soulless aisle looking for merchandise.  If you approach a Wal-Mart employee, they scurry away and hide in the back like cockroaches because they don't want to deal with you.  I use two rules of thumb when I shop at any superstore.  Number one, never buy time-dated merchandise on the way in.  It's clearly an exit strategy because it could well be out of date.  Number two, always carry emergency rations. If you see a man with a two- or three-day stubble walking around looking dazed and confused, give him a candy bar and show him the exit.  It's the superstore Saint Bernard model.  It's what you have to do.

          I'm not exaggerating; it's basically like that.  I mean, at Circuit City and Best Buy, the strategy seems to be to hire 16-year-old, pimply-faced kids who sell refrigerators in the morning and stereos in the afternoon.  Ask them a question, something very complicated like, “What's the warranty on this product ?” . . . well, I know I'm getting old because they stare at you the way only a teenager can and talk without moving their lips.  When the Web first came out, I think it was Best Buy and I think they since changed it, but, if you wanted to have a technical question answered, you went to their store, logged on to one of their computers and used the Internet to get your answer.  What's the value-add of being in the store if decision-making is occurring outside the channel?  These guys have a very serious problem.

          The problem with the Internet is actually this¾despite all the hype, and I think the corrections are occurring now, the Internet is not going to be overnight death, destruction and chaos.  In most cases, the Internet will be much more evil than that.  Any manager worth his or her salt can manage a way out of a true crisis, because it's all or nothing¾focus the entire company, and solve the problem.  For most companies, however, the Internet is the slow erosion and the death of a business model.

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          When I was with IBM from 1982 to 1988 I saw a company going through “strategy by denial.”  Every quarter they would lose a few customers.  Every quarter, products were not selling as well as they thought they would, so they introduced new products more quickly, lowered the price, doubled the number of salespeople.  Each time they expected the hockey stick phenomenon of sudden up-growth.  Instead, it continued to decline.  All of a sudden, you lose $5 billion.  Even when you were setting record profits four or five years earlier, it's hard to ignore that.

          This is exactly what the Internet will do, because every quarter you're going to lose a few of your best customers.  Every quarter, a few of your best employees will leave because they see the handwriting on the wall.  By the time you realize what's happened, the financial markets have tanked you and you have no clout from which to rebound.  IBM clearly rebounded, but let's be very clear.  If I had come to anybody in 1985 and said, “IBM is going to lose $5 billion in 1992,” I probably wouldn’t have had a lot of takers on that bet.  If I had asked in 1992, “Will IBM be where it is today?”  Again, unlikely that I’d have many takers.  I think the best thing that happened to IBM, is that this happened in 1992 and not today.  By it happening then, they had a chance to rebuild themselves, which I'm not sure they could today.

          Anytime somebody has a business model like this, ask them two questions.  Number one, “Is your business model viable if you lose 20% of your customers?”  As I said, the Internet's not going to be death and destruction.  Sensitivity analysis is the fundamental thing we have to think about, because we all know the future is going to be a hybrid of complex segmentation.  Yeah, yeah, I'll buy all of that crap.  Do a sensitivity analysis.  Is your business model viable if you lose 20% of your customers?

          After Mr. Wal-Mart passes out and you revive him, assume that meant “no.”

          Then ask them a second question, “Can you guarantee that you're not going to lose 2% of your sales a year to alternate channels?”  Two percent a year means that in a decade you're dead.  For US retail, on average, it's worse.  The best data I've seen from an Ernst & Young study said 15%.  If they lose 15% of sales, the channel is no longer viable.  Why?  Because they've been playing this distribution game.  Leverage is a double-edged sword.  These channels are very volume sensitive because the fixed to variable cost ratio is enormous.  If they lose a little bit of volume, the whole thing comes undone.  Be aware of what's happening to you as you play these kind of games.

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dr. jeff’s prescriptions

          I can't predict the future, but I can tell you things that you absolutely have to get right, otherwise you're going to die.  Let me start that laundry list right now.

1

 Do a sensitivity analysis around your current business model.  That's the obvious thing.  If you don't do that, you're dead.  If you're attacking the big players, you’d better understand that sensitivity analysis to know when you're going to get their attention.  The last thing you want to do is wake up the sleeping giant before you're ready for a full frontal attack.

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You’d better have very accurate customer profitability data, and very few companies do.  The people with the benchmark are the credit card companies, Capital One, MBNA, those kinds of companies.  They are amazing at customer profitability data.  Why?  Can anybody tell me that there's going to be less competition?  Can anyone tell me customers are not going to have more choice as opposed to less?  As a businessperson, you are going to have to make the hard decisions to say, “Fine, I don't want your business.”  If that customer's a significant customer, the natural gut reaction will be to say, “Yes, I want you.  I will keep you.”  Then, all of a sudden, you are going to have the ugly phenomena in which business is good, but I wonder why we're not making any money.

          Do we have anybody in the credit card industry in the room?  Good, I can make up anything I want.  I like that.  How many people have an MBNA or a Capital One credit card?  Both are very interesting.  Next time you’re ready to renew your credit card, call them up and try to cancel.  One of two things will happen.  They'll either say thank you very much, we didn't like you anyway . . . well, that's what they're thinking, anyway.  It's probably people like you that will happen to, people who pay the bill off in full every month and use them for a free float.  If you're a person who carries a balance, however, that's where they make their money.  In that case, something very interesting will happen.  You get sent to a different area in their call center.  As soon as you give them your credit card number, a customer profitability matrix comes up on the screen.  There's something called the minimum level of profitability.  The person on the phone gets a commission on the difference between anything he or she can get you to do to renegotiate your terms and conditions and the minimum level of corporate profitability.  That's not some minimum wage person on the phone, it's a profit-incented salesperson.  Do you want no annual fee?  Fine, that's gone.  That lowered the profitability to here.  You want a different interest rate?  Fine, we're still ahead.  In some cases they take off part of the balance.  They'll do whatever it takes to stay above the line because they have the exact data.  In many cases, these are customers with a few thousand dollars a year, and they have that real-time decision making capability.  It's hard to compete against that because they have the facts.

          Those kinds of information systems don't happen overnight.  I would suggest that what happens in credit cards is something that happens in many industries.  It's a very skewed bell curve in which there’s something like 10-15% at each tail.  In the credit card industry that means most of the profits at this end, the middle gets them nothing, and they lose money on the far end because those people don't repay.  MBNA has been very good at asking, “How do I tackle the profitable part of the market?”  They don't want to serve the whole market, and they select very carefully through customer profitability analysis.  You had better do that.

3

The flip side, of course, is that you'd better have very accurate cost data¾very accurate, very granular, real-time cost data.  If we believe in mass customization, if we believe in build-to-order, if we believe in any of those kinds of concepts that are being floated around, what do they mean?  They mean you can't produce 100,000 black boxes and average the cost across all of those units.  Could Dell have a build-to-order PC model if they didn't have very accurate cost data?  The price of the components changes almost daily.  They have to have very, very accurate cost data.  Take Cisco, one of these big companies that's doing extremely well.  If you order products from them and you want to change your order before it's been delivered, go to their Web site.  You can tell them the changes you want to make and it will come back with the cost to make those changes, real-time, depending on where your order is in the production process.  It can calculate it and come back and tell you the difference.  You’d better have very accurate cost data because people are not happy taking things off the shelf.  They want what they want, and you had better understand the cost of doing those changes or you're absolutely going to get killed.

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4

The fourth thing you have to worry about is cross-subsidies.  Any time you see a business model with a cross-subsidy in it, technology will absolutely rip it apart and blister you.  That's what's happened in credit cards because banks service the entire spectrum, right?  They said, “These people will cross-subsidize here and here.  These people we break even on, so that's what we're going to do.”

          How many business models have a cross-subsidy in them?  Look at what's happening in the music industry or the publishing industry.  Eighty-five percent of music recorded today does not make a profit.  It does not recover production and A&R costs.  Now, that's a bad industry when you have stars and dogs.  Where is the brand recognition in that industry?  Name any recording label and I'll bet that you can’t think of six artists on that label.  The brand equity is with the individual artist, not the label.  Well, what happens when artists can walk?

          We’ve heard about Napster out the wazoo, but let me give you a very clear example of how powerful this is.  I taught an undergraduate class when I was visiting at Wharton, earlier this year.  I've taught MBAs and executives and such, but never undergrads.  These were like 19- and 20-year-old kids and very smart.  The average SAT score in the Wharton undergrad business school is 1570 out of a possible 1600. They’re not stupid.  At the same time, I had a problem because they thought I was an old fart.  You could tell the way they looked at me, like here's a guy who doesn't understand the world.  “What are you doing here?”  About halfway through the term we started talking about music.  I asked how many people listen to music.  All  65 kids raised their hands.  I asked how many buy music.  One kid raised his hand.  I asked where they were getting the music.  The obvious choices came up Napster, etc.  They had stored between 300 and 5,000 songs on their computer hard disks.  Now, the one kid who bought music was not stupid, so I continued to probe what he was doing.  He bought the CDs, took them home, burned and returned them.  This kid obviously made an A, right?  You've got to reward that.  So, the one person buying music was using sort of a complicated free rental scheme, but there was nobody really buying music.  It’s the same thing that's happening in the publishing industry and other kinds of business models where there are inherent cross-subsidies.

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5

What you have to look for in any industry is a bottleneck.  In any industry, the value chain is not one dimensional or two dimensional; it's always three dimensional.  At some point there's a bottleneck, then it fans back out.  You want to own that bottleneck.  Technology creates the bottlenecks because of the leverage points.  As those leverage points change, this bottleneck is no longer desirable and future bottlenecks get created.  If you can be the person who either undoes a bottleneck or creates the next bottleneck, you're going to make a lot of money.

          The bottleneck in the recording industry used to be very simple¾shelf space.  That's the bottleneck in almost any consumer goods industry.  How many brands of laundry detergent does  Procter & Gamble make?  Too many is the answer.  They make about 10 or 12.  How many of those brands make money?  Two.  In any consumer category, the answer's always two.  One makes a lot of money and one barely breaks even.  Why the other nine brands?  That's not a rhetorical question, I'm looking for some help here.  Because they clog up the shelf space.  The discussion between the manufacturer and the retailer is, “You're going to charge me that profit margin?  Fine, then you've got to take these six dogs if you want my number one brand.”

          What happens with the Internet is that you enter a channel with unlimited shelf space.  That is not good if your entire business model is premised on blocking and controlling that scarce resource.  What happened to P&G's stock price earlier this year within just a couple of days?  It wasn’t good.  P&G has cut out over 4,000 SKUs from their product line this year.  That's different sizes and such, not just the number of brands, but it’s because they realize that their business model cannot sustain cross-subsidies.  They realize that it is fundamentally, economically nonviable to have a cross-subsidization business model, and they're in the process of retooling themselves.  Bottlenecks in any industry get eroded with new technologies.

          Let's play the game one more time, just ballpark to make sure that you understand the concept.  What happens in a grocery store?  What is the hardest category in a typical grocery store to try to introduce a new product?  Cereal?  Milk?  Soft drinks?  Potato chips?  Any other guesses?

          Ice cream.  It's frozen foods.  Why is that?  Because it requires dedicated freezer space.  Any other product I can sell on a shelf, so it's a much more complicated algorithm.  For frozen foods, it's a fixed capacity.  If I want to introduce more products, I have to convince the retailer to dedicate another shelf of freezer space, so it's very costly.  When Dove Bars and others wanted to start selling premium ice cream for a buck a pop, were they able to get shelf space?  No.  What did they do?  They gave these small, free-standing freezers for the checkout areas in convenience stores and said, “You know, you have underutilized floor space there.  We'll put the freezer in for you.”  They drove up sales and, once they had enough sales, they went to the big chains and said, “Look, we want in the frozen food area.”  They had to create their own shelf space.

      On the Internet, you get shelf space for free, so the whole business model and bottlenecks are shifting.  Bottlenecks are always created by technology.  Whether it’s distribution, channel combinations, production, whatever, you want to own that bottleneck.  We're seeing a fundamental shift in where these bottlenecks are occurring, so anybody playing this game is going to have to rapidly adapt to a shifting bottleneck model.  Any time you see cross-subsidies, attack them viciously, or, if they're your cross-subsidies, you’d better change very quickly or you're going to be bludgeoned.  That's what's happening in this world.

[continued]

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