The Hoffmann,LaRoche and Wang examples illustrate that arriving first to market can give a company a substantial advantage. If the first,mover firm arrives long before competitors, it may be the only seller of a product or provider of a service, allowing it to charge a premium because of its status as a monopolist. In addition, being first can enhance the first mover’s ability to control a market for long periods into the future. Some, times first movers can exclude entrants, build brand equity, create for the product a large loyal following unlikely to switch, and achieve economies of scale and experience curve effects unavailable to later entrants.
The Hoffmann-LaRoche and Wang examples also illustrate that under, lying the ability to be first is a composite of unique intangible assets: know, how. These include the technology necessary to build and manufacture the product, knowledge of unmet customer needs, and the marketing skills needed to introduce a new product quickly. Know,how can also be used to enter the market after the first mover. Advantages are derived from the development of know,how and its application as either a first mover or a later entrant.
The shareholder,value model of strategy, described by William Fruhan, explains why these advantages create value for shareholders.2 According to this model, the timing advantage (or first,mover status) offers a unique asset or skill that can be used to earn “rents” (abnormal profits). As long as these assets/skills remain unique, the company can charge these high rents to customers who need them.
Even though the customer buys a product, it is really paying for the use of the firm’s unique ability to build and design the product. Unlike the cost,quality view of competitive advantage in the previous chapter, this suggests that the components of the product and the product itself are rarely where the value is. The uniqueness of the intangible assets (i.e., the know,how) that are necessary to invent and make a product are what allow the firm ( 1) to charge more than the cost of the unique asset as a rent on the asset and (2) to take advantage of opportunities not open to other firms.
The duration and growth of these rents determine the value created by a firm for its shareholders. That value is the net present value of the future cash flows generated by investments to create the unique assets/skills. However, the duration of these cash flows rarely approaches perpetuity.
Once these intangible assets/skills are imitated or replaced with a new set that can be used to serve the same customer need, the first mover begins to lose its ability to charge high rents because the firm must compete with other firms seeking to rent similar assets to the same customers. Over time, followers insure that the assets/skills are no longer a resource that the firm can use to generate rents.
While Fruhan’s analysis deals largely with one-shot developments such as Wang’s office system, the erosion of rents leads to the ultimate conclusion that companies need to develop a series of advantages to succeed. As the rents of the first initiative begin to erode, the company must have a second initiative in progress or face the fate of Wang, whose original advantage was eroded before it had established a new one.
1. Resource-based Strategies: Pre-positioning and Strategic Postures Based on Intangible Assets
The firm’s ability to push into new markets—especially in high-tech or industrial markets—is determined by its strategy in developing technology and other know-how and by its ability to exploit these intangible assets better than anyone else. By building unique tangible and, especially, intangible assets, the firm can position itself to take advantage of two different types of timing opportunities: being a first mover into new markets or a close follower of the actions of competitors. The way the company approaches the development of this experience base is critical in determining the type of offensive moves that the firm can mount.
How does the firm go about developing new know-how? The company can choose a revolutionary or an evolutionary strategy. The revolutionary strategy attempts to introduce a sharp, discontinuous technological change, while the evolutionary strategy works on a series of incremental improvements, either to the product or to the production process. The revolutionary strategy is the strategy of the first mover. The evolutionary
strategy is the approach of second or later entrants into new markets. First movers, in particular, need a strong base of intangible technological resources to make big jumps in product design and manufacturing. Moreover, the firm’s resource posture, especially its stocks of intangible resources, pre-positions the firm for entirely different types of strategic actions.
RESOURCE INVESTMENTS FOR REVOLUTIONARY LEAPFROGS
Investments in developing radically new technology or accumulating radically different skills and experience can be staggering. In high-tech industries, in particular, the company is sometimes required to “bet the firm” to move to the next stage in its technological development. The challenge is to assure that these investments are taking the firm in the right direction. The role of the strategist in planning for product markets is to decide in what direction to drive technology so that the firm can navigate from its current design to a future design that gives the maximum increase in value to the customer per dollar of development cost. Some technological advances will open up large new markets for new products, while other efforts will have little or no effect. The key is to drive the development of intangible assets such as technology and marketing or production knowhow in the direction in which it will not hit a technological barrier, an unsolvable technical problem.
To make this decision, managers must analyze their markets and technology. As we will examine in our discussion of the New 7-S’s in Part III, understanding stakeholders and looking ahead to changes in technology through strategic soothsaying are crucial to success as a first mover. Companies need to know the key attributes that their customers want and the limits of technology and know-how. They must overcome those limitations in a way that enhances the attributes desired by customers. A firstmover strategy that ignores customer needs will end up on the scrap heap with such revolutionary new products as Polaroid’s “instant” movie camera and Federal Express’s ZapMail. A strategy that fails to examine the shape of know-how barriers may cause the company to make costly investments in new technology that are impossible to achieve. As the scientist and inventor Sir Alastair Pilkington commented, “A large part of innovation is, in fact, becoming aware of what is really desirable. [Then you] are ready in your mind to germinate the seed of a new idea.”3
2. Useful Insights from the Resource-based View of Competitive Advantage
BUILDING CORE COMPETENCY AROUND KNOW-HOW
The view that timing advantages are based on unique know-how advantages has produced several particularly important insights. Prahalad and Hamel, for example, reconceptualized the mission of firms as based on building up their core competencies (i.e., their underlying know-how) rather than on their product markets.4 Honda is not a car company. It is a company whose mission is to dominate small engine design and knowledge about how to apply it to multiple products. In contrast, the less successful firms of Chrysler and GM have missions to be vehicle companies, wherein engines are just a component used in making them. Thus, Honda extends its product line by putting its world-class engines in cars, motorcycles, lawn mowers, recreational vehicles, motor bikes, snow blowers, snowmobiles, chain saws, and many other products. In contrast, GM extends its product line by making trucks, vans, and all sorts of cars, and Chrysler even out-sources its engine design and manufacturing. The main difference is that Honda focuses on building a knowledge base (about small engines), while the American firms focus on making products. As discussed earlier in this chapter, competitive advantage is rarely in the product; it comes from underlying knowledge that firms develop and exploit.
Consider another example. IBM’s mission is to be a computer company. It makes chips and software for use in its computers. In contrast, NEC has emerged as a world leader in semiconductors and telecommunication technologies, which it applies to making mainframe computers, telephones, facsimile machines, and laptop computers. NEC’s approach allows it to fully exploit its investment in know-how by using its know-how in several ways. IBM’s approach leaves many potential applications of its technologies unfulfilled, inefficiently using its vast know-how and wasting some of its technological investment by not capitalizing upon it.
This view suggests that unlike physical assets, competencies do not deteriorate as they are used. Unless replicated by competitors, they should grow as they are used. Over time, core competencies can be combined to generate a whole new family of products. Canon combines its know-how in several areas (precision mechanics, fine optics, and microelectronics) to make several products (see Figure 2-1). Each time it uses its knowledge about precision mechanics, fine optics, and microelectronics, this knowledge base expands.
CORE COMPETENCIES AT CANON
Source: An exhibit from “The Core Competence from the Corporation,” by Prahalad and Hamel (Harvard Business Review, May-June 1990). Copyright© 1990 by the President and Fellows of Harvard College; all rights reserved.
Under this view, firms are reconceptualized as portfolios of competencies that create many products and businesses, instead of as portfolios of products. Resources are allocated to building and exploiting competencies, not to SBUs (single business units) defined by the products they make. Top management’s role is to build and transfer know-how from product SBU to SBU, carefully managing the usage of each competency to maximize its exploitation, to build its potential, and to plan for new competencies that secure the future. As such, top managers must monitor the value created for shareholders by the firm’s intangible assets.
MONITORING THE VALUE OF INTANGIBLE ASSETS
Every firm has a “going-concern value.” Part of this value is due to the cost of replicating the firm’s physical assets. The rest is due to the value that is created by how these physical assets are used. This is the know-how of the firm; i.e., the management talent and intellectual assets used to employ the firm’s physical assets. Based on appraisals and engineering studies, the replacement value of the physical assets can be calculated and subtracted out of the going-concern value of the firm. The value of these intangibles is the net present value of the rents on a firm’s investments to create the unique intangible resources that we mentioned earlier in this chapter.
The simplest way to monitor the value of intangible assets is through Tobin’s q, which is the market value of a firm’s equity divided by the replacement value of its tangible assets. The intent of this measure is to capture the stock market’s estimate of the value added by intangible assets (like technological know-how, management skill, and other core competencies) to the firm’s physical asset base. (Sometimes Tobin’s q is proxied with an easier number to get, the market value of equity divided by the net book value of the firm [from financial statements].) Figure 2-2 shows how firms can monitor their intangible resources (as estimated by the stock market) over time.
Competitor A is building its intangible assets relative to the rest of the industry, while competitor B is depleting them. Note that it was mentioned earlier in this chapter that core competencies don’t deteriorate when used. They can, however, deteriorate if a firm’s core competency loses its uniqueness or becomes obsolete. In Figure 2-2, competitor B no longer has any unique know-how, and competitor A is outmaneuvering competitor B over time, obsoleting competitor A’s know-how.
CHANGES IN INTANGIBLE RESOURCES OVER TIME
ECONOMIC VALUE IS DRIVEN BY THREE STRATEGIC LEVERS—SPREAD,
GROWTH, AND DURATION
This analysis provides a view of whether the intangible assets of the firm are building or declining due to replication or obsolescence. However, it does not provide any detailed analysis about why this is occurring.
Based on a set of complex formulas and assumptions, which can be found in published articles on value creation, 5 several consulting firms produced a more extensive analysis designed to identify the source of the value created by a firm’s physical and intangible assets. Figure 2-3 shows three levers that can be expected to create or destroy the economic value of the firm: spread, growth, and duration. Each of these is defined in Figure 2-3.
The formula that holds all of these together is:
where S = spread between return on equity and cost of equity
k = cost of equity
g = equity growth rate
n = duration (number of years) beyond which S = 0 is assumed.
The formula itself isn’t as important as recognizing that, while spread is the key determinant of value creation, a company can achieve different economic values by different combinations of spread, duration, and growth.
These three levers—spread, duration, and growth in equity—can be further linked to a comprehensive set of performance measures, as illustrated in Figure 2-4. The detailed components of two of the levers (spread and growth in equity) can be calculated using historical data from the firm’s financial statements. With this data one can ask questions that reveal strategically important information.
Consider the following analysis of Dr Pepper versus Royal Crown Cola in 1975 and 1980. An analysis using Figure 2-4 would reveal that in both years, Dr Pepper (Dr P) was more successful at creating value than Royal Crown Cola (RCC). When you ask why by looking at the detailed breakdown of spread and equity growth in Figure 2-5, we see that Dr Pepper’s equity growth and spread stayed high in both years, but Royal Crown Cola’s equity growth and spread fell sharply.
RCC’s declining value seems to be the result of falling operating margins and asset utilization. There was no or little disadvantage in the cost of equity or the contribution to ROE made by increasing the firm’s leverage. Thus, through this analysis, we have found that financial decisions are not responsible for the declining value of the firm. Operating decisions are. This suggests that RCC’s core competencies are losing their uniqueness. RCC’s core competencies were its unique cola-based taste and its diet cola, which it introduced to the market first. However, competitors like Pepsi and Coke replicated these intangible assets, while they did not replicate Dr Pepper’s taste. Coke’s Mr. Pibb never took off (even though Coke thought it was a Dr Pepper fighter). RCC’s niche was evaporating in the late 1970s because its core competency was no longer unique. Dr Pepper’s niche was not threatened.
A more detailed analysis can be done. ROS can be broken down into ROS by product or division. Asset utilization can be broken down by asset type (e.g., inventory, receivables, plant and equipment, land, etc.) or by specific plant. Once the location of the eroding ROS or asset utilization is identified, it can often be linked to the erosion of uniqueness in specific intangible assets associated with the product, division, asset type, or specific plant.
Notice that this analysis of RCC did not provide any explicit analysis about the duration; that is, the amount of time that the spread would remain greater than zero. Calculation of duration is more problematic than calculation of growth and spread. Duration requires a projection into the future, while the formula uses historical growth and spread data. Because the model provides no guidance on how the competitors may act in the future, the model necessarily provides a “naive” estimate of the firm’s eco- nomic/book value that
LEVERS OF ECONOMIC VALUE
COMPARISON OF ROYAL CROWN COLA (RCC) WITH DR PEPPER (Dr P)
- is based on historical growth and spread and
- assumes a duration (typically set at ten or fifteen years for the sake of analysis)
If a simple ten- or fifteen-year assumption is not used, some consultants inappropriately extrapolate how long the spread will stay above zero. According to Figure 2-5, Dr Pepper’s spread declined 1.5 percent (from 10.2 percent to 8.7 percent) over five years. At this rate of decline (0.3 percent per year), it will remain above zero for approximately twenty-nine years. For extremely successful firms, some consulting firms that have used a similar model assume that the duration is infinite. This allows them, through mathematical derivation, to reduce the original model to a more simple model:
This simplification is rarely realistic, so further analysis is often done. The naive calculation of economic/book value (assuming historical spread, historical growth, and an arbitrary duration) can be compared to the market’s estimate of the value of the firm’s equity/book values. When the naive calculation is below the market’s, one asks: Why does the market believe that the firm will do better than the historical assumptions used in the model? When the naive calculation is above the market’s, one asks: Why does the market believe that the firm will do worse than the historical assumptions used in the model?
The answers to these questions often depend upon dynamic shifts in the future that make historical estimates of spread and growth and linear extrapolation of duration irrelevant or impossible. Thus, the dynamics of the future can only be guessed at when using the traditional models that are based on the economic rents created by unique intangible resources called core competencies.
Source: D’aveni Richard A. (1994), Hypercompetition, Free Press.