Microsoft

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Microsoft

• Jonathan Leonard

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The market value of Microsoft exceeds that of all
other firms except General Electric and Exxon
Mobil
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Microsofts performance 1990-2001
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Remarkable

• For more than a decade, Microsoft grew revenues
  and profits at more than twice the industry
  average.

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How Did They Do That?
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Some Simple Economics of Bundling
Hypothetical Example of Willingness-to-Pay and
Profits
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You Just Invented the Telephone

• Too bad no one can take your calls.

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Network Externalities

• Definition The value of the product or service
  grows with the number of other users.
• Communications effect
• Telephone, fax machine, IM client
• AKA real/connection/ direct network externalities
• Complement effect
• Value of Xbox depends on the number and quality
  of software titles
• Incentives of software publishers to develop new
  titles depends on the size of the current
  installed base of Xbox and the forecast of the
  future installed base of Xbox
• AKA virtual/indirect network externalities

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Adoption Dynamics

• Positive Demand Side Feedback
• Similar to Learning Curve on Supply Side- Easier
  if Youre Ahead.
• Tipping in Market Share

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Strategic Implications ILeading or Bleeding Edge

• Consumer Expectations are Critical
• Manage Expectations
• Vaporware

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Strategic Implications IIGet Big Fast and First

• Preemption Consumer Expectations are Critical
• Penetration Pricing
• Patent Race Dissipates Future Profits?
• Pharmaceutical Game Revisited

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Strategic Implications IIIAlliances and
Complments

• Value depends on Complements
• ISVs attracted by market size
• Virtuous cycle in variety and price of complements

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Key Assets in Network Markets

• First-Mover Advantages
• Installed Base
• Intellectual Property
• Ability to innovate
• Complements
• Brand

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Rivals Options

• Evolution
• Revolution

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Microsofts Winning Formula
Network Externalities Increasing Returns to
Scale Profit! (They understand Network
Economics)
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Stylized view of the role of cost and
differentiation in generating competitive
advantage
Microsoft
Average Industry Profits

Industry average competitor
Successful differentiated competitor
Competitor with dual advantage
Successful low-cost competitor
Price
Cost
Source Ghemawat, 1999
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But will it last?

• Can Microsoft sustain its competitive advantage
  in operating systems and desktop applications?
• Can Microsoft extend its competitive advantage to
  other businesses to drive growth?
• Server software
• Non-PC
• Games
• Handhelds
• Enterprise software / .NET

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Consistent out-performance is the exception
rather than the rule
ROI in Year 0
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3
Bottom Half
Top Half
Source Pankaj Ghemawat, Commitment (New York
The Free Press, 1991)
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Threats to Sustainability
Substitution
Imitation

• Compaq vs. Dell
• Atari vs. Nintendo
• RyanAir vs. BA /AL
• Nutrasweet vs HSC

• Barnes Noble v Amazon
• NetFlix vs. Blockbuster
• Firefox vs. IE
• Sun vs. Microsoft(Platform-independent SW)
• Linux vs. Microsoft(Open source SW)

• Unions at Wal-Mart
• Players in MLB
• Govt, competitors in Microsoft (may depend
  onyour view on the legalityof MSs competitive
  tactics)

• Talent at Microsoft
• Corporate-level productivity at Crown Cork Seal

Hold-up
Slack
Source Ghemawat, 1999
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Imitation-Evolution

• Imitation increases the supply of what a firm
  uniquely provides
• Profits draw a crowd
• Imitation is pervasive
• Intel in DRAMs
• IE in browsers
• But imitation can be deterred
• Crown Cork Seals pioneering rights
• Nutrasweets patents brand
• Dell Computers activity system
• Ryan Airs Airport Revenues

Source Ghemawat, 1999
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Barriers to imitation

• Scale or Scope Economies
• Experience/Learning (Tacit Knowledge)
• Relationships
• Reputation
• Retaliation
• Response Lags
• Upgrading/Investments
• Fit

Source Ghemawat, 1999
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Substitution-Revolution

• Substitution reduces the demand for what a firm
  uniquely provides by shifting the demand
  elsewhere
• The better mousetrap
• Exploit changes in technology, customer needs,
  input prices, etc.
• Substitution threats can be subtle and unexpected
  and can come from other industries
• Videoconferencing vs. air travel
• Conventional contact lenses vs. disposables
• Digital photos vs. film
• For this reason, substitution is an especially
  effective way to attack dominant players

Source Ghemawat, 1999
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Substitution of integrated steel mill production
by minimill steel
Sheet steel
Steel Quality
Structural Steel
Other bars rods
Quality of minimill-produced steel
Rebar
Same story in digital photography
1990
1975
1980
1985
Source Clayton Christensen and Bret Baird,
Continuous Casting Investments at USX
Corporation, HBS 5-697-066, April 24, 1997.
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Responses to substitution threats

• Dont Respond.
• Harvest. Manage business for cash, anticipating
  exit / reduction in scale
• Fight. Invest to improve the value generated by
  the existing products / business model
• Straddle. Short run measure to delay the
  penetration of rivals business model
• Recombine. Incorporate elements of rivals
  business model
• Switch. Complete conversion to rivals business
  model

Source Ghemawat, 1999
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Responses to substitution threats

• Respond
• Fight the threat
• Incorporate their benefits (e.g., orange juice
  supplemented with calcium)
• Incorporate their cost reductions (Internet
  kiosks to support sales at BN)
• Face up to your loss of added value, and reduce
  price before the substitute gets a foothold
• If you cant beat them, join them
• Take the money and run

• Anticipate
• Scan the landscape broadly for threats
• Understand underlying customer needs
• But be prepared to ignore the needs of current
  customers

Source Ghemawat, 1999
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Generic barriers to effective responses to
substitution threats

• Substitutes tend to start out in small, less
  profitable niches, and are at their most
  dangerous when they initially underserve the
  needs of existing customers (but get better
  fast!)
• Substitutes tend to inspire mixed motives in
  incumbents, who may believe that their incentives
  to respond are dissipated by cannibalization
  threat
• There may be ambiguity about which business model
  will win out
• Responding to substitutes may require
  capabilities that incumbents lack and that are
  hard to acquire

Source Ghemawat, 1999
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Hold-up

• Hold-up is especially threatening when parties in
  a relationship have invested in assets that are
  specific to that relationship (so its hard to
  walk away)
• An electric plant built at the mouth of a coal
  mine
• A railroad spur laid to a particular factory
• Skills that are tailored to a particular employer
• Hold-up diverts value to customers, suppliers, or
  complementors who have some bargaining leverage
• They have bargaining leverage because they have
  something you need and cant get elsewhere (added
  value)
• Ex Who makes all the profits from PCs?

Source Ghemawat, 1999
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Hold-up in the PC industry
Source Orit Gadiesh and James L. Gilbert,
Profit Pools A Fresh Look at Strategy,
Harvard Business Review, May-June 1998, p.145
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Hold-up Genex and G.D. Searle

• Co-developed a process for making one of the two
  key amino acids used in NutraSweet
• Genex entered into a long-term contract to
  supply Searle and built a new bioprocessing
  facility
• Searle began to renegotiate price within months,
  and initiated internal production within one year
• Genex went bankrupt

Source Ghemawat, 1999
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Anticipate hold-up

• Multiple sourcing (Niintendo)
• But investments in relationship-specific assets
  are important
• Tough negotiation
• Contractual arrangements
• But contractual incompleteness limits this option
• Vertical integration
• Dont base your competitive advantage on specific
  assets you cant own (like a particular
  individual)

Source Ghemawat, 1999
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Slack

• Slack, or waste within the firm, dissipates value
• Slack is hard to identify...
• Plush carpets for their own sake are slack
• But plush carpets to win customers and recruit
  talent might be wise investments
• Slack tends to be worst under certain conditions
• Forgiving competitive environments
• Settings in which managers must have wide
  discretion over productive processes

Source Ghemawat, 1999
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Slack in Major League Baseball?

• ANYONE WHO WANDERS into major league baseball
  can't help but notice the stark contrast between
  the field of play and the uneasy space just off
  it, where the executives and the scouts make
  their livings. The game itself is a ruthless
  competition. Unless you're very good at it, you
  don't survive in it. But in thespace just off
  the field of play there really is no level of
  incompetence that won't be tolerated. There are
  many reasons for this, but the big one is that
  baseball is structured less as a business than as
  a social club.
• Out of their Tree Michael Lewis Sports
  Illustrated, March 1, 2004

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Slack the theory of free cash flow

• Principal-agent problems between managers and
  stakeholders
• Managers have incentives to grow the resources
  under their control
• Free cash flow enhances managers ability to
• Invest resources in negative-return activities
• Waste resources

Source Ghemawat, 1999
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Slack at Microsoft or problems with
organizational design and motivating tech workers?

• Microsoft isnt exactly in fighting trim
  Indeed, four years have passed since Microsoft
  released a piece of software that generated the
  kind of buzz Google seems to generate every month
  As of March roughly 100 Microsofties had left
  for its search nemesis. Microsoft executives
  compensation is based on the success of their own
  organizations, which means, says a former
  executive, that every interaction with the
  Underdog team comes with strings attached.
• Gates vs. Google Search and Destroy
  Fortune, May 3, 2005.

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Responses to slack

• Monitoring of performance
• Benchmarking
• Time-motion studies
• Outsiders on Boards
• Managerial incentives
• On average, top executives get roughly 3.25 for
  each 1,000 of shareholder value created (Jensen
  and Murphy)
• Commitments to return cash to shareholders
• e.g., dividends
• Appeals to a higher calling, a sense of mission

Source Ghemawat, 1999
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Building sustainable advantages

• Understand your own uniqueness
• Scan the environment for
• Technological changes
• Variations in input supply
• Demand shifts
• Invest in opportunities that fit

Source Ghemawat, 1999
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Conclusions

• The best defense is a good offense, i.e., defend
  your advantage by continually upgrading it
• Seek out ways to increase willingness to pay
  without incurring commensurate supplier
  opportunity costs
• Seek out ways to reduce supplier opportunity
  costs without sacrificing commensurate
  willingness to pay
• Make yourself a moving target
• Remember that the landscape can shift under your
  feet

Source Ghemawat, 1999