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Guru of the New Economy

Worried about keeping up with the dot-coms? Top business strategist Adrian Slywotzky offers plenty of sage advice.

1Sep


A CFO Interview by Edward Teach -- the extended, Internet-only version.


Sooner or later, the Internet keeps every manager awake at night. There's an entrepreneurial exuberance in the air, but there's a lot of fear and anxiety around, too. Companies fret that their bricks-and-mortar businesses will be "Amazoned" by dot-com barbarians, who roam unburdened by channel conflicts or profit pressures. In every industry, managers struggle to comprehend the changing rules of competition.


They may find enlightenment from Adrian J. Slywotzky, whose charting of the tectonic shifts in business has made him one of today's hottest corporate strategists. Not that there's anything flamboyant about the 48-year- old vice president at Mercer Management Consulting. Genial in manner, wonkishly bespectacled, Slywotzky more closely resembles, say, Warren Buffett than Tom Peters.


His reputation rests largely on a trio of books: Value Migration (1995), The Profit Zone (1998), and this year's Profit Patterns. Their unifying theme is the quest for value in a rapidly shifting business landscape. Today, the market prizes superior business models above superior products or technology, insists Slywotzky. And it showers its rewards on companies that are the first to recognize, and act on, patterns of strategic change in their industries.


Profit Patterns, co-written with David J. Morrison, is a compendium of 30 such patterns. These include, for example, "convergence" (when competitive boundaries between industries fall), "collapse of the middle" (when competitors migrate toward the extremes of cost, benefit, and focus), and "conventional to digital business design" (separating "atoms" from "bits" and managing the bits electronically). The latter pattern, whose description draws on a distinction made by MIT professor Nicholas Negroponte between materials and information, should be a concern for every company, says Slywotzky.


Recently, Slywotzky spoke with senior editor Edward Teach about the promise and perils of the new economy (or next economy, as he prefers to call it). Although it may seem that everything solid is melting into air, the Mercer guru says there's more need than ever for command of the business basics--and for experienced CFOs.



Companies are supposed to ask themselves, "What business are we in?" But you maintain the question should be...

"What's the next-generation business model that we should be running?" That is, the one that best responds to customer priorities and is so resource-efficient that it becomes highly profitable.



The customer, then, drives business-model change?

Yes. Power has gone to customers, because they have more choices. In the last economy, owning capacity was your source of strategic control. Today there tends to be overcapacity around the world. What's critical now is understanding the customer and, whenever possible, owning the relationship with the customer.


Some companies reinvent their business model every five or six years. GE is one. Coke is another. Charles Schwab is a third.


In fact, Schwab is a very good example of a company that consciously thinks about the needs to reinvent its business model every three to four years. Dell is a company that, in a recent conversation about technology disruption, said, "We understand technology disruption and it's important, but from our perspective, business-model disruption is even more important. We have been a business-model innovator, and we need to continue to be one if we're going to be successful."



Changing to a new business model isn't something like a eureka moment; it's something companies have to work out. Even Dell stumbled on its way to its current business model.

Many times, and Schwab stumbled on its way many times. Everyone is comfortable with the notion that when we do product innovation, we fail a lot on the way to creating great products. Business-design innovation is exactly the same thing, although the failure you have to put up with is much less frequent than in product innovation. All the great companies that do great business-model innovation do great strategic experimentation. They are smart about it because they isolate the experiment. They want to do it in a low- risk way, but they know that they have to incur a few failures in order to get it right.



Describe how one of these companies repeatedly changed its model.

Perhaps the best example is General Electric. In 1980-81, GE understood that in order to win, you had to be number one or number two in your industry, and at that time market-share leadership really did translate into profitability leadership. By 1986-87, market- share leadership was no longer enough, because GE was selling to huge, powerful customers like Wal-Mart, Boeing, GM, and Ford, which were asking for the lowest price. That caused GE to say, We have to translate that market share into the most productive position.


By 1991-92, being number one in market share and being the most productive turned out again not to be enough to create profit growth, simply because there was too much capacity in the businesses where GE competed. So GE moved to the next model, of creating services and solutions for growth.


Now it's 1999, and within the last couple of months, Jack Welch and GE have said that our number one, two, three, and four priorities are Internet and digital commerce. So the next progression for GE is, We have to move from the things we do conventionally, on paper, in personal meetings, and so forth, to understand how we can add more value to the customer with a digital business design.



What do you mean by "digital business design"?

When I talk about digital business design, it is not a technology-centric conversation--"How can we digitize what we do?" The best practitioners, whether it's Microsoft or Schwab or Amazon, start in a very different place. What are the top five business issues that face our organization? What are the smartest design choices on those issues that we can make that are customer relevant, highly profitable, and organizationally doable?


Then, which of the activities around those choices are atoms versus bits; and then finally, why aren't we managing 100 percent of the bits electronically? And you can essentially rethink your entire activity chain, from customer interaction to selling to marketing to manufacturing to purchasing, and ask along every step of the way, Which of the activities are inherently bits by nature, and why aren't we managing them electronically? Now this also helps to explain the Internet, because the Internet is very often taking the selling and service step of the value chain and doing it electronically.



Digital business design is something all companies should be doing, not just high-tech or Internet companies.

Yes. These companies include manufacturers like GE, cement makers like Cemex. They include pulp-and-paper companies, like Weyerhauser. So this next economy is an equal- opportunity economy, from atoms makers to pure knowledge creators.



Another company that is generally regarded as a poster child for the next-generation business model is Cisco.

Cisco makes 70 percent of its revenue electronically, but it understands that digital business design is not just about the selling step. It's the whole system. Cisco has brought digital technology to recruiting, to training, to interactions with suppliers.


But Cisco is much more impressive for its command of the business basics. John Chambers [Cisco's CEO] spends 40 percent of his time with customers. Not just with satisfied customers, but more important, with dissatisfied customers--to understand why Cisco isn't measuring up and in which direction the customer is headed.


The best business-design innovators are always outside listening to or arguing with their customers. They get more of the data directly, to understand what the next two or three patterns of strategic change in their industry are going to be. And then, it takes a courageous management to say, as Coca-Cola did in the early 1980s, "The thing that has carried us so far is no longer going to be enough."



In terms of shareholder value, Coca-Cola outpaced Pepsi in the 1990s. What did Coke learn from its customers that Pepsi didn't?

Companies that succeed in reinventing their business models do not accept the conventional definition of who the customer is. Coke is a classic illustration. The conventional definition of Coke's customer is the consumer. Strategically, nothing could be further from the truth.


For Coke, consumers are important, but much more important are the bottlers. In that industry, profitability is concentrated in vending and fountains, not in the grocery. It was only when Coke changed its relationship to bottlers around the world that it succeeded in making the product available in the most- profitable environments.


The case of Microsoft is similar. Their key customer is the application developer. This doesn't mean the PC user or the corporation is not important, but what drives adoption of the system is the thousands of applications that developers write for it. Apple invented the focus on application developers, but Microsoft did it 10 times better.



Doing it 10 times better can make a huge difference in stock valuation, which you refer to as "value polarization."

That's something that we didn't see in the economy 15 years ago--the ability of a business-design innovator to create such a leadership position that its value is 3, 5, 10 times greater than the second-place finisher. We used to live in the age of market share. Today, increasingly it is mind share that matters--mind share with customers, with investors, with talent.


The great business-design reinventors create a better deal for the customer, who rewards them with sales and profitability. Because of their ability to reinvent consistently, investors place a much greater degree of confidence in them.


This ability to create a rising valuation becomes the killer competitive advantage in bringing the best talent to the organization. And then these three things reinforce themselves: customer mind share, investor mind share, and talent mind share.



How is corporate finance changing?

The role of finance, I think, will grow dramatically for a couple of reasons. Clearly, the message of this whole conversation is that understanding the customer, the profit, the business perspective is becoming increasingly important. And in many organizations, the primary spokesperson for that perspective, in addition to the chief executive officer, is the CFO.


I think the second thing that changes and makes the role of the CFO more important is this whole shift from the last economy to the next one profoundly changes our metrics. In the last economy, if you and I had a business that was growing at 20 percent a year, it was obvious to everyone that we would need to have access to capital, whether equity or debt, to support that growth. That was a reasonable thing to do, and the challenge was to get that financing on the most favorable terms.


The combination of business-model innovation and the opportunity to digitize business models is turning a lot of the rules of finance upside down. Dell, for instance, has always been a lean company. Its working capital as a percent of sales in the early-to- mid-1990s was 12 to 14 percent. By moving to a digital business design, Dell achieved negative working capital.



And by digital business design, here we're talking about direct sales of computers over the Internet, made to order?

Correct. We're talking about moving from direct to direct electronic. We're talking about customers paying Dell in a couple of days and Dell paying its suppliers in 20 or 30 days. Most important, we're talking about the cutting down of cycles wherever possible--not just externally, vis-à-vis the customer, but internally, in what the company does.


Even more remarkable than Dell's negative working capital is Microsoft's negative asset intensity.



Define asset intensity.

Total net assets of a company relative to sales. In a very asset-intensive industry, you'd need a dollar of assets to support a dollar of sales. For many companies, it would be 60 to 70 cents. For many software companies, it would be 15 to 20 cents. For Microsoft, the number is negative. Microsoft has built a business model lighter than air. It can grow and throw off cash, which is why its cash hoard is so great.



How can asset intensity be negative?

In traditional business models, companies have positive asset intensity. In a digital business design, this principle can be overturned. Microsoft receives payment from customers, some part of which it does not recognize as revenue until certain service obligations are met, over a one- or two-year period. These unrecognized revenues are accounted for as a liability on Microsoft's balance sheet. The liabilities exceed the assets, adjusted for cash and investments.



Many stock prices are lighter than air, too. In the case of dot-com companies, valuation is rising to almost an absurd extreme. Investors are saying, in effect, "You lost a lot of money last quarter. You lost even more this quarter. Keep up the good work!"

It is an extreme. But buried within that extreme is a bunch of very good business designs that may not be worth $20 billion, but may be worth $7 billion to $10 billion. Amazon and Priceline and Ebay have very powerful business designs. They have a profit model, and they have a strategy for creating greater and greater strategic control.


The problem with dot-coms and the Internet economy is that if you ask basic business- model questions--What is the unique value proposition? What is the profit model for this business? What is its source of strategic control?--there is no answer. So in the next year and a half to two, we will see in this space what we've seen many times before in other spaces.


Go back to 1989. Remember the wonderful PC software companies? Very low cost of goods, phenomenal profit growth of 40 to 50 percent, and no basis of strategic control--and 90 percent of them disappeared. We'll see that in the Internet economy.


However, in that economy there are genuinely powerful and effective new business designs that are being created, and there is an underrepresentation by incumbents in the creation of those new business models. That's because, in many cases, the incumbent companies already have the information about what's important to customers and how the economy works to start that new business design--but are reluctant to do it for a lot of reasons that tend to deal with cannibalization or organizational unreadiness.



Customer acquisition seems to be the basic business model of Internet companies like Amazon.com. They seem to regard product almost as content, needed to attract and retain customers.

I think the business model they're building highlights another dimension of what's different about the next economy. In the last economy, what mattered was capacity utilization. That's still important if you're in an asset business, but for value creation, the analogue now is customer-relationship utilization. As a stand-alone bookseller, Amazon.com could be profitable in three to four years, but that's not its intent.



And that's not why investors have poured money into it.

Correct. It costs Amazon x dollars to acquire a customer, but as it grows, it will be in a position to get a very high utilization of the customer relationship.



What strategic pattern is Amazon.com following?

It is a new pattern occurring with increasing frequency on the Internet, something we call a cornerstone pattern. You do a great, A-plus job for the customer in one area, whether it's books or auctions. Then you figure out the next logical step, and then on and on. Schwab has done this, Microsoft has done this, Dell is in the process of doing this.



Unlike those companies, Amazon.com isn't making any money yet.

Amazon is a tough and important case that is a challenge for financial people. In the last economy, if you and I wanted to start, say, a chemical company, and we had to invest $1 billion in assets to get started and therefore had to report losses for three or four years, everyone would understand that. In fact, they would help us by allowing us to amortize that investment over 20 years. Amazon's investment is acquiring customer relationships. But they are not allowed to amortize that; they have to expense that.


So the key question with Amazon and all the Amazon-type business models is not to ask whether they're losing money in the aggregate, but are they or are they not making money on the customers they acquired in 1996?



For every next-economy company like Amazon.com or Dell, there's a last-economy company facing wrenching changes in order to keep up. Compaq, for example, has a difficult challenge --moving to direct sales.

Here we have a helpful comparison, because if the Compaq challenge is significant, the IBM challenge was much more significant. And yet IBM did it. The two patterns that did Compaq in are the same patterns IBM is taking advantage of. In the first, a collapse of the middle [of the market, where products offer neither superior cost, benefit, nor focus] to low cost and high service, Dell owns the low cost, and IBM is getting to the point of owning the high service. In the second pattern, the shift from conventional to digital business design, Dell has done it internally, while IBM is helping its customers do that. If a company of that size and that history can do it, there's hope for everybody.


When you talk about the wrenching changes companies have to undergo, some are learning that the quality and intensity of communication to employees inside the company-- call it marketing--are as important as the quality and intensity of communication to the outside customer. What makes change more wrenching is that often, management underinvests in the crafting of the message and the continued delivering of the message on the inside. Companies that are good at reinventing their business designs are great internal marketers.



What other new metrics will CFOs need to navigate in the next economy?

The investment world has moved from EPS to EPS plus asset efficiency. An organization can move from EPS to EPS plus asset efficiency, to new benchmarks for maximum asset efficiency.


Then there are a couple of new arenas where the metrics might be less formal than GAAP principles but are extremely important. Understanding customer profitability is one of the most critical pieces of information systems to develop. Also, turnover, especially of top-decile employees, is a powerful leading indicator of how healthy an organization will be tomorrow. When too many of our good people are leaving and too many of our weakest performers are staying, what do we need to do about that?



How is recruiting done in a digital business design?

Recruiting in the traditional world has kind of been a neutral marketing exercise. I write in my résumé what I ask you to read, and you represent about the firm what you want them to hear. By introducing a digital framework into that conversation--again either a Cisco or Dell can serve as an example, or Microsoft-- you don't send them the résumé that you want to write. You fill out a set of answers to a set of questions that are related to the kind of job that you're applying for.


Second, you don't have to do a lot of hunt-and- peck for what jobs are available, because their Web sites provide data on what kinds of jobs are available, what the requirements for those jobs are, etc. So it is a shift from kind of mutual marketing at each other to an information exchange as the first step in the process. That, in turn, weeds out poor matches and allows more time for high-likelihood candidates to spend talking to the right people in the organization.



So talent can be recruited much more efficiently and cost-effectively.

Yes. Now, just one caveat, going back to basic principles on digital business design. It's not about the technology, it's about the business issues. The best digital framework in the world won't work unless the company has thought through and articulated its recruiting strategy. Who do we really need? Who are the right people for these jobs?



You maintain that CFOs should have a good knowledge of numerous business designs and patterns of strategic change, as you discuss in Profit Patterns. Why?

Ten years ago, life was simpler, because there were one or two basic manufacturing business models. There were one or two retail models. Today there are at least two- or three-dozen different business designs, and within any company there may be six to ten important ones that the company doesn't practice but may need to know about--either because competitors are adopting them or because one might be the next best one for the company. That may mean, for example, moving from products to services or from products to solutions, or from a product line to a product pyramid, or from a soloist to a partner model.


The important thing is understanding on a going-forward basis, What is the true range of business designs that we ought to be considering? I think developing that lexicon and developing the associated financial characteristics of those business designs is a very, very important contribution, because it will be a way to challenge the thinking--in a constructive way--of the business units.



The next economy seems in many ways to be a lot riskier than the last one. Is it?

The level of risk for every organization has gone up dramatically. There are traditional operational and hazard risks, there are financial risks, and there are strategic or business-model risks. Many people will say that traditional hazard risks represent 20 percent of total enterprise risk. The strategic risks represent 50 or 60 percent, so if I get the business model wrong, I can lose 50 to 60 percent of my value.


This next economy needs a reconceptualization of what the total risk for the enterprise is, measured in terms of threat to the market value of the enterprise.



Everything we've been talking about concerns the acceleration of change--how quickly business models become obsolete, how easy it is for a company to fall behind. Many executives may worry whether they themselves are becoming obsolete--even "finished at 40," as a recent Fortune cover story put it. They may be asking, What is my experience worth today? Am I still valuable?

If I had been doing the same thing for 20 years and had not been learning and turning over the stock of what I know, those would be tough questions.


But let's see whether this is about age. Ray Kroc started McDonald's at the age of 55. I don't know how old Jack Welch is, but he is a better innovator and strategic thinker than 90 percent or more of the new Internet players. I don't remember how old Sam Walton was when he died, but Sam Walton reinvented the Wal-Mart business model every five or six years since 1945, over a three-decade period. I don't know how old Warren Buffett is, but Warren Buffett has been consistently changing over what he has been doing for three decades.


I have a hard time accepting the proposition that age has anything to do with it. The critical factor is acquiring knowledge. More important, applying that knowledge, and then refreshing it over time.


At no time has creative and rigorous business thinking been more important. Most Internet companies are great at digitization but terrible at business design. They don't have the profit-model issues nailed. They don't have the unique value-proposition issues nailed. They don't have the strategic-control issues nailed.


So I think the ultimate answer is, if you are a learner and an applier, age is completely irrelevant.

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