Corporate Darwinism in the Digital Age

Corporate Darwinism in the Digital Age

The Delta Perspective
Authors Juan Jose Rio - Partner - jri@deltapartnersgroup.com
Vincent Stevens - Manager - vs@deltapartnersgroup.com
 
Overview
  • The telecom industry finds itself at a tipping point: traditional cash-cow services such as voice and messaging are being substituted by data access revenues, which come at lower margins.
  • Operators may recognise that an industry cycle is ending. Most of them, however, have yet to address this certainty. As a result, innovation is not yet prominently positioned at the top of their agenda. Furthermore, operators’ current innovation efforts are largely aimed at improving existing products (also known as “sustaining innovation”), which is fundamentally different from the disruptive nature of “radical innovation” that a transition in the industry cycle requires.

    This white paper aims at addressing the following questions:
  1. Why is radical innovation a critical topic for telecom operators?
  2. What are the key success factors for radical innovation?
  3. How can telecom operators put these theories into practice?
     

Introduction

Change is necessary for survival. As Charles Darwin famously wrote, “As many more individuals of each species are born than can possibly survive […] those who learn to collaborate and improvise most effectively prevail. […] I have called this principle, by which variations, if useful, are preserved by the surviving species, by the term of Natural Selection”.
 
Such a ruthless selection cycle is also present in the corporate world. Companies who recognise, embrace and change according to the varying conditions of markets and customer behaviour have a better chance of surviving industry cycles.

This is particularly true in the present situation of the telecoms industry.

The future of telecoms – revisited

A previous Delta Partners white paper (“The Future of Telecoms: New models for a new industry”, February 2012), argued that operators need to decide which markets to address in the new cycle and adapt their business model accordingly.
 
The dramatic shift that the telecom markets are witnessing is driven by the explosive demand for data access. As a result of such demand, new waves of services, some of them at lower margins, are replacing traditional cash cows for operators such as voice and SMS. This sharp decline in some traditional revenue sources is being partially offset by the rise of data access revenue contribution. However, this contribution needs to be complemented by additional income streams to sustain the revenues and margins of traditional operators going forward.
 
The previous white paper argued that in order to address these changing market conditions, operators can either evolve into “utility” operators or play further up the value chain and become “2.0” operators.
The key success factors for a utility operator lay around running the most efficient network and managing to leverage its capital structure in exchange for cash flow visibility on the back of multiyear wholesale agreements. The “2.0” operators, however, needed to expand into non-traditional services, with a strong, ROIC-based understanding of markets and services outside their core competencies, while being able to compete or collaborate with more agile players (OTTs, Apple, IBM, etc.) in new, evolving and fast-growing markets.
 
Innovation is critical to achieve these objectives in both cases.

This white paper aims to address the following questions:
  1. Why is radical innovation a critical topic for telecom operators?
  2. What are the key success factors for radical innovation?
  3. How can telecom operators put these theories into practice?



Why is radical innovation a critical topic for telecom operators today?

Radical innovation: necessary for survival

The average life expectancy of a company in the Fortune 500 index in the 1960s was 55 years; today this life expectancy is merely 15 years^1.

The mainframe market was disrupted by PCs which in turn are being disrupted by mobile and touch-friendly tablets. Similarly, telecommunications have been disrupted many times, from Morse code through fixed telephony to mobile telephony. Today, it seems that traditional mobile telephony is increasingly being disrupted by data-fuelled OTT services (see exhibit 2).

With the industry’s natural tendency towards being disrupted, radical innovation is key for survival. An emphasis on radical innovation does not only give companies the chance to survive but also to create a high-growth business by changing their operations very significantly as the industry transition takes place (see exhibit 3).


Telecom operators: good sustainers, not good disruptors
 
Operators have had a good track record in sustaining innovation. They successfully brought SMS, VAS and other services to the market in collaboration with OEMs. They entered the mobile data connectivity market and incrementally innovated with the adoption of subsequent technologies (GPRS, EDGE, HSPA+, WiMAX, LTE etc.).
 
So far, however, only a handful of traditional telecom players appear to be actively pursuing a “2.0” strategy while the majority of operators remain undecided. They may recognise that an industry cycle is ending, but they have yet to translate this certainty into action (and investments).
 
As a result, telecom operators are still investing in innovation at a lower intensity than the companies they encounter in their non-traditional markets (see Exhibit 4). As a result, their innovation output is lower compared to other technology-related companies/sectors. In 2012 only one operator had a spot in the IFI Top 50 Patent Assignees (see exhibit 5). Very few operators (if any) have launched a new service category/family in the last five years that could generate at least 20% of total revenues. There are however specific operators who have understood the need to increasingly focus on radical innovation and thus launched two innovation initiatives:
 
  1. The set-up of a Digital Business Unit, which focuses on future products and services as well as driving the required innovation to become a “2.0” operator. E.g. Telefonica and SingTel.
  2. The set-up of proprietary venture funds or partnerships with established VC funds, usually with a presence in Silicon Valley. E.g. Vodafone, SK Telecom, Telefonica, T-Mobile, NTT Docomo, Singtel and Orange, etc.
 
Although these are steps in the right direction, there remain questions around such initiatives.
 
  • Are the current digital  organisations being put in place
  • by these operators sufficient to drive radical innovation?
  • Are these new digital units  equipped with the necessary processes and responsibilities to develop and commercialise radical innovation?
  • Are the innovation budgets  being channelled into true radical innovation units or being diverted to marketing-related initiatives for existing products/markets?

Key success factors for radical innovation: An outward look at disruption and the lessons learned

Several studies^2 reveal that mature companies which attempt to enter new businesses fail in more than 90% of the cases. This illustrates the difficulties that companies face when trying to radically innovate and expand.
 
This section examines how operators can tackle radical innovation by examining the four key ingredients for a successful approach:
 
  • Overall innovation strategy
  • Governance 
  • Operational approach 
  • Funding 
 
Overall Innovation strategy
 
To succeed in radical innovation, two elements need to be present: first, the strategic focus to develop radical products and services, and; second, the fortitude to commercialise and stick with the developing initiatives.
 
Radical innovation requires assimilation into the overall vision and mission of a company - a transformation into one of its core strategic elements. Top management needs to demonstrate their support for radical ideas and provide teams with the necessary tools and assets to develop them.
 
.Many companies have failed to embrace radical innovation for different reasons. Blockbuster missed the importance of radical innovation, whereas Netflix thrived on the fast adoption of digital technologies. Kodak lacked the courage to self-disrupt, inventing yet choosing not to commercialise the digital camera. Nokia underestimated the potential of disruptive innovation, believing that the risk-reward equation was stacked against its Nokia 7710 (a mobile internet device with a full colour touchscreen) which, back in 2004, would have predated the Apply iPhone by three years. Conversely, Apple pushed ahead with a radical innovation strategy, launching the iPhone despite knowing that it would likely cannibalise the iPod and, more recently, launching the lower-priced iPad Mini despite knowing that it would likely cannibalise the iPad.


 
When companies become large and/or start operating in more mature industries, management focus changes from innovating to meeting quarterly profit targets. As this shift takes place, longer-term projects focused on unproven markets that could take years to develop tend to be deprioritised in favour of shorter-term, more impactful projects.
It is however the investment in such radical longer-term projects that will protect companies from industry cyclicality albeit at the expense of a Focus on the long-term and not only on the short- term slight impact on short-term profitability.
 
Amazon is known on Wall Street for prioritising longer-term strategic innovation projects over shorter-term profitability expectations. The company spends heavily on Kindle development, additional data centres and new warehouses. These investments led to poor net profit in 2012 – the company’s lowest in the last five years. Jeff Bezos, Amazon’s CEO, famously stated that he could not predict how long the investment phase would last (“and even if I could, I wouldn’t tell you”). Conversely, HP lost its way in recent years due in part to a lack of focus on innovation. The company did not release a single hot consumer product between 2008 and 2010. Instead, it emphasised financial management and cost cutting: R&D spend plummeted from 6.0% of revenue in 2002 to 4.0% in 2005 and 2.5% in 2009. HP attempted to buy innovation through its US$13bn acquisition of EDS and its US$11bn acquisition of Autonomy, yet has since written off US$8bn and US$9bn on these investments respectively. Between early 2010 and late 2012, HP’s share price dropped from US$53 to US$14.
 
Short-term innovation is therefore mandatory. Zara updates its collection every two weeks, Nike every three months while Apple forces itself to launch a breakthrough innovation every year.


 
In the early 2000s, telecom operators were addressing the need for increased innovation through large corporate alliances. Examples of such alliances and partnerships include the Nokia and Vodafone 2004 alliance for the simplification of Java standards and the 40+ operator Wholesale Application Community (WAC) alliance. Nonetheless, few innovative products were produced by these large alliances.
 
During the same period, many of today’s most successful digital/internet companies laid their foundations in Silicon Valley. Innovation hubs have since emerged globally (Boston, Bangalore, Haidian-Beijing and Tel Aviv) and have attracted billions of dollars in investments as well as some of the world’s brightest enterpreneurs and innovators.
 
Competing against these global and well-funded innovation hubs requires an alternative innovation strategy.
  • This open innovation strategy should be driven by two complementary models in telecoms operators: The top-down VC approach: tapping into innovation through a portfolio approach focused on investments which bring incremental value to the traditional business.
  • The bottom-up targetted  investment / partnership approach: complementing or accelerating specific innovation/technology or capability needs through acquisitions or partnerships. (See Exhibit 6 for examples)

Governance of radical innovation

Radical innovation needs to be managed in a separate, autonomous business unit. Sustaining innovation is focused on efficiency, working closely with the core business and making rational decisions. Radical innovation includes “blue sky” thinking, developing new markets (not existing ones) and potentially challenging the core business. Sustaining innovation is driven by concrete analyses, short-term market movements and/or competitive pressure. Radical innovation is driven by creativity and characterised by uncertainty. The sustaining culture does not accept failure. The radical innovation culture is about accepting failure and continuing to seek another path to success. Culturally these two “attitudes” are mutually exclusive. This exclusivity is best managed through separating the two innovation centres as well as staffing these units with different profiles.

Moreover, the size of organisations is generally inversely correlated with the effectiveness of developing radical innovation. Smaller units can be more effective, especially in the ideation and prototyping phases of new product development. Once finalised, the prototypes should be handed over from this smaller unit to another organisation (parent or new company) with more structured and defined capabilities for their monetisation.

Stories of a couple of friends disrupting industries from their garage or dormitory are ample: Facebook, Google, Apple and Microsoft to name but a few. Another striking example is IBM. Realising the potential danger of the growing PC industry, the company acted swiftly by appointing a small, autonomous team to develop a PC product. This team had permission to bypass normal company processes and limitations. The team abandoned the established IBM practice of doing everything in-house and built the machine with “off-the-shelf” parts from other manufacturers. They also decided on an open architecture, so that other manufacturers could produce and sell peripheral components and compatible software without purchasing licenses. The new PC – the Compaq Portable - was delivered in only a year and became a huge success.

Contrary to IBM’s approach, Nokia decided to merge their smartphone and basic-phone operations in 2006. With this merger, the basic phones business (carrying the biggest and most profitable P&L) took over the newly-integrated operations, conceiving many of the challenges apparent in the company today^3.

Sustaining innovation is usually managed in launch-gate processes. These processes aim to create the operational roadmap and rules for delivering innovation from the idea phase to the commercialisation phase. As part of these rules, gates control the innovation roadmap by offering evaluation checkpoints that ultimately aim at creating Go/Kill decisions. Typical gate evaluation criteria include ROI, NPV as well as market and company revenue projections. Whereas projecting these criteria with a significant level of accuracy is feasible for sustaining innovation, it is almost impossible for radical innovations.

Radical innovation requires processes to manage resources, budget allocations and project development. The processes and criteria to evaluate its potential however need to be markedly different. Evaluating disruption needs to be less around projected ROI and NPV and more around qualitative assessments such as answering customer needs, drastically improving customer experience or making something remarkably more affordable, etc. Once a prototype is developed, it then goes into commercialisation.

Examples of failures in understanding these dynamics are plentiful in corporate history. During the early 1980s AT&T’s research arm Bell Labs had invented the wireless telephone and just launched a commercial wireless telephony project in Chicago. It projected that the market would be relatively minor with 900,000 subscribers by 2000, leading AT&T to abandon the wireless telephony project. By 1995, US mobile subscribers amounted to 109 million, leading AT&T to buy its way back into wireless telephony that year with the US$12 billion purchase of McCaw.
 

Operational approach

It is critical for companies to identify the unique capabilities they possess to benefit from their core competencies in new markets.

Amazon made its name as a strong online book vendor. It subsequently made use of this platform to expand into new products and eventually drew upon its vast experience in managing data centres for its online shop to become one of the pioneers in cloud services.

With telecom operators converging with OTT players, it is even more important that operators fully understand what their core capabilities are and, moreover, fully exploit these to collaborate, address new competitive threats, expand into adjacencies and disrupt – before getting disrupted (see exhibit 7). When innovations aim at expansion into adjacent markets, operators need to carefully consider how well positioned they are to compete with the new breed of players that they will encounter. Are they better positioned to develop M2M devices and applications or more suited to complement M2M hardware and software providers with advanced analytics, billing and existing customer relationships?

The Vodafone 360 project was a potentially-radical, innovative project launched in 2009 – a predecessor to cloud-based services. It had to be abandoned due to Vodafone’s decision to launch dedicated phones and operating systems for this purpose, an area in which it could not compete.
Nevertheless, several companies have enjoyed significant success by exploiting their core competencies to enter new markets:
 
  • Nike expanded its markets and products by continuously following its four key strengths: branding, athletic partnerships, design and an efficient supply chain across low-cost production centres
  • Apple has so far focused relentlessly on improving customer experience in the electronics market by venturing into new product categories
  • Corning leveraged its core skill of processing glass to expand from lamps into televisions and, recently, smartphone screens.
Radical innovation fulfils a customer need in a simpler way – more affordably, more conveniently and/or with higher accessibility – thus significantly improving customer experience. Whereas sustaining innovation aims at understanding and addressing incremental customer needs (what MMS was to SMS), disruption has to understand the customer needs which future customers themselves are not yet aware of (or what BlackBerry’s email service was to SMS). The additional challenge with radical innovation is that companies often fail to understand the embedded intrinsic value.
 
Many companies developed great disruptions to address real customer needs. P&G did it with the Swiffer by analysing how people cleaned their floors, Netflix did it for people who did not want to physically go to a store and risk getting late-return penalties while Facebook won the battle against MySpace by offering what subscribers to social networks really wanted: social interaction with other subscribers.
 
Funding of radical innovation
 
Willingness to invest in R&D is a necessary but not sufficient condition for innovation. Overall investment effectiveness in radical innovation boils down to the combined effect of a company’s effectiveness to generate innovative ideas and transform them into a commercial product. Several studies have revealed that the most relevant factors behind R&D effectiveness are strategic alignment and a culture that supports innovation.

How telecom operators can put these theories into practice: The set-up of radical innovation in a “2.0” telecom operator

Delta Partners believes telecom operators should follow a six-step approach to successfully establish the capabilities required for radical innovation.

  1. Define fundamental radical innovation areas based on core capabilities
  2. Identify current innovation Capabilities
  3. Establish a separate Radical Innovation Unit
  4. Adjust internal processes to foster disruption (including remuneration)
  5. Set up long-term contribution objectives and meritocratic funding mechanisms
  6. Hit the ground running: start with quick wins

Define fundamental radical innovation areas based on core capabilities

To foster radical innovation beyond basic telecom services, operators need to focus on a limited number of areas where they have the greatest likelihood of success. Examples of such areas are communication applications, m-payments, digital advertising and movement patterns. When considering potential innovative ideas in the selected focus areas, some funnelling criteria should be applied to ensure that focus is attained (see exhibit 9).

Once an area has been selected, operators should decide where in the value chain their chances of success are optimal.

An example of a company that tried to innovate in unknown areas is Lego. Its attempt to launch, among other things, clothing lines and operate theme parks resulted in dismal financial results forcing it to return to its core capabilities of construction toys in 2004 . Their subsequent foray into gaming has been more successful.

Identify existing innovation capabilities

Once the areas of focus for radical innovation are identified, it is important for operators to take stock of their existing skills and capabilities. In general, innovation requires: (1) organisational skills for ideation and execution; (2) technical platforms for development and testing, and potentially; (3) partnerships to increase efficiency and improve the chances of success.

Set up a separate Radical Innovation Unit

Radical innovation needs to be managed in a separate and autonomous business unit with culture, people, processes, modus operandi and objectives that are very different from the core business. To ensure autonomy, it is recommended that the unit is not a business unit under the CCO, COO or CTO – true autonomy will arise in a separate Radical Innovation Unit under the direct supervision of the CEO or Board.

For the build-up of capabilities required within the unit, operators should use a combination of:
 
  1. Transferring core capabilities from the core business (e.g. ideation and idea development)
  2. Recruitment / procurement through M&A to accelerate the sourcing of critical yet absent capabilities
  3. Secondment from the core business (e.g. technical platforms, partnerships, etc. to develop and commercialise ideas and administrative capabilities)

Adjust internal processes

Radical innovation mostly targets unexplored markets and hence requires internal processes, policies and standards very different from those in the core business:

  • Incentive / remuneration schemes require special attention to attract the right talent (e.g. patent revenue shares, prospects of becoming shareholder in a potential spin-off)
  • Idea portfolio management (i.e.  ensuring resources are deployed optimally across the pipeline of ideas and in line with the unit’s objectives) should use financial KPIs only at later development stages (see Exhibit 10), instead prioritising value-add, customer relevance and technical feasibility in earlier stages. Projects that involve radical ideas should have the option to be put on fast-track, skipping process stages and/or merging with other related projects whenever idea development benefits from it. The idea development stage should finish only when a fully-tested and proven prototype is in place
  • 2022 
Sustaining innovations are usually commercialised by the operator itself. In the case of radical innovations, the operator is not always best-positioned for commercialisation. To optimise chances of success, the Radical Innovation Unit should have the option to commercialise externally, for instance through licensing or spinning-off a team that is responsible for monetising the innovation. It is however critical for the Radical Innovation Unit and the core business to communicate frequently on the development and commercialisation of ideas.​
 
Define a funding mechanis
 
Meritocracy is a prerequisite for funding any type of business with high uncertainty. Allocating a fixed annual budget to an innovation unit will undoubtedly lead to investment of the entire budget regardless of whether good ideas were sourced or not. Funding needs to be linked to the number of fertile ideas as well as their nature, development stage, risk and, of course, their potential.
 
Given the grave downsides related to radical innovation, spreading risk is critical. Clear guidelines on the maximum budget allocated per innovation domain (e.g. analytics or m-payments) and development stages (e.g. ideation or prototyping) are essential.
 
Furthermore, long-term focus is required when deciding on the funding principles for the innovation unit. Rather than allocating an annual budget and targeting short-term objectives, providing a cumulative budget for five or more years with objectives spanning a similar timeframe will allow the unit to focus on truly-radical innovations.
 
Funding should however be released selectively as dictated by the factors described previously (number of ideas, development stage, etc.).
 
Hit the ground running: start with quick wins

Just as with any new initiative, a Radical Innovation Unit should target a strong start to build and maintain stakeholder confidence – be they investors, management or the employees within the unit. As an outcome of Step 3 (identify existing innovation capabilities), operators should know which domains are likely to provide fertile ground for the unit to drive break-through innovation. Existing, well-developed innovation skills and radical innovation projects initiated within the core business can serve as an anchor in the early days of an innovation unit. Coming up with a success story quickly is critical for gaining the attention and endorsement of the traditional arms of the organisation.

What’s next?

Telecom operators looking to become a “2.0” operator need to expand into non-core telecom services where they face more agile competitors and potential collaborators. Radical innovation is critical for surviving this paradigm shift.

To assess if your operation is ready to address this industry transition, ask yourself the following questions:

  1. Does your long term strategy  recognise that your revenue and profit sources (products) will be fundamentally different in five to ten years? What is the role of radical innovation in that transition?
  2. What are the major non-traditional markets that will be relevant for you in the future?
  3. What are the unique capabilities which you possess that can be leveraged to disrupt these markets?
  4. How are you going to build up the required ecosystem of capabilities to develop radical innovations? Organically, through M&A and/or through partnerships?
  5. How is radical innovation going to be leveraged to become effective and efficient (organisation, processes, culture, staff)?
  6. Where do you source your leads for radical innovation? Are these sources comprehensive yet mutually exclusive?
  7. How much are you planning to invest in radical innovation in the next years? How are you planning to invest?

If the answer to any of these questions is not clear, your organisation most likely has untapped radical innovation potential

 

 


 

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