Concepts

The mechanics of disruption

This article explains with a simple model of value chains and technology why disruption takes place and why it is a result of efficient capital allocation.

Part 1: The value chain model

We start by looking at a standard value chain in a very simple way. We basically have a core industry player, like an automobile manufacturer with clear suppliers in the upstream and distribution networks in the downstream. pic1 We assume that all companies in the value chain are coupled using supplier contracts and a level of integratedness. The integratedness is defined by several factors:

  • Communication interfaces, such as IT integrated purchasing and delivery tracking systems or simple processes of aligning expectations and executing on the exchange of goods.
  • All exhibit solid financial performance and a good valuation. They are run efficiently and use the latest technology that is typical for the industry
  • There is a partial monoculture in the industry. All people in accounting are classical accountants, people in production and supply chain management are trained in business schools or learned business engineering. Production managers are engineers. Everyone else in the lower ranks went through vocational and on the job training.

We hence consider all providers of human capital, technology and process know how as suppliers of technology. In the following graphic, we show a simple model of this interconnection of outside technology providers and the value chain. We seperate providers that provide only two adjacent companies to provide some heterogeinity in technology effect and a general technology provider that services all.

Pic2.PNG

The next step is the emergence of a new technology provider. This provider services all or most of the companies in the value chain.

pic3

So far so well. In our single market model, the next step basically says that the innovator will grow its services and capabilities as to replicate the capabilities of the entire value chain. And even more, being yound and innovative, it will bundle the entire value chain in one single efficient company structure that now directly competes with the original value chain.

pic4

In the single industry model, this is a bit inplausible and harder to understand. It becomes more ineresting when looking at the multi industry model. And it will all make more sense when we look at the structural deficiencies of the old value chain.

pic5

The concept is the same. But now the innovator services many different value chains / industries at the same time. This basically increases its growth and financial stability, the higher the lock in. Allowing it to concentrate more resources on attacking single value chains.

pic6If the growth and future outlook of the company is strong enough, it will become attractive to key employees of the old industries it wants to attack. Aligning its hiring stratetegy to exploit this, the innovator will focus on draining the brains of the target value chain. If the number of industries under attack is large enough and success in a disruptive attempt becomes more likely and visibly,  the innovator can pay better, provide better salaries andoffer less old-fashioned and corporate politics and inefficiency driven cultures. While offering the same long-term stability and the potential of rising the ladder faster. Seems too good to be true. And with the brain drain happening, the replication process of core processes and built up of know how can start.

pic7Finally, the innovator disrupted some of the value chains it serviced, maximized its offerings in services to the remaining value chains it was not able to disrupt. Simple, right? But why does it happen? What are the determinants?

Part 2: Value Chain Inefficiencies as disruption inhibitors

To build a solid understanding why such disruptions happen and are capital efficient on the market view, we have to look at how industries normally evolve.

Pic8.PNGTypically, in every part of the value chain we find micro markets with competing players. Specialists sometimes spin-off and de-couple the value chain, but in our model world we want to focus only on the X-Axis of the value chain and the companies that compete for their market share in the value chain, the Y-Axis.

The competition is the most normal thing we observe in markets. They drive the development of markets and micromarkets within value chains and increase the efficiency and diversification of strategy in every segment in the value chain. That is principally good, but will be an issue later.

More importantly, in this B2B setting, market size is determined by the core of the value chain. There are very few possibilities to grow the market size, as it is all defined by the total market size of the  core industry players (the white balls) and their ability to create new distribution channels and their ability to capture consumption on the global macroeconomic levels. For the microsegments, this implies that there is little chance to grow, except in the X and Y axis dimension.

pic9pic10

This is where M&A and private equity comes into place when we look at growth via acquisitions and consolidation plays by private equity companies. This only happens, however, as long as some structural issues do exist, among which we have executable synergy and financial capacity. Financial capacity requires the M&A actor to have the financial power to actually buy a competitor. This is a must, even if synergy is not present and the investment would be dilutive. Without the financial power or after the financial power has bled out, there is simply no merger happening. Lack of treasury stock, over-leveraged companies, volatile- or at-risk sales trajectories or whatever. Whatever prevents is, at some point the financial capability is just not there. What remains is the private equity game looking at consolidation.

Consolidation plays don’t run well if dilutive. They typically have to be accretive and require hence some form of synergy value captured in the long run. This requires that the companies are run inefficiently enough – and competition drives this inefficiency towards zero – and that the potential synergy value is possibly captured. If the asset base of the company that creates the synergy can not be disposed of or the disposal value plus remaining asset base would kill the cost of debt to an amount that makes the transaction unfavorable, it will not happen. If the labour laws kind of eliminate the possibility of capturing savings from downsizing administrative forces and complexity, the same issue exists.

The idea here is not to say that disruption will only work in markets that are efficient. But the more efficient an industry and its value chain segments are, the less likely they are attractive for a consolidation. Without a consolidation, there is simply no way that the industry will achieve either the level of integration into a single company that would eradicate the thick wasteline in the industry to compete against our innovator, nor is there any hope that the entire market will invest into new technologies and restructure itself in a way that it achieves a level of competitiveness that the entire value chain can compete on key metrics against the innovator. The problem is simple: technology adaption and reduction of bad habits of companies is way harder to coordinate over a long chain of companies that form a value chain than it would be for an integrated old company. And even that integrated old company would be ridden by cultural and technological legacy issues that it would not be able to keep up with a new company if it is managed right.

Part 3: Opening the gates for disruption

The disruption model still requires the disrupter to get a foot into the industry. And this is driven by yet another simple model.

pic2Coming back to the picture in the beginning, it is clear that someone that attacks one of the small orange triangles on the lower side will not get a food into the door. Or at least, it is way harder than targeting the company at the top of the graphic. We will discuss this soon. At the same time, competing directly with the big triangle on the top will be too hard. There are too many trust issue and coordination issues and entry barriers will likely be too high. It is easier to target the total set of capabilities of the small triangles and enter the market by servicing  the core industry player – the white ball.

Pic11.PNG

Once servicing the core player and obtaining a hold of a core operational activity and the direct interface to key suppliers and distributors, it can enforce one of the competing value chain players to adopt its technology as to increase the ease and cost efficiency of the coopreration. Once a foot in the door in the adjacent value chain micro markets, it can build moments of suprise and customer successes that not only lead to higher revenues, but also reduce the cost base and efficiency of operations. This will lead to imitation throughout the value chain and percolation of the technology into the entire industry. Integrating process chains and technology, but also integrating the human resource capability and hence increasing the mobility of the workforce among companies, driving user adoption of the technology and awareness of the product. Thereby increasing the brand value and lock-in of the solution.

Having earned this level of trust within the entire value chain, new developments on the product will grow into the operational networks within each company and a deeper knowledge of processes and pain points is collected by the company.

Simple.

Summarizing: Value chains composed of efficient companies with little financial capabilities are perfect candidates to disrupt. It is both the disaggregated existence of the chain and its legacy technology that keeps it from competing with a disruptive new player. The disaggregation will not be overcome by rapidly consolidating the industry and legacy in technology combined with frictions on adaption will make the industry cope slowly and insufficiently, opening the gate for the disruption even more. A disrupter will know how to enter direct competition with the entire value chain by creating service lock-ins and will at some point start to brain drain the target industry. The structure of the industry makes it a bad investment once a disrupter comes into existence, providing way better expected returns.

This is of course only a simplified model on how reality could work. Hope you enjoyed the ride.

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