Inside the Tornado: Strategies for Developing, Leveraging, and Surviving Hypergrowth Markets

INTRODUCTION

When I’m writing a book, I typically save the introduction for last, the theory being it’s much easier to tell people where you’re going once you can see where you’ve been. But being able to write a second introduction some four years after the book’s initial publication—now that’s a special treat. For this way I get to incorporate and respond to feedback from a variety of people, all without having to write another book! It’s a laborsaving device indeed.

The feedback on Inside the Tornado has been deeply gratifying. The high-tech industry, particularly in the United States, has embraced its key concepts and made its core metaphors common vocabulary for assessing the maturity of emerging markets and the status of vendors within them. The Chasm Group has made the book the platform for its primary practice offerings and in so doing has grown from three to six partners, and now we are in the process of adding affiliates. That practice is rapidly becoming international, with the book being translated into Chinese, Japanese, Korean, French, German, and Portuguese, with clients on six continents and affiliates on three. The book is also used as a standard text at Stanford, Harvard, MIT, Northwestern, and a host of other business and engineering graduate schools, so that a new generation of entrepreneurs is coming into the market already versed in its ideas. It is hard for me to imagine an author asking for more, and I very am grateful for this response.

That being said, feedback isn’t much use if it does not also point out opportunities for improvement. Virtually every model in the book has undergone some level of metamorphosis over the past four years, as the pressure of real-world consulting engagements force contradictions and flaws to the surface. For the time being my colleagues and I have been able to contain these learnings in updates to our PowerPoint library of slides. They have not yet overflowed these banks, but no doubt they eventually shall, at which point I’ll put them into a revised edition and test the industry’s support once more.

There has been, however, one tsunami of change in the form of the Internet and the emergence of e-commerce that simply cries out to be addressed at this juncture. But before so doing I must issue a word of warning: to apply the ideas in this book to the Internet marketplace, I have to assume that you as a reader are already familiar with them! Unless you are clairvoyant, this seems a bit presumptuous. So, unless you are picking up this book for a second read, let me first of all say welcome; second, say thank you for buying the book and giving it your time; and third, suggest you dog-ear this very page right now and skip to Chapter One. Then, at the end of the book, if you are still willing, come back and finish here at the beginning, taking the introduction as an afterword.

[Interlude, during which first-time readers peruse the remainder of the book, and other readers pass on to the next paragraph.]

Ah, there you are. Welcome back. OK, now that we’re all on the same footing, let’s get down to a really key question: in the entire manuscript of Inside the Tornado the Internet is referenced precisely three times. How in the world did I completely miss what will arguably be the grandest tornado of all time? Well, all I can say is that it’s a gift.

But in my defense, the manuscript deadline was June 1995, a full six months before Netscape released Navigator 1.0. At that time it certainly felt like the Internet would be the next big thing, but I for one had no ideal how quickly and comprehensively it would happen.

As of this writing, it is approaching the end of 1998, and there is no sector of the American economy that has been untouched by the Internet. Internationally, on the other hand, the pace of adoption has been substantially slower, gaited by the gradual deregulation of the telecommunications industry. Nonetheless, to put things in the vocabulary of this book, we are witnessing a worldwide series of tornadoes, and I think we are far enough into it to project a trajectory of where things might go next.

First, to review how far we have come, in 1996 and 1997 we witnessed the first Internet tornado, focused on the browser. In this competition Netscape Navigator was virtually a gorilla at birth, skyrocketing to more than 80 percent market share in the hypergrowth market. That lead should have been insurmountable, it should have institutionalized Netscape as the de facto standard, conferred upon it gorilla status, and set up its shareholders for very long-term gains. What happened?

Microsoft made a brilliant strategic response and then executed it with draconian efficiency. The key strategy was to clone the Netscape browser, not compete with it. Microsoft, in other words, played monkey, not chimp, to this dangerous gorilla threat. By so doing, it was able to co-opt the very market Netscape was creating. However, a clone response alone would not have been enough because Netscape still had the gorilla’s right to set extensions to the standard going forward, in the manner that Intel has used to maintain its lead over AMD and National Semiconductor, for example. But here a strategic flaw in Netscape’s plan emerged: the technology of the browser was not all that difficult to reverse engineer. As a result Microsoft caught up to Netscape’s lead in less than a year, with its Internet Explorer 3.0 reaching parity. This then allowed it to compete head to head—still using monkey tactics—to win major deals on price, where the price was free.

Meanwhile Microsoft’s underlying strategy began to emerge, along the following lines:

No one can beat a gorilla on its own turf, but

Netscape’s turf has to ride on top of our turf, the Windows operating system, so

Let’s incorporate the browser into Windows and thereby

Defeat the gorilla by dissolving its turf.

Once this strategy became evident, it was game over for the browser wars. Everyone could see that Microsoft’s play was undefeatable, and Netscape’s stock plunged virtually overnight.

As a consequence, our society has begun an extended debate on the implications of this strategy and its outcome, one that will force all of us to rethink our understanding of competition, monopoly, restraint of trade, economic freedom, capitalism, regulation, political and social responsibility, and the like. The issues are deeply intertwined and hugely complex, and no single set of rulings will be definitive. Rather it will be part of an ongoing cultural adjustment to the larger movement from an asset-based economy to an information-based one. But in the meantime, the hypergrowth of the Internet continues, and we cannot let its opportunities slip from our grasp.

The second Internet tornado, hitting full force in 1997 and still raging as of this writing, is the explosion in web sites. Whereas the killer app for the browser tornado was, well, browsing, the killer app here is taking advantage of all those browsing eyeballs by letting them look at you. For corporations a web site has become a necessary address, a place to stage its public information, an anteroom if you will to the buildings proper. As the leverage in web sites became clear, IT professionals readily yielded to their deployment, thinking no doubt that the wave of change could be held at bay here, giving everyone some time to settle down and approach future changes more deliberately.

But no. Almost instantaneously internal corporate users became caught up in what was the original purpose of the web—to share information among related working groups—and the real web site explosion happened under the banner of the intranet. The intranet, prodded by email, has now become the internal information pathway of choice for all high-tech companies and for technology-enabled services such as banking and brokerage. It is a testimony to the success of this deployment that most people, in these sectors at any rate, already are feeling glutted by this new arrival.

Both the public Internet and the internal intranet tornadoes have driven demand for web servers and software, not to mention Internet connectivity, all of which has driven infrastructure players like Cisco, Sun, Microsoft, and Netscape to prominence. At the same time, the Internet has also driven the transformation of electronic mail from proprietary software from Lotus and Microsoft to a simple common Internet email protocol. And as this new world of unified addressing emerges, email itself is becoming a tornado market force in its own right, driving traffic volumes up dramatically (thanks in large part, unfortunately, to spamming), and creating a whole new market in directory services.

Huge increases in traffic, in time, are impacting everyone’s networks. As organizations seek to offload this deluge, they turn to colocating facilities like Exodus or to complete out-sourcing from a value-added internet service provider such as an MCI/Worldcom or a GTE/BBN. These institutions’ networks, in turn, impinge upon the publicly switched telephone network—our voice heritage—which is hopelessly swamped by what looks, to it, like an epidemic of phone callers who simply won’t hang up. That in turn is driving more infrastructure innovation—and dramatic merger and acquisition activity—as voice switch and data communications vendors seek to match up systems for the new world. NorTel buying Bay Networks appears to be no more than the opening move in what looks to be an extended game.

All this tornado activity to date has been driven almost exclusively by the three information-sharing killer apps of browsing, web publishing, and email. At this stage of market evolution, the infrastructure players are the key competitors, with the rest of high-tech serving primarily as the first bowling alley of pragmatic adopters. As 1998 comes to a close, however, we are seeing two other bowling alleys come onto the scene—telecommunications itself, and financial services—where the killer apps are, respectively, customer care and electronic financial transactions. In both cases we are seeing the beginnings of a second series of tornadoes, this one emerging not from investments in infrastructure but rather investments in applications.

The customer service implications of the Internet are simply huge. In technology-based businesses, the Internet has already become the first stop in customer support. Combined with email, and backed up by customer service applications from Vantive, Clarify, Baan (Aurum) and Siebel (Scopus), web-based support systems are already reengineering the way companies interact with business partners, with interactions with end customers not far behind. All this in turn will become part of a series of tornadoes in the customer relationship management and supply chain management areas. In every case what we are seeing is the grafting of a new communications medium onto business processes that are externally focused—the complement of all the back office automation that has been driven by replacing internal systems in preparation for the year 2000.

As application vendors get swept up in the Internet tornado market forces, they must review their fundamental strategic assumptions. Bowling alley strategy is best for most application vendors most of the time. Tornado forces, however, reward marketshare land grabs. The problem is that rapid customer acquisition is fundamentally in conflict with complex business process reengineering, and so application companies are torn between losing out to a competitor or underservicing a valuable customer. The fundamental lesson of tornado marketing, however, is clear on this part: beat the competition first, apologize to the customer later.

In the domain of financial services, in additional to customer care applications, we are also seeing the emergence of commercial transaction processing—real e-commerce. Thus on-line portfolio management, a customer service, is being paired with on-line stock trades, a transaction service. This slight break in the dike portends gargantuan flooding to come. Historically, two infrastructures have developed to support traditional transaction processing—the Verifone network for consumer credit cards, largely from MasterCard and Visa, and the EDI protocol for purchase order processing between companies in the same supply chain. Both will be overwhelmed and assimilated by the coming Internet-based tide. Vendors in each category must begin creative self-destruction in order to compete effectively for their own future. There is no more challenging management task than, as the folks at H-P like to put it, eating your own lunch.

Consumer e-commerce, however, is currently stuck on a presales challenge, that of adopting its shopping mechanisms—not its buying mechanisms—to the web. More specifically, it’s a catalog problem. For style-differentiated retail items, the problem is largely photogenic—paper catalogs represent the pinnacle of photo finishing, towering over the lowly image resolution available on the web. Moreover, most retail customers access the web via dial-up connections that have limited bandwidth and will continue to do so for many years to come. And finally, attractive as the Internet is as a source of new prospects, it represents a very small portion of the total retail traffic. All this has combined to make investing in on-line retail a patchy rather than universal phenomenon for the foreseeable future.

That being said, where these exigencies can be got around, there are huge market share grabs under way. The poster child for such efforts is Amazon.com, and it is worthwhile to see just how many unique attributes have contributed to its astounding success. First, as many have noted, books are one of the few retail items that do not have to be tried on in some way before purchase. So shopping is not significantly impaired coming to the store on-line. Second, the catalog problem had already been solved by the industry’s existing distributors—it had to be converted for on-line use but not assembled for the first time. Third, while book shoppers will continue to frequent bookstores, book buyers like the convenience of not going. Fourth, the book buyer demographic is particularly strong in business people who access Amazon.com not from home but from work—at much higher network speeds, creating a much more user-friendly transaction. And, fifth, book buying does not require purchasers to release confidential personal information, something that can challenge other commercial transactions. And sixth, the inventory distribution, and returns systems for book buying and selling that Amazon.com leverages were also already in place from its inception.

Now, to be sure, Amazon.com has done a superb job at reinventing the consumer buying experience for the on-line world, making its site a must-view for anyone else seeking to conduct e-commerce. But other companies need to carefully vet their own whole product to make sure it too can make the transition.

The other glitch that is slowing the adoption of e-commerce is on the business-to-business side, where the challenge is to front-end existing enterprise systems for customer registration, order management, credit checking, inventory availability, logistics management, and billing and collections. For companies run off a simple integrated package, this is predominantly an interface and security challenge. But for companies that comprise multiple heterogeneous systems, this is a showstopper. There is simply too much complexity, both initially and in maintenance over time, to retrofit this overlay. That portends, in time, yet another tornado as the whole world swaps out client/server infrastructure for web-enabled.

And so, with Internet commerce deferred for a prolonged interval, we can also expect all its extended implications to be deferred as well, many of which have been build around the promise of one-to-one marketing. While that premise is compelling, it must remain dormant until the order transaction flow has been fully Internet enabled.

In the meantime, the e-commerce market’s growth and focus is shifting from the product providers, who have profited heavily from the infrastructure tornadoes, to the service providers, who have the upper hand in the coming application phase. There are two fundamental classes of service providers—professional services, typically consultancies, which focus on bringing up new systems, and transaction services, typically sites, which focus on using the new ‘systems to the end-customers’ benefit. The former should be thought of as technology-enabling services, the latter as technology-enabled.

With the tectonic shift toward an information economy, the demand for Internet-enabled suppliers is hugely backlogged, and the talent pool to work off that backlog is scarce indeed. As a result, professional services firms that historically have been valued at one times revenues now have valuations five or six times that. This shift in valuation permits aging companies who have failed to introduce compelling new products to redefine themselves as consulting firms with compelling new services. As long as widespread demand continues to be wedded to inherent complexity, demand in this arena will be effectively unlimited, and the competition, as in all tornadoes, will be won by those who are best able to leverage supply.

Once any infrastructure is substantially deployed, power shifts from the builders—the professional services firms—to the operators, or what we have come to call the transaction services firms. The key to the transaction services model is that the requisite infrastructure has already been assimilated (keeping support costs down) and amortized (minimizing ongoing investment). Unfortunately, neither of these conditions is even remotely approximated by the current state of the Internet. As a result, transaction services companies are at present operating at extraordinary deficits, and all are forced to raise money in a kind of Ponzi scheme that, hopefully, gets renewed by the emergence of stable conditions before it runs out of capital-raising capabilities. Downturns in the world economy, such as the one currently threatened, put such funding mechanisms severely at risk, and investors will need ironclad stomach linings to survive the coming years. That being said, where the infrastructure has stabilized (at least for now), one can find some of the most highly valued companies in high-tech today—Yahoo!, America Online, and Amazon.com being the most visible.

Nonetheless, the sweet spot for transaction revenues is Main Street, a time when the core technology has been commoditized, and companies differentiate based on the variety and customer fit of the offers they can field. With this realization we can close by summarizing the findings as follows:

For every stage of the Technology Adoption Life cycle, there is an optimal business model:

The Internet market tornado, however, is so powerful that it has sucked all four models into its vortex.

Thus each model has its own peace to make with the tornado, and indeed since there are multiple tornadoes within the general one, to make with each of these as well.

In light of the above, our consulting practice at The Chasm Group, which has traditionally been targeted at product companies, no longer can sustain that focus. The product/service interchange has become so fundamental to navigating the Internet-impacted waters that every company needs to retain some flexibility to go the other way. This represents the single biggest change in perspective since Inside the Tornado was written, and since the author did not have it then, I ask that you the reader bring it with you now.

And with that, I wish you all the best as you go out into the world and invent this new economy.

PART ONE

THE

DEVELOPMENT

OF

HYPERGROWTH

MARKETS

CHAPTER  1

THE LAND OF OZ

At the beginning of The Wizard of Oz, Dorothy and Toto are caught up inside a tornado, swept away from their mundane world of Kansas, and deposited into the marvelous land of Oz. This miraculous form of ascension is also reenacted from time to time on our own public stock exchanges.

Consider the following:

Compaq Computers, which in recent years has overtaken IBM as the leader of the Intel-based PC market, grew from zero to $1 billion in less than five years.

Ditto for Conner Peripherals, the disk-drive storage company who slipstreamed Compaq’s hypergrowth by supplying it, as well as many of its competitors, with low-cost Winchester hard drives.

Over a six-year period from 1977 to 1982, Atari’s home game business doubled in size every year, driving the company from $50 million to $1.6 billion in revenues.

In successive years during the mid-1980s, Mentor Graphics grew from $2 million to $25 million to $85 million to $135 million to $200 million.

For the entire decade of the 1980s, Oracle Corporation grew at an annually compounded rate of 100 percent.

More recently, Cisco Systems and Bay Networks have appeared out of nowhere to become billion-dollar companies—leaders, respectively, in the network router and the network hub markets. We didn’t even know what routers and hubs were until just a few years ago.

In the seven years prior to 1992, Sony shipped their first ten million CD-ROM players. The next ten million were shipped over the following seven months, and the ten million after that in the following five months.

Hewlett-Packards PC printer business, a $10 billion enterprise in 1994, shipped its first product a scant ten years earlier.

And finally, Microsoft in less than fifteen years has grown from a boutique language software company focused on BASIC to the richest and most powerful software company in the world.

Such are the market forces generated by discontinuous innovations, or what more recently have been termed paradigm shifts. These shifts begin with the appearance of a new category of product that incorporates breakthrough technology enabling unprecedented benefits. It is immediately proposed as the natural replacement for a whole class of infrastructure, winning early converts and enthusiastic predictions of a new world order. But the market is a conservative institution, and it presses back against the new changes, preferring to stay with the status quo. For a long time, although much is written about the new paradigm, little of economic significance happens. Indeed, sometimes the innovation is never embraced, falling back into some primordial entrepreneurial soup, as did artificial intelligence in the 1980s and pen-based computing in the early 1990s. But in many other cases there comes a flash point of change when the entire marketplace, under the pressure of continually escalating disequilibrium in price/performance, shifts its allegiance from the old architecture to the new.

This sequence of events unleashes a vortex of market demand. Infrastructure, to be useful, must be standard and global, so once the market moves to switch out the old for the new, it wants to complete this transition as rapidly as possible. All the pent-up interest in the product is thus converted into a massive purchasing binge, causing demand to vastly outstrip supply. Companies grow at hypergrowth rates, with billions of dollars of revenue seeming to appear from out of nowhere.

We have seen this happen again and again in our own lives. Take communications. After the better part of a century being content with letters, telegrams, and telephones, we have in the past thirty years adopted touch-tone phones, direct-dial long distance, Federal Express, answering machines, fax machines, voice mail, e-mail, and now Internet addresses. In every case, until a certain mass was reached, we didn’t really need to convert. But as soon as it was, it became unacceptable not to participate. As members of a market, our behavior is invariable: we move as a herd, we mill and mill and mill around, and then all of a sudden we stampede. And that is what creates the tornado.

Nowhere has the tornado touched down more often in the past quarter-century than in the computer and electronics industry. In the domain of business computing, it began with the proliferation of the IBM mainframe, which won worldwide support as the first major computing infrastructure standard. Then, in the space of less than a decade beginning in the late 1970s,