Netflix's tremendous success with consumers and investors points the way to a simple investment strategy: consider buying stock in companies whose CEOs actively lead the transition to a disruptive technology -- rather than hiving it off in a separate subsidiary to attack the parent as Clayton Christensen advises.
Before getting into the details of this strategy, let's take a look at how Netflix -- in which I have no financial interest -- has been doing since CEO Reed Hastings decided in 2007 to shift Netflix from DVD-by-Mail to Online Streaming.
Over those seven years, its revenues have increased an average of 23.6% a year to $4.4 billion; its net income rose 12.5% a year to $112 million; and its stock price soared a whopping 1,503% while the S&P 500 rose about 26%.
What does Netflix have to do with Christensen? He defines two kinds of technologies:
- Sustaining technologies that yield incremental improvements to a product serving the same customer set, same value proposition, and same channel partners as the company's core business; and
- Disruptive technologies that serve different customers with a different value proposition, and different channel partners than the company's core.
To manage disruptive technologies, Christensen advises that an established company set up a separate subsidiary to "attack the parent."
Founder and CEO of Netflix, Reed Hastings, class of 1983 (Photo credit: Wikipedia)
In a letter to the New Yorker last month responding to Jill Lepore's The Disruption Machine, I argued that online streaming was a disruptive technology for Netflix's DVD-by-Mail business. Yet Netflix did not succeed in online streaming by setting it up in a separate subsidiary and freeing it to attack the parent as Christensen prescribed.
I was surprised to receive an email from Christensen in early July. It asserted -- without explanation -- that online streaming is not a disruptive technology but a sustaining one. Therefore, he implied, it was not and should not have been set up in a separate subsidiary.
Netflix's success was due to the direct leadership of Hastings who poured capital into building the online streaming service -- since he wanted to be sure another company did not bankrupt Netflix as its DVD-by-Mail service had done to Blockbuster through a service that delivers DVDs to consumers' mailboxes with no late fees.
Netflix's move to online streaming was not glitch-free. In September 2011, Netflix announced it would force customers to use its DVD-by-Mail service through a separate subsidiary, Qwikster, while making them purchase online streaming through Netflix. The move also included a 60% price increase and quickly led 800,000 subscribers to bolt -- contributing to a 25% plunge in its stock. Netflix reversed the policy a few weeks later.
Did the idea of creating a separate subsidiary contribute to Hastings's Qwikster blunder? Maybe Hastings misunderstood Christensen because he put Netflix's core business into a separate subsidiary -- not the disruptive one.
Here is why I think online streaming is disruptive:
- Different customer set. When Netflix started offering online streaming -- the year
Apple introduced the iPhone -- people could not watch DVDs on their smartphones. So many of the initial consumers of Netflix's online streaming service were different from the ones that used its DVD-by-Mail service. - Different value proposition. Instead of ordering a DVD, waiting for it to arrive, walking to your mailbox and putting it into your DVD player, online streaming enabled consumers to watch movies on their iPhone within a minute or two by swiping its screen a few times without having to get off the couch. This was at least as big of a value leap as DVD-by-Mail was for Blockbuster customers.
- Different partners. The partners with DVD-by-Mail were DVD wholesalers and the postal service – whereas online streaming demanded different partners like the content creators who came up with new shows like House of Cards and broadband service providers like
Comcast and Verizon.
In short, online streaming was a disruptive technology and Netflix succeeded by doing the opposite of what Christensen prescribes.
As I first argued 14.5 years ago, the idea of setting up a separate subsidiary to attack the parent does not make practical sense to me. That's because the subsidiary is starved for resources and focuses on the wrong goal -- attacking the parent, rather than creating superior value for customers.
Netflix is not the only company that has excelled by doing the opposite of what Christensen prescribes. Another example of this is
In pulling the plug on its best-selling boxed software, Adobe's CEO jeopardized its 12.8 million users of Photoshop, Illustrator, and InDesign. Instead, Adobe decided to sell Creative Cloud -- a monthly, cloud-based subscription service.
Is Creative Cloud disruptive? It's certainly a different value proposition -- customers pay $50-a-month while its boxed software used to cost $1,900 upfront. And it is targeting some different customers too -- in June Adobe estimated that "roughly 20% of Creative Cloud's 2.3 million subscriptions are new users," according to Barron's. It even has attracted new investors who look out four years instead of three months.
The amount of cash Adobe received in the short-term is much lower, and its revenue and profits in that time haven’t been a pretty picture -- in 2013 its revenues and earnings fell 8% and 42%, respectively.
But Adobe’s stock has more than doubled because it did a great job explaining to customers and investors -- who as its CFO told Barron's look to how the new strategy will play out by 2018 rather than focusing on quarterly results -- what they were doing during this transition. As I posted in June, Adobe has been able to beat expectations because customers like the service.
It's nice if being part of the disruption crowd gives you a dopamine rush.
But if you want to enhance your portfolio look for companies whose CEOs do the opposite of what Christensen prescribes.
