INNOVATION IN BOOM OR BUST

Tom Flaherty is a senior partner with Braxton in Dallas, TX.

Top companies grab competitive positions and hold them through new approaches to their business models.

The march toward liberalization of electricity markets since the mid-1990s irrevocably changed the power sector's ground rules and the strategies for both new and established players.  Nontraditionalists captured headlines and dared to raise expectations within a sector thirsty for growth and loftier values.

But a funny thing happened on the way to hoped-for prosperity. Fundamentals shifted, sentiments changed, and markets spoke loudly. In the last two years, those forces have caught many companies by surprise, leaving them unable to set a different heading or to convince skeptics of the wisdom and sustainability of their charted course.

Now, the power sector needs to restore an image of stability and durability across tumultuous cycles. The foundation for this demonstration is the business model itself—the defining architecture of how a company will compete. Having succumbed to or survived (so far) the current low end of the boom-and-bust cycle, companies now must redefine their business models for the next stage of their evolution. Other industries have successfully shifted business models, and individual companies have prospered. What are the lessons from outside the power sector that can help companies reshape their businesses for the next cycle of change? What are the characteristics of companies that successfully transform themselves? A look at how companies innovate around their business model can yield insights into how the next evolution of change can be more sustainable.

Changes in Direction
The power sector's rapid devaluation in the last two years reflected reversals in attitude about growth potential, risk management, and balance sheet integrity, as well as a belief that the "nontraditional" business models were ill defined and unsustainable. The merchant model—heavy on trading and intellectual capital and light on assets, equity, and simplicity—became exposed.

On another front, the preservation of and (in some cases) increases in stock prices and price-to-earnings ratios (P/Es) for more traditional integrated or network companies occurred due to a shift in financial investment objectives and a bias toward familiarity with a more commonly understood business model. Even so, some of the integrateds have suffered the farther they migrated from a traditional integrated model. Network companies have maintained a stronger relative position without the nature and level of volatility characteristic of the other segments. (See Figure 1.)

Are these results simply a reflection of a fickle and vengeful market, or are the rules of financial and competitive engagement forever changed? Many merchants presented an attractive alternative to traditional electric utility investing—they recognized a coming boom cycle and catapulted themselves to the forefront of the market with a message of high growth, enlightened management, unconventional financing, risk management acuity, and adherence to a code of aggressive action. That model was a siren call to a market flush with available capital and accustomed to bold behaviors from dot.coms and high-tech companies. Energy companies that had vision, that "got it," were the custodians of a culture that power-sector investors valued highly.

The business model many believed to underpin the early success of merchant companies was based on a combination of new market philosophies, business principles, management processes, financial theories, and behavioral attitudes. "Innovation" was marked by the destruction of traditional structures and their replacement by untested models. But with the boom cycle headed toward bust and planned growth curves flattened, investors viewed the new model as unsustainable in cyclical markets—it was a flawed experiment. The beneficiaries of this change of heart were the more traditional network and integrated companies: Investors recognized that companies with more stable cash flow and familiar business scope were both easier to understand and less prone to volatility in their earnings outlook.

Indeed, their business model characteristics are easily contrasted with those of the merchants. (See Table 1.) While current market reactions and valuations may resemble more of a flight toward comfort and familiarity rather than a permanent rethinking of intrinsic growth potential, it is clear that the investment community now highly values certain characteristics. There is a clear sentiment against complexity and volatility. Investors now prize simplification, rather than elegance—but that does not mean they have eschewed innovation or that they believe companies can't greatly outperform their competitors.

Toward Sustainability
Still, in this simplified environment, developing an outstanding, sustainable business model becomes challenging. In our recent research about how companies—new and established—created and sustained their competitive position, we found that while many pursue competitive superiority, there are actually few realistic options for attaining it. (See Figure 2.) Unable to distinguish themselves within their sectors, many companies simply represent the industry norm. For others, the sector's unique structure may allow a company a solitary position. Some companies may be able to create value through superior execution if they are agile enough or blessed with a management prowess that exploits and captures all available advantages.

In a crowded field, however, those companies that can differentiate themselves through their business models are the ones that can create new sources and levels of value. Business model innovation—identifying and pursuing new business opportunities before your competitors do—is a prime component of differentiation.

Industry leaders such as Dell, Southwest Airlines, Harley Davidson, GE, Wellpoint, and Charles Schwab outperform their competitors by effectively changing the fundamentals—the where, what, and how—of business in their sector: the targeted segments or customers (where); the value delivered (what); and the business structure and execution (how).

Braxton conducted research that found that financial and competitive success was not limited to new entrants that created disruption or carved out niches in an existing market. Established companies that redefined their marketplace or reshaped how they would participate in markets also tended to perform well and attain top competitive position.

Our research covered six principal industry sectors: consumer business, energy, healthcare, financial services, manufacturing, and telecom. Out of almost 170 companies, the research identified 16 as having used business model innovation to drive their success. These companies are household names—some were industry upstarts (Wal-Mart, Starbucks), and others redefined themselves (Wellpoint, Paychex)—and represent a large portion of the shareholder wealth created over the last 30 years. At the time the research was conducted, these business model-innovators were clear financial performance leaders in their sectors. In most cases, they produced top value positions in the areas of total shareholder return, cash-flow return on investment, market valuation, and market premium measures.

How did they do it?

• First, they thoroughly understood the current business context of their sector.
• Second, these companies exploited opportunities for innovation across the three dimensions of the business model (where, what, how).
• Finally, they did everything they could to ensure that the new business model created sustainable competitive advantage.

Each company created unique approaches to its sector given the maturity of markets, current competitive position, view of market and direction, and sense of untapped potential. Their solutions helped them capture and maintain sector-leading positions while achieving superior financial performance. (See Figure 3.) Business model innovation was the common underpinning of their strategies.

Context
To understand their context, companies need to make a clear and full assessment of the external factors driving or affecting the sector as well as the company's internal capabilities. In almost all cases, the industries we studied were largely homogeneous. Many cases were characterized by such external factors as regulation or socioeconomic shifts. In most cases, changes within customers or from competitors became driving forces. In response, companies leveraged attributes such as brand equity or existing customer loyalty or unique resources and capabilities that competitors couldn't.

While outside forces may act as catalysts for a new business model, they are less important than being able to think and move beyond industry norms. Most companies innovate by leveraging what exists rather than relying on the introduction of enablers that did not previously exist. So, to that extent, the greatest opportunity for business model innovation is found in industries that are established and characterized by strong norms in how business is conducted. For example, despite operating in a long-established payroll services industry, Paychex identified a market segment—small employee-based businesses—that was simply not on competitors' radar screens. By focusing on an under-served segment, Paychex carved out a leading share in a large market.

Where, What, and How
Between context and sustainability in the innovators' business model architecture are the three things a company should understand about itself and its markets before changing its model. These identify the segments, products, channels, activities, partners, and so on, that define a company's fit. They comprise the DNA of a business model.

• Where—defining the markets in which a company will compete. Most markets are not uniform in how they operate or what their profitability is. A company needs to analyze the business territories, segments, and customer groups on which it will focus. Understanding how the value chain can be disaggregated and how current markets are served are fundamental to this assessment. So is defining the needs of those customers. In our research, most innovators focused on unserved or underserved needs rather than creating new requirements. Harley-Davidson, for example, improved its earnings by focusing on an upscale market.
• 
  What—defining the company's offerings to its markets. As it assesses the scope of what it provides, it should address the nature of products and services that customers demand and whether the company has or could possess the capability to meet those needs. Identifying unserved customers may help in this context, because the means by which these products or services are offered are also important. How to deliver that value and engender repeat business are also vital. In general, business model innovators pursued structured changes (rather than improvements) to offerings with such levers as simplification, bundling or unbundling, personalization, risk sharing, expanding channels, or increasing selection. Starbucks, for example, offered unique products and setting, thereby creating a unique customer experience.
• 
  How—understanding how the business will operate according to the new framework. Overall structure, management and execution processes, business relationships—and the ability to deliver products and services effectively and at low cost—are all part of this. For the companies in our research, execution within the business model was addressed by restructuring the value chain to better meet customer requirements or fundamentally redesign the underlying delivery process and cost structure. A good example is Charles Schwab, which redefined an aspect of the financial services industry by simplifying the process: The drop-in investment center changed the customer-interface and cost-of-delivery models.

Sustainability
Understanding competitor disadvantage and the advantages of being an innovator are important elements of defining a hard-to-imitate business model. Innovators are able to capitalize on disadvantages its new model creates for competitors. In many cases, given its existing business model and inertia, a company cannot react effectively to another's business model changes. Response requires radical change by incumbents, and culture, costs, and position are all impediments. Whether the disruption to existing models is real or psychological, incumbents find it difficult to adapt.

The innovators themselves create advantage rather than relying on any existing incumbent position. In our research, successful innovators seized real advantage by creating strong brand equity, capturing efficiencies from economies and learning curves, and leveraging the network effect. They used their first-mover status to create barriers to imitation. Southwest Airlines, for example, leapt ahead of competitors with its point-to-point service and customer approach.

Powering Innovation
Compared to the power industry, businesses in the sectors we researched have relatively more freedom of movement within their markets, which allows companies to focus directly on customer groups. They have a relatively easier time figuring out where to compete, what will create value, and how the business will operate. Power sector companies do not enjoy the same degree of customer flexibility; instead, they focus less on end users and more on where they will participate along the value chain and how the business would be structured and executed. Companies in this sector seek to understand the requirements of successful competition in various segments and how to enhance current positioning through innovation. This may drive companies to redefine relative concentration in certain customer segments and reshape their role where they choose to compete.

Regardless of the approach, power sector companies have to satisfy a harsh set of investment community critics that a business-model change is both justified and executable. Currently, the community is not interested in transformation that looks like financial engineering. Still, investors do recognize that companies need to define differentiating approaches to the market and that there is appeal to being unconventional—if there is substance to the model and transparency in governance processes. Business model innovators in the power sector will need to convince the skeptics that fresh thinking does not equate to a risky adventure. (See the sidebar, "Keep Innovation in Play.")

The power sector's business models are generally limited and common. Most are characterized by a reliance on self-performance and comprehensive presence. Yet the very purpose of business model innovation is to challenge these norms.

The questions remain:

• Where will it compete?
• What will it offer?
• How will it operate?
  Answering them can provide a glimpse of how a power company can pursue differentiation through alternative approaches. (See Figure 4.)

Where: Value Chain Positioning
Most companies in the power sector typically view the business on an end-to-end basis. In reality, each value chain segment-generation, transmission, delivery, retail, etc.—is comprised of multiple, discrete subsegments. In delivery, for example, there may be almost 20 separate elements of the business that can be defined.

A company can determine whether to participate in each element or rely on others for specialized capabilities that complement the company's competencies. Each link of the value chain also carries its own profitability, stability, and growth characteristics that need to be assessed.

Given the uniformity that exists across companies with respect to value chain presence, it can be difficult to identify where to obtain competitive advantage. This advantage can likely be better established by focusing on how greater value can be extracted within a segment through a different form of participation.

Centrica, for example, has positioned itself to focus on the retail business and the customer relationship. Its business scope is clear, and this allows it to focus on creating new sources of revenue through broad personal and financial service offerings to its customers. ONCOR is trying to create a new business in the infrastructure services area. This business is focused on screening a smaller customer base—the sector itself—with the leverage of operating competencies acquired as a unit of TXU.

What: Creating Value Sources
Selecting the segments on which to focus simply sets the table for the next consideration—identifying how value will be created. Fulfilling the requirements of segment participation and meeting the needs of related customer groups are the foundation for determining necessary solutions to the value equation.

In nonregulated markets, innovators tend to create competitive advantage by finding and developing unserved or underserved customer groups. Regulated companies can't—unique offerings may be viewed as discriminatory to other groups. Nonetheless, the portfolio of products and services offered, the means by which it is offered, and the basis for pricing still provide some potential for companies to develop new revenue sources and stronger links to their customers.

Redefining customer groups and expanding the company's role with respect to specific groups are routes to pursue. This offers companies the opportunity to serve customers differently and to think about customer needs in more creative ways. At the business segment level, companies can define broader services that extend the traditional boundaries of performance. Companies may also be able to step into broader roles to supplement those typically performed within the market at another level or by the customer.

Using creative approaches to broaden a portfolio of products and services is a more controllable means of creating value than repricing or creating new needs to be fulfilled. Changing the manner in which operating performance is assessed at the regulatory level may also be a way to create additional value in the business.

At the advent of deregulation, many merchant companies were naturally drawn to serving large entities like other wholesalers, co-ops and municipalities, and large commercial and industrial companies. Companies such as Xcel and Cinergy, however, brought particular market focus toward smaller commercial customers. These companies developed a variety of energy management and commodity sourcing services designed to provide new flexibility and opportunity to customers.

How: Operation of the Business
Redefining the contours of the business segments or the product and service portfolio is important—but incomplete without considering how the business should operate. Companies maintain almost total control of decisions about business performance, and this latitude creates opportunity to differentiate a company in either regulated or unregulated markets.

Modifying the business model at the operational level generally involves reshaping the business' structure and the roles to be performed at the corporate and business unit levels. The creation of business units forces both autonomy and accountability for operations and performance. Changing the manner in which companies compete and create value may also mean redefining these units' roles to match the quest for competitive advantage.

Day-to-day business operations can be extended to redefine the company's role in performing related activities. Some activity may no longer be justified, given both the need to create value and the options available in the market. In this case, seeking lower-cost options may lead companies to contract with third parties for certain activities to reduce costs or achieve excellence in operations.

Such operating model constructs vary widely. Exelon, for example, has relied on a highly decentralized model where business units are responsible for the ownership and execution of most business-related activities. AES's units are wholly autonomous from the headquarters group and reflect different, localized operating protocols.

Redefining business models in the power sector will mean creating a different architecture for the business and a different basis for executing at the operational level. Some companies will simply stick to their knitting and remain integrated with little substantive change to operations. Some will seek to become more specialized in where they compete along the value chain and how they leverage internal strengths and capabilities. Others will seek to build a synthetic model that relies on blending internal expertise with external competencies to achieve improved competitive position. A few may opt to become a "virtual" owner, relying on third parties to operate the business. In each scenario, managing the risks associated with design, management, and execution of the business model will be critical.

Building Change
The business model is a company's underlying architecture which will translate strategic direction into tactical execution. As such, it provides substance to the white space between a company's vision and its business operations activities. (See Figure 5.)

Innovation in the business model demands a different perspective on how to create value, a perspective developed through the eyes of the market or customer served.

• Remove the blinders. Be prepared to ignore everything that is based on the industry norm. Believing that historical business models are still suitable will lead to an inability to visualize the opportunity and differentiate among like-minded adversaries.
• Throw the old planning model away. Innovation doesn't start with traditional views of beating competitors at their own game—it forces companies to base thinking on customers rather than the current business model.
• But don't tear it all down. Innovation requires creative thinking and new insights about customers. But it does not mean that the entire infrastructure is valueless and incapable of being leveraged to reposition a company.
• Find the breakthrough "how." Converting the notion of achieving competitive superiority into marketplace reality requires that the operations of the business be reshaped to support a different business delivery model. Transformation of roles, technologies, processes, and customer relationships will all be contributors to the new model.

For many companies in the power sector, the business model needs redefinition, and they can make it an innovative one—building differentiable and sustainable financial and competitive advantages depends on innovation more than standardization. The recent upheaval in the industry ought to be seized as an opportunity for companies to break the mold and overcome the comfort that limits their competitors.

© 2008 Edison Electric Institute