NBA 600: Session 3 Strategy and the Internet 28 January 2003

1. NBA 600: Session 3Strategy and the Internet 28 January 2003 Daniel Huttenlocher

2. Today’s Class • Finish Thursday’s discussion on structure of the Internet • Clarification: Internet routers make local decisions about where to send packets • Packets just have addresses, not “active” • Payment models • Start discussion of Porter-Tapscott “debate” on strategy and the Internet • Porter argues the Internet is like any other IT advance of the past 25 years • Tapscott argues it is a fundamental change, like electricity or railroads

3. Recall: Internet Structure • 1: The Internet is a collection of networks • Held together by standard “protocols” (TCP) • Like road networks • Local, county, state, national • Agree on where to connect and how to drive • 2: Packed switched data • Information broken up into small packets each addressed separately to the recipient • Unique addresses – “IP address” • Like filling up envelopes and sending to same address • Each is routed separately, reassemble at end

4. Payment Structure of the Internet • End-users pay for bandwidth • $20/mo 56kb dialup (consumer) • $40/mo 128kb upstream - 768kb downstream broadband (consumer) • $900/mo 1.6mb T1 (commercial) • $40k/mo 155mb OC3 (commercial) • Commercial users tend make higher use • Asymmetric broadband – market segmentation • Some leases charge for usage over given level • Each of these categories generates $100’s millions of monthly revenue

5. How Internet is Constructed • Each network provider (ISP) builds its own network • Chooses what other network(s) to connect to • Chooses what traffic to accept from connected network(s) • Pairwise peering arrangements govern what inter-network traffic will be carried • Sometimes involves charges, sometimes involves trades – local decisions by two ISP’s • Each ISP motivated to provide connectivity needed by their customers

6. Connectivity of Internet and Web • Evolutionary rather than designed • Shows many patterns similar to natural or “organic” growth phenomena • E.g., neurons, “six degrees of Kevin Bacon” • Good routes evolve through needs of end-users • Any two hosts about 15 hops (degrees) apart • Aside: analogous structure in hyperlinks between Web pages • This structure is used for search engines, e.g., Google

7. Geo-Location in Internet • The cabling and “routers” (connections) of the Internet are in physical locations • Often in or near big cities where the traffic is • These physical locations are not evident in the IP addressing scheme • Companies sell services that try to determine geo-location from IP address • For marketing, security, legal and other uses • Large service providers need to combat physical location • Packet transit times in the network too slow • Potential for congestion with single site

8. Reflect: Conclusions We Can Draw • Relentless, organic, drive to connectivity • Services that do not connect to the Internet are at risk • Case of AOL’s free AIM client • What does this say about text messaging • Consider Blackberry/RIM or Bloomberg messaging niche businesses • Global, highly interactive services need multiple physical locations in the network • Simply slow if interacting users far apart • Pricing models differentiate consumer and commercial use

9. Porter: Strategy and Internet • Internet has been used as excuse to ignore strategy – yielded bad decisions • Forfeit proprietary advantage by rushing online • Focus on price rather than quality/features • Winners will use Internet as complement to, not cannibal of, traditional competition • Simply another step in IT evolution, like object oriented programming or relational databases • Internet not necessarily a blessing • Tends to dampen profitability and have leveling effect on business practices

10. Porter: Internet Trends • Rising power of customers • Better informed, easier comparison/substitutes • Lower switching costs, less loyalty • Real value not just gimmicks • E.g., Priceline model has limited appeal • Note: PCLN reports selling price as revenue (about $1B vs. EXPE $750M of commissions) • First-mover not an advantage • Dis-intermediation not much of a threat • Enhancing operational effectiveness • Decrease in communication/coordination costs

11. Porter: On Business Models • Destructive way of thinking • Loose terminology, far cry from creating economic value • Invitation to faulty thinking and self delusion • What matters is strategy • Critical to consider competitive forces and industry structure • Notions of e-business and e-strategy similarly problematic • Encourage consideration of Internet in isolation rather than as complement to existing business

12. Tapscott: Internet Changes Things • The Internet provides a fundamental improvement in communication • Improves outsourcing, contract manufacturing • Enables true sales partnerships • Challenges industrial age corporate structure • Porter takes a truth and misapplies it • The truth: profitability matters • Not eyeballs, hits, stickiness, etc. • But does not support false thesis that Internet is simply another incremental change • Business as usual; vertically integrated corp.

13. Tapscott: Impact of Internet • An added piece of the wealth creation infrastructure • Power grid, railroads/highways, telephone • Now the Internet too • Internet growing to take over or connect to most other communication mechanisms • Voice over IP, Internet radio, cell phones • Distribution of content: print, audio, video • Internet enables new business models • Strategy has tended to ignore, because traditionally each industry has a fixed model

14. Tapscott’s “B Webs” • Companies that draw on all resources to create profitable business • Deep partnerships • Only possible through Internet communication • E.g., coordinating joint sales efforts between two companies • Example of IBM customer relationship management (CRM) business • Dropped own software, partnered with Siebel and others – joint selling services • Now multi-billion dollar business for IBM • Also driving hundreds of millions of DB2 sales!

15. Analysis of the “Debate” • Agree on some terminology • Strategy: being profitable by choosing what to do and what not to do • Consistent direction; not all things to all people • Based on analyzing structure of industry • Competitors, suppliers, customers, new entrants, substitutes • Business model: where the revenue is going to come from • Who will pay, for what, when, why, how much? • Operations: doing better at what doing • Industry-wide best practices

16. What do You Think? • Have I mis-characterized Porter or Tapscott’s positions? • Missed something important? • Have they mis-characterized each other? • Where do they agree more than they might initially appear to? • Who or what do you think is right? • What do you think is really going on regarding strategy and the Internet? • Support arguments with company examples or your own experience

17. Internet Changes Landscape • Increases need for strategy • Increases bargaining power of customers • Can decrease bargaining power of suppliers • Either lowers or raises switching costs • Change to substitutes generally easier, except in industries where “network effects” • Less clear general effects on barriers to entry or competitors • Creates need to consider business models • May enable new sources of revenue or undermine current sources

18. First Mover Myth • Being there first does not by itself provide much advantage • E.g., Priceline was early in online travel • But its model not what people wanted • Even for business with network effects • Where customers benefit from a single product or service (e.g., computer software) • Though eBay has exploited this • Good strategy and execution what count • Provide what customer wants, deliver more effectively

19. First Mover Myth: Beyond Internet • Betamax vs. VHS videotape formats • Huge network effect for rental market • Started as on-air recording business; shifted • Sony’s go-it-alone strategy lost to consortium • Microsoft repeated dominance • DOS vs. CPM, Windows vs. Mac or OS/2, IE vs. Netscape, Excel vs. 123, Word vs. Wordperfect/ Winstar, … • HP dominance of laser printer market • Invented by Xerox but didn’t want to undercut high end printing business

20. Internet and Bargaining Power • Provides vastly improved ability to search and compare • Uncensored public opinion • Advertising and product descriptions • Discounted pricing • Empowers purchasers • Both consumers and companies • Tilts balance so that suppliers become weaker and customers become stronger • Exceptions where effective monopolies

21. Internet and Industry Structure • Fundamental changes to any content creation or distribution business • Music, movies, telephone, broadcasting, … • Digital content opens totally new means of distribution and protection • Technologically possible to control the experience of the content after purchase • E.g., force watching previews on DVD’s • Experts able to circumvent controls • Possibility of unfettered illicit copying • Raging battle over degree of control

22. Internet Substitutes • Newspaper industry major source of revenue is classifieds (about $20B/yr) • Web provides substitute for classifieds • Arguably better once credible • What is happening, where might it end up • Collectibles already have moved to eBay • But were low revenue for newspapers • Employment moving to Monster, Yahoo • Perhaps not yet replacing, but high revenue risk • Real estate still strong, but online just starting • Major revenue source

23. Substitutes: Online vs. Offline • Book sales • Amazon dominates the online market • Borders strategy is to supplement stores • Outsourced online sales to Amazon • Prominent link to stores site • Provide access to store inventory • Competitive advantages and disadvantages • Does attraction of “in stock” over-ride disadvantages of “out of stock” • Barnes and Noble separates businesses • Only offer online directions and in store returns

24. Internet and Outsourcing • Contract manufacturing • Has become a large business • Top 5 over $50B annual revenue • Requires close interaction, facilitated by Internet • Outsourcing of operations functions • Travel, benefits management done on Web • Joint sales • IBM has been champion in this regard • Solutions and business bundles hardware, software, services • Joint selling with other vendors

25. Summing Up • Importance of Internet to strategy • Changes to industry structure require strategic analysis that accounts for effects • Internet does change the rules in many industries • But primarily changes that are well handled by strategic analysis • Customers, suppliers, competitors, substitutes, new entrants • First mover advantage does not exist • Business models are more important now

26. Next Time • Discuss business models and the Internet • What business models are, how they are important • Relationship to strategy • Clear articulation of industry business model(s) and potential alternatives • Especially alternatives enabled or facilitated by Internet • New models are rare, but that doesn’t make it any less important to consider