Asymmetric business models and the true value of innovation

A few weeks ago, in association with Ericsson, we published the Telco Innovation Toolbox discussion paper. It introduces ten economics and strategy frameworks that will help operators to accelerate their “digital” strategies, make the right innovation investments and avoid costly mistakes. Previous four chapters of the paper were published on our blog. Today we are publishing “Asymmetric business models” and “The true value of innovation and the cost of doing nothing” chapters.

For previous chapters from the report, go here. You can download the full PDF report here.

Asymmetric business models

As OTT players put increasing pressure on traditional telco profit centers, it is tempting to see them as direct competitors. Yet they don’t compete for profits, but for control of the value chain.

Mobile Internet has become an integral part of the digital services and content ecosystem. In that context, mobile operators, Internet companies, handset makers, software vendors and content providers are part of the same value network.

As OTT players put increasing pressure on traditional telco profit centers, it is tempting to see them as direct competitors. Yet, OTTs do not compete for telco service revenues; instead, they compete to control key links in the digital value chain, with business models that span consumer electronics, online advertising, software licensing, e-commerce and more. Thus, competition is not symmetrical, because unlike carriers, OTTs do not bear the burden of providing mobile Internet service. Connectivity may be as important to their business model as gas to a car; yet, it’s the telcos who supply it, not the OTTs themselves. This asymmetry makes it difficult for telcos to protect the profitability of some legacy business models.

In economic terms, telco connectivity complements OTT business. A complement is a product that is consumed together with another product. Demand for a product increases when the price of its complements decrease. For example, gas and cars are complements. Cheaper gas means people drive more, and car manufacturers see their business grow.

Similarly, the common interest of OTT players is to drive commoditisation of the telco connectivity business. Affordable mobile broadband means that more smartphones are sold, more ads viewed, more software sold and more ecommerce sites visited.

While there is a symbiotic relationship between telcos and OTTs at the connectivity business layer, the nature of asymmetry is different at the telco services layer. Because connectivity costs are paid by the user, OTT players have great flexibility in their business models. OTTs can monetise ads, downloads, analytics or acquisitions, and are thus able to price their services either free (e.g., Viber),  close to free (e.g., Whatsapp), or even less-than-free (in the case of Google sharing app revenues with operators).

The vertically integrated, “all-in-one” telco business model of bundling connectivity and service costs makes it impossible for telcos to compete with free or less-than-free OTT alternatives. Telco core voice and SMS services are suffering “collateral damage” in the wake of successful OTT strategies, rather than suffering as a result of direct competition.

Because of the asymmetry in telco and OTT business models, telcos should avoid investing in head-on competition with OTT services. OTTs don’t see telcos as competition, but rather as a complement to their business.

More importantly, the telco digital business needs to be measured not by direct revenues, but according to whether it helps to grow and protect core telco business by increasing usage, creating user lock-in and driving subscriber acquisition. Similarly, success of Amazon’s Kindle is not measured by the number of units sold, but by content revenues and the amount of traffic to Amazon e-commerce properties.

Instead of copying OTT initiatives, telco innovations should leverage unique advantages, in order to create user value that OTT players cannot match, such as localization, user targeting, privacy controls or MVNO service customization.

Key questions telcos need to ask when evaluating innovation investments

• How does the asymmetry of business models affect your project? Does the project drive the telco core business or does it attempt to compete with OTT players head-on?
• Does the project incorporate unique aspects of value that OTT players cannot match (e.g., localization, user targeting, privacy controls, or MVNO service customization)?
• What are the complements to the telco core business (e.g., user identity management API) that if freely given will drive core telco business, attract developers or weaken OTT players?

 

The true value of innovation and the cost of doing nothing

Traditional financial tools are designed for stable market environments, but fail predictably when applied to innovation under conditions of uncertainty and rapid change, which characterizes today’s telecom market.

Traditional financial tools work well when evaluating investments in capital-intensive telecom infrastructure. In such investments, future costs and revenues can be predicted fairly accurately by using traditional financial forecasting tools like discounted cash flow (DCF) or net present value (NPV).

Traditional financial tools are designed for stable market environments, but fail predictably when applied to innovation under conditions of uncertainty and rapid change, which characterizes today’s telecom market. The reason for failure is that traditional financial tools systematically undervalue innovation by disregarding the costs of doing nothing, as explained in Harvard Business Review article “Innovation Killers, How Financial Tools Destroy Your Capacity to Do New Things” by Clayton M. Christensen, Stephen P. Kaufman, and Willy C. Shih.

There are two “costs of doing nothing” for telco that escape the attention of traditional financial tools: The risk of non-linear deterioration of the telco business and the missed opportunity to develop new capabilities necessary for the future.

Traditional telco financial tools implicitly assume that business is stable and its present state will persist into the future. In other words, if an innovation investment is not made, things will be at least as good as they are today. This is definitely not the case for telcos trying to adapt to the new basis of competition. The commoditization of core telco services and the entry of disruptive OTT players will inevitably result in the decline of the telco business. Therefore, the true value on innovation is not in improving on the status quo, but in preventing future deterioration of the telco business.

The second “cost of doing nothing” is the missed opportunity to develop new capabilities critical for future telco competitiveness.
It’s a common practice to evaluate investments based on marginal costs and revenues while ignoring sunk and fixed costs. I.e., investments are valued based on their potential to produce valuable goods or services based on current assets. That only makes sense when the market conditions are stable and the current telco assets are expected to retain their competitive value in the future.

Let’s take the example of Rich Communication Services–enhanced (RCS-e), which leverages expensive IMS infrastructure. Marginal cost analysis makes it an attractive choice for new presence and messaging services designed according to traditional telco service models. However, according to the new basis for competition, the scalability and interoperability offered by IMS are less important than flexibility. Telcos could be better off investing in new, more flexible infrastructure better suited for experimentation with new services, use cases and business models.

Due to the changing basis of competition, future success requires new capabilities that telecom operators are missing today. Marginal cost analysis, however, will systematically undervalue investment in creating such new capabilities. Incremental investments into the existing assets, such as network expansion, will always seem more attractive compared to the full costs of creating new competitive capabilities. For example, Blockbuster saw Netflix developing new models for movie delivery. Marginal cost analysis, however, could not justify building new capabilities, and instead Blockbuster continued investing in its current assets, which soon will become obsolete. Blockbuster’s 2002 press release read: “We have not seen a business model that is financially viable in the long term in this arena. Online rental services are ‘serving a niche market.’ ”

Netflix didn’t have this dilemma, and for it the “niche market” looked to be an excellent opportunity. The rest is history, as Clayton Christensen explained in his Harvard Business School article on the Trap of Marginal Thinking.

The challenge for telcos isn’t that OTT companies outspend them in innovation. It’s that marginal cost analysis steers telcos towards investments in capabilities that were relevant in the old basis of competition, rather than toward developing new capabilities relevant for the new basis of competition.

Telcos need to consider the costs of doing nothing and invest in innovation well before traditional financial analysis shows attractive returns. They must adopt discovery-driven planning methods suited for the prevailing conditions of high uncertainty. We will introduce these methods in the following chapter.

It is important to see the biases inherent to traditional financial analysis tools. The true value of innovation investment can only be seen when measured against the real costs of doing nothing, including the likely possibility of deteriorating telco business, and missed opportunities to develop new capabilities and competences.

Key questions telcos need to ask when evaluating innovation investments

• How often do you use NPV/DCF financial tools for evaluating investments in telco innovation?
• Are you investing enough in developing capabilities relevant for the new basis of competition?
• How would you build new products for the new basis of competition, if you were a startup starting from scratch today?

“Dealing with uncertainty: Discovery-driven planning” and “Ecosystem as a new distribution channel” chapters will follow next week. Don’t forget to download the full report.

As usual, we are looking forward to your feedback! Please leave a comment below or send us an email to strategy /at/ visionmobile dot com.

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