The Innovator's Dilemma

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Even though Clayton Christensen's The Innovator’s Dilemma was written back in the Dark Ages (1997), it is more pertinent today than ever before, with Netflix's (Nasdaq: NFLX  ) decision to split off its DVD-by-mail service and rename it Qwikster.

Christensen's book should be required reading for any investor; the ideas behind it have led to some of the great Rule Breaking finds of the past decade.

But today's -- and in fact, the past three months' -- developments at Netflix are likely to be worthy of a sequel from Christensen, as this saga is going to be in the textbooks for years to come. Here's why.

The failure of once-great businesses
In short, Christensen argues that great businesses fail because they get out-innovated. And oftentimes, it's not due laziness or complacency; it’s because businesses listen to their customers when they shouldn't.

Sound confusing and counterintuitive? It should. It flies in the face of just about everything we think of about capitalism.

To get to the bottom of this, let's take a quick look at the two types of innovations that Christensen says exist in the marketplace:

  1. Sustaining technologies: Improve the performance of established products. "Most technological advances in a given industry are sustaining in character," Christensen says.
  2. Disruptive technologies: Initially, these result in worse product performance, but over time, they offer a more attractive value proposition than what was available before. Disruptive technologies are more rare.

Christensen argues -- and this part is crucial -- that customers almost always clamor for sustaining technologies but rarely warm up to disruptive technologies … until they do.

The business of books
Let's rewind to January 2006. Business at Barnes & Noble (NYSE: BKS  ) is humming along nicely. The company's stock has just hit an all-time high, and people seem to appreciate the products it offers.

Let's say the company put out a questionnaire that asked what customers would like more: a deeper selection of books in-store, or the chance to buy something called an e-reader. It may be hard to believe right now, but the former would have gotten far more positive responses than the latter.

And then (Nasdaq: AMZN  ) came along and offered up the Kindle. After initial customer trepidation, it was warmly embraced by all.

Don't believe that customers can be wrong?
Exhibit B is one of my favorites: Apple's (Nasdaq: AAPL  ) iPad. Our own Tim Beyers was forced to ask, after the product's unveiling, whether Steve Jobs had lost his touch. Several of the commenters to Tim's story dismissed the iPad as simply a "big iPod Touch that no one would buy."

Well, 9.2 Million iPads later (that's just the past quarter!), I'm sure Steve Jobs and Apple are thanking their lucky stars that they didn't listen to those naysayers and vocal customers. The iPad has been nothing short of a blockbuster success.

Speaking of Blockbuster …
The recent turn of events for Netflix has allowed this narrative to come full circle. Netflix completely disrupted the way the now-DISH Network (Nasdaq: DISH  ) -owned Blockbuster did business.

There was very little Blockbuster could do once Netflix came along -- other than acquire it. Blockbuster had too many bricks-and-mortar buildings to afford a switchover to DVD-by-mail, and if it wanted to make its stores into DVD warehouses, it was neither big enough nor strategically located near post offices to make it work.

Blockbuster's customers at that time most likely wouldn't have liked the move, and its shareholders would have been up in arms.

Which brings us back to Netflix
If you're following along, you can see what I'm getting at here. The Innovator, Reed Hastings and Netflix, is trying its darndest not to be out-innovated by a host of rivals -- among them Amazon's streaming option, Coinstar's (Nasdaq: CSTR  ) Redbox, or content providers such as Starz (Nasdaq: LSTZA  ) .

Christensen offers up a solution for a company on the precipice of change, but it's not one that too many CEOs have opted for in the past: "Companies need to take distinctly different postures depending on whether they are addressing a disruptive [streaming] or sustaining [DVD-by-mail] technology."

Christensen goes on to say that management needs "to create a context in which each organization's market position, economic structure, developmental capabilities, and values are sufficiently aligned with the power of their customers that they assist, rather than impede, the very different work of sustaining and disruptive innovators."

Check out Hastings' blog post on splitting up Netflix (the streaming option) and Qwikster (the DVD-by-mail option), and you'll see that this is exactly what he's trying to do -- create distinctly different postures to distinctly different markets.

Will it work?
Though it may sound as though I think Hastings will pull this off without a hitch, there's one crucial variable Hastings has to deal with: a huge PR problem. I wrote to Hastings about this in the past, and he responded with an apology. He took that apology a step further today, saying he "slid into arrogance based upon past success."

If this weren't such a consumer-facing company, I could see Hastings being quickly forgiven for this misstep. But Netflix was rated No. 1 in consumer loyalty this year, before the price increase, and when anything is put on a pedestal like that, its fall can be fast and furious. If you don't believe me, check out the Brett Favre shirts that Packers fans wear in my native Wisconsin.

Will customers eventually forgive Netflix and flock back to its unique value proposition? Use the space below to sound off. And don't forget to add Netflix to your Watchlist.

Fool contributor Brian Stoffel owns shares of Netflix, Apple, and Amazon. You can follow him on Twitter at @TMFStoffel. The Motley Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of, Apple, and Netflix, buying puts in Netflix, and creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 20, 2011, at 11:46 PM, kyjohnso wrote:

    I think that while there are certainly similarities between the examples of companies given in the article and what Netflix is going through, there exists a main difference in that Netflix is the leading distributor of the disruptive technology. It would be interesting to know what fraction of Netflix's income comes from the physical DVDs and what fraction from their streaming products. If the DVD side is draining profit from the streaming side the split makes sense. However if the split is just to shake a fading technology, I think it might be premature.

  • Report this Comment On September 20, 2011, at 11:56 PM, dsachdev wrote:

    Personally I don't think that The Innovator's Dilemma can be referenced without going into the hard drive company scenario. I'll do one better and provide a link to the book on google books where you can read the first chapter.

    I think that the problem Netflix is having is that in the same month they 1) raised prices 2) limited streaming to a single device at a time 3) failed to get new movie contracts 4) made the service harder to use and 5) placed much of the burden of their changes on the user.

    In the end, it might be good - but the transition could have been handled better. And customers who defended 1 and maybe understood 2 got more annoyed as more and more disappointments piled on.

    But the stock..and the company I think is ready for a rebound:

  • Report this Comment On September 21, 2011, at 10:45 AM, jkiso wrote:

    From an abstract business point of view, I think this is the right move. The DVD part of the company will only get more expensive to service (and it is alarmingly inventory-intensive) and the stream-only part of the company shouldn't be tied down to it.

    Unfortunately, it's only the DVD part of the company that provides Netflix with its protective moat. Even Redbox can't provide the extensive library of older releases that many of Netflix's oldest, most loyal customers crave. At its heart, this is why Netflix has a core base of happy subscribers (the old timers) and this is the only part of the company that is currently "locked in" because streaming content is hardly a Netflix exclusive (pending the next round of negotiations with content providers, of course).

    If you're going to shunt your oldest, most loyal customers to the side, you should at least do it with a little more regard. Also, you should probably have your marketing folks check on the demos for this group, which I suspect is not made up of people who will find the name Qwikster to be anything but another annoyance.

    I would suggest that Reed and his team take a step back and rethink the transition a little bit. So far, the whole deal has been entirely for the benefit of Netflix/Qwikster (and, worse, it is transparently so). Drop your old customers a bone here to make the transition smoother and maybe you can defer some of the defections until next year.

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