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 (NAS: 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 customerswhen 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 (NYS: 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 Amazon.com (NAS: 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 (NAS: 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 (NAS: 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 (NAS: CSTR) Redbox, or content providers such as Starz (NAS: 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.

At the time this article was published Fool contributorBrian Stoffelowns shares of Netflix, Apple, and Amazon. You can follow him on Twitter at@TMFStoffel. The Motley Fool owns shares of Apple.Motley Fool newsletter serviceshave recommended buying shares of Amazon.com, Apple, and Netflix, buying puts in Netflix, and creating a bull call spread position in Apple. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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