Playing To Win
Substitutes & Strategy
Five Types, Five Distinct Strategic Imperatives
I had an interesting discussion about the role of substitutes in strategy at a client recently and thought would make sense to do a full Playing to Win/Practitioner Insights (PTW/PI) piece on the subject. It is called Substitutes & Strategy: Five Types, Five Distinct Strategic Imperatives. As always, you can find all the previous PTW/PI here.
History of Substitutes in Strategy
Michael Porter brought substitutes into the realm of strategy with his unveiling of the Five Forces model in his 1980 classic Competitive Strategy, in which one of those forces is Threat of Substitutes.
He focused on substitution as a governor on the profitability of an industry, which is a key object of the Five Forces analysis. If an industry faces a high threat from substitute offerings — like steel facing the threat of substitution by aluminum or ceramics in certain uses — it would need to be more price competitive and (other things being equal) would experience lower profitability. If, in contrast, the substitute for a pharmaceutical drug is continued suffering and/or perishing, then the threat of substitutes is low, and the industry will be — guess what — highly profitable.
The same logic applies to his Threat of New Entrants force — i.e. easy entry bad, difficult entry good. For what it is worth, I have always viewed the vertical axis of the Five Forces as determining how much value is available for the suppliers, firms competing, and buyers on the horizontal axis. And those horizontal forces (Supplier Power, Rivalry among Existing Competitors, and Buyer Power) will determine who gets what share of the value. High supplier power extracts profit out of the back of the industry. High buyer power extracts profit out of the front of the industry. And intense rivalry dissipates profits into thin air.
For those who want a bit more background on the role of the Five Forces framework in strategy, I did a PTW/PI piece on it several years ago.
Substitution & Growth Prospects
The focus of this piece is how being a substitute offering relates to your growth prospects. The answer is that it really depends on the substitution context. Some contexts cause slower growth for the substitute against the established offer, while others offer the possibility for explosive growth. It is important to know in which context you are operating because the strategic imperatives differ greatly.
I see five fundamentally different contexts for substitution. There may be more, but these are the ones that have meaningful differential strategy implications for me.
1) From Unpaid to Paid Task
Sometimes the substitute compels customers to pay for a task that was previously either not done at all or done without an outlay of cash. The former category includes going to the dentist versus doing without. To use the substitute for doing without, the customer must pay for something not previously paid for. The latter category includes buying and using an automatic dishwasher to substitute for handwashing dishes or going to the nail salon instead of doing your own nails.
The challenge here for the substitute is that potential customers must reallocate cash from some other use to dedicate to your use. That will slow substitution. All customers won’t immediately say: “Wow, that solution is great; I will buy now.” For example, it took 40 years for the automatic dishwasher to reach 50% US penetration.
The strategic imperative in this context is to help the potential users understand the value of the substitute to them and to be careful about building capacity too far ahead of demand. Demand will grow steadily if the substitution creates true user value — as with automatic dishwashers. Of course, the better the value equation for the user, the faster the substitution, so costs do matter. But costs don’t matter as much as making the value compellingly clear to the user — so that the user is compelled to make the needed new investment in the task.
2) Already Paid, but Gated by Infrastructure
For some substitutes, the user already pays for the task — which is good because investment is already allocated to the task — but the substitute’s adoption is gated by the necessary infrastructure. This was the case for television as a substitute for radio. It was a superior substitute for many, though not all, uses. However, it took a while to penetrate fully.
A reason was that television penetration was gated by the content infrastructure. When television came to be, there was little video content for television. That infrastructure had to be built to make the television a valuable substitute for radio. It became the gating function for the substitution of television for radio.
The strategic imperative in this kind of substitution is that the provider takes responsibility for ameliorating or eliminating the infrastructure gating function. That happened in television as the leading television manufacturers, RCA and General Electric, made huge investments in content creation. For example, RCA created NBC to generate content. In the modern world, Tesla has had to invest in creating a charger infrastructure to spur substitution of electric vehicles (EV) for internal combustion engine vehicles (ICE) — which is smart strategy.
3) Already Paid, but Gated by Costs
For other substitutes, the rate of substitution is gated by its cost — and therefore the price at which the substitute can be offered. This is the case for the EV versus ICE substitution above. Customers are already paying for ICE vehicles — which is good for the substitute, EV. But (currently) the cost of an EV makes the price to customers sufficiently high that the substitution is slow — it is gated by costs. (Note, this is not the case in China where low-cost/low-price EVs are abundant, have high penetration — and are a looming threat to American producers).
In the US, the dominant proportion of EVs sold are currently in the ‘luxury’ category because of the costs/prices of this substitute, and luxury vehicle sales make up under 20% of vehicle sales in the US market. That is a substitution gating — and the reason for the electorate’s lack of enthusiasm for the 2021 EV mandate. That having been said, substitution of EV for ICE is most certainly happening, driven by Tesla.
Another cost-gated substitution was solar power substitution for conventional power. Solar was once severely gated by costs — which for conventional power was cheaper. But over two decades, solar power (in some but far from all circumstances) has been cost-reduced to the extent that it ceased to be a cost-gated substitute.
And that illustrates the strategic imperative for cost-gated substitutes for existing paid-for alternatives. You simply must get your costs down to drive speed of substitution. Without cost proximity, you will be a fringe player/industry forever — often dependent on regulatory mandates for customer use.
4) Already Paid and Ungated — but You are the Incumbent
In some situations, the incumbent develops a substitute for its own offering. I have been close to two of these. When I went on the board of Thomson-Reuters, its Westlaw business had a hugely successful business as the dominant supplier of case law books to legal libraries. For every case that came out of the US legal system, Westlaw created a short summary of it (a ‘headnote’) and had a proprietary numbering system that categorized the content of each case in a way that helped law librarians (which every firm had one or more of) find the case law relevant to a partner’s current case.
When the Internet came along, clever folks at Westlaw figured out that a fantastic substitute for libraries full of leather-bound books was an online service that enabled the lawyers themselves — without the help of librarians — to search for case precedents from their computer desktop.
The amusing thing about that particular substitution journey was that the Westlaw online folks would come to board meetings enthusing about the massive year-over-year growth of their business, but then the head of the overall Westlaw business would have to give us the sad news that the Westlaw print business was declining rapidly (despite all their efforts) so that the overall growth of Westlaw was relatively slow. The penny hadn’t dropped for them that the new business was gaining one client for every one client from the old business.
The decision to substitute for itself before someone else substitutes for you was brilliant, but they didn’t understand the growth implications. The same kind of substitution happened at P&G as a 100% powdered detergent business converted to a nearly 100% liquid business. But P&G was more sophisticated and knew that the liquid business couldn’t grow explosively while the powdered business remained stable.
The imperative here is to bravely substitute for your own offering. Don’t wait for competitors to do so before you do — because it will be much harder to win in the new offering market and that is the future. But be very realistic about overall growth. Don’t tell the capital markets that you have a great new growth engine that is going to power the top line. No, you have traded customers up, not created myriad new customers.
5) Already Paid and Ungated — and Somebody Else is the Incumbent
In 1999, there were 283 million handsets sold in the world — devices that would soon come to be called ‘feature phones’ — with Nokia, Motorola, and Ericsson combining for over half the market share. In 2000, BlackBerry began selling a substitute — the smartphone — and in 2007, Apple crashed the party with the iPhone. Neither made nor sold a single feature phone.
That is the perfect substitution context in which you don’t have to kill your own business to grow your substitute. It is the same as Southwest Airlines substituting for Greyhound buses. Or Amazon substituting clicks for bricks. Or more obscurely southern hemisphere hardwood pulp — mainly from fast-growing eucalyptus trees — substituting for northern software pulp — from slowly growing coniferous trees — in making the largest grades of paper, which are photocopy and notepad paper.
The strategy imperative in this context is to run fast — before the incumbent wakes up and strikes back. Amazon did that to perfection — and it is still in the catbird seat decades later. BlackBerry tried but was overwhelmed by Apple and then the various Android players. By running fast, Apple built a $200 billion iPhone business. Only one feature phone player — Samsung — successfully transitioned to smartphones, and that is probably because it was a small feature phone player, and that business wasn’t a big part of its portfolio at that time. By substituting for Greyhound, Southwest was ignored by the major airlines for far to long for their collective health.
Practitioner Insights
Being an attractive substitute for an existing situation can be very lucrative. But the growth prospects and strategy imperatives as a substitute vary greatly by context.
If your substitute takes the customer from the realm of unpaid to paid task, you need to be patient with growth and concentrate on selling value.
If your substitute is gated by infrastructure, debottleneck your market by investing in the requisite infrastructure to increase growth.
If your substitute is gated by costs, work first and foremost on getting cost proximity with the offering for which you are substituting in order to spur growth.
If you are the incumbent, don’t hesitate to drive substitution because if you don’t, someone else will and you will shrink not grow. But don’t expect big net growth because your legacy business will die as you build the substitute one.
Finally, if your substitute is ungated and you aren’t the incumbent, push growth as fast as you can — even if it means giving up some of your equity to finance it — to build an unassailable position before the incumbents wake up to what is happening to them.
