Measuring Up

Geoffrey Moore, Forbes ASAP, 04.03.00

The ramp creates eye-popping revenue that is the envy of management teams in slower-growth markets. So who wouldn't want to be dropped smack-dab in the middle of such an opportunity? Actually, perhaps you, if you are an executive in an esteemed blue-chip Forbes 500 company. All too often, the ramp has made successful, traditional management teams look bad.

With its triple-digit revenue growth, the ramp is a quickly moving, dynamic beast, and old-style management often doesn't know how to keep on top of it. Not surprisingly, it's management teams in the tech sector that have evolved the best strategies for anticipating and harnessing the power of the ramp. Here are some of the strategies they've developed. CAUTION! VISION REQUIRED In the preramp stage, the marketplace becomes aware of a new disruptive technology, such as the Web, and begins to speculate on its future value. Early adopters make high-risk bets that the technology will become the next big thing, while pragmatists take a wait-and-see approach. The good news for traditional management is that there is no need to take the early-adopter route. Disruptive technologies often fail, validating the wait-and-see tactic.

But management must not ignore the dynamics of the preramp market. Instead, it should watch the stock market carefully to see if new issues are gaining exceptional support. Such upthrusts in market capitalization indicate that at least some investors believe there is a fault line forming. It behooves everyone to read the prospectus and find out just whose oxen these newcomers intend to gore. If you and your company are the target, spring into action immediately.

How? Back in the 1970s and 1980s, the idea was to stonewall upstart innovation. The preferred marketing tactic, practiced to perfection by IBM and Microsoft, was to spread FUD--fear, uncertainty, and doubt--about the new technology, causing pragmatists to recoil. The strategy worked fine for a while, but we live in a Darwinian world. New startups have mutated their marketing strategies to get around this barrier. As a result, the preferred tactic today (once again practiced to perfection by Microsoft) is to embrace and extend the new wave. That is, express interest, enthusiasm, and support for the new paradigm while working to meld the technology into your existing industry infrastructure.

Prior to the ramp, you don't want to take this strategy too far. All you have to do is publicly support the next wave, not actually invest heavily in it. More than anything else, you want to make sure you don't miss out on new wealth creation, which, by the way, has no basis in earnings or in revenues. Instead, it's entirely about vision.

And that brings us to the key metric for the preramp stage, what Nick Earle at Hewlett-Packard likes to call the price/ vision ratio. Earle has earned the right to coin such terms because he magnificently repositioned HP for the Internet economy. Earle says that we are now in "Chapter Two of the Internet," a phrase he's coined to acknowledge that while Sun and IBM may have won the first round for corporate and carrier Internet infrastructure, the winner hasn't yet been named for the next wave of innovation: corporate application outsourcing. Whether HP will succeed in this new chapter remains to be seen, but investors bid up its stock price solely on the basis of the new story--a clear victory for P/V thinking. ENJOY THE REVENUE Good visionary talk is sufficient to manage the challenge of preramp, but it isn't enough once you're on the real thing. We saw it with mainframes, minicomputers, and PCs, and now with e-commerce. Once a technology wave starts to truly crest, it is imperative that you and your company get in position to ride it out. Trying to stand firm against it only results in getting washed away.

Here, the critical issue is determining what is becoming the de facto standard. This is determined solely by market share. If you are a skeptic--as any team that has stayed on the sidelines during the preramp phase is likely to be--you must delay your decision long enough to be sure of the outcome. Is it Netscape's value chain or Microsoft's? Is it Cisco's or Wellfleet's? There is no benefit to guessing early: Wait and see.

Once you have "seen" the outcome, however, don't delay. Become part of the new value chain, first as a customer and then as a provider of technology-enabled value-added services to your customers. The earlier you get in, the greater your chance to take market share from your slower-moving traditional competitors. You may even be able to expand into other markets before they wake up to the opportunity.

America Online, of course, is the poster child for this strategy. It properly held back from embracing the Internet as long as there was a chance that its proprietary network would win out. But once AOL realized that the wave was truly cresting, it embraced the Web. CompuServe and Prodigy, its two rivals, failed in this effort.

Why did CompuServe and Prodigy hold back? Why, for that matter, did Merrill Lynch hold back from Internet trading, allowing Charles Schwab to steal its market leader position? Why have car dealerships held back, allowing CarsDirect and Autobytel to erode their positions? In every case the traditional management view was the same: This new technology will be ruinous to our earnings. We imply cannot adopt it.

As sensible as this position seems at the time, it is wrong. Yes, in the short term, margins will take a hit, and yes, investors who were counting on short-term earnings will sell your stock. But here is the kicker: If you successfully communicate that you have indeed caught the next wave, other investors--growth investors as opposed to earnings investors--will begin to pick up your stock. They will reward you with increasingly higher market capitalization.

In ramping markets, competitive advantage is determined almost entirely by market share, most easily reflected in revenue and revenue growth. Thus price to sales ratio takes over from price/vision ratio as the key metric. All companies in the ramp see a significant jump in P/S ratio, and as one company emerges from the pack as the leader, its P/S increases beyond that of its competitors. This is the signal to everyone--investors, partners, customers, and employees--that the dominant player, the gorilla, the company with the right to set the de facto standards going forward, has arrived. EXIT TO EARNINGS The ramp ends when revenues from existing customers catch up to and eventually overtake revenues from new customers. This signals that the technology adoption life cycle has passed its meridian, and the market is well and truly launched. Going forward, this market may generate 10, 100, even 1,000 times as much money as it did during the ramp phase, so earnings potential has just begun to be tapped.

Market share among various established competitors, on the other hand, will remain relatively stable, virtually for the life of the market. Because companies have little chance to change their market share, their economic trajectory becomes a function of macroeconomic forces, modestly impacted by execution. Because investors see no huge future opportunity, they turn to the standard price/earnings ratio to value the company.

P/E ratios function something like interest rates: They let investors compare projected returns between any two investment opportunities. With the rise of the technology sector, however, they have posed a problem, since they are only well suited for postramp markets. They must take their place in line behind the P/S ratio, which in turn takes its place behind the P/V ratio.

Of course, all this sounds simpler than it really is. Taken in isolation, each of the three stages is readily understood. The challenge is that they rarely appear in their pure form in the real world. This leads to volatility in investment and causes management teams to stumble. The tools presented here do not solve this problem, but they do create a vocabulary for discussing it. And before you can gain control over any phenomenon, you must first give it a name.

Geoffrey Moore is the chairman of The Chasm Group, which provides strategy consulting services to high tech companies. He is coauthor of The Gorilla Game.