Established companies are often late to spot mortal threats to their business model. Here’s how they should respond when industry disruption strikes.
Digital disruption isn’t just for hip start-ups. Incumbents can not only compete but actually lead radical industry change if they pay attention to the way their business model is shifting and act boldly in response. In this episode of the McKinsey Podcast, McKinsey partner Chris Bradley and senior partner Angus Dawson talk to Cam MacKellar about the life cycle of digital disruption, what it means for incumbents, and how executives should react. An edited transcript of their conversation follows.
Hi, I’m Cam MacKellar, from McKinsey’s Sydney office, and I’m delighted to be speaking today with Angus Dawson, a senior partner of the firm’s Strategy Practice throughout Asia; and Chris Bradley, a partner here in Sydney.
Both Angus and Chris have recently published articles on digital strategy for McKinsey Quarterly. Chris, along with his colleague Clayton O’Toole, coauthored an article published in May called “An incumbent’s guide to digital disruption.” The article looks at how companies can avoid becoming victims of digital disruption by recognizing crucial thresholds and acting in time. Angus and Chris, thank you very much for spending time with us today.
Cam MacKellar: Chris, it’s clear that the champions of disruption are more often attackers than incumbents. Why is that? And why is it so difficult for incumbents to respond rapidly to disruption?
Chris Bradley: I think companies are well geared for running their business at current course and speed or responding to a very immediate and real crisis. But disruption is in between those two goalposts because it’s uncertain, and it plays out over a very, very long period of time, and we get the proverbial boiling-frog problem in a company where the pressures of the short term and what’s real and what’s in front of your face are so all encompassing that the disruption gets underplayed.
Angus Dawson: There’s nothing that a CFO dislikes more than a business case that’s based on preventing decline. When you put a business case up, if you’re going to get investment you’ve got to show how it’s going to add to growth and profitable growth, and disruption is actually saying we’ve got a different baseline and that’s one of decline, and that conversation often just gets shut down.
Chris Bradley: Psychologically accepting a declining baseline in a business that you’ve grown up in and that you love and that you’ve actually got to take as the status quo or as the default reality, the idea that this business will decline, other things being equal, inference being big investment and big effort to maintain today’s position, that’s a big bridge to climb, and that’s why often you won’t see the response until that baseline doesn’t become a counterfactual; it becomes the factual.
Cam MacKellar: For incumbents who may realize disruption is out there, it’s perhaps lurking on the horizon, and they know that it exists, how should they determine what’s a real trend and what’s just noise? How can they work out which digital trends are going to influence their business and which ones are simply hype?
Angus Dawson: We’ve got to have a bit of empathy here for executives who are being hammered every day with trends and reports of how the whole world is going to change, threats on the horizon both from people outside the organization as well as from people inside. To be honest, most of them aren’t going to eventuate. We’re starting from a position of trying to pick the few things that really matter and the approach that we advocate is to come back to the fundamentals of the industry and how money gets made. We’ve got all the economic essentials to understand and to unpack what will change and why it will change and what are the markers of that to try to get through all the noise.
Chris Bradley: When these disruptions affect some of the deep wiring in the industry, you know it’s real, but a lot of the trends operate at this surface level. The other point I would add is that it’s nonlinear, so the world changes slowly until it doesn’t. That’s why when I look back through my career, most of these big changes, we’ve underestimated the impact of them but overestimated how quickly they would happen. I started my career around the time of the first dot-com boom, and I don’t think anyone at the time realized how profound the real Internet revolution would be, but that it would be pretty well 20 years later that we’re talking about it, with real depth. It’s that nonlinearity that’s important and why we’ve made the S-curve one of the central analytical ideas in there, because it’s nonlinear and because at any point where you extrapolate on an S-curve linearly, you’re going to get it completely wrong because you get this everything goes slow until it happens really, really quickly.
Angus Dawson: The other thing that’s going on, of course, is that it’s not like you come in with an idea of a source of disruption and a good executive in a well-managed company says, I never heard of that, or, I never thought of that. They’re thinking about these things. They’ve got lists of them, they’ve got workshops that they do as part of their strategy process every cycle, and there’s usually some things that are mapped to it in terms of initiatives or responses. The question is one of adequacy and being ready to scale those things up when it becomes clear that these trends are fundamentally reshaping the business rather than just mosquitoes around the edge.
Cam MacKellar: Which is a strong point. Good executives are going to be aware of the trends at play in their field. But once they’ve seen the trends and are aware of them and are reviewing them on a regular basis, how does an incumbent make the move to action?
Angus Dawson: It comes down to the very simple idea of resource allocation and the resources that we talk about having to allocate are obviously financial resources in terms of budget and capital and also talent and where management teams spend their time. So it’s recognizing that the response to these trends needs to be substantially elevated on all those dimensions, and spend real time on it because it’s still not like in the midst of all that you know exactly how it’s going to play out. You’ve got to stay continuously vigilant and pick up all the signals and work out when the acceleration is going to happen.
Chris Bradley: We think about it like you need to do a venture capital–style growth plan for the new business, which is aggressively driven on growth and doing everything you can to make it work, while at the same time you do have to do a private equity–style workout on the older business where cash flow is king. Unfortunately, given the power structures in most companies and the mind-set, the very opposite actually ends up happening. You get a huge amount of scrutiny and cash-flow pressure on the new growth business and the existing business is presumed innocent before guilty. There are some compounding factors, though, because once that disruption starts hitting and it’s no longer a theory but it’s real, the resources you have start declining. This resource allocation that Angus is talking about, you have to do that in the midst of a declining resource pool, which basically means that the new businesses for them to get this venture capital–style push for growth, the old businesses have to decline.
There’s a lack of calibration around how radical that shift is.
Angus Dawson: And you’ve got to remember the executives who are in charge are those who have grown up in the era predisruption. They’re actually the architects of the existing business model. Their conviction in the basis of that business model and the way of competing and their expectations around consumer behavior are all based in the status quo, and so they’re just not wired as much to understand where the disruption is, and you combine that with the boy-who-cried-wolf syndrome over and over again and them being right, they end up having a fair bit of conviction that ignoring a lot of the merchants of doom who are trying to sell a story to radically disrupt yourself, they end up believing that’s actually right, and so they miss that 1-in-20 big shift that’s happening, or at worst it comes to them a bit too late, and then they’re facing all the inertia that is in a large organization that makes it hard to respond.
Cam MacKellar: Which brings us to the question of motivation: How do you find the conviction within the organization to respond quickly and decisively to disruption in the face of inertia and the many competing priorities at play in the management team?
Chris Bradley: It takes leadership, so you can’t look at responding to disruption in some kind of theoretical view, where it’s not about people at the end of the day making really bold choices. One thing we want to be presenting though is a very empathetic view on this, because we’re with our clients in these situations, and Angus talks about the boy who cried wolf. That’s true; these management teams are going to be right and right and right again until finally they’re wrong. Angus talked about what made these executives successful and the skills they have, and the whole basis of disruption is a new basis of competition in the industry or a new business model; it’s highly unlikely that the old management team is going to have the skills to do that.
Sometimes we expect not only this terrific flexibility of people to see what’s coming but also to be able to do themselves out of a job, because the reality is many of these new businesses require new leadership and new management teams to do it. The analogy of the boiling frog—and I’ve tried to prove whether the boiling-frog analogy is real or not, and if you Google it you get about a 50-50 on whether it’s real or not. I’m not willing to do the experiment on myself, but the idea is if you put a frog in really hot water, it jumps straight out, but if you put it in the cold water and then slowly raise it to the boil, by the time it realizes it’s too hot, its capacity to act has gone.
Whether it’s apocryphal or not, it’s a useful analogy because the difficult thing about navigating disruption is if by the time you really, really need to act, your capability and capacity to act has taken a severe blow. Therefore you have to act before you have to act, and that’s what’s hard given all the things we’ve talked about before: the pressure from the board, the pressure for continuation, the boy who cried wolf, and the management’s own fears and concerns that they might not actually know how to run that new business you’re talking about.
Angus Dawson: Because faced with a genuine crisis, most management teams are very good and they know how to respond. It’s turning a potential crisis into the same set of urgency and actions that you would have. Too often, the early stages of disruption create a sense of overconfidence in response. The management team will have a set of actions that they’re taking, and usually if they’re one of the better incumbents they’re actually doing just fine. But let’s go out of digital for a second and look at the supermarket industry in the United States through the rise of Walmart. What happened is, Walmart swept through the country with their supercenter offer, which included grocery. The supermarkets that got wiped out were the worst ones and the weak ones. If you were sitting there as a better incumbent, you did just fine. You could have convinced yourself that your business model and your proposition was resilient to what Walmart was doing. It’s the old, I don’t need to outrun the bear; I just need to outrun my friend who is also running from the bear. Well, eventually when the bear has eaten your friend, the bear is going to then come after you, and that, I think, is what happens. That period of false confidence can also just lead to, in the most important moment of response, it being undercooked.
Cam MacKellar: To carry on that analogy, how do you speed up when you realize the bear is onto you, it’s eaten your friend, and you’re firmly within its sights. How does an incumbent accelerate the rate of transformation within their businesses?
Chris Bradley: The best way to speed up is to get a head start. When you haven’t sped up, adopting that more radical response and that sense of crisis—and it comes down to accepting your baseline and the word that a client would use—that tells me they haven’t accepted the baseline is the word cannibalization, and you will hear it again and again and again, which is, we can’t do that, it will cannibalize our business. Now, of course, if your friend has already been eaten by the bear, it’s not cannibalization at all.
Angus Dawson: That’s a really important element of what you need to do to respond. You need to do real strategy work. You need to step back and say, do the businesses we own make sense in the way in which the world is unfolding, and are they going to create value, and are we the best owners of those businesses to create value, and then, where else do we need to think about investing, what’s the bar on the capabilities that we have, and how much has it gone up, and are we at scratch or are we going to end up being out-competed by somebody else who just reconceives what’s possible? It’s that thought process that we would encourage the management teams to start and to make it not the fringe that’s having these discussions, but to bring it front and center into their leadership discussions about what’s really going on with disruption, and let’s play forward a few scenarios as to what could unfold and under those scenarios what are the things we wished we would have done in terms of buying or selling particular businesses, in terms of shifting resources, in terms of really beefing up particular capabilities, and so on.
Chris Bradley: It’s a bit to me like quitting smoking, and I may or may not have once loved to smoke. You had these contests as the smoker between your current self that loved that next cigarette and your future self that didn’t want to live with the consequences of many years of smoking and knew that once you were actually out of that vicious cycle of smoking you would actually be happier.
Angus Dawson: And there was the in-between self that was very, very grumpy.
Chris Bradley: Apparently. But these are deep-seated habits, so trying to get a CEO or a board or a management team to act like they would thank themselves for in five years’ time is really hard because the current self does have these fairly strong feelings and these pangs and these urges to keep the current habit going. Now, smoking at least is a solo game, but this one you all have to stop smoking together; the board, the management team. That’s where I say the defining characteristic of these companies to me that have navigated disruption well, whether it’s Netflix or Tencent or Facebook or Axel Springer, is incredibly strong leadership from the top.
Cam MacKellar: Can we expand on that a bit, Chris? What role can the board play? How does that leadership work?
Chris Bradley: The board conversation can be one of the toughest parts. Partly it’s because it’s quite hard at times for a board to disentangle all this talk about declining baselines and threats with, is the management team doing everything they can to run the business well? You’ve got to remember, when this all starts happening, the company starts hitting air pockets of performance, the board stops seeing that steady growth and natural questions arise in what is the management team doing and are they doing everything they can? Unless you have this very strong compact between the management team and the board that says this is our real baseline we’re working against, you’re going to have constant questions about, well, is that performance you’re getting, are you blaming the disruption for a mediocre management performance? As a board member, I imagine it’s very, very difficult to prize the contextual factors behind performance from the company-specific drivers of performance, and that’s one of the toughest things boards have to do.
Angus Dawson: Boards want to do the right thing here. They encourage management teams to have quite honest and sometimes profound conversations about what’s going on in the industry and the implications for them. I’ve seen a number of boards be quite nervous when they’ve seen management put up ambitious near-term financial budgets about what they’re going to achieve and wondering whether or not they’re investing enough in doing the right things in the future. But, at the same time, it takes a very courageous board to step out of the status quo in terms of how they incentivize management, and most boards will insist that management is incentivized on returns-to-shareholder measures.
If that company is starting, as most of these incumbents are, with pretty healthy earnings and pretty healthy multiples, then it’s very, very difficult for that management team to improve total returns to shareholders in the near-to-medium term without driving near-term financial performance. Actually, a narrative to the market, which is our earnings are going to take a dip, and, by the way, our industry is being disrupted, is going to trash the stock price, and at that point the inevitable conflict of the board wanting to do the right thing and think long term and the management team being incentivized in the near term, the near term wins over and over and over again.
Cam MacKellar: I’d like to talk briefly about incumbents who perhaps haven’t adapted by this stage. A clear new business model has made itself known but the necessary preemptive change and adaptation hasn’t been made in the company. What are the challenges for the management team at this stage?
Chris Bradley: Suppose it has been too long to respond; it’s rarely the same management team that’s dealing with the adaptation that dealt with the other sides of the curve, and it’s probably the easiest time to pursue reforms, and where you see incumbents doing the most radical things is in the adaptation phase. Typically, what you get is radical responses to drive cost on the old business. The question is, is it too late in the newer business models to get a head of steam?
Angus Dawson: You see actions being taken to respond to the urgency of the crisis that are probably appropriate, but a huge amount of value can get destroyed in that frantic set of measures to try and be doing the right thing. Either incumbents can slash prices aggressively when they realize that they’re out of the market, without having worked out what the financial profile is of what they need to do to recover. You see businesses get disposed of in a way that sometimes can just be, let’s just rip the Band-Aid off and get rid of it. There are two different types of telco all around the world with their directories businesses; those who sold it 5 to 10 years ago to private equity for billions of dollars, and those who sold it for very small amounts in the last year or two as they just were trying to get rid of it and accept the fact they had made a mistake.
It’s a pretty dangerous time, and Chris has used the word a number of times through this conversation about the role of leadership, and more than ever, when incumbents miss the boat, there needs to be that kind of steady and assured leadership about what is the path out of the problem that you’re currently in, at the same time as being willing to make really tough decisions on a whole number of fronts about which businesses you own, what to do with the cost base, how to compete in the marketplace, and so forth. At the same time, usually on the management team and the board there’s a bit of a blame game going on as to who was around during that process, and they usually will have undersold to the market the pain of the turnaround path as well, which is why often actually the better owner of a business through a period like this is private equity. That’s a very natural place for them to come in.
Chris Bradley: That’s why in this article we’ve kind of tried to say hindsight is 20-20, it’s all very clear, and what we’re trying to say is, what kind of leadership model do you have to have for 20-20 foresight? At the point of adaptation, there are three possible models; model 1 is you actually can reform your business and be part of the new guard. There’s number 2, which is you’re stuck in the incumbent business model and it might be smaller; it might not be growing as much but it’s still a viable business. But part number 3 is one that’s hard to stomach but often the case, which is it’s unclear that the old technology has a viable place in the new world, because disruption is not new. I think it’s happening more often because the technological drivers are there. When personal computers came and disrupted Wang with its mainframes, we’ve seen this all play out before. The question is that unfortunately, sometimes in that new reality there might not be a business model to adapt to.
Cam MacKellar: Well, thank you both for your time. We really appreciate it, and enjoyed that discussion.
Angus Dawson: A pleasure. Us too.