It's Rishi

It’s been a while since the last review I posted and I must admit that the pace at which I’m going through The Personal MBA reading list is not as brisk as I would like. The good news, though, is that I just finished reading Blue Ocean Strategy by W. Chan Kim and Renée Mauborgne.
The book has quickly garnered a laundry list of awards and is endorsed by one of my business-world idols, Carlos Ghosn. My curiosity was piqued so I hopped over to Amazon and ordered it.

The book promises to teach the reader “how to create uncontested market space and make the competition irrelevant”. That’s a pretty bold promise. So, does the book deliver? I think so. Or about as well as a book can.

So “What’s this ‘Blue Ocean’ thing??”, you might ask. Well, to define what a Blue Ocean is, it’s easier to first define what it’s counterpart, the “Red Ocean”, is.

Red Oceans represent all the industries in existence today or, in other words, the known market space. The boundaries in such industries are well-defined and the competitive rules of the game are known. Companies in Red Ocean industries try to outperform their rivals to snag a greater share of existing demand. Because of such factors as accelerating advances in technology, trend towards globalization, and stagnant worldwide demand, industries have witnessed accelerated commoditization of products and services. This commoditization means that buyers increasingly select based on price which leads to price wars which leads to shrinking profit margins. Every industry is or will eventually become a Red Ocean and companies regularly employ traditional competitive-stategy techniques to survive in bloody Red Ocean environments.

However, for a company to sustain high performance, it must look beyond it’s current environments and grab new profit and growth opportunities. This is precisely what a Blue Ocean offers. Blue Oceans represent all the industries that don’t exist today or, in other words, the unknown market space. (If you raised the BS flag after reading that sentence, think about this: Many multi-billion dollar industries of today did not even exist 30 years ago e.g. bio-tech, personal computers, mutual funds, cell phones, express package delivery, coffee bars, and the list goes on… )

The underlying process of creating a Blue Ocean is something the authors call value innovation. Instead of focusing on beating the competition, focus on making the competition irrelevant by creating a leap in value for buyers. Value innovation is contradictory to the commonly accepted competition-based strategy concept of a “value-cost trade-off” which says that there must be a compromise between product differentiation (added value) and low cost. Blue Oceans achieve differentiation and low cost simultaneously.

The authors cover the basic analytical frameworks of the Blue Ocean strategy: the strategy canvas (the value curve), the four actions framework, and the eliminate-reduce-raise-create grid. In later chapters, the authors go into further detail about the formulation and execution principles (there are 6 in total) of the strategy.

One thing I really liked about the book was that the authorss unit of analysis is a single strategic move of a company, not the entire company or industry. In the first chapter, the authors find fault in books such as In Search of Excellence and Built to Last which had put several companies on a pedestal as “model” firms, yet, today, many of these firms are far from being industry leaders. The authors reasoned that if the same company can be brilliant and lame at different points in its history, then it doesn’t make sense to make the company the unit of analysis for studying strategy.

Another aspect of the book that I really liked was the extensive use of case studies. They helped to solidify the concepts being explained as well as making the text more enjoyable to read.

Overall, I would highly recommend this book. This shouldn’t be the only book you read about competitive strategy, but I think it should be on your reading list if you want a more complete perspective of the subject. At the very least, find a copy of the book and read the first section as it does a nice job of covering the key points of the strategy.

Note: As I did before, I made fairly detailed notes while reading the book. If you would like a copy of the notes, shoot me an e-mail and I’ll be happy to send you a copy.

Last month I wrote a mini-essay titled “It’s cool…but I wouldn’t pay for it” in which I briefly discussed a phenomenon that is becoming more and more common. A company launches a good service but has trouble finding users who will actually open up their wallet and pay for that service. This has led most recent web-based companies to either offer their service free of charge – relying exclusively on ad revenue for cash flow – or give away the basic service free and try to upsell premium services.

After making that post, I started to think about what does make consumers open up their wallets. What are their motivations? I want to answer the simple question: Why do people buy stuff?

After a lot of thought, I came to the hypothesis that each purchase is motivated by the following 2 factors:

Functional – Many products we buy fulfill a tangible function. In other words, they have a measurable utility to us. Each function of a product has varying utility to each consumer depending on his or her needs. For example, a BMW M5 has a top speed of 205MPH. For the average buyer that function is offers little utility. But for a German driver who needs fast transportation on the Autobahn, the utility might be very high. Similarly, the fact that a buffet is all-you-can-eat may have high utility to a football player but little utility to someone dieting. On the other hand, a bottle of water has universal and similar level of utility to most consumers.

Emotional – There are a few primary emotional states that all humans strive for (whether they admit it or not): happiness, security, attractiveness, belongingness, and, above all, a feeling of importance. The interesting thing about emotional-based purchases is that they have no bound. Humans always want more. A man who owns a Casio wants a Seiko. A man who owns a Seiko wants a Rolex. Similarly, people are generally interested in spending money to achieve higher levels of the aforementioned emotions.

this leads us to…

Rishi’s laws of Consumer Behavior

If your product appeals primarily to the consumer’s functional needs: That consumer will likely open their wallets to you, but will probably do so unwantingly. Nobody particularly enjoys buying milk, toilet paper, or store-brand cola, but they do so because it fulfills their needs.

If your product appeals primarily to the consumer’s emotional needs: That consumer will likely want to open their wallets to you, but will probably not do so. People want Porsche 911’s, Rolex watches but few buy them, even if they could technically afford it. Now, if you intend your product to be a niche-market, luxury item then there’s no problem.

If your product appeals both to that consumer’s functional side and emotional side: The consumer will likely open their wallets to you, and feel happy about doing so. Ideally, you want your product to fit into this last category: appealing both to the functional and emotional side. This is not so much a product design exercise but a marketing exercise. The art of branding is all about how to make a product sell for more than it would if it was perceived as just a commodity (only functional). It’s the reason why Ralph Lauren (declare to the world that you’re successful with the Polo logo) can charge $60 for an ordinary polo shirt or why Coca-Cola (make every moment a memory by drinking a Coke) can charge more than store-brand cola. But, to accomplish this, it’s also important to remember that you must also fulfill a clear functional need for your consumer. A great (if obvious) example of a product which accomplishes both is the iPod. There are several competing hard-drive based MP3 players which are very competitive. Apple is able to not only dominate the market, but do so selling it’s products at a significant price premium. Through a combination of product design, packaging, and marketing, Apple has consistently made each iPod hip and luxurious. They made the MP3 player be more than a functional purchase, they made it an emotional purchase.

Few companies in the computer industry have been able to appeal to the emotional motivations of consumers. Specifically, I can’t think of a single software company that has. Possibly video game software, but one could also argue that it’s also functional: video games provide the function of entertainment. What about on the web? Are there any websites that you pay for that appeal to your emotional side? This is something I’ll be thinking about for the next few days…

My friend Rob Poitras pointed out to me that YouSendIt, one of the most popular free file hosting services, serves up a whopping 44TB of data every single day. He mentioned that as far as he knows, they are not profitable either. So, I was curious about how sound their business model is. I have to think that it is because just in the past year, there has been many other essentially identical services that have launched.

Unfortunately, I couldn’t dig up any hard numbers so we’ll have to base this analysis off of fairly rough details. The facts from YouSendIt.com claim 44TB of data daily and “over 8 million unique visitors” monthly.

Costs
It doesn’t take a genius to realize that by far the primary cost of doing business for a file hosting service is servers and bandwidth. I’m guessing the latter far outweighs the former. Not only are they serving an insane amount of data, but also for a file hosting service to compete, it needs to offer fast download speeds to users.

44TB of data flows daily and there is 86,400 secs in a day. At any given time, there is an average of 0.5GB/sec (which is 500MB/sec or 4000Mb/sec) being transferred. I really wish I had a good number of how much it costs to serve data on like a per GB basis. I can imagine some ways I could go about calculating it but without accurate starting data, it’s probably not worth the time. I saw some numbers like 1U rack space + 100Mbps unmetered for $2500/month. Let’s just say that you bought 40 of these. Each 1U file server maxes out its 100Mbps connection. Let’s say each file server is leased and runs about $500/month. So total cost for all this is 40 x ($2500+$500) = $120k/month. Obviously this is a very crudely made number and I’m sure that the scale that YouSendIt is doing things, it should be cheaper. However, there is a significant operational cost to keep such a large service like this running and there is some development cost for various software and tools and such. Let’s say total for everything costs $175k/month. (I still did not include general personnel and administrative costs for YouSendIt)

(Advertising) Revenue
YouSendIt makes money via advertising. However, because this advertising space is not very targeted (really the only way to target is the name of the file which is not necessarily meaningful at all), I just can’t see it having as high a CTR (click-thru-ratio) as a contextual systems like AdSense or keyword systems like AdWords. YouSendIt has two types of ads on their site, image/banner ads and text ads. My *guess* is that the image/banner ads are sold on an impression basis not CPC. I think that is typically the case with image ads because they are so imposing on a page, that it’s hard for the user not to notice it. The question is how expensive? Since it’s just not that targeted and users don’t really spend that much time viewing the page (just click download link and leave), I could see it going for $5 CPM (cost-per-thousand-impressions) which is $0.005/impression. For text ads (looks similar to AdSense text ads but it’s managed by a company called BidClix), depending on the type of business the advertiser is, YouSendIt charges a minimum of either $0.25 or $0.50 for each click. Looking at the current bid amounts which are a few pennies above the minimums, let’s assume an average of $0.40/click.

So to calculate monthly ad revenue, let’’s refer to the 8 million unique visitors per month. Let’s say that results in 10 million file-download-page views (the pages that show ads) per month (average of 1.25 page views per unique user per month). Each page view includes 2 of the banner/image ads so that’s 20 million impressions. At our figure of $0.005/impression, that’s $100k. For the text ads, since again they are not very targeted, a CTR of say 1% seems reasonable. 3 text ads are displayed at a time. So total clicks on average per page is 0.01 x 3 = 0.03. Multiplied by 10 million page views that’s 300k clicks per month. At an average of $0.40 per click, that’s a total revenue of $120k for click revenue. Total ad revenue estimate is $100k + $120k = $220k.

Final Analysis
So my estimate cost of operating this service is $175k and estimate of ad revenue is $220k on a monthly basis. So we got a profit right?! Well, as I mentioned earlier, I didn’t include administrative costs. Let’s just assume that’s a paltry $25k/month which is mainly salary for the key administrative individuals. Luckily the service sort of markets itself virally so I’m guessing marketing costs are very low. Anyways, so *total* montly cost is $200k and revenue is $220k. $20k/month profit..we’re in the black!

Again, this is an extremely rough conclusion. I am curious how far off I am though. What does interest me is that I think some of these file sharing sites received venture investment. I assume this means that these sites plan to leverage their traffic or content (somehow) into a more profitable business. The content seems like a tough play since it’s private and also a lot of it is probably (illegal) copyrighted material. Without such a long-term vision though, sites like these seem to me like a commodity. Even if I were to double my estimate for CPM to $10, the company still is making about a $1MM profit annually. The problem is growing that. Maybe a better operating margin can be squeezed out by improving efficiency or somehow offering more targeted advertising, but still it doesn’t seem like it would offer the growth potential that venture investors would want to see.

Anyways, I’d love to hear some comments on this analysis. If any YouSendIt guys read this, wanna tell me if my analysis is even remotely accurate? =)