Outinnovating on the web

This is the financial results period in the US and yesterday both Yahoo and eBay reported their earnings which generated disappointment as their stellar growth rates and cocaine-like margins are slowly falling victim of gravity. In yet another good article, Richard Waters, the Information Industries Editor for the Financial Times, explains why the web behemoths are facing difficult challenges ahead as smaller companies keep on out-innovating them.

And before you go any further, Apple also announced its financial results for the quarter and they indeed managed to sell 270k iPhones during the first 30 hours, which means that they actually sold 2.5 devices per second nonstop! Even though it is less than expected, they maintained their forecast that 1 million devices will have been sold come October.

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Web giants Biters bit
How web giants are losing business as start-ups scurry in.
By Richard Waters
July, 25th 2007
(c)2007 The Financial Times Limited. All rights reserved

In the late 1990s, as the internet boomed, the bosses of many established companies were transfixed by the risk that some online upstart would spring from nowhere to up-end their business. Chief executives lived in fear of being “dotcommed”.

A decade on, the fear is back. This time around, though, some members of the -original dotcom generation of disruptive internet companies are among those that are starting to run scared.

The extent to which the latest wave of online innovation is starting to wash up against some of the established internet powers was on display last week. Yahoo and Ebay, companies that can lay claim respectively to the biggest shares of the online display advertising and electronic commerce markets, sounded in contrite mood as they announced their latest earnings.

In both cases, the symptoms of the malaise can be seen in slipping growth rates and an admission that they have lost some of the creative dynamism that propelled them to global leadership in the first place.

“The user experience fell behind a little bit,” Meg Whitman, Ebay chief executive, confessed of her company’s slipping growth rate. From a company that has long been the leading case study in how to build and nurture communities doing business onthe internet, this amounted to quite an admission.

Ms Whitman’s prescription: more innovation is needed across the board, in everything from Ebay’s internal search engine to a revamped version of the feedback mechanism that lets buyers and sellers on Ebay’s markets each rate how well the other performs. Ebay has also been racing into new businesses such as classified advertising and online comparison shopping.

Yahoo, whose position in online advertising has been seemingly as entrenched as Ebay’s place in e-commerce, is suffering even more. Until now, the focus has been on the company’s lagging search advertising business, reflecting a failure to keep pace with Google. It appears, though, that Yahoo’s core business of online display advertising – a market Google is just beginning to enter – has also started to founder.

“We have not continually driven innovation in our display business,” Sue Decker, Yahoo’s new president, conceded last week. The internet company had stuck to the market it knew best, she added, selling space to big advertisers that wanted to run brand campaigns online. “We were slow to see the growing demand” for other types of online marketing, she added.

Admissions such as these do not just point to isolated instances of companies that took their eye off the ball. Rather, they are indicative of a broader shift. “The web has changed quite dramatically,” says Ms Whitman, referring to the latest developments as “the next level of internet innovation”.

Behind this lie the rising expectations of advertisers and internet users, the improved measurability of search advertising, the rise of social networks that meld communications and entertainment features in new ways, and experimentation with other “Web 2.0” technologies that have made the decade-old approaches of some of the “Web 1.0” giants look distinctly dated.

“This is changing things quite dramatically at the margin and exposing the complacency of the early leaders,” says Roger McNamee, co-founder of Elevation Partners and a veteran valley financier.

In many ways, Google has become the poster-child for this new wave of inventiveness. With its striking attempt to embed creativity – the famous “20 per cent time” that allows engineers to pursue personal projects for one day a week – Google set out from the beginning to protect itself against the entropy that often afflicts companies as they get bigger.

Yet the pace of change has, in some important markets, outstripped even Google’s ability to keep up. The most obvious examples were last year’s purchase of YouTube for Dollars 1.65bn (Pounds 800m, Euros 1.19bn) and a down-payment of Dollars 900m to secure MySpace as an advertising partner, deals prompted by Google’s failure to build successful video and social networking services of its own.

The root cause of this acceleration in online innovation, according to Ms Whitman, has been a fresh boom in start-up investment. This is a complete reversal of the market that companies such as Ebay and Yahoo faced in the first half of this decade. “The market dried up,” the Ebay chief says of the access to venture capital available during those years. Disruptive new competitors were in short supply. “Now, we’ve seen the next wave of innovation.” The change in speed has exposed the extent to which the big internet concerns sat back.

To be sure, the amount of money flowing into online company formation has not reached anything like the level of the dotcom boom. In the peak year of the bubble it topped Dollars 100bn, more than three times the amount likely to be put to work this year. However, US venture capitalists are currently investing at a faster rate than they have for almost six years, and at a level that is almost 50 per cent higher than in 1998, itself a historically active year in the start-up financing business.

That has been enough to trigger a race to capture some of the big new markets opening up online, from video to internet tele-phony. Innovation is happening “because everyone is pushing the gas pedal”, says Bill Gurley, a partner at Benchmark Capital, a venture capital firm that first sprang to prominence during the dotcom boom thanks to its backing of companies such as Ebay.

This is the brand of capitalism that Silicon Valley knows best. To the more cautious managers of established companies, it can look reckless. An estimated 30 start-ups have, for example, raised venture capital to build consumer video sites. Many will fall by the wayside. Periods of overinvestment like this, however, lead to the sort of experimentation on which the Valley thrives and which has been the source before of unexpected upheaval.

“Risk is being discounted pretty dramatically,” says Mr Gurley. “It does lead to quite disruptive ideas.”

What does this wave of creativity mean for the established internet powers – not to mention the many traditional businesses in industries including media, retail, communications and software that are still trying to adjust to a world where many of their customers are now to be found online?

In one sense, the fate of companies such as Yahoo and Ebay lies in their own hands – as it always has for big companies with entrenched market positions that face a period of rapid change. They start with some of the world’s most powerful consumer brands and audience reach that few offline companies can match. Yet their assets will quickly erode if they do not continually find better ways to please their customers.

Even Yahoo is only scratching the surface of the internet’s real potential: the ability to deal with users based on personal interests and to exploit the interactive power of the medium to its full. When it comes to targeting advertisements and measuring and improving the effectiveness of marketing campaigns, “we’re still at the experimentation stage”, says Todd Teresi, head of Yahoo’s display marketplaces business.

Jump-starting their stalled innovation machines will not be easy. Yet with massively more data at their fingertips about how users behave online, large and established companies such as Yahoo should still be in a strong position to lead the next round of innovation.

In some cases, though, the issues run deeper. The need for operational improvement is one thing; competing with a radically disruptive business model can be much more demanding. “All these guys are facing world-class cases of ‘the innovator’s dilemma’,” says Mr McNamee, referring to the Clayton Christiensen book whose analysis of the problems established companies have competing with disruptive newcomers is the standard text on the issue. He puts much of this down to the emergence of new “person-to-person” businesses such as social networks, which are changing the behaviour of many online users.

Another engine of this disruption, adds Mr Gurley at Benchmark, is the flood of advertising making its way online. This is at the root of much of the experimentation taking place, he adds: virtually any business accustomed to receiving a subscription, transaction fee or other payment is facing competition from an advertising-supported rival.

Companies in industries such as software and telephony find themselves in the unenviable position of trying to guess how much of their business will move to this advertising-supported sector – and how quickly they need to respond. Acting too fast could undercut their existing sources of revenues needlessly, while moving too slowly will allow new rivals to become established.

For Microsoft, which faces encroachment from Google’s advertising-supported internet applications, that threat means juggling two very different approaches. “The real opportunity is to be nimble enough to use a core code base in a variety of delivery mechanisms and support different business models when that’s what the market merits,” says Jeff Raikes, head of Microsoft’s business division. One technical platform can, in other words, be employed to serve different sets of users, some of whom will pay while others will instead see advertisements.

If companies such as Microsoft are right, this Darwinian struggle need not lead to the extinction of established business leaders – even if succeeding in this world will take exquisite timing and a business agility that few giant corporations can manage.

According to the optimists, meanwhile, there will be enough to go around. Provided they act fast enough, the Yahoos and Ebays will remain powers on the internet, even as newcomers create large businesses from scratch. “I think both types of company will do well,” says Marc Andreessen, a co-founder of Netscapewho has joined the latest start-up wave with Ning, his social networking company. “The market is so big now and there’s so much to do.”

There are, however, two caveats to this broadly optimistic view. One is that the need for new investment will prevent the internet giants from sitting back and reaping the rewards – structurally, the industry may be facing lower profit margins than had seemed likely. That seemed to be the message in last week’s news that Google’s costs had been rising rapidly. As Jerry Yang, Yahoo’s co-founder and new chief executive, said: “Make no mistake: we are in investment mode.” The full extent of those investments is still unclear.

The second caveat is that the history of this new business medium is still being -written. The internet is barely more than a decade old as a mass market phenomenon. Certainly, it seems that new businesses can still rise with remarkable speed. ” Google came from nothing almost overnight,” says Benchmark’s Mr Gurley. What has yet to become clear is whether well-known internet businesses can fade almost as fast.

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