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Any manager or growth investor should read the excellent and revolutionary book, "Innovator's Dilemma" by Clayton Christensen. We know that it was one of Steve Jobs' favorite books and "deeply influenced" him. I was very surprised, however, that Elon Musk had not read it (as he confirmed in an email exchange with me on December 25). From the outside, he seems to know perfectly how to attack a new market with a new type of product, but he was never confronted directly with the problems of large successful corporations considered by Christensen, i.e., their chances of entering new markets being crippled by the way previous successes shaped them (see below).

This article proposes a comparative analysis of how Apple (NASDAQ:AAPL) has solved and how Tesla (NASDAQ:TSLA) is trying to solve the very difficult problem of going to market with revolutionary products. These two companies don't follow the strategies proposed by Christensen, demonstrating out-of-the-box thinking in every aspect. They're probably evolving new paradigms for the business world.

While I don't dare to attempt to condense the book's contents to just a few sentences, here are some ideas, an exposition. (For anyone who wants to dig deeper into the subject, this book is mandatory reading.) Large and successful companies have a near-perfect score maintaining the lead in innovations that improve their current successful products (called sustaining innovations in the book). When innovation produces cheaper, lower quality products, they are seen as insignificant because their market is not defined (current customers wouldn’t accept an inferior product) and their gross margin would be lower, so the company wouldn't be able to maintain its (short term) growth rate. Those innovations are called disruptive by Christensen. They evolve in tandem with the new markets they create.

Even if one bright manager could see the long term future of the innovation, it may be nearly impossible to fight the company's processes and values (internal targets for rate of success and gross margin, among others). One of the solutions the author of the book proposes in this case is to set up a different entity inside the company, with different management structure, shielded from the usual fight for resources.

By contrast, small companies, especially startups, might get excited by small orders with low profitability. Moreover, if they manage their resources right, they can absorb high(er) rates of failure. After all, nonexistent markets cannot be analyzed and those small companies will discover the shape of new markets at the same time as their customers. In contrast to sustaining innovations, in disruptive markets there's a clear first-mover advantage.

Therefore, one of the classic mistakes of incumbents is to wait to push innovation internally until it can compete in the established market. In the meantime, they evolve toward the high end of the market since technological progress is usually faster than the increase in market demand. As James Allworth noted, when the disruptive innovation is ready for prime time, it’s already too late:

Anyone familiar with Professor Christensen's work will quickly recognize the same causal mechanism at the heart of the Innovator's Dilemma: the pursuit of profit. The best professional managers—doing all the right things and following all the best advice—lead their companies all the way to the top of their markets in that pursuit... only to fall straight off the edge of a cliff after getting there.

Apple

By the strict definition of disruption, the iPhone is no such innovation. Its effect on the (smart)phone market, however, was definitely disruptive: not only many incumbent giants have stumbled (some did not even believe the iPhone was possible in 2007), but most of today's smartphones have no keyboards, have large touchscreens and some are designed to look disturbingly like clones of the iPhone). The original iPhone started as a portable browsing appliance that combined a phone and an iPod, looked good, and was easy to use. However, it was very expensive and its battery life was relatively poor; it had only one carrier partnership (with numerous complaints about the reliability of the service for the iPhone), and it lacked some functionalities and a keyboard, which, Steve Ballmer said at the time, "doesn't make it a very good email machine".

Before analyzing these aspects, I was amazed to read that Christensen, the father of disruption theory, himself thought in 2007 that the iPhone would be a flop. Speaking of Apple four years later, he told James Allworth, "There's just something different about those guys. They're freaks."

What was Apple's problem in 2007? Their successful iPod line growth was slowing down and the product was attacked by music functions embedded in mobile phones. The mobile phone market was dominated by giant incumbents, each with hundreds of carrier partners, having strong value networks (manufacturing, distribution, services, etc.), and mostly happy customers. Not only did Apple need a strong product (they had that by 2007), but a go-to-market strategy was vital. They chose the high-end market, using a different proposition. Instead of long lists of features, users got beautiful and thoughtful design, ease of use, and a new type of device that promised the full internet in your pocket.

Targeting the general population rather than businesses, Apple took advantage of the fact that their buyers are people, and they found the niche where product metrics are different: design is more important than functionality (usually referred as features for phones) and ease of use is more important than price. Also, they had quite a different marketing message: Think different. (Not differently, but think different.) In a business context (targeting other businesses as customers), using that beautiful-design-and-ease-of-use strategy would have probably failed at that time, although the iPhone is now used by many businesses.

The iPhone is actually a computer disguised as a phone. Entrenched competitors had to change their very roots to compete effectively. Even if it could be seen as a sustaining innovation, its implementation at large scale couldn't be realized without huge sacrifices (to which Nokia (NYSE:NOK) and RIM (RIMM) committed very late, for example).

Come back to Allworth's thoughtful article for a fourth time to see how Steve Jobs solved the innovator's dilemma with internal competing products and hard-to-overcome processes and values:

When describing his period of exile from Apple when John Sculley took over—Steve Jobs described one fundamental root cause of Apple's problems. That was to let profitability outweigh passion: 'My passion has been to build an enduring company where people were motivated to make great products. The products, not the profits, were the motivation. Sculley flipped these priorities to where the goal was to make money. It's a subtle difference, but it ends up meaning everything.'

When Jobs returned in 1997, the company was restructured to completely avoid the dilemma. Different teams inside Apple compete with products on the market with different gross margins and value networks (see carriers' subsidies, for example), as long as those products are great (and profitable). The iPad, competing against the Mac, disrupting the netbook and arguably the PC industries, is just another example.

As Horace Dediu has argued, Apple has what it takes to produce hits reliably, just like Pixar. We find similar ideas in one of Roberto Verganti's articles:

My 10 years of research on breakthrough innovations by companies such as Apple, Nintendo, and Alessi, which are summarized in my book, Design-Driven Innovation, shows, however, that these radical proposals are not created by chance. And they do not simply come from intuition of a visionary guru. They come from a very precise process and capabilities.

Tesla Motors

Tesla Motors entered a US industry that had seen its last IPO (Ford Motor Company (NYSE:F), 1956) more than 50 years before: building cars. But Tesla is building something different, something that has given headaches to established car makers for quite some time. Tesla designs, builds, and sells electric vehicles (EVs). Christensen’s book contains a chapter about EVs.

About a decade ago, the then state-of-the-art battery technology left them behind internal combustion engine cars (ICEs) by almost any metric: slower acceleration, lower top speed, shorter range, lengthy charging time (vs. refilling the gas tank) and higher initial expense. Forced by a California clean air law, GM, Ford, Chrysler, Honda (NYSE:HMC), Nissan (OTCPK:NSANY), and Toyota (NYSE:TM) built some 5,000 EVs which were supposed to compete with ICEs, but after a lawsuit in Federal District Court, the State of California reversed the law in 2003.

Tesla has proprietary technologies, tested for several years in the market with more than 2,000 Roadsters sold worldwide. Both the Roadster and Model S, the new premium 4-door sedan to be released by Tesla in about six months, have better acceleration and environmental credentials (a disputed claim) than competing ICE cars, more than adequate top speed as well as adequate range. In addition, according to Tesla, the sedan will have better handling, acoustics, safety, and more storage space than competing ICE cars; unique features like a 17" touch screen connected to the internet by 3G/4G technology; relatively short charging times (30 minutes for 150 miles with special chargers to be installed along major highway corridors in the US); and a competitive price when subsidies and fuel economies are taken into account. (It's much cheaper in some countries like Denmark where ICEs are heavily taxed compared to EVs.) Just like Apple with the iPhone, Tesla is building a niche market (creating new devotees, if you will) where product metrics differ considerably from those found in textbooks. The bet is that the general mindset will change, following early adopters, as happened with the iPhone and the iPad.

Tesla Motors seems to be governed by a long term goal (which is not profit). Making money along the way is simply a necessity to achieve the goal (and a very nice byproduct to have), like Apple. Another element in support of this speculation is that Tesla offers its drivetrain to any willing competitor. They already have such development and supply contracts with Daimler and Toyota, both set up to evolve to a new level of commitment (according to company comments during earnings conference calls). Their vision will be exploited in their marketing message.

An investor view

Both companies are set to produce blockbusters in the future. I have compared them in the past from a different point of view.

Apple is already a huge company and its market valuation somewhat reflects this. With a P/E lower than the general market and trailing twelve-month-earnings growth above 80%, I think it is severely undervalued; future growth also seems grossly underestimated. Apple will continue to grow, but the next decade will definitely see less growth than the last. With cash reserves approaching $100B, the right processes, values, and culture, Apple is sure to produce many market-changing products in the future. Occasional failures will not affect them much.

Tesla Motors is in a very sweet spot for spectacular future growth, but they have only one shot with their Model S. Tesla doesn't seem to leave any aspect of their business to chance: they have already built a fully integrated manufacturing facility, have secured battery supply from Panasonic (PC) for several years, have their own network of retail stores, and are in the process of building rapid charging networks in the US—and Europe. If, however, the Model S fails to gain traction or to produce enough profits, the company will be in great danger and shorters will win big time.

Acknowledgment. I would like to thank John Markuson for his help with English grammar and style for this article.

Disclosure: I am long AAPL, TSLA.

Additional disclosure: I leverage my investments using options.

Source: Apple And Tesla Motors: Serial Disruptors