Sedan smashes into streetcar

Head-on collisions: Lessons from the storage industry

Building a new product or a service is a challenging endeavor. As an entrepreneur you will need to figure out why customers care about your product — it’s value proposition. You’ll also need to figure out who your customers are, how to reach them, how to price your product and so forth. You’ll also have to understand the competitive landscape: who are the other players in your market and what if any are the substitutes facing your product. You might find yourself selling into a new market with very few competitors, or conversely in a crowded and hyper-competitive market with powerful incumbents. In this article, I will focus on market dynamics that I dub a head-on collision.

Before I define what a head-on collision means, I want to first present a very simple value-chain model. Companies build products, which they then place in distribution channels to ultimately reach their customers. These channels could be physical like retail stores, virtual like websites and could include all sorts of intermediaries like re-sellers, consultants, partners and so on. There are obviously many other aspects of the product value chain that this model ignores.

The world’s simplest value-chain

You can apply this model to almost any market. Ford makes trucks, sells them to dealerships all over the country. The dealerships then ultimately sell cars to you and me. Microsoft makes software, some of which it sells to Dell which places them on laptops and then resells them online or in stores to consumers and enterprises. And so on.

A head-on collision is when a new company (NewCo) tries to enter a market whereby the following three conditions are satisfied:

  1. NewCo’s product is no different than that of incumbent
  2. NewCo and incumbent share the same channels
  3. NewCo and incumbents sell to the same customers

If the above three conditions are satisfied, then NewCo is about to enter into a head-on collision with the incumbent in this market. That head-on collision could pose a significant hurdle into NewCo’s ability to sell its product, especially if the market is not growing rapidly or is faced with external threats. The software storage world bears witness to this phenomena.

The storage world: A petri-dish of head-on collisions

Before I dive into the world of software storage, I should note that I spent the past 6 years working at a storage startup — Qumulo. The opinions expressed are solely my own and do not express the views or opinions of Qumulo.

The on-premises software storage market is dominated by two very large incumbents: Dell EMC and NetApp. These companies have a wide array (pun intended) of different on-premises storage products ranging from block, file and object storage. Their products come in different sizes, performance characteristics and price points. Moreover, the on-premises storage market has been under intense pressure from cloud service providers like AWS and Azure. These vendors offer products like S3, EBS, Azure Storage, Azure Blob and so on that are a great alternative to products offered by Dell EMC and NetApp.

Over the past years a few startups, the most notable being ones like Pure Storage, Nutanix and Nimble Storage entered this space. The products these companies offered where either very similar, or identical to ones offered by the incumbents. If there was any differentiation, it was very short-lived and the incumbents typically responded with like products in a relatively short period of time. Moreover, the channel these products were sold through were the same across these companies and EMC + NetApp. Lastly, the buyers tended to be the same. The folks who bought Nimble Storage, likely had NetApp or EMC products. Likewise for Nutanix and Pure.

In a nutshell, the dynamics in this market satisfy the criteria laid out for a head-on collision.

Pure and Nutanix were all able to IPO, which gives us a chance to evaluate their performance in this market. Nimble also IPOed, but had a rough time scaling their business and was eventually acquired by HPE for about $1B, which was far less than its market cap at the time of its IPO in 2013.

The chart below presents the performance of both Pure Storage and Nutanix from the time of their IPO up to the end of June 2019. The performance of this stocks is compared to the S&P 500 which is a good proxy for the overall market. The approximate returns of the S&P 500 over that period of time were +45%, while Pure’s stock yielded -17% and Nutanix’s stock returned -49%. As an investor, you were much better off investing in the S&P 500 over these two stocks.

Even more interesting is looking at the sales growth for these two companies since their IPO. Both Pure and Nutanix were able to grow their sales anywhere from 7x to 9x from the time they IPOed. That’s spectacular growth, yet the results reflected on their share price are very poor. Why is that?

Short answer is that they are growing their sales figures but unable to generate operating cash making their businesses economically unsustainable. The chart below plots the free cash flow (FCF) of these two companies from time of IPO to their most recent annual filings. Witness that both have spent most of their life-time as public companies with negative FCF.

So why are these two companies, and Nimble before them, struggling?

Simple. Head-on collisions with existing incumbents along with great alternatives from AWS and Azure have resulted in these new companies competing with the existing incumbents on price and price alone. When your product is no different than every other vendor and the intermediaries and buyers are the same, you will resort to trying to win business by price alone. That’s not sustainable, especially if the other companies do the same.

So is it all doom and gloom then? Well, not quite. I’ll try and present a few strategies that can help companies navigate through head-on collision. The strategies proposed and in no way comprehensive nor are they mutually exclusive.

Segment the market

Segmenting the market allows NewCo to look at customers that are unserved by the existing incumbents. NewCo specifically targets those customers as a means to completely bypass the incumbents. Slack is a good example of this strategy.

On paper, the messaging market doesn’t look that appealing. The consumer side of this market is dominated by the likes of Apple’s iMessage and Facebook’s WhatsApp. Similarly, the enterprise side of this market has been historically dominated by Microsoft’s Skype for Business, now known as Teams and Cisco’s Unified Communications suite led by WebEx. Yet somehow Slack was not only able to penetrate this market but thrive.

What Slack did is focus on the enterprise side of this market, which as mentioned earlier was dominated by Microsoft and Cisco. However, instead of targeting the same buyer, typically a CIO persona, Slack went directly to the end user. Slack realized that its value was to focus specifically on tech teams, small companies and startups that work quickly and needed communicate quickly with tech features integrated in their product. Slack’s products were offered for free, were easy to download, install and use and as a result spread like wildfire.

The end result of this strategy was Slack’s ability to grow a substantial user base within Microsoft and Cisco’s market yet completely circumventing the incumbents’ value chain. Had Slack attempted to sell directly to CIOs they would have met resistance from Microsoft, Cisco and other players in the enterprise messaging market. The outcome could have been dramatically different.

“Spread it did. Where HipChat had gotten businesses chatting, Slack got everyone chatting. The free version was Slack’s trojan horse. Whether you ran a small team in a corporation, launched a startup, or just wanted to organize your local sports team more effectively, Slack worked for everything.” When Slack Won the Team Chat Market

Create new channels

Tesla is a good example of a company entering a very crowded and competitive market — the auto industry. One thing to note about Tesla is that its product was quite different than other auto manufacturers. Tesla offered 100% electric vehicles which is in stark contrast to the rest of the auto manufacturers who predominantly rely on gas/diesel based engines.

However, Tesla coupled that with another interesting move. It built its own distribution channel. Unlike traditional auto manufacturers who rely on a network of third party car dealerships to sell their vehicles, Tesla built its own network. Tesla decided that it was far better off owning the channel and building its own versus having to rely on the existing auto dealership channels.

In this article, Tesla’s general council, Todd Maron, outlines some of the main reasons why Tesla went to great lengths to build its own dealerships. Reason #7 outlined in this article shows how building its own network of dealership allowed Tesla to avoid a conflict of interest and a collision with the existing auto dealerships.

7). Gas conflict of interest: Tesla is striving to replace gas-powered cars with its electric cars, and promotes its models as superior to those with internal combustion engines. However, the vast majority of cars sold through dealers are gas-powered cars. Tesla’s Maron said that dealers, therefore, wouldn’t be the good advocates for electric cars that Tesla needs.

Redefine the product

Zoom is a very interesting case study of a company that decided to enter a very crowded and highly competitive market. The enterprise web conferencing market has been historically dominated by the likes of Microsoft, Cisco and Citrix. Even more interesting is the fact that Zoom’s value chain looked identical to that of its competitors: similar products, very similar channels and the same set of customers. Yet Zoom is by all means a very successful company. So how did they do that?

I’d argue that Zoom’s success was predicated on having a much better product. Zoom’s audio and video quality is far superior than that of its main competitors. Zoom came out with a product that was far superior than its existing competitors and was duly rewarded.

“[Cisco and Skype] have been relentlessly trying to win us back since we switched to Zoom five years ago. We use video and collaboration tools for remote physician check-ins. We need high quality, reliable video in all locations — not just the ones with high bandwidth. Zoom was the only one that could deliver that. Zoom was easier to use, cloud-based, did not require a hardware investment, and its pricing model — a freemium pricing model when we signed on — made it convenient to try without an investment. We reconsider our videoconferencing needs every year — but we stay with Zoom because they listen to what we ask for and unlike the others, they actually provide it. For example, we asked for digital signage and room scheduling and they delivered.” Dennis Vallone — BAYADA Home Healthcare

Own the value chain

Netflix started out by first offering rental DVDs that were delivered to its customers home by mail. Soon afterwards, the company decided to fundamentally change its business model and offer content over the internet. Initially the content on Netflix was not its own, it was content developed by third party studios.

However, Netflix wasn’t done yet. The company realized that “content is King” and decided to make another interesting change to its business. It developed its own content. More recent figures peg Netflix’s spend on its own content at ~$15B.

These moves show Netflix’s strategy of trying to alter the value-chain and ultimately owning it. By first offering DVDs via the mail, Netflix was able to completely circumvent the traditional retail route that its main competitors at the time — Blockbuster — adhered to. Once Netflix pivoted to streaming content over the internet its ability to create its own content allowed it to bypass its main competitors large movie and animation studios. With this latest move, Netflix is now able to completely control its value chain from content creation, distribution all the way to customers.

If you can’t beat them join them

Exactly. In fact, the general model for successful tech companies, contrary to myth and legend, is that they become distribution-centric rather than product-centric. They become a distribution channel, so they can get to the world. And then they put many new products through that distribution channel. One of the things that’s most frustrating for a startup is that it will sometimes have a better product but get beaten by a company that has a better distribution channel. In the history of the tech industry, that’s actually been a more common pattern. That has led to the rise of these giant companies over the last fifty, sixty, seventy years, like IBM, Microsoft, Cisco, and many others.Marc Andreessen

Again, the storage industry is a great example of seeing how this plays out. EMC in particular has a long history of acquiring companies and plugging them into its massive sales and distribution engine. Some of the notable storage acquisition by EMC include DataDomain and Isilon. More recently, HPE acquired Nimble Storage, a once high flying storage startup that IPO-ed in 2013, only to find it increasingly difficult to scale its business in an economically viable fashion.

Much like with driving vehicles, I strongly recommend that you avoid head-on collisions for your products and services. However, should you find yourself about to enter in a market dynamic with head-on collision characteristics, then perhaps consider one or more of the strategies mentioned in this article. You might be able to avoid the crash.

Tech leadership at various early stage startups: Qumulo, Dremio and now Kheiron Medical

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