Mistakes Made On The Road To Innovation

The perennial underdog is challenging Intel with a new class of microprocessors


When Eastman Kodak (EK ) vowed in 2000 to become a leader in digital cameras, the idea seemed ludicrous. The old-line Rochester (N.Y.) company had film and print all through its DNA. Yet by 2005, Kodak ranked No. 1 in the U.S. in digital camera sales. Its digital sales surged 40%, to $5.7 billion, even as its film-based businesses fell 18%. The key: product innovation, something Kodak knew how to do oh-so-well. The company designed one award-winning breakthrough after another to make digital photography nearly as simple as pointing and clicking.

So why does Kodak Chief Executive Antonio M. Perez now dump on digital cameras, calling them a "crappy business"? Simple: While blazing growth of camera sales has helped blunt the effects of Kodak's fast-fading film revenues, it hasn't replaced the rich profits of the film business. Even the best mass-market cameras yield slim profit margins. So, although Kodak's digital camera business was a roaring sales success, it turned out to be a crushing profit disappointment. Perez, who arrived at Kodak in 2003 and became chief executive last year, had championed a dramatic change only to find it wasn't the right model for turning the company around.

Now he's crafting yet another strategy for Kodak, its third in less than a decade. Building on the mistakes made and lessons learned in recent years, Perez is attempting innovation of another sort -- reinventing the company's core business model. He aims to make Kodak do for photos what Apple does for music: help people to organize and manage their personal libraries of images. He's developing a slew of new digital photo services for consumers that he expects to yield higher returns. They include everything from online photo sharing to a rapid-fire scanning system, called Scan the World, that takes shoe boxes full of yellowed snapshots and converts them into crisp digital images organized by the date originally printed. But the shift from hard product to digital services is a huge challenge. It's "a very hard transformation," says Perez. "History says very few companies have made it."

In an era when innovation is all the rage, many CEOS, like Perez, are discovering that product innovation alone isn't enough to save sick companies or turbocharge healthy ones. For many, their core businesses are being disrupted by globalization, technology shifts, and new competitors. They must reinvent the company. Even at healthy companies, business model innovations are essential to retaining their competitive positions. Microsoft (MSFT )Chief Executive Steve Ballmer says he no longer thinks of his competition as individual companies. Instead, "it's alternative business models that we'll have to compete with or embrace," he says. His two biggest threats are the open-source phenomenon and advertising-supported software.

There's no better example than Kodak of the importance of coming up with new ways of doing business -- and the difficulties of succeeding. At its peak, Kodak was an icon of American technology innovation. Now it's fighting to recover from a tech revolution that is strangling its core business. Kodak was late to recognize the problem, slow to react, and then went down the wrong innovation path. It faces many of the problems and is making many of the mistakes that any company can make when so threatened. Because of these delays and missteps, it's still far from clear how Kodak's story will play out. Yet it provides a vivid case study for businesses facing similar challenges. A March survey commissioned by IBM (IBM ) showed that 65% of the world's top CEOs plan on radically changing their companies in the next two years.

This reinvention stuff can be a tough slog. "Business model innovation is harder than product innovation. It's harder to visualize, and the scope is larger and much more complex. It includes everything the company does. Everything has to be changed," says Jay Desai, chief executive of management consultancy Institute of Global Competitiveness.

Apple Computer (AAPL ) shows how it's done. Here's a company that was trapped in an ever-dwindling niche of the PC business. Then came the iPod, a must-have device for music fans, and iTunes, an online music shop that turned music downloading into a profit-making business. By making iPod and iTunes work with Windows PCs, Apple broke out of selling only to its niche of loyal fans. But its transformation is even more profound than that: In essence, it switched from being a great designer of computer products into a great designer of consumer experiences delivered via devices and services. Now music represents 44% of Apple's revenues, and an even larger share of profits.

Kodak's Perez dreams of replicating Apple's success. "In two to three years, this will be seen as one of the most successful transformations in the history of our country," he predicts. Maybe. Wall Street doesn't share his optimism. Kodak's stock is trading at about 26 per share, down from a high of 95 in 1997. Kodak has been in the red for eight consecutive quarters, losing a total of $2 billion. It hopes its new strategy will get it into the black by yearend 2007.

Many of Kodak's problems can be traced to the successes of its past. Wherever Perez turns in Rochester, N.Y., he is haunted by the specter of George Eastman, one of America's greatest innovators. In spite of the fact that Eastman died in 1932, his mark is still huge on the company he founded in 1880. Decades after his death, it remains difficult to change Kodak's long-established ways. One of them is a hierarchical culture that believes in the omnipotence of leadership. It's so powerful a habit that when Perez came to Kodak from HP in 2003 as chief operating officer, he couldn't get people to openly disagree with him. "If I said it was raining, nobody would argue with me, even if it was sunny outside," he laments.

WATCH FOR TREACHEROUS SHIFTS Before Perez arrived on the scene, Kodak was in denial. The company had supposedly been on a decade-long journey to digital technology, yet very little had actually been done. The pressure to rethink the business didn't seem that great. There was no crisis. It wasn't until 2001 that film sales dropped, and even then insiders attributed the financial shocks to the September 11 attacks. The hope was that Kodak might be able to slow the shift to digital through aggressive marketing.

The company hedged its bets and launched an all-out blitz on the digital camera market. Its family of digital cameras, called EasyShare, was widely praised. The company spent a tremendous amount of time and energy studying customer behavior. It found that women in particular loved taking digital photos but were frustrated in moving them to their computers. It was just too hard. Kodak's researchers had found a key unmet consumer need -- a huge opportunity.

Once Kodak got its product development machine humming, it cranked out model after model offering consumers top-quality cameras at reasonable prices that made it easy to share photos with friends and family members via their PCs. One of the coolest innovations: a printer dock. Consumers could insert their cameras into this compact device, press a button, and watch their photos roll out.

But there was a fatal flaw in Kodak's strategy. Its executives didn't anticipate how fast these digital cameras would become commodities, with low profit margins, as every competitor raced into the market. Then film really began to tank. Perez had counted on rising demand for traditional photography in China to slow the fall. But China went digital as fast as everybody else.

Perez began investing heavily in digital technologies, shutting down film factories and eliminating 27,000 jobs. He spread the word that Kodak would have to come up with new services and new ways of capitalizing on its technology innovation to boost profit margins. When he was promoted to CEO in May, 2005, he summoned his top seven executives to the President's Room, a spacious, wood-paneled conference space on the second floor of the Kodak tower. The most dramatic change in Kodak's strategy in over a century was under way, and there would be no turning back. "You have to burn the boats," the Spanish-born Perez told them, quoting conquistador Hernán Cortéz.

For the new service-oriented business model to work, Kodak had to throw out some of its most cherished notions. No longer would it fool itself that product innovation would be sufficient for it to be successful. And no longer would it try to do everything itself, from manufacturing to selling finished products.

GET YOUR BEST PEOPLE BEHIND THE PROGRAM Perez found he had to replace a lot of executives to get the company on a new track. The film-era lifers just didn't get it. Of the company's 21 executive officers in 2003, the year Perez arrived, only three remain. Most of their replacements came from outside Kodak, and most had digital experience.

Perez believes that in any organization, one-third of the staff will readily support a change, one-third can be convinced, and one-third will be unwilling to make the shift. He calls it The Rule of the Thirds. To help him win over a clear majority, he assembled a group of people who were skeptical by nature and assigned them to a committee he called the R Group. ("R" stood for rebels.) He asked them to make suggestions on how the company could be improved. Those discussions contributed to the strategy of coming up with new digital services and new ways of commercializing existing technology. Also, once these people felt like they were part of the conversation for change, they spread the word throughout the organization that Perez was a good leader. And, because they had credibility, their opinions influenced many others.

Other companies haven't been as fortunate. Take Siebel Systems. When the idea of delivering software as a service emerged as an alternative to selling packages of software, Siebel Systems CEO Thomas Siebel threw his weight behind it. Yet even his influence wasn't enough. A watershed moment came when Siebel competed against upstart Salesforce.com for the business of tech giant Cisco Systems (CSCO ). Even though Cisco was tilting toward Salesforce.com, (CRM ) Seibel's sales people pushed traditional product software because they'd get richer commissions that way. Siebel lost the deal, and its business was forced to sell out to Oracle (ORCL ). "There were groups of disbelievers in the organization, which is a recipe for disaster," says Bruce Cleveland, who ran the software-as-a-service initiative.

GIVE YOUR NEW INITIATIVES ROOM TO BREATHE A company's core business and its new initiatives are typically at odds with one another. Force them together, and the old business may well smother the new one. Kodak tried it both ways. For two years it placed the digital camera group within its film business so they could share resources and digital could grow more quickly. But last year it split them off again. "One really couldn't piggyback on the other," says Pierre Schaeffer, chief marketing officer for the digital business.

Other companies have scored big by managing their new businesses separately from the start. When Dow Corning conceived of its e-commerce business, Xiameter, the idea was to run it independently. The company didn't want to devalue the Dow Corning brand, which is equated with premium service. Xiameter was about selling large quantities of silicone at low prices with no services attached. Since its 2002 launch, Xiameter has grown to about 15% of Dow Corning's total sales.

MAKE PAINFUL BREAKS WITH THE PAST Switching business models requires a thorough rethinking of everything a company does, from planning to manufacturing to marketing. For 120 years, Kodak had done everything for itself. At one time, it even raised its own cattle and used the bones for making photographic gelatin. When it tried to collaborate with others, the results could be messy. For instance, it sought outside expertise from Adobe Systems (ADBE ) in 1999 when it was developing a product for transferring consumers' photo prints to compact disks so they could be viewed on PCs. Yet the alliance was fraught with bickering. When Adobe people came up with suggestions, the knee-jerk reaction from Kodakers was "This will never work," recalls Brian Marks, a 19-year Kodak veteran.

Today, Kodak has had a complete change of heart. In early January, Perez and Motorola (MOT ) CEO Edward Zander stood together at the International Consumer Electronics Show in Las Vegas and announced a 10-year partnership in which Kodak would provide chips to operate high-quality cameras in Motorola's cell phones. It was a startling break with Kodak's past. An organization that had always built its own products would now provide technology for somebody else. Kodak will also help consumers transfer images to PCs or online galleries (75% of all photos never leave cell phones).

Perez is gambling that the match will be well worth all the contortions Kodak is going through. He expects much of the growth in digital photography to happen in mobile phones, and he believes profit margins for sensor chips will be twice those of the digital camera business.

In spite of the changes Perez has made, he admits he still has a lot to do. Old habits die hard. At Kodak, it's standard procedure to test a new product or service -- and then test and test again to make it perfect, even if that stretches out the journey to the marketplace. Case in point: Kodak has been talking up its Scan the World consumer service for a year, but it's still not sure when or how it will be introduced broadly. The company hopes to sell or lease scanners to photo shops, plus get a piece of the fees charged to customers for the service. Among other things, it's wrestling with the $50,000 cost of the scanner. Will Kodak be able to adjust quickly enough to meet the demands of new and untried markets? Not clear.

DON'T CONFUSE WHAT YOUR COMPANY DOES WITH HOW IT DOES IT It is taking time for Kodak to understand that it is an image company, not a film or camera company. Perhaps it should take lessons from Western Union. (WU ) Founded in 1851, the company has managed to ride each successive wave of change in its history rather than getting swamped. (A bankruptcy protection filing in the early 1990s was caused by management mistakes rather than external threats.) After handling the first transcontinental telegram in 1861, it spotted the opportunity to transfer money by wire 10 years later. Then, a series of firsts: a city-to-city facsimile service, a microwave communications system, a commercial satellite network, and online money transfer.

Why has Western Union been able to adapt to severe disruptions and survive over so many years? It never confused the business it was in with the way it conducted its business. At its core, Western Union was about facilitating person-to-person communications and money transfers -- whether via telegraph, wireless networks, phone, or the Internet. "We always saw ourselves as a communications company," says president Christina Gold. Contrast that with Kodak. By defining itself too narrowly as a product company all those years, it was headed for a fall.

Kodak teeters on the precipice, and with it stand some of the other once-great businesses of the 20th century, from autos to newspapers. They were immensely successful and proud, but their very success made it difficult to adjust. "The more successfully you use a way of working, the stronger your culture is, which is a great strength right up to the time when you need to change," says Clayton Christensen, a professor at Harvard Business School. All innovation is hard. Reinventing your entire business is the hardest innovation of all.

By Steve Hamm and William C. Symonds

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