Philips and the Light at the End of the Tunnel

When disruptive innovation hits an industry, usually the light at the end of the tunnel for an incumbent belongs to an oncoming train. Philips was one of the three leading players in the lighting market in the era of incandescent lighting when disruption hit the industry in the form of LED lighting. Yet this incumbent appears set to survive and flourish.

I was curious to understand how they pulled this off and was fortunate to have an opportunity to speak with someone at Philips who fleshed out the back story for me. I wrote this up as a case study to use in my innovation courses, so it's longer than most posts, but I think some readers could be fascinated by the story so I'm posting it here.

Philips Transition from Conventional to LED: Spotlight on the Response to Oncoming Disruption
With background information from Maarten Vernooij



Background
Philips, one of the three dominant manufacturers of incandescent light bulbs, is making a successful transition from incandescent to LED technology. Let's examine the industry before and after and assess Philips' strategy to deal with the disruption. [We'll compare and contrast Philips' situation and response to Kodak, the poster child of an incumbent that was destroyed by disruption.]

We'll examine the story through the lens of Philips' Lighting Division alone. Although part of a diversified company, the Lighting Division is a separate business unit accountable for its own strategy and profits.

The Philips 'conventional' lighting business consisted of two components:

• Light sources (incandescent, halogen, fluorescent, sodium and mercury bulbs): Three big players dominate light sources: Philips, GE and Osram (formerly Siemens Lighting). This business is a high margin, replacement-purchase business. The need for big factories and scale translates to a high barrier to entry and results in a small number of competitors. [Note the uncanny resemblance to disruption's poster child, Kodak, with its high margin replacement-purchase film business.]
• Light fixtures: Essentially the 'metal around the light source', the light fixtures business has a low barrier to entry, lower margins and thousands of competitors. The characteristics of this market led Philips to attempt - unsuccessfully - to sell this division in 2003-2005.

The conventional lighting business is changing. As always, it's not the new technology that is the biggest change agent; it's the new business model.  Although the target customer remained the same, just about everything else about the business model changed:

• LED bulbs have a life of 20-50 years as opposed to conventional bulbs with a life of 1-10 years.  This spells the doom of the replacement-because-the-bulb-burnt-out business model of the past. Once you've sold a bulb, you're not selling a replacement for at least 20 years! There is one saving grace here: at least the new bulb costs much more than the old bulb so there's a spike in revenue. So essentially the new model moves many years of revenue forward into the present. [Note the contrast with poor Kodak which had to compete with NO revenue for digital photography.]
• Whereas Philips manufactured conventional light source products in their own factories, the LED light sources are mostly outsourced to third-party manufacturers such as Foxcomm. Philips has been steadily closing down factories as a result. [Conversely, Kodak was still building factories as digital photography grew].
• Whereas light sources and light fixtures were purchased separately in the past, in the LED market, they are purchased as a unit. Thankfully, Philips had been unable to sell that unit in the early 2000s.
• Although the replacement-because-the-bulb-burned-out business will atrophy with the introduction of LED, there is a new replacement-because-my-bulb-feels-old-fashioned business opportunity if you can tempt customers to replace old LEDs with smarter, feature-rich new LEDs or even entire new systems of lighting. Lighting could evolve to the most ubiquitous sensor network in the Internet of Things. An example of this is the Deloitte office tower in Amsterdam, called "The Edge", which features Philips' connected lighting system with sensors that capture data about many environmental conditions and can be addressed by mobile devices. It was recognized in January 2015 as the most sustainable building in the world. This requires a totally new skill set revolving around software and systems, as opposed to expertise in large-scale manufacturing. [The 21st century opportunities in the world of photography revolve around social media. Being mostly free to consumers, this didn't offer much of a traditional consumer revenue opportunity and entering advertising sales was hard for Philips to get their heads around. Of course, some built businesses worth tens of billions of dollars around photos on the web.]

How Philips Approached Disruption

Philips understood they were about to be disrupted and that they had to undergo radical innovation and transformation to survive this disruption, and to flourish after disruption. There were several factors that enabled this.

Leadership Attitude: Philips' approach to disruption was led from the top (CEO of the lighting division). The company recognized the threat, and accepted it. This activity started under the direction of CEO Theo can Deursen, a Philips veteran with a long history in lighting, and continued when Rudy Provoost, with a history in Consumer Lighting, took over. In some ways, this is remarkable, as old hands in a business are often the most reluctant to accept that disruption is happening and to act on it.

Strategic Philosophy: Philips recognized the threat of LEDs to their business early. A strategic deep dive in 2004 cemented Philips' conviction that LEDs were the future of lighting. There were many copies of The Innovator's Dilemma floating around and management had been trained in disruption theory, so there was a clear understanding of the danger. Strategy sessions revolved not around whether there'd be a transition to LED but the speed of adoption curves. In the end, the transition happened as quickly as their most aggressive scenarios.

New Business Model was Attractive and Not Totally Alien: Incumbents usually resist moving to a new business model because of its lower profitability. In this case, the higher prices for LEDs made the new business model attractive, even though it required retooling the whole business. [Note the contrast to Kodak's situation where they were facing zero revenue for film, by far their most profitable product.]

Closing Competency Gaps Through Acquisition: Philips acquired three key companies:

• The first move came in 1999 when Philips created a joint venture with San Jose-based Agilent Technologies, called Lumileds. Agilent was home to significant expertise and intellectual property around high power LEDs and LED dies (semi-conductor components). The JV was headquartered in San Jose, with considerable autonomy and a separate management team, even when Philips acquired full ownership in 2005. By 2015, the die technology had become less critical and Philips sold 80% of Lumileds to a private equity group.
• Color Kinetics: Philips completed the acquisition of Boston-based Color Kinetics in 2007, primarily for its strong intellectual property portfolio, with important patents relating to intelligence and control technology for LED lights. This company was left quite separate.
• Genlyte: Philips acquired this lighting fixture business in 2008 for the strength of its North American sales and distribution.

Organizational Choices: There were many strategy discussions about whether the new business had to reside in a completely separate company (a recommendation in The Innovator's Dilemma) but in the end, the businesses were run as fairly distinct entities within the existing lighting business, although in separate geographies and with distinct cultures. 

In particular, it was decided not to create a separate sales force for efficiency reasons. To overcome resistance, the sales force was given specific targets and special incentives to sell the new products, and of course the fact that LEDs were more expensive made them an attractive product to sell. Incentives (and a certain amount of weeding out of those unable to make the transition) took five to eight years to transform the sales force to the new business dynamics. Five to eight years! This certainly underlines the need to start early.

Infusion of New People: Philips' employees were traditionally long tenure, and there was little history of hiring mid-career people from outside and from different industries. In order to bring in new attitudes and approaches, there was a deliberate effort to bring in new people to help in the transition.

A typical recruit was Maarten Vernooij, who joined in 2008 as a Director of Strategy and Business Development after a successful career in sales and marketing at Unilever and an MBA these entitled "Strategy in Times of Radical Innovation". 

Although there were few transfers from Color Kinetics (entrepreneurial employees in the acquired companies enriched by the Philips purchase were reluctant to transfer to the Netherlands for the completion of their lock-in periods), there were a number of Philips employees who spent time in Boston to absorb knowledge and culture.

Luck: The hike in short-term revenues made the strategic shift more palatable. Because Philips had failed to sell its Light Fixtures division, it had in place internal capacity in both light sources and light fixtures - capabilities important in the LED market. The strategic moves to address disruption originated in the Light Fixtures division, not surprising as LEDs gave this division a new lease on life.

Lessons from the Philips Experience:

We can take several lessons from Philips:

• Understanding the theory of disruption helps a company design a viable strategy. [Netflix is another company that has successfully migrated to a new business model after disruption. Before the major strategy shift, Reid Hastings had often spoken publicly about the dangers of disruptive innovation and was clearly a student of The Innovator's Dilemma.]
• It's important to start early. Philips clearly saw the risks and opportunities afforded afforded by the transition to LED. They were thinking about this as early as 1999, with a full bet from 2004 onwards, while incandescent lights were still legal in the major US market (incandescent was not banned there until 2014). [Kodak of course 'started early', at least in a technical sense as Kodak employee Steve Sasson invented the digital camera in 1975. However, the quality of early digital photographs were treated with disdain and Kodak did not act on digital photography as a business.]
• Leadership is vital: Philips' transformation was led from the top. [Kodak's leadership, on the other hand, has been widely criticized for its lack of foresight, its ossification, and just plain stupidity.]
• It's hard to effect radical innovation and transformation with the people with a vested interest and dependence on the previous business model. Philips realized it needed an infusion of people, skills, intellectual property and a new attitude toward the future. Philips made acquisitions and recruited people from outside the industry. 
• Adjusting the inventive scheme is an important way to effect change, as with Philips' special incentives for sales people. As stated above, it helped that the LEDs are more expensive. Leading a sales force out of their comfort zone is easier when they can earn more commissions selling the new product. [Kodak didn't have this luxury.]
• Philips made use of partial separation, though not the creation of a new company, to protect new acquisitions as a separate competing force. They left Agilent and Color Kinetics with separate management  in California and Boston respectively. On the other hand, they integrated the sales forces, resulting in a mixed organizational model.
• Philips had spent a tremendous amount of time on forecasting technology improvements and adoption curves. These insights created a sense of urgency and allowed proper preparation both in therms of scaling down conventional product capacity as well as building up new competencies to bring LED solutions to market.
• There was strong alignment with the company - everyone acknowledged that LED would dominate at some point in time. Debates were thus not about IF it would happen, but about WHEN and in which segments first.
• Philips jumped on early niche segments, like for example refrigerator lighting. These relatively small commercial opportunities were great learning exercises.

It's clear from this case history, and indeed others like Netflix, that the gloomy predictions of The Innovator's Dilemma have awakened some executives to understand and withstand the onslaught of disruption. Some disruptions are more insidious than others but none are easy. Clay Christensen, the author of The Innovator's Dilemma has made a huge contribution to strategic thinking. No wonder he's been twice named top Business Thinker globally and The Economist has named The Innovator's Dilemma one of the six best business books of all time.