The Brampton Factor: Do great firms innovate?

Huge mergers like Microsoft's Yahoo! bid just destroy economic value…

Despite the rhetoric, most large firms are simply poor at innovating. Microsoft is no exception and its bid for Yahoo! just emphasises its route to success, argues Martin Brampton.

"Innovative" is one of those words that always seems to have a positive ring. Rather like "new" or "modern". The assumption is always that any successful IT company has to be innovative.

But the current gyrations around Microsoft, Yahoo!, Google and others call into question the idea that new really is always better. And innovation is not the only route to success.

There is a difference between technical development and innovation. Great skill is demanded of the scientists who work for chip manufacturers, and progress depends to some extent on new ideas.

Likewise, given the concept of a novel software product, much work goes into its refinement and improvement. This, though, is different from the kind of innovation that creates a new product category.

The dot-com years were a gold rush of innovation. Every investor hoped to buy into "the next Microsoft", a company that would start from next to nothing and grow massively.

Another popular phrase was the "killer application" that would launch an otherwise unremarkable development into a bonanza. The dot-com collapse only partially tarnished those ideas. It seems that they still hold an allure for some top executives.

Mobile telephony has long been engaged in a relatively fruitless search for new killer applications. Text messages were a hugely successful, if largely accidental, innovation. Texting is a hard act to follow.

People may be persuaded to send more pictures. They may be willing to browse or watch television from their mobile phones but they have plenty of options available. Vodafone chief executive Arun Sarin wants to lock on to such innovations to avoid just being a "bitpipe".

But in these days of credit crunch, investors are looking askance at innovation, preferring a more mundane perspective. They remember the ground-breaking merger of AOL and Time Warner, which resulted in a combined company worth a 10th of the firms' pre-merger values.

And that brings us back to the attempt by Microsoft to challenge Google, with or without the Yahoo! purchase.

These are big companies, although Yahoo! is considerably smaller than either of the others. All three have some claim to have innovated, although the extent of this is frequently exaggerated.

Microsoft played a significant role in the spread of the PC to the point of near ubiquity. Yahoo! was the leader of the search portals. And Google is now the undisputed king of online search, as well as holding the keys to a uniquely successful advertising model.

Yet once their road to greatness is established, few companies achieve genuine innovation. Most large companies, whatever the rhetoric, are simply not very good at innovating.

As they become larger, they are obliged to become better organised, and their strength shifts from creating new ideas to being effective at delivery.

Microsoft follows this pattern much more closely in reality than in the popular imagination. The DOS operating system was bought in by Microsoft, Windows was based on ideas from Xerox Palo Alto Research Center already implemented by Apple, word processing was well established before Word, spreadsheets were popular before Excel and so on.

The company grew big by achieving dominance in growth markets that may have limited further growth.

From the investors' point of view that is not necessarily a bad thing. There is no point owning Microsoft shares for the dividends alone, since they are currently only about 1.5 per cent.

So investing in Microsoft needs faith that the profits that are not distributed as dividends will be either retained or spent on something that will yield good future profits.

The market clearly thinks spending the profits on buying Yahoo! does not fit into that category. The total value of Microsoft's shares has fallen since the bid for Yahoo! by not far short of the value of the Yahoo! bid.

In other words, investors think Microsoft would be worth little more with Yahoo! than without. In effect, the view is that Microsoft's value lies in its ability to generate cash from its existing businesses.

So can we turn to Google to find an innovative giant in the IT sphere? In terms of future expectations, the answer is probably no. It would, of course, be foolish and wrong to deny that Google's inception involved several important innovations.

Google's search technology was revolutionary and, combined with a radically different approach to the user interface for a search engine, took the world by storm. Equally significant is the novelty and effectiveness of Google's advertising scheme.

By becoming a public corporation, Google acquired a huge cash pile, and is now involved in developments of all kinds. However, it is questionable whether there is much innovation involved. And why would there be?

The problem for a company that becomes as large as Google is to maintain profitability and growth at levels that satisfy investors. Profitable innovation is both difficult and risky and so fails as a prudent commercial strategy.

Just as with Microsoft's attempt to buy Yahoo!, Google's corporate acquisitions are hard to justify in their own terms. The difference is that Google's purchases have been aimed at defending its core market position, whereas Microsoft has been attempting growth in markets where it has only a weak presence.

Likewise, many of Google's technical developments are aimed at tilting the balance of the internet world in such a way as to weaken possible rivals and to strengthen Google. Innovation is very much a secondary consideration.

The sad thing about huge mergers and acquisitions is that it is well known that they destroy economic value. What we need is for the managers of giant IT companies to realise they may well have reached a point where aiming at rapid growth no longer makes sense.

If it can be gained only at the expense of profitability, it simply becomes self-defeating. And since most innovations occur in small companies, buying up the best of them still remains the greatest way for large companies to develop.