We have shared four separate interviews of John Malone recently. We love listening to him due to both his incisive thoughts on the media industry and his generosity in sharing this thought process with the public. It is particularly helpful that he speaks in a language that resonates with most of us - that of an investor.
In the speeches that we took notes on, there are a few interesting insights which we thought was worth delving deeper into.
Clash of the Mental Models - First, why Netflix won't survive. Then why it will dominate.
Before we delve too deep, let us first recall Munger’s thoughts on mental models:
'Especially big forces often come out of these 100 models—which several models combine…You get lollapalooza effects when two, three or four forces are all operating in the same direction. And, frequently, you don’t get simple addition. It is often like critical mass in physics where you get a nuclear explosion if you get to a certain point of mass—and you don’t get anything much worth seeing if you don’t reach the mass.
More commonly, the forces coming out of these 100 models are conflicting to some extent. And you get huge miserable trade-offs. But if you can’t think in terms of trade-offs and recognize trade-offs in what you are dealing with, you are a horse’s patoot.’
The above is a powerfully important idea (the use of two grand adjectives indicate the extent to which we think the idea is vital).
Among all the mental models, two of the more powerful models (there isthat adjective again) are that of win-win relationships and scale.
We love business models built on win-win relationships. As we mentioned before, we have waxed eloquent (again and again and again and again and …) about our undying, eternal love for win-win relationships. The readers probably think we sound like a broken record on this particular trait - and if you do that means we are doing our job.
When a business creates win-win relationships across the value chain - taking care of its customers, suppliers, government and others then it is really hard to dislodge the business.
And ideally this should hold true for industries as well. If an industry is serving all the actors in the value chain well it should ideally survive for a long time.
This is exactly what Malone and Zaslav were referring to in the Vanity Fair interview covered here when they were comparing the business model ofincumbent broadcasters versus the model that Netflix was creating.
In their own words, the current media business model was built on strong win-win relationships and reducing confusion for the consumers :
"We built this great business with a curated platform of basic cable with some premium services and it works terrifically around the world. Its a great economic model that gives us the ability to invest substantially in content. We at Discovery invest about $2.5 billion on content. We are in 230 countries .Our sub fees alone are above $2.5 billion dollars. So we cover the cost of our investment, if we can then create great content around the world, we can get advertising and cover the other costs of our company and make a profit. Soits a very strong economic model that rewards the people that can create great content and great brands. And it is a terrific ecosystem. You know, people need content to be curated. One of the things you saw throughout the last ten years or so is VOD or hit a bunch of buttons and have a choice of 5000 shows. You know 5000 equals 0. You know behaviorally we have gotten comfortable everywhere in the world having a choice of 40-50-100 channels and we have 6 or 8 that we love, and a good model. And this fight over does the content win or the distribution win? I think very clearly if we got together…if you look at Netflix or any device or any offering, if you do not have great content, people are not going to pay for it.
And I think people (programmers) are going to look back at the last five years or so and say - what happened? We have great content, great storytelling and great brands, and there were some platforms that came and said - we would like your content. And instead of saying - Ok, we would like to build a model together that works, and build an ecosystem so that in these new windows we can both do well, we kind of collapsed for checks and we put our content in to an ecosystem that had no commercials and no branding."
As Zaslav so eloquently explained, the existing model generated enough revenues to satisfy all in the value chain. Then what happened? It clashed with another fundamental force in the world - that of scale.
Scale happens, and some inefficiency removal as well:
Scale is one of Munger’s and Buffett’s favorite mental models. They have spoken about it in a number of talks and majority of the businesses they have acquired benefit from this advantage.
John Malone also repeatedly talks about the importance of scale in the media business. He has emphasized the importance of scale in media in each of the interviews we have covered.
Netflix stayed under the radar and slowly built scale while providing a better value proposition to the customers. While the existing video model involved certain inflexibility - customers had to watch the programme when it was aired - Netflix gave that choice to the consumer. While the traditional cable and satellite model required customer to pay huge monthly fees Netflix charged them a much lower monthly fee. While customers had to sit through advertisements in between their programmes in the traditional channel, Netflix provided an ad-free experience.
To harp on a particular point, Netflix built an environment without any ads. As any media guy would know, advertisements are a major source of income for any broadcast company - sometimes forming more than 50% of revenues. It is an important source of revenues if one wants to create quality content. But Netflix was able to circumvent this ‘law’ of the broadcasting business.
It built its platform slowly but the fact remains that the company built a franchise which the customer loves and is willing to pay for. And it did this through scale. Its huge base of subscribers allowed it to spread the content acquisition costs such that the per unit costs were quite manageable. The power of the scale of operations is evident in the fact that HBO, which was the big daddy of content production in the old world spent around $2-$3 billion while Netflix was last spending $14 billion. In fact, Netflix is spending around $400 million on original Indian content alone.
The ultimate test of anything is reality and survival. And the reality is that Netflix is surviving quite well (thriving perhaps) while the incumbents are scrambling to remain relevant in the next decade. Thus reality says that scale is quite powerful.
Which brings us to Zugzwang
Zugzwang is defined as “a situation in which the obligation to make a move in one’s turn is a serious, often decisive, disadvantage.”
The term sort of belongs to the same family of that Sun Tzu quote:
“Do not engage an enemy more powerful than you. And if it is unavoidable and you do have to engage, then make sure you engage it on your terms, not on your enemy’s terms.”
Netflix’s model of allowing the customer to watch what they want to, when they want to, is very powerful. But given it was a small player, it was out of the radar of its competitors. Until suddenly it was too big not to be noticed.
Once it gained enough scale it forced everyone to play the ‘video content delivery on demand’ game on its turf. The competition could not avoid responding to Netflix. It forced the broadcasters and distributors to make a decision which brought them into an area in which Netflix had years of insights and was far ahead of majority of the competition.
It is a strategy we keep watch for - when a company takes a strategic step which forces the competition to respond and fight on disadvantageous terms. We wrote about it in the case of Apple and Wonderla.
There is one more important thing that John Malone’s interview re-emphasizes to us.
When facts change you change your mind
It is fascinating to observe the extent to which Malone changed his mind on the Netflix’s business model. In the Vanity Fair interview, Malone seemed skeptical about Netflix’s business model in 2015. And a few years later he went so far as to say that Netflix is surely going to be a survivor in the streaming wars - along with Amazon and Disney. Now that is quite a powerful group of companies to be a part of. He went so far as to wax eloquent about the scale of the business coupled with its direct to consumer relationship and pricing power.
The ability to destroy one’s own best loved idea is a trait that is much admired by Munger. He repeatedly gives the example of the eminent biologist Charles Darwin- who despite not as intellectually gifted as many scientists, cherished destroying his best loved ideas - and that led him to be honored with a burial next Isaac Newton, one of the greatest scientists of all.
Disclaimer: We may/may not have positions in the companies mentioned in the blog. This case study/article is not a stock recommendation. We are not SEBI registered investment advisors. Our Intelligent Fanatics Case Studies and Articles are meant to retell the stories and strategies used to create exceptional businesses so that we can learn from them.