How Netflix smashed TV’s business model to bits

Today I want to show you how Netflix has grown into a $50bn market cap stock market giant (at the expense of the existing TV companies).

Last week I wrote about an obscure law of business strategy: This “law” predicts which businesses will make it.

It’s about “the law of conservation of modality”. (Horrible name, I know – henceforth I’m calling it LOCOM). I said it was “an incredibly useful and powerful way to think about business strategy”, and that it could be applied to any type of business.

Today I want to use LOCOM to explain how Netflix has grown into a $50bn market cap stock market giant (at the expense of the existing TV companies).

How companies prioritise

Here’s how I described LOCOM last week.

“The theory starts with a product.

Think of a product as a company’s solution to a problem. For example: “people need a device to help them work while they’re at the office.”

In order to solve this problem, the company builds a desktop computer.

But the computer is really a number of different solutions in one. It has a screen to solve one problem, a hard disk to solve another problem, and so on.

Now, for any product, there’s always going to be one part of the problem that’s harder to solve than the others. In the example of the desktop computer, the hardest single problem to solve is making a processor that’s fast enough.

Making a fast processor is the single biggest challenge. So the computer engineers optimise the entire computer around the processor. Optimising around the processor means making all the other components – the mouse, screen, motherboard, RAM and the like – interchangeable.

In a nutshell, that’s Christensen’s Law. He says that for any given product, a company optimises around the single hardest problem to solve, and the remaining parts of the problem become interchangeable…

… The business implication of all this is that there’s no money to be made from solving the less difficult parts of the problem. All of the value, and all the profits, are made from solving the hardest part of the problem. ”

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The TV business model is getting smashed to bits

So how does it fit the TV business? What are the different parts of the problem?

– The first part is creating entertaining TV shows – “content”.
– The second part is choosing which shows to make and promote – “production”.
– The third part is reaching customers – “distribution”.

In the traditional TV business model, the TV networks integrate the hardest parts of the problem: content and production. They make TV shows in-house. They decide which shows to make, and which to promote, in-house.

The networks don’t handle everything themselves though. Just like LOCOM says, they modularise the least important part of the problem, which is distribution. Most TV networks rely on local affiliates (in the states) or cable companies (like Sky or Verizon) to get their product into people’s homes.

In other words, the networks focus their energies on the most important part of the problem (integrating it). And they leave “the small stuff” for other people to figure out (modularising it).

Enter Netflix.

Netflix uses new technology to reach subscribers directly. Anyone with a computer, a phone or a modern TV can access it. And people find Netflix fun to use. It’s more convenient than old fashioned broadcast TV. It’s able to offer a wider range of shows, whenever wherever the viewer wants them. And it doesn’t rely on Sky or Virgin media or Verizon to reach its customers.

All of which is to say that Netflix has integrated distribution, the third part of the problem I described earlier.

The new streaming technology has changed the game. Because of changes in technology, distribution has gone from being a secondary problem for TV companies to being the most important problem, the one you optimise and build the entire business around.

The TV networks are finding it hard to match Netflix’s user experience (aka, distribution). They might have great in-house content, but that no longer matters if their distribution isn’t as good as Netflix’s.

As for Netflix, they’re behaving just like LOCOM predicts. They’ve farmed out the content side to others – in other words, they’ve modularised it. They buy in great shows and leave the details of content-creation to the experts.

Netflix is just one example of the general principle of LOCOM, which is as follows: a new entrant to the market can profit by integrating a part of the business model which had previously been modularised, and modularising the parts of the business model which had previously been integrated.

So when you see Uber valued at $62bn, or Amazon gobbling up the retail industry, or use money supermarket to choose a credit card – now you know what they’re up to!

If you’ve made it this far, you’re probably like me – a bit of an investing nerd. I find all this stuff interesting because it helps me in my day job as editor of The Penny Share Letter. It helps me think about disruptive companies and new business models – exactly what I’m after as a stock picker.

So if you want to see how I put all this to use, click here.

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