The film business doesn't seem very enticing these days. Home video is down. Film slates are smaller. Even the pay and perks once lavished on stars are diminished. And if it weren't for the higher ticket prices justified by 3-D, the box office would also be down.
Times haven't been this bad since the 1950s. That's when a war-weary nation plunked itself in front of the boob tube rather than round up the family for routine outings to the silver screen. There was grousing then, too. It got so bad it even turned into boasting when, in 1958, Paramount Pictures Corp. sold its pre-1948 film library.
The price was, at the time, an eye-popping $10 million. Executives at the studio weren't just pleased to have unloaded what they characterized in Variety as "miles of useless old celluloid." They were exultant. Through a single deal, they crowed, Paramount Pictures Corp. realized profits that would have taken the studio's regular operations years to duplicate.
The boasting stopped, however, once MCA Inc.'s Lew Wasserman dispatched his agents to shop the library of 700 feature films he had just purchased from Paramount. It proved an easy sale, because the country's 492 television stations in 1958 showed remarkable receptivity to such reel-to-reel relics as "The Lost Weekend," "Trouble in Paradise" and "Double Indemnity."
Exactly how easy remains subject to debate. Some accounts claim the peddling of broadcast rights to the $10 million library recouped $30 million inside of a month. Others say it took only a week.
A lot has happened to film libraries since MCA netted its quick $20 million from Wasserman's insight that TV would supplement the film business rather than undermine it. Most noteworthy is that the product itself has engendered additional revenue streams. Between its theatrical exhibition and free TV airings -- the leap so spectacularly exploited by Wasserman's MCA -- a film today passes through three other windows: home video (retail and rental); pay per view, or PPV; and pay TV.
Yet the malaise afflicting the industry appears '50s-like to an uncanny degree. The culprit isn't TV this time but new technologies under the rubric of electronic distribution, or ED. These not only promise to upend the entertainment firmament, just as TV did in its early days, but threaten to take piracy to a level that reduces film libraries to values they haven't seen since, well, the '50s.
In its most recent edition of "Global Entertainment and Media Outlook," PricewaterhouseCoopers LLP categorizes the newest of film wild cards as "digital downloads," which is synonymous with ED. For their initial recording, in 2006, PwC assigns digital downloads a domestic value of $24 million. In 2009, the amount PwC ascribes to the category surges to $364 million.
ED's most explosive growth, though, lies just ahead. And it's going to test the relationship between a film and its windows as never before. Only the original -- theatrical exhibition -- stands to escape unscathed. The rest will be either squeezed or subsumed by ED's two basic offerings: rental and ownership.
Film rental via electronic distribution already manifests itself as video on demand, or VOD, and PPV, which will no longer exist as a window but become a permanent option. Film ownership via ED occurs through electronic sell-through, or EST, and download-to-own, or DTO.
The transition to electronic distribution is not for the acronym-phobic, obviously, or for the faint of heart. In addition to fanning fears of piracy, it has pundits predicting digital pennies from ED will replace the physical dollars flowing into film's home video window.
Many in the industry, citing a disconcerting downturn in DVD sales, believe there couldn't be a worse time for such a deep dive into the digital future. Their concerns are real. In North America, DVD sales peaked at $18.6 billion in 2006, according to PwC. They've fallen in subsequent years, declining a cumulative 23% to total $14.4 billion in 2009.
The handwringing over DVDs -- by far the most important driver of film since their introduction in 1997 -- even explains why the historically coveted libraries of Metro-Goldwyn-Mayer Inc. and Miramax Films linger for sale after months on the market. The cloudy future of DVDs also played a role in Liberty Media Corp.'s recent decision to dissolve Overture Films LLC instead of sustaining a search long under way for a suitor to the holding company subsidiary.
Still, while undeniably valid, such concerns obscure ED's positives. The most obvious of these include an end to film's inventory problems, a reduction in distribution costs and a change in the consumer purchasing decision: from deliberative to impulsive.
But let's also not overlook the potential of ED to access disparate film libraries to create hybrid collections unmatched in quantity, quality and availability. And let's appreciate that only ED can provide a direct path from these libraries to their end users, one capable of circumventing gatekeepers and eliminating middle men. Moreover, thanks to net neutrality, this unobstructed path could soon be legally guaranteed.
Then, too, ED promises to benefit from the sensibilities of the post-Napster generation. This is the generation trained by iTunes as toddlers, a cohort impervious to the notion that content has to be free. What's more, as veteran pay-for-play customers, they're poised to join those young adults who constitute film's most important demographic.
So maybe the future of film won't be as dire as many currently envision. Maybe all the business really needs is a catalyst -- a visionary dealmaker, say, with the courage and the conviction of a Lew Wasserman.
As complicated as film's traditional windows can be, the art of valuing them has evolved into a science. Five years ago, in an effort to reduce the headline price of its acquisition of DreamWorks LLC, Viacom Inc. enlisted George Soros. Viacom wanted $900 million removed from its $1.5 billion purchase of DreamWorks' live-action film unit. So it sold Soros a 51% interest in the acquired library's 59 titles, with the understanding the multi-hyphenate investor would sell his stake back in 2010.
Viacom declared in its announcement of the deal that the buyback price would reflect "fair market value" -- an amount Soros retained Salter Group LLC to forecast.
Although the Los Angeles-based advisory firm won't comment on its role or its view on value, sources report that Salter's projections for the five years came within a few percentage points of nailing the library's aggregate return over the forecast period.
It was a valuation that, among a host of other variables, managed to discount the unexpected decline in DVD sales, a deeper-than-anticipated advertising recession and the arrival of kiosks as a legitimate film dispenser.
This isn't to suggest libraries are easy to value; they're not. Not only must each film be analyzed individually, but each of its rights -- theatrical, home video, PPV, pay TV and now, importantly, digital -- must be assessed for whatever trickle of cash flow it can contribute to the stream. It helps, though, that each window has rules of thumb about duration and compensation.
The most fundamental is that, after ending a theatrical run that rarely lasts longer than 10 weeks, a film eschews free TV for 30 months. The initial take from theatrical exhibition comes from a 50-50 box office split between a film and its exhibitor. Then, 30 months later, the film begins to fade as a revenue generator. In exchange for licensing fees, theoretically renewable in perpetuity, it appears regularly, then irregularly, on free TV.
While theatrical exhibition and free TV serve as a film's bookends, the more recently established windows segment the marketplace in ways designed to wring as much as they can from advertisers, broadcasters and consumers. The home video window, for example, lasts between six and 15 months. And for each retail transaction, it returns between 25% (a DVD/VHS rental) and 75% (a DVD/VHS sale).
PPV, the dominant outlet from month 15 to month 18, repatriates about 50% of whatever the film generates from consumers who actually do pay per view. This is followed by the pay-TV window, which kicks in around month 18 and acts as the primary platform through month 30. The payback here is a function of the number of airings, the broadcaster's subscriber base and the film's advertising attractiveness based on subject matter, target audience and box office performance -- all incorporated into a single one-year fee.
Although the dollars may be stagnant, they still add up. According to PwC's most recent "Outlook," the global filmed entertainment market topped $93 billion in 2009, representing an absolute increase of nearly 20% since 2003. Meanwhile, its home video segment, pegged at $63.3 billion by PwC, outranks the $30.1 billion that consumers spent at the global box office by a factor greater than two.
PwC doesn't break out data for film's other windows. But in a Skillset white paper, "Revenue Flow and Making Money out of Film," Malcolm Ritchie, a co-managing director of London-based Qwerty Films Ltd., estimates PPV, pay TV and free TV collectively account for 28% of a film's revenue stream.
Ritchie's analysis also credits 25% of a film's revenue to theatrical exhibition, 40% to home video and 7% to ancillary revenue accruing from a film's music, publishing, sponsorships and product placement deals.
These and other analyses indicate that, for every $1 it brings to the box office, a film today commands no less than $3 from its other windows. So, despite their crazy quilt of timetables, interdependencies and compensation schemes, windows have served film well pretty much since their inception.
As Harold L. Vogel writes in his classic text "Entertainment Industry Economics," they've allowed the business "to sell a lot of old wine in a wide variety of new bottles." The question now: Will consumers continue to drink from these bottles once ED offers a better buzz out of cheaper containers?
"You want to watch 'Toy Story 2' on your TV? Your iPad? Your smartphone? Whatever -- boom -- you got it. That's another buck-fifty on your account."
So says Wedge Partners Corp. analyst Robert Routh on being asked to describe streaming-video transactions coming soon to devices near you. The scenario succinctly identifies what's so appealing to consumers about ED. Note the ease of ordering, the title's instant availability and a price almost everybody can afford.
It also hints at the utopia awaiting studios once they domesticate what's generally conceded to be home entertainment's final frontier. No bickering with Blockbuster Inc. over shelf space. No getting displaced by Wal-Mart Stores Inc. to accommodate products with superior returns per retail foot. And no losing a sale due to an inventory shortfall.
So why aren't the studios there yet? The technology is in place, after all. So is consumer interest.
Neither was enough, apparently, to motivate studios to make a go of Movielink LLC. That joint venture, established in 2002, served as the studios' first attempt at a cooperative movie download service. Only it got so frustrating that, for a mere $7.7 million five years later, Movielink co-founders MGM, Paramount, Sony Pictures Entertainment Inc., Universal Studios Inc. and Warner Bros. Studios induced Blockbuster to take it off their hands.
What has changed since then? Two words: Netflix Inc. The video rental service has unequivocally demonstrated ED is too big to ignore. As company CFO Barry McCarthy put it during last month's earnings call: "Why were profits so strong this quarter? The answer is 'streaming.'?"
Netflix's CFO then reminded investors that, a year and a half ago, he observed declines in DVD usage among early adopters of streaming. "Now, six quarters later, the data clearly suggests that the substitution behavior first exhibited by early adopters is also being exhibited by mainstream subscribers."
The mainstream arrival of ED has even caught film's cagiest players flat-footed. In 2008, for an annual fee of $25 million, Liberty Media licensed the digital rights of Starz Entertainment LLC, its premium movie service, to Netflix.
The terms didn't just cover Starz content but also product from Sony and Walt Disney Co. made available to Liberty through previously negotiated output deals. This allowed Netflix to boast, as it did in a release announcing the digital-rights arrangement, "2,500 movies, TV shows and concerts [are] available to be watched instantly by Netflix members."
Starz content continues as the cornerstone of Netflix's increasingly popular "watch instantly" program. And the sweetheart deal by which it was obtained continues to serve as a cautionary tale to content providers everywhere. "There's no way they're going to let those rights go for such a cheap price again," Routh says.
They're also not going to let those rights go for very long, at least not until ED assumes some of the predictability of film's more established windows.
Consider, as a case in point, the deal Warner Bros. struck last month to extend Netflix's right to continue streaming its content. Terms announced in the second half of 2010 are valid only through 2011, giving the contract a life about as long as it took the lawyers to draft it.
Before the contract ends, nonetheless, Warner Bros. and other studios expect ED's many moving parts to have settled enough to permit much better clarity. Of particular interest, in addition to Netflix, is EPIX -- the premium TV channel and subscription VOD service set up by Lions Gate Entertainment Corp., MGM and Viacom's Paramount. This joint venture could emerge as an industry-preferred ED vehicle simply by expanding its ranks to include other studios.
Showing similar promise is Hulu LLC, whose strategic owners already include Disney, NBC Universal Inc. and News Corp. The issue here, in addition to expanding the joint venture's roster for industrywide representation, is whether Hulu would resonate as well with movie streamers as it does with TV streamers.
The most recent contender, introduced last month with details yet to come, may well be the most ambitious. Backed by a consortium of studios, equipment makers and technology companies, a service called UltraViolet will enable consumers to enjoy whatever digital content they purchase across any platform they want: TVs, computers, game consoles, smartphones and even tablet PCs.
At UltraViolet's core will be a digital locker that collects proof-of-purchase tokens for content obtained by any legal means. This, in turn, will allow qualified owners to access their content in any location and on any digital device, regardless of where the original purchase took place or for which platform it was originally intended. And because plans call for UltraViolet to have an "open standard," it will issue a direct challenge to the proprietary format adopted by Apple Inc. for ED devices such as the iPhone, iPad and Apple TV.
While it's too early to call this contest for ED dominance, many consider it Netflix's to lose. After all, with a market capitalization of $5.5 billion, the video renter and movie streamer seems destined for last-man-standing status in the multichannel film business once owned by Blockbuster. It also already enjoys relationships with the studios, which may work to its benefit as these owners of film libraries take back control of their destinies.
That the studios will take back control -- that they will exploit technological advances to give themselves a direct path to the end users of their libraries -- is no longer in doubt. Sources say even Netflix privately acknowledges there's no way it can keep studios at bay. They own the content, which in the ED era catapults them to the top of the digital food chain.
The obvious parallel here is the Organization of the Petroleum Exporting Countries: as independents, a bunch of hapless sovereignties at the whim of an erratic market over which they exercised little control; once organized, the world's richest cartel. All anyone else has been able to do since is pay, partner or get out of the way.
As the studios' ED partner, provided it wins the assignment, Netflix would have several cards to play besides maintaining the infrastructure. It could embark on a systematic ownership retreat that manages to bring in studios as equity holders without unduly disrupting its stock price.
That is, in exchange for giving away a series of ownership stakes in the company, Netflix could obtain the right to stream studio libraries over a corresponding series of intervals. It could also assume a United Nations-like role, keeping studios at peace with one another and satisfying antitrust concerns by opening up membership to exhibitors and others wary of the consortium's monopolistic tendencies.
Most tantalizing, though, is Netflix's ability to usher in valuation metrics that capture the worth of a film library as a collection of ED properties. These are the metrics quantifying not just the complete access consumers will have to an endless inventory of film, but also the volume increases triggered by impulsive buying and the fat margins a combination of digital delivery and net neutrality virtually guarantee.
Netflix is believed to be close to cracking this valuation code, which is no surprise, given its location at the epicenter of film e-commerce. And once it takes the new paradigm public -- sometime between 12 and 18 months, sources say -- film libraries are in for a jolt they haven't experienced since Lew Wasserman seized the day.