• by Diane Mermigas , August 14, 2009

Fear of diminishing returns from digital distribution is fueling Hollywood studio ire with Redbox's $1 daily rental of new movie releases in what is shaping up to be a major test of new media economics.

The numbers tell the story. Redbox movie rentals are frequently offered for "free" by local merchants seeking to drive store traffic. The increasing numbers of Redbox vending machines (expected to reach 22,000 by year's end) provides the local convenience of a self-serve neighborhood Blockbuster compared to the mail-wait of Netflix.

The most immediate options -- video-on-demand and iTunes downloads generally $3.99 or $4.99 for a limited viewing window -- seem expensive by comparison. It leaves little doubt about the deteriorating appeal of DVD sales at $15 or $20 a hit, even before you take rampant piracy into account.

While there are more platforms and devices on which to access, view, store and share content, they will collectively render less revenues to content producers, who have done little to alter their creative costs. The modest pricing and free giveaways change consumer psychology about the overall value of Hollywood entertainment that costs billions to produce. Hollywood is under pressure to retain every dollar of income as traditional exhibition windows implode.

Against that backdrop, major studios are locking horns with Redbox and even Netflix over holding new films to the 28-day DVD release date for rentals to avoid compromising earlier box office, pay and other exhibition windows. Netflix's successful migration from postal to streaming films is similarly eroding more expensive distribution revenues from DVDs, video on demand and subscription pay channels.

Time Warner on Thursday proposed the most aggressive new arrangement yet with Redbox and Netflix, which rigorously limits their access, use and compensation for movie rentals. Universal and Twentieth Century-Fox also have proposed similar conditions on making their films available, to which Redbox has responded with lawsuits focused on copyright misuse, anti-trust and existing supply contracts. The three movie studios represent about half of new title releases of Redbox, which commands about 15% of the DVD rental market.

A restrictive pact with Lionsgate for new releases the same day they are available elsewhere could generate an estimated $158 million over a period of five years, and Sony's new deal with Redbox should generate about $500 million in revenues over five years, according to related documents filed by Redbox owner Coinstar.

So far, Disney and Viacom's Paramount continue to make films available directly to Redbox, but it's just a matter of time before studios lock arms against what they perceive as an escalating threat to their economic well-being and ability to control pricing and access to their content.

"Redbox's current business model poses a substantial risk to the future of the movie industry, as it sets an ultra-low price point for movie content that will impact consumers' decision-making process about all forms of movie-related commerce," observes Pali Capital analyst Rich Greenfield.

Studio profits are heavily weighted toward sales vs. rental, and the pendulum is swinging so quickly in the rent and free access direction that the ultimate mix and shift can be disastrous, given the already risky ROI. Total entertainment media spending by consumers will grow an average annual 3% over the next five years to more than $68 billion by 2013 despite an increase in access outlets and devices, according to equity investor Veronis Suhler Stevenson.

Home video will decline an average 2% to $22 billion by 2013, while box office revenues will remain flat at about $10.4 billion in five years. Consumer spending on entertainment media on Internet and Mobile Services will soar an average annual 23% to nearly $15 billion by 2013.

As the shift to Internet and mobile services takes hold, even Redbox, Blockbuster and Netflix will find it increasingly difficult to compete. Although Blockbuster is on track to have 500 Blockbuster Express kiosks operating this year, CEO Jim Keyes concedes: "One dollar for viewing is not a sustainable industry model." Even today's disruptors eventually will be disrupted. Until then, even television is not safe from Redbox, given the rental company's keen relationship with brand advertisers.

A vending kiosk on-site at a store provides marketers immediate opportunity to motivate consumers with instant coupons, discounts and other offers and a new place to shift their dollars from television and network-branded Web sites that generally host the same fare and format.

This new David versus Goliath conflict has its quirks. Redbox's simple distribution option is likely to disappear as storage, streaming and sharing capacity and behavior grows. Redbox's own economics are fragile, even with $345 million from DVD rentals in the first half of 2009, 16% earnings margins and about half of its kiosks only 1 year old. For now, it is a recession-busting strategy for consumers and retailers.

Picking up a little Tinsel Town escapism along with a gallon of milk at the Wal-Mart, Kroger and other grocery stores are resonating with high-tech consumers riveted on price and convenience.

Redbox is the brainchild of McDonald's and the anti-Apple alternative to waning DVD sales, streaming, downloading and box-office revenues that are key to the industry's strained economics. "Having our movies rented at $1 is grossly undervaluing our products," Chase Carey, newly minted News Corp. president, told analysts during a recent earnings call.

There's always the advice entertainment conglomerates would rather not hear:

*Make movies so good consumers line up to see them at the theater.
*Reconfigure film production budgets more in-line with future revenues.
*Remember that walled gardens eventually collapse; just ask AOL. So do old rules carried over to a new marketplace.