Now Playing: High Costs, Low Returns and New Tech Promises

A slowdown in private-equity investment and consumer spending will force Hollywood's biggest film studios to rethink their business models, even in an era of exploding digital content distribution options.

The question is: how far and how fast will film studios change to avert a free fall into marginal or no growth through the decade's end? That would prompt headcount reduction and other severe cutbacks now sweeping through the television and publishing sectors. New tech distribution will not be adopted broadly enough to serve as "the magic bullet to revitalize studio revenue growth," says Bernstein Research analyst Michael Nathanson. The collective boost of new technologies, such as Blu-ray DVD, cable VOD and Internet downloads, will reverse an estimated 2% decline in studios' home entertainment revenues to a modest 3% gain by 2011.

Unlike years past, film studios cannot expect private-equity financing to remain robust. "The wave of outside funding created a double-edged sword that generated higher distribution fees for studios, while also driving greater competition for consumer awareness and spending," Nathanson says. Dissatisfied with ROI, many private-equity backers are reducing their film exposure and seeking to renegotiate existing deals. While these funds are difficult to quantify, Nathanson has accounted for $4 billion in financing deals at all major studios since the beginning of 2007--which has helped share risk, but inflate budgets.



Film studio expenses at Time Warner and Viacom have exceeded revenues over the past five years, while both News and Disney maintained more than 16% earnings growth margins by cutting costs to below revenues levels--which will become more difficult this year.

The studios' fiscal crunch has been long in the making. Over the past six years, the film entertainment revenues from the four studio divisions of News Corp., Time Warner, Walt Disney and Sony have grown a mere 4.4%, even as they collectively represented 60% of last year's box office. The 9.4% top-line growth between 2002 and 2007, against a reasonable 3.4% increase in expenses, was primarily driven by franchise film momentum at Disney and Fox.

That snapshot masks a sharp change in competitive factors, such as the decline in home video rentals, the drop in DVD sales, and box-office growth shifting from the U.S. (just 2%) to foreign markets (growing at 5%). A protracted recession will only exacerbate the situation as consumer spending--which has grown only 2% in the past decade--could decline.

The studio operating profit and revenue forecasts through 2010 are generally dismal, Bernstein says. For the period of 2007 through 2010, Walt Disney will experience a decline of 8.4% in studio operating profits on essentially flat revenues; News Corp's studio operating profits will decline nearly 2% on a 1.5% increase in revenues. Time Warner's studio operating profits will rise 5.5% on 4% revenue growth through decade's end, and Viacom's studio (with DreamWorks live action in tow) could see operating profit leap more than 35% on just 2.3% gains in overall revenues on the wings of upcoming "Transformer" and "Indiana Jones" franchise sequels.

However, the sustainable lift of such cyclical hits is increasingly uncertain as the revenues generated by traditional distribution systems abate faster than new media revenues can ramp. Domestic home video market revenues will remain flat on the retail side and rise only 3% on the wholesale side through decade's end. The new Blu-ray standard for high-definition DVDs will offset an anticipated decline of 2% in DVD sales boosting domestic home entertainment retail revenues by 2.4% through 2011--blunted by uncertainties about Blu-ray's installed base, the rate of growth, pricing and consumer demand.

The Holy Grail for studios should be VOD, since it allows them to retain 70% of retail revenues (compared to 30% with DVDs). But the installed base is only about 33% of U.S. homes (compared to 80% for DVD-type players). The tradeoff between physical rental and VOD is big: A gain of 133% per transaction for studios that will reverse a decline of 2% in wholesale revenues to a 6.8% gain through 2011.

Online film distribution, another potential growth catalyst, hinges on partnerships likes Apple's iTunes. Intriguing recent developments range from Paramount producing the first full-length film made for the Web ("Jackass 2.5") and movie clips for Facebook to Sony's plans for full-length movies on AT&T cell phones.

Nathanson's enlightened report is lacking only in possible solutions for developing new models. For years, Viacom's MTV and Nickelodeon have produced low-cost, high-return demo-tailored films. News Corp.'s Twentieth Century Fox also has generated double-digit returns on independent gems, such as "Juno" and whimsical animations like "Horton Hears a Who!"

Disney best epitomizes Hollywood's film studio challenges. Sales of new and catalog releases generated 90% of its 2007 studio earnings, even as its DVD sales fell for the first time by 3%. The mounting difficulty of managing home video and other exhibition windows to fuel profits could result in a 16% decline in studio earnings on a 3% decline in revenues in fiscal 2008, Bernstein says. Home video comprises more than half of Disney's film studio revenue; 18% comes from theatrical release, 15% from TV distribution and 14% from theatre and ice show extensions--and all are recession-sensitive. It's enough to give a deafening quality to Nathanson's warning: "Studio owners should begin aggressively to rethink their operating cost structures and capital's time to rethink the film studio model."

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