Showtime Hit Hard By Paramount Movie Venture

Paramount's decision to channel its movies into a new premium TV, VOD and online joint venture rather than continue supplying CBS' Showtime is more a survival tactic than a case of sibling rivalry, as characterized by many in the press.

With Viacom's Paramount delivering the lowest earnings contribution among the top four studios owned by other media conglomerates, it's seeking to take control of its destiny in a digital marketplace that thrives on the ripoff of copyrighted materials. However, creating yet another walled garden of branded content--such as and iTunes --will not necessarily ensure success.

The weekend announcement of a new premium film service for television and other digital Internet platforms by Paramount, MGM, United Artist and Lionsgate pulls the rug out from Showtime, which will no longer have access to the studios' film libraries after the new service launches in fall 2009. Time Warner rival HBO draws from Warner Bros., News Corp.'s Twentieth Century-Fox, NBC's Universal Studios and DreamWorks SKG. Liberty Media's Starz draws from Sony and Disney.

The creation of the unnamed premium service represents a devastating blow to CBS, whose pure broadcasting fortunes have been failing. Showtime has succeeded in large part with its own original television production ("Dexter" and syndicated gems like "The Sopranos"), but also pays as much as $400 million annually for outside studio film rights. Paramount does not have a TV studio like its peers, although Viacom CEO Philippe Dauman has said it will ramp up higher-margin television production for cable and for the new premium service. Television production can prove more lucrative given after-market sales, which have included traditional syndication.

This surprise development underscores the heightened tensions between Viacom and CBS, which split in 2006 with mostly complementary assets. However, they increasingly mirror each other. In an effort to make itself less dependent on volatile television and advertising revenues, CBS recently began producing its own branded theatrical films.

But the movie business has its own problems. Major U.S. studio 2008 top-line revenue will decline for the second consecutive year to $37 billion, down 3% from last year. All theatrical revenue streams--such as box office, the shrinking DVD market, pay TV and free TV licensing fees--are growing below the rate of inflation. VOD is the exception, growing 28% off of a small base. Domestic box office release of an average 600 new films will remain flat at about $10 billion, according to CitiGroup analyst Jason Bazinet. The pay TV window generates nearly $3 billion of annual revenues for studios.

Viacom's recent studio results have been "baffling," according to Bernstein Research analyst Michael Nathanson. Despite reporting a 28% rise in studio revenues (of $1.2 billion in new revenues), Viacom's filmed entertainment division posted lower operating profit (down $28 million). Since its 2006 acquisition of DreamWorks live action, Viacom film entertainment division incremental revenues have expanded by $2.57 billion, mostly consumed by expenses that have increased by $2.51 billion.

While Viacom's film operating profits and margins have contracted in recent years, other major film studios are growing, and posted a combined 9.4% increase in earnings from 2002 to 2007. Viacom's film studio operating profit declined during that same period to $104 million in 2007, from $267 million in 2002. Its operating margins and return on assets are both below 2%. Because theatrical revenues contribute about 33% to Viacom's overall revenues, film failures can have a devastating impact without some cushioning from pay TV and other exhibition windows.

Clearly, Viacom is seeking ways to realize significant upside from its studio business, which is only about 5% of overall earnings and well below its peers. Nathanson forecasts that most of Viacom's overall 10% operating profit growth in 2008 will come from its cable networks. Paramount Pictures' "Iron Man" is expected to be a summer box office hit that will boost earnings. "Iron Man" will be among the 2008 releases that will play prominently in the initial offerings of the new premium service late next year, bolstered by such film library favorites as "James Bond" and "The Godfather."

Dauman says the premium partnership will give Viacom more flexibility to use digital technology to innovate consumer-centric approaches to presenting and distributing films than is possible in restrictive pay-TV deals with others. It will benefit from developing new digital economic business models for on-demand, rather than subscription, distribution of high-end fare. Although Paramount will no longer receive an estimated $200 million in fees paid by Showtime, it should be able to generate comparable or better revenues from its own platforms.

Bear Stearns analyst Spencer Wang said Paramount will likely have majority equity ownership of less than 50% of the new joint venture that is expected to pay the studio at rates potentially higher than those paid by Showtime. Paramount could have some asset value creation potential from the pay TV joint venture. Viacom's cable network division will be paid to manage affiliate sales for the new service.

The risks to the new venture include the highly transactional nature of pay TV and VOD business that require different packaging, pricing, and management expertise than Viacom's basic cable business. Also, the new venture will need to "bulk up" on other library content to offer a full 24-hour schedule, although it does not yet appear to have supply agreements with competing studios.

Still, the risks are worth taking, given the increasingly competitive entertainment environment. It could mean the difference between generating a modest $128 million in studio profits this year and many times that in a few years' time. Viacom figures it won't know until it tries.

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