Hollywood Credit Isn't Gold

The inability to project the return on investment for films was never more challenging than during the ongoing shift from traditional film exhibition windows to an anywhere distribution that is as friendly to free and illegal access as to tiered pricing. And the current credit crunch and consumer-led recession don't help much either.

Such factors surely contributed to Deutsche Bank's decision not to provide $450 million in funding to Viacom's Paramount Pictures, representing as much as 25% equity or a maximum $30 million for each of some 30 films. Instead, Deutsche Bank is exiting the film financing business. While a growing amount of film financing is available from international sources (India and China), studios and their corporate parents have to assume more of the financial debt and risk. Under those circumstances, future film slates (which include DreamWorks pictures) could be smaller and more selective.

The prospects for eventually generating more content revenue in new ways do nothing to bolster current film investments. While advertiser and consumer spending shift to developing digital devices and platforms, it will take time before new revenue streams offset or exceed losses from traditional businesses. Film merchandising and other consumer spending will be restrained into next year. Declines in box-office sales and ad spending are already evident, and a global economic slowdown is underway. Such trends have prompted widespread downgrades and lower earnings forecasts among industry analysts.



Box-office revenue in 2008 is expected to grow a paltry 1.5% to 2.5% over 2007, with declining attendance offset by higher ticket prices. DVD unit sales will be flat to down marginally, according to Morgan Stanley analyst Benjamin Swinburne. The time between a film's theatrical and home theater release will likely hold at an average four months, which may shift increased consumption to movie rentals, purchase and pay TV in a tough economy. The threat of a Screen Actors Guild strike already has caused a 31% decline in film production starts in the second quarter and nearly the same year-to-date, according to JP Morgan analyst Imran Khan.

Because an average film is unprofitable in the theatrical window, a strike would adversely impact profits in later quarters and slam studios with higher operating margins, such as 20th Century-Fox and Buena Vista.

It is unknown what level of return Paramount delivered to Dresdner Kleinwort when it previously provided $225 million in funding for 25 films and $300 million for 30 films in simultaneous years.

Private investment finances about one-third of Hollywood's film costs--representing about $15 billion since 2000, according to UBS analyst Matthieu Coppet. With the exception of animated and some franchise films, such film funds generally provide financing for half of all production costs (and as much as 75% in the case of the latest Universal deal). The annual returns have been on par with or beyond traditional equity film financing when projects are successful, Coppet said. It is unclear whether that return will be possible now.

With limited available film financing these days, Viacom likely will opt to completely self-finance a smaller slate of theatrical films over the next several years, which would increase Paramount's risk profile--especially given the rising cost of gap financing or mezzanine loans (with rates as high as 19%) to cover the difference between film production cost and upfront payments for international distribution rights. Or it may have to offer better terms to a new partner.

Paramount contributes only 7.7% of Viacom's operating income, but generates 38% of total revenues--the largest portion of any of the major studios. Paramount is the smallest of the major studios, generating an estimated $277 million in operating income on $5.4 billion in estimated revenues in 2008. Based on its box office hits like "Iron Man," "Kung Fu Panda" and the "Indiana Jones" sequel, Paramount could realize up to $100 million in incremental earnings in 2008, Swinburne said. Analysts say Viacom produced the three films for a combined $440 million, and primarily assumed the risks associated with advertising, marketing and distribution.

This year, the other major film studios, generally comprising up to one-fourth of their corporate parent's overall revenues, were expected to each generate about $1.2 billion in operating income. Time Warner's primary financing partner, Legendary Pictures, has a $1 billion funding deal in place through 2012, and has committed more than a total of $2.5 billion. Kingdom Films, one of Disney's partners, restricts its funding for Pixar and Disney animation. Dune Fox II, News Corp.'s film financing partner, recently closed on funding for 40 films, Coppet said.

Still, Lehman Brothers analyst Anthony DiClemente said he expects that film spending (production, promotion and advertising) is likely to decline 15% over a year ago. "Given the dissipation of some hedge-fund film financials this year, we also believe there will be fewer mid-level or "indie" films crowding the marketplace this summer. That could bode well for individual per-film returns for the majors, even in a market where total box-office revenue could come in 10% lower on a year-over-year basis," DiClemente said.

In fact, Bernstein Research's Michael Nathanson is among the industry analysts who advocate the need for a new film studio model. Although consumer spending has grown only 2% in the past decade, film studio output has increased 4%, partly as a result of the credit bubble that drove a wave of easy film financing from third parties. While it generated higher distribution fees for studios, it also intensified competition for consumer awareness and spending. As a result, studio returns have not meaningfully improved the past decade--which, combined with the current financing crunch, is ample reason for studio owners to aggressively rethink their operating cost structures and capital allocations.

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