The Hollywood Economist 2.0

by Edward Jay Epstein

  Moreover, the shift to home entertainment is gathering momentum as couch potatoes find more convenient ways to obtain movies in a high-definition format, such as Netflix (which by 2009 had streamed more than 1 billion movies) and cheaper rentals, such the vending machines of Redbox, which in 2009 offered them at 99 cents per night and accounted for almost one-third of DVD rentals. Since the average ticket at the multiplex costs over $7, this new 99-cent rental price could induce more and more people to skip the theater. Of course, there will always be a niche audience for movie theaters, if only among teens who want to get out of their homes on weekends, but that niche will not be a significant profit center for the new Hollywood. Already, theatrical releases, despite the blinding allure they still hold for the media, serve essentially as launching platforms for videos, DVDs, network TV, pay-TV, games, and a host of other products.

  This transformation is not necessarily bad news for Hollywood’s big six studios. Ever since the 1970s, they have produced the largest share of television’s most successful series, including such hits as the various CSI shows. Their immense libraries syndicate or license to cable networks and local stations most of their movies and television shows, and they earn a royalty from each movie sent out at Netflix, as well as licensing fees on moves rented at Blockbuster and other videostore chains. Even Redbox pays the studio the same wholesale price as other video stores (about 65 percent of the retail price). Consequently, it isn’t surprising that the studios are now promoting executives who are more experienced with the mass audience than with the vanishing movie-theater audience.

  THE LAST DAYS OF THE VIDEO STORE

  In 1997, mogul Sumner Redstone warned Hollywood studios that the video store business “is going into the toilet” if it didn’t get some help. His company, Viacom, not only owned Paramount, but Blockbuster Entertainment. Rentals from Blockbuster’s 6,000 stores put $3.9 billion dollars in the six major studios’ pockets, and he argued that “the studios can’t live without a video rental business. We are your profit.” As a result, the studios agreed to share the cost of stocking Blockbuster’s stores in return for a share of its rental revenues. He won that battle, but lost the war. Fourteen years later, two thirds of America’s video stores have closed and Blockbuster has gone bust. In April 2011, Dish Network bought it out of a bankruptcy auction with plans to convert what remains of its rental store business to streaming a la Netflix and movie vending machines. The other major rental store, Movie Gallery, had liquidated its 4,700 stores in April 2010.

  “The store model is now dead,” a former top executive close to Blockbusters wrote me recently. “The move to $1-per-day rentals has done it in.”

  The pioneer in dispensing $1 rental DVDs out of kiosks in fast-food restaurants and supermarkets is Redbox. It was created in 2004 as a joint venture between McDonald’s and Coinstar, which then bought out McDonald’s. By doing away with clerks, real estate leases, and the store itself, Redbox created a business model with which no brick-and-mortar stores could compete.

  Redbox did have a stumbling block: It had to finance the purchases of new titles weekly. To get the wholesale price of $15–$18 per title from the two main wholesalers, VPD and Ingram, it needed a large minimum order. “The capital needed to fill the … machines was outstripping Redbox’s earnings,” said one person involved in the business.

  The irony here is the studios provided Redbox a solution. To please an angry Walmart, the studios’ largest DVD customer—which sold most of its new titles in the first two weeks of their release—it needed to delay Redbox’s releases. So Warner Bros. and Fox made a deal in which Redbox delayed its rentals for 28 days, in return getting the revenue sharing that Redstone had gotten for Blockbuster a decade earlier.

  Redbox got its titles at a lower manufacturing price, and didn’t need to raise capital for large advance payments. Even splitting the rental revenue with the studios, it worked out to no more than it had previously paid wholesalers. Redbox resumed its explosive growth in 2009–2010. This became the tipping point.

  The other nail in the video store coffin came from Netflix. In October 2008, it added free streaming of movies and TV series to its $8.99 mail-in service. Content was sub-licensed from Starz at a bargain price. Brick-and-mortar stores couldn’t compete with $1-a-day rentals and free streaming.

  Even with video stores dying, the studios did not lose entirely. While they made about 50 percent less from $1-a-day revenue sharing, Redbox and Netflix, along with Walmart, became their biggest customers. A slim-downed cash cow is better than none.

  In 2010, for example, Time Warner harvested nearly $4 billion from its home video unit (i.e., DVDs and Blu-rays), which, though about 30 percent less than the peak in 2007, was still a rich lode. Other major studios did almost as well. The losers included indie and lower-budget movies. Redbox concentrated on the wide-opening Hollywood films that have been hyped with $30–$50 million ad campaigns. Since there is limited space in vending machines, indie movies are often not carried. That leaves Netflix. But as Netflix moves from physical DVDs to streaming, it no longer needs to purchase DVDs. For indie producers, this is nothing short of a disaster.

  Another casualty is original TV series. Streaming has all but wiped out the sale of boxed sets, and without such prospects, networks are cutting back on producing additional seasons. Netflix has tiptoed into the breech, helping finance one new original series and the 5th, 6th, and 7th seasons of Mad Men, but such deals are few and far between. For the creative community, the death of the video store presents a considerable challenge. The studios meanwhile have to grapple with a brave new world in which their valued movies are reduced to a cheap commodity.

  AND THE END OF THEATRES?

  On March 31, 2011, Warner Bros., Sony, Universal, and Fox confirmed their plan to carve a new video-on-demand window out of the theatrical window. It will be called “Home Premiere,” and for $30 a movie a couch potato can get a current movie beamed into his home from a DirecTV satellite or over a Comcast Cable just eight weeks after it opens in the multiplexes. This means the home audience can see a movie in high-definition in the comfort of their home at least three months before it is available at Netflix, the vending machines of Red Box, or at the video stores.

  To these four studios, this is a new window of opportunity. The math, at first glance, looks appealing. The average ticket price in 2010 was $7.89. The studio’s share is between 40 to 50 percent depending on its deal with the theaters. (Under some contracts, the studio’s cut decreases after two weeks.) This means that at best studios wind up with $3.95 per ticket sold. But for every Home Premiere viewing they wind up with $21 (after giving DirecTV and Comcast their cut.) Even if people watch it in groups, studios can afford to kill off five ticket sales at the box-office per home viewing, and still make money. According to the estimate of a Warner Bros. executive familiar with the research, the studios expect this service will skim off no more than 5 percent of the theater audience. As the Warner Bros. executive calculated it, “we cannot help but make money.”

  No doubt the studios will harvest money from this new service, and even draw away part of the Netflix audience, but, what is conspicuously missing from the equation, is what the theaters might lose. Virtually every modern theater is in a leased premise, with fixed overhead, and a payroll to meet. It makes most of its money, not from the proceeds of movie tickets, but from popcorn and ad sales. The concessions have an 80 percent profit margin; advertising, 90 percent. Together, these two operations, which studios do not get a penny from, provide 75 percent of the multiplexes operating income. If they lose only a small fraction of their audience, this income diminishes accordingly. So how seriously would a 5 percent drop in attendance hurt them? A former senior studio executive who was also responsible for that studio’s movie theater investments, pointed out that in 2000–2002 just a 3–5 percent drop in tickets sold caused almost half of all the theaters in the US to file for bankruptcy. He added ominously that “A 10 percent drop in ticket
sales, and the attendant decline in concessions income and advertising income will close over two-thirds of the American movie theaters—and they will never re-open.”

  If so, the studios, which now are run mainly by former TV executives, are undertaking a highly risky business. They are offering the public the possibility of watching new movies at home without the hassle and expense of hiring a baby-sitter, driving to a megaplex, and buying food at the concession stand. True, such an offer may appeal to only a small part of the theater-going audience, but their assumption that it will not hurt theaters is nothing more than “I-can-have-my-popcorn-and-eat it too” wishful thinking. At this stage no one can predict whether such defections will reach the critical 5–10 percent level. If it does, this new studio harvest might well destroy the exhibition system that created Hollywood—and the movie experience that goes with it.

  DOWNLOADING FOR DOLLARS

  Up until 2007, the studio’s principal access to the home market came through pay-TV, free television, video rentals, and DVD sales. But now, with products such as Apple’s iPod and TiVo-type digital recorders becoming widely available, Hollywood is inching towards an even more lucrative way of exploiting the home market.

  Disney’s ABC network, for example, made a deal with Apple that will allow iTunes users to download and watch shows for $1.99 an episode. The other networks, CBS, which is still controlled by Sumner Redstone, and NBC, a subsidiary of NBC Universal, are selling their programs for 99 cents a viewing via linkups with cable and satellite providers.

  This downloading strategy is particularly appealing to the broadcast networks because, unlike cable networks, broadcast networks presently get little cash compensation from cable operators. (Though this is changing as broadcast stations negotiate retransmission fees from cable and satellite operators.) But by offering their hit programs for downloading the next day, networks get cash from the cable audience. A cost of 99 cents a pop is hardly trivial when multiplied by a cable audience of thirty or so million. The downside is that they may lose part of their regular TV viewers, and the advertising revenue that goes with their loyalty. But the networks are betting that their regular audience, which can watch the programs free, would have little incentive to wait a day and download them for a fee.

  The studios stand to gain even more from a huge audience willing to pay to download movies from their libraries. Unlike DVDs or Blu-rays, which require manufacturing, warehousing, distribution, and disposing of returns, it costs almost nothing to download a movie or cartoon. Indeed, all of the costs of transmission would be borne by the cable operator (or a site like the Apple iTunes Store), whose cut would be less, under present arrangements, than retailers get on DVDs. So if a movie were a huge hit, such as Shrek, and millions of orders flooded in, the marginal cost of filling them would be near zero. The consumer, once he bought the download, could watch it where and when he chose to, just as he once watched a DVD.

  The real issue for the Hollywood studios is how they can dig into this potential gold mine without undermining their existing revenue streams.

  With the possibility of costlessly providing millions of downloads to consumers of both their older and new films, the studio heads, including Disney’s Robert Iger, are openly discussing a radical revamping of the window system. Obviously, if a home download of a movie were available at the same time (and price) as its DVD release, the download option might replace retail sales. To avoid that outcome, and a potentially dangerous confrontation with Wal-Mart, the studios would have to delay the download release until well after the DVD release. But while the studios may find this embarrassment of choices somewhat paralyzing at present, as more and more consumers get digital recorders or video iPods, downloading for dollars may prove irresistible.

  THE NETFLIX FAILURE: A LESSON FROM HOLLYWOOD

  Netflix had been a phenomenal success up until 2011. It began as a mega video store that took orders for DVDs over the Internet and delivered them in red envelopes through the US Post Office. A large part of its appeal was as a huge aggregator of film titles. Because it bought physical copies of almost every DVD title that was released to video stores, it could offer its subscribers any title from any studio soon after it was released. It could rent these DVDs because of the so-called “first sale” doctrine, which says that if you buy an item, you can resell it or rent it, so long as you do not copy it.

  Meanwhile, the entire video business was being upended by new technology. By 2010, Redbox, which dispensed DVDs from vending machines, for less than one dollar a night, was undercutting brick-and-mortar stores, who, with their higher rent and overhead, could not compete. The two largest DVD rental chains, Blockbuster and Hollywood Entertainment, entered bankruptcy, effectively killing the studios’ system for licensing newer titles on DVD. As these stores closed, consumers, unable to find a nearby source for older titles and television series (since they were not carried by Redbox), turned to Netflix to fill the gap. But even though Netflix’s growing numbers impressed Wall Street investors, Reed Hastings, the founder and chairman of Netflix, had to consider the uncertain future of the DVD. The DVD was merely a convenient means of storing a movie. It had been adopted by Hollywood studios in the late 1990s, and had replaced VHS video in a few years because its smaller size made it easier to ship. But it was based on twentieth century technology that was developed before it was feasible to stream movies directly to consumers and store them in the so-called cloud. It was only a matter of time before the DVD was replaced by streaming, cloud storage, and other twenty-first century technologies. When that happened, Netflix’s postal delivery system would be bypassed.

  Hastings therefore decided to build a streaming service. In 2008, he offered Netflix subscribers free streaming of movies to supplement their mail deliveries of DVDs. Copyright law prevented Netflix from streaming the DVDs it purchased. Instead, it had to license the electronic transmission rights to each and every title it elected to stream. Hastings therefore made a four-year sub-licensing deal with the Starz pay-TV channel, paying about $25 million a year. Since these rights had little value in 2008, Starz was happy to add $100 million to its bottom line. This gave Netflix access to a large number of titles for streaming since Starz had output deals with two major studios, Disney and Sony, as well as its own original programming.

  By 2011, Streaming proved so immensely popular with Netflix subscribers that Hastings decided to redefine Netflix as a streaming service. His plan, which he announced on his blog, was to spin off the mail-in service into a separate company that would be called Qwikster. What remained would be a digital deliverer that would have no need for red envelopes, postage stamps, shipping centers, disc cleaning, or an inventory of DVDs. To pressure subscribers to move to this digital service, he planned to raise prices for Qwikster. Of course the new Netflix would no longer be the aggregating service on which its success was built. Now its subscribers would receive only the newer studio movies via Starz. The problem here was that the deal with Starz expired in February 2012.

  When Starz signed the Netflix contract in 2008, it did not foresee the rapid growth of streaming. By 2011, however, it became clear to Starz executives that Netflix’s streaming was competing with its own pay-channel, and, even more importantly, with those of the cable and telecom systems who were Starz’s principal clients. These clients were now demanded pricing “parity,” which meant it would have to change the terms of the Netflix contract so that it could not undercut the prices of its clients. This change would force Netflix to charge premium prices for these newer films, which would mean abandoning Netflix’s policy of charging a single price for all its titles. When Netflix refused to accept this change, Starz broke off the negotiations, and announced in July 2011 that it would not renew the Netflix deal.

  Without Starz, Netflix would be without a deal giving it access to the films of two of the largest studios, and, as a result, would not be able to provide any of the newer films from the five largest studios, Warner Bros., Disney, Fox, Sony, a
nd Universal, until eight years after they were released to the video stores. This would reduce Netflix to a niche service for older movies and TV series.

  Meanwhile, Netflix subscribers began rebelling at the change. Many refused to join Qwikster to obtain DVDs by mail, and others, unhappy with the selection of movies for streaming, quit Netflix. So Netflix reversed itself and eliminated the scheme. Qwikster was killed and Netflix provided both mail-in and streaming. As a result, it still had all the costs of running the mail-in service as well as the costs of obtaining licenses for its streaming services.

  As Netflix’s other contracts expire in 2012–2013, its other content suppliers, including television networks, will also hike the price. To stay in the game, Netflix’s licensing cost will rise, according to the estimates of content providers, by at least a half billion dollars. That is in addition to the $1.2 billion it is presently paying to license digital content (including its deal with EPIX).

  Netflix would require 5 million or so new subscribers to offset the additional $500 million cost. Finding them will be far more difficult than when it launched its service and had no formidable competition in the streaming arena.

  Now it has competition from all directions: Amazon has just launched a movie streaming service that is absolutely free to its 10 million users of Amazon Prime. Apple’s iTunes store and Google (YouTube) are also moving more deeply into the streaming business.

  Then there is Facebook. Here Warner Bros. broke the ice by using it to stream the Batman movie The Dark Knight. And by now all the major TV networks and pay-TV platforms are streaming their programs from their websites on demand. There are also new developments with cloud storage, which allows customers to watch any movie they have purchased on their smart phone, tablet, computer, or other digital device anywhere and anytime without paying additional charges. All the major studios, other than Disney, which has its own cloud storage, plan to offer cloud storage via Ultra-Violet, a service which allows any purchaser of a DVD to keep a digital version of it in a “cyber-locker” which can then be viewed on any digital device. All consumers need do to get their DVDs in this cyber-locker is to register them. Meanwhile, HBO is also offering free streaming of movies, television programs and its original series to its subscribers, and other cable systems, including Comcast, are planning to offer similar services.