The Hollywood Economist 2.0

by Edward Jay Epstein

  Delivery in the future will no doubt take advantage of cloud technology to provide movies and TV shows to the growing number of iPads, Kindles, Nooks, and other tablets. In this new environment, Netflix will have no advantage over anyone else that owns or licenses content.

  While there is a plethora of digital entertainment in the world, there is only a limited number of movies and television series that people will pay to see. This is the premium content that Hollywood makes. It is content that it establishes in thousands of theaters, hypes through $40 million ad campaigns, attaches the names of iconic stars, and, in the case of its TV series, shows on the major television networks. The lesson Netflix learned is that for a digital distribution business it is necessary to license or control this premium content. As long as Hollywood maintains a near monopoly over premium content, it has the winning hand, now and in the future.

  TRADING ANALOG DOLLARS FOR DIGITAL PENNIES

  In early 2008, a top studio executive, discussing the previous year’s revenue numbers, said, “Who in their right mind would swap these analog dollars for digital pennies?” The “analog dollars” he went over with me were indeed impressive. They came from DVDs (though they are not analog products), pay television, cable and network television, local stations, and licensing products. The “digital pennies” he referred to came mainly from downloading from Amazon Video on Demand, the Apple iTunes Store, and other websites. Since most of the audience still watched their movies on TV sets rather than on their computers, he saw little reason for the studios to jettison what in the past ten years had proved to be a highly lucrative business model for a nebulous one. The studios’ 2007 numbers powerfully supported his point. The six major studios’ “analog dollars” amounted to $42.9 billion, with $8.8 billion coming from theaters, $16.2 billion coming from pay and free television, and $17.9 billion from DVDs. That year, the studios’ “digital dollars” from downloads amounted to less than $400 million.

  Less than two years later, this same top executive had radically revised his thinking. He said that the home TV sets on which 100 million Americans watched the studios’ movies, either on DVDs, pay-TV, or free-TV, would soon act as computers. The “tipping point” will come as new sets allow the audience to surf the web with their remote control. By the end of 2010, almost all major TV manufacturers in Japan, Korea, and China will equip their sets with this technology. At the very minimum, this development will mean that the TV audience will have at their fingertips an immense amount of non-Hollywood product. Consider that in 2009 alone, YouTube streamed more than 9 billion videos; Hulu, a service that did not even exist in 2007, sent TV programs to 35 million computers, and Microsoft’s Xbox, Sony’s PlayStation, and other game machines had 40 million users. Clearly, as couch potatoes become websurfers Hollywood will have to compete with all this material for their limited time, or “clock.”

  Even more threatening, the TV-as-computer hybrid will give the entire home audience far easier access to pirated versions of Hollywood’s movies and TV programs. For most of the twentieth century, Hollywood could control its movies because it had a tangible product: reels of film that it could deliver and retrieve from theaters. But the digital revolution changed everything. Movies now can be distributed by a digital formula. And from those ones and zeroes, the movie can be reconstructed in perfect fidelity by a tiny computer chip. Even with the support of governments, private detective agencies, and armies of litigators, the studios have found it difficult if not impossible to quash the copying of these digitalized formulae over the Internet. Each effort to suppress them has led to more ingenious ways to share them. Consider, for example, the recent spread of “cyber-lockers,” which are essentially online storage sites. They hold a large number of movie-sized files that can be downloaded by anyone who has been given, or bought, a password. Because the studios’ enforcement agents cannot ascertain the contents of these lockers without the passwords, the lockers are almost impossible to police. Compounding the problem, the hosts are often located in countries outside the purview of American or European copyright laws. As a Warner Bros. technical operations chief explained in 2008, many now serve as “facilitators to access pirated content.”

  Such piracy cuts directly to the heart of the studios’ current practice of staggering the release of their products over a long period—the so-called “windows” system. As Howard Stringer, the chairman of Sony, explained to me, studios depend for their profits on their ability to “optimally leverage” their movies in these different media markets. So after the multiplexes play a movie, it is released first in video stores, then on pay-TV channels such as HBO, Showtime, and Starz, and later on free and cable television. Thus each market gets an exclusive window for its version of the movie. But if the vast home audience can get immediate access via downloads from cyber-lockers and other Internet sources, the exclusivity loses its value, and the entire window system cracks. Why should HBO pay $15 million for rights to an exclusive window for the latest Harry Potter movie when its viewers can download it from the Internet?

  By 2009, the handwriting was on Hollywood’s wall: its windows could not be kept open in an age in which its crown jewels—movies—could be perfectly replicated on a computer. One alternative would be for Hollywood to attempt to protect the windows by stamping out digital piracy. Such a feat would require not only the cooperation of authorities in every country that could host a website or cyber-locker, but a global campaign to change the values of users who see nothing wrong with sharing digital downloads. Another alternative would be to abandon the windows system and attempt to preempt the effects of digital piracy by releasing movies almost simultaneously to multiplexes, video stores, download services, and television. One top Paramount strategist foresees a scenario in which, after multiplexes are converted to digital projection, “a movie opens on 25,000 screens around the world in a single weekend, and within a week it’s available for downloads, Netflix, video stores, and cable television.” This would allow the ad campaign—and its word-off-mouth—to promote it in any form that anyone is willing to pay for. Such a drastic remedy could not help but affect which films the movie studios produce, since to activate the interest in a global mass audience, new movies will require universally appealing elements (action, graphic content) and easily comprehended themes.

  Hollywood, to be sure, is not a single entity. Between them, the big six studios—Disney, Fox, Time Warner, Viacom, Universal NBC, and Sony—control almost all movie distribution in the United States. Their corporate parents have very different interests. Universal NBC, for example, makes most of its money from its ownership of television and cable networks, whereas Sony, which owns no television networks, make a large part of its money from manufacturing digital hardware, including its PlayStation, DVD players, and high-definition televisions. These companies also have very different leadership styles. But even if they wanted to collude on their responses to the digital challenges—or on the pricing of downloads and DVDs—they would be prohibited from doing so by both American and European antitrust laws. Perhaps they will fare better than their counterparts in the music business did in suppressing digital copying; if they don’t, they will almost certainly suffer a similar withering-away of the “analog dollars” that flow in through their staggered windows. The separations between these windows will make less and less sense, and at some point, one studio owner—my candidate is Rupert Murdoch—will decide to break with the status quo and move toward the alternative of simultaneous releases. Others will then follow right on his heels. Hollywood will swap its vaunted analog dollars for digital pennies, but it may well discover that there are billions of those pennies out there.

  EPILOGUE

  HOLLYWOOD: THE MOVIE

  Hollywood has spent the better part of the last century making movies out of the great inspirational sagas of human history. Ironically, the one epic it has yet to make is one about a uniquely American achievement that has and continues to mesmerize the world: The Rise of Hollywood.
Here is a true Sturm und Drang melodrama, full of fascinating characters from the edges who overcome seemingly impossible obstacles to build a new industry that today defines the world of mass entertainment. The scenario would follow the classic Hollywood three-act formula.

  ACT ONE

  Fade in on the men who founded the studios of Hollywood. These are self-made and self-educated Jewish immigrants from European ghettoes, who, before they got into the movie business, had been ragpickers, furriers, errand boys, butchers, and junk peddlers. They are true outliers: men like Louis B. Mayer, Samuel Goldwyn, Jack Warner, Adolph Zucker, William Fox, Carl Laemmle, and Harry Cohn, who first scraped together money to build arcades and nickelodeons to show movies, then resourcefully expanded into theater circuits, using bicyclists to deliver reels between their theaters. As movies become a national craze, they build distribution networks to service other exhibitors, and then studios to assure that they have enough movies. Along the way, they battle part of the establishment in the form of the powerful Edison Trust, which, aside from its patents on electricity generation, holds numerous patents on movie cameras and projectors. When “the Trust,” as it is ominously known, attempts to use the courts in New York and Massachusetts to take over the movie business, the movie-makers move their studios to the newly incorporated village of Hollywood, a place they can control and build. By the mid-1920s, 57 million people—over half the population—are going to their movies every week. Yet the saga is just beginning. In 1927, sound comes to the movies. After audiences are mesmerized by Al Jolson in The Jazz Singer, Hollywood, in one of the great technological feats of modern history, converts most of the 21,000 movie theaters in America to sound and turns their studios into sound stages. The studios create new galaxies of stars for their talkie movies. Despite even the great depression of the 1930s, the weekly audience grows to 75 million, who go to their neighborhood theaters not just to see feature movies, but newsreels, comedy shorts, action-packed serials, and cartoons. A new generation of talent, including such brilliant innovators as Walt Disney, expands its realm to children’s entertainment, and color adds to its ability to entertain the public even in the bleak years of the Depression and the grim war years of the early 1940s.

  ACT TWO

  The Second World War has ended, the troops have come home. By 1948, the studio system is at its zenith. More than 90 million Americans—two-thirds of the population—go to the movies on a weekly basis. The studios produce more than 500 feature movies per year, have all the major stars under ironclad contract, and employ more than 320,000 people. Their illusion-making technology is unmatched anywhere in the world. In little more than a generation, its founders have literally gone from rags to riches. The studio heads, now called “moguls” after Oriental potentates, are among the highest-paid executives in the world.

  But a new invention is casting an ever-darkening cloud: television. Even with its fuzzy black-and-white pictures, it offers nearly free stay-at-home entertainment, which gradually captures a larger and larger portion of the studios’ habitual audience. In addition, a long-simmering antitrust action severs the studios’ hold on American theaters. According to the consent decree they sign, they must divest themselves of the theaters they own and give up their practice of forcing independently owned theaters to book an entire package of movies if they want any at all. The final blow to the studio system comes when stars, at the behest of their newly empowered agents, refuse to sign long-term contracts. The moguls now have to compete with independent and foreign producers for both theater bookings and stars.

  After color TV is introduced in the 1950s, the movies’ weekly audience goes into free fall. By 1958, it is less than half the size of the 1948 audience. Drive-ins, Cinemascope, 3-D, Surround Sound, and other innovations fail to win back the audience from television. The entertainment landscape in America has changed, and reflecting this change, the stock prices of studios plummet to levels not seen since the Great Depression. Prophets of doom predict that the end of Hollywood is near.

  ACT THREE

  However, the prophets have underestimated Hollywood’s resourcefulness. For a half-century, its genius has been its ability to adapt to new circumstances. It is, after all, in the business of entertaining mass audiences, and those audiences, though diverted, have not vanished. So Hollywood reinvents itself. The old studio system, with its contractual control of theaters and stars, is dead; long live the new studio system. Unable to depend on a habitual weekly audience that has defected to television, it turns television to its own advantage by using national TV advertising to create tailor-made audiences for each and every movie. It greatly expands its reach overseas, creating a second stream of revenue from theaters and television abroad.

  Nor does the new Hollywood limit itself to theaters. It finds new sources of revenue in licensing its movies to television, originating prime-time series, renting its movies on home video, putting them on planes and in hotels, reincarnating their characters as toys, and then, with the digital revolution, putting its movies on DVDs, Blu-ray discs, video-on-demand, cell phones, and the Internet. Since networks are restricted by a Federal Communication Commission rule from having a financial interest in their programming, the studios become the main suppliers of prime-time television (which they could later sell to local stations). This expansion not only keeps the movie business alive, it makes it central to the world’s entertainment economy. But beyond the movies, the money, and the job creation, Hollywood produces another form of wealth: the pictures in our head by which the world at large defines the phenomenon of American culture. What a movie that achievement would make.

  APPENDIX I

  WARNER BROS.

  DISTRIBUTION REPORT #6

  Midnight in the Garden of Good and Evil,

  September 30, 2007

  This report reflects the financial status of the 1997 movie Midnight in the Garden of Good and Evil eighty-seven months after its release, a span long enough to reflect TV licensing and other back-end revenue. Based on the hugely successful novel by John Berendt, it was directed by Oscar winning director Clint Eastwood, and starred Jude Law, Kevin Spacey, and John Cusack.

  1. “Defined Gross” is a term of art in Hollywood accounting used to avoid any confusion or litigation over what is meant by “Gross.” In the case of everything but video, it is the total revenues that are received from all sources. In the case of video (which includes both VHS and DVD), it is a royalty, which, in this case, is 20 percent of wholesale sales.

  2. “Fee” refers to the fee taken by the distributors, Warner Bros. Pictures and Warner Home Video, both of which are wholly-owned subsidiaries of Time Warner, which financed the movie.

  3. The advertising and publicity expense of $33.8 million and the print cost of $3.4 million include foreign as well as domestic costs.

  4. “Residual Payments” include the fixed amount deducted from television licensing for pension plans. This applies to every film made with union labor (which is virtually every studio-made movie in the world).

  5. “The Defined Proceeds,” in this case a deficit, is $85.5 million. This includes interest of $22.7 million, which is a notional charge (though studios do pay interest on their lines of credit).

  6. “Negative cost” refers to investment in the film itself. It includes above-the-line expenses, such as the money paid for the book, script, producer, director, and principal actors, and the below-the-line costs, which include daily shooting, editing, and post-production.

  7. “Total Domestic Theatrical,” which includes Canada, is $10.3 million. Since the theater box office is $25.5 million, the studio gets only about 40 percent of the box office. This is probably due to the release deal in which theaters reduced the distributor’s share after the first two weeks as the price of extending its run. It is also interesting to note that the off-the-top expenses of $32.7 million are more than three times more than the studio’s share of the domestic box office (even though it ranked fourth the week it opened).


  8. In addition, a $3 million distribution fee was deducted. Warner Bros. could charge a 30 percent fee because it financed the film.

  9. The film also lost money on its foreign theatrical distribution, with the expenses of $6 million almost twice the gross. In addition, there is a distribution fee of $1.23 million.

  10. The richest profit is the nearly $10 million from US pay-TV. This is a result of an output deal that Warner Bros. has with HBO, another Time Warner subsidiary. Note that unlike theatrical release, there are only $308,000 in expenses.

  11. Foreign pay-TV revenue of $9.6 million is also the result of Warner Bros. output deals.

  12. The domestic video gross of $4.7 million is the 20 percent royalty received from wholesale sales of $23.5 million by Warner Home Video. Warner Home Video retains the balance of $18.8 million to pay the costs of manufacturing and selling the videos, which is probably less than $3 million.