Morgan Stanley's Swinburne says film biz has lost half its value

As showbiz congloms tally up quarterly results, they face a harsh realization: Homevideo revenue is still declining, which has slashed the value of film operations at the majors during the past five years, according to one Wall Streeter.

In a provocative report based on corporate earnings and other public data, Morgan Stanley’s Ben Swinburne estimates that 20th Century Fox, Warner Bros., Universal, Paramount and Disney lost an average of 52% in value from 2007 to 2011. (The numbers do not include the studios’ TV operations or consumer product divisions.) Sony breaks out fewer numbers for its film biz and therefore wasn’t included.

Of the majors, U took the biggest hit, down $6.5 billion, while Par was affected the least, down $1.5 billion.

While the discussion isn’t new, the effect has rarely been laid out in such stark terms. Studio execs were quick to question Swinburne’s methodology and conclusions.

The report is making waves just as media congloms prepare to roll out first-quarter earnings, inviting more scrutiny of Hollywood’s shifting economics. Hollywood values could continue to fall, Swinburne said earlier this month, “leading us to the conclusion that only through significant realignment of cost levels, particularly in the area of marketing and distribution but also overall production costs, can values be maximized given the revenue outlook.”

In other words, homevid revenue can no longer make up for the rising production and marketing costs of most studio movies.

But execs at four studios begged to differ. Most said it would be near impossible to derive Swinburne’s numbers using available data. Some studios combine film and TV production in their earnings reports and none break out costs.

One studio rep noted that Universal fell much more than the others, skewing Swinburne’s average, which the rep said “was kind of unfair.” He also noted that the report valued U about the same as much smaller Lionsgate Entertainment, which has a market cap of $1.5 billion.

The 52% figure “is completely off base. I don’t think it’s fair or accurate,” said a top exec at a major studio.

But he and others mostly put the emphasis on opportunities going forward — in international markets, particularly China, new services like UltraViolet and Blu-ray and stronger VOD are seen as ways to help revive homevid divisions. “Obviously our industry is shifting, and that’s no secret, and we are trying to shift with it,” said an exec at another major.

By Swinburne’s estimates, Universal’s value took the biggest hit over the past few years, dropping from $8.1 billion to $1.6 billion by the beginning of 2012. Disney follows, going from $10 billion to $7 billion. The report values Paramount at roughly $2.6 billion, down from $4.1 billion in 2007. Fox dropped from $10.2 billion to $4.2 billion, while estimates peg Warner Bros. at $3.9 billion, down from $7.8 billion.

In an earnings preview Monday, Michael Nathanson of Nomura Securities said homevid unit sales for the three months were down 5.3% — an improvement from the high single-digit declines in the fourth quarter but worse than the third quarter, when DVD sales dipped only 2%. The data excludes one of the market’s bigger physical distributors, Walmart, but he said, “we believe it to be a good proxy of industry health, which we still believe to be a secular declining business.”

Nathanson said NBCU’s film studio led its peers with 17% growth, while Lionsgate, Sony and 20th Century Fox all declined by more than 20% due to tough comps and less product for sale.

Swinburne acknowledged that growth in international box office and TV markets and emerging digital distribution models have helped offset homevid revenue declines. But these streams haven’t yet made up for lost ground at a time when consumers are getting more used to paying less for content.

Richard Greenfield of BTIG Research asserts that “Hollywood’s problems go beyond declining interest in buying movies — consumers are also less interested in going out to the movies.” Home theaters are taking off, with the average TV purchased for a U.S. living room now a 44-inch HDTV screen, he said, calling for a united effort to collapse theatrical windows to four weeks, despite pain to exhibitors. “Movie studios need to focus on generating returns on their investment that is acceptable to justify their continued investment in making movies.”

While the overseas box office has helped recoup some of the homevid declines, according to Swinburne, movies cost more to make and market and splits are less favorable overseas. That’s led to an average 12% annual decline in cash flow between 2007 and 2011.

Lucrative sell-through models have ceded ground to lower margin rental businesses like Redbox and Netflix, which offer nothing like the traditional cash flow from the old-time Blockbuster Video stores that used to dot virtually every corner.

Rental has grown at 5% a year since 2007, while sell-through declined by 10%-12%. Kiosks and subscription services made up 53% of total homevideo spending last year, and Swinburne sees that going to 60%-65% by 2015.

Netflix and Redbox “are growing at the expense of high contribution margin ones,” Swinburne noted. “From a consumer point of view, spending 50¢ per film on Netflix, the incentive to rent a film at $4 to $5, or buy a digital copy at $10 to $15, goes down considerably. The delayed Netflix window may not be enough to make up for the lower price point.”

Swinburne also notes that cloud service UltraViolet had a bumpy start and Blu-ray is growing but not fast enough yet. Consumers are buying more discs but not replacing entire libraries as hoped, while VOD is still evolving.

One positive is that more players are entering the streaming contest, which will likely drive up the price of content. Verizon and Redbox are teaming to take on Netflix along with Blockbuster’s Movie Pass, Comcast’s Xfinity Streampix, Amazon and a handful of others.

Studio execs note that UltraViolet just got a big push from Walmart, which will take hard discs and transfer them to a cloud locker for a small fee. Once it takes off, studios will be able to tell who’s buying what, and the ability to market efficiently will improve exponentially – “effecting studio economics in a profound way,” said one exec.

Studio execs also cite the massive Chinese market: It seems to be opening to Hollywood, allowing in more foreign films, and the number of theaters is exploding. It’s also an untapped homevideo market, although piracy is a major issue.

And there are other areas studios could trim, according to some experts.

“The country offices can be dramatically consolidated,” said attorney David Stern, a partner at Jeffer, Mangels, Butler and Mitchell. “Many studios operate multiple distribution arms … multiple business affairs departments, multiple participations payable departments … Maintaining some of these back-office operations separately is classic empire building and vanity.”

Greenfield is focused on the window between theatrical and home entertainment. Collapsing it has been successful for some independent films. “Unfortunately, the major Hollywood studios that attempted to ‘trial’ or ‘test’ releasing movies earlier have succumbed to the aggressive push back from exhibition chains. The time has come for every studio to stop trialing and permanently collapse windows as the new Hollywood business model. Exhibitors will acquiesce, as they simply cannot afford to be without content from Hollywood. It is time for studios to play offense.”

Meanwhile, studios may just have significantly less tolerance for costly flops. Walt Disney’s Rich Ross left his job as head of the studio after the division took a painful $200 million loss on “John Carter.”

Media companies are not going to exit the film biz. Studios on average make up 15-20% of their parent’s profits, “not nearly as big a deal as it was ten or twenty years ago,” said Alan Gould of Evercore Partners.

Since analysts are generally upbeat on TV, they aren’t all fret
ting over the studios or the stocks, which some think are even undervalued. From Wall Street’s perspective, said Gould, is that congloms have “morphed into being cable network companies.”

Likewise, if one of the major studios ever does goes on the block, it would fetch a price well above Swinburne’s valuation.

“There’s a scarcity factor. There are only a few studios and the barriers to entry are impossible,” said one exec.

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