The Hollywood Economist (16 page)

The answer, alas, is that the indie financier is essentially correct. The hoary game of using foreign pre-sales to finance the production of American films, which was pioneered by the Italian impresario Dino Di Laurentiis in the 1970s, is now nearly over. It involved using what were essentially promissory notes from foreign distributors as collateral to borrow the funds necessary to make a movie. Here is how it is (or was) played.

First, an indie producer assembles a script, director, and stars acceptable to a “territorial buyer.” The most important territorial buyers are distributors in Germany, France, Italy, Britain, Spain, and Japan. Then he signs a contract giving the buyer theatrical, DVD and TV rights to the territory in return for an agreed-upon sum to be paid at a future date when the completed film is delivered. Ideally, the foreign buyer also provides an assignable letter of credit that will become effective on delivery. The producer repeats this process with other foreign buyers for different territories until he has enough paper commitments to finance the movie. But before he can
monetize them, he also needs to get a completion bond, backed by an insurer, that guarantees that the film will be completed with stars and other essential elements specified in the contracts. This requires the producer furnishing a budget to a completion bond company and accepting its conditions. Finally, he goes to a bank with the completion bond and the contracts and borrows the money covered by the pre-sales agreement. The bank takes only a limited risk since if the film is not completed and delivered, it is repaid by the completion bond company, and if delivered, it is repaid by proceeds from the letters of credit from the foreign buyers. So it deducts the pre-paid interest and other banking fees, and gives the producer the balance. As complex and time-consuming as the process is—it can take years to complete—these pre-sales had been the mainstay of the indie industry for three decades up until 2008. Then came the perfect storm.

First, DVD sales fell by more than 20 percent in all the major pre-sales markets in 2008, and even more in 2009. Given this trend, the foreign buyers realized that they could no longer rely on DVD revenues in the future to make up the gap in their commitments. To make their situation even worse, television stations in Europe, which had been the largest buyers of movie rights in Europe, found
their budgets constrained by the financial crisis and severely cut back on their future purchases. On top of these problems, the rapid expansion of broadband in Europe and Asia greatly increased the ease of digital downloading. Since many of these territories opened films many months after the American release, the availability of pirated versions threatened to undercut the stream of revenues from theaters. As a top executive of a French distributor said, “Why should we buy in advance the exclusive rights to a movie when our potential customers can download it before we can release it?”

Further dampening these foreign buyers appetite for making pre-sale deals was the failure of indie films to get distribution in America (which they often depended on to generate publicity for their release). As one indie producer wrote me “foreign distributors tend to buy films that have meaningful US muscle behind them,” but by the time she arrived at the Cannes festival in 2008 to look for such deals, five major US distributors for indie films—New Line Cinema, Fine Line Features, Picturehouse, Warner Independent Films, and Paramount Vantage—announced they were closing, while others, such as the Weinstein Company, said they were running out of money. By November 2009, the situation grew even gloomier, with Miramax announcing
it was closing its main office in New York. The bottom line for foreign buyers is that many of the movies being offered to them for pre-sales after 2010 may never have a major opening—or publicity blitz—in America.

The coup de grace may have been the global financial crisis. Some banks, whose balance sheets were hurt by bad debt, such as Deutsche Bank, closed down their film financial units and others now insisted on far more strenuous, and onerous, terms to finance pre-sales. One indie producer based in New York complained, “Even if one can find pre-sale deals it is now almost impossible to get money. The banks that used to lend us money against these licensing contracts are now demanding written guarantees from the territorial buyer that they will be paid even if the movie is not delivered.” To get a foreign buyer to agree to such terms—which in effect makes him responsible for the completion bond—would require further concessions by the producer. Moreover, each new turn of the screw by banks escalates the producer’s legal costs, especially if they are billed by the hour. According to the New York producer, his transaction costs for pre-sale deals both in terms of time and money have now risen to the point that “they no longer make financial sense.”

This confluence has left indie movies in a dire situation. Nevertheless, in the curious mirror world
of Hollywood, hope springs eternal, even if it comes in the form of a rich relative, Chinese tycoon, or Indian industrialist entranced with a movie fantasy. While studios are increasingly concentrating their energies on comic book sequels, indie producers have shown great resourcefulness in exploiting original ideas, such as
Slumdog Millionaire
. All they need is to find a new strategy for financing their alternative to Hollywoood.

In the new millennium, Robert Iger, former head of ABC television, got Michael Eisner’s spot at Disney. Brad Grey, the former head of a television production company, Brillstein Grey Entertainment, became the studio head at Paramount. Howard Stringer, a former president of CBS Television, became the first non-Japanese chairman of Sony. Peter Chernin, a former president of Fox broadcasting, became chairman of the Fox Entertainment Group, which includes the Twentieth-Century Fox studio. Robert C. Wright, the former head of NBC television, became head of NBC Universal, which owns the Universal studio. And Jeff Bewkes, the head of HBO, became chairman of Time Warner. That all of Hollywood’s new moguls have come from the
realm of television reflects a singular if dismal reality: in 2009, only about 2 percent of Americans went to the movies on a given day, whereas more than 90 percent of them watched something on television at home. What used to be a business centered in movie houses has been transformed into a one centered around TVs and computers. In 1948, ticket sales from theaters provided all the studios’ revenues; in 2007, theaters in the United States and aboard accounted for just over 20 percent of the take. Instead, home entertainment provided nearly 80 percent of the revenue.

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 station 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.

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 number 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-of-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 3, 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.