The ability to watch a movie or TV show at home on a videocassette, or DVD or Blu-ray disc, has had a profound impact on the economics of the motion picture and television business. Not only has the video market altered the consumer’s consumption pattern of watching movies, but it has also changed the underlying financial modeling of whether a movie, and in cases TV shows, are made in the first place. Despite the rapid and wide market penetration of new technologies such as DVDs, it is a testament to the cultural impact of videocassettes that the studios, at least colloquially, still refer to their divisions as Home Video. In fact, the word “video” in this context has become a misnomer, a catch-all of sorts that conceptually captures the varied devices that have evolved allowing consumers to watch films on their television, over a computer, via game systems, or more recently via tablets and other portable means.
In terms of profitability, the video market has provided a boon to studios’ bottom lines. While the profitability on a new movie is generally measured in a single life cycle (e.g., theatrical, video, television, ancillary and new media revenue streams), the video market has added the magic of reincarnation by inducing consumers to keep buying the same product again and again with each new technological upgrade. The net result is that home-video revenues (i.e., revenues from sales of physical discs) grew to represent about half of studios’ total film revenue. Figure 5.1 below illustrates how, in the early to mid 2000s, video captured nearly half of a studio’s revenue pie1; Figure 1.5 (see Chapter 1), in contrast, depicts how that percentage has dropped precipitously to roughly one third in the last five years or so.
Figure 5.1 Studio Revenue Breakdown, 2007
© 2009 SNL Kagan, a division of SNL Financial LC. All rights reserved.
Although this percentage has been steadily declining from its peak of roughly 50 percent of total revenues, the absolute numbers remain significant, and entering 2012 video still remained the single largest revenue segment (again, see Figure 1.5). Additionally, and quite importantly, beyond capturing the biggest slice of the revenue pie and exploiting the churn factor, the studios have managed to keep a larger share of the video revenues. Typically, studios (and networks, as applicable) pay participations based on a royalty percentage rather than accounting for the gross sums, which in turn makes video distribution uniquely profitable.
The evolution of the home video business is not over, and in this chapter I will review the genesis and growth of this approximately $14 billion market segment (down from a peak of $24 billion; see Table 5.1 on page 207), explore the radical changes that have taken place at retail distribution since the early 1990s, and discuss the underlying P&L models of how the business works and why videocassette/DVD/Blu-ray distribution returns some of the highest margins in the distribution life-cycle chain. I will also review how this ancillary revenue source has spawned profitable original production (i.e., made-for-video), discuss marketing nuances driving home video consumption, outline some of the profound technical changes that have been catalysts for a reinvention of the category, and explore the impact that video release patterns/windows and piracy have had on the other parts of the business.
Finally, although new technology applications, including downloads and video-on-demand (VOD) access are inextricably tied to the future of the video market, I address these growing markets (together with watching video via tablets and other portable means) in Chapters 7 and 8, and focus here on the traditional video market. Nevertheless, I will touch on aspects such as the intersection of electronic sell-through (i.e., downloads to own) and the implications of infinite shelf space and depth of copy compared to physical retail sales.
In summary, this chapter will explain how and why the video business (again, here meaning physical discs as opposed to on-demand/digital permutations) has emerged to drive the largest positive cash flow of any studio division, while at the same time providing the safety net for studios to make certain pictures at all. With this level of vested interest in the business, it is not surprising that studios and networks alike are schizophrenic regarding download and other new technology platforms that are expanding video’s reach while threatening to replace what has evolved into a pillar of the studio distribution (and financing) infrastructure.
To grasp the value-for-money proposition inherent in marketing a DVD of a hit movie, simply pause to think about one of your favorite recent films. That movie probably took over five years (and likely many more) to move from concept to release in theaters; over that period, hundreds, if not thousands, of people were involved in the production and release of the movie. On the financial side alone, and assuming the film is a major studio picture, it probably had an investment risk, including costs of producing, marketing, and releasing the film, of over $100 million. Wrap those years of hard work, incalculable passion and creativity, and dollars together and what do you have? You, the consumer, can take home a product that cost the studio over $100 million and years of work for about $20, and often less; better yet, you can rent the movie for about $3.
Whether renting or buying, the product is also perfectly tailored to the freedoms made possible via innovations in the consumer electronics industry: you can watch it when you want and where you want. This pitch is not often made overtly, but at a subliminal level, when advertisements say “own it today” or “bring it home today,” they are saying you can own for $20 what it took us over $100 million to make, and you can watch it over and over for free and at your leisure. You do not have to go back very far when the concept of an average citizen owning a movie and watching it at home was beyond the grasp of reasonable expectations.
What other products can compete with the value of a video? Perhaps a record or CD of a concert, capturing the moment, are somewhat equivalent. If you had asked the people starting up studio video divisions, many of whom migrated from the record side, whether they would be happy to be as large as the record companies, they would have thought you were crazy. Certainly, it was not within upstart business plans that the revenues could come to surpass the music industry. It is not a stretch to state that video recorders and videos, and the improved technical iterations spawned, including most prominently DVD and now Blu-ray, have been considered the most important product invention to hit Hollywood since television. And yet, as grandiose and accurate as this statement may be, the pace of change in the online world has been so great that it is conceivable to view VOD access as quickly usurping the video mantle; VOD access, though, benefits enormously from the consumer renting culture spawned by home video, and to understand the shifts today and the economics of VOD access (whether à la carte or subscription, streaming or download) it is important to appreciate the models, history, and economics of video that paved the way for personal/home viewing.
Accordingly, I will touch on a number of questions: How did video turn into big business? Where is the business headed, and why has it become the lifeblood of studio profitability? Is it possible that just as quickly as the video market grew to dominate distribution revenues, we are at the cusp of a decline so steep that in a few years, videos/DVDs/Blu-rays may disappear? Will the traditional video market be relegated to a historical footnote along with physical film prints, and be entirely replaced by on-demand digital media accessible via a range of new devices, including living room staples (TVs and game systems) and a host of portable devices (e.g., tablets)?
History and Growth of the Video Business
Early Roots: Format Wars and Seminal Legal Wrangling
The first consumer-targeted videocassette recorders were marketed in the 1970s, when Sony introduced the Betamax VCR. The introduction of the VCR faced the same chicken-and-egg dilemma that now seems commonplace with every new technology targeted at consumers’ consumption of entertainment: Was there a match between the hardware and software base? When Sony’s system was introduced, there was essentially neither software nor hardware available, much like the problem facing the launch of the DVD industry 20 years later in the mid 1990s.
To overcome such a hurdle, at least one party needs to take an enormous risk. In the case of the DVD, it was Warner Bros. leading the charge (see page 212, “Early Stages of the DVD: Piracy Concerns, Parallel Imports, and the Warners Factor”), but the true early pioneer of the business was Sony in the days of the Betamax introduction. Interestingly, and disproving the first-mover advantage, despite building the market (and to many having a superior format/product), Sony did not emerge as the leader.
Sony’s visionary idea was that consumers would pay to be freed from television’s broadcast schedule (sound familiar today?): the Betamax VCR would allow them to watch programs when they wanted, not as dictated by the network’s broadcast schedule. The VCR was not originally positioned as a playback device for movies. Sony’s CEO, Akio Morita, said at the time: “People do not have to read a book when it’s delivered … Why should they have to see a TV program when it’s delivered?”2 Accordingly, Sony marketed the Betamax VCR hardware player, which utilized a proprietary tape generically called the Beta format. Its marketing campaign echoed Morita’s theme, pitching the player as a machine allowing consumers to “time-shift”: consumers could record television programs and view them later at a more convenient time.
Whether history is repeating itself or technology advances enabling services such as Hulu are finally realizing Morita’s original vision, it is clear we are now on the threshold of totally taking the programming out of the broadcast scheduler’s hands. As alluded to in Chapter 6 and further discussed in Chapter 7, not only have DVRs made recording easier, but we can now envision (and, in fact, already experience) future iterations where TV is consumed in a playlist fashion, where viewers through VOD or other access select the programs they want to watch and then consume them according to their own programming schedule (which may be optimized or random).
Returning to the roots of the business, two factors greatly contributed to the explosive growth of the VCR market. First, and a point not often cited (and I will admit somewhat subject to challenge), the advent of the VCR was in the same general period as the emergence of cable TV in the U.S. Not only was the notion of time shifting attractive, but it was even more attractive in an environment of blossoming program choices. For decades, U.S. consumers were limited in programming choices to the three major broadcast networks plus a handful of local UHF stations; with cable TV came an explosion of choice.
Second, and more importantly, the ability to rent movies from video stores caught on like wildfire—the concept of building a library of tapes and renting tapes out for a price no more than a movie ticket proved revolutionary. Independent stores, which quickly gained the industry nickname “mom and pops,” led the growth and proliferated throughout neighborhoods. It was an ideal small business, preying on pent-up demand and taking advantage of modest start-up costs (including the need for limited space); further, video rental was a cash business that built a loyal customer base virtually on its own via a regular supply of new product.
As great as this seemed for Sony and the new breed of video rental entrepreneurs, the whole notion of video rental seemed a looming disaster for the Hollywood studios who produced the films. The studios saw the VCR as a means of copyright infringement. The underlying economic fear was that individuals would copy movies and TV shows (and keep them for a home library), which would undermine the market to exhibit the programs on television. Universal’s president, Sidney Sheinberg, upon seeing the Betamax time-shifting campaign, and fearing the loss of revenues that could lead from unauthorized copying of Universal’s product, sued Sony for copyright infringement.
The resulting case, which was initially brought in 1976 and ultimately decided by the U.S. Supreme Court in 1984, was a landmark lawsuit that paved the way for DVDs, arguably saved the studio system, and is once again being pointed to as threatening the integrity of the distribution system (as new online services push the VOD envelope).
The Betamax Decision: Universal v. Sony
The ultimate finding in what has come to be known as the “Sony Betamax” case is that time-shifting via home copying for noncommercial purposes was permitted (in legal jargon, a fair use and non-infringing of copyright; for a further discussion of copyright, see Chapter 2). Before the Supreme Court reached this verdict, Sony Corp. v. Universal City Studios3 went through a litany of phases, with each side supported by name-brand media allies. Universal was joined by Disney, who saw similar infringement of its copyrights and potential loss of television broadcast revenues. Sony was supported by the sports leagues, including commissioners of the national football, basketball, baseball, and hockey leagues; these leagues believed that VCRs were a benefit to live events, allowing fans/consumers to see games they would have otherwise missed. Another important Sony supporter was the Corporation for Public Broadcasting, believing that it was a good thing for children to be able to see educational programming and that VCRs promoted this end; further, it was endorsed by Fred Rogers, the star/producer of the classic preschool show Mister Rogers’ Neighborhood.
In the end, after an eight-year legal odyssey, the Supreme Court reasoned that a significant number of copyright owners would not object to their content being time-shifted, that there was insufficient proof the ability to time-shift would undermine the value copyright holders would receive from licensing their content to TV (which proved to be true, as license fees increased over the following years), and therefore the Betamax was capable of “substantial non-infringing uses.” Interestingly, the Supreme Court, in an almost prescient statement recognizing that new technological advances—advances like the Internet, file sharing, and VOD access via social media, of which it could not have been aware—would force it to consider the broader issues in the future:
… One may search the Copyright Act in vain for any sign that the elected representatives of the millions of people who watch television every day have made it unlawful to copy a program for later viewing at home, or have enacted a flat prohibition against the sale of machines that make such copying possible.
It may well be that Congress will take a fresh look at this new technology, just as it so often has examined other innovations in the past. But it is not our job to apply laws that have not yet been written. Applying the copyright statute, as it now reads, to the facts as they have been developed in this case, the judgment of the Court of Appeals must be reversed.
It was a close decision (5–4), and whether or not one agrees with the logic (or cynically believes that the court needed to craft a political opinion, allowing the flourishing video business to continue), the video business was officially sanctioned. By 1986, just a couple of years after the landmark Sony decision, combined video rental and sales revenues ($4.38 billion) exceeded the theatrical box office ($3.78 billion) for the first time. By 1988, rental revenues alone ($5.15 billion) exceeded the theatrical box office ($4.46 billion).4
Among the ironies of the case is how the party most vested in the case (Sony) ended up losing the battle for consumer dollars, and how the plaintiff (Universal) came to be bought by one of the hardware manufacturers that benefited from the verdict. Matsushita, the parent of the Panasonic brand, and sister company to JVC (together with nonaffiliated Hitachi), developed and marketed the rival VHS format, which was incompatible with the Sony Betamax player. It was the VHS format that took hold and, by the mid 1980s, dominated. Video retailers did not want to stock alternate formats, and as VHS players became more dominant, more VHS titles were stocked and the spiral grew until Sony’s Beta format was doomed. Within a few years of the Sony v. Universal decision, Sony threw in the towel and started manufacturing VHS players. Perhaps adding injury to insult, only a few years later the format war winner Matsushita bought MCA/Universal in an acquisition touting the merger of hardware and software.
The Sony Betamax case continues to mark an important turning point for the distribution of content onto in-home hardware, as well as serving as a precedent for the current age of digital age cases such as Napster, Grokster, and Cablevision (see Chapter 2).
The Early Retail Environment: The Rental Video Store
When videocassettes were new, and market penetration of VHS recorders was growing in the 1980s, the video business was almost entirely a rental business. By rental, I mean conventional rental stores such as Blockbuster Video or Hollywood Video (household brands that many under 25 may now not know).
At first, when the rental market was exploding, it was dominated by neighborhood video stores. The economics were relatively simple. The video store would buy units of movies from the studio distributor, and then rent the cassettes out to customers. The store would perform a simple break-even analysis of how many times a particular unit would need to be rented to turn a profit. There were some add-ons to mimic movie environment, such as selling popcorn or candy to take home with your movie. Marketing was relatively unsophisticated, led by film posters supplied by the studio distributors to advertise the hit and coming films.
As the business grew, chains formed and eventually dominated. At first, it was actually an acceptable retail strategy to be out of stock. If a store did not have enough units of a title, people would rent something else and come back for the other film; disappointment was a fundamental and accepted marketing strategy. This allowed the store to profit on two fronts: retailers could keep inventory down, not making risky decisions of possibly overbuying on a title, while virtually assured of repeat-customer business.
For a period, consumers seemed to accept the delay as part of life, and would happily rent a movie other than the one they had come in for. The out of luck, but somehow not entirely dissatisfied, customers would come back for the film they really wanted when: (1) the store called to let them know the title was back in stock (if they had placed their name on the reserve list); (2) at a somewhat random later date in the hope that they would be lucky and a copy would be available; or (3) at an even later date when they felt demand must have waned and they would have a really good chance that the title would be available to rent.
Amazingly, this lottery style mentality to renting did not dissuade consumers, and to some degree it helped fuel the growth and diversity of content offered by video retailers. Video stores recognized this phenomenon and were pleased for customers to rent a second- or third-choice title; as previously noted, this virtually guaranteed repeat business when the consumers returned the title they rented, but had not really wanted, and came back to rent the film they had come for in the first place. As a business model, this was almost too good to be true. Whenever one can make this type of statement, though, change is afoot. With the maturity of the business, impatience grew and consumers no longer accepted dissatisfaction as the rule.
Over time, rental stores became more competitive and needed to develop more traditional marketing campaigns to ensure customer loyalty. All types of schemes were implemented, from “rent 10 videos, get one rental free” loyalty programs, to store clubs that came with discounts, privileges, and mailings. More sophisticated chains divided customers into complex marketing matrixes, looking at who were frequent renters, casual renters, deadbeat clients, etc., and devising targeted campaigns to increase rental frequency and store loyalty. As the chains grew, they also started to advertise directly, advising customers “Come to Blockbuster and rent growing their business with an injection of direct marketing dollars plus cooperative marketing spends set out in their agreements with the product suppliers. As in any other product category, choice, growth, and competition added complexity, and rentals started to have price differentiation. Examples of offers included: “buy two, get one for free” deals, keep the title for the same price for the weekend, and rent new titles at full price for one night while offering older titles for the same or lesser costs to keep for three or five days.
Finally, as a tangible example of the market maturing and retailers acknowledging that disappointing customers was not the best long-term strategy, marketing schemes shifted 180 degrees to implement guarantees that new titles would be in stock (and, if not, the rental would be free). When a new title came out, there would often be pent-up demand similar to that which creates lines at movie theaters. To the “I’ll wait to see it on video” crowd that had socially developed in response to the growth of the industry, the video release date was like a premiere. New titles, which a few years earlier would be gulped up the moment they hit shelves and be out of stock, would now be available in large quantities.
This marketing shift also had a direct economic consequence on competition. To satisfy demand, a store needed to have key new titles in sufficient quantity, which required a larger upfront investment. Whereas 10 or 15 copies may have been fine before, 10 times that number would now be required. An average retail price, which, at the time when rental was king in the 1980s and early 1990s, was approximately $70–$100, could change the inventory investment for one title from $700–$1,000 to over $10,000. Volume discounts may have allowed some lower average pricing, but the elasticity was not great and the net effect was pressure squeezing the smaller, “mom and pop” accounts. Not surprisingly, this timing coincided with increased clout from major chains, such as Blockbuster and Hollywood Video, which had begun expanding and gobbling up smaller outlets to become independent market forces. Between 1987 and 1989, Blockbuster grew from a 19-store chain to over 1,000 outlets, and in 1988, with just over 500 stores, became the country’s top video retailer, with revenues of $200 million; growth did not slow down, and through further expansion and acquisitions the chain grew another 50 percent to 1,500 by 1991 before finally being acquired in a merger with Viacom in 1994.5 The market was vibrant enough that, with enough stores, chains could go public, and rival video chains Hollywood Video and Movie Gallery both completed public offerings in the early 1990s.
And change was just beginning. The dominance of the rental store was about to give way to the sell-through market, with rental revenue sharing becoming an intermediate solution to lower-priced units in a still-vibrant rental market.
During the growth of the rental video market, a new pattern was slowly emerging that would ultimately overwhelm rental sales and even threaten to eliminate the rental store completely: direct sales of videos to consumers. In trade lingo, this became “rental versus sell-through.” Today, the rental store seems to be facing extinction, combating the dual forces of downloads for purchase—“electronic sell-through”—and VOD access for rentals (both forces are discussed in more detail in Chapters 7 and 8, and serve as fodder for analysts who forecast new technology applications leading to the demise of historical markets).
The challenge in this earlier battle for survival was not played out as a public drama, as sell through was not initially perceived as a threat to rental’s dominance. In fact, conventional wisdom questioned whether consumers would want to purchase a videocassette when it had become so easy and relatively inexpensive to rent a film. One threshold issue was: Would people really want to watch a particular movie more than once? The general consensus was no. Those customers who were passionate about a particular movie might rent it a few times, but for the rental store, which had invested substantial sums per copy of a title, there was every incentive to entice these fans back to re-rent the title.
For the video store, the game was still all about amortization of inventory cost based on turn: How many times did an individual cassette/copy need to be rented to break even? Obviously, it was an attractive business model to turn a copy many times rather than sell it once. Simply, if a copy of a blockbuster cost the rental store $50, and the outlet charged $5 per rental, the store needed to rent that copy 10 times to recoup. Moreover, because each film is unique, inventory obsolescence only applied to the physical materials (e.g., how long a cassette could be rented before the tape quality degraded to an unacceptable level). A title that had paid for itself could sit on the shelf as catalog inventory, providing pure profit for the indefinite future (subject to the number of copies originally stocked, as a store would obviously keep fewer copies in catalog than were acquired during the peak rental period of initial video release). In fact, one might say this was the first iteration of the “long tail” now so commonly discussed online. Accordingly, a hit title that needed 7–10 rental turns to recoup might have multiple future rental turns left, yielding more than a 100 percent return on investment on a per-copy basis.
If a title was able to generate over 100 percent ROI, then the business model to sell that unit was initially far from compelling. Ultimately, the model comes down to the simple elements of units and pricing. At the early stages, the cost per cassette made it difficult to create a margin allowing for markups to challenge the relative earning power of a rental unit. Even at a substantial markdown, such as to $20 inventory cost, the retail pricing was quite high; moreover, there was a disincentive to lower pricing significantly when the rental business was thriving. A bigger obstacle, however, was simply the pattern of consumer consumption. The whole video market had exploded seemingly overnight, and people were used to renting, not buying. Something would have to fundamentally change to shift that pattern, including a dramatic lowering of inventory cost.
Table 5.1 U.S. Retail Home Video Industry ($ billions)
Not surprisingly, though, as in most consumer goods markets, prices inevitably started to come down. This was forced by pressure from large chains that demanded lower pricing for buying greater depth of inventory. More important than pressure from the rental stores, however, was the fairly rapid market shift from a predominantly rental business to a retail-dominated industry. Just like renting had before, buying videos became a quickly adopted consumer behavior.
By the time the DVD market reached its peak in 2004–2006 (see the next section), and as evidenced by Table 5.1, the percentage of sales for sell-through had shifted to close to 70 percent, whereas only a few years before the split was nearly even.
Key Factors Driving Growth in the Sell-Through Market
Among the key changes driving the growth of the sell-through market were: (1) the growing trend for consumers to collect videos; (2) the decline in pricing, allowing consumers to purchase titles for the same amount of money as (or at least not much more than) a record/CD; (3) studio efforts to sell mass volumes of select hit titles; and (4) the growth of the kids video business, initially led by Disney.
Examining these factors in a bit more detail, as the pattern of watching and renting videos matured, people started the habit of collecting titles. Although now accepted as commonplace, this was hardly an inevitable turn. Market research will tell that most purchased videos sit on the shelf: How often do you re-watch a movie that you have bought? For some favorites and classics, of course, the answer may be yes, but once collecting transitions from buying your favorite film to a habit, the answer will likely be different. And that is the key—becoming a habit—seducing you to purchase titles that do not quite make your top all-time list. As collecting became in vogue, studios started to mine their libraries and make older titles available, expanding the range of consumer choice. First there were books, then records, and now videos; in fact, the lingo that evolved was “video libraries.” People started to buy videos, sometimes never even watch them, and keep them on the shelf as a new sort of trophy or archive.
And once a piece of media becomes a collectible, it becomes a gift, opening an entirely new marketing direction for sales. Studios, if nothing else, are brilliant marketing machines, and all video rights holders drove a truck through the opportunity to encourage sales as gifts. The fourth quarter is now the largest period for video sales (with the holidays an ideal time to launch gift sets and special editions), which is a far departure from the origins of the video rental business.
Second, and somewhat hand in hand, the market saw a reduction in pricing and a corresponding upturn in sales of mass volumes of a title. By the early 1990s, as the rental market was maturing and chains grew and consolidated, there was a rule of thumb that you could place 200,000 to 300,000 units of a key new title in North America. For a title that was not a hit or one without a star driving sales, this number could be halved, while a big hit might sell twice this number of units. The key point is that there was limited elasticity of volume in rental.
Studios salivated at the notion of selling millions of units of a title, and on big hits it became commonplace to run break-even comparisons to assess how many units would need to be sold at retail to justify a “sell-through” release (sales direct to consumer as opposed to rental). While sell-through means direct sales to consumers, what it implicates at the distribution level is a whole new set of pricing and a dramatic expansion of retail outlets. The retail infrastructure for direct-to-consumer sales had to be built, and the expansion of outlets to mass merchants, drug stores, supermarkets, record stores, and independents took years to mature. In point-of-sale terms, this could mean going from low thousands of outlets at video rental to over 30,000 outlets for direct-to-consumer sales.
The challenges that came with the sell-through market were the same as any other consumer product: inventory management, advertising, in-store merchandising, physical distribution, and order of magnitude issues in physical manufacture. This was a daunting and, at some level, risky challenge for an industry that was thriving on limited distribution to a finite group of key customers, and where inventory management (video rental was largely a no-returns business) was a relatively minor issue.
So, putting aside the growing pains of becoming another consumer product challenging soap for advertising time and store shelf space, the nuts-and-bolts question became: What was the multiple needed to sell at sell-through versus a rental release? An important, and to the studios somewhat comforting, element in the matrix was that rental was still important. On any title significant enough to justify a sell-through release, there was a built-in sale to all video stores. The studio could still sell its few hundred thousand units into the channel; it would simply earn a significantly lower margin, charging a wholesale price of $15–20+ as opposed to the highly profitable $50–70+ rental price. For a period, and for many years following in several international markets, there was even the ability to price differentiate. The supplier (i.e., studio) would charge a higher price for rental units sold to video stores, and create a separate, lower suggested retail price (SRP) for mass-market sell-through buyers.
The analysis was then a straightforward break-even equation, taking into account the sales uplift needed from a lower-priced good to surpass the revenue and contribution margin of the higher-priced, lower-volume rental units (with variable manufacturing and marketing costs factored in on the expense side). As a rule of thumb, it turned out that a title needed to sell a roughly 4:1 or 5:1 ratio to justify a sell-through release.
The ultimate accelerant for the sell-through market was kids videos, in particular the emergence of Disney as a dominating force via its video division, Buena Vista Home Entertainment. Earlier, I pointed out the issue of whether people would watch a video repeatedly; the one area where this was clearly true was with children. Simply, kids would watch the same video over and over and over. It does not take a brain surgeon to recognize as a parent that buying a cassette for $20 that your kids will watch seemingly 100 times is a good investment. To the parent that can gain an hour or more of near-guaranteed peace and quiet, the value of the purchase is worth infinitely more than the cost. Hardly a babysitter could trump the satisfaction of a Disney video, and the combination of a babysitter and a Disney classic was as good a bet as there was out there.
Disney quickly recognized the gold mine that lay before it, and the timing not so coincidentally dovetailed with the reinvigoration of its animated film business. With hit after hit, commencing with Beauty and the Beast in 1991 and Aladdin in 1992 (see Table 5.2), Disney was validating a new market and spinning box office gold both in theaters and then again on video—a classic example of repeat consumption as a key factor in maximizing value per Ulin’s Rule. Then, in 1995, The Lion King broke out of the box, reportedly selling a staggering 30 million units,6 with reputedly 20 million units in its initial release window. The notion of 20 million units of a title had been seemingly unimaginable previously, and once the pattern of high volumes proved repeatable, there was no stopping. It continued for more than a decade, with Finding Nemo selling 20 million combined DVD and VHS units in its first two weeks of sales in November 2003, including 8 million on its first day of release for a record beating the prior Spider-Man tally.7 Everyone tried to jump on the bandwagon, but during the 1990s growth spurt, Disney seemed to have a lock on printing money between box office success of animated titles and the amazing upside that the video industry provided.
Table 5.2 Disney Animated Releases by Year
Year (Theater) |
Title |
1989 |
The Little Mermaid |
1991 |
Beauty and the Beast |
1992 |
Aladdin |
1994 |
The Lion King |
1995 |
Toy Story |
1996 |
The Hunchback of Notre Dame |
1997 |
Hercules |
1999 |
Tarzan, Toy Story 2 |
Year after year, they continued to release a new hit, which became an instant classic given the numbers (though nothing again reached The Lion King heights) and had strong enough brand awareness to spur made-forvideo sequels (see later discussion, “Beyond an Ancillary Market: Emergence of Made-for-Video Market).
The success of Disney videos catapulted the head of Disney’s video division, Bill Mechanic, into executive stardom, and in the mid 1990s, he left Disney to become president of 20th Century Fox studios. In terms of animation, Mechanic never hit the peaks at Fox he experienced at Disney; acquiring Don Bluth studios and launching titles such as Anastasia helped Fox enter the lucrative market, but they failed to create a Disney-like brand engine from the genre. (Note: Fox eventually succeeded years later in building an animation brand via Blue Sky and its computer graphics hit franchise Ice Age.)
The Emergence of and Transition to DVDs
The video market has been nothing short of a cash flow godsend to studios and producers. After the initial growth of rental and the consumer acceptance of the direct-to-retail sales model, the market took off again. The next phase was the development of the digital video disc (“DVD,” or in technical circles actually the digital versatile disc).
Technology had advanced such that it was possible to make a leap in video quality similar to the transition the record industry had gone through years before in converting from cassettes to compact discs (CDs). The CD quickly replaced the cassette when Phillips invented the digital encoding technology; the marketing thrust, and inevitably the driver in quick adoption, was that: (1) CDs were claimed to be indestructible (as opposed to cassettes, where the tape could get caught, jammed, or warped, permanently ruining the copy); (2) the sound quality emanating from digital encoding was a quantum leap forward from analog tape; and (3) CDs were smaller and therefore more portable than 12-inch vinyl records. While the random access convenience of just jumping from song to song on a CD was compelling (as opposed to fast-forwarding or rewinding), the notion of having a portable, near-perfect hiss-free and non-degradable crystal clear copy of music persuaded consumers. Sometimes, with technology, there truly is a better product, and CDs were a case in point.
I have digressed into the record business because the same forces were aligned against videocassettes. Different consortiums of motion picture studios, teamed with various consumer electronics manufacturers (e.g., Toshiba, Matsushita), pioneering DVD technology. They believed that the DVD offered the similar quantum leap from digital to analog quality that consumers had so overwhelmingly embraced in the record industry when moving from cassettes to CDs. As in the early days of the video-cassette, where format wars erupted between the Betamax and VHS formats, similar format wars took place on the DVD battlefront. Matsushita, the Japanese consumer electronics company (Panasonic brand) that had pioneered the VHS format and acquired Universal Studios (only to later divest majority ownership in a sale to Seagrams) was supporting one standard, whereas Toshiba and Warners were supporting another.
An entire chapter could be written about these format wars, but suffice it to say that given the investment, historical fallout from prior format disputes, and the potential market size, the studios banded together to “adopt” a format.
How Does a DVD Work?
The underlying technology of DVDs is compression, or the ability to take a huge amount of data and store it efficiently. Accordingly, there is a level of randomness, since there is a direct relationship between the amount of data stored and the end quality; the more information, the better the resulting output quality. The inherent problem concerning compression for DVDs is that the amount of information that needs to be processed for a moving picture is staggering relative to an audio file. For a movie, each frame needs to be stored, including all the elements, ranging from backgrounds, to characters, to colors, shading, audio, etc.
The quantity of pixels that need to be reduced to digital 0s and 1s to compress a color film image was, in fact, too great to fit onto a disc, which was a driving technical hurdle preventing the invention of a disc or technology that could mimic a CD for film. The breakthrough came with the notion of looking at the differences between frames and only storing the differences; in this way, the amount of data that needed to be converted and stored was dramatically reduced. DVD compression actually “cheats” by omitting data. The compression digitizes and stores new elements, but in terms of going from frame to frame, only differences need to be kept. This efficiency trick, combined with massively greater storage/data capacity compared to a CD, enabled compression of sufficient data to allow a typical film to fit on a single DVD disc.
Early Stages of the DVD: Piracy Concerns, Parallel Imports and the Warners Factor
At the Consumer Electronic Shows of the mid 1990s, gawkers and industry executives watching DVD demonstrations could intuitively grasp the leap in quality. DVD pictures were undoubtedly better, and the DVD offered the same type of ancillary upgrades to consumers that the CD had offered. Videotape often got stuck in machines, and DVDs eliminated those concerns, and were marketed with an aura of discs being “ultimate” and “permanent” (no one was talking about scratches, of course). Another user-friendly element was the elimination of having to rewind a tape. Rewinding a tape at the end of a movie is a universal nuisance, and some video rental stores even charged penalties if tapes were returned unwound. With a DVD, when the movie ended, you just hit a button—no rewinding, no hassle. As silly as it may sound, consumer market research regularly found the elimination of having to rewind as one of the most significant benefits of a DVD, which was statistically on par with the improved picture quality. Never overestimate the consumer!
A better mousetrap does not guarantee adoption, and in the case of the DVD, adoption was further hampered by studios’ reluctance to market and sell properties on the new format: virtually all major studio executives recognized the benefits of the DVD, but concerns over piracy and parallel imports were sufficient barriers to move slowly, if at all.
The following was the cost-benefit matrix of the time:
Costs/Negatives:
■ expenses to encourage consumer adoption
■ need to manage duplicate inventories (video and DVD)
■ piracy—DVDs held the potential of people making perfect digital copies
■ parallel imports (see later discussion)
Benefits:
■ better quality and durability
■ favorable user-friendly features (e.g., no rewind)
■ smaller packaging needs
■ less expensive manufacturing costs, therefore higher margins
■ ability to turnover library/catalog product by selling new format
Despite the apparent edge to the benefits, the inherent nature of the DVD as a perfect digital copy created significant anxiety at the studios. Intellectual property is the lifeblood of the system, and while video piracy was always a key concern, that concern heightened with digital copies. If just one person were able to make copies from a DVD, then, in theory, a pirate could have access to a digital master and illegally distribute perfect copies into the marketplace. This had the potential of undermining franchises, new releases, and entire studio libraries. The risk was simply too high, and until sufficient security was implemented most studios held back DVD releases of new titles (another form of windowing).
Adding to the problem was a concern about parallel imports. While it is commonplace to theatrically release a major movie on the same date worldwide (day-and-date release, as discussed in Chapter 4), this was rare to nonexistent back in the mid 1990s when DVDs were first introduced to the market. Parallel imports means buying goods in one territory and importing them into another. For example, if a movie were released in May in the United States, it might be planned for a release in Europe or Asia at Christmas, the same time the DVD of the title would be coming out in the United States. There was nothing to prevent a retailer from buying quantities of the DVDs in the United States and importing them to the market where the movie was just releasing in the theaters, or worse, in advance of the theatrical release. What would happen if consumers could view (or worse, obtain) a perfect copy of the movie before it was even released in theaters? The potential of parallel imports had always existed, but, like piracy, the quality of digital copies heightened people’s fears. The box office revenues in international territories were growing consistently, and the theatrical release was too important a driver of the entire studio system to risk.
A key strategy to combat this practice and enable the broader introduction of DVDs was the implementation of regional encoding. This was a process devised by the studios where DVD machines and related DVD software would only work within specific territorial boundaries. For example, a chip would be placed in a machine telling it that it was a “European” encoded player, and this player would only play a disc encoded as European. If you put a disc from the United States (encoded as a United States disc) into a European player, the codes would not match and the disc would not play. The studios managed to gain acceptance from consumer electronics companies manufacturing players (likely helped by Matsushita’s relationship with Universal and Sony’s ownership of a Hollywood major), and all parties agreed to a worldwide map.
Interestingly, regional encoding is akin to a form of hardware-based digital rights management (DRM), and was instituted to restrict how and where a consumer could play back a copy. Conceptually, DRM systems enable the same type of restrictions, but further open up a panoply of options down to managing how many times a product may be played on a specific machine (or overall). Regional encoding is still enforced today, and software bought in one territory will not play on a machine manufactured and sold in a different region. For those wanting to defeat the system, region-free players (which will play a disc regardless of which region it is encoded to) are available, but obviously for a premium price.
The net result of these fears, regarding piracy and the potential of undermining carefully orchestrated release windows, was that most studios were not releasing any titles on DVDs. Those studios that were entering the market were dabbling with older catalog titles where there was obviously no risk to current theatrical release. Sound familiar today? Again, history repeats itself, and the adoption of downloads or over-the-top releases of premium product and vesions (e.g, HD versions) has been slowed by fears of pirating a perfect digital copy (just like the introduction of the DVD); accordingly, content owners often lead with catalog titles to mitigate the risk.
One exception to this initial reluctance to release a broad array of titles on DVD was Warner Bros. The president of Warner Home Video, Warren Lieberfarb, was among the earliest and most vocal proponents of DVD technology. Warners invested in a DVD authoring and replication facility, and simply believed that the DVD was such a superior technology that it was inevitable consumers would adopt the platform (not to mention the benefit of holding several related patents). For pioneering the technology, and championing its introduction against naysayers and those who wanted to delay launching, Warren Lieberfarb has been called “the father of DVD.” Even within an incredibly competitive industry, people acknowledge Warners’ leadership position as the catalyst for the transition to DVD from video. Most people forget, or were oblivious to, the significant risks to protection and window management of vital intellectual property assets that stalled and almost prevented the introduction of DVDs.
Influence of Computers: Cross-Platform Use of DVDs Speeds Adoption
One significant factor in the acceleration of DVD penetration was the crossover between consumer electronics players and computers. DVDs had an exponential increase in storage capacity versus floppy discs and CDs. (Note: A standard DVD holding a two-hour movie plus customary ancillary value-added materials (VAM) has roughly 9 GB of content, while Blu-ray boasts an increase to 50 GB.)8
As DVD drives slowly replaced other storage mediums on PCs, it was only a matter of time for convergence to take place. With a common software medium, consumers could store data, download pictures and music, and watch movies all with DVDs. Further, this convergence dovetailed with the increased penetration of laptop computers. It was now possible to bring a DVD of a movie on your laptop for a plane ride, jumping between spreadsheets and entertainment. History would repeat itself once again, with integrated systems used to drive adoption—Sony included Blu-ray players with its next-generation PlayStation 3 console system, hoping the consumer electronics product (this time a games system rather than a PC) would help drive adoption.
Recordable DVDs and Perceived Threats from Copying and Downloading
Once it became clear that DVDs were the medium of the future and would replace VHS cassettes, the next obstacle was the ability to record. For the same reasons that slowed the introduction of the DVD, piracy and economic fears tied to the ability to make digital copies, a recordable feature was delayed in the marketplace. It was one thing to allow a DVD, but the dangers ultimately seemed manageable without the ability of the consumer to burn copies of movies. As an accommodation to the concerns of the studios, the major consumer electronics manufacturers launched play-only DVD machines; when compared to the complexity of regional encoding, this was a relatively easy measure to assuage the software distributors.
Over time, however, pressures for recordable players overwhelmed this protectionist direction; moreover, the consumer electronics industry was not in a position to stop the computer manufacturers from deploying recordable drives. Memory and storage is the mantra of the personal computer industry, and computer manufacturers were inclined to encourage data storage rather than impede it. Whether music or digital camera/pictures, the new applications were growing at breakneck speed. It was unrealistic to expect that DVDs could record everything but visual entertainment software.
Giving the studios solace in terms of DVD burners becoming a standard accessory was the fact that movies are not easy to copy. The amount of data compressed is staggering, and it is cumbersome and complicated to copy a movie relative to a business file or music CD. Moreover, anti-copying mechanisms are encoded on films preventing the simple copying of a movie on DVD. The larger fear is the Internet, and while lengthy download times for movies (hours rather than minutes) seemed initially to pose a significant enough hurdle to give distributors comfort, technology again advanced and P2P file sharing exposed the underlying fear that had loomed with digital copies since the advent of DVDs.
At first, digital rights management systems (and the lure of new revenue streams) seemed to have progressed quickly enough to temper those fears and promise significant and ongoing roadblocks to the easy pirating of copies; however, it was this backdrop that caused the studios to take a strong stand in the Grokster case when the ability of P2P services demonstrated facility and scale for making pirate copies. This created the biggest challenge to the industry since the enabling Sony v. Universal case roughly 20 years before. (Note: See Chapter 2 for discussion of file sharing, P2P downloading technology, and the Grokster case in terms of the relationship to piracy and digital downloading.)
Intermediate Formats: Laserdiscs and VCDs
Finally, it is worth mentioning that, as in most areas of technology, there were intermediate steps between VHS and DVD adoption. Some may remember the laserdisc, which was dominated by companies such as Pioneer. Laserdiscs were about the size of an old phonographic record and had better clarity and durability than standard VHS tape; they were, accordingly, priced higher, and the early adopter videophiles built up collections of laserdiscs. Laserdiscs were still, however, based on analog technology and were ultimately doomed with the advent of the digital age. Consumers that always wanted the best available technology/presentation of the time built up collections, but the life of laserdiscs was comparatively short and the penetration of the hardware players relatively limited when compared with the mass-market adoption of both VHS and DVD and then Blu-ray.
Similarly, in Asia, and in particular Southeast Asia, a market grew up for video CDs (VCDs). These are CD size and look like DVDs, but simply have inferior compression and memory, and accordingly inferior picture quality. VCD distribution grew quickly in markets rife with piracy, and a consumer could usually find a low-quality and unauthorized version of virtually all studio blockbusters on VCD in the local markets. Because penetration grew quickly, it took some time for DVDs to supplant this market. However, with VCDs and laserdiscs both intermediate and inferior products to DVDs, these formats began to quickly diseppear; in fact, I suspect most readers of this book will never have heard of them.
Revenue Sharing—Consequence of a Hybrid Market and Aid to DVD Adoption
Revenue-sharing arrangements took off in the late 1990s. This was a scheme where the major studios gave the major video rental chains, such as Blockbuster and Hollywood Video, their titles on a consignment basis. Rather than charge $29–40 for a title, the studios deferred the upfront revenue in favor of a split of rental income. Although deals differed, it was reputed that a rule of thumb granted the studios 60 percent of the revenue from rental transactions; moreover, once a title had been past its peak release period, excess inventory was sold in-store ($5–15 range), with the proceeds shared between the distributor and rental chain.
Some have theorized that the introduction of revenue sharing was a gambit to increase DVD penetration, as the studios encouraged the shift away from VHS (in fact, some former video division heads have alleged just this tactic).
Once DVD penetration had hit mass-market levels, prices started coming down for both players and new release titles and revenue-sharing schemes waned. The Hollywood Reporter cited these factors and attributed the decline in revenue sharing to the increase of the consumer purchase market at the expense of the video rental store:
… Once DVD hardware market penetration reached about 50 million players in U.S. households by 2002, WHV and other major Hollywood studios began ratcheting down their rental revenue-sharing participation, while aggressively discounting the wholesale and retail price of movies on DVD. The new popularity of DVD, combined with low-priced hit new releases and classic catalog product, energized consumer spending on home videos, resulting in a national average household buy rate of 15 DVDs a year at an estimated price point of $19 or more each. That consumer action translated into triple-digit revenue gains at the studios. At the same time, the paradigm shift had reduced in-store foot traffic at video rental outlets nationwide, taking a huge bite out of gross consumer spending on movie rentals.9
Beyond an Ancillary Market: Emergence of the Made-for-Video Market
Direct-to-Video and Made-for-Video Markets
As video matured, and retail points of sale expanded, it became clear that there was an opportunity to release new/original product directly to the video consumer.
Paralleling the growth of the video market overall, the natural target base was the consumer buying the seemingly dizzying number of Disney videos. If it were possible to sell over 10 million copies of a movie such as The Lion King or Beauty and the Beast, would the same consumer buy a branded property that was not released in the theaters and was instead an original property for the home video market? With the benefit of hindsight, clearly the answer is yes. The simplest and most successful path was to create sequel properties. Disney perfected this almost to an art, and empowered a specific division focused on producing spin-offs. Examples of “video sequels” or spin-offs during this video renaissance included:
■ The Return of Jafar (1994)
■ Aladdin and the King of Thieves (1996)
■ Beauty and the Beast: The Enchanted Christmas (1997)
■ Pocahontas II: Journey to a New World (1998)
■ The Lion King 2: Simba’s Pride (1998)
■ Hercules: Zero to Hero (1998)
■ The Little Mermaid II: Return to the Sea (2000)
■ Lady and the Tramp 2: Scamp’s Adventure (2001)
■ The Hunchback of Notre Dame II (2002)
■ Tarzan & Jane (2002)
■ 101 Dalmations 2: Patch’s London Adventure (2003)
■ The Jungle Book 2 (2003)
■ The Lion King 1½ (2004)
■ Mulan II (2005)
■ Tarzan II (2005)
■ The Fox and the Hound 2 (2006)10
Fox jumped on the bandwagon with titles such as FernGully 2: The Magical Rescue, as did Paramount, leveraging well-known characters and brands, such as Charlotte’s Web 2: Wilbur’s Great Adventure. Independents that had strong children’s properties expanded their brand. A prime example was Lyric Studios franchise Barney; in addition to taking television episodes to video, live Barney concerts were perfect fare to release on DVD.
Perhaps the most successful example of a made-for-video property came from Universal Studios. Universal had theatrically released a film called The Land Before Time, executive produced by George Lucas and Steven Spielberg, to moderate success. Recognizing the inherent appeal of the characters, children’s love of dinosaurs, and the franchise potential, Universal invested in video sequels. The Land Before Time franchise became so successful, and the potential for other made-for-videos was considered so high, that Universal created a new division called Universal Family and Home Entertainment. Headed by the former president of Universal’s video division, Louis Feola, Universal produced a series of animated (e.g., Balto: Wolf Quest) and live-action (e.g., Beethoven’s 3rd, Beethoven’s 4th, Beethoven’s 5th, Slap Shot 2: Breaking the Ice) properties under this banner. (Note: More current made-for-video titles include The Scorpion King 2 and the American Pie Presents sequels (Band Camp, The Naked Mile, Beta House), the latter of which are estimated to have sold 1–2 million copies each.)11 The Land Before Time property spawned more than 10 sequels, making it one of the most prolific and successful children’s franchises in the marketplace.
DVD as a Fallback Release Outlet
“Made-for-video” titles are often confused with releases that may otherwise go direct to video. A title such as The Land Before Time 3 is made for debut in the video market, but with the expense of marketing and releasing a theatrical film, studios soon realized that certain films that did not pan out as planned could go straight to video. This outlet developed into an important revenue stream, given that there are many films made that never see the light of day in theaters or may have a very limited theatrical release to brand them theatricals (or otherwise qualify them for pricing tiers downstream delineated by output deals that have a theatrical release tier threshold). Interestingly, this has developed as a two-way street: there are also instances of film produced for the video market that come out well, and the studio may subsequently elect to release them theatrically. It is often hard to pinpoint these titles, however, for the distributor will likely be reticent to publicize that the title was originally intended for the video market for fear of souring the caché value.
Niche and Non-Studio Direct-to-Videos/Made-for-Videos
In addition to mainstream videos, the opportunity in the video marketplace led to numerous niche opportunities. One of the strongest sectors was health and fitness/exercise. Swimsuit models and supermodels competed with the likes of Jane Fonda to release aerobic and other workout-related tapes.
Another burgeoning area was concert films. With the enhanced video and sound quality possible with DVDs, it became more attractive to sell a video from a concert tour or a specific performance to complement CD sales.
Finally, with the upside potential in the family/kids market, it was only a matter of time before toy companies capitalized on their key brands and expanded into the video market. Lego produced Bionicles, and Fox announced a partnership with Hasbro to produce and release titles based on several of its popular brands. I could go on and on talking about documentaries, music videos, and a variety of other genres, but the point is that DVDs opened up a new market for virtually all forms of content production.
Next-Generation DVDs: Blu-Ray versus HD-DVD—Format War Redux
In 2006, two new competing high-definition DVD systems were introduced pitting rival Japanese consumer electronics manufacturers against each other (again). Blu-ray, developed by Sony, and HD-DVD, developed by Toshiba, were pitted against each other, offering high-definition images (1080) and a remarkable amount of storage capacity (25–50 GB). Different partners lined up behind each, with Microsoft in the HD-DVD camp and a greater number of Hollywood studios (e.g., Disney and Fox) initially jumping on the Blu-ray bandwagon. Adoption was slow, however, as no parties wanted to be beholden to a format that might not win, the initial price points for players were high ($350+), and consumers were not convinced that the quality differential from standard DVDs warranted a pricey upgrade. Unlike earlier format wars, both sides tried to speed adoption by integrating the new players into other hardware: Sony including a Blu-ray player in each new PlayStation 3 game console, while Toshiba bundled its HD-DVD drives into notebook computers and Xbox 360 game systems.
It was a déjà vu scenario, with full-scale war between two major Japanese consumer electronics companies, billions of dollars potentially at stake, and the consumer caught in the middle, waiting out the format winner. With both sides having sold approximately 1 million units by the end of 2007, there seemed no clear winner in sight, and headlines abounded. This one was seen in the International Herald Tribune on New Year’s Day 2008, just days before the annual mass gathering at the consumer electronics show in Las Vegas: “The Format Wars: Titans Stuck in a Stalemate—Despite Months of Tussling, No Clear Winner Has Emerged in the Battle Between Blu-ray and HD-DVD.”12 I was even part of the prior lobbying efforts, with studio partners and other vested parties alike courting Lucasfilm for an endorsement. What do you do when you have different franchises with different studios, and you do not know who may distribute your next film or TV series?
Then, suddenly everything changed and the battle was literally over. In February 2008, Warner Bros., the pioneer in traditional DVD, had been on the fence and then came out in favor of Blu-ray; within the same week or so, Walmart came out and announced it would no longer stock HD-DVDs or HD-DVD players. With the market share leader for DVD sales at retail and Warners both coming out in favor of Blu-ray, it shocked the market, and Toshiba pulled out.13 No doubt, there was growing fear that delay could doom the entire industry, and if all the studios did not start lining up behind a common format, the danger existed that high definition would miss its window and be bypassed entirely by the growing download markets, akin to CDs being replaced by digital files.14 In a sense, as typical with the introduction of new technology in the media, one battle had ended and another was just beginning.
Finally, one feature of Blu-ray put the physical media on a path to embrace the Internet—perhaps consciously designed to ensure a place working within the new Internet world rather than having to simply compete against it. “Blu-ray live” enables an interactive feature that allows viewers to simultaneously watch a film along with its director, seeing commentary and chat live while the movie is playing. Among the first tests of this component was an invitation to watch The Dark Knight along with its director, Christopher Nolan, and reportedly up to 100,000 people were supposed to be able to watch along together.
Blu-ray is providing industry optimism after years of decline in the video industry—growing by roughly 20 percent in 2011, cresting $2 billion for the first time, and then seeing a 13 percent sales increase through the first half of 2012, Blu-ray sales are now material and mass market.15 Part of the growth has been organic, but industry insiders acknowledge that Avatar helped fuel the growth, with Blu-ray sales of the film reaching 11 million units worldwide. With this market penetration, by the end of the third quarter, 2011 revenues from Blu-ray sales for the first time surpassed revenues from rental kiosks ($423 million for Q3 2011 from Blu-ray versus approximately $414 million from kiosk rentals).16 This was extremely good news for the video industry, because margins tend to be higher from the sale of retail products than from rentals, and the only material growth in the prior few years had been from low-cost rentals, including, most importantly, Netflix and Redbox (see below for further discussion). Despite all this positive spin, it is important to put Blu-ray in context, as the increase in Blu-ray has been more than offset in declines in traditional DVD sales.
In addition to the general video window of releasing a movie six months or so after theatrical release, it became economical to market other product at retail. Two major categories were exploited: catalog titles and television shows. As for catalog, every studio has a group of classics in its library, whether themed to stars (Betty Davis collection), awards (Oscar winners), or simply “classics.”
When releasing these films, the practice of having the producer, or more often the director, create a special edition (e.g., director’s cut) evolved. This could entail releasing an extended version of the film or re-editing parts that may have been cut out for theatrical release (often dealing with time constraints that did not apply to home viewing). Additionally, in some instances special editions would “clean up” elements in the master, given advanced technology (e.g., remastering, taking advantage of computer cleanup or digital sound), and in other cases the creator may have even produced new elements and re-edited the films. When George Lucas released the original Star Wars movies (A New Hope, The Empire Strikes Back, and Return of the Jedi) on DVD for the first time in 2004, all of these elements came into play: (1) all of the movies went through extensive cleanup, utilizing a computer digital restoration facility; (2) all of the movies included remastering sound elements; and (3) a few new elements were introduced, utilizing special effects to alter select sequences.
Another growth area was releasing “seasons” of television series. This became popular, initially, with longstanding hits such as The Simpsons, as well as fare that had developed a strong following on limited services such as pay TV but had not been exposed to a larger audience. HBO titles are a perfect example. Consumers that were aware of a show such as The Sopranos or Sex and the City but did not subscribe to HBO could rent entire seasons and watch them like a miniseries.
Soon, collections became the rule rather than the exception, and full seasons of top TV shows could be found on shelves: Alias from ABC, 24 from Fox, and the complete Seinfeld. By Christmas 2004, box sets abounded at retail, so much so that video distributors and retailers for the first time started worrying about saturation and how far the market could expand. Collections, special editions, etc. are all further illustrations of Ulin’s Rule—distribution maximizes revenues through repeat consumption opportunities, tied to differential pricing and timing.
Maturation of the DVD Market and Growing Complexity of Retail Marketing
The DVD/Blu-ray/video supply chain, being tied to a physical consumer product, is far more complicated than the chain of licensing and delivery of movies and TV shows, respectively, to theaters and broadcasters. Figure 5.2 exhibits the key components of assimilating a variety of content into a product distributed in multiple SKUs and formats to outlets of fundamentally different character (rental versus sale), and marketed to the customer by both the distributor and point-of-purchase retailer.
Peaking of the DVD Curve and Compressed Sales Cycle
By the late 1990s, it was clear that DVDs were the format of the future, and in the ensuing years literally exploded. Growing from less than 10 percent in 1999, by the end of 2006 penetration exceeded 80 percent and had bypassed VCR penetration.17 By 2003, annual DVD rental revenues exceeded VHS revenues,18 and by 2005 the number of VHS units of a major title relative to DVD units was negligible. In fact, by 2005 many titles, such as Star Wars: Episode III – Revenge of the Sith, were released only on DVD.
Figure 5.2 Complexity of DVD/Blu-ray Supply Chain
With the growth of DVD, the balance between rental and sell-through started to shift dramatically toward sell-through. The durability and quality of DVDs, together with the ability to include special features (see discussion regarding VAM), made them ideal retail items, as well as perfect gifts. All of a sudden, it was not just Disney selling huge numbers of children’s videos, but key titles from all studios were selling in the millions. And for children’s properties, the numbers simply kept growing. Shrek, released in 2001, reportedly sold 2.5 million units in its first three days19 en route to selling upwards of 20–30 million units worldwide, as did Disney–Pixar’s Finding Nemo.
Depending on whose statistics one believes, the DVD/video market peaked somewhere between 2004 and 2006, and by the end of 2005 it was evident that the market was entering into a phase of decline, both on a by-title basis as well as overall. Given the size and importance of the home entertainment market in the media sector, this was massmarket news, as USA Today highlighted: “For the first time in home video’s nearly 30-year history, sales and rentals slipped in 2005 as slowing growth of DVDs couldn’t overcome falling prices and a dying VHS market.”20
While, historically, home video revenue from most blockbusters equaled or surpassed that of their box office take, the trend seemed to have peaked. Describing the drop in conversion rate—the ratio of video sales to theatrical—Variety reported that the theatrical gross exceeded the DVD revenues of films such as Batman Begins and War of the Worlds (e.g., Batman Begins video revenues $170 million versus $205 million theatrical gross).21 There has been a continuing decline in the DVD market ever since this peak22 and, as noted and demonstrated by comparing Figures 1.5 and 5.1 (studio revenue breakdown in 2007 vs. 2012), the impact has been a steep fall in terms of the percentage of the overall studio revenue pie attributable to the video market (down to 30.4 percent from 48.3 percent). 2008 typifies the dramatic nature of the falloff, when there was a precipitous drop in new release volumes, estimated to be down close to 20 percent.23 Illustrating the severity of the decline on a by-title basis over almost a decade, Table 5.3 lists the top-selling DVDs for 2003 versus 2008 and 2011 in the United States.
Given the overall importance of DVDs to the studio revenue base and ecosystem, this pace of decline continues to set off alarm bells; the cause can no longer be attributed solely to a recessionary climate, and the shift is putting even more emphasis on the future of electronic sell-through, subscription streaming, and other new consumption patterns in the digital space.
Compressed Sales Cycle
The other factor impacting the market maturation was an increasingly compressed sales cycle. This has been accentuated by the flood of additional product trying to take advantage of DVD dollars. Whereas only a few years earlier shelf space competition was between different hit movies, the largest growth sector became TV product and box sets; with a glut of new and catalog TV releases, together with made-for-DVD product, competition became fiercer, shelf space turned over more quickly, and sales cycles compressed. In a sense, the DVD retail cycle was beginning to mimic the box office, with revenues more front-loaded by the year, and films earning the majority of their video revenues within the first two weeks of release.24 In fact, most studios acknowledge that the majority of sales on a title now come in this short period. The Wall Street Journal highlighted this shift: “a typical DVD release would rack up about one third of its total sales during the first week of release; the figure was even lower for animated movies, which tended to have longer legs. DVD sales would then steadily mount over weeks or months. But these days, DVD releases are generating a huge percentage of their total sales—typically over 50 percent and in some cases, up to 70 percent—in the first week.”25
Table 5.3 Top Five DVDs of 2003, 2008, and 2011
Studio |
Title |
Date |
Units |
Disney |
Finding Nemo |
2003 |
26,000 |
New Line |
The Lord of The Rings: The Two Towers |
2003 |
21,050 |
Disney |
Pirates of the Caribbean: Curse of the Black Pearl |
2003 |
19,450 |
Warner Bros. |
The Matrix Reloaded |
2003 |
15,520 |
Universal |
Bruce Almighty |
2003 |
12,650 |
Warner Bros. |
The Dark Knight |
2008 |
12,385 |
Paramount |
Iron Man |
2008 |
11,375 |
Fox |
Alvin and the Chipmunks |
2008 |
10,560 |
Warner Bros. |
I Am Legend |
2008 |
10,125 |
DreamWorks Animation |
Kung Fu Panda |
2008 |
9,750 |
Warner Bros. |
Harry Potter and the Deathly Hallows: Part 1 |
2011 |
8,565 |
Disney |
Tangled |
2011 |
7,635 |
Warner Bros. |
Harry Potter and the Deathly Hallows: Part 2 |
2011 |
7,065 |
Disney |
Cars 2 |
2011 |
5,340 |
Universal |
Bridesmaids |
2011 |
4,695 |
Notes: Units are projected lifetime shipments of the film on home video.
© 2012 SNL Kagan, a division of SNL Financial LC, analysis of video and movie industry data and estimates. All rights reserved.
This trend developed outside the pressures of new media, making the issue of how to window downloads that much more complicated. The DVD cash cow was set for a reversal of fortune, and no studio wanted to accelerate that trend. Unless downloads could be proven to add incremental value, let alone not cannibalize DVD, there was little impetus to experiment with key new releases.
Expansion of Retail Mass-Market Chains: Walmart, Best Buy, Target, etc.
Routinely selling more than 5 million copies of an A-title and, on occasion, over 10 million copies of select hit children’s/family titles could only occur with the expansion of retail distribution. Video rental stores jumped on the bandwagon as a point of sale for DVDs, but their bread and butter remained rental, and the vast majority of sales took place at mass-market retailers.
Because DVDs as a software entertainment commodity offered a unique product with each release (as does a CD or video game), both suppliers and retailers quickly realized the marketing opportunities. Not only could DVDs sell in record numbers, but DVDs could actually drive consumer traffic into stores. If the next Star Wars or The Lord of the Rings movie were being released on DVD, customers would crash stores in droves. It was like Christmas time with each new major release.
Of course, nothing is that simple, and greater sales and expectations were also driven by increased marketing. To sell several million copies of a title, it is necessary to advertise the release, and advertising budgets for DVD releases multiplied several-fold. Studio video divisions became expert at running sophisticated P&L models, trying to gauge the saturation threshold after which increased marketing spend would not yield additional positive contribution margin.
Increased marketing expenditure could ultimately only be justified with concomitant retail support. Accordingly, retailers went through a maturation period as well, with more shelf space dedicated to DVDs. In-store marketing campaigns grew in importance, with dedicated instore display packs, such as towers themed with images from the movie, adding additional capacity during a title’s initial release. Executing a compelling in-store campaign involves elements including:
■ posters
■ additional signage
■ stand-alone themed display towers
■ placement of stand-alone displays and regular shelf placement (e.g., on new release end caps versus off-the-aisle placement)
■ employee education
■ in-store trailers
■ dedicated retailer advertising
■ trade advertisements
■ store circulars in newspapers, etc
To achieve this type of coordinated campaign at retail, several economic incentives evolved. Industry practice developed such that studios offered an allowance for both market development and cooperative spending. Typically, studios will allow retailers to spend a small percentage of the wholesale revenue against their marketing costs directly related to the title. Additionally, studios will allow another line item for cooperative advertising expenditure. Where these lines are drawn is a bit fuzzy, with cooperative advertising a bit easier to track, in that it is supposed to be allocated for actual advertising, whether print media, radio, or television. Cumulatively, a retailer may have a few percent of actual wholesale revenue to apply against its costs in advertising, marketing, and merchandising the title.
These sums are paid by the studio/video retailer, but in practice are administered as an allowance. The amounts calculated for marketing and co-op expenditures are deducted from the revenues otherwise due, yielding a net amount paid, thereby having a negligible cash flow effect. These are real costs, however, to the video distributor, and are a key line-item element of the overall video marketing budget, just as direct advertising creation costs and costs of buying media (TV and radio advertising) are costs driving the P&L analysis and ultimate contribution margin.
Retailer-Specific Implementation
Implementation of marketing programs is tailored at the retail level, typically tiered to the anticipated volume. In all markets, it is common to have a key account list, which will vary by studio and type of product (e.g., specialist account), but mainstream releases would typically include the following U.S. retailers (excluding wholesalers): Amazon, Best Buy, Walmart, Target, BJ’s Wholesale Club, Borders, Circuit City, Costco, and Hollywood Video. (Note: A number of those outlets, including Borders, Circuit City, and Hollywood Video, have since filed for bankruptcy—a telling sign of the overall retail marketplace.) Depending on the title and studio, a select few top accounts, such as Walmart, Target, Best Buy, and Amazon, could easily account for over 60 percent of the total volume.
For the top-volume accounts, and on certain key new release titles, it may make sense to customize programs. Types of programs can obviously vary widely, but examples of specialized focus may entail:
■ special product placement, such as guarantees of being positioned near the checkout register
■ unique creative campaigns for posters, or buttons for staff
■ rebate programs tied to individual purchases, such as point-of-sale rebates, or overall volumes
■ discounts tied to sale of other purchases
■ discounts tied to store gift cards
■ customized packaging
■ customized value-added offers (e.g., bundled merchandising, such as an action figure)
■ special merchandisers, such as product towers
■ special placement in circulars or flyers
■ consumer prizes/sweepstakes
There is no limit to the creativity of a campaign.
Deals and programs will naturally depend on both the leverage of the title and market clout of the retailer. In many cases, it is the retailer, with the premium shelf space as the interface to the consumer, that can dictate terms. In fact, retailers with large traffic volume sometimes charge placement fees, such as to stock a video title in the end cap at the checkout lanes (e.g., charging a per-unit fee, and in extreme cases even holding a mini-auction and granting the space to the highest bidder).
Loss-Leading Product and Fostering Consistent Consumer Pricing
Another product of leverage is loss-leading a product. For a big enough title, it is not unusual for a retailer to deeply discount the title for a limited period if it is likely the special price offer will bring customers into the store. Many of the top accounts obviously carry a wide range of product, and the likelihood of additional sales if they can attract a customer into the store is high enough that sacrificing margin on a video title pays off. In extreme cases, the store is even willing to lose money on a title.
Although this sounds like a good deal to the video distributor (you can hear the video salesman gloating, “they want my product so badly they’re willing to lose money!”), the trick to successful sales is managing the overall market, and one account can cause havoc. If a particular retailer dramatically undercuts its competitors, such that traffic is truly taken away from its competitors, then for the distributor the increased volume at that one chain better make up the difference. Otherwise, the distributor will be looking at lots of disgruntled customers who may want to return the product or may not be as accommodating on their next title or campaign. Remember, the wholesale pricing will have been relatively consistent, so a sale from Store X is relatively fungible to a sale from Store Y, and success is driven by making retail sales successful across the entire channel. No distributor wants to spend millions of dollars on an overall advertising campaign to support retail only to have one or two retailers undermine the overall effectiveness.
It is illegal to set onward retail pricing, and once a video is sold the buyer who bought in order to resell is free to set its price (U.S. first-sale doctrine, antitrust, price fixing); accordingly, a video distributor cannot prevent a specific retail account from pricing as they choose. A retailer could elect to give the DVD away for free, regardless of the price it paid for the unit to the distributor. If they want to lose money, that is their prerogative.
There is one accepted practice, however, that buffers this risk: establish minimum advertised price (MAP). A distributor is not obligated to financially support the retail marketing campaign, and there are certain quid pro quos established for committing to cooperative advertising and market development fund dollars. To be eligible for MAP contributions, a distributor may dictate that the retailer may not advertise the product for a price below $X. With this arrangement, the video retailer ensures a relatively consistent price band, yet the retailer maintains flexibility for the ultimate on-shelf price.
When MAP policies are set, they are almost always limited in time, such that on expiry the retailer is free to set and advertise pricing at will. In some cases, a distributor may strategically set MAP expiry to dovetail with a specific anticipated time of re-promotion or anticipated markdowns (especially if dealing with seasonal dates).
E-Tailers and Next-Generation Retail
Beyond the growth of mass-market retail, the video market has benefited from e-tailers such as Amazon stocking new and catalog DVDs. The growth of online shopping has been a boon for video, as DVDs were a natural complement to book sales, and Amazon has matured into a key customer for distributors. What is particularly helpful beyond actual sales is the predictive nature of online sites. E-tailers customarily take preorders for titles, and the relative volume of preorders can often be a good barometer of total retail sales.
Although e-tailers tend to thrive on margin, offering lower pricing given the absence of physical retail space, this is one area where the online stores can struggle to be the low-price leader. In an environment where mass-market physical retailers will, on occasion, loss-lead product to drive profit, and where competition between physical retailers is cutthroat, it may be a challenging proposition for an e-tailer to undercut offline retail. What they can do, however, is more quickly implement temporary and targeted sales (namely, it is easier to change a price online than physically re-sticker physical stock, creating pricing pressure for their physical retail competitors by offering customers competitive pricing, coupled with convenience, preorder reservations, and targeted recommendations).
The Return of Rental and Transactional VOD as the Virtual Video Store
As sell-through retail video sales came to dominate the economics of the video market, it was unclear what the future of rental would be—in fact, at the time of publication of my first edition, the prior leading rental chains were struggling (and Blockbuster and Hollywood Video subsequently filed for bankruptcy), talk was all about the decline of the video market, and few were bullish about the prospects of a resurgence of video rental. Since 2009, however, the dual forces of rental kiosks, led by Redbox, and the growth of transactional video-on-demand (both from cable operators and from Internet-enabled streaming services such as Amazon and Netflix) have not only made the rental market viable again (at least in the U.S.), but have started an inevitable trend whereby rental will likely again come to dominate the video market. Although the scales have not yet tipped, I believe the somewhat irrational underpinning of the sell-through market (see prior discussion), combined with the efficiency of the realization of the virtual video store (whether via subscription streaming or transactional VOD), will force this shift. The growth of Netflix is a compelling example of consumer demand for rental, and yet Netflix as a subscription service is merely one option. Once access is improved via over-the-top systems (see Chapter 7), consumers become accustomed to having a choice among types of transactional VOD offerings (subscription versus à la carte), and vibrant competition diversifies the market (as is happening among Amazon, Netflix, Hulu, and new entrants such as Verizon and Comcast’s Xfinity; again, see Chapter 7), there is every reason for consumers to embrace the virtual video store.
The only factor that could impede the virtual video store’s inevitable success is if services cannot offer enough relevant content to satisfy and attract customers. Video rental stores succeeded because they truly stocked all the titles you wanted to see. If transactional VOD and streaming services fight for content and control titles exclusively, then some of these services could come more to resemble pay TV services than video stores—in Chapter 7, in fact, I argue that Netflix, known as a video company, is in fact more akin to a pay TV company, in that what is offered is subscription rental. Subscription rental when one company has all the content is the equivalent of a pay TV monopoly—in essence, this was Netflix’s position, and offering the only viable service, combined with all the possible content, fuelled its spectacular streaming growth. When Netflix is no longer the only player, and if content is bid for and secured exclusively by a range of services, then there will be inevitable fallout. Content owners therefore face the conundrum of thwarting a monopoly (which Netflix was fast becoming) versus parcelling out content exclusively, which yields short-term gains (large minimum guarantees akin to pay TV), while to some degree risking the longer-term salvation of the virtual video store rental market (because a video store with only some of the content is a less compelling consumer proposition). Will consumers be willing to go to one service that has Avatar, and yet have to search a rival to find The Hobbit: An Unexpected Journey or The Hunger Games? Arguably, yes, but there is only so much fragmentation that will be accepted.
Redbox and the Growth of Kiosks
For years, video distributors have been trying to improve the accessibility of renting programs. Video kiosks were once predicted to be the rage, with vending-type machines located in high-traffic areas (e.g., lobby of large office buildings): customers would pay, get the DVD through a slot when it dropped out, and return it to the machine within a day or two. Although kiosks were found selectively worldwide, including in supermarkets and in international territories where retail space is at a premium such as Japan, video kiosks never caught on as projected—until the last five years. Growing out of kiosks within McDonald’s restaurants, Coinstar, Inc. grew its U.S. base from just over 1,000 locations in 2005 to over 35,000 at the beginning of 2012 (see Figure 5.3); in fact, near the beginning of 2012, Redbox touted on its website that its kiosks had rented more than 1.5 billion discs, and that more than 68 percent of the U.S. population lived within a five-minute drive of a Redbox kiosk.26
How did it achieve this growth? In short, price. While Redbox was undoubtedly helped by finding a niche between Netflix switching its focus to streaming and the largest video rental chain, Blockbuster, going bankrupt, it nevertheless defied conventional wisdom to increase its DVD rental share in 2011 by 10 percent to garner 35 percent of the market and become the leader in the U.S.27 Barrons, talking about the bargain that Redbox offers consumers, highlighted its price advantage and strategy: “Redbox had more than 500 million rentals in 2011’s first nine months. In a tough economic climate, it isn’t hard to see why. While the newly released move The Help can be rented at Redbox for $1.20 a night, it’s for sale at $16.99 at Amazon.com (AMZN) and costs $4.99 to rent on Comcast (CMSSA) or Time Warner Cable (TWC).”28
Seeing the success of Redbox, Blockbuster, coming out of bankruptcy and now owned by Dish Network, started Blockbuster Express kiosks to compete—that bet paid off in 2012 when Coinstar/Redbox announced a purchase of Blockbuster’s 9,000 kiosks for $100 million. Depending upon the number of Blockbuster kiosks Redbox maintains and converts to its branding, Redbox locations could grow to over 40,000 (in early 2012, the total number of kiosks still remained around 35,000, but by 2013 the numbers started increasing again).29 This is an amazing turnaround in a market where DVD sales (Blu-ray and DVD) dropped 12 percent in 2011,30 and led Redbox’s SVP of marketing to boast: “We have more locations than McDonald’s and Starbucks combined.”31
Figure 5.3 Redbox’s Growth from 1,000+ Locations to Approximately 30,000 in a Five+ Year Horizon
Data © 2012 Redbox (excerpted from Redbox.com/history)
The growth of Redbox and its comparatively low pricing prompted a new window debate. Studios had generally structured a 28-day holdback from video release to Redbox rentals. At the beginning of 2012, with its deal with Redbox set to expire, Warner Bros., looking to further protect the window for customers to either buy a new DVD or rent it via VOD, demanded that the holdback be doubled to 56 days; Redbox balked, and Warners cancelled its deal, believing that in the long run, $1 rentals would undermine the studio’s profitability versus higher margins in the VOD and sell-through markets. Redbox, without a Warners deal, simply opted to buy Warner Bros. titles at retail outlets, still able quickly to stock its kioks with hits such as A Very Harold & Kumar 3D Christmas, and simply accepting a smaller margin than if it had the benefit of buying from Warner Bros. directly. When Universal’s deal similarly came up for renewal (Q1 2012), the studio was rumoured to want to join Warners in requiring a 56-day delay, but ultimately backed down and maintained its 28-delay (i.e., holdback between when DVDs first are available for purchase by consumers to when they are made available for rental at Redbox kiosks).32
Arguably, succumbing to the pressures of Redbox and its low pricing is not in the best long-term interests of studios whose bottom lines would benefit from preserving the highest margin access to its product (i.e., Warners’ position). The challenge for the frustrated studios, however, is how hard to fight when, to many, Redbox is a surprise buffer (if not godsend) against a declining market. Without Redbox kiosks, the studios could face the once-unimaginable notion of the disappearance of physical discs for on-location rental. The entire Redbox story and the behind-the-scenes strategizing with respect to its window (imagine, a window just for kiosk rental!) is a perfect example of the disruptive force of digital systems and the desperate effort of content distributors to preserve windows.
Netflix and the Growth of Subscription Rental
Although I discuss Netflix, and in particular its streaming service and access points (e.g., Roku) in Chapter 7, the service and company also has to be discussed here, given its roots in the video market.
Netflix’s original secret sauce was to combine the inventory management and ease of access of the Internet with old-world fulfillment—the mail. A customer could scan a seemingly infinite catalog of titles (online viewing is not constrained by physical retail shelf space, i.e., the wide tail) and then simply place an order. Fulfilment was then quite clever: order one or more, and every time you returned a DVD you could select another one that would be shipped out to your home. The movies came in simple paper cases (without the bulky video box) with prepaid envelopes: just seal and return. Netflix grew dramatically from a 1998 launch with less than 1,000 titles to over 1 million subscribers by 2003, at which point it had delivered over 100 million DVDs (and, by 2007, over 1 billion).33 This was essentially a virtual video store, and the only drawback was fulfilment delay. That lag did not turn out to be the obstacle some thought, perhaps due to the ability to order in volume, so it was possible to build an inventory at home and always have something ready to watch while you decided what to see next.
By 2006, Blockbuster was on the ropes and Netflix had passed the 4-million-customer mark. Blockbuster and other traditional video retailers had to compete directly, and Blockbuster launched a home delivery service, even going so far as to advertise the new option during the Super Bowl (February 2006). While achieving these numbers and starting to overtake the historical market leader Blockbuster may have seemed like success in itself at the time, Netflix’s growth only started to accelerate. By 2009, it passed 12 million subscribers, and by mid 2011 that number had doubled to more than 24 million, making it the media industry’s largest subscription business.34 Netflix’s stock rose in similar hockey stick fashion, hitting a high of nearly $305 in July 2011, before crashing to $62.37 just months later35 after decoupling its physical and digital business and rebranding its streaming service to Qwikster.
In less than a month’s time in September 2011, Netflix announced and then abandoned a new brand, Qwikster, which will live on in business school case study lore—of what not to do. In the summer of 2011, as its stock hit an all-time high, Netflix announced: (1) that it was significantly increasing the price of its service that allowed customers to obtain DVDs through the mail and access unlimited streaming of titles online: instead of only $9.99 per month, customers would have to choose between now paying $15.98 for the bundled offering, or pay $7.99 per month month for streaming access only; and (2) that Qwikster would be the new name/brand for its streaming-only service. The Economist, in an article titled “Netflix Messes Up,” described how Netflix, fearing “being left behind by technological change, like AOL with its dial-up service,” saw its future in streaming, but failed to anticipate the customer hostility that led to jamming the company’s switchboard with complaints, being deluged with hostile comments on its Facebook page, and causing the stock to plummet: “The company’s reputation for top-notch customer service has been tarnished … Netflix has made a tactical error and treated its customers shabbily. It has also jumped too hastily into the future—as if Renault were to declare that electric cars are the future and rename its petrol car division Qwikmobile.”36
The Wall Street Journal, citing famous branding mistakes such as Coca-Cola’s failed introduction of “New Coke,” stated: “Netflix joins a list of companies with embarrassing flip-flops,” and graphically plotted the failed introduction against the company’s falling stock price (see Figure 5.4). (Note: As discussed later, Netflix quickly rebounded and its streaming business grew to dominate, if not define, the SVOD business; see next section and also Chapter 7).37
Figure 5.4 Quitting Quikster
Reproduced by permission of the Wall Street Journal.
The Slow, Steady Decline of Netflix’s Physical Disc Rental Business, and its Belief in Streaming Focus Vindicated
Although Netflix may have created marketing and branding sins that may take years to overcome, it was nevertheless correct in its core assumptions: its recent growth had been fueled by a surge in streaming customers, streaming was its future, and offering a competitively priced subscription streaming-only option would dovetail with ultimate consumer demand. Despite having subscription levels drop from a former high of nearly 25 million, in Q1 2012 the company still had nearly 22 million streaming subscribers, was on track to add streaming customers at the same pace it had seen a year earlier, and was seeing its total subscriber count climb back above 23 million.38
Netflix believed it had weathered the storm, and was managing the reality of losing traditional DVD customers, hoping to mitigate these losses and even grow by building its streaming base and expanding internationally. After losing 2.8 million DVD customers in the last quarter of 2011 and expecting to lose another 1.5 million in the first quarter of 2012, the Wall Street Journal noted that in an analyst call, Neflix CEO Reed Hastings admitted he has no plans to promote Netflix’s traditional DVD business, and even stated: “We expect DVD subscribers to decline steadily for every quarter forever.”39 Against this forecast, but for the growth of Redbox described above, it would be easy to write off physical discs and begin drafting the obituary of DVD rentals; as described in Chapter 7, even Redbox is joining the streaming competition, partnering with Verizon for Redbox Instant, and it is entirely possible that, as quickly as kiosks grew, they could become obsolete. Arguably, the transition is inevitable (Why not even smaller kiosks, coupled with electronic outlets such as ATMs—plug in your USB and download?), and the only question is the speed at which customers without broadband access will delay the switch, given the large installed base of DVD players and the cheap rental options (e.g., Redbox) available. Technology has a way of increasing adoption faster than anticipated, and with nearly 1 billion people on Facebook, it would be hard to argue that the streaming generation has not already arrived. As for Netflix, with its new focus on streaming and further feuling subscriptions with the launch of original series (see Chapter 7), by mid-2013, its streaming subscribers grew to 30 million in the U.S., and nearly 38 million worldwide.40
Netflix’s Next Big Challenge: The Cost of Content
As Netflix grew and became the proverbial 10,000-pound gorilla, two different pressures were bound to develop: competition would evolve, and content suppliers (who, as studios, were also would-be competitors) were likely to charge more for content, or withhold it altogether. Big media companies, at once grateful for Netflix as a buyer yet increasingly wary of its dominance, started to snipe. Jeff Bewkes, Time Warner’s CEO, famously scoffed to the New York Times: “It’s not like the Albanian army is going to take over the world.” Time Warner was often quoted as raising concerns about deals with Netflix eroding the value of content. The CEO of TBS (a Warner company), Phil Kent, went so far as to openly warn those who would sell programming to Netflix to think about the impact on downstream syndication deals, advising suppliers that Netflix streaming deals were “going to have a significant impact on what we’re going to be willing to pay for programming or even bid at all.”41
First, suppliers started to withold content, including Sony Pictures Entertainment, and then Starz. Starz was a significant blow, for it was one of Netflix’s earliest deals, struck in 2008 before streaming had mushroomed for what was reportedly $30 million per year.42 Netflix essentially added the streaming rights for nominal amounts under the original deal, but if one now viewed Netflix streaming more akin to a pay TV service where pricing is on a per-subscriber basis (see Chapter 6), then the pricing would go up dramatically. The Hollywood Reporter43 gave the example that at 25 million subscribers, Netflix would “pay 10 cents a sub for each month for Starz content—compared with the estimated $4 a sub Starz gets for its premium movie service from Comcast, DirecTV, and other multisystem operators …” While estimates of the value of renewing the Starz pact, which included Disney titles such as Toy Story, were speculated to be from $200–300 million (and Reed Hastings even being quoted as saying that $200 million per year “wouldn’t be shocking”),44 Starz ultimately elected to cut its ties, and its properties were removed from Netflix.
Although Netflix lost Starz, it added other content and continues to aggressively court content producers for rights. (Note: In an interesting twist in the evolution of Netflix and the industry overall, Netflix, as discussed in Chapters 6 and 7, has evolved into more of a pay TV company, offering a similar subscription aggregation service online as opposed to over cable, and as such is now competing with Starz for content, and wrestled the Disney output deal away in 2012.) Examples of deals concluded include:45
■ 1,000 titles from Epix, reputedly paying $200 million for five years, outbidding an offer from Showtime for $175 million, with titles such as Iron Man and G.I. Joe: The Rise of Cobra streaming 90 days after Expix debuts in its pay TV window.
■ Relativity films, including titles such as The Fighter, available within a few months of its DVD release.
■ Disney/ABC television product, valued at over $150 million, including series such as Lost, Scrubs, Desperate Housewives, and Hannah Montana, where all six seasons of Lost are reportedly valued at $45 million.
■ Fox television titles, although tilted toward cancelled series, including Lie to Me, Prison Break, Bones, and Arrested Development.
■ Disney movies (including Marvel and Pixar) starting in 2017, at an estimated annual cost of $350 million.46
■ Select Warner Bros.-produced network titles, such as Revolution (NBC) and The Following (Fox).47
Another factor in the rise of the cost of content is that the DVD rental market and the streaming market, though similar, are based on different rights grounded in different legal protections. While the core notion of physical DVD rentals versus streaming access is an example of the infinite divisibility of intellectual property (see Chapter 2), the difference is exacerbated by the first-sale doctrine. The first-sale doctrine, as earlier discussed, essentially holds that once a retailer sells a product, it cannot restrict the onward sale of that product—a tenet that underlies secondary markets such as eBay. This is also the principle pursuant to which Redbox could walk away from Warner Bros. and simply elect to buy the titles from third parties post release to then stock in its kiosks. In contrast, since streaming rights are transitory and tied to a license, Netflix needs to negotiate for these rights. The Economist highlighted this issue in contrasting the ability of Netflix to start renting DVDs as soon as that window opened: “To stream a film via the Internet, in contrast, Netflix must strike an agreement with the studio or TV firm that owns it. As Netflix has become richer and scarier, negotiations have become harder. The company must wait eight or nine years to stream many studio films.”48 Further, other providers such as HBO “refuse to let Netflix stream their shows at all.”49
Combining all of these factors, the net result is that content is becoming increasingly more expensive, and the days of acquiring streaming rights somewhat under the radar and without major competitors bidding are long gone. It is difficult to estimate Netflix’s total cost for content, but the Hollywood Reporter quotes a Lazard Capital Markets analyst as predicting that the company will spend upwards of $1.2 billion in 2012 for streaming rights,50 and the Wall Street Journal estimated that, as of September 2012, Netflix had $5 billion in streaming liabilities for content, up from $3.5 billion the prior years.51 Again, paying in the range of $1 billion for content sounds more akin to a pay TV service, competing with the likes of HBO. In fact, as more of Netflix’s content skews toward television fare—a consequence of cost, and despite its efforts to be the aggregator of all movies and TV shows—Netflix is aware that distributors of premium television content will quickly become its chief competition. Netflix is famous for publicly describing its strategy, and in its “Netflix Business Opportunity” slide deck posted on its website,52 it both describes itself as an Internet Network (as opposed to broadcast or cable), and under “Long-Term Threats to Netflix” highlights: (1) TV Everywhere, noting: “Great Internet apps on all screens for all existing networks, at no extra consumer cost, would eventually mean less watching of Netflix, less desire by networks to license prior seasons to Netflix, because they can self-monetize in their app”; and (2) “Our most direct competitor for viewing time will probably be HBO GO.”
It is important to remember that the discussion started in the context of the decline of the home video market, and how Netflix and Redbox were, to a degree, white knights infusing cash into the video kitty. What is clear, however, is that regardless of Netflix’s roots and its success with DVDs, the company does not see that as a viable long-term market and is focusing all of its efforts on building its streaming business—a business that more resembles, and by its own definition is, a new form of a television network. Neither Redbox nor Netflix are tempering the decline of the more lucrative sell-through market, and if these services, over time, morph more into streaming TV-like services, then it is highly unlikely that this expanded TV universe (even if a slightly different window, and therefore additive) can make up for the demise of the corresponding video market. Given the historical importance of the video market—almost 50 percent of all studio revenues at its peak—the implications of this seismic shift underlies studios’ and networks’ justified fear of the disruptive force of digital distribution, even as they move to embrace the inevitable new landscape.
Window Movements
There is no doubt that given the importance of DVD revenues, there has been pressure to tinker with the window. In analyzing the tug of war between competing media, Business Week summarized:
To capture that DVD gold, Hollywood has for years made its flicks available to TV viewers only through a carefully structured system of “windows.” DVD retailers waited six months after the theater premiere; cable’s and satellite’s video-on-demand (VOD) got the film 90 days after that, and HBO and other pay TV services six months following VOD. But the windows have been slowly closing, and studios now ship DVDs to market sooner than ever before—on average, in 137 days (versus 200 days in 1998), according to DVD Release Report …53
While this may sound dramatic, I would argue that the shrinking of the window has been merely iterative; in fact, and perhaps not surprisingly given the continued importance of both the theatrical and video markets, the window for video release, while accelerating, has stayed relatively static for several years. Window protection is so important for theatrical releases that the cinema chains exert extreme pressure, and will even in extreme cases boycott studios that test closing the gap by accelerating a DVD release date too close to the theatrical release.54 The movie cinema trade association National Association of Theater Owners (NATO) goes so far as to track the window/gap studio by studio, down to average days post release and “announcement” dates. Table 5.4 is a schedule of the video release window by year, as reported by NATO.
While there is significant experimentation with download/electronic sell-through and VOD windows (as discussed in Chapter 7), the DVD window, even if narrowing a bit, seems to remain a relatively stable fulcrum around which manifestations of physical and electronic video sales and rentals are trying to balance. As discussed above, there are changes in holdbacks to lower priced rental options, such as in the case of Netflix and Redbox, but this is generally fine-tuning around the broader DVD window; as services morph from being perceived as video rental to being more akin to pay TV, however, then the windows will shift more fundamentally—as is already starting to happen, including the introduction of a new Digital HD window.
I asked Mike Dunn, president of 20th Century Fox Home Entertainment, what he thought about the video window relative to expanding digital options, and he confirmed the continuing importance of physical media while highlighting the need to provide alternatives in order to fulfill the consumer’s demand for digital access across a range of devices:
Digital is redefining home entertainment, with consumers’ changing habits influencing the way TV and movies are delivered and enjoyed across a range of screens. While physical media remains a key part of the industry, with Blu-ray flattering large-screen, Wi-Fi-enabled HD and 3D televisions in the living room, the need to meet consumer demand for access across all their connected devices has fostered new momentum and innovation for digital downloads and electronic sell-through models.
Table 5.4 Average Video Release Window
Year |
Average Video Release Window |
1998 |
5 months, 22 days |
1999 |
5 months, 18 days |
2000 |
5 months, 16 days |
2001 |
5 months, 12 days |
2002 |
5 months, 8 days |
2003 |
4 months, 27 days |
2004 |
4 months, 20 days |
2005 |
4 months, 18 days |
2006 |
4 months, 11 days |
2007 |
4 months, 19 days |
2008 |
4 months, 10 days |
2009 |
4 months, 11 days |
2010 |
4 months, 12 days |
2011 |
4 months, 5 days |
2012 |
3 months, 29 days |
NATO memo, September 27, 2012, Re: Average Video Announcement and Video Release Windows (as of September 24, 2012).
At Fox Home Entertainment, we understood the potential for Blu-ray to demonstrate for consumers what was possible in digital. We heighten the relationship fans have with their favorite entertainment by making available new content through downloads and second-screen engagements. Not only could fans view TV shows and movies in stunning visual quality, but they could receive new narratives, unseen footage, and commentaries, as well as purchase in real time the clothes and accessories worn by their favorite characters. This willingness for consumers to engage and embrace digital through Blu-ray, along with the evolution of portable devices on which content is enjoyed, seeded consumer interest and drove our leadership in new digital delivery models.
Our digital strategy supports fostering easy, affordable, and accessible ways for consumers to access their entertainment anytime and enjoy it across all of their devices. This approach is also leading to new business models, while fostering the evolution of UltraViolet and other ways for consumers to amass digital collections. In 2012, as an example, we launched Digital HD, which redefines electronic sell-through and combines for unique benefits: early access, affordable pricing, cloud storage, and availability across multiple devices. The Ridley Scott epic Prometheus was our first Digital HD title, and was available three weeks ahead of its physical media launch into the home market. With a single purchase, consumers can enjoy the movie on any screen in the highest quality possible. The success of the release, and others that have followed, demonstrate the opportunities that come with embracing what’s next and appealing to what consumers say they want: convenience for our digital lifestyles.
Physical Disc Inventory Management and Impact on Pricing and Profits
Probably the biggest single issue impacting the release of a title into the sell-through market is managing inventory. Rental units are generally firm sales, and when a rental chain decides it is overstocked or inventory has reached obsolescence, it can either destroy the units or sell them. Sell-through units/DVDs are, however, no different than any other consumer product, and excess stock is most often subject to return.
There are multiple steps in inventory management, and I will briefly touch on the life-cycle sequence in which they occur: (1) initial shipments; (2) replenishment; (3) returns; (4) price reductions and price protection; and (5) catalog management. While managing this process has been the focus of video divisions for years, a move to digital distribution (whether streaming or EST downloads) eliminates the need to manage inventory, as well as the risk associated with insufficient or excess stock. If electronic/digital distribution were therefore wholly substitutional for physical discs, there would be no reluctance, and in fact exuberance, in shedding the burden of managing physical stock. It is because we are not yet at this point, though, and because video still remains a very significant revenue source (not to mention the impact these factors have had on the evolution of the market), that I will discuss them in detail below.
Parallels in Games Market
Before addressing these elements, though, I want to briefly highlight that the same issues apply to most packaged-goods entertainment, and especially to the video-game industry. The implications of the shift to digital distribution in the games market is heightened due to an advantage not found with video—not only can distributors of product made for the major console platforms (Nintendo Wii, Microsoft Xbox, Sony PlayStation) eliminate inventory risk if games are downloaded via online networks such as Xbox Live Arcade, but game distributors also have the ability to update games with patches, new levels, and character add-ons. Moreover, these same online distribution platforms enable networked playing and other interactive features, providing further additional benefits to transitioning.
Similar to the video scenario, these benefits do not come challenge-free, as digital distribution is simultaneously enabling new competitive download options. The games industry is watching carefully the growth of fully online portals such as Steam, which bypass the console platforms entirely and allow 100 percent digital PC access; there is less risk to the ecosystem at the moment with such outlets, however, as the content providers must first port the games for play on these platforms. The combination of being able to control whether to port games to nonconsole digital platforms, coupled with the generally inferior user experience versus utilizing controllers (though you can now buy plug-in joysticks, etc.), ensures, at least for the time being, that these online systems remain ancillary. The major console manufacturers who dominate the games market, having created a captive vertically integrated end-to-end ecosystem, can accordingly limit downstream applications via licenses and benefit from the fact that, unlike videos, games can be updated and expanded via digital downloads. This measure of control enables the same players to manage the expansion and integration of new download experiences—as discussed in Chapter 8, the threats faced by the old guard are more from social games, which leverage digital distribution and “freemium” business models. Although these new types of games may create some pricing pressure, it is generally considered a different market, appealing to a different and expanded user base (“casual” games versus “core” games), thus holding more potential for market expansion than cannibalization. The end result is generally benefitting the games business, and the longer-term challenge will be how producers can maintain high product price points (pricing has always been artificially high, given the need to pay manufacturing fees to the console owners that keep manufacturing captive under the guise of proprietary patented systems and the need to recoup costs of developing upgraded next-generation systems). Digital distribution with games, as with videos, eliminates the physical disc costs, and it is harder to justify a high per-unit cost, even if that is tied to a licensing and systemaccess model. Accordingly, the games business, which has always benefitted from high pricing and margins, will benefit similarly from reduced distribution costs, but those same pressures will ultimately force lower pricing, with the danger that margins will fall as well.
Initial Shipment
This is by far the most important step, because miscalculations on initial placement will plague the title’s performance all the way downstream. It is debatable whether it is worse to over-ship or under-ship, but if demand outstrips supply and a title has been under-shipped, there are really only a couple of issues to address.
First, the obvious consequence is lost sales, and opportunity costs are always the hardest element to accurately forecast. If the under-shipment is recognized early, by utilizing an efficient supply chain (see later discussion) it is still feasible to capitalize on demand. However, because marketing campaigns are designed to create intense demand on release, absent a honed and tightly managed supply chain it is obviously difficult to reach fully substitutional sales outside the window of coordinated advertising and retail marketing/focus.
Second, the distributor needs to confirm how feasible it is to quickly replenish inventory and mitigate lost sales. In the mid to late 1990s, this would have been difficult, but as the market has matured, so has the replication and distribution system. Today, single plants may be able to produce 1 million discs per day and deliver them nationwide to out-of-stock retailers within the week—full replenishment may not be possible literally overnight, but it is feasible in a matter of days. Again, days count when dealing with a coordinated marketing campaign; the consequences of being out of stock and replenishing late include: (1) losing retail placement position; (2) losing retail focus; (3) selling against a new competitive title; and (4) missing key sales days such as weekends or seasonal-specific dates.
If, in contrast, the initial shipment has glutted the market and it turns out the distributor has materially over-shipped, there is likely to be pressure to take returns. This leads to complex management challenges, including price-protection decisions, as discussed later. Moreover, overstating revenues and having to reverse out-earnings due to returns is a serious problem and (as also discussed later) has been responsible for significant downturns in the stock prices of companies who miss their targets.
Replenishment, Fulfilment, and Logistics
The sophistication of the market largely dictates how replenishment works. In the United States, the video arms of the studios and supply chains of the replicators and distributors are models of efficiency. On a major release, a studio has visibility into its large direct customers to the extent that it can check sales periodically during the day. The inventory and sell-through numbers are constantly updated, and it is possible to see how a title is progressing on release early in the week and top up SKUs as necessary for the weekend. Replicators able to churn out hundreds of thousands of units per day (if not more) then further decide how many units to build at which stage of production, balancing finished-goods inventory versus elements needed for a quick turnaround on the assembly line.
As the sell-through business matured, the duplicators recognized that they could fulfill additional distribution functions. Not only could they make the physical good, but they could handle the logistics of sorting SKUs, packing the product, and shipping the product. This step is frequently referred to as “pick, pack, and ship,” and involves the logistics of everything in the chain, from completion of the physical good to delivering the good to the retailer. It may seem simple here, but the process of sorting inventory for delivery to retailers is a mechanized art.
The management of the backroom logistics does not stop there, however. The replicator has now taken on the task of processing returns, repurposing stock, invoicing the client/retailer, processing related credits, and even handling some collections. Basically, the entire chain, from manufacturing, to delivery, to payment, can be outsourced, leaving the intellectual property owner to focus on marketing the product and setting customer-specific terms.
The less sophisticated the retail market, the harder it is to replenish efficiently—the replicators have the systems, but without the retail systems to report offtake efficiently, the distributor is left to place all its product up front. Otherwise, the distributor risks out of stocks without the ability to replenish; this is not a viable option when the product has a short shelf life, driven by a burst of front-loaded advertising to drive consumers to purchase in a relatively short window. As discussed previously, the decay curves for video sales are becoming steeper, with an ever-increasing percentage of total sales on a unit in the first couple of weeks of release. Again, this correlates to increased competition and the fight for shelf space, with most displays rotating out on a regular weekly or biweekly basis and restocked with the “new title of the week.”
No matter how efficient the supply chain and replenishment logistics, there is no guarantee of sales and always a risk of over- or under-stocks. While the risk is not nearly of the scale as on the theatrical release (as theatrical results convert the product from a nobody-knows experience good to a property that can be more accurately forecast for subsequent market sales—conversion rates), significant risks, even if more bounded, still exist. Because of the marketing profile, the trend has been to over-supply to ensure against out of stocks, as well as secure optimum store display. While every distributor knows they need to ship in more than 1 million units to sell-through 1 million, the art is to narrow the gap as much as possible without jeopardizing sales—the greater the efficiency in this stock management, the greater the margins and profits.
Returns
Historically, distributors have negotiated returns provisions with retailers that tend to be account-specific. A customary provision, for example, may be that an account is allowed a returns provision of 20 percent. It is also possible to negotiate for zero returns (a “firm sale”) or allow a retailer 100 percent returns. A 100 percent returns allowance usually occurs when either a retailer has enough clout to insist on this flexibility, or the retailer has agreed to take extra units and aggressively market the title. Regardless of what is negotiated, it is important to keep in perspective that these provisions may change after the fact—a retailer that has agreed to 20 percent returns and finds that the title significantly underperforms is likely to ask for relief and return a much higher percentage. If this is a key customer and the distributor has another title coming out the following month it wants to push, it may not be so easy in practice to rigidly enforce the hard 20 percent number. The success of a title ultimately depends both on the distributor and retailer market, and both parties need to juggle short-term performance versus long-term relationships. This is where friction arises with producers, as someone involved with a specific title will not accept the sacrifice of his or her title’s performance to accommodate client relationships that may bear no direct impact on his or her film’s video revenues.
For accounting purposes, returns caps allow the distributor to take return reserve provisions; namely, in accounting for sales, a provision will be taken for returns based upon the contractual return allowance or a permitted reserve. When accounting for sales, there is always a gap, and several elements need to be reconciled: What has been shipped into the retail channel? What units have actually sold-through to date (bought by a consumer as opposed to bought by the store)? What number of units is likely to remain at retail for future/continuing sales? What number of units is likely to be returned?
Returns impact participation statements (see Chapter 10) and need to be looked at in terms of how returns are treated between the distributor and retailer, and how returns are accounted for between the distributor and the producer/participant. There may be separate deals, and this may not be (though often is) strictly a pass-through relationship. One can theoretically imagine a producer with sufficient leverage inserting a returns cap in its deals to protect against a distributor favoring a retail customer or making a decision based on retail relationships as opposed to strictly on the title.
There may also be contractual provisions regarding the timing of returns and reserves. In addition to or unrelated to a returns allowance percentage, the parties could strike a deal prohibiting returns for a period of time (e.g., no returns for 90 days or six months); this has the advantage of keeping the product on shelf, and may allow for increased sales over a different or incremental selling season that would not take place without the protection (shelf space otherwise ceded to a competitive title).
On the participant side, there may be a push to stipulate that returns allowances may only be taken for a limited period of time and then released; it is customary to negotiate periods during which returns reserves need to be liquidated. Because the reserves are allowed, the distributor will naturally take advantage of potential returns and keep the money (in anticipation of returned units); however, these returns may never materialize, and all the while the money is held and not paid over to the producer. This practice, which is equivalent to the concept of “float” in other industries, means that the negotiated reporting and liquidation periods can be quite significant.
Spotlight on DreamWorks Animation and Pixar in 2005
The issue of returns was highlighted in 2005 when both Pixar and DreamWorks Animation were hit with returns on, respectively, The Incredibles and Shrek 2.
The tempest was set off by DreamWorks statements and filings. In January 2005, DreamWorks Animation stated that it had sold 37 million units of Shrek 2 worldwide. However, in March the studio reported that it had only sold 33.7 million units and that it expected the title to continue with a strong performance and sell over 40 million by the end of the first quarter. When the day of reckoning came in May, DreamWorks Animation reported that it had only sold 35 million units (not 40 million), and admitted that the rate of sales that propelled the title to the top video seller of 2004 did not keep pace into 2005.
The reporting caused DreamWorks Animation’s stock to fall 12 percent on the disappointing earnings, and the entire issue of returns and slowing down of the video market started making headlines. The Wall Street Journal reported: “In just its second quarter since becoming a public company, DreamWorks fell short of earnings forecasts by 25 percent and its stock tumbled as Wall Street wondered why the mistake wasn’t disclosed sooner.”55
Beyond the hit in stock price and negative publicity, the misjudgement on sales and returns even led to lawsuits, which in turn made headlines:
Shrek 2 DVDs Subject of Lawsuit. Shareholders sue DreamWorks alleging misleading projections…. A proposed class-action lawsuit, filed in federal court in Los Angeles today, seeks unspecified damages from DreamWorks Animation for allegedly misleading stockholders about prospects for sales of Shrek 2 DVDs.”56
In the wake of this news, Pixar warned that it would have larger-than-expected returns on The Incredibles; on June 30, 2005, Pixar cut its earnings per-share estimate for the second quarter from 15 to 10 cents, citing slower-than-expected sales. The issue became prominent enough that even the SEC started to examine the reporting process for each of these studios. Ultimately, the SEC’s local arm investigating DreamWorks recommended that no enforcement action be taken, and Variety reported: “While the SEC itself still has to make a formal decision, recommendation makes it very likely that DWA will escape government sanction for failing to warn investors, before first-quarter earnings were announced last year, that returns on the Shrek 2 DVD were running much higher than anticipated …”57
While the issue of returns seemed like a revelation to the press and some investors, the difficulty of managing inventory levels and balancing returns was nothing new to industry insiders. What had changed were two factors. First, as earlier discussed, there was a slowing down of sales in the industry, and within 2005 the market seemed to have hit its by-title ceiling; the overall market was still healthy, but with title saturation and withering competition the market appeared to be retrenching on the high end of sales. This was a trend that had been predicted, but the reality came quicker than anticipated and started to send shock waves through the market.58 Second, with a microscope on the industry, there was the ability, in the case of both Pixar and DreamWorks Animation, to see the impact on a specific title. This transparency was rare, for studios would otherwise report numbers on a consolidated basis, and to outsiders it was impossible to glean the numbers or even trends on the basis of a single title. With The Incredibles and Shrek 2, there was no way to hide the line-item performance.
Format and SKU Variables
An important variable in managing inventory and returns is also managing product SKUs. In some cases, a video or DVD release will be split into pan-and-scan and widescreen versions. Typically, a traditional box-shaped TV screen plays a 4:3 aspect ratio, which is referred to as pan and scan. In contrast, the horizontal aspect ratio of widescreen, replicating the rectangular movie, is 16:9. The widescreen aspect ratio matches the way a movie has been shot and edited, capturing the full breadth of the scene. To create a pan-and-scan version, the filmmaker actually has to create and approve another version, because the picture cannot simply be squeezed into the other shape. Accordingly, a pan-and-scan version will often cut off images at the margins.
The advent of widescreen monitors and increased consumer market knowledge led to an increase in widescreen versions. For years, pan-and-scan dominated, as widescreen was limited to the “purist” consumer who wanted to see the picture as the director intended it/as seen on film, so elements and scope are not compromised (and would put up with the black bars at the top and bottom of the screen). With the market maturation, plus increased consumer awareness of formats and the growth of rectangular flat-screen monitors, the SKU balance started to equalize on “collector”-type titles. By 2003–2004, certain titles were selling a greater number of widescreen versions, a trend that had been predicted but until this point of intersection (DVD growth and alternate monitors) had not happened. With each year, the proportion continued to shift in favor of widescreen—in fact, widescreen has become the de facto standard with pan and scan set to disappear.
Finally, in terms of SKUs, studios started to offer special “2-disc sets” of key titles, with one disc containing the film and the other disc filled with bonus material (or, in video parlance, value-added material or “VAM”; see Chapter 9 for more discussion of VAM in the context of marketing). The extra material both justified a higher price point and had become a self-fulfilling expectation from the standpoint of consumer demand—once it was commonplace, it became an expected component. The net result of the bonus disc was the studio distributor had a choice whether to release one version including the bonus material, or two versions with the alternate SKU comprised of just the film disc. If two SKUs were released, this obviously complicated the release matrix: Would the physical packaging change? Would the artwork change to distinguish SKUs? Would the price points vary? Would the distribution points of sale change?
Today, the existence of “VAM” can be a differentiator helping justify the purchase of physical versions versus digital copies that frequently only offer the movie or TV show itself. In a world with cloud access and storage and digital rentals via Netflix and cable VOD, VAM offers premium content valuable to the collector and often only available with purchase.
Pricing, Price Reductions, and Price Protection
Pricing is not quite what it seems from customarily quoted numbers, and to understand the economics it is important to appreciate net pricing. The price charged by the retailer to the consumer is called the retail price. Because it is illegal to set an onward price, what is usually set is the SRP; MAP is a vehicle to influence the SRP, but ultimately there is market flexibility and neither the SRP nor MAP actually locks a retailer into a specific sales price. (Note: When you hear about a store advertising as a low-price leader, or matching in the market, it is important to discern between whether a specific store in the chain will alter pricing within the store to match a competitor, or whether the chain/store is actually advertising a specific price to the consumer. It is very different to claim you will match a price (where no figure is stated in the ad) and to actually advertise a specific price in newspapers and circulars.)
The price that the distributor charges the retailer is often called the dealer price, which is the video term for wholesale price. As a rule of thumb, the wholesale price tends to be roughly 60 percent of the SRP. The wholesale price is basically fixed across the U.S. market (in accordance with the Robinson–Patman Act); nevertheless, there can be marginal account differences in the wholesale price, as juggling can take place with marketing allowances (market development funds and cooperative advertising allowances) and tailored programs.
Like any consumer product, over time there are markdowns as new items enter the market. In the video sector, product is generally segmented into “new releases” and “catalog.” When a product transitions from a new release to catalog, however, the price is not fixed, although generally product is re-categorized after its initial release cycle. The challenge of a distributor is to manage its library of titles, find ways to turn over its catalog titles, and maintain demand and premium pricing for the key titles in its library. Accordingly, segmenting the library becomes an important marketing proposition, and to generate demand and interest titles are often themed or grouped (e.g., marketed as classics, award-winners, part of director’s collections).
In terms of life-cycle management, studio distributors are always running models (and conducting market research) comparing units and corresponding contribution margins at differing pricing; for example, will dropping the price from $19.99 to $14.99 generate sufficient incremental sales to outweigh the lower per-unit profit? Managing price is an art, not a science, and is influenced by factors such as the nature of the title, the competitive environment, retail pressures, inventory in the market, seasonality, life-cycle promotional opportunities, and rebate programs.
On a typical release, it would be customary to release at a higher price (but a price that hopefully yields maximum net profit/contribution, taking into account the matrix of pricing and volume), and then to reduce the price downstream; for example, if a movie came out at Christmas, and the video came out in late spring the following year, the price may be reduced in the fourth quarter for a Christmas promotion. If competitive product pricing is lower, there will be retail pressure to match, and subsequent price reductions will be implemented. All this activity may generate incremental sales, but there are two issues that need to be weighed. The first is that, except in rare instances, it is very difficult to raise a price—once it sinks to a certain level, it is apt to stay there. Namely, once in the bargain bin, it will be very difficult for the distributor to sell more units into a retailer at a higher price. The second key issue is price protection.
What is Price Protection?
Price protection is money paid by a distributor to a retailer when the distributor drops its wholesale price and sells more units into the market at a price below what it charged the retailer for the retailer’s previously purchased on-hand inventory. For example, if Studio X sold units into the market at a wholesale price of around $12, such that Retailer Y generally priced the title at $19.99 to the consumer, and the studio had a promotion where it wanted to sell in more units of the movie at $9 to drive a retail price of $14.99, it might have a price-protection issue. The issue would arise because retailers would have current stock at the higher price, and would want to be equalized such that all stock had the same cost basis. To take in more units, it would insist that the studio pay or credit it back the difference between $9 and $12 on all units it had. This $3 difference is the price-protection payment charged to the distributor.
The retailer holds the leverage here. If the studio does not equalize the stock, the retailer would likely have the option to return its unsold product for full credit.
Price protection generally occurs in two scenarios. The first is when a title has been successful and there is an opportunity to sell in additional units, such as implementing a seasonal promotion dropping the price after the title has already been in the market for a period. Even with success, individual stores within the same account are apt to be out of stock and others to have excess units—in a perfect world, the retailer would stock balance, excess units would sell-through, and price protection would not be needed; however, the reality is the distributor is likely to bear the brunt of this evening out via price protection, which, if executed well, may only be a credit against new units sold in and would not incur any actual out-of-pocket cash payments. A second scenario can occur when a title has severely underperformed. If a title is not selling-through, and there is so much excess inventory that retailers are threatening to send it back (retailers will want to maintain whatever product is generating turnover and margin), then the distributor may need to drop the product’s price just to keep it on shelves. If they can convince accounts to take in more units when the price is dropped, then there is the potential for netting the price-protection costs against the additional revenues from new units—a scenario akin to a successful title; however, if new units are not ordered or the units do not generate enough revenues to cover the price-protection costs, then the distributor may have to pay the difference in cash. Usually, return reserves will cover this deficit, but if price protection is needed to keep the title on shelf and the liquidation of return reserves (sums held to offset returns) provides insufficient funds, then the distributor can find itself in the loselose position of lower price (and therefore reducing its margin) and paying cash out of pocket for the privilege of cutting its margin. This can, obviously, be a disaster scenario.
Point-of-Sale Rebates
While price protection impacts the entire channel and effects a permanent pricing change, point-of-sale (POS) rebates are a mechanism to implement a temporary price rollback. A supplier may authorize a limited-time price cut, either across the retail channel or with specific accounts, which is implemented at checkout. To create an incentive for the retailer to reduce the shelf price from $19.99 to $14.99, a supplier may offer a $5 POS rebate, which will be applied at the wholesale price level, with the expectation that the full discount will then be passed along to the consumer, lowering the shelf price as just described. The advantage to the supplier is that they only need to credit the stores for units actually sold rather than on the entire inventory. This is a strategy frequently used for promotional sales, or during key holiday periods where the seller is trying to move units during periods of heavy foot traffic, but where the seller does not want to implement a permanent price cut.
Moratorium
Another tool that a distributor can use both to manage inventory as well as pricing is to put a title on moratorium. This means simply that the title is no longer available for purchase. By limiting supply, this may help stabilize either pricing or inventory levels, as stores may be less likely to return product if they are unable to later reorder units. Also, putting a title on moratorium may stimulate sales: “order now or else …” Disney has used this strategy very effectively on its animated classics, advertising that a title is available for a limited period only, helping to spike interest and demand. The product is then literally rested until another cycle or perhaps another special version is later released.
Putting a title on moratorium is especially useful in the instance of multiple SKUs. This may help send a message to retail that the current version of a title will not be replenished (staving off potential returns), and further limits supply to clean out the channel before a different version is released. One of the goals is to avoid market confusion, so that the new version (e.g., a special edition) is the only widely available version, allowing focused marketing campaigns both at the retail and consumer levels.
Price Erosion and Bargain Bins
One of the most difficult elements in managing a title or catalog is dealing with price erosion. As noted earlier, new titles can command a premium price, but once the initial sales cycle has passed the product is perceived as older and will often be repriced in an effort to stimulate sales.
What counters price erosion is that, unlike consumer goods, which are fungible, every movie is a unique piece of software. There will only be one The Godfather or Titanic, and pricing does not need to drop for that film to compete because there is another identical product coming into the market; instead, pricing may need to move for the consumer to view the title as competitive against other similar films. If a competitor has a classics line that underprices its rival studios, price sensitivity alone may influence the consumer’s selection.
Managing consumer expectations is tricky, and, as previously noted, once there is a perception that pricing is at a certain level, it can be difficult to move back up to a higher cost basis. Ultimately, pricing is based on brand and catalog management, and can be influenced by seasonality, new formats coming into play, inventory levels, and even corporate revenue pressures (e.g., dropping a price and stimulating sales can help achieve hitting an earnings target).
It is now common for certain retailers to sell older titles in “bargain bins,” where consumers may buy DVDs for a couple of dollars. Even high-profile titles can be steeply discounted for promotions, as has been the case on Black Friday in the U.S., when some of the Harry Potter titles and The Lord of the Rings films could be found in the $5–6 range. This is a far cry from the former high-priced rental market, and many video distributors bemoan the price erosion in the market. The discounting may be fine if volume is stimulated, but if volumes do not meet projections and the pricing becomes a consumer expectation, rather than a limited promotion, then the high margins the business has enjoyed are put in jeopardy.
Ultimately, there are no other Harry Potter movies, so how and when to move price and launch promotions is the realm of brand management that makes the video market so interesting. Again, even though all films fall into categories, all individual films remain unique, challenging video divisions to hit targets by simultaneously macro- and micromanaging its catalog of product.
Most of the information discussed in this chapter applies equally to the international marketplace, but there are both obvious and subtle differences. It is beyond the scope of this book to delve into territory-specific nuances, but I will try to highlight a few significant areas of difference.
Release Timing and Development of Market
Although video and DVD technology has been driven by European and Asian (in particular Japanese) consumer electronics companies, market growth and penetration has been driven by software and Hollywood pressures. The international video and DVD markets have usually lagged the United States in terms of maturation and retail sophistication.
In terms of retail and consumer patterns, the DVD and Blu-ray market has generally mirrored the prior VHS sell-through market. In territories such as France, for example, where there was a long sell-through tradition and sophistication of key retailers such as the hypermarkets (Auchan, Carrefour) the DVD market has followed a similar pattern. Accordingly, key retailers such as the hypermarkets, or entertainment software chains such as Virgin Megastore or FNAC, tend to have the same challenges that exist in the North American market: How is the product merchandised? How is it displayed? What are the promotional campaigns? Is the price point appropriate?
Additionally, with sophisticated merchandising and placement usually comes quality reporting. The ability of the distributor to see through to actual consumer sales forces the development of state-of-the-art inventory management systems and distribution that allows quick, store-level replenishment. Stock balancing can occur on a daily, and at minimum weekly basis, affording the distributor to respond to consumer demand while maintaining a greater level of flexibility in creating product.
The ability to tinker with stock balances, replenish inventory, and top up manufacturing is only possible with this level of reporting from retail, and the parallel ability of retail to handle changes rapidly. The type of systems that can report and consolidate by-title sales at store and chain levels on a daily basis, however, are only justifiable with certain threshold volumes; in essence, the entire supply side feeds on itself with volume driving sophistication, and fulfilment, merchandising, and manufacturing capabilities evolving with demand. The United States is such a large market with diverse and distant retail distribution requirements that it developed this level of maturity quickly. That process has lagged in many international markets, but has now caught up in sophistication across the territories one would expect (e.g., much of western Europe, Australia). (Note: Not surprisingly, many of the trends discussed above, including, for example, the use of reserves and price protection, is similarly applied in the sales and stock balancing of other physical copies of packaged goods media, such as videogames; additionally, as the same mass-market retailers tend to stock both movies and games, inventory systems have improved and have, to some measure, converged—though movies/DVDs are still managed separately.)
Outside the pure supply chain, considerations such as competition and external factors in the local marketplace tend also to mimic the U.S. market. Regarding external factors, video releases may be tied to natural key sales periods, such as national holidays and vacation periods. As for the impact of competition, all distributors similarly analyze the release schedule of competitive product and date (“street date”) their releases to try to secure the optimal window for sales.
Any and all of these factors are reasons why a DVD may come out on a different date in different territories. Weighing against these factors, however, will be concerns about piracy and parallel imports: once a product is out in the worldwide marketplace, there is a danger it may find its way to the local consumer before the product has been directly released in the country—an issue that is now exacerbated with Internet access, especially for English-language product.
Localization Challenges
The main challenge of international markets is the creation of language-specific SKUs. Each DVD will need to be authored and compressed like the United States, but across the rest of the world there will be multiple SKUs covering both dubbed and subtitled versions.
In addition to language versions, marketing campaigns will be tailored to the specific market as will, in cases, the packaging. Whenever a creative campaign is changed, and especially when it is uniquely tailored to a specific territory, there is inherent delay. Additionally, depending upon contractual requirements, time may need to be allocated to obtain approvals from talent, as well as for home office executives to coordinate their approvals with both international branches and the producer/production company that made the film. Hopefully, these elements have been planned for (and lead times built into release schedules), but the potential for delays is obvious.
Pricing: Variable Pricing to Customers and Net Pricing
Pricing internationally can be a “free-for-all” relative to the U.S. market where distributors set the same dealer price for all customers and do not differentiate price based on volume commitments. Instead, distributors have to manage the retail channel by other means, including marketing commitment (co-op marketing and market development fund), returns policies, inventory placement, etc.
In contrast, historically in some European markets and specifically in highly price-sensitive retail markets, the distributors may set different prices for different customers. Not only can the actual dealer price vary, but there may be different discount schemes applied to varying accounts with variable pricing at each stage of the chain: retail/shelf price, dealer price, net invoiced price.
Obviously, the distributor needs to ensure a certain range to avoid chaos and resentment in the marketplace. This is usually achieved by applying larger discounts to key accounts, which in turn often break out based on relative volumes. While this may all sound simple in practice, think about having to account for net pricing at the retail-chain-specific level, rolling up to the market overall, and then equalizing pricing by backing out applicable VAT taxes and harmonizing exchange rates. The simple question, “What is the price in the market?” could easily have different answers.
Table 5.5 is an example. Within each market, the distributor needs to customize its terms with retailers, and will generally fix both the SRP and the DLP; however, the wholesale price/DLP may have significant discounts applied that can be sliced in a variety of ways. There may be standard discounts and rebates, which may be within a continuum (e.g., standard discounts within a band of 20–25 percent), or the formula may be quite complicated. Some markets may apply layers of discounts, applying at chain level and tied to variables such as cash payment/payment terms. Accordingly, historical relationships, retailer-level commitment to placement and marketing, trading terms, payment terms, volumes ordered, and return provisions all factor into the relationship matrix and ultimate per-unit/per-retailer pricing structure.
Another factor that is quickly impacting pricing patterns is the Internet. By cutting out the middleman, certain e-tailers can effectively undercut traditional retail pricing. This puts pressure on margins, which comes back to the distributor in the form of physical retailers wanting additional discounts. In markets where differential dealer pricing based on volume commitments is legal, this can create enormous challenges in managing the market.
Video Economics and Why Video Revenues are Uniquely Profitable to Studios
The video business emerged as a kind of hidden caryatid holding up the theatrical film business on the back of its retail sales. While there is a general awareness of the importance of the video revenue stream (approximately 50 percent of the total revenue pie at its peak, and still among the most important overall revenue sources), what is less understood is that video is uniquely profitable for distributors and accordingly provides the studios with its most important source of positive cash flow.
Video/DVD revenues grew to become so significant that for more than a decade they represented a critical if not the primary hedge strategy against the risk of making a film. There is an assumed floor for video units, and even a movie with disappointing box office results can earn significant video revenue.
How video revenues are calculated depends upon one’s participation deal. From a studio standpoint, the calculation is straightforward:
(dealer price) × (net units sold) = video gross revenues
However, video revenues as regards third parties are often calculated on a royalty basis. This is the case for most participations (see later cash flow discussion), as well as in licensee arrangements. In the case of a studio licensing video rights to a third party in a territory where they do not distribute directly, the third party licensee is likely to account and pay on a royalty-per-unit basis (see the next section for further discussion on the basis and structuring of royalty payments).
Video Royalty Theory and Influence on Cash Flow
When the VHS video business first launched, videos were likened to an ancillary revenue stream such as soundtrack records. Following the record model, the conventional method of paying producers and artists was on a royalty theory: 20 percent of video revenues would be put into the general pot out of which profits would be paid. Seen generally as found money, this methodology was accepted and only later became the bane of artists who felt unfairly compensated from the windfall studios were making on video sales. This remains an undercurrent of guild–studio tensions in residual negotiations, where guilds are wary of leaving Internet and other new media revenues on the table and repeating the sins of video deals past (see Chapter 7 for further discussion).
This royalty theory and calculation is a fundamental element in the calculation of net profits (see Chapter 10). In a typical studio definition of net profits, video is accounted for only based upon the 20 percent royalty from video net revenues. The other 80 percent of revenues are simply kept by the video distributor, creating a significant stream of free cash flow.
Why Uniquely Profitable—at Least in Perception
Video divisions appear uniquely profitable for two simple reasons. First, pursuant to accounting for revenues on a royalty only, the vast majority of revenues are shielded from participations and kept captive for the distributor. Second, as an ancillary revenue, the video division is not directly responsible for production costs; the division applies a gross margin calculation that, in terms of content production, generally only accounts for video transfer and mastering costs, as well as the creation of any bonus material. (Note: The studio accounting divisions will, however, keep track of all costs and revenues for creating film ultimates.)
Once fixed costs of mastering, authoring, and compressing material are recouped, video profits are based on the variable costs of manufacturing and selling-through units.
While true revenue sharing breaks down video economics based on line-item revenues and costs, many video deals are royalty based and do not go into this level of detail and accounting. In fact, many royalty negotiations are simply haggling over a percentage or two, with the parties recognizing bands of historical rates or perhaps reverting to custom. However, there is grounded economic reasoning underlying rates, even if actual negotiations fail to delve into the detail. In theory, it is possible to deduct the assumed costs from wholesale revenue and arrive at an amount of profits available on a per-unit basis. From this number, the parties can then negotiate a percentage split of profits; the percentage that the producer keeps could then be expressed instead as a royalty based on the wholesale number. Table 5.6 is an example.
From this available profit, the distributor and producer will share in an agreed proportion; in this example, at a 50/50 split the producer would keep $4.12 as its profit per contribution. Another way to arrive at this figure would be to ask what royalty rate on the dealer price the producer would need to receive the same profit. The answer is a royalty of about 27.5 percent (0.275 × $14.99 = $4.12). Similarly, if it were agreed that the producer should keep 60 percent of the profits, then the royalty rate would edge up to almost 33 percent (0.60 × $8.24/$14.99). What percentage each party keeps is the subject of negotiation and should reflect the relative values of what each is contributing. This is simpler in theory than practice when needing to weigh the relative value of content contribution versus distribution and perhaps financing.
Retail Cost |
$24.99 |
|
Dealer Price |
$14.99 |
(at about 60%) |
Cost of Goods |
$3.50 |
(estimate) |
Other Costs |
$1.00 |
|
Marketing |
$2.25 |
(assume 15%) |
Profit remaining |
$8.24 |
(about 55% gross margin) |
While there can be many other factors in the negotiation, at minimum this is a credible way of examining how to split the pie. Moreover, even though this calculation is based on a myriad of assumptions, it has the end logic of simplicity. All the parties need to track is the wholesale price and the units sold in order to calculate, report, and pay a participation. This is infinitely simpler and less controversial than tracking all revenue and cost categories; moreover, it likely avoids auditing costs, which can multiply exponentially when adding on the complexity of multiple countries and currency conversions. (See Chapter 10, section titled “Online Accounting: Simple Revenue Sharing and the Net Profits Divide,” for a discussion regarding Internet revenue sharing versus royalty accounting.)
Advances and Recoupment
Once a royalty rate is set, the other key item to agree on is an advance, if any. An advance will likely be due if the product is an acquisition. The amount of the advance will be a relatively simple calculation matching the expected unit sales multiplied by the revenue that will be due based on those sales—again, this is an easier calculation if it is based on a royalty per unit. The variables will be the royalty rate and the unit assumptions, and then what percentage of the total expected value should be covered by a minimum guarantee.
Table 5.7 Hypothetical Video P&L
The next step is confirming out of which revenues the distributor will then recoup the guarantee paid. If it is a 50/50 costs off the top split of revenues deal, then it will take twice as long to recoup/reach overages than if the recoupment were out of 100 percent of revenues earned. This example, however, assumes a straight sharing without factoring in a fee. No distributor would likely agree to pay an advance, recoup the advance, and then start sharing profits without ever having taken a fee.
A further wrinkle on this is preventing a fee-on-a-fee scenario (i.e., double-dipping). The following is an example:
$300,000 advance and a 20 percent fee
20 percent fee on the advance = $60,000
20 percent fee with a $300,000 advance
= $375 to recoup, for it takes $375,000 of gross to recoup the
advance plus the fee
Advance
1 – fee = gross necessary to recoup plus fee
300/(1 – 0.20) = 375
Video P&L
Table 5.7 is a hypothetical video P&L, which further exhibits the complexity of gauging the net profit amount and why royalties, being much easier to calculate and track, are instead frequently used. Additionally, below I describe in more detail several of the line-item cost categories.
Probably the best way to illustrate video costs is to walk through the costs at various stages of exploiting a new-release DVD or Blu-ray title. I will break this into three sections: building and encoding the DVD material, manufacturing the DVD, and marketing and distributing the DVD. Paralleling the complexity of the DVD supply chain, the logistics of creating, manufacturing, and fulfilling DVD orders is a complicated process. The DVD is an inherently complex product and the physical plants are high-tech, secure, impressive facilities that rival the efficiency of any assembly line.
Building and Encoding DVD Material
The first stage consists of two parts: what material will physically appear on the DVD, and how that material will be converted to compressed digital form. Regarding the materials, it is important to recognize on the cost side that a DVD involves much more than simply transferring a film or TV show to the DVD. The value of the market and ability to tinker after the fact have created a consumer value proposition mandating that the DVD (for a major title) offers something extra. That something extra includes vast amounts of VAM, as well as navigation. (Note: As discussed earlier, VAM may not be offered in rental options, and some consider VAM the differentiator justifying purchase of a title; essentially, VAM can be leveraged as a mechanism to preserve sell-through/ownership tied to higher price points in an environment when cloud access can otherwise eliminate the impetus to purchase.) The entry point to a DVD is called the menu, and each major DVD has a uniquely produced menu and interface to enhance the experience. This is the interface screen that asks whether you want to watch widescreen or pan and scan (if the particular DVD gives you a choice), has a play button, and lists the other options that the particular DVD may give you. This can include traveling to all sorts of VAM, jumping to specific chapters, hearing director or talent commentary, watching trailers or altering the presentation settings.
All of these choices are then integrated to a user-friendly environment that will thematically pull from the title. The page may be static, scrolling, or may have visual cut scenes that play and then dissolve into the static menu page. All of this obviously takes time and money, and depending on the budget and consumer expectations, very significant sums can be spent creating additional material and the navigational interface through which the consumer can explore the hours of extra content. Because of these features, the DVD has become an interactive product, allowing the viewer to customize his or her viewing experience and delve into extra features that can be much longer than the actual content around which this VAM is built. It is not unusual for a major two-hour film to come with four or more hours of “bonus material.”
Once all the elements are set (the title, the menus, and the bonus material), then all the material needs to be encoded. This step is called authoring and compression, which is technical lingo for transferring the material to the digital medium. There are specific authoring and compression houses who bid out product and create the masters from which the DVDs are then replicated. There has been a natural consolidation of video replicators and compression houses; in fact, some of the replicators have acquired authoring companies, thus allowing them to offer customers one-stop shopping through the production chain. Similar steps are required for online/digital versions delivered via broadband access, or cloud-based and other over-the-top distribution channels, as discussed in Chapter 7. In those instances, content is ingested and transcoded as appropriate for delivery via servers that then provide VOD access through digital rights management software. DRM systems, coupled with additional security through transmission and playback schemes, then enable consumers to gain access to the content based upon whatever rules (How long is the access? How many times can a program be viewed?) are put in place and economic systems (e.g., rental versus sell-through) are offered.
The cost of authoring and compression has come down over time, with improvements in both technology and competition. One of the more significant costs comes from the international side, where different language masters require several different masters to be configured, authored, and compressed.
Manufacturing the DVD
Manufacturing costs are broken out into pennies—and pennies matter in a business with slim replication margins and unit volumes that can be in the several millions. Like any other good, the manufacturing costs of physical discs are a roll-up of lots of sub costs, since every DVD/Blu-ray is customized.
As a rule of thumb, usually half to more than half of the total costs come from the physical replication of the disc and the cost of the plastic DVD case (Amaray case). What the actual disc costs are per unit will vary according to vendors and market conditions. Many studios have overall long-term deals with replicators. The vendors benefit from having secure capacity filled, and the studios benefit by incentives to lock up their business. If a distributor is able to bid out replication on the “spot market,” they may or may not strike opportunistic deals. If the manufacturing is in the peak period where every studio is pumping out DVDs for the fourth-quarter gift season, and capacity is constrained, then costs may go up. However, depending on the replicator, its particular flow of product from its studio deals may be up or down depending on the actual title performance (does the studio have three hit titles or three dogs?), and pricing may fluctuate given the actual capacity expected. One thing is for certain: every studio wants secure capacity with the absolute lowest price, which virtually ensures a consistently competitive market.
The following are examples of the types of elements in the manufacturing process that go into assembling a finished-goods price:
■ physical disc replication, for which price may vary by the memory size of the DVD
■ price of the Amaray case
■ costs to create/print menus, sleeves, and then insert the material into the case
■ spine labels
■ security tags (different retailers may require different tags/configurations)
■ booklet and disc insertion
■ shrink-wrapping the finished product
■ external stickers
■ barcodes
■ freight costs for delivery (if distribution bundled with manufacturing costs).
The above is the baseline, as the process can become more complicated for special gift SKUs, bundling product together (e.g., pack-in toy), or special cases.
One great advantage DVDs had, which helped spur adoption, was that the physical replication costs were low when compared to making a VHS tape. The costs continued to drop over time, so not only were more DVD units of a title being sold, but the margins based on manufacturing alone were in parallel going up. The timing, product, and type of DVD (e.g, DVD-9 or DVD-5) can all influence price. As noted previously, this is a negotiation of pennies, and it is the pennies that ultimately determine the margin and profitability of the DVD duplicator.
Electronic Sell-Through Advantage
Regardless of how low costs are pushed, a challenge the DVD market faces is that physical costs can never drop to the level of digital goods—where except for server and bandwidth costs, which are usually borne by the retailer (e.g., Apple, Netflix, Amazon), the manufacturing costs are effectively zero. Accordingly, a very compelling argument for downloads is the elimination of nearly all of the foregoing costs. Although limited costs such as compression remain, the cost reductions in delivery via electronic sell-through drop directly to the bottom line. The issue is then whether the same product is being delivered, and therefore whether pricing should be reduced. Often, downloads are priced the same as physical copies, but with no physical costs and without VAM, digital goods should cost less and yield greater margins. Until competition further develops or consumers balk at the prices and opt for physical discs, download services will likely continue to charge these premiums—initially justifying the lack of discounting on the cost of building market share and needing to amortize back-end infrastructure. However, over the long run, the pricing relative to costs is not rational, and we will see prices coming down, including differentiated pricing based on the quality and volume of material.
Marketing and Distributing the DVD
(Note: The following is a summary overview of some key costs, but for a more complete discussion see Chapter 9.)
Marketing of DVDs entails two primary costs. The first is the consumer marketing and advertising campaign costs borne by the studio distributor. This entails the same types of categories as theatrical marketing, ranging from print ads, to TV spots, to online promotion—where online promotion itself is now diversifying to segment digital advertising promotion and leveraging social networks. Beyond paid-for media, advertising costs (again, like theatrical) also include posters, trailers, press/PR activity, and even junkets. As the upside for DVDs/Blu-ray has grown, the marketing campaigns have become that much more complex—often planned months, if not a year, in advance of the release.
The other major cost category is trade marketing, given the importance of incentivizing retailers both to execute at point of purchase and to advertise themselves, utilizing DVD/Blu-ray product to attract store traffic. As mentioned earlier, distributors will therefore offer market development fund and cooperative advertising allowances that the retailers may spend on in-store campaigns, circular advertising, and general promotions (including online banners, home-page and above-the-fold placements, etc.). These sums are variable and tied to a percentage of wholesale revenues: the more units bought, the more money available for promotion.
Sometimes, with a significant enough title, the retail campaign can also be stimulated with customized product or tie-ins. These can take the form of retailer exclusives, special product SKUs (e.g., double packs, packed-in merchandise), and rebate programs. If programs are customized by the retailer, then a key customer such as Walmart or Media Markt may be able to differentiate its offer and advertising, creating an incentive for the chain to advertise the product and perhaps feature the unique SKU in circulars. There is no limit to tie-ins, and with the release of the DVD for Star Wars: Episode III – Revenge of the Sith, Fox and Lucasfilm executed a unique program with Best Buy involving the Donald Trump television hit The Apprentice; the task for the contestants on the show was to build a display that would showcase Episode III and related product (Star Wars video game) at Best Buy stores, and then a version of the winning team’s display would be utilized in select Best Buy retail outlets.
Finally, in very limited instances there may be the potential for promotional partners, akin to theatrical tie-ins. It is the bane of video marketing chiefs that, despite the size of video revenues, and the critical importance of DVD/Blu-ray sales in the life cycle of any title, such deals are the exception and not routine. DVD sales simply do not piggyback on marketing waves of theatrical release scale and are still largely viewed by consumer brands as ancillary.
Technology is ever marching on and impacting the future of video; in fact, as quickly as DVDs appeared, it is possible to imagine them becoming as extinct as VHS.
iPods, tablets, and other digital storage devices demonstrate how DVDs could become supplanted with hardware capable of holding vast digital files. Imagine your library of DVDs all on one machine or storage box … an iPad can hold your library of music CDs, your lifetime collection of photographs, and your DVD collection. Conceptually, it is only a matter of storage, an issue that the studios (via UltraViolet) and companies such as Amazon are solving via cloud-based digital lockers (see Chapter 7). In my prior edition, I pointed to the prospect of this growth (noting future devices would hold not simply music, but also videos), but in many ways the future is already here, with devices such as Amazon’s Kindle Fire, Samsung’s Galaxy tablet, and the iPad (none of which existed at the first printing of this book in 2009), enabling personal digital video libraries.
How quickly these options will further erode the DVD/Blu-ray world is a matter of speculation. People still love browsing book stores, and there is an element of passion in collecting DVDs; however, it seems unlikely that the desire to collect boxes or a preference for physical artwork over thumbnails are strong enough forces to hold back the convenience (and, arguably, inevitability) of digital copies. One countering force is retail pressure, as key chains will have every incentive to slow the shift and try to thwart the demise of a multi-billion dollar product line. Whether, or how long, the DVD can coexist with the next generation of VOD, streaming services, and digital storage devices is ultimately up to the consumer.
I asked long-term industry veteran Louis Feola, former president of Paramount’s made-for-home entertainment division (Paramount Famous Productions) and former president of Universal Home Entertainment, how quickly he expected the full digital transition to take place:
The film and television industry has endured a century of new delivery systems that, upon their introductions, were predicted to displace prior points of distribution. It was the rarest of situations when that actually occurred quickly. Business transitions and consumer adaptation simply take time. Digital and Internet technology will indeed overpower DVD and Blu-ray, and while no one can predict the future with absolute certainty, in the short- to mid-term brick-and-mortar and electronic will coexist. The industry will continue to maximize mature revenue streams while developing new revenue streams.
Online Impact
■ An entirely new category of “video distribution” has emerged in the form of downloads, with purchases via an iPod, tablet, or other system now labeled as “electronic sell-through.”
■ “E-tailers” such as Amazon have developed a significant market share and are pioneering new ownership constructs, such as the ability to purchase content and maintain it in a remote digital locker; e-tailers are also putting pressure on retail pricing (given lower cost structure), as well as enabling new predictive release metrics via preorder commitments.
■ VOD services (both streaming and download), available either over-the-top or through traditional access points, are threatening the existence of video rental, the sector that launched, and once was the entire, video business.
■ Transactional VOD, whether subscriber-based as offered by Netflix, or à la carte via services such as Amazon, has made the virtual video store a reality; additionally, cloud-based infrastructure has enabled limitless depth of copy (wide and long tail) accessible via a multitude of connected/Internet-ready devices, posing a near-insurmountable challenge to traditional video rental.
■ Online services are enabling greater depth of available titles, given the elimination of physical shelf-space constraints (wide tail).
■ Linked online applications enable interactivity, such as a Blu-ray feature allowing a “live” version, where you can watch a movie along with the director, who is simultaneously commenting.
■ Kiosks, such as those operated by Redbox, have created a low-price rental option that, at least temporarily, has defied those predicting the death of physical rental. Will kiosks, to retain relevance, become digital, such that consumers can download video content to devices with a flash drive/USB connection (or even phone) by simply plugging in (or downstream by near-field wireless)?
■ Piracy concerns from file sharing are, similar to the theatrical market, leading to more front-loaded day-and-date releases and the compression of the video sales cycle.