Eyes Wide Shut: Why Journalists Don't Understand Hollywood

There was a time when the box office numbers that were reported in newspapers were relevant to the fortunes of Hollywood. Up until the 1950s, the major studios owned most of the large theater chains and made virtually all their profits from their theater ticket sales. This was before television sets, VCRs, and DVD players became ubiquitous in American homes, and before movies could be downloaded and streamed into computers, smart phones and Ipads.
Today, Hollywood is in a very different business: creating rights that can be licensed, sold, and leveraged over all many different global platforms, including movie theaters, Pay Per View, DVDs, pay television channels, cable television, free television, and toy licensing. And while the box office at American theaters continue to be a part of this stream, they account for less than 15 percent of the total revenue. Yet, media continue to breathlessly report the American box office numbers every week, as if they still represented the profits and losses business of Hollywood.
Such reporting leaves their audience, much like a movie audience, in the dark about the true business of Hollywood. Even the numbers themselves are grossly misleading when used to describe what a film or studio earns because they represent what theater chains get from ticket sales, and the studios no longer own or control these chains. The distributor of a movie gets a portion of these ticket sales, usually about 50 percent and then immediately deducts from these proceeds its outlay for prints and advertising, which is called "P&A". In 2007, the most recent year for which the studios have released these expenses, P&A averaged about $40 million per title, which was more than they typically received from their share of American ticket sales In addition, the distributor deducts a hefty distribution fee, usually between 15 and 33 percent of the total theater receipts. Therefore, no matter how well a movie appears to fare in the box office race reported by the media, it is usually in the red at that point. Indeed, studio executives correctly assess, that as a rule, they lose money on "current production," their term for the American box-office. Their profit comes on most from the so-called "back end", including DVD, television and foreign receipts. In 2007, according to the secret numbers of their trade association, the MPAA, almost 90 percent of the revenue of the major studios came from world DVD sales, multi-picture output deals with foreign distributors, pay TV, and network television licensing.
There are of course notable exceptions, such as "Avatar" in 2009 and 2010, which broke all records for tickets sales, and, unlike the average movie, made a fortune at the American box-office (even though 72.5% of its revenues were abroad). Such successes, which often siphon off audience from other movies, do not change the reality of Hollywood. They are the exceptions that prove the rule. For the vast majority of movies that do not make a penny at the American box-office, the only useful thing that the newspaper box office story really provides is bragging rights: Each week, the studio with the top movie can promote it as "Number 1 at the box office." Newspapers themselves are not uninterested parties in this hype: in 2008, studios spent an average of $3.7 million per title placing ads in newspapers. But the real problem with the numbers ritual isn’t that it is misleading, but that it distracts attention from the realities that are reshaping and transforming the movie business. Consider, for example, studio output deals. These arrangements, in which pay-TV, cable networks, and foreign distributors contractually agree to buy an entire slate of future movies from a studio, form a crucial part of Hollywood’s cash flow. these unsung deals allow studios to stay in business. The loss of an output deal, uch as the termination of New Line Cinema's deal with HBO, doomed the studio, even though it had produced such immense box office successes as the Lord of the Rings trilogy. Yet, even the existence of output deals is seldom mentioned in the mainstream media. As result, a large part of Hollywood’s amazing money making machine remains nearly invisible to the public. The problem here does not lie in a lack of diligence or intelligence on the part of journalists. It proceeds from the entertainment news cycle, which generally requires a story about Hollywood to be linked to an interesting current event within a brief time frame. For such a story, the only readily available data are the weekly box office estimates; these are conveniently reported on websites such as Hollywood.com and Box Office Mojo. If an intrepid reporter decided to pursue a story about the actual profitability of a movie, he or she would need to learn how much the movie cost to make, how much was spent on P&A, the details of its distribution deal and its pre-sales deals abroad, and its real revenues from worldwide theatrical, DVD, television, and licensing income. Such information is far less easily accessible, but it can be found in a film’s distribution report. But this report is not sent out to participants until a year after the movie is released, so even if a reporter could obtain it, the newspaper’s deadline would be long past. Hence the media’s continued fixation on box office numbers.

Angelina's Bottom Line For Planet Money

Hollywood studios' invisible financing, including government subsidies and tax-credit deals, is no where better illustrated than in the way Paramount put together the deal for Lara Croft: Tomb Raider. The budget, including Angelina Jolie's $9 million fee, was a staggering $94 million on paper. But after Paramount applied the arcane art of studio financing, of which the deal is a minor masterpiece, the studio's outlay was only $8.7 million.
First, it got $65 million from Intermedia Films in Germany in exchange for distribution rights for six countries: Britain, France, Germany, Italy, Spain, and Japan. These "pre-sales" left Paramount with the rights to market its film to the rest of the world.
Second, it arranged to have part of the film shot in Britain so that it would qualify for Section 48 tax relief. This allowed it to make a sale-leaseback transaction with the British Lombard bank through which (on paper only) Lara Croft was sold to British investors, who collected a multimillion subsidy from the British government, and then sold it back to Paramount via a lease and option for less than Paramount paid (in effect, giving it a share of the tax-relief subsidy.) Through this financial alchemy in Britain, Paramount netted, up front, a cool $12 million.

I recently explained how this worked on NPR's Planet Money.

Wall Street 2

In November 2009, Oliver Stone literally put me in the picture. I was seated at an oval table
under an eerie light in what purported to be the office of the Chairman of New York Federal
Reserve Bank. As the meeting continued throughout the night, people around screamed about
the “moral hazard” of saving a failing investment bank. At one point, there was even a call from the White House dooming the bank in question. The frenetic scene is no more than a consensual hallucination directed by Oliver Stone for the movie Wall Street 2: Money Never Sleeps. (A sequel to his 1987 Wall Street.) The magnificently wood-paneled room is actually the executive conference room of an insurance company, Metlife, which is serving as a location for this part of the filming. The eerie glow comes from powerful lamps lights ingeniously suspended from helium balloons above us. The shouting is coming from actors Frank Langella, Eli Wallach, and Josh Brolin. Although I had only a bit part in this drama, it provided me with an opportunity to see how a Hollywood is made from the vantage point of the set.
The project was initiated in 2005 by Edward R. Pressman , the producer of the original Wall Street, after he saw the fictional villain of Wall Street Gordon Gekko (portrayed by Michael Douglas) on the cover Fortune accompanied by a headline about the return of greed to Wall Street. Pressman reasoned that if 18 years after the movie, Gekko was still the media’s icon for greed on Wall Street, Pressman, a sequel was in order. He owned the rights for the sequel but sought to interest Twentieth Century Fox, which had distributed the original Wall Street. Getting a movie made in Hollywood when the hero is not a comic book character was not an easy task. Just getting a script that was acceptable to Fox took four years– and 3 different (and very expensive) writers. Even then Fox’s approval was conditional on the stars and director, as are almost all movie deals. Pressman persuaded Michael Douglas to again play Gekko, a role for which he had won the Oscar in 1988, and Oliver Stone (who had dropped out of the project earlier), to again direct Wall Street 2. Fox then agreed to finance it.
Part of this $67 million budget could be retrieved from New York State and New York City’s tax credits (which effectively reimburses 35% of the production budget spent in New York.)
The Federal Reserve meeting scenes were filmed over a long weekend about midway in the
11 week shooting schedule. Through the seemingly endless retakes in which actors repeats
virtually the same lines while extras behind them– each of whom is called by a number rather
than a name– moves to the exact same “mark” ,or position, Stone gradually perfects the illusion.
Between each take, the time on the grandfather clock in the office is reset to the exact time at the start of the previous scene. The process is not unlike the never-ending day in the movie
Groundhog Day. But surrounding the illusion-in-the-making is an envelope of reality. It is
peopled by a small army of technicians, including make-up artists, hair stylists, script
supervisors, technical advisers, continuity girls, stand-by carpenters, wranglers, costumers,
sound boom men, camera operators, film loaders, set decorators, and electricians. They work
ceaselessly, rushing onto the set between takes, to maintain and repair the illusion. One of the
advantages of a top director such as Stone, is that he can get the best of the below-the-line talent, in this case such Oscar nominees as Rodrigo Prieto, the Mexican-born Director of Photography whose credits include Frida, Brokenback Mountain, and Babel, Kristi Zea, the production designer, whose credits include Revolutionary Road, Goodfellas, and The Silence of The Lamb,and Tod Maitland, the versatile sound technician who won the Oscar for Sea Biscuit.
Stone him self is constantly moving around the set, viewing scenes from different angles and talking to the actors and extras, often in whispers. At other times, he confers with technical advisers, including Brian Cartwright and Alex Cohen, two former SEC lawyers who had actually attended the Fed meetings, asking them about such details as how
coffee cups would be placed on the table or how precisely a phone call from the White House would be answered. When any unexpected difficulties arise, such as the camera dolly creaks audibly on its tracks, he jokes with the cast, having a gift for putting actors at their ease. But even with the amicable atmosphere, he has to keep the movie running on a tight schedule. Just the below-the-line expenditures for Wall Street 2, which does not include the compensation for the stars, writers, producers, or the director, is running about $220,000 a day for interior scenes (exterior and crowd scenes can be much m ore expensive.) So unless he shoots the planned number of script pages a day, he will run over budget. While Hollywood players are often depicted in the media as profligate spenders, the opposite is true when it comes to studio executives supervising a movie that they are financing. Before
Wall Street 2 went into production, Fox went through the budget line by line, squeezing every penny it could out of the budget., even attempting to reduce the fees of major actors (all of whom have a “quote”, or established price per movie.. If the shooting ran over budget, Fox could ask that plans scenes be cut out of the script to get it back on track or use money from the post-production budget, which includes putting in visual effects (which are crucial in Wall Street 2 since some scenes are shot with blank backgrounds), adding sound, and editing. So Stone manages to adhere to the schedule, even when it requires him– and his assistant directors-- working grueling 14 hour days (as in the Federal Reserve
Bank scenes). And, as it turns, out he completes the movie within a day of the targeted end of shooting.
When I arrive at the wrap party at the club Spin, the cast, crew, and friends are huddled around
plasma TV screens, watching clips from the movie. For most of them, it is their first opportunity to see how Stone actually realized the scenes they had worked in or on. As they watch, visibly impressed, they often cheer with the sort of gusto one might expect at a Superbowl party when a touchdown is scored.
Everyone embraces Stone, the hero of the evening, as he passes through the room. Spin is owned by Susan Sarandon (who had acted in the movie) and features ping pong tables (where Josh Brolin and Mel Gibson(who was not in the movie) engaged in wild game. ,The calibration continued into the early hours of the morning.
Unlike independent movies, which usually take years to reach the theaters, studio movies have a built-in release date from the moment they are green-lighted. Wall Street 2 was scheduled to open at the multiplexes across America on April 23, 2010. However, in March, after getting the competition report showing what other movies would draw the adult audience away from Wall street 2, Fox pushed the opening back to September 12, 2010. Even so, Fox's marketing department is already working on the advertising and marketing
campaign, which will require a huge investment in spots ads on cable and network TV in mid-April. The worldwide P&A budget will probably exceed $40 million, which will bring Fox’s total outlay to about $100 million.
The original Wall Street did far better in earning critical acclaim and buss than
money. Fox’s share of the American box office was only $20.2 million– and it fared far worse in foreign markets. The problem Fox had then, and faces again now, is that movies that involve complex issues, such as a financial crises on W all Street, did not necessarily draw the teen-age audience conditioned to expect the action heroes and fast tempo of the studios’ comic book sequels. The $100 million gamble for Fox is that it will be able to find an
adult audience for the multiplexes.
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Hollywood's Real Money Machine

This Sunday a global audience, second in size only to the Super Bowl, will watch television's most lucrative infomercial—the 82nd Annual Academy Awards. For some three and a half hours, interspersed with clips from currently-available movies, Hollywood's most publicized stars will ecstatically award the winners 13-inch-high gold-dipped statuettes known the world over as the Oscars.
The initial purpose of this gala event, which the studios created along with the Academy of Motion Picture Arts and Sciences in 1927, was, in the words of its main architect Louis B. Mayer, "to establish the industry in the public's mind as a respectable institution." But it was also designed to market and create "stars." Mayer was cofounder of Metro-Goldwyn-Mayer, one of Hollywood's most successful studios during its Golden Age (1930s-1950s), and is known as the father of Hollywood's "star system" of marketing.
Yes, the stars will be out Sunday night, but to further enhance its global audience this year, the Academy has doubled the number of Best Picture nominees. Even with this expansion, attention remains focused on two polar-opposite films: Kathryn Bigelow's "The Hurt Locker," and James Cameron's "Avatar," both of which have garnered eight other Oscar nominations
The Hurt Locker" is a reality-based film about a squad of courageous American soldiers who defuse bombs under horrendous conditions in Iraq. By Hollywood standards, it is a very small movie, costing only $15 million to produce and another $15 million to publicize and distribute. And although critically acclaimed, it sold only $18.5 million in tickets worldwide. With theaters keeping roughly half of these box-office sales and the distributor deducting its expenses off the top, it is deeply in the red. Nevertheless, for many among the Academy's nearly 6,000 voting members, it represents the kind of intelligent realism that Hollywood is capable of making for an adult audience.
"Avatar," on the other hand, is a fantasy-based movie about alien life forms who need to be rescued from neocolonialist corporate exploitation on a planet called Pandora. The film, enhanced by brilliant visual effects, may be the most expensive ever made. According to a top executive at Fox, it cost over $225 million to produce and another $150 million to publicize and distribute—a number that has been hyped to as much as a half-billion dollars.
Whatever the cost, "Avatar" has been an immense success, selling a record-breaking $709 million of tickets in the U.S., where it is shown in 3D as well as the traditional 2D format, and more than twice that amount overseas, where it's shown mainly in 2D. For Rupert Murdoch's 20th Century Fox, which gets its distribution fee off the top (as well Dune Entertainment and Ingenious Partners, the private equity funds that provided 60% of the financing, and James Cameron's production company, Lightstorm Entertainment) it is a veritable El Dorado.
The film's success at the box office has also excited hopes that its 3D visual effects will restore the Golden Age of movie attendance, a time before television when two-thirds of Americans went to the movies in an average week. Nowadays less than 10% go to a movie theater in an average week.
The overall box-office numbers, however, provide little grounds for such optimism. "Avatar" no doubt has enriched many theaters charging a premium for the 3D experience, but it did so largely at the expense of theaters showing other movies. In the eight weeks that "Avatar" dominated U.S. box-office receipts (Dec. 18 to Feb. 11), total movie attendance increased by about 6%.
But even if the audience resurgence is no more than a pipe dream, "Avatar" represents for many in the Academy the idea that Hollywood's ultimate salvation lies not in superior story-telling and acting but in eye-popping visual effects, stunning animation and state-of-the-art 3D projection that immerse the audience in the illusion.
Regardless of box office receipts, Hollywood's major studios have a sure-fire engine for making money from viewers who don't regularly go to the movies. It's what the studio calls its "library," which contains the rights to all the movies and television series that it has ever produced or acquired. By relentlessly licensing and selling the rights to these titles, studios harvest money from home audiences decades after a film plays in theaters.
Consider, for example, the Time Warner library. It has more than 45,000 hours of feature movies, cartoons and TV episodes, dubbed or subtitled in more than 40 languages, that it licenses to pay-TV, cable TV, satellite telecasters and television stations in more than 175 countries. These titles are often bundled in take-it-or-leave-it packages (a practice that is prohibited by U.S. anti-trust laws in distributing movies to theaters), which helps optimize profits. In 2009, just the television distribution part of this operation brought in more than $2 billion, according to one source at Warner Brothers. A revenue stream this lucrative, even after paying residuals to guilds, labor and other participants, would be enough to pay for most, if not all, the costs of Warner Brothers's new movies.
Libraries, of course, also pull in huge revenues from the global sale and rental of DVDs. (Technically, newly released titles are not included in the library for two years.) Even though DVD sales of movie titles and TV series are now waning, on the horizon is another promising revenue stream: digital rights for Internet delivery. While at present these rights provide little more than pocket change for studios, future revenues are due to explode with the proliferation of smart phones, netbooks, tablets, game consoles and other such gadgets. In any case, as one Viacom executive recently told me, "No studio could stay solvent for long without a library."
If the studios' libraries, the reality-based money machines that boost the bottom line, do not receive accolades or even a mention at Sunday's Academy Awards, it isn't that their value is unappreciated. It's because Hollywood's real genius is understanding that its audience prefers illusion to reality. The stars shine brightest on Oscar night. And that's show business.

Bad News For MGM

The bad news came in a non-public conference call this Monday (February 22nd) to the 140 banks and hedge funds holding nearly $4 billion in MGM debt. MGM CEO, Stephen F, Cooper, the turn-about specialist brought in to save the one-proud studio, revealed in the call that the secret numbers memo circulated to potential buyers in the confidential deal had been seriously inflated by MGM’s own over-optimistic estimate of its 201o television revenue. The memo, which had been sent out by Moelis & Company to solicit offers from potential buyers, stated that "Television distribution has generated over $500 million of Library cash receipts in each of the last four fiscal years ," estimating it would produce "$529 million" for fiscal 2010 (which ends March 31, 2010). A library is made of two components: DVD sales and the licensing of movies and TV series to pay channels, cable networks and broadcast television. So, with the DVD market collapsing in 2009, the stability of television revenue, as represented in the memo, was (at least until Monday) a key selling point to the remaining potential buyers– Time Warner, Lionsgate, John C. Malone’s Liberty Media, Rupert Murdoch’s News Corporation, Ryan Kavanaugh’s Relativity Media, Anil Ambini’s Reliance ADA Group, and Leonard Blavatnik's Access Industries.lain . Now, Cooper had stunning news. He told the 140 creditors that the library sales had been anything but stable, and plunged in the fourth quarter (so far) to the extent that the estimate had to be reduced by almost $30 million for that quarter. If annualized, that would amount to a decrease of about $120 million in revenue. Even worse, this severely reduces the value of the library since, as those in the business know, when MGM renews its multi-year contracts, the money it will get for aging product will drop precipitously.In MGM’s case, as I pointed out previously, a large part of these revenues must be split with "third parties." This includes producers, stars, directors, writers and Hollywood guilds, and, in 2009, amounted to over 40 percent of the total take.
The forbearance that MGM’s creditors extended to MGM in October runs out in 10 weeks so Cooper can sell it. Now all the remaining bidders will have to drastically recalculate, if not, reconsider. the amount they are willing to gamble. The Wall Street investors who put up most of the equity for the 2004 takeover have already seen their investment effectively wiped out. The suspense that remains in this Hollywood thriller is the degree to which the bond-holders will suffer the same fate. The bond holders cannot put the company in bankruptcy without jeopardizing the valuable remake rights to James Bond movie. So if the bidders pull out, or offer only pennies on the dollar, the only alternative open to the bond holders is to themselves take-over MGM by swapping their debt for equity– but this is not the Hollywood ending they want.

The Secret Numbers Behind The MGM Fiasco

MGM, once the shiniest studio in the Hollywood galaxy, has fallen on hard times. Last October it failed to make the interest payment due on its $3.7 billion debt, and even with the six month forbearance granted by its creditors, it is hovering the threshold of bankruptcy. Its equity investors — including three big hedge funds — have been all but wiped out. The 140 banks that financed the leveraged part of the leveraged buyout deal are in danger of losing over $3 billion. With the creditors demanding their money, and the clock running on its forbearance, MGM had put itself up for sale, retaining investment bankers Moelis & Company to solicit offers from potential buyers that were due in mid January 2010. For a movie studio that was bought for $4.85 billion in 2004 (which is over $5 billion in 2010 dollars), the bids that have come in so far are shockingly low. Time Warner, for example, is offering under $2 billion and the bid from Lionsgate, once the leading contender, is worth even less.

The secret numbers in the confidential information memorandum sent out by Moelis explain the problem, which goes to the root of what is happening to the movie business today. MGM's main asset, as is true in the case of all Hollywood studios, is its library comprised of 4,100 film titles, including all the James Bond movies, and 10,600 television episodes. The money that comes in through this library comes from DVD sales — mainly older titles sold in discount bins at Wal-Mart and other retailers -– and television licensing packages to Pay TV, cable networks, and television stations around the world.

The bet that the hedge funds made when they put up most of the equity for the $4.85 billion LBO in 2004 was that DVD revenue from the library would hugely increase when people replaced their standard DVDs with the Blu-Ray high-definition format that was just being introduced. But their projections proved to be pipe dreams. Instead of expanding, MGM's DVD revenue plummeted, according to the confidential memo. MGM's DVD revenues fell from $394.7 million in 2008 to just $69.8 million in the 2010 fiscal year (which ends March 31).This huge drop was attributed to a host of factors, ranging from the worldwide downturn in DVD sales to fewer new MGM releases. What turned out to be the real killer for MGM's library was what the memo termed "significant price erosion." Wal-Mart, pressured by competition from Netflix, Red Box, and video downloading, drastically reduced the "price point" that it would buy older (or so-called "catalogue") DVDs, driving prices down to less than $5 a copy. So studios' saw the stream of profits from older DVDs wither away.As with other studios, the larger part of MGM's library's money comes from television licensing. At first glance, these revenues appear remarkably stable, declining a mere one percent from $535.1 million in 2008 to $529 million in 2010. But like other phenomena in Hollywood, appearances can be deceptive. MGM had structured its long-term licensing contracts so the cable networks wind up underpaying for the early years and overpaying for the later ones, which is a common practice at studio libraries. As a result, even as properties lose value over the course of the contract (old films are worth less than newer ones), the illusion of stability is maintained . Of course, when MGM renews these multi-year contracts, the money it gets will drop precipitously.And as impressive as $529 million in revenues may seem, it is not the amount MGM actually gets to keep since it must split these proceeds with various "third parties," including producers, stars, directors, writers and Hollywood guilds. For example, the revenues from the 24 James Bond movies — which are the library's most valuable asset generating nearly 30% of its revenue — have to be split 50-50 with Danjaq LLC, the holding company for the Broccoli family that originally created the franchise. These participations and residuals (which is what the guilds get for their pension funds) totaled $235.2 million in 2010. In addition, there were $33.2 million in other expenses, such as calculating and issuing more than 15,000 different checks per quarter to participants.MGM also had to pay Fox a fee of $22.2 million for distributing its DVDs. What MGM kept turned out to be not enough to pay its overhead — $135.9 million in 2010 — and other costs, leaving it with a negative operating cash flow of $52.4 million. The bottom line here is that MGM cannot pay off its $3.7 billion in debt. And even if a white knight gallops in to carry off the library, the investors and creditors will take a bath.

Is Netflix The Next HBO?

Netflix, through the simple device using the post office to bypass video stores, has become one of the great success stories of the new entertainment economy. It now has 11.8 million subscribers who pay a monthly flat fee for an unlimited number of rentals. It gets its DVDS from wholesalers and even retail stores. It can then rent them because of a court-approved "First Sale doctrine," which says that once a person buys a DVD, he can re-sell it or rent it out. Last year Netflix took in $1.67 billion in subscription fees, but because of the high cost of mailing some 2 million discs a day from 50 distribution centers, it only eked out a profit of $115 million.
So it is moving onto the Internet, substituting digital streamed movies for ones that are delivered by the postman. Subscribers get them on their TV via a set top box or game console without any additional charge. This "Watch Instantly" service effectively creates a virtual channel that directly compete with Pay-TV for the wallet and clock of viewers. Such a challenge by Netflix could also result, as Frank Biondi the former head of HBO, terms it, "a terminal career decision if you get it wrong."
The problem is that the First Sale doctrine does not apply to streaming or downloading DVDS so Netflix must buy digital rights, which is exceedingly expensive for new titles. In late 2008, Netflix found a temporary way around this stumbling block by making a deal with Starz Entertainment, a subsidiary of John Malone's Liberty Media, to sub-license the streaming rights of the titles it had obtained from Disney, Sony and smaller studios in output deals. Starz held it could sub-license these rights because Netflix was merely a "content aggregator," but the studios took a dimmer view of this loophole. Disney, according to a top executive involved in the dispute, has warned Starz that it will not renew its output deal (which expires in 2012) unless it either cuts Netflix out or pays Disney a rich premium.
Netflix chief content officer Ted Sarandos portrays the issue as merely a communication glitch, saying, "We have to fight against their fear that we~ll destroy the ecosystem." Despite this well-meaning new-age talk, what is really at stake here is old-fashioned money. The most profitable part of Hollywood's "ecosystem" is the output deals through which studios license movies to Pay TV channels, cable networks and broadcast stations. According to the studios's internal all-source revenue numbers, the six major studio took in $16.2 billion from pay-TV and television licensing of their movies in 2007, which was almost all profit. So the threat of sub-licensing for Internet circulation involves a good more than studio paranoia.
As for HBO, a subsidiary of Time Warner, it is the undisputed leviathan of Pay-TV. It has over 40 million subscribers, $4 billion in revenues, and a cash flow of $1.3 billion. And, unlike Netflix, it owns the digital rights to a large amount of exclusive material, much of which it produced. Over the past decade it invested heavily in original programming, creating such series as The Sopranos (which cost $2 million an episode) to retain subscribers. This made economic sense because cable systems paid it about $6 a month for each subscriber. As a top Time Warner executive who had authorized much of this original production explained to me, the name of the game is subscriber retention.
So HBO is not about to cede cyberspace to Netflix. It's in the process of rolling out an Internet service called HBO Go which will allow all HBO subscribers to get, as the executive puts it, "anything they want to see, anytime, anywhere, over their laptop, Iphone, tablet, Playstation." Bolstered by its exclusive content, HBO will initially offer some 800 hours a month of programming a month. Its 40 million subscribers can get at no additional charge over the Internet the linenew titles HBO acquires through its output deals with Warner Bros, Fox, and Dreamworks, past and present original series, HBO boxing, and even so-called "late night" fare such as Alien Sex Files.
Netflix, on the other hand, has almost no exclusive content with which to compete with HBO. Back in 2006, it attempted to produce its own original content through a subsidiary called Red Envelope Entertainment, but closed it down in 2008. The brutal reality is that Netflix, with only one-eighth the cash flow of HBO, does not have the scale to produce its own material. Of course, whether or not the Starz deal is renewed, Netflix can exclusively license programming through output deals. But competing in this game, in which the licenses for a slate of two dozen movies can cost in excess of a quarter of a billion dollars, could prove prohibitively expensive. Last year Netflix reportedly spent $100 million on licensing just non-exclusive rights to movies for streaming from Starz and studio libraries. Although this saved postage, Netflix still has to pay the overhead for its distribution centers. Adding hundreds of millions of dollars in output deals to this equation could wipe out much, if not all, of its profits.
Netflix has brilliantly carved out for itself a niche audience who largely enjoy the convenience of receiving older movies, which accounts for about two-thirds of its revenue. It will no doubt continue to satisfy and expand this audience via mailing and streaming. But what it lacks is the wherewithal to do is to replace HBO.
Edward Jay Epstein is the author of 14 books, including two examining the movie business: The Hollywood Economist: The Reality Behind The Movie Business will be published by Melville House later this month, which follows his 2005 book The Big Picture: Money and Power in Hollywood.