And the loser is ...

After years of exceptionally strong growth, Hollywood must contend with the decline of the DVD format which is causing revenues to tank, throwing a tried and true formula into complete disarray.

FT.com
When a tuxedo-clad Hugh Jackman strolls on to the stage of the Kodak Theatre in Hollywood on Sunday evening, the host of the 81st Academy Awards will be working harder than his predecessors. In a departure from the Oscars’ usual format, the X-Men star will perform song and dance routines with celebrity guests beneath an arced curtain of Swarovski crystals.

Behind the glitz and glamour of Hollywood’s big night, the executives who run the entertainment industry – worried for reasons that go beyond whether their films pick up a statuette or two – are also having to put in some extra effort. They are battling twin forces that look every bit as powerful as Jackman’s mutant Wolverine.

Time Warner, News Corporation, Walt Disney and the other media conglomerates have been hit hard by the global economic downturn in recent months. Perhaps more disturbingly for their longer-term prospects, the studios have also begun to witness the slow death of one of their most profitable revenue streams – DVDs. Unfortunately for them, there seems little that they can do to reverse its decline.

The DVD is the unsung hero of Hollywood. When it launched 11 years ago there was widespread scepticism about whether consumers would replace their video collections with a new format. But it quickly took off, propelled by special effects-laden titles such as The Matrix. Five years after they were unleashed on the market, DVD rentals and sales were worth more than $10 billion a year to the industry.

The DVD was cheaper and easier to produce than a video cassette and generated significantly better profit margins for the studios. Its rocketing success and the easy availability of cheap financing from Wall Street fuelled an industry boom and changed the economics of film. With international distribution pipelines to serve and consumers building vast DVD libraries, studios were able to ramp up their production slates knowing that most titles would make money – even if they were panned by critics or performed poorly at the box office.

But a decade of DVD growth appears to be over. Sales of new, high-margin titles fell more than 20 per cent in the last quarter of 2008, according to Nielsen, the industry monitor. Figures compiled by Digital Entertainment Group show that shipments to retailers in the US and Canada fell 32 per cent in the same period – the biggest decline recorded since the birth of the format.

Blu-ray, the format identified by Hollywood as the successor to the DVD, has grown in popularity but is not close to making up the ground left by the decline of its predecessor: consumers spent $750 million on Blu-ray discs in 2008 compared with $21.6 billion on DVDs. The Dark Knight is the best-selling Blu-ray title, with about 2 million copies, but sales of other titles are being held back because too few Blu-ray players have been sold. "People don’t have the money to buy players and they’re not looking to spend as much on building a Blu-ray library,” says Wade Holden, an analyst with SNL Kagan, which tracks studios’ finances.

This is a horror movie for Hollywood, which depends on income from DVDs. When deciding how much to spend on a film, a studio will use an "ultimate” – a calculation based on the earnings potential over its lifetime at the box office, on DVD and its eventual screening on television. The contribution from DVD has typically represented more than half of the profits generated by a film. But the slide in demand for the format is forcing studio executives to overhaul financial projections.

"The deterioration in the performance of new release DVD titles will likely force a re-evaluation of film ultimates, which may lead to write-downs as estimated DVD sales don’t materialise,” wrote Michael Nathanson of Bernstein Research in a recent note. The ailing DVD market would have "negative near-term implications on media conglomerate earnings”.

Time Warner, which owns Warner Brothers Entertainment; Viacom, owner of Paramount Pictures; News Corp, which owns 20th Century Fox; and Walt Disney are already feeling the effects of the slowdown. The recent quarterly earnings of all four companies were marred by the retreat in DVD sales: not even the storming box-office performance of Warner’s The Dark Knight could prevent filmed entertainment revenues from falling at Time Warner.

But while the first three made only passing reference to the DVD decline, blaming it on weaker economic conditions, Bob Iger, Disney’s chief executive, has warned that the bedrock of media earnings has shifted. "We believe that it’s likely that there are secular things going on here that are not related to the economy,” he told the FT recently.

There is plenty of evidence to support this argument: most people who have a DVD player also have shelves groaning under the weight of old DVDs and are unwilling to buy more. Meanwhile, video games, online video and social networks such as Facebook and Twitter are all vying for the attention of consumers. "There’s more competition for people’s time and it’s extraordinary how that has increased,” said Mr Iger. With such a significant revenue stream in decline, he suggested Hollywood needed to take a close look at its expenditure. "It is imperative for us to manage our expenses more carefully and create value for the consumer.”

He has advocated trimming the extras that accompany a film on a disc and reducing costs in production, distribution and marketing. No one else in Hollywood has taken such a public position on what is, in the entertainment industry at least, a sensitive subject. But in six months, if DVD sales continue to fall, there more in Hollywood will agree with Mr Iger.

Others in the industry argue that the economy on its own explains the DVD sales downturn. Jim Gianopulos, who heads Fox Filmed Entertainment, News Corp’s film division, says the decline accelerated in October, just after the banking crisis reached fever pitch. "It was a moment in time when people were putting their cards into the ATM machine and not knowing if any money would come out. They were not buying anything at that time, never mind DVDs.”

He also says the performance of "genre” films, which appeal to particular audiences, has held up on DVD. He points to two Fox releases – Max Payne and Babylon AD – released recently on DVD. Both were oriented towards young males and had performed in the mid-range at the box office. "The conversion rate of DVD sales from box office was consistent with past experience,” Mr Gianopulos adds.

Richard Greenfield at Pali Research also regards it as premature to say the DVD is in long-term decline. "The extreme change is clearly the economy. Consumers are crushed ... and the DVD business was simply not positioned to weather an economic meltdown like the world is experiencing.”

But whether the DVD is doomed or poised to stage a stirring comeback before Blu-ray takes over, Hollywood has a problem it cannot afford to ignore. Analysts say the severe fall in home entertainment revenues will continue throughout 2009. Also, thanks to the credit crunch, there is less third-party money available for studios to offset the risk of film productions. So the companies have a choice: put the cost of more productions on to their own balance sheets, or make fewer films and cut costs.

Most have opted for the latter route. Time Warner merged its New Line Cinema label with Warner Bros Entertainment last year and recently closed two niche labels that specialise in edgier films – Warner Independent Pictures and Picturehouse. The company also cut the number of films it releases from a peak of about 40 a year to 25 in 2008.

With rivals such as Viacom’s Paramount Pictures also releasing fewer films, the industry appears to be contracting. Arthur Sarkissian, producer of the Rush Hour trilogy, says a shake-up will be good for Hollywood. "Studios have spent the last few years green-lighting everything ... They weren’t paying attention to the script, the characters or the story.” This led to a decline in quality that "has hurt the industry more than anything”.

The DVD decline is having other repercussions. The pay of film stars is being curtailed by studios desperate to cut expenditure. Gone are the days of the so-called "first-dollar gross”, which entitled the star to a percentage of a film’s revenues before the studio has made its money back. "They’re really clamping down on talent pay and they’re not making as many movies,” says one Hollywood agent.

Such concerns will be set aside for Oscar night, when the stars begin their walk down the red carpet at the Kodak Theatre. A night of tension and tearful speeches awaits. But when eyes have dried and all have gone home, the studios will still have a problem that all the Oscar statues in the world will be unable to solve.