The Entertainment Glut
This is how it's supposed to work: The Walt Disney Co. made The Lion King for $55 million in 1994. The animated movie took in $313 million in U.S. theaters and $454 million abroad, sold $520 million worth of videos, and was a main attraction on cable's Disney Channel. Fans spent $3 billion on Lion King merchandise. The Disney-produced soundtrack sold 11 million copies, and Disney used the film again in September, 1996, to boost the ratings of its struggling ABC network.
And The Lion King is still roaring. In November, the Broadway musical debuted in a new Disney-run theater in Times Square. Within days, tickets with a face value of $70 were being scalped for $1,000 each, and Disney is toying with the idea of staging additional productions to meet the overwhelming demand.
Home runs like that have made entertainment an enormously alluring business. The formula for success is straightforward enough: Produce something for a fixed cost and exploit the hell out of it, selling it over and over in different markets, venues, and formats. And if enough people see it, the property becomes a cultural touchstone that can continue to draw in revenue for decades. Just look at old movies such as Casablanca and Star Wars, TV shows such as I Love Lucy, books such as Gone with the Wind, or records such as Fleetwood Mac's Rumours, which continue to sell well and attract new audiences long after they were created. By now, those sales are almost pure profit.
CROWDS OF GIANTS. But something is happening to alter, and perhaps destroy, this neat paradigm. In recent years, in an effort to capture ever more revenue, entertainment and media giants have bulked up with new divisions--new record labels, new movie studios, new broadcast and cable networks, new theme parks, new online ventures. Sectors of the business once ruled by just a few big players are now crowded with perhaps a dozen or more major entities hustling to create content that will win audiences.
And they're spending huge sums to do so, believing that only the glitziest and most star-studded offerings stand a chance of drawing more than fleeting notice in this cacophonous environment. It's a brutal battle, especially as audiences fragment amid the flurry of competing choices. Notes Booz, Allen & Hamilton Inc. media consultant Michael Wolf: "There is such a tremendous glut of product out there, as well as this need to keep spending more and more to exceed the quality standards established by other producers."
This dynamic--spending more on content as audiences splinter--is weakening margins across all segments of an industry never known for particularly fat profits (charts, page 90). Disney, for instance, had operating margins of 25% in 1987, compared with 19% last year. Viacom Inc.'s 1987 operating margin was 13%, but is down to less than half that. It's the same story at both News Corp. and Time Warner Inc. "These companies are in a race between the slower growth of their profits and their ability to restructure their balance sheets" to weather the tougher competitive climate, says Cowen & Co. media analyst Harold L. Vogel. Consumer spending on entertainment is slowing, he adds, "and the cost of marketing continues to soar, because that's the only way these giant brands can be maintained. It's a very tenuous situation."
Indeed, fragmenting audiences are robbing entertainment companies of the mass scale that made their businesses so attractive in the first place. It's extremely difficult to amortize higher costs over fewer customers. Says Universal Studios Inc. Chairman Frank J. Biondi: "If there's a way to have too many choices, that's what we have. Finding a way to bring [the consumer] to us instead of the other guy is the toughest thing we do."
Here's a hint of the competitive frenzy of just the past few months. PolyGram, the music giant, has launched a major film studio. Fox, Tele-Communications, Cablevision Systems, and NBC pooled resources to create Fox Sports Net, which competes with Disney's ESPN. ESPN is starting a magazine to compete with Time Warner's Sports Illustrated. Sports Illustrated teamed with sister Time Warner unit CNN to launch CNN/SI, another challenger to ESPN. New studio DreamWorks SKG is busy making movies, TV shows, music, and elaborate video arcades. NBC and Time Warner are mulling the launch of a new football league. Universal and Disney are both spending billions to build new theme parks to compete with their own existing parks in Orlando. Fox and NBC each launched all-news cable channels to take on CNN. Universal and Disney acquired record labels to buttress their music divisions. Fox, DreamWorks, Warner Bros., and Paramount are spending hundreds of millions of dollars to challenge Disney's long dominion over animated films.
And all the while, a potentially limitless number of Web sites, some developed at great expense by these and other companies, are also claiming eyeballs, further fragmenting audiences. Sighs Biondi: "You come into the office each morning, and you dread looking at the latest figures."
Even broadcast television, so long the lucrative playground of a few elite players, is splintering. There are now six networks, and there soon will be eight, as former Fox chief Barry Diller and infomercial king Bud Paxson each launch new broadcast networks this year. "These are the inevitable problems when a business has achieved a certain level of success and lots more entrants want to get in," says NBC CEO Robert C. Wright.
And if consumers aren't already overwhelmed, just wait a few years: A News Corp. study estimates that the total number of options available to a TV viewer will grow from about 75 now (largely made up of the average number of cable channels) to 1,000 by 2010, when digital compression of TV signals makes room for hundreds of channels, and the linkage of TVs to the Internet becomes a reality (chart, page 94).
But already, the problem isn't just that fewer people are watching each channel. With more bidders in the game, programming costs are skyrocketing. In January, stung by the loss of Seinfeld, NBC agreed to pay nearly $900 million to renew No.1-rated ER for three years. That's a tenfold increase in the show's cost--taking a big chunk out of the network's future profits, which were about $500 million last year. And NBC is run by the most fiscally conservative executives in the industry.
It's even harder to see how the other networks, all of which are only thinly profitable or losing money, can justify the combined $17.6 billion they recently agreed to pay for eight years of football rights. Although football ratings have fallen in recent years, CBS, Fox, and ABC will now pay a combined $745 million more each year for football (excluding ESPN's cable deal), while the three networks' combined income from network operations last year was just $32 million, estimates Montgomery Securities analyst John Tinker. "This is going to set off wide reverberations in a lot of areas," says Tinker, as the networks look to advertisers, affiliates, and their own employees to make up the difference.
So far, consumers have been willing to pay more for the explosion of choices, but the growth in that spending is tapering off, even in the current flush economy. Tele-Communications Inc., for example, faced with sharp increases in the rates it must pay cable networks such as ESPN, saw an alarming number of customer cancellations when it pushed through a 7.5% rate hike last year. Now, TCI President Leo J. Hindery Jr. is trying to get the entire industry to hold off on sizable increases. But it's hard going. Programming networks are "paying more for movies, for shows, for sports rights, and they all want me to pay more to carry their stations," grouses Hindery. TCI's rate increases just barely cover its higher programming costs, he says. "We're not getting any richer off those increases, I know that."
What will it take to survive, or even flourish, in this new, tougher world? Entertainment executives, long a corporate species apart, are finally adopting some of the basic tactics used by the rest of Corporate America. The savviest are already engaged in more rigorous cost-cutting, layoffs, more sophisticated market research, and the formation of strategic joint ventures to breathe life into weak assets. To avoid risk and boost the appearance of returns, they are taking on partners and using off-balance-sheet financing to make profits look stronger.
Some on Wall Street, weary of bankrolling media executives' excesses, are beginning to evaluate these companies by their ability to generate free cash flow or net profits, rather than just by their earnings before interest, taxes, depreciation, and amortization (EBITDA). Reporting in EBITDA drew attention away from how outright unprofitable many of these companies have been for years. Time Warner, for example, has posted a net loss for 28 of the past 31 quarters, and Viacom has done so for 13 quarters over the same period. The practice of reporting in EBITDA also perversely encouraged some to disregard what they spent to acquire assets since those costs weren't subtracted from any revenues generated. Running companies on EBITDA, acknowledges one top industry executive, "encouraged people to spend too much money and not take into account how much money it took to invest to get earnings."
Entertainment giants are also trying to cut out the middlemen between their products and customers. And they're spending lavishly on individual properties, such as current blockbuster Titanic and bombs such as The Postman, that they believe are capable of breaking through the clutter. At the same time, they are trying, with varying levels of success, to stop producing modestly budgeted fare that gets lost in the crush.
TITANIC DREAMS. The endgame for the big companies is to create a product so distinctive or magical that it becomes a cultural icon, a fixture in the public's imagination. They are all trying to find ways to recreate the mass scale their products enjoyed in the more profitable past. To do that, they're creating new distribution channels that give them the opportunity to capture enough viewers or readers, in the aggregate, to pay for what they have made. That's what NBC, Disney, and Fox are doing when they put a large number of their own shows on their networks' schedules, hoping to reap huge windfalls down the road as those shows are sold into syndication or, in some cases, aired on their cable channels in the U.S. and abroad. Titanic, a monster hit for Fox and Paramount that has already led to book tie-ins, a No.1 soundtrack, and a $30 million sale to NBC for TV rights, appears capable of doing that. And that's what Disney has pulled off so expertly with The Lion King, exploiting the property again and again in different venues.
But creating a new, more profitable economic framework for entertainment will demand countless adjustments to the way each sector of the industry does business. To reduce risk in ever more costly ventures, for instance, it's increasingly common for big stars and directors to take smaller paychecks up front in exchange for a percentage of the box-office revenue. Big-time author Stephen King recently struck a deal with publisher Simon & Schuster in which the author will take a smaller advance in return for a greater share of any profits. Simon & Schuster may not make as much on a King blockbuster--but it doesn't take on as much financial risk, either.
And though most entertainment companies view their rising talent costs as immutable, some are trying subtle tricks to ease the pain. Big record companies, for example, aren't taking on as many new groups, releasing only a smaller number of records that can be marketed aggressively. "Fewer acts are being signed," says PolyGram music executive Danny Goldberg. Studios, meanwhile, are trying to sign just one expensive big star per picture, instead of the galaxy of big names piled on in the past. Such tactics dramatically reduced the cost of such recent movies as Jerry Maguire and As Good as It Gets. And book publishers are cutting back on the number of titles they release. Simon & Schuster's trade division published 650 titles in 1996 but will publish only 550 this year.
But the lion's share of cost-cutting is occurring, literally, behind the scenes. Time Warner, for example, is in the midst of a program to trim $700 million in costs by next year. With only a handful of exceptions, gone is the private car service for employees in Manhattan before 8 p.m. Cheaper paper in its annual report is saving the company $200,000 a year.
With everyone else spending so lavishly on content, though, Time Warner isn't taking an ax to its creative costs. Instead, it's pushing hard to find new places to sell its stuff. "You cannot totally control talent costs," says Time Warner Chief Financial Officer Richard Bressler. "It's a reality of the business we operate in. What it drives us to do, on all the product we make, is maximize all revenue streams."
Bressler means that Time Warner may lose money as it makes an individual movie, creates a new cable network, or launches a magazine. But the company's ability to deploy its huge assets (26,000 TV programs, 6,000 movies, a dozen well-known magazines) over dozens of distribution channels gives it many more opportunities to milk assets for a return.
ASIAN FALLOUT. Another critical strategic push is to shorten the path between an entertainment company's products and the consumer. Profit margins are too thin to support middlemen. Disney owns its TV network and theme parks, and has a long-term lease on the Broadway theater showing The Lion King, so little of that revenue leaks outside the company. When PolyGram's Goldberg predicts with absolute certainty that record sales will boom again, he's anticipating consumers' ability one day to order over the Internet whatever they want from PolyGram's huge library. That would result in huge savings in distribution costs.
Much of this bullishness depends on the development and deployment of new technologies, from the next generation of cable boxes to digital videodisks (DVD). Yet the clutter plaguing entertainment content is also reflected on the hardware side. The players in consumer electronics now include computer companies such as Microsoft and Compaq. But the group has been unable in recent years to agree on technological standards to launch new products that would create fresh revenue streams (box).
Also troublesome is the slowing of revenue growth from foreign markets. Entertainment executives have been counting on surges in consumer demand in Latin America and Asia to save the day; now, financial turmoil jeopardizes those assumptions. The industry has "lost all its growth and faces potential receivables problems," says Cowen analyst Vogel, if Asian buyers, with their weaker currencies, can't meet their obligations.
But even before the Asian meltdown, establishing beachheads abroad had proved far more difficult than many anticipated. From Asia to Latin America to Europe, consumers are demanding expensive-to-produce localized content that U.S. entertainment giants can hardly claim an edge in providing. That's what made Rupert Murdoch alter plans for his Star satellite service in Asia. It was originally a pan-Asian, English-language service, and it would have been cheap to produce and extraordinarily profitable--if only people had wanted to watch it. Years later, Murdoch is launching separate satellite services with costly local programming for India, the Philippines, Indonesia, China, and Japan.
With new technologies and foreign revenue so elusive, some executives are clearly nervous about how they'll cover rising costs in coming quarters. "There was always something you could count on" for fresh revenue, says former Fox Studio chief Strauss Zelnick, now the president of Bertelsmann's U.S. operations. "In the '80s, there was video, cable, and the foreign markets. Today, there's nothing."
PLATEAU? Nor can companies look to U.S. consumers for drastic increases in the time and money they spend on entertainment. As the supply of entertainment and media offerings balloons, consumers' appetites may have hit a plateau. Investment banking and research firm Veronis, Suhler & Associates Inc. reports that per capita consumer spending on media and entertainment in 1997 will be about $546. That's up a healthy 49% from 1990, but expenditures will increase by only 19% over the next three years, despite the booming economy. That's not even close to the pace at which costs have been rising.
The time crunch is even more severe. Americans already spend an average of 9 1/2 hours each day watching television, going to movies, renting videos, reading magazines, listening to music, or surfing the Web, according to Veronis Suhler. "There are just so many hours in the day, and it looks like we've reached the saturation point," says President John S. Suhler. "Now, for every winner, there has to be a loser."
Already, the explosion in the number of entertainment choices has caused unit sales in several key sectors of the industry to shrink, or for the growth rate to slow markedly (charts, page 90). And the scary thing, at least for the moguls in their corner offices, is that this is happening during a period of roaring prosperity in the U.S. Consumers are confident, and a lot of them have plenty of extra cash to spend on nonessentials such as tickets to Titanic, subscriptions to HBO, and funny hats at Disneyland.
Along with healthy consumer spending has come a booming ad market, alleviating the pain in many entertainment sectors. Ads are so strong that companies have been able to increase ad revenue even as their audiences shrink. But in ad-revenue gains, too, the networks, at least, may be hitting a limit. The cost of ad time isn't going up; "the networks are just jamming more spots into each half-hour and hoping the TV audience won't notice," says Jon Mandel, the top media buyer at Grey Advertising Inc. In 1986, ABC aired an average of 6 1/2 minutes of ads per hour of prime time. Now, ABC treats viewers to an average of 9 1/2 minutes of ads.
Ironically, ad buyers are still clamoring to buy time on the networks' biggest shows. Their rationale: It's the best gambit amid the clutter. "A broadcast network is still the only place you can get 30% of the audience in one shot," Mandel adds. "But you have to wonder how much longer it's going to be like that."
For several years, Wall Street has had doubts, too. The stocks of many big entertainment companies have badly underperformed the otherwise booming market in the past few years, though the shares of several have rallied recently. But the big institutional investors are hanging tight, convinced that the giant entertainment companies will amass the scale to eventually prevail in the years ahead. The payoff may well be years away. "These companies decided five or six years ago that it was important for them [in the decades ahead] to have much larger distribution and production capabilities to become big global players," notes Gordon Crawford, an influential media investor. "So they larded up their balance sheets. [But] most of these decisions make sense long term, and 20 years down the road, they're going to be all right."
There will probably be some winnowing before then, as profits continue to be squeezed. Already, a few companies have jettisoned or are considering selling off major divisions, as Disney did with newspapers and Viacom may do with its Blockbuster video-rental chain and part of its Simon & Schuster publishing unit. "Eventually, someone loses enough shareholder money so that management gets thrown out," predicts media investor Larry Haverty at State Street Research & Management Co. "My guess is that we're six to eight years from that happening."
In the meantime, entertainment moguls are begging investors less philosophical than Crawford to be patient. Even Rupert Murdoch, still very much in expansionist mode, is carefully trimming expectations for News Corp. At his mid-1996 annual meeting, Murdoch promised his shareholders 20% annual earnings growth. He ended up delivering a 30% decline after taking a big publishing-related charge. By the time he addressed shareholders again, in mid-1997, a less exuberant Murdoch promised only "satisfactory" financial performance in the year ahead.
"Satisfactory" is hardly what the entertainment industry has grown used to in recent years. For more than a decade, the world hasn't seemed large enough to contain the industry's potential. Anyone familiar with the success of Disney's Lion King knows that entertainment can be one of the sweetest businesses going. The problem is that too many players are at the table, and it's ruining everyone's hand.