Premiere day was fast approaching for The Hulk. The film's budget had already climbed to more than $150 million, including an extra $20 million for George Lucas' special effects company to give the giant green hero an extra dose of ferocity. Even the red-carpet ceremony was in flux, with a last-minute move at the insistence of director Ang Lee from historic Grauman's Chinese Theater to the Universal Amphitheater, where the sound was sharper. But that 11th-hour nitpicking was nothing compared with an earlier uproar at Universal Pictures: Two weeks before Hulk's June 20 release, pirated versions of the blockbuster (BBI ) hopeful were already circulating on the Internet after a New Jersey man got his hands on an early copy and surreptitiously posted it on the Net. Worse yet, the film was getting nasty reviews from disappointed sci-fi buffs.
For Hollywood moguls, that script is more terrifying than anything they could ever put on the big screen. More and more, the first showings of the latest Julia or Mel flicks aren't in just the local cineplex. They're on KaZaA, Morpheus, or iMesh, Internet sites known mostly for music file-sharing but now snapping up pirated movies with remarkable ease. Within a few days of Keanu Reeves battling his first black-suited bad guy in theaters in The Matrix Reloaded, an estimated 200,000 folks had already taken in the action, according to an online rating agency, downloading the long-awaited sequel in their dens and dorms. New episodes of HBO's hit Six Feet Under are on the Net, too, and you needn't be a computer whiz to find them.
It's all too reminiscent of the monster that ate the music business. For a town that loves a good sequel, that's one repeat performance Hollywood isn't keen to produce. Only five years ago, music sales were booming. Today, the industry is nearly paralyzed by piracy. Illegal downloads and file-sharing were partly responsible for last year's loss of an estimated $2.6 billion in worldwide music revenues, about 8%, says PriceWaterhouseCoopers. The speed at which music was brought to its knees makes Hollywood execs tremble. "We may not be the smartest guys around," says Peter Chernin, president of News Corp. "But we'd have to be brain-dead to ignore what it did to those guys."
Can Hollywood avoid getting Napsterized? Right now, the pirates are only nibbling at the $65 billion-a-year film and TV business. Downloading a movie is still a clunky affair that can take a few hours, and only 27% of the country's 66 million online homes have the superfast broadband connections to do it.
Most of the piracy so far is through good old-fashioned counterfeiting. The ripping and burning of movies to DVDs is growing into a global underground industry that last year cost film studios an estimated $3 billion in lost DVD sales. It's prodding the guys in Guccis into action: Security folks outfitted with night goggles routinely patrol press screenings, searching for illicit camcorders. Former FBI agents are leading raids of illegal DVD copying plants in Thailand and Malaysia. Industry lawyers are flooding court dockets with lawsuits against all manner of thieves (page 82).
But the digital threat is looming as ominously as the thick flock of crows gathered on the jungle gym in Alfred Hitchcock's The Birds. Technology is coming on quickly that will make the prospect of copying movies and TV shows much more tantalizing -- and far easier. Already, some 600,000 copies of films a day are being downloaded illegally, according to industry estimates, which could cost Hollywood hundreds of millions of dollars in lost video sales. A new crop of gizmos, from digital televisions to personal video recorders (PVRs), will soon make duplicating anything on the tube -- from Fox (FOX ) Broadcasting Co.'s 24 to the latest Jennifer Lopez flick -- a couch potato's dream. And within three years, half the online population will have broadband, making it easier to pass programs captured in digital form around on the Net.
The living room is center stage for all this new digital entertainment. But will it be a war zone or a thriving marketplace shared by the creators of content and the makers of the cool machines that deliver it? That's the urgent question facing studio execs. It's not that they can't envision a rosy scenario for convergence, where there's money to be made at every turn -- from movies on demand to Sex and the City fans streaming their favorite episodes on the PC to teens watching videos on handhelds. "We would certainly like to be able to make our content [increasingly] available in a digital world," Comcast (CMCSK ) Corp. CEO Brian L. Roberts told the National Cable & Telecommunications Assn. convention in early June. "But we need to feel secure that we're going to get paid for [it]."
The next few months will be crucial for the Hollywood gang, who are currently wrangling with cable operators, consumer-electronics makers, and the technology industry over protecting their digital gold. Each group has its own philosophies about how much protection -- mandated and voluntary -- the content needs. Historically, working hand in hand with disparate interests has been anathema to the moguls, a single-minded, ego-driven bunch for whom compromise doesn't come easily.
But for everyone's convergence dreams to come true, that must change. The studios are already taking tentative steps toward recalibrating their lucrative business model, which now guarantees earnings on every movie for months after release, as films cascade through theaters, video stores, and cable TV. They are testing new ways to serve up Hollywood fare faster and cheaper, with an eye to deterring Net pirates. And they are also inching toward key agreements with gadget makers over just how much copy protection will be built into new generations of TVs and cable boxes.
Looking ahead, retooling for the Net is the most important gambit, if potentially the most perilous. Execs are clearly energized by the early success of Apple Computer Inc.'s iTunes Music Store, which offers a road map for selling their wares online. At 99 cents apiece, more than 5 million songs have been sold in two months -- in part because iTunes offers flexibility, allowing users to make copies they can move to other computers. The moguls see iTunes as proof positive that consumers are willing to accept limits on copying if the price is right. "[Apple CEO] Steve Jobs has liberated us," Sony Corp. of America CEO Howard Stringer told a group of media executives on June 25. "We will all be doing something similar."
Many studios are already laying the foundation for digital delivery. In fact, Hollywood is proving quicker in proposing an alternative to file-sharing than music ever was. That's critical because absent that innovative spirit, things could get grim. Consider projections made by research company Sanford C. Bernstein & Co. now reaching moguls' desks. Analysts there estimated what the blow to earnings would be at the big entertainment companies if in one year they suffered the same level of declines from piracy and file-sharing as the music industry. The results: At heavily movie- and TV-dependent Vivendi Universal Entertainment, operating earnings would fall 43%. Disney's would drop 17%; Viacom's and AOL Time Warner's, 4% to 6%.
The impact of new technology will hit hardest over the next three to seven years, the report predicts, giving the media folks little time to adjust. "The message here is that the studios have to move faster," says Thomas R. Wolzien, one of the Bernstein report's authors. "They can't be like the music industry, deer-in-the-headlights for the past five years."
Hollywood still harbors some of music's protectionist urges, though. It is battering downloaders with lawsuits and pushing broad-brush copy-protection laws in many states -- all of which could backfire with Internet-savvy consumers. Then again, grudging adaptation to technological change is nothing new in the media business. Back in the 1950s, studio kingpins like Jack Warner refused to license films to TV, fearing a blow to the box office. But eventually studios embraced TV and subsequent technologies, from videocassettes to DVDs, and made bundles of money in the process. Today Hollywood takes in more cash from DVDs and home videos than it does from theaters, while the No. 1 video chain, Blockbuster Entertainment, is owned by Paramount parent Viacom Inc. This time around, though, there will be some bloody battles and financial setbacks as the new and even more disruptive technologies take hold. Still, Hollywood leaders seem ready to roll up their sleeves. "We not only need to work together within industries but across industries [for a solution] that touches not just the content creators but the software industry and the consumer-electronics industry," AOL Time Warner Inc. CEO Richard D. Parsons told the cable powwow. "Let's all work together to come up with ways of protecting this goose that's laying the golden eggs."
Hollywood surely has been spinning gold lately. This year will see $11.4 billion in DVD sales, up 34% from 2002 and twice as much as in 2001. The industry thrives on a "windowed" distribution system, which maximizes revenue by stoking demand. Movies don't come out on DVD until five or six months after hitting theaters; premium cable gets them five or six months after that. Today, DVDs and videos supply about 50% of a film's revenues. But as more folks can click, copy, and transmit, they'll likely seek out new flicks on the Net rather than wait for local video stores to stock them.
Changing the model will be tough, as each sector clings to its piece of the status quo. "As much as they are loath to admit it publicly, the studios cannot afford to circumvent us," John Antioco, CEO of Blockbuster Inc., said in a recent speech. "They have too much to lose." Theater owners, too, are threatening revolt. When Fox recently announced plans to release DVDs of From Justin to Kelly, about the American Idol stars, just six weeks after its premiere, theaters refused to show the film. Their beef? That Fox was enticing folks to bypass theaters and go straight for the rental.
Yet even as the financial bennies of the old system still flow, Hollywood's moguls are learning some lessons from the record companies. The labels squandered the rollout of their own online services like MusicNet and pressplay by not having licensing agreements for all songs from all labels and by forcing a subscription model. By the time the Big Five music empires ironed out deals, pirated music had crushed them.
By contrast, Hollywood has already made inroads with pricing, variety, and copy protection. Five Hollywood studios began offering movies through Movielink last November. And CinemaNow, operated by the independent film studio Lion's Gate Entertainment (LGF ), began selling films on the Web in early 2001 and recently has begun offering higher-visibility films from MGM, Warner Bros., and Fox. CinemaNow allows some limited downloading of movies and gives consumers up to 48 hours to watch each flick before the file expires. The service says it has 25,000 customers who pay $9.95 a month -- although many of them may have signed up to get adult films. Sony Pictures Entertainment, through its Web site SoapCity, offers Net downloads of The Young and the Restless and As the World Turns, two long-running soap operas it produces. They're available the day of airing for $1.95 a show or for a $9.95 monthly sub. Down the road, Sony hopes to deliver programming to its Vaio computer and handheld Clie.
Come this October, Walt Disney (DIS ) Co. launches tests of its MovieBeam (DIS ) service, which will deliver up to 100 movies a month to folks in Salt Lake City, using bits of the unused digital spectrum from its ABC affiliate in that city to send flicks directly to a Disney set-top box. "If we don't offer consumers our products in a timely manner," Chairman Michael D. Eisner said when he announced MovieBeam in April, "the pirates will."
Still, the movie sites have a ways to go to win a mass market. Movielink does not include films from Disney or Fox. CinemaNow boasts nearly 1,000 movies but has only about 100 of Hollywood's recent hits. You can get the second Harry Potter or Barbershop, but you can't get the wildly popular The Matrix. The sites may also want to put more emphasis on their per-flick payment system instead of subscription models, which online users don't like much. Another obstacle: Superstar directors like Steven Spielberg and George Lucas, who don't trust current protections, are refusing to license their films to any Internet service.
Of course, the quality of online viewing is still iffy. Unlike songs, which can be captured quickly and stored on portable players, downloading movies is glacial. And not everyone wants to watch them on a computer screen. Some execs figure that the less-than-desirable quality of pirated movies may buy them some time.
As the industry maps its Net strategy, it's also trying to shore up another vulnerable front: digital TV. This is a potentially huge source of digital leakage and widespread copying right smack in the heart of the living room. Studios were jolted awake in 2001 when tiny SONICblue (SBLUQ ) offered up ReplayTV Inc., a PVR that not only recorded shows but also allowed consumers to share them over the Net and even zap commercials. The studios faced down the threat by suing the company, whose owners deny liability; the suit is still pending. ReplayTV's new owners, who are not party to any suit, have agreed to pull back on ad-skipping features in new machines due out in August, but they'll still have a fast-forward button.
Although PVRs have been slow to take off, the number sold annually could quadruple to 1.3 million by 2005, according to the Consumer Electronics Assn. Nearly 1 million of satellite operator EchoStar Communications (DISH ) Corp.'s 8.5 million subscribers have PVRs with a 30-second skip button. TiVo has fast-forwarding. With enough scale, such machines could set off a virtual A-bomb on broadcast and cable networks' traditional advertising model, which brings in an estimated $30 billion a year. Indeed, ad viewing will drop by 19% by 2007, figures Forrester Research (FORR ) Inc. "It is the perfect storm of hardware devices getting cheaper and more powerful and broadband arriving big-time," says Eric Garland, CEO of BigChampagne LLC, which collects data on movie downloading.
Yet even as it grapples with PVRs, Hollywood is making progress with makers of digital-TV sets. The studios and consumer-electronics companies are circling in on agreement over new standards. New rules before the Federal Communications Commission would make it impossible to record broadcast TV shows, now delivered digitally, and ship them out onto the Internet. This would lessen the vulnerability of digital-TV shows sent over the air to the 20 million or so U.S. homes, about 18% of TV households, that don't have cable or satellite. Protection would come in a so-called broadcast flag, software in programming that tells TVs and recording devices whether the content can be sent over the Net.
An accord has also formed over what's known as the "plug-and-play" proposal, submitted to the FCC for review last December. This would build safeguards into set-top boxes, TVs, and PVRs that handle digital shows sent to the 80% of U.S. households receiving cable and satellite service. Consumers would be able to make as many copies as they like of broadcast shows like CBS (VIA ) CSI: Crime Scene Investigation, only one copy of a cable show like HBO's Curb Your Enthusiasm, but no copies of pay-per-view offerings. Viewers can burn that single copy on a DVD, but if they try to make a second, the first goes blank.
But a contentious Hollywood wants more and may hold up a pact on plug-and-play to get it. It is demanding safeguards for the hundreds of millions of analog TVs in existence. And the studios' preference for regulation rather than a private-sector accord on the broadcast flag worries some tech companies. Fighting for market share in a harshly competitive market, the purveyors of PCs and other devices want as few restrictions as possible to entice buyers of their gadgets. By trying to lock in too many controls before cutting a deal, techies argue, Hollywood is alienating customers and slowing the growth of a huge new digital audience. "You need to do a number of things concurrently," says Andrew Moss, director of technical policy at Microsoft Corp.'s Windows division. "It's not a matter of stomping out all the piracy first and then enabling new distribution mechanisms later."
Indeed, Microsoft itself is maneuvering for a role as power broker on the digital entertainment scene, now that it has settled its browser battle with Internet rival AOL Time Warner. As part of its late May deal, Microsoft may license its copyright-protection software to Warner Bros. for its TV shows and movies. The software giant, along with Intel, is also developing Trusted Computing, copying controls built into the next generation of computers. Microsoft's push into digital-rights management shows how crucial technology is becoming in the battle to turn Hollywood's digits into dollars on the Net.
What if the pirates continue to run amok? More rigorous regimes for ensuring payment for copying would probably emerge. Among them might be compulsory licensing, in which a Net service provider or a file-sharing service would track downloads and charge a fee at the end of the month. Prices could be set by industry groups or even the government, and the studios would get some slice of the revenue. Hollywood doesn't like this much, because it loses pricing control, but some tech groups back the idea. Another concept: a tax on blank DVDs, PCs, or PVRs. This would essentially be a piracy tax creating a huge pool of money earmarked for the studios. The tech companies see this as an unnecessarily blunt instrument that treats all users as pirates-in-waiting.
Media moguls are realizing that what they really need to do is turn pirates into paying customers. That's why, for so many in the industry, Apple's iTunes has become a demarcation between eras. And this from execs who were recently fuming about Jobs's "Rip. Mix. Burn" marketing blitz, which seemed to them to promote piracy. Now Hollywood recognizes his genius stroke: When it comes to entertainment, you have to give the people what they want.
By Ronald Grover & Heather Green
With Tom Lowry in New York, Catherine Yang in Washington, and Cliff Edwards in San Mateo, Calif.