Movie Downloads: A Studio Happy Ending?

Hollywood has an interest in having more than one platform to avoid losing control of pricing to Apple or another intermediary

Entertainment companies now find themselves in uncertain times as they redefine how they sell their goods. Determining the successful business model for Internet distribution is among the entertainment industry's highest priorities. In the second of a two-part article, Standard & Poor's Ratings Services will look at the challenges facing flimed entertainment companies (read part one, on recorded music outfits).

In contrast to the progress of the music industry, Hollywood studios have not yet crystallized an Internet strategy. Clearly, it is in their economic interest to develop an online business model for the sale of first-run and library films, to avoid the early experience of the music industry, in which piracy and copyright infringement robbed major players of significant income.

Because feature films take up significant bandwidth, downloading Lord of the Rings: The Return of the King presents a different technological undertaking than downloading a three-minute music video. Even with the reduction in download times achieved in recent technology developments, many challenges remain.

New Devices on the Way

Several services are now available or will be soon. Akimbo Systems (unrated) offers a recording device that allows consumers to download and store digital feature films for future viewing—on either a rental or purchase basis. Apple (AAPL) has introduced its iTV device, which will allow users to wirelessly stream digital video from a computer to home TV sets.

Consumers will be able to access digital content in their iTunes library files, including previously purchased films downloaded from the iTunes Store, but this proprietary system will not enable them to gain access to downloads from other online video sources, such as (AMZN; BB-). Amazon's Unbox service enables consumers to download movies directly—and legally—onto their home PCs by means of a proprietary program. The Amazon service still has the shortcoming of offering only PC viewing rather than connecting with consumers' TV sets.

Warner Bros., a subsidiary of Time Warner (TWX; BBB+), reached an agreement with BitTorrent (unrated) in 2006 to sell certain films and TV series concurrently with their DVD release. BitTorrent uses a peer-to-peer, file-sharing technology similar to that of Napster, which is different from iTunes' centralized online retail model.

Home Video Is Still King

Until now, movie-download services have not permitted consumers to make their own DVDs, a reflection of Hollywood's piracy concerns. Early 2007 announcements from the annual Consumer Electronics Show in Las Vegas have addressed this with a device and a licensing arrangement that will facilitate at-home or in-store DVD burning. Consumer use will be subject to limitations set by studios on the number of copies that can be produced.

For all of these businesses, the ability to obtain comprehensive access to Hollywood films ahead of their DVD release, priced competitively with home video, and with technology permitting both a short download time and playback on TV, will be important to their success. None can boast all of these attributes, but we expect that the successful ones will. Hollywood continues to rely on home video for the largest percentage of revenues of any distribution channel—notably through Wal-Mart Stores (WMT), Target (TGT), and other large mass merchants, which use DVDs to draw store traffic. Hollywood cannot gamble this revenue source without being certain of an advantageous outcome.

In contrast to the music industry, studios may have a strong interest in the success of more than one platform, for both ubiquitous availability and pricing clout. The goal is to avoid the music industry's situation, in which iTunes Music Store has determined retail prices. On the other hand, the iPod device's lack of able competition clearly has fueled its meteoric adoption by consumers and rapid growth of downloads. Standard & Poor's believes that the Hollywood studios, at least over the near term, will have a strong incentive to negotiate a download model with a retail price not significantly less than what Wal-Mart charges for promotional DVDs—about $10.

Investors Could Get Frustrated

All these services are so new that no one can foresee how they will ultimately affect the Hollywood film producers. We continue to believe that it will take several years to develop, launch, and gain significant traction with paid legal downloading services. We still view this as having only a minor impact, if any, on the ratings of the major movie studios, largely because they are part of much larger, diverse entertainment conglomerates.

The effect may be primarily indirect if delays or execution issues cause investor disappointment and dips in share prices that entertainment firms attempt to address with increased share repurchases and other shareholder-friendly measures. But as entertainment companies continue to fight illegal copying of their product, efforts to implement legal downloading business models will undoubtedly occupy a high priority.

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