A Boffo Summer for Entertainment Companies?

Hollywood is feeling the heat as summer nears. Major entertainment companies such as Walt Disney (DIS), Time Warner (TWX), and Viacom (VIA) have a lot riding on summer film releases, whose box-office take typically represents 40% of annual movie revenues.

That's especially important in an economic downturn. Moviegoing is one of the few discretionary purchases by consumers that have held up during this recession, despite an unemployment rate near 9%, mounting foreclosures, and greater commitment among U.S. households to paying down debt and building savings for a more uncertain future.

Last year, U.S. box-office receipts totaled $9.63 billion, essentially unchanged from $9.66 billion in 2007. Movie attendance dropped by 4.8% but was mostly offset by a 4.4% rise in the average ticket price to $7.18. That's all the more impressive given the sharp drop in consumer spending amid a harsh economic backdrop and the fact that 2007 was a banner year for movie sales, analyst Tuna Amobi said in a recent research report for Standard & Poor's. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)

"The traditional thought is that [theatrical entertainment] and going to the movies are a countercyclical market because generally they're lower-ticket items than other forms of entertainment like travel," says Robin Diedrich, an analyst at Edward Jones in St. Louis.

Nightmare on Wall Street

This year's box office is materially better than last year's so far, but analysts aren't clear whether the cause is the trading-down effect—or just better films. However strong box-office receipts were, the stocks of the companies that own the movie studios didn't avoid getting hammered in the past year, along with virtually all other stocks. As a result, most of these media and entertainment names look fairly attractive now and their earnings are bound to improve with the broader economy, analysts say.

This summer's box office could be flat to as much as 5% higher than last year's record-breaking figures, says Jeffrey Logsdon, an analyst at BMO Capital Markets (BMO) in Los Angeles. He expects Paramount Pictures, a unit of Viacom, to rake in the most cash. Big-name releases such as Transformers: Revenge of the Fallen, Star Trek, and G.I. Joe: The Rise of Cobra are sure to be popular and should boost the studio's revenue by 15% to 20% over last summer. Since opening on May 7, the rebooted Star Trek has already earned $200 million domestically, quickly catching up to year-to-date sales for Monsters vs. Aliens, released by Paramount on Mar. 27, and produced by DreamWorks Animation (DWA).

Logsdon believes 20th Century Fox, a unit of News Corp. (NWS) will pull in $750 million this summer on titles such as Night at the Museum: Battle of the Smithsonian, Ice Age 3: Dawn of the Dinosaurs, and X-Men Origins: Wolverine, nearly triple the $267 million it made last summer.

Disney's revenue is likely to be up 25% from a year ago, in spite of the "creative downswing" criticism it's taken in recent years. The new animated feature from its Pixar unit, Up, had a more profitable opening weekend than last year's Wall-E despite opening on 5% fewer screens than the average for Pixar's last four releases, driving up revenue per screen 19%, according to analyst Spencer Wang at Credit Suisse (CS).

Looking Up

In a June 1 research note, Wang said, "The solid performance of Up reinforces our view that the Disney and Pixar brands resonate strongly with consumers and that Disney's focus on producing fewer but higher-quality films is the right strategy as barriers to entry in content creation fall and content choices proliferate."

Of all the studios, Warner Bros., a unit of Time Warner, will have the toughest sales in comparison with last year. The studio's biggest title, Harry Potter and the Half-Blood Prince, the sixth in the popular series, opens in July, but its box-office take will pale next to Warners' Batman opus The Dark Knight, which grossed $533 million domestically last year, says Logsdon at BMO Capital. He thinks the new Harry Potter film could take in $250 million to $300 million with broad enough distribution.

Small studio Lions Gate Entertainment (LGF) isn't even in the game this summer, saving big releases such as Tyler Perry's I Can Do Bad All by Myself and Saw VI for the fall. One of the few surviving pure-play studios, Lionsgate prefers "to almost counterprogram" by opening "medium-risk, medium-upside movies in less crowded seasons and day slots" instead of the so-called tent pole, or big movie release, approach, says David Bank, an analyst at RBC Capital Markets (RY) in New York. As such, he doesn't think the lack of summer product will hurt the studio much.

On June 2, Lionsgate reported a net loss of $1.40 a share for fiscal 2009, more than double the 62¢ loss a year earlier, despite an 8% gain in revenue. Underperforming theatrical releases in the second and third fiscal quarters and a $36 million charge it took on DVD distribution of HIT Entertainment's family entertainment titles were the main drivers of the 2009 loss.

Beyond the Big Screen

Since the studios are a low-margin business, the conglomerates that own them look beyond a film's box-office results for additional revenues, from DVD sales to video-on-demand to licensing of characters and concepts to toy and video game merchandisers, says Bank.

By that measure, Paramount may be the least profitable studio with the lowest return on its assets, since it doesn't own many of its franchises. Iron Man was a big hit last year but netted Paramount just 8% of the film's box-office revenue, while Marvel (MVL), the film's producer, got the bigger share. With Star Trek and the Transformers sequel, both of which it owns, Paramount could be on the verge of turning that around, however, says Bank.

News Corp.'s 20th Century Fox and Fox Searchlight have been the objects of envy for their consistent profitability, he says. But filmed entertainment accounts for only 20% of News Corp.'s total revenue, compared with 40% for both Disney and Time Warner, says Christopher Marangi, an analyst at Gabelli & Co. (GBL) in Rye, N.Y. Sony Corp.'s (SNE) film division gets less attention from analysts because of how small it is compared with the overall company.

U.S. DVD sales slid 7.3% from 2007 to roughly $21.6 billion in 2008, after falling 3.3% from 2006 to 2007. Sales of high-definition Blu-ray discs jumped almost threefold to $750 million, or 3.3% of total home video sales, driven by more than 11 million units of The Dark Knight, according to the S&P report. Discounted prices during the holidays helped drive a surge in the installed base of Blu-ray players, which reached 10 million by the end of 2008. Prices for Blu-ray players are down dramatically, from more than $400 to under $300, with some models available at big-box retailers such as Target (TGT) and Wal-Mart (WMT) for under $200.

Blu-ray's Impact

With consumer adoption of the next-generation format growing, S&P said that Blu-ray sales could overtake standard DVD sales in the years ahead. But the change in format won't be the cash cow it was for studios when consumers migrated their home libraries to DVD from VHS, generating $5 billion in profits, says BMO's Logsdon. That's because standard DVDs can still be played on most Blu-ray players and few consumers care about the expanded storage space for additional extras in the Blu-ray format, he says.

The hope is that electronic distribution, including video-on-demand and downloads to iPods, will make up for moderating physical growth in home video sales, which peaked in 2004 and 2005 with restocking of home libraries, says Gabelli's Marangi. A studio typically gets about 70% of the fee a viewer pays a cable station to see a recent movie, vs. 30% of the $4 rental cost on a DVD from Blockbuster (BBI), he says.

For now, VOD, streaming video, or iPod downloads account for very little dollar volume for the studios, but they will be a bigger factor three to five years from now, says Logsdon.

How do Wall Street pros view the prospects of the media giants? Analysts think Disney's pipeline looks even stronger in fiscal year 2010 with the release of Toy Story 3 and the re-release in theaters of the first two films in the franchise in 3D. Credit Suisse has an outperform rating on Disney with a $28 target price that "assumes the stock can trade at a price-to-earnings multiple consistent with our five-year [compounded annual growth rate] of 15% to 16%" on an earnings estimate of $1.77 a share for fiscal 2010. Disney's theme parks and cable networks, which depend less on advertising than those of its competitors, warrant the 16% premium p-e multiple to its peers, said Wang.

Marangi at Gabelli is recommending Time Warner to clients more than Disney, since he believes Time Warner's stock is undervalued more than Disney's and has more upside growth potential. But with 70% of its earnings coming from the cable networks, the film business isn't the driver of Time Warner's strength, he says.

Pinning Hopes on Fab Four

Viacom, too, is dominated by its cable networks, including Comedy Central and MTV. Viacom is addressing some ratings issues at MTV, and Paramount has gained new life since Star Trek's release. Another source of profit should be The Beatles: Rock Band music video game, which Gabelli's Marangi expects to be a big hit when Viacom's MTV Games unit releases it in September. Viacom will sell replicas of the instruments the Fab Four played, plus microphones, and software discs or downloads of the songs to play on the instruments, as a bundled package for $250 and will sell the songs alone for $60.

Corporate restructuring may be equally important to these companies' ongoing profitability. Time Warner is slimming down to become more streamlined with the separation of Time Warner Cable (TWC) in March and the planned spin-off of AOL by the end of 2009. In January, the company said it would cut its global workforce by 10%, or 800 jobs, and pare its annual release slate to 25 from 40.

Disney unveiled a plan in January to merge its ABC broadcast network with its production unit, ABC Studios, to result in an estimated loss of 200 jobs. In December, Viacom said it was cutting 850 jobs, with Paramount axing almost 100 positions, while NBC Universal, a unit of General Electric (GE), is slashing 500 jobs, or 3% of its workforce.

The studios are lucky if they break even on a theatrical release after production and marketing costs and whatever percentages a film's stars are entitled to, says Diedrich. After that window, the home video release is where they make most of their money, and there's also a chance to make some money from video-on-demand.

"It's a balancing act about going digital and how to do that and what to charge," she says. "The big question for these companies is how they manage those windows. There's constant evolution for that industry." The movie biz, which has withstood upheavals from talkies to the birth of television, must be used to that by now.

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