April 22, 2009 / 9:14 PM / 9 years ago

Poor DVD sales hamper U.S. film financing deals

LOS ANGELES (Reuters) - As the credit crisis forces banks to scale back investments in Hollywood, a weak DVD market -- long an industry growth driver -- is adding to the challenges of getting films financed.

<p>A woman walks inside a DVD rental shop in Taipei February 18, 2008. REUTERS/Nicky Loh</p>

U.S. consumer spending on home entertainment fell 4 percent in 2008, in the first decline since the advent of the DVD, according to Bernstein Research analyst Michael Nathanson. DVD sales are estimated to have fallen 6 percent last year.

Operating margins at film studios, which have grown on the back of DVD sales for most of the decade, contracted 110 basis points in 2008, Nathanson wrote in a report on Wednesday.

He predicted demand for DVDs to fall further over the next five years as the maturing market slowly transitions to high-definition Blu-ray and digital distribution models, which offer lower profit per transaction.

Bankers say these trends are factoring into financing negotiations between lenders and studios, such as Time Warner Inc’s Warner Bros, Viacom Inc’s Paramount, News Corp’s Twentieth Century Fox, Sony Corp and Walt Disney Co.

“Consistent with the financial markets as a whole, film lenders and investors are taking a much more conservative approach to structuring deals then they previously had,” said Eileen Burke, principal of West End Capital and Advisory.

“If a company’s business plan relies on robust DVD revenues, it’s likely to be an area where lenders will haircut projections and their lending advance rates. It’s a part of the overall analysis you do when determining how much ‘lending currency’ is available for a particular deal,” she said.

From 2005 to 2008, hedge funds partnered with all the major banks from Merrill Lynch to Lehman Brothers to pour about $15 billion into films, financing studio “slates” of as many as a dozen movies at a time and collecting returns after the films were released or started generating DVD and TV revenue.

But after some box office duds and the credit freeze, most banks with the exception of JPMorgan have cut back in Hollywood.

“Every company in the industry is looking at the DVD market and how it affects it going forward. Some genres will be harder hit than others and certain companies will be harder hit than others. It will play a major factor in terms of financing,” said PriceWaterhouseCoopers Managing Director Ron Cushey.

Stephen Prough, founder of Salem Partners, which advises investors on how to maximize film investments, agrees.

“The decline of video revenue is something the industry will have to deal with. Economic expectations will have to be adjusted and production costs will have to come down,” he said, noting studios run “green-light” models to analyze releases.

After coming up with potential high and low box office ranges, video and TV revenue assumptions, studios determine whether a film has a good chance of turning a profit, he said.

“What’s happening now is that lower video estimates are going into those models, which means that you either don’t do a film, or have to do something on the cost side. The largest and most vulnerable line item is talent costs,” he said.

“Video is the largest source of revenue on a new release, accounting for about 40 percent, but new release video is off 25 percent from a year ago,” he said.

In the second half of 2007, for instance, a film yielding $100 million at the box office may have sold about 10 million DVD units in its first 12 to 18 months of release.

In the second half of 2008, a film of that stature may have sold only 7.5 million to 8 million units.

Some studios like The Weinstein Co and DreamWorks Studios, led by Steven Spielberg and Stacey Snider, are seeking financing. Others like Viacom’s Paramount ditched efforts to raise $450 million for a slate of films, and instead will co-finance on a picture-by-picture basis, after many of the big slate deals of recent years did not deliver as expected.

“It’s a different era from four years ago when people were clamoring to be in film deals. It’s kind of boiled down to some very professional folks who pay a lot of attention to the industry,” said Tom Adams, president and senior analyst with Adams Media Research.

Editing by Matthew Lewis

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