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Here’s a good reason for the movie studios to worry: 2007 could be the first year in which consumer spending on DVDs actually declines. Richard Greenfield, an analyst with Pali Research, addressed that issue and a few others in a research note on Friday.

The basic issue on DVD sales, Greenfield reports, is that there has been a decline in catalog sales, as the “halo effect” from an expanding DVD consumer base is over. In short, almost everyone now has a DVD player, and they’ve replaced their VHS catalog titles - so now the market will be driven largely by the ability of the studios to produce hits.

Greenfield notes that household penetration of DVD players is now over 80%. He says “wholesale pricing is going to come down on DVDs,” the only questions being “how fast and how much.” Meanwhile, he notes that digital film distribution will enable “the ultimate price competition,” pressuring “bricks-and-mortar” DVD retailers. He also notes that digital movie distribution will have to compete against free, pirated versions, as has beeen the case in the music industry.

As for the next generation DVD players - the Blu-Ray and HD-DVD formats - Greenfield says they will not have a material impact on studio revenues and profits in 2007. “It remains highly unclear which format will win (as both sides continue to make serious errors), not to mention that consumers without 50-inch or large HDTV [sets] are unlikely to appreciate the improvement in picture quality.”

Greenfield says studios with a higher percentage of back catalog DVD sales are more vulnerable to the shifting landscape - he says Warner Brothers (NYSE:TWX) is “particularly exposed.” He says he would also worry about smaller pure-play movie studios, including DreamWorks Animation (NASDAQ:DWA), Lion’s Gate (NYSE:LGF) and Marvel (MVL). He thinks Disney (NYSE:DIS) and Fox (NASDAQ:NWS) are better positoned, thanks to recent theatrical successes.

On the issue of how the movie business might benefit from digital distribution, he concludes that, basically, it might not.

While the music and television industries are likely to benefit from an increased array of opportunities in digital distribution, it is not clear to us how the movie industry benefits... We believe the inherent value of what a movie is implies that most consumers will want to view most movies in a high-quality experience…the more we think about the movie industry, we keep thinking, what is the benefit from digital? Cheaper distribution and no physical inventory? That sounds great at first, but if the product has to be sold at a discount (comparable to the lower cost to create/disitribute) because it is inferior to physical DVDs (in picture quality and usage restrictions/DRM), how does it help the studio business?

Here’s the bottom line, according to Greenfield:

Keep an eye on 2007 film industry profits, we suspect the risk to expectations is increasingly to the downside, with downside risk growing into 2008 unless there is a notable acceleration in Next-Gen DVD sales and/or a more attractive business model emerges for digital movie distribution.

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Source: Not Many Hoorays in Hollywood: DVD Sales Slump, Digital Distribution Looks Like a Bust