Hollywood's DVD Problem Is Different Than The Music Industry's CD Problem

| About: Dreamworks Animation (DWA)

On February 28, 2012, Dreamworks Animation (NASDAQ:DWA) reported fourth quarter and year end earnings. The company acknowledged on page 10 of its 10-K, "Since 2005, there has been a general decline in both the number of DVD units sold and the profitability of such units, and such decline accelerated during 2010 and 2011."

In its most recent 10-K, for the fiscal year ended March 31, 2011, Lions Gate Entertainment (LGF) stated on page 22, that video piracy is "prevalent across the entertainment industry" in part due to "the ease with which DVDs and Blu-ray discs may be duplicated."

This DVD and Blu-Ray problem may initially appear all too similar to the problems with music piracy leading to plummeting compact disc sales in the recording industry. Investors who followed that industry saw former "big four" record companies Warner Music Group taken private in 2011 after years of losses, and EMI taken over by Citigroup (NYSE:C) after EMI was unable to pay its debts. Citi announced last year that it intended to sell EMI in pieces to the other former "big four" members, specifically, a group lead by Sony (NYSE:SNE) and Vivendi's (OTCPK:VIVHY) Universal Music. However Citi's deal has yet to meet regulatory approval.

As Sony is also in the film and television businesses, one would hope that any lessons from the fall of the CD would, if possible, be applied to the current problems leading to declining DVD and Blu-Ray sales. So, I thought I'd compare some of the music industry's problems with the challenges facing the television and motion picture industries.

1. The Experience Of Live Performances Cannot Be Pirated.

As record labels realized that they could not rely on significant album sales, they also realized that they could sign artists to "360 deals". 360 deals let the labels take a cut of other streams of revenue created by artists, including concerts, merchandise, and endorsements. In a recent regulatory filing for a senior note issue, Warner Music Group stated that over 50% of its artists are signed to 360 deals. And as CD sales declined, the price of the average concert tickets rose 40% from 2000 to 2008, according to Pollstar data cited by Music Think Tank. Investors who think the long-term trend will be for more artists to sign 360 deals and perform more often live may want to take a look at concert-promoter and Ticketmaster owner Live Nation (LYV).

Similarly, the experience of seeing a film on a big screen cannot be pirated, especially when the film can be seen in 3D. In addition, Disney (NYSE:DIS), with the benefit of owning rights to Spiderman and the Lion King, and DWA owning Shrek, have been able to earn revenues through live musical performances. According to DWA's most recent conference call, $9 million in revenue was from Shrek the Musical, and as I discussed in an article available here, DWA has plans to open a live arena production this year of Kung Fu Panda in China, and since that article, has opened a joint-venture production of How To Train Your Dragon in Australia. While the vast majority of films produced in Hollywood will not wind up on Broadway, companies that are able to create or buy popular film franchises have the potential to earn new revenues through live performances, to somewhat compensate for lost DVD revenues.

2. The Music Industry May Have Different Attitudes About Digital Distribution.

Nine Inch Nails multi-platinum selling alternative rock star Trent Reznor said in an interview in 2009 that: "Anyone who's an executive at a record label does not understand what the internet is, how it works, how people use it, how fans and consumers interact - no idea. I'm surprised they know how to use email. They have built a business around selling plastic discs, and nobody wants plastic discs any more. They're in such a state of denial it's impossible for them to understand what's happening."

Music executives may take issue with Reznor's depiction, as record companies attempted various online ventures in the late 1990s, some of which are described in this Wired article from 2000. In contrast, the film industry had a head start selling its works directly to mainstream consumers without a physical good changing hands. As an example, Viewer's Choice Pay-Per-View channel (now "iN DEMAND") debuted in 1985. Of course, the music industry also had a negative head start on dealing with high-speed, widespread piracy, when Napster and other similar file sharing services launched in 1999. These differing head starts may have lead to different sentiments toward digital sales for these the music and film industries.

When an analyst asked CEO Jeffrey Katzenberg during the conference call how digital sales of movies were doing in stores like iTunes and Amazon.com, he replied:

"No, actually conversion to digital so far has been very, very modest. It's a very small part of our business, and again I think all of us are very excited about the potential of digital delivery and for sure it is coming. But if you're asking right now, boots on the ground what are we seeing on a month to month basis right now, it's pretty miniscule." Unlike the record executives Reznor spoke about three years ago, Katzenberg understands the digital transformation as it is occurring.

The current problem does not seem to be a lack of acknowledgment by film execs like Katzenberg that there will be a transformation to digital sales of content currently sold on DVDs and Blu-Ray. Rather the problem seems to be finding a catalyst to allow for that transformation on a larger scale.

3. The Role of Apple and Its Competitors

In August 2011, a poll paid for by Google (NASDAQ:GOOG) indicated that 30% of Americans illegally download video, and of those 30%, 40% say that they the emergence of legal streaming video makes them unlike to do so, according to Bloomberg. In February, 2012, the Globe and Mail reported that according to its sources a new Apple iTV was being tested by Rogers Communications (NYSE:RCI) and BCE (NYSE:BCE) in Canada.

If this is true, is it possible that the music industry helped lay a road map for the film industry, that could be improved upon, as the film industry deals with similar problems years later?

In 2008, Apple's (NASDAQ:AAPL) iTunes store surpassed Wal-mart as the largest music retailer in the U.S., according to Apple. An annual study released by NPD indicated that the number of paid download buyers across digital music stores, including iTunes and Amazon's (NASDAQ:AMZN) MP3 store, increased 14% in 2011 to 45 million customers. Interestingly, while total CD sales declined, the total number of CD buyers also increased 2% in 2011 to 78 million people, according to the study, which would seem to indicate that discs, whether they play music or video, will not disappear overnight. Further, total paid music tracks through CDs and digital downloads increased 4%, suggesting that the music industry has stopped the bleeding.

As Apple is the most successful music retailer, it would appear that Apple has significantly contributed to the increase of paid digital music downloads. Part of this success lies in the fact that music can be easily purchased on iTunes and then listened to on multiple devices.

It seems that since Apple has had success with smaller iPhone and iPad screens that adding full-sized television sets is a logical extension of the Apple ecosystem. As it is in Apple's interests to create a device that makes it difficult to download content without paying for it, one might expect that it would do the same thing with a television.

The NPD study on music indicated that a reason consumers still buy CDs is that they are passionate about owning a physical product. This may be due to concerns that one hard-drive mishap could delete their entire library. Time will tell if services such as Apple's iCloud, Amazon Cloud Drive and Google Play alleviate such concerns, especially as music or video accessed from the cloud cannot be scratched and damaged like a disc.

While the movie and television industries face a challenge in transforming from a disc-based to paid digital purchase model, the music industry has shown that eventually a point can be reached where combined disc and paid digital sales increase during a year. Investors speculating whether Apple can deliver a blockbuster-selling device to help facilitate a similar DVD-to-digital-paid-download transformation may want to consider Apple's prior success with the iPod and iTunes transforming the music industry. Further, investors who believe that Apple or its competitors may succeed at facilitating such a transformation may have less reason to worry about the long-term prospects of production companies like DWA, despite recent declines in DVD sales.

Disclosure: I am long AAPL, DWA.

Additional disclosure: Disclaimer: The commentary expressed in this article is not legal advice, nor investment advice, and is subject to Seeking Alpha's Terms of Use, which are available here: seekingalpha.com/page/terms-of-use

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