In our first piece, we confronted the fact that the US film industry has stagnated: underlying demand continues to fall, with (nominal) revenue growth held-up only by a mix of population growth and pricing increases. In this piece, we assess why this is a particularly big concern for independent studios – and what they can do about it.
Despite persistent declines in theatrical ticket sales, the independent film segment appears to be booming: in 2013, indies released nearly 600 films – a historical high and 22x increase over 1983. Yet, this growth has not been without consequence. On an inflation-adjusted basis, the average box office revenue per film has plummeted more than 85%, proving out a statement made by Janet Pierson, Head of the SXSW’s Film Festival that “the impulse to make a film has far outrun the impulse to go out and watch in a theater.”
Falling production costs have relieved some of this pressure, but the state of indie filmmaking remains grim. Studios today must contend with declining consumer demand, excess industry supply and deteriorating revenue profiles. In this environment, then, how can an indie survive – let alone grow? There are a few options, but first, it’s essential that we understand the competitive structure and underlying viability of modern independent filmmaking.
The Great Reconstruction
One of the key drivers behind surging indie output has been the tremendous growth in industry participants. In 1983, there were only 19 active market players. Twenty years later, this figure has grown sixfold.
Though the number of active players had stabilized by 2003, the market remains extremely turbulent:
Since reaching an effective cap of 122 studios, an average of 36 indies have entered and exited each year. Given declining fundamentals, significant exits and failures aren’t surprising. But the entrant rates are. What’s more, this trend is unlikely to reverse itself any time soon. In June, Bloomberg BusinessWeek wrote that competition to invest in “independent filmmakers” had become “fierce”, with Big Banks and billionaires, such as John Paulson and George Soros, looking to enter the space. In one instance, a source tells the magazine that “bankers [were] falling over themselves” to finance a new studio – despite having “never met anyone involved in the company”. David Shaheen, a 21-year veteran at JPMorgan and current Managing Director of its entertainment group, commented that the space was now busier than he had “seen in a long time.”
As long as investor capital proliferates, we will continue to see added pressure placed upon the indie segment. What’s interesting, though, is that these investments are far more precarious than their ubiquity suggests: Bloomberg BusinessWeek notes that “there’s no shortage of wealthy individuals who lend at low rates in exchange for receiving producing credits on a film.” However, investors need to disabuse themselves of the notion that indie investments will be anything but a vanity expense.
Indie filmmaking is, in fact, more prone to failure than even the infamous restaurant business. After three years of operation, only 28% of new indie studios are still releasing new films – while 43% of restaurants continue to serve meals. After only one year, nearly 48% of indie studios will have exited the market (defined as not releasing at least one film over the following two years). Keep in mind, too, that this figure excludes studios we’ve deemed “non-commercial”, namely those that released only one film that grossed less than $25,000 in inflation adjusted revenue.
By their fifth year of operations, indie exit rates halve to only 15%. This is likely explained by the significant increase in film output, which helps to insulate the studio from the failure of any one film.
After understanding the time horizon and output with which independent studios will need to recoup their investments, we can look at the final input: revenues. Though the distribution is far from a flat line, average performance is so anemic it would give most indie investors a heart attack: 71% of films generate between $5,000 and $1,000,000 in box office revenue; 50% will fail to cross $250,000. After the theater’s cut of revenue (~45%), production, marketing and distribution expenses, there can be limited profit left for overhead expenses, lenders or shareholders. Billionaires may not flinch at such losses, but it’s doubtful they take much pride in being a producer of a little-seen film.
Yet, even if the industry begins to digest the economic improbabilities of indie filmmaking, the segment’s problems are unlikely to go away. It takes only one benefactor or overconfident industry insider to stand-up a studio, after all. Scripts, actors and production assets are abundant. Furthermore, today’s oversupply is driven not just by the number of market participants (which has been flat over the past decade), but also the annual output of each individual studio (which has grown 38% over the same period). As they grow older, each independent studio is likely to expand their film slates to match their growing ambitions or simply to further de-risk operations.
To many, this tragedy of the commons will suggest the industry is ripe for consolidation. It’s not. While the Top Six Majors control 75% of the domestic box office with only 14% of all films released, the Top Six Independents (or “mini-majors”) capture 80% of the remaining value with only 10% of output. This means a handful – or even a dozen – acquisitions is unlikely to solve for competitive dynamics. What’s more, barriers to entry and exit are too low for any reduction to persist.
As a result, enhancing indie profits or improving survival odds will need to come from a more traditional effort: increasing prices or sales volumes. Fortunately, there may be some hope. For some, at least.
The Pricing Burden
As we’ve previously discussed, tiered pricing is one of the film industry’s most absurd and atavistic characteristics. It’s particularly confusing when looking at true arthouse films, which can have exponentially lower production costs and smaller audiences than $200M+ blockbusters, but find their end-consumer pricing nevertheless identical. This is obviously inefficient. However, determining whether indie prices should go up or down is difficult on both an average and per film basis.
Given their cost profile, it’s easy to make the argument that indie prices should be lower – not higher. Last year, Steven Spielberg famously stated that Hollywood would soon need to charge “$25 for the next Iron Man” and “probably only… $7 to see Lincoln”. Though his point was mostly focused on mega-blockbuster profitability, it’s not clear that an indie price drop would drive the increased ticket sales needed to offset per viewer revenue losses. In fact, when one looks at ticket volumes, a different hypothesis appears to emerge:
Nearly 50% of last year’s 540 indie releases sold fewer than 15,000 tickets. 25% fell short of 5,000. With so few attendees, how many viewers would really be lost if prices were raised a dollar? Or even five? After all, the indie segment tends to cater to wealthier-than-average filmgoers and typically offers more niche and differentiated content than those offered by the mass market majors. Now, that’s not to say all indie studios or films should pursue higher prices – but for some, the strategy may offer considerable upside. And if consumers do truly value the ability to pick from 500+ films – to say nothing about the preservation of artistic integrity above commercial viability – they need to start paying to sustain it.
Of course, theater operators will also need to embrace the move. Though higher ticket prices offer incremental revenue, they do risk cannibalizing concession sales – which increase the average per customer spend by nearly 40% and offer theaters 1.7x the gross margin of a ticket. As a result, change is unlikely to happen unless a rigorous trial is executed and evaluated. But theater chains may still offer indies new opportunities…
Distribution: An Open Road
With pricing out of the way, indies must look to enhance sales volumes. This means looking at distribution. One of the more interesting opportunities may be to pursue more theater chain partnerships. In 2011, Regal Entertainment and AMC Theatres (the first and third largest theater chains in the United States) banded together to form a new independent, Open Road Films. With ORF, the two hoped to reduce their reliance on the investments (or strategies) of the industry’s largest distributors and stabilize plummeting seat utilization. Since releasing its first film, Killer Elite, in late 2011, the distributor has quickly picked up pace. In 2013, it released seven films and plans to release eight by the end the year. Yet, performance to date has been mixed – even after including Regal and AMC’s full share of a ticket (i.e. they get both the theater operator and distributor’s portions) plus concessions.
On the whole, Open Road Films has averaged an estimated 20% loss in the theatrical channel. Though the Majors average a 15% loss, Open Road’s ancillary sales – which are the key to the majors’ ultimate profitability – are likely to be far less plentiful. Not only is Open Road’s library less conducive to home video sales and merchandising opportunities, the distributor has little negotiating leverage with the HBOs and Netflixes of the world. However, there’s a hidden trend in the above chart:
As Open Road scales its budgets, the distributor’s returns tend to deteriorate. This shouldn’t be a surprise. The studio wasn’t established to compete with the Majors and top tier independents, such as the Weinstein Company. As a result, it doesn’t deploy the capital required to buy distribution rights for the most promising mass market films and it likely lacks the marketing machine needed to promote them nationally. However, the company excels at identifying and releasing small budget films, averaging a +52% return on all films that cost less than $30M all in (which is not a particularly low ceiling) – and 900%+ on A Haunted House’s $2.5M budget and estimated $1.25M marketing expenses.
The point of this interlude is to demonstrate that theater chains may be the key to growing the independent market – not brand name distributors. Not only does the group offer strongly aligned incentives, they also have the local market insight and focus that arthouse films need. This won’t solve for 500 films, but short rotations mixed with market-specific releases (and potentially timed around Big Six scheduling gaps) will allow the theater operators to improve utilization and help independents increase revenue. This doesn’t mean that the theater chain must always fulfill the role of distributor (à la Open Road), but deeper, market-specific partnerships can be a key driver in today’s challenging market.
Distributors: Going Beyond Theaters
One of the primary barriers to indie success and growth comes from screen distribution. In 2013, 50% of indie films were released on fewer than ten screens – nearly half of which maxed at only two. The reason for this is simple: the audience for the average indie film tends to be small and heavily concentrated in select cities (New York, San Francisco, Portland). As a result, expanding a film’s footprint into additional markets – even cities such as Seattle, Washington DC or Atlanta – can be financially destructive. Yet, even as the theater count is scaled, total performance can remain modest.
As a result, VOD and digital distribution should represent the indie priority – not just another non-theatrical channel. However, this means far more than pursuing a common release date across all mediums, penetrating a wide variety of different providers (Netflix, Amazon, Apple etc.) or standing up a direct-to-consumer distribution portal. Indie studios will still need to find a way to stand out among the 500+ other indie titles per year (not to mention thousands of pre-existing major and indie catalogue titles). What’s more, revenues will still be too slight to fund elaborate marketing campaigns nationally. As such, studios will need to establish and cultivate direct-to-consumer relationships through which they can inform individual consumers of any new releases that might be of interest and help guide them to the appropriate distributor (e.g. Netflix, iTunes etc.). If this is done well, indies may even be able to use consumption and interaction data to guide future film investment decisions (as the major studios, as well as OTT video providers do).
The Future of Indie Studios
In many ways, indie filmmaking may appear to be healthier than ever: 2013 saw more releases than at any point in the segment’s history and these releases came from a near record number of active studios. Despite this, indie attendance continues to decline. As a result, indie studios have experienced a staggering drop in average revenue per picture and shockingly high failure rates. Until studio heads and investors come to terms with the economic reality of indie filmmaking, these pressures are unlikely to subside. The problem, after all, is not talent – be it creative, production, marketing or acting – but demand.
“Historically,” the New York Times wrote before this year’s Sundance Film Festival, “independent cinema has served as a counterweight to the studios, a space where filmmakers could grow into artists, even if they also often had to function like business people.” If they hope to survive with their creative integrity intact, indies need to start pushing commercial boundaries, not just narrative ones.