Regal Entertainment: "Exploring options" in a new world

Yesterday, Regal Entertainment, the largest movie theater chain in the U.S., announced that it's exploring "strategic alternatives," including selling the company. Regal has long been the top buyer of theater chains around the country--it now owns 574 theaters with 7,349 screens. However, when there's a run of unpopular movies, as happened this summer, Regal and other theater operators suffer; the company's revenues and profits from the summer quarter fell sharply year-over-year.

Regal's decision to explore a sale is being driven by several trends:

• Industry revenues from theatrical exhibition have increased modestly over the last decade, but the number of tickets sold has been in a long decline. Theaters and movie studios have maintained their revenues by increasing ticket prices, in part by showing 3D movies at higher prices and by installing IMAX and similar panoramic projection systems. No one really knows at what point higher prices will lead to diminishing returns, but many people in the industry are afraid that ticket prices are close to that "tipping point" already.
• Netflix's recent moves to fund and distribute its own movies are sending shock waves through the industry. Regal and the other three of the four largest U.S. theater chains announced that they would refuse to show any movies distributed by Netflix. However, that didn't stop companies like The Weinstein Company and IMAX, or actor Adam Sandler and his Happy Madison production company, from signing up to produce and distribute movies with Netflix. "Direct-to-home" movies have long been a staple of the home video business, but those titles are usually either not good enough or appeal to too small of a niche audience for theatrical distribution. That's going to change with Netflix, and likely other companies, pumping money into producing theatrical-quality movies for the OTT streaming audience.
• As I've written before, High Dynamic Range video, which is under development by several companies, will provide in-home viewers with a picture that's superior to anything other than IMAX. Currently, the only way to view HDR is with a modified HDTV or Ultra HDTV. In order to view HDR in a movie theater, it's likely that entirely new projectors or huge flat-panel displays will be required, which will require major capital investments less than a decade after theaters replaced their film projectors with digital models.
• Many Chinese and Japanese investors, including Alibaba and Softbank, are exploring investments in the U.S. entertainment industry. AMC Theaters, the second-largest U.S. theater chain, was purchased by China's Dalian Wanda Group last year for $2.6 billion.

Put those four trends together, and it's likely that this is the right time for the big theater chains to consider selling. Ticket prices are about as high as they can go without dragging down top-line revenues, non-theatrical competition hasn't yet made a dent in theatrical revenues, the major capital investments to support HDR are still a few years away, and there's a lot of foreign money looking for a home in the movie business. 

Netflix jumps into the movie production business

Many people in the movie and television businesses have believed that given Netflix's success with original television series, it was only a matter of time before the company would begin producing movies. Those beliefs have been confirmed in a big way: Last week, Netflix announced that it has partnered with The Weinstein Company and IMAX to produce a sequel to "Crouching Tiger, Hidden Dragon" called "Crouching Tiger, Hidden Dragon: The Green Legend," and today, Netflix announced a four-picture production deal with Adam Sandler and his Happy Madison production company.

The terms of the deals aren't public knowledge, but some of the plans have been revealed: In the "Green Legend" deal, IMAX was brought in to distribute the film to IMAX theaters. IMAX develops the cameras, projectors, screens and processing software for its various formats, but its theaters are actually owned and operated by other parties, and a number of those parties in the U.S. are very unhappy. The four largest theater circuits in the U.S., Regal, AMC, Carmike and Cinemark, have said that they won't show the sequel. Cineplex in Canada and Cineworld in Europe have also refused to show it. That doesn't completely eliminate IMAX as a viable outlet for the movie, because there are many IMAX theaters operated by museums and public institutions, and smaller theater chains with IMAX theaters may decide to show it.

It's not clear whether Netflix changed its strategy overnight or whether it had already expected the theater chains to react the way they did, but in today's announcement, Netflix said that none of the four movies to be produced by Adam Sandler will be shown in theaters. In addition, they also made clear that none of the movies that Adam Sandler or Happy Madison are already committed to for other producers or distributors are included in the four films.

No one should be surprised that big theater chains won't show Netflix's films--they've pushed back against major studio day-and-date Video-on-Demand (VOD) tests (the movie is released in theaters and on VOD on the same day,) starting with Universal's "Tower Heist" in 2011. By and large, the big studios have backed off of day-and-date VOD, but they're aggressively testing shorter windows between some movies' theatrical release and their availability on VOD. Smaller independent studios such as Magnolia Pictures have adopted day-and-date VOD releases. 2929, parent company of Magnolia, also owns Landmark Theaters, which has 50 theaters in 21 markets, so Magnolia is guaranteed of theatrical distribution in many major cities, no matter what other theater chains decide.

It's likely that Netflix is structuring its movie production deals with the expectation of no domestic theatrical revenues. Whatever theatrical distribution Netflix gets will be promotional, not a significant revenue generator. Over time, if Netflix's movies prove very popular, the big theater chains may be forced to start bidding for the right to show them in their markets. However, for now, the safest move for Netflix is to budget movie production in line with VOD revenues.

Earlier today, The Verge reported on Adam Sandler's deal with Netflix, and wrote:

Under the deal, Sandler removes the burden of risk. Netflix will solely fund the films, taking full responsibility for providing investment — and securing additional investment — off Sandler's Happy Madison Productions. Though Netflix will be the sole financier, the films will still have their $40 million to $80 million budgets. Sandler's payments are a large chunk of his films' budgets. He reportedly receives $15 million and over per film as an actor, and can make an additional $5 million as the producer, which explains how Grown Ups 2, a comedy with a handful of special effects, reportedly cost $80 million. On top of all that cash, it's likely Sandler and his production company will make an additional, undisclosed lump sum of money simply by signing the deal. Netflix decline to provide comment to The New York Times on the specifics of the agreement.

It's inconceivable to me that they would agree to pay production costs anywhere near $40 to $80 million or $15 million per picture for Sandler's acting, especially since Sandler's last several movies have bombed in the U.S. Netflix probably has a "back-end" deal with Sandler that pays him additional compensation if the movies reach or exceed performance targets, such as the number or percentage of subscribers who watch them. As the Verge article points out, Sandler laces his films with product placements, which can defray some production costs, or put money into his pocket. That might be enough to enable Sandler to, say, produce a film for $25 million, get $10 million in product placement funds, deliver the movie to Netflix for $20 million and put $5 million before tax into his pocket.

Netflix may be the first VOD company that will underwrite major motion pictures for its own distribution, but it almost certainly won't be the last. I expect Amazon to follow suit, and possibly Redbox. (Update, October 4, 2014: TechCrunch reported today that Redbox will shut down its streaming service on Tuesday, October 7.  That makes it much less likely that the company will get into original production.) SoftBank, the owner of Sprint in the U.S, SoftBank Mobile in Japan and the single largest shareholder of China's Alibaba, just invested $250 million for 10% of Legendary Entertainment, with options to invest a total of $750 million more between now and the end of 2018. Legendary, whose movies are co-financed, marketed and distributed by Universal, could produce movies for SoftBank and Alibaba should either company decide to distribute its own original titles.