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Is the DVD Market Spinning Down?

Recent developments signal change in the DVD business.

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The entertainment industry includes a wide array of businesses. Demand for news, information, and entertainment remains strong and the distribution and consumption of media content will continue to evolve with advances in technology. In this article we discuss some recent developments in the filmed entertainment industry.

DVD sell-through (both sales and rentals) has been the key profit contributor for the filmed entertainment industry for the past decade. The home entertainment category typically generates about 50% of movie studio revenue, and we estimate that the studio retains about 80% of the retail price on a DVD. Even after accounting for production, distribution, and marketing costs, we estimate that studios earn their highest profit margins on DVD sales, especially relative to DVD rentals.  Time Warner (TWX),  News Corp. (NWSA),  Disney (DIS), and  Viacom (VIA.B) are the media conglomerates in our coverage universe that own studios within their collection of businesses.

DVD Sales Declining
Sales of DVDs have been declining over the past few years, a concern for the movie studios. According to Adams Media Research, sales fell 7% in 2008 and 13% in 2009; however, we don't think this indicates a shift in demand for watching movies as U.S. box office sales increased 10% in 2009. Additionally,  Netflix (NFLX) added about 2.8 million subscribers in 2009, ending the year with over 11.9 million, indicating more people are renting versus buying. The recession had some impact on DVD sales last year, but we believe the value proposition for renting versus buying a DVD has also played a meaningful role. Netflix offers customers a vast library of titles at less than $2 per rental (assuming a $9 monthly subscription and five movies per month) and Redbox's kiosks offer rentals for $1 per day.

Redbox filed lawsuits against Time Warner, News Corp., and Universal last year after these studios separately ordered their distributors to cut off supplies to Redbox. The studios took this action after Redbox refused to agree to a "nonrental" window immediately after new DVD releases. The studios wanted a sale-only window before rentals were available, particularly when the same retail location was selling DVDs for $20 and renting them at a kiosk for just $1. Time Warner recently reached a two-year agreement with Redbox that allows for a 28-day window before new releases are available for rental, the same window established with Netflix in January. Time Warner lowered the prices of its discs to the rental companies in exchange for the window. Warner Bros. claims a significant portion of DVD sales occur in the first 28 days, so this should help boost sales. We expect other studios to pursue similar deals with Redbox and Netflix.

Transition to Digital Distribution
The first sale doctrine is what allows rental companies to rent DVDs and has been crucial to the rental business since the VHS days of the 1980s. In a nutshell, anyone that buys a DVD is free to sell, exchange, rent, or lend it to others. Therefore, companies like Netflix and Redbox can buy DVDs from the cheapest source (movie distributors) and rent them as they please. Because of this law, the studios don't control pricing, and these rental companies are free to charge as much (or little) as they want. However, the first sale doctrine only applies to physical products (DVDs, books), and does not apply to electronic copies. Therefore, a company wishing to rent movies cannot simply buy digital copies at the lowest possible price and rent them. As a result, we think the studios will regain some pricing power on rentals as digital distribution of movies becomes a larger part of the business model.

Even with declining sales, DVDs remain key profit drivers for the studios, so they will not go away overnight. Additionally, with six major movie studios having their own viewpoints on how their content is monetized, we think implementing a common digital distribution strategy for the industry could take longer than it should. We assume several vendors will be looking to distribute movies on their proprietary platforms. While the studios welcome multiple options for distributing their content, too many options could stall the transition period or create confusion for the consumer. Existing pay TV distributors such as  Comcast (CMCSA) and  Direct TV (DTV) already deliver on-demand movies into the home, and we expect firms like  Apple (AAPL),  Amazon (AMZN), and upstarts like Vudu, which was recently acquired by  Wal-Mart (WMT), to join the fray. In addition to meeting consumer demand, another motivation for the studios developing a cohesive digital strategy is to fend off piracy, which has always been a risk for the movie studios. We believe most consumers are willing to pay for content when convenient and at a reasonable price. If the movie studios and their distribution partners wait too long or make it difficult for consumers to access content, the risk of piracy increases.

Implications for Industry Participants
We think the transition from physical DVDs to digital distribution will occur gradually over the next several years. During this period, the movie studios will be offering consumers more ways to watch movies from home, while generating as much money from DVDs as possible. We think this transition period will put pressure on profitability for the studios. Of course, annual sales and profitability can swing based on the number of hit films released in a given year. Time Warner and News Corp are the media conglomerates with the most relative exposure to the movie business, with about 15%-20% of overall operating profit coming from their filmed entertainment segment (after backing out estimated profits from the television studios). Both stocks are currently trading right around our fair value estimate.

Netflix has taken steps to build its movie downloading service, but its core business model is still based on subscribers receiving discs in the mail. We believe Netflix stands to benefit from the current trend of more people renting movies, given its distribution advantage with physical DVDs. However, we think Netflix shares are overvalued, especially when we look beyond the next several years. Because we think the studios will regain some pricing power in digital distribution, we expect content costs to rise for Netflix. Additionally, we expect additional competition in digital delivery to pressure Netflix's long-term sales and profitability.

Michael Corty does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.