The
Hollywood Economist
The numbers behind the industry.
Back in 2003, after Kirk Kerkorian 1et it by know that he
was (yet again) prepared to sell MGM, Viacom, which owns
Paramount, considered buying it. Although MGM no longer
had sound stages, backlots or other physical facilities,
and now produced only a handful of movies, it owned an incredibly
valuable asset: a film libraries with 4,100 motion pictures
and 10,600 television episodes. The crown jewels of this
collection was its James Bond movies, which was possibly
the most valuable entertainment franchise ever created.
By licensing these titles over and over again to Pay-TV,
cable networks, and television stations around the world,
and selling DVDs from it,, this library brought in roughly
$600 million a year. But that gross was an elusive number
as it had to be split with others who had rights in the
titles. Each title had its own contractual terms governing
payments to partners, talent, guilds, and third parties..
Just making these payments entailed issuing more than 15,000
checks per quarter. Not only did titles have different pay-out
requisites, but their future revenue stream depended on
factors specific to each movie, such as the age of its stars,
its topicality, and its genre. To figure it out, Viacom
assigned a team of 50 of its most experienced specialists
to estimate the how much each and every title would bring
in over a decade. The Herculean job took the team two months.
From this analysis, as well as considering other benefits
of merging MGM with Paramount, Viacom’s executives
agreed MGM was worth between $3.5 and $4 billion. But before
they could arrive at a bid price, Viacom’s President,
Mel Karmazin, asked them whether the value of the MGM vast
library go the way of the music industry, which had been
decimated by Internet down-loading. When none of the executives
could rule out that possibility, Karmazin said “In
that case, we are not bidding on MGM.” Disney, after
a similar deconstruction of MGM’s complex library,
valued it at $3 billion, and also opted not to bid on the
company.
Sony had a very different agenda for MGM. Since it had staked
much of its corporate future on Blu-Ray as a high-definition
format, it needed to get other major studios to choose it
over a competing format, backed by Toshiba and Microsoft,
called HD-DVD. Sony had learned from bitter past experience
that format wars are often decided not by superior technology
but by side payments made to studios. Toshiba and Microsoft
(which had X-Box) were already offering huge cash inducements–
one studio would get $136 million– to put their titles
exclusively on the HD-DVD format. Such a pay-off competition
could prove extremely expensive given the deep pockets of
Toshiba and Microsoft, so Sony, which needed to establish
Blu-Ray for its Play Station 3 as well as its movies, sort
another route to victory. If it could put the huge library
of MGM titles exclusively on Blu-Ray, together with its
own library and the Columbia Tristar library (which it also
owned), Toshiba and Microsoft, no matter how many side payments
they made, would not be able to establish their rival format.
To this end, Sony did not need to itself spend billions
to acquire MGM, it only had get effective control of MGM’s
library for a few years. So it put together a consortium
that would be financed mainly by Wall Street private equity
funds. And it would lead the consortium.
Even though the LBO would wind up costing $4.85 billion,
Sony invested only $300 million of its own funds (and for
that it got the profitable right to distribute MGM movies).
Another $300 million came from the Comcast Corporation in
return for the rights to put the MGM’s library on
Pay Per View on its vast cable system. The rest of the equity
money came from renowned Wall Street investors Providence
Equity Partners, Texas Pacific Group, DLJ Merchant Banking
Partners, and Steve Rattner’s Quadrangle Group. These
savvy funds put in a cool billion dollars. The leverage
part of the deal was organized by JP Morgan Chase, which
very profitably arranged, since it also got a fee, for the
consortium to borrow $3.7 billion (or up to $4.2 billion,
if needed) from some 200 banks. The deal closed in September
2004.
For Sony, the gambit succeeded brilliantly. Putting some
1,400 MGM titles exclusively on Blu-ray, helped established
Blu-Ray as the industry standard for high-definition, and
it won the format war. It also made back a large share of
its $300 million investment just on the distribution fee
it earned on two new Bond movies (Casino Royale(2006) and
Quantum of Solace (2008). But for the Wall Street players,
it was nothing short of a disaster. To cut to the chase,
they lost almost all their entire billion dollar investment.
They had relied, perhaps naively, on impressive-looking
projections showing that the net cash flow from the MGM
movie and television library would be sufficient to pay
the interest on the nearly $3.7 billion of debt over s decade.
What they had not counted on was a sea change in DVD sales.
In the US alone, MGM’s net receipts from DVDs fell
from $140 million in its 2007 fiscal year (which ends March
31st 2008) to just $30.4 million by 2010. As a result of
collapsing sales, higher pay-out for participants, increased
distribution costs and other distribution problems, MGM’s
crucial operating cash flow catastrophically fell from $418.4
million in 2007 to minus $54.2 million by 2010. In addition,
it owed Fox Home Video $60 million for an “adjustment”
in the DVD distribution contract it had taken over from
Sony. By October 31, 2009 MGM, sinking in a sea of red ink,
found itself unable to make its mandated interest payments
on the $3.7 billion it owed banks.
Ordinarily when a company fails to make such payments, its
bank creditors can seek to recover their money by forcing
the company into bankruptcy. With MGM, however, the bankruptcy
option presented a real problem since many of its intellectual
property rights, including those to make sequels in the
James Bond franchise, stipulate that in the event of bankruptcy
they would automatically revert to another party. In the
case of the James Bond franchise, for example. the sequel
rights would revert to Danjaq, LLC. (These bankruptcy clauses
are not mentioned, even in a footnote, in the 38-page “Confidential
Information Memorandum” that MGM sent out to prospective
buyers in the winter of 2009.) So the creditors learning
that bankruptcy would destroy a significant part of the
remaining value of MGM, gave it a three month “forbearance,”
which meant it had until January 31, 2010 to come up with
the money. The idea was that MGM would sell itself to a
white knight and use the proceeds to repay the banks. The
deal book ws sent out to a dozen or so prospective buyers
calling for bids by January 15th. The replies, according
to a source close to Moelis & Company, which is MGM’s
financial advisor, have, as of January 22nd, have been “disappointing,”
with none of the serious bids coming within $1.6 billion
of what MGM owes its creditors. As for the hedge funds,
they have already written down 85 percent of their billion
dollar investment in preparation for what may be a near
total wipe-out. The lesson here for Wall Street that when
a Hollywood deal seems to good to be true– it may
not be.
***.
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