FOOL ON THE HILL
DVDs and Happy Endings

Movie studios are gearing up for what is shaping up to be another huge summer at the box office. However, the enthusiasm isn't being translated into buoyant share prices for the filmmakers. With the intriguing dynamics of the booming DVD market, one Fool thinks that it's time to give the studio stocks their time under the spotlight.

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By Rick Aristotle Munarriz (TMF Edible)
May 2, 2002

What a tangled web this Spider-Man weaves. Here we are, on the eve of Spidey's eagerly anticipated theatrical debut and something's amiss. No, it's not the Green Goblin at play. Green has little to do with this, actually. One would think that the studio putting Spider-Man out -- Sony (NYSE: SNE) through its Columbia Pictures subsidiary -- would be slinging its sticky webbing like graffiti down Wall Street. Between Spider-Man and Men in Black 2, it should be a powerful knockout blow this summer. But, what's this? Sony's stock is trading at levels it hasn't seen in three years.

Granted, the music industry is in a rut and it'll take another couple of years before PlayStation 2 video game sales hit their stride. You can't fault Sony's slide strictly on the celluloid. Still, the movie malaise doesn't end with Sony.

AOL Time Warner (NYSE: AOL) is trading at prices unseen since America Online and Time Warner were swinging singles. Didn't anyone pick up on the fact that between Harry Potter and The Fellowship of the Rings, Time Warner rocked the movie world over the holidays?  

Here we are, setting record-breaking box office tallies at a time when filmed entertainment is providing the perfect escape, and optimism can't even land a bit part in these equity epics. I mean, you'd think that the summer slate is filled with nothing more than Ishtar 2 or Return to Waterworld.

Maybe the problem is that Hollywood is too good right now. The studio companies are spending great sums of money in producing high-profile flicks, only to have little choice but to wedge them between other blockbusters-in-waiting. It's hard to stand out in a pretty crowd. That creates moviehouse disappointment. After all, while the media is misleadingly quick to tie a film's box office results to its shooting budget, the studio really only gets between 40-60% of the booty. After all, even a $5 ransom for a tub of popcorn isn't enough for the movie theaters to get by on. But there's something else that the naysayers are missing -- the DVD market.

A lot has happened since the DVD format was rolled out stateside five years ago. At the time, the average system cost a mind-blowing $700. Today, entry-level DVD players can be had for less than a hundred bucks.

With more than 30 million players out there domestically, DVD movies are now outselling their VHS counterparts. While VHS systems naturally outnumber the quantity of DVD-stocked homes, the average DVD owner bought 15 discs last year. That's twice as many movies as the video buff scooped up.

More ambitious buying patterns? For a studio-friendly format? The only missing ingredient would be growth and the DVD market has that in strides. DVD makers expect to move another 15 million units this year, creating a 50% spike in the format's installed base in 2002.

So let's get back to the moviemakers. While Harry Potter and Frodo Baggins combined to produce $1.8 billion in worldwide theater ticket sales for AOL Time Warner, now is when the gravy begins to pour on thickly. Harry Potter and the Sorcerer's Stone hits the home market later this month while the first installment in the Lord of the Rings trilogy is scheduled for an early August retail release.

Want to know the only thing that would make these DVD releases any hotter? Time. Yes, time. Because every day that passes by means another 40,000 new DVD players are being connected. So while the industry applauded Titanic when it became the first title to ship a million copies during the summer of 1999, the critically panned Pearl Harbor sold three million units on its first day alone back in December. The only two titles to top the five million mark -- Shrek and Gladiator -- have been relatively recent releases. 

How many millions of DVDs will Harry Potter move later this month? How many more will Lord of the Rings manage two and a half months later?

So while near-sighted analysts will be pegging Fox's (NYSE: FOX) filmed entertainment prospects on how well Star Wars: Episode II, Attack of the Clones fares in a few weeks, care to wager on the chances of the movie becoming the first 10 million DVD seller next year? If Harry or Frodo don't get there first?

The DVD medium rocks in many ways. They are cheaper to produce than the bulky VHS tapes. Retailers and rental chains love them because they are easier to stock, taking up less shelf space. Consumers love them because of the enhanced digital quality as well as their add-ons. The fact that the format creates a storage buffet gives the studio endless possibilities on ways to repackage the DVD for eventual re-releases.

And while the studios won't say this out loud, one can also assume that the present scarcity of recordable DVD devices is helping cut down on piracy as your Aunt Wanda won't be down in the basement duping dozens of video copies of Toy Story 2 for her family and friends.

This isn't the music industry where Internet peer-to-peer pilfering has the five major recording labels wondering what hit them. And, sure, the doomed major labels include movie studio powerhouses like Sony, AOL Time Warner, and Universal parent Vivendi (NYSE: V). That's not a liability for investors to take lightly. But while pirated feature length films are online for the taking, few have the time to download movie files that are not only at least a hundred times larger than their musical MP3 counterparts but also lacking in both quality and portability.

This summer movie season is packed with family-friendly releases. With four animated releases to go along with seemingly shoo-ins like Spy Kids 2, Stuart Little 2, and the live action treatment of Scooby Doo, if your kids aren't tugging at your sleeve, borrow your neighbor's children. The crowded stage might make it hard for any one flick -- even Disney's (NYSE: DIS) Lilo & Stitch -- to stand out the way it would have with less box office clutter. However, there will be elbow room to spare when the DVDs hit the stores. After all, if you're like me, your DVD collection has two family titles for every one that you really wanted.

Maybe that's why Shrek's two-disc set is the best-selling DVD to date -- a crown that will be contested when Pixar's (Nasdaq: PIXR) Monsters, Inc. hits the shelves come September -- only to be tried again once Fox releases Ice Age. With DVD players selling briskly, it's no longer a question of whether a new release will topple the top dog, but when. So while Viacom (NYSE: VIA) is dolling up popular Nickelodeon properties like Hey! Arnold, The Wild Thornberrys, and Rugrats for movie releases between now and next year, just look a few months further out to the DVD releases where the real money waits to be made.

So go ahead and enjoy Spider-Man this weekend, if you can manage a ticket. Watch a young, orphaned Peter Parker come into his own, accepting the fact that with great power there must also come great responsibility. When the lights return and you peel your feet off the Jujy Fruit stuck to the theater floor, begin to ponder the value of what the movie's intellectual capital will be worth with 50, 60, maybe even 70 million DVD players in place.

It's the happy ending no one sees.

Rick Aristotle Munarriz owns small stakes in a few movie-related companies. AOL Time Warner. Disney. Pixar. He'll invest in your film school graduate project if you ask nicely, too. Rick's stock holdings can be viewed online, as can the Fool's disclosure policy.