The Movie Exhibition Industry: 2010

INTRODUCTION

This case is an in-depth study of the motion picture exhibition industry. Emphasis
is on value chain dynamics and operating variables that impact the profit potential of
movie theater owners. Trends that influence consumer decisions and constraints within
the studio-dominated business model are also highlighted for review.

The objective of this case is to thoroughly examine industry conditions and key
industry participants in order to identify strategic measures that might improve the
viability of major exhibitor operations. By profiling the external environment, the
industry’s competitive forces, competitor circumstances and approaches, and the standard
business revenue/cost structure, strategic alternatives can be generated to address the
challenges confronting movie theater owners and to increase their likelihood for success.

 Review trends in the general environment that affect the movie exhibition
business, and establish their potential to help or harm theater owners.
 Assess the five competitive forces at work in the industry environment. Which of
the forces threatens the profitability of major movie theaters? What level of
competition can be anticipated among industry rivals?
 Perform a comparative situation and strategy analysis of the four companies with
dominant market share. What are the advantages and disadvantages for each of
the industry’s top competitors?
 Evaluate the revenue sources and major costs for exhibitors. Discuss how the
income structure impacts their financial results.

ANALYSIS

 Review trends in the general environment that affect the movie exhibition business,
and establish their potential to help or harm theater owners.

A variety of forces exist in the general environment that is beyond the control of
companies competing in the film industry. These external conditions can create
opportunities and/or threats that influence firm growth and performance.

» Unstable conditions in the domestic economic sector continue to exert financial

pressure on consumers. In the past, downturns in the economy led to a rise in theater
receipts (in other words, created an opportunity for cinemas to grow ticket sales).
However, because of aggressive hikes in ticket prices in recent years and due to an
increase in the number and availability of substitute products, expectations for a
“recession effect” cannot be certain.

» Remarkably, Americans spend a record amount of time—nearly 40%—on

entertainment, and movie viewing is a very popular form of entertainment in the US.
Though this sociocultural condition should be viewed with optimism, opportunities
for movie viewing outside of the theater have increased dramatically (including new

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and popular media viewing opportunities on portable devices). Meanwhile, average

attendance rates and ticket sales have fallen to their lowest levels in 15 years.

» Demographic trends show positive long-term implications for cinemas. Over the next
15 years, movie theaters can expect to benefit from a growing domestic population.
Despite the fact that its core age group is growing more slowly than the overall US
population, potentially 4 million more core audience members are anticipated by
2025, representing an attendance increase of 700 viewers per theater (or 100 viewers
per screen).

» In the technological segment, digital advancements have changed movie distribution

methods substantially. The number of digital theaters is rapidly expanding, and 3D
movies have become a mainstream product in the market. Conversion to digital
production eliminates the costs associated with film print from the value chain, but
this benefit accrues to the studios. Theater owners, on the other hand, incur the
investment costs associated with upgrading their projection operations. Although 3D
movie production has provided an unexpected opportunity for cinemas to increase
revenues, the continued appeal of 3D movies over time is unknown.

Furthermore, technological advancements in electronic equipment have increased the

availability, affordability, and quality of the “home theater.” Coupled with trends in
the use of portable devices, these developments are having a transformational effect
on movie (and media) viewing choices and are reducing the novelty of the theater
setting. These conditions are threats that are likely to have a negative impact on the
profit potential of film exhibitors.

» As family income and time for leisure activities rise in emerging markets, global
conditions offer growth opportunities for theater owners who are motivated and
capable of expanding internationally.

 Assess the five competitive forces at work in the industry environment. Which of
the forces threatens the profitability of major movie theaters? What level of
competition can be anticipated among industry rivals?

Today's movie exhibition industry is experiencing a fall in attendance rates,

limited growth prospects, and screen overcapacity. The strength of each competitive
force is estimated below to determine which ones have the potential to stimulate
competitive rivalry and reduce profitability.

Threat of New Entrants – Low

New direct competitors are unlikely to enter the market because of industry
consolidation and existing screen overcapacity. Typically these conditions would increase
rivalry, but because major competitors are positioned in different geographic markets,
direct competition should not be overly intensified. However, electronics firms that have

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ignited the home theater and portable viewing movements might pose an entry threat if
they decide to venture into commercial settings at some point.

Supplier Power – Very High

Exhibitors, and their financial well-being, are heavily dependent on studio policy
decisions. Motion picture studios control product licensing, DVD sales, and distribution
windows. 80% of box office revenue is generated from just 20% of all films produced by
the top 6 motion picture studios. These content providers have the power to deliver,
withhold, or establish exclusive distribution of movie content throughout the industry.
They also determine distribution timing, which can help or hurt different channels.
Though they have recently seen an increase in revenues, they are under continual
pressure to deliver profits in an environment of rising film production costs, high
marketing expenses, and unpredictable audiences. Seeking ways to fortify their revenue
streams, studios have experimented with narrowing the window of time between theater
release and broader distribution of content (DVD, pay-per-view, etc.). This practice
serves to accelerate investment returns and allow marketing messages to be consolidated,
but negatively impacts consumer demand for theater movie viewing.

Even though content suppliers maintain strong bargaining power, larger movie
theater groups do have greater negotiating capacity than smaller operators when sourcing
films, concessions, and national advertising. The major exhibitors in the industry need to
use this power to strengthen relationships and coordinated efforts in dealings with
studios.

Buyer Power – Moderate

The industry's core customer audience is 12- to 24-year-olds, who purchase 40%
of all movie tickets sold. Their preferences and tastes can be erratic. The half of this
group who attend movies frequently (at least once a month) drives industry profits.
However, moviegoers do not have cumulative bargaining power, and their demands do
not result in significant price changes. In their favor, switching costs are low. It is easy
for customers to change theaters if they have a poor experience. And as the quality or
value of the theater experience declines, customers will continue to seek alternative
movie viewing options, new forms of entertainment, or new ways to escape daily
pressures. To satisfy moviegoers and achieve profitability, exhibitors must discover and
offer a more attractive and sustainable value proposition.

Product Substitutes – High

While the industry is seeing the appeal of its value proposition and the theatrical
experience diminish, product substitutes are rapidly expanding. Release dates for popular
DVDs are constantly shifting forward, and movie availability outside of the commercial
theater is widespread. Advancements in the electronics industry are eroding the
uniqueness of the theater experience and creating a variety of mobile movie/media
viewing options that are popular among the core demographic. As it becomes more

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affordable, replicating the immersive experience of the theater at home is becoming more
common. Equally important, alternative forms of entertainment are varied and numerous.
These competitive forces threaten to have a direct and continued impact on the financial
performance of theater operations.

Intensity of Rivalry – Moderate

Driven by declining ticket sales and rising operating costs, theater closings and
consolidation in the industry have reduced the total number of competitors in recent
years. There are 20% fewer competitors since 2000, but the total number of screens
(39,717) is at a historically high level. Replaced by theater complexes, single screen
theaters have seen a dramatic decline since the 1980s. Now, four major theater
companies, with just 23% of all cinemas, own 43% of existing screens. Megaplexes, with
16 or more screens per site, now represent 10% of the market and are responsible for the
increased number of screens.

Even with fewer competitors, the excess number of screens affects competition.
High costs associated with the development of megaplexes and with the conversion to
digital projection create high strategic stakes for theater operators, further increasing the
level of competitive rivalry among them. The pressure to compete can be great among
smaller cinemas that have a high degree of market dependence, but these businesses tend
to have fewer resources to make competitive moves. And despite the prevailing
influences, most markets have just one theater option for patrons. Therefore, direct
competition in distinct geographic locations is limited to dense areas where the public can
choose between theater sites.

Where customers do have a choice, it is difficult for participants in the industry to

distinguish themselves from other competitors, secure strong customer loyalties, and
reduce rivalry. Opportunities for differentiation are minimal. It is a fast-cycle market
where imitation is rapid and inexpensive. Firms are not insulated from competitor efforts
to attract customers, but they can quickly adopt successful strategies employed by rivals.
Consequently, competition in these markets is based on the theater’s distance from home,
conveniences (such as parking), and proximity to restaurants.

 Perform a comparative situation and strategy analysis of the four companies with
dominant market share. What are the advantages and disadvantages for each of
the industry’s top competitors?

An overview of the top four competitors’ business situations and approaches

provides valuable insight for industry participants seeking to improve performance. The
table on the next page presents a comparison of the market focus, facilities, pricing, and
costs for each of the four companies that dominate the market. Digital conversion
strategies and (dis)advantages for each of the rivals' positions are then outlined.

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Regal AMC Cinemark Carmike

Market Focus Mid-size Urban Smaller Rural
# of Locations 548 297 294 244
# of Screens 6,768 4,513 3,830 2,277
Ave. Screens/Site 12.4 15.2 13.0 9.3
Ave. Ticket Price $8.15 N/A $5.46 $6.56
Cost/Screen $430,000 ~ Regal’s $367,000 $206,000
Screens Converted Approx. 25% Approx. 25% Approx. 25% Over 90%
to Digital
10% 3-D 10% 3-D 10% 3-D 22% 3-D
Digital Conversion
Strategy DCPI Partnership DCPI Partnership DCPI Partnership Lease-Service
Approach
Financing
Plan  $5–10K screen  $5–10K screen  $5–10K screen  $800 screen
conversion conversion conversion installation
 Per admission  Per admission  Per admission  $2340 annual
royalty fees royalty fees royalty fees service/maintenance
 Most power to  Located in  No competition;  Highest per patron
bargain with largest cities or 80% of markets concession revenue
studios & other population sites  Best price position  Markets have few
suppliers due to  Lower fixed  Lower fixed costs entertainment
organizational costs per screen; per screen; options
size conversion charge conversion charge  Best cost position
 Quality theater paid up front paid up front  Good price point
Advantages
setting assumed  Largest presence  Higher revenues
 Lower fixed internationally after fixed costs
costs per screen;  Highest net and covered for digital
conversion charge operating income screens
paid up front  33% attendance  Significant lead in
growth in 5 years digital conversion;
double 3D capacity
 Highest price  Greater direct  Capacity may  Small market size
point and indirect exceed market size (populations under
 Greater debt competition  High facility costs 100,000)
level assumed  Greater debt  Ongoing DCPI  Facility quality
Disadvantages
 Ongoing DCPI level assumed royalty commitment may be inferior
royalty  Ongoing DCPI  Higher fixed costs
commitment royalty associated with
commitment lease-service terms

 Evaluate the revenue sources and major costs for exhibitors. Discuss how the
income structure impacts their financial results.

A close look at the theater business model reveals that cinema managers have
limited ability to impact revenues with existing tangible and intangible resources. In
addition, restricted power or flexibility to control product costs leaves operating margins

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near just 10% across the industry. (With facility and labor costs factored, net income is
marginal or negative.) These constraints severely limit financial control and profit
potential for theater owners.

The table below dissects the revenue structure and helps identify earnings barriers
faced by movie theater managers.

Percentage Margin
Revenue
of Total Over Direct Comments
Source
Revenues Costs
Loss leadership on movies; ticket
Ticket revenues merely cover commitment to
65% 0%
Sales studios and costs of operations, facilities,
and debt.
Mixed evidence of impact to bottom line
3D 11% ??%
and to sustainable appeal.
Largest source of exhibitor income.
Concession Highly influenced by attendance, but also
30% >85%
Sales pricing and supply costs. Prices at
maximum. Caps on volume per patron.
Highly profitable. Expected to increase
Advertising 10% annually over next decade.
5% 100%
Sales Attractive source of income, but low
audience tolerance.

Movie theater profitability is severely hampered by this income structure, and

when trends in both the general and industry environments are also considered, long-term
viability is uncertain. Because of the power imbalance with studios, increasing box office
receipts provides virtually no additional income for theater owners, even though they
represent the greatest source of revenue. In addition, consumer tolerance for higher ticket
prices (which have doubled in the past 15 years) is beginning to hit a ceiling. Even 3D
movies, which have supported recent revenue growth appear to have a long-term
downward trend. And although concession sales are the largest source of theater profits,
they are also the basis for customer complaint. Tolerance for high prices has already
reached its limit. Therefore, the likelihood of generating additional revenue through
concession sales is small. Like the other revenue streams, opportunities to generate
additional income from advertisements are also limited. As another source of customer
frustration, increasing screen advertisements may result in driving away more customers.

On the cost side of the equation, the most significant factor for theater managers
is high facility costs. Fixed asset costs per screen influence company performance and
strategic choices (such as the level of technology and facility design materials). As the
earlier competitor analysis demonstrates, cost per screen directly translates to price per
ticket, which has an inverse affect on demand. In addition, the rapid expansion of digital
film systems has introduced new investment expenses that are straining exhibitors’
already weak financial positions.

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STRATEGY

The situation overview pinpoints the factors that are diminishing movie theater
profitability. Today, cinemas are operating from a position of weakness. They are
competing against substitute products, constrained by supplier power, and managing an
unprofitable business model. To find success, industry leaders must minimize pressures
that are squeezing earnings from all directions and develop conditions that create superior
value for which customers are willing to pay.

Even though geographic market variations provide some incentive for

establishing differentiation or cost leadership strategies, existing business conditions
deem these standard business-level strategies unsuitable. Differentiation is unsustainable
against competitor imitation. A low-cost strategy (1) has limited effectiveness because
operators have already removed excessive costs from the value chain, (2) is unappealing
due to location dynamics, (3) can have a negative effect on the customer's theater
experience, and (4) passes low costs on to customers to attract business, which in turn
reduces profit margins. A focus strategy might be beneficial if directed toward the core
audience, but theaters need to expand their customer bases, and a focus strategy may
distract them from finding opportunities outside of the target consumer group. Finally, an
integrated strategy, combining any of these strategies, would be ineffective for the same
reasons.

Because participants in the industry cannot rely on standard business-level

strategies and because of their inability to increase margins by controlling revenue or cost
variables, leaders will find it necessary to discover new and creative strategic measures to
improve or sustain the profitability of ongoing operations.

Recommendations for Consideration

To enhance performance and improve the likelihood of future success, theater

operators need measures to reduce the bargaining power of studios and to stimulate
demand for established cinema complexes. It is a question of enhancing profits and
taking steps to reduce uncertainty. The following list of recommendations offers feasible
strategies for meeting these objectives. Suggestions range from smaller scale actions to
larger scale cooperative strategies and facility redesign. Due to the failing business
model, retaining patrons and growing profits may require dramatic actions by exhibitors.

o Expand operations internationally. Whereas domestic growth rates are faltering,

revenues are growing at 35% in international markets. Studios are earning a higher
share of income in foreign markets, where attendance is rising. Without another 3D
phenomenon in the wings to stimulate growth, expanding internationally is the single
best opportunity available to movie theater owners.

o Engage studios in mutually beneficial partnership agreements. While delivery

channels are emerging and evolving, studios are taking steps to recover lost DVD sales
and to react to the success and power of VOD providers. Even though they are relying

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on the box office more than ever, their strategic decisions to accelerate and maximize
returns often have negative consequences for theater owners. Strong partnership
agreements are needed to intricately link their mutual success and facilitate the
achievement of both parties’ objectives. Where studio actions are incompatible with
(early DVD releases) or costly for (conversion to digital projection) theaters,
arrangements must be closely managed to ensure viability for the exhibition stage of
the motion picture industry.

o Cater to semi-frequent and frequent moviegoers. To deliver the “experience”

being sought by their core audience and to increase attendance of tentative patrons,
theaters need to overcome the declining value proposition and initiate customer
outreach efforts. This involves deepening the richness and affiliation of customer
relationships and focusing on quality measures.

The case material emphasizes that cost, home viewing options, theater
interruptions or distractions, inconvenience, and screen advertising all impact the
quality of the theater experience. Perceived quality can be enhanced through expanded
service features, improved courtesy, consistency, and convenience, greater schedule
flexibility (perhaps introducing immediate viewing options), and other subjective
dimensions that impact the customer experience. These types of service improvements
can heighten quality, create value, and stimulate demand.

o Seek alternative facility uses and content. With conversion to digital projection
underway, great potential exists for finding and offering alternative content. The
greatest advantage of this strategy is that it reduces theaters’ overdependence on
powerful studios, removing income restraints and providing protection against failing
to receive viable hit films (as occurred in the summer of 2010).

Unique content ideas suggest innovative uses for established theater sites. Owners
can identify and promote events that would be enriched by the use of a commercial
screen size and theatrical sound system. Suggestions include sporting events (like play-
offs, NCAA tournaments, Kentucky Derby, or other racing events), birthdays,
“premiers,” “previews” (negotiate for exclusive first releases), educational showings,
school activities, or other celebratory events (such as reunions or couples’ wedding
showers). Theaters might be able to restage classics or offer series marathons, turning
them into social events, particularly during slow sales periods.

This strategy to promote a variety of new venue opportunities depends on the

creative use of vacant space and the ability to attract new forms of entertainment that
provide “escape” value to the audience. It also requires more creative and marketing-
oriented management talent to implement at the local level.

o Expand entertainment value of offering. Similar to steps taken by Gold Classic

Cinemas, this option may involve diversifying into other forms of entertainment and
services. Partnering with commercial development, restaurant, or other entertainment
groups is a potential way of expanding the service “menu” at theater facilities. This

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might involve ideas such as bringing in unique snacking options (such as ethnic foods,
like Mexican or Asian) or using lobby space to house cafés, mini-flight simulators, and
other entertainment activities. This strategy reduces dependence on competitive factors
related to location and parking convenience and offers complimentary entertainment
services to attract patrons. However, any food service additions will have to be
evaluated carefully because they are likely to cannibalize profitable concession sales.
Any new food offerings should be coupled with thoughtful pricing strategies that
maximize margins per guest.

Perhaps the most promising new entertainment offering would be a venture into
interactive digital experiences (made possible by the conversion to digital projection
systems, which is already underway). The core theater audience is a media-driven,
gaming generation. Cooperative strategies with gaming companies could generate
especially appealing prospects. Not only could they offer exciting new experiences for
targeted electronic “gamers” to increase demand, but if successful, they would create
competition for studios to book theater space (decreasing supplier power). Leaders who
adopt this type of strategy should move quickly to gain first mover advantages and
choose their partners wisely. Competitors can be expected to follow, and new entrants
(such as gaming retailers) may be motivated to set up their own interactive gaming
facilities. Struggling DVD rental retailers may also be drawn toward this type of
offering to make use of excess or unprofitable store locations.

o Redesign facilities to develop smaller viewing venues. Another possibility is to

restructure multiplexes to accommodate a variety of mini-theater designs. Smaller
screen settings offer several advantages for theaters. The viewing atmosphere can be
better controlled to reduce interruptions experienced in larger spaces. Privacy or
intimacy needed for new content or event venues can also be created.

With this suggestion, viewing selections and flexibility can be increased,

particularly with the growing availability of original digital content. Alliances with
companies like Netflix, Comcast, Blockbuster, or other major content providers (even
television and cable networks for marathon events of popular series, such as ‘Lost’ and
‘24’) would secure viewing material and, again, reduce dependence on studios.

Mini-viewing settings might build on the home theater concept, attempting to

deliver an experience a notch above what can be created in the home and possibly
discovering a way to deliver a “wow” experience. Innovation and comfort can extend
the life and novelty of this strategy. Leaders should keep in mind that a company like
Blockbuster could execute this type of strategy in its retail sites, and this approach can
also be imitated by competitors. And managing more screening rooms would likely
increase labor costs. Finally, moving quickly to achieve first-mover advantages and
wise partner selection increases the potential value of this strategy.

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