Having worked in the entertainment industry for 3 years, I have learned the internal workings of how movie studios make money. After countless hours discussing business models and technology, I’ve come to believe that the hollywood studios have strategically positioned themselves on the wrong end of an innovation disruption.
First, let me tell you the classic story of how disruptive innovation destroys companies.
A brief example
By definition, disruptive innovation creates a new market by applying a different set of values, which ultimately (and unexpectedly) overtakes an existing market (source: http://en.wikipedia.org/wiki/Disruptive_innovation).
When disruptive innovation begins to undermine existing business models, large corporations do not typically have the political will to kill their affected business sectors. Instead, they try to defend their products from disruption (especially, if the disruption affects their high profit margin products).
At some point, they try to squeeze as much money as possible from their existing business models, once they realize that they can no longer defend against the disruption. After that they can either retreat somewhere they feel that the disruption cannot reach, or somehow include the new market into their existing business models. However, by that time, anything they do will be “too little and too late”.
Take the example of Eastman Kodak.
Eastman Kodak invented the business of selling inexpensive cameras. Their business model worked so well that at one point, they commanded 90% of film sales and 85% of camera sales in the US.
When consumers started to demand digital photography products, Kodak did not move fast enough to meet that demand. At that time, digital photography had very low profit margins, and also undercut its existing high profit margin film business. By the time digital film generated high profit margins, other companies had already outmaneuvered Eastman Kodak in that space. Eastman Kodak could not do anything to take the existing market share from their competitors.
Ironically, Eastman Kodak invented digital photography in 1975. If they pushed digital photography early they could have easily owned the emerging digital photography market. However, they dropped that product because they feared it would threaten their photography film business.
The studios’ problem
Enter the giant Hollywood Studios (i.e. Disney, Warner Brothers, Universal, NBC, etc …).
Hollywood movies have “release windows”, and each release window has a different set of players who take a cut of the profits.
The different “release windows” typically goes in this order: (a) theaters, (b) dvd/bluray, (c) pay-per-view, (d) premium cable channels, (e) network and cable tv, and (f) syndicated tv.
Before a movie ever gets released, the “profits” have already been divided among the different players in each “release window” through contractual agreement. This situation makes it nearly impossible to adapt to a disruption because everyone depends on the studios for content.
For example, movie theaters threatened to boycott the movie “Tower Heist” when Universal tried to experiment with releasing it on VOD in some markets just three weeks after its theatrical debut. They intended to test the viability of “premium VOD”. Rather than risk a complete loss, Universal capitulated to the theaters, and from then on never attempted to enter the “premium VOD” market ever again.
This situation places all the Hollywood studios in the exact same losing position of Eastman Kodak: trying to defend their nameplates from disruption instead of adapting to it.
In the Eastman Kodak situation, they had an entire business model around film development that would kick and scream if Kodak did anything to undermine them. However, at some point building a digital camera got so easy and inexpensive that pretty much anyone could do it.
Why buy film when your cell phone already has a built in camera? Oh, you need high quality photos well consider the various SLR digital camera’s from Nikon, Cannon, Sony, and … not Kodak.
The rise of digital photography made consumers value film less. To consumers, digital photography added value because it provided more convenience at less cost with more quality. However, Kodak anchored themselves to a business model that opposed the new value system.
Similarly, the rise of video on demand has changed the values of consumers. However, none of the studios can adapt to the new market without undermining their already existing business units. At most, they can only do half-hearted attempts of addressing what consumers really want.
Consider the case of Ultraviolet and Digital Copy. This allows you access to video streaming as long as you purchase a DVD/Blu-ray copy. This goes at least part way to close the value-gap. However, it does not go far enough because it does not really add value from the consumers viewpoint. It is simply another way for the studios to “collect rent”.
The studios think that they are “adding value” when they “collect rent”. However, customers don’t see it that way. To consumers, video piracy and netflix add value because they are less dependent on the studios.
That does not mean that the studios should not have created their own streaming services, though. Given the circumstances, they made the best move they could. Providing that service themselves could not have made their situation any worse; so, why not? However, it simply is not enough to get them the traction they need in the new marketplace.
Now the studios can only milk their nameplates for as much money as possible and attempt to retreat upmarket.
For example, Disney and WB do not really make money selling movies. They make money selling cult memberships.
The studios can always count on their franchises to collect a few very loyal consumers that will buy almost anything packaged with a certain branding. For example, I could literally take a pile of bull shit, wrap it in a Game of Thrones package, sell it, and someone would buy it. See here.
While this has worked very well the last couple of years, I does not seem like a very sustainable business model.
The moral of the story is buy more Netflix stock.
Updated: I corrected a misspelling based on a commenter’s observation that “Kodac” should be “Kodak”