$42 billion dollars.
That is the amount of money grossed by films at the global box office in 2019.
Impressive? Definitely. Surprising? Probably not, especially when you
consider that global box office revenues have increased year-over-year since 2005.
That was, of course, until COVID.
As you’d expect, the pandemic has devastated Hollywood – resulting
in an unprecedented seventy-one percent (71%) decline in global box office revenue.
Worse yet, we all have to go another year without Daniel Craig’s No Time To Die –
a title that has since taken-on somewhat of an eerie meaning.
But putting the absence of James Bond aside ... movie ticket sales have actually been on the
decline for nearly two decades – despite a steady increase in population over the same period.
So, if people are going to movie theatres less often – and they are –
then what exactly is driving the growth behind global box office revenue? [note]
To answer this question, you have to understand the economics of Hollywood.
How do movies get funded?
What is the role of government subsidies and alternative revenue sources?
How can a movie gross more than its budget and still lose money?
And finally, what are the economics behind movie
theatres and their twenty dollar buckets of popcorn?
Hollywood: the undisputed movie capital of the world.
This thirty-square-mile area plays an
instrumental role in shaping western culture – as well as how others perceive western culture.
In addition to this chief role, Hollywood is also a very material component of the U.S. economy.
If you’ve ever sat through a movie credit reel, it’s little wonder why the film and television
industry supports nearly two and a half million jobs.
For perspective, that’s greater than the number of people employed as farmers or miners.
Keep in mind: these are good-paying jobs. According to Motion Picture Association,
the industry pays more than $181 billion in wages each year.
That’s impressive because it also means that people employed in this sector earn around 47%
more than the national average. Although, when you consider how
expensive it is to live in Los Angeles, that’s essentially what you’d expect.
So, what exactly is driving Hollywood’s growth?
Twenty years ago, the answer would’ve been in-person movie going.
The studios made the movies. The theatres showed the movies. Everyone was happy.
Things were simpler then.
But considering that you’re now watching this video on YouTube, it’s probably not a surprise to
learn that the way we consume content has changed drastically.
As a result, U.S. moviegoing has been on the decline for nearly two decades.
But how can there be growth at the box office if fewer people are going to the movies?
The answer is mostly two-fold: increasing inflation and decreasing demand.
Going to the movies is simply more expensive than it used to be.
This is, in part, due to inflation.
In 1910, the average price of a movie ticket was a mere seven cents.
Today, that number is a relatively staggering nine-dollars and twenty-six cents:
a one-hundred-and-thirty-two-fold increase.
On top of this,
fewer people are physically going to the movies – despite an increase in relative population.
Streaming has completely flipped the theatre business upside down.
Notably, some recent films – like Greenland and Disney’s Mulan – have cut out theatres
all together and are now releasing films online, directly to viewers.
This may sound like a novel concept … but it’s not.
Shark Tank star and billionaire Mark Cuban pioneered a very similar
distribution concept in the early 2000s; the dawn of online HD video.
Long before Disney and Netflix, it was Cuban’s Magnolia Pictures which
released films through the internet and theatres ... at the same time.
However, it’s worth noting that this concept wasn’t actually successful – as evidenced by
the fact that you probably haven’t seen any movies using this dual distribution model.
Arguably, the biggest beneficiary of all these technological advancements in the past two decades
– excluding you, the consumer – have been the largest film studios: also known as the big six.
The big six dominate the box office charts.
Part of the reason why these studios are so big… is because they have big budgets.
Budgets that are often in the hundreds of millions of dollars.
But, how do movies get funded?
Movies are companies.
Not just in the profit-driven sense.
I mean, movies are literally companies – just like Apple, Google, and Australia.
Studios incorporate their films for a number of legal reasons.
But the main reason they incorporate is to raise capital.
In this way, films are like pre-revenue startups:
they don’t have a product yet, and they need funding.
Just like the startup world, there’s an investor ecosystem for the movie world.
An investor ecosystem that looks for the same things that all investors look for:
the opportunity to earn solid
returns from a venture managed by an equally solid management team.
Naturally, this raises a couple of questions: who provides the funding to the
studios? And, do you need a nine-figure budget to make a wildly successful movie?
To answer the latter question first: absolutely not.
Case in point: the supernatural horror film Paranormal Activity.
Made on a shoestring budget of just fifteen grand, the film brought in nearly $200 million
dollars.
Another notable success is Super Size Me – a documentary about fast-food …
which, in its own right, is also a real-life horror film.
Like Paranormal Activity, the movie was shot on a modest budget. Sixty-five thousand dollars.
It also crushed it at the box office, raking in over $29 million dollars.
Most of the viral success behind these kinds of indie films is attributed to the internet.
Tech-savvy filmmakers now have an infinite array of ways to advertise their movies.
Sites like YouTube can make your trailer go viral.
And after going viral, you can then sell your movie’s
rights to a platform like Netflix or Amazon Prime.
But the internet isn’t only disrupting how films are distributed – it’s
also disrupting how they are financed. Namely thanks to crowdfunding platforms,
which enable you to invest in movies and receive royalties.
Now as for producing big-budget films, the investors in these movies are usually private
equity firms and hedge funds. Although, it’s not uncommon to also see family offices as investors,
as well as ultra-high net worth individuals.
Almost always, these investors are “Limited Partners” – or “LPs”– meaning they take
a passive ownership stake and don’t get involved in the movie’s production process.
Hedge funds and P-E firms are often looking to allocate capital toward what financial analysts
call “Uncorrelated Return Streams” … which is a pretentious way of saying an alternative asset
that has an income stream unaffected by the forces that usually affect other
types of traditional assets, like stocks.
People continue going to movies during economic downturns as a form
of cheap entertainment. meaning the money still keeps coming in.
Music is another perfect example of this – one that is also very synergistic with
the movie industry. Look no further than any Sony Pictures movie featuring music
from – you guessed it – a Sony-owned record label like Columbia Records.
But even with the financial backing of large institutions, studios rely on two other
important funding sources: paid product placement and government subsidies.
Paid Product Placement
It’s the reason why you see
so many brand advertisements in movies – some of which are just laughably unbearable.
For studios, paid product placement is a critical fundraising tool: one that allows them to retain
a larger ownership stake in their movies. Without it, a studio would have no other choice
but to raise more money from their investors – which, in turn, dilutes the studio’s ownership.
So, how big of a deal is paid product placement?
Well, if you’re an indie filmmaker, it’s usually not even a remote possibility.
Good luck trying to get Apple to sponsor your home movie.
But if you’re a major studio, it’s an entirely different story.
Consider the James Bond franchise.
The upcoming film No Time To Die will reportedly feature over 90 million dollars
in paid product placement, which equates to about 36% of the movie’s entire budget.
At this point, perhaps the movie should be renamed to “No Time For Anything Other Than Ads”.
But, it’s worth noting that James Bond is more of an outlier.
Most movies don’t receive paid product placement revenue anywhere near those numbers.
But perhaps the most interesting thing about paid product placement
is that sometimes you don’t even know it’s there. And that’s the point:
it’s meant to be subliminal – you’re not supposed to notice it.
The reason films don’t disclose their brand placements, is simple: they don’t have to.
It’s not legally required.
The movie industry argues that making disclosures mid-movie would be disruptive,
which makes sense. After all, fans of James Bond already know
that Daniel Craig is getting paid to drive that slick Aston Martin.
The real ethical issue here – one that is,
arguably, criminally overlooked – is paid product placement targeting children.
Children who are easily manipulated and don't have any concept whatsoever
of the dynamic between brands and their non-transparent advertising.
Case in point: the sugary pastry company Cinnabon sponsoring the Bee Movie.
[Que the clip on YouTube]
Interestingly, movies aren’t even the biggest recipient of paid product placement dollars.
Not even close. That crown belongs to T.V.
This lack of disclosure is a double-standard that doesn’t receive nearly enough attention.
If a YouTuber is paid any amount of money to promote anything – the FCC strictly
requires the creator to be transparent and disclose such information to their audience.
Failure to do so can result in a hefty fine and potentially jail time.
On the other hand, film and TV essentially get a pass.
This leads us to our next topic: Hollywood’s very powerful lobbying
industry and the role of government subsidies.
Government Subsidies
Lobbyists for Hollywood
argue that the movie business is tough … so, of course, they need a tax break.
Now, hearing this alone as a state legislator should be enough justification to at least pause.
Because, as mentioned before, if you exclude 2020, Hollywood has never done better.
As a reminder: global box office revenues haven’t declined in over 15 years.
And as we’ll discuss later in this video, Hollywood films are rarely profitable –
at least that’s the way the industry’s creative accountants make it appear to the IRS.
So, the idea that a booming movie industry – which doesn’t even make
money on its films – needing a tax break is a little ridiculous in and of itself.
Even the independent non-profit Tax Foundation describes these incentives as:
“Failing to live up to their promises to encourage economic growth overall and to raise tax revenue.”
For context: these tax breaks are called MPIs – or “Movie Production Incentives”.
They’re exactly what their name implies: tax incentives for the movie industry to
incentivize film production. Or, at least, in theory, that’s what they’re supposed to do.
Originally conceived in 1992 by the state of Louisiana,
the concept was to bring film production jobs to the state. And to their credit,
they have created some jobs – albeit, almost always at a very high cost to taxpayers.
They’re provided on a state-by-state basis and most states have them.
Speaking of states, here's what’s most paradoxical of all:
The most generous MPIs are typically provided by states with the highest
income tax rates like New York, Connecticut, Massachusetts, and Hawaii.
On the contrary, states with lower income state
taxes tend to offer fewer and less generous MPI subsidies.
In fact, of the nine U.S. states that don’t have any state income taxes,
four don’t offer any MPI subsidy programs at all.
If you look at the data behind this paradox, you can begin to understand the criticism that
Hollywood studios are subsidizing their films with taxpayer dollars.
And, not to pick a side here, but that’s not even criticism. It’s just a fact.
As any rational economist will tell you:
taxpayers always pickup the tab for ineffective government subsidies.
In Massachusetts for example, one study found that each film job
created by the state’s MPI program cost taxpayers a whopping $324,000.
“But, wait”, you say.
“What about independent filmmakers? Surely, it’s not only the most powerful studios
that don’t actually need these subsidies who can take advantage of them … right?
Unfortunately, not. Before being eligible to enjoy these sweet tax breaks,
production companies are often required to spend hundreds of thousands of dollars.
And as if that wasn’t bad enough,
many states even offer MPIs with cash rebates on qualified purchases.
Now, to be clear: we’re not talking about tax rebates.
We’re talking about production cost rebates.
Meaning, costs that are incurred by the studio: which the studio then submits to
the state for reimbursement. Specifically, costs that are considered “qualified”. A
percentage of which is kicked back to the studio – typically around 20 to 25 percent.
In a way, it’s the same concept as cash back rewards. Except, to be eligible for
these cashback perks, you don’t need good credit: you just need to be a big studio.
This free money is provided courtesy of … you guessed it: taxpayers.
As if that wasn’t egregious enough, these production costs submitted to the state for
reimbursement are sometimes artificially inflated. You tell the state what you paid for the qualified
purchase, and they send you a check for 20 to 25 percent of the amount that you claim.
It’s basically the honor system.
If all of this sounds like it’s prone to abuse,
that because it is. And, indeed,it has been abused.
Several film directors have been charged with tax fraud for telling state governments one inflated
number and paying their production staff a significantly lower number.
As of the time of this video: twenty-two states offer cash rebate programs.
The percentage varies from state-to-state, as does the definition of a “qualified purchase”.
Now, if all this corrupt corporate lobbying sounds like it’s out of a movie: it’s not.
Understandably, if there’s one movie that’ll probably never
be made by Hollywood it’d be on this very subject.
But, if movies can be such a great investment – then why do so many Hollywood films never generate
a profit for their investors – despite having tax credits, hundreds of millions in funding,
tens of millions in paid product placement – and, to top it all off,
extraordinary sales at the box office which even exceed their budgets.
Two words: Hollywood accounting.
That’s not a term that we came up with – it’s what the industry calls it.
Hollywood’s accounting methodology is so
infamously opaque that it even has its own Wikipedia page.
The scheme works by using questionable legal, and sometimes illegal,
expensing systems to reduce profit.
For example, consider a movie studio that also owns a subsidiary costume company.
On the surface, it’s a perfect synergy.
Studios make films. Films need actors. Actors need costumes.
So, if you own a studio, why not also own a costume company?
It’s a textbook perfect vertical integration, right? Well, not so fast.
These structures don’t work in reality because there’s an obvious conflict of interest.
Namely, the studio can mark-up the price of their costumes – purposefully
over-billing their own film. The studio artificially increases their expenses
to shift the profit that would’ve been distributed to the investor,
to the costume company – which – surprise– the investor does not own.
This type of conflict-of-interest profit-shifting happens all the time in Hollywood.
Infamously, the creator of Spider Man, Stan Lee, was promised 10% of the Net Profits from
anything based on his characters. Although the case was later settled with Marvel,
Lee ultimately never received royalties.
Lee is by no means alone. Screenwriter Ed Solomon, claims that his Sony-owned blockbuster
Men In Black is still not “in the black”. This is after nearly a quarter of a century since its
release and despite grossing over six-hundred million off a ninety million dollar budget.
Not to mention – three sequels.
Movie studios have precise meanings assigned to terms like “Net Profit”.
In the practice of law, the term you see here is what’s known as a defined term. Almost all
contracts have them. And, to be clear: there’s nothing inherently sinister about defined terms.
That is, unless, you’re a film studio that decides to define such important words in ways that are
intended to be ... dare I say, “subjective”, and thus open to interpretation in the courts.
But this raises a different question: are movie studios really the villain here?
One group that would likely say “yes” would be the venues that show the studios’ films:
movie theatres.
Online streaming has massively disrupted the in-person moviegoing industry.
But contrary to popular belief,
movie theatres are still a multi-billion dollar revenue stream for Hollywood.
To understand the economics of movie theatres, you have to understand how they generate revenue.
Movie theatres – or “cinemas” as our viewers in
the U.K. like to call them – are not in the movie business.
Movie theatres are in the refreshments business.
Because AMC has the largest theatre market share in the U.S.,
we’ll use them as a proxy for the industry.
According to their 2019 annual report, food and beverage sales accounted for nearly a
third of the company’s total revenue, clocking-in at $1.7 billion dollars.
Even more impressive: the net margins on that revenue: 84%.
This, of course, begs the question:
If theatre companies like AMC generate over a billion dollars a year in profit
from food and beverages, then why does this industry as a whole lose so much money?
Well, in a way … the losses are a tad exaggerated.
If you look at the last five years of AMC’s financial performance,
it certainly doesn’t look great.
Just look at their 2019 annual report, and you’ll see that they
“lost” 149 million dollars off nearly five and half a billion in revenue.
But if you don’t factor-in “depreciation”, you’ll see a completely different story.
Sure, on a taxable basis, AMC lost $149 million. But if you add back-in depreciation –
which you should because it’s not a real capital expenditure and therefore distorts the real
financial picture – you can see AMC actually had a net profit of just over $300 million dollars.
But even $300 million in quote on quote “real net profit” off five and a half billion in revenue
isn’t a great business. Put another way, that means your real net margins are only five percent.
So, why is this? Food and beverages are obviously not the problem:
that segment of the business is a cash cow. What’s dragging down the net income of movie theatres?
The answer to this question has to do with the way theatres charge studios to show their films.
In the first week of a film’s premiere, theatres may only receive 20 to 25 percent of the film’s
ticket price – with the remaining 75 to 80 percent going to the studio.
In the second week, the revenue share changes – with a higher
percentage of revenue going to the theatre and less to the studio.
By around week six,
the theatre is usually receiving the majority of the movie’s ticket revenue.
This continues every week until the movie is eventually no longer shown in theatres.
This adaptive revenue share is precisely the reason why your popcorn is so darn expensive.
Now, if you think that studios are simply squeezing movie theatres, well, you’re not alone.
Disney received a ton of backlash after they told theatres that they’d be receiving a zero
percent revenue share on all ticket sales during the premiering week of their new Star Wars film.
That may not seem like a fair deal. But if you run a movie theatre: what are you going to do?
Suppose you own a theatre and decide not to show the new Star Wars film because you
don’t generate any revenue from ticket sales. You risk losing potential customers who will
take their business to a different theatre that is showing the new Star Wars film.
In the eyes of Disney’s critics, they are like the monopolizing death star;
crushing theatres one galaxy at a time.
But to the capitalist Jedi looking-in from the outside,
we can see that such an argument is a difficult one to win.
Disney isn’t a monopoly.
They're not using Darth Vadar’s invisible
force choke to strangle theatres into showing their movie. No, not even close.
The reason Disney has the pricing power they’re criticized for holding is because...
…they simply make great movies.
That is the beauty of the inter-galactic system we call … free market economics.
The video you just watched would not have been possible if it wasn’t for our sponsor Skillshare.
Not just because they provided us with funding, but also because I learned so
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