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HIVE EXCLUSIVE: Is the Price Right?

25 May, 2001 By: Thomas K. Arnold

It was at the 1999 VSDA convention that Warner Home Video president Warren Lieberfarb first floated the idea of revenue-sharing for DVD.

"I know that revenue-sharing is viewed by many retailers as a threat, but with the right split it can be beneficial to both the studios and the retailers," he said during a panel discussion on DVD’s future. Atthe time, it was becoming clear that despite its low list price, DVD would not become an exclusively sellthrough item, as Lieberfarb and many of his influential studio peers had hoped. Rental dealers, encouraged by the low cost and escalating consumer demand, were buying DVDs to rent them to their customers.

Studios were fearful that if a viable DVD rental market emerged, it would eat into their profits, since rental-priced VHS cassettes, evenunder the most generous copy-depth and revenue-sharing programs, were still fetching upwards of $40, or more than twice the wholesale cost ofnew DVDs.

A year later, at the next VSDA convention, Lieberfarb made a more strong-arm pitch for revenue-sharing on DVD, warning retailers that ifthey didn’t start sharing revenue on disc rentals, he could retaliate either by shortening pay-per-view windows or by cutting off VHSrevenue-sharing deals.

Lieberfarb’s zealous pursuit of revenue-sharing on DVD underscores the philosophical divide that continues to widen between suppliers andretailers as the DVD rental market gathers more momentum. Studios want a bigger piece of the pie, since DVDs sell for a lot less than VHS rentalcassettes. Retailers, meanwhile, prefer keeping things the way they are,saying they can already bring in more than enough copies of hot new DVDs at $17 a pop to satisfy rental demand.

"I would have no interest in revenue-sharing DVD at its current price level. It just wouldn’t make sense," says John Heim, owner of Video Cityin Littleton, Colo.

"At the price structure it is at now, it makes no sense but to buy," adds Steven Scavelli, president of Flash Distributors, a Brooklyn,N.Y.-based wholesaler that services primarily independent video stores.

In all likelihood, however, retailers are going to lose this round. And if they’re reluctant to share revenue because DVDs are so affordable, consider this: Several studio executives are silently mulling adopting atwo-tier pricing model for new DVD releases similar to the existing VHS pricing structure.

Speaking off the record, executives say DVDs would be priced at $39 to $49 out of the gate, then repriced for sellthrough between two and four months later. The rental version would be the movie only; the later, sellthrough edition would be packed with special features. This way,studios hope to control the "previously viewed" market and prevent retailers from selling used discs instead of the repriced versions.

A similar strategy is working quite well in Great Britain, studio executives say, with an even longer repricing window. But unlike here inthe United States, Britain has yet to develop a formidable DVD sellthrough business — which makes transporting the same model stateside a tougher nut to crack.

"No one’s even talking about anything until after the fourth quarter,"acknowledges one studio executive who asked his name not be used. "We don’t want to shoot any arrows into DVD’s growth at sellthrough." Still, he adds, the studios must do something — otherwise they can expect to see their losses mount as more and more retailers pass on high-priced VHS rental cassettes and buy the cheaper DVD versions instead.

Blockbuster Inc. has been the sole retail voice suggesting two-tier pricing for DVD. In fact, earlier this year Blockbuster executiveslaunched a campaign to convince studio executives a limited rental window was in their best interests, showing a study that claims studiosleft an average of $1.1 million in profit per title on the table last year by pricing all DVDs at sellthrough.

Mark Wattles, c.e.o. of Hollywood Entertainment Corp., the nation’s No. 2 video specialty chain, hasn’t said whether or not he favorsrevenue-sharing and two-tier pricing on DVD. But in a May 7 conference call with analysts, he said he certainly believes it’s going to happen.

"Based on my conversations with studios," he said, "the majority anticipate raising the wholesale price of DVD and the reason they wouldlike to do that is they would like to get their hands onrevenue-sharing, because revenue-sharing works so well for them on the VHS side."

As far as Wattles is concerned, the key issue is how long studios will wait between releasing a higher-priced DVD to the rental market and repricing it for sellthrough. It’s a sensitive issue, he concedes, because of the strength of the big DVD sellers like Wal-Mart and Best Buy.

"The real question is, what is the time difference between the day in which it’s released on revenue share and the date it’s available atWal-Mart?" he said. Wattles predicts the studios will adopt a 90-day window between rental and sellthrough pricing so they would "still be able to take advantage of the momentum around rental advertising and rental promotion."

Not a single independent video retailer interviewed for this story came out in favor of two-tier pricing. Any such move, they say, would almost necessitate revenue-sharing, which they passionately detest.

"Strictly from the point of view of an independent video retailer, the current sellthrough pricing structure of DVD seems the most beneficial and viable," says Mick Blanken, owner of Superhitz Moviez & Gamez inDelaware, Ohio, where DVD accounts for 16% of rental revenue and 25% of rental inventory.

"Any significant increase in price designed to steer consumers away from purchasing and toward rental would likely result in theimplementation of revenue-sharing for DVD," he adds. "And just asindependents are suffering today with VHS revenue-sharing models, they would also suffer should revenue-sharing become the only model under which they had the opportunity to satisfy demand in their marketplace."

Blanken doesn’t think much of Blockbuster’s pitch for a rental exclusive. "The persuasive argument the chains are making that two-tier pricing would generate more DVD revenues for the studios (and, of course, forthemselves) is very shortsighted," he maintains.

"It is logical to conclude that the huge growth in DVD is, to a large degree, a result of the affordable availability of software at retail. Eliminate that availability to the consumer and it is likely that DVD growth would slow significantly.

"So, while it may be possible that the studios and chains might realize more revenues today by adopting an 'exclusively' rental mentality, the revenues they would realize tomorrow would be considerably less."

Tom Hannah, the outspoken owner of Video Quest in Joliet, Ill., agrees. "There is a saying, 'Fool me once, shame on you; fool me twice, shame on me,'" Hannah says. "We tried revenue-sharing on VHS and it didincrease rentals at our store. It also increased our costs so much we did not make any additional profits."

Rental-priced DVDs, Hannah believes, would be a disaster. "DVDs are not nearly as durable as VHS tapes and stores simply cannot afford to pay high prices for discs that will have to be replaced in the near future,” he says.

"Now that the big chains flood the market with lots of copies, new releases have very short legs. Back when VHS rental pricing started,stores could depend on long-term rentals to recoup the high prices. That is no longer a viable business strategy."

Studios would also anger the big sellers of DVD, Hannah asserts. "Economics dictate that any studio foolish enough to try rental-priced DVDs will fail miserably," he says. "The backlash by retailers such as Best Buy would be hard and swift."

Flash’s Scavelli, however, believes that in the long term, a two-tier pricing structure might be the best solution for all parties concerned, consumers included.

"Right now I’m in favor of a sellthrough price and just letting people buy what they want," Scavelli says. "But as the mass majority, theaverage consumer, becomes a DVD customer and as DVD replaces VHS, at some point I think it is in the industry’s and in the consumer’s bestinterest if the price is raised a little higher, maybe $39 or $49 retail, with dealer prices in the $25 to $30 range.

"This way, real movie lovers can buy it if they really want to buy it, but retailers can still have that rental window because most consumersdo not have the disposable income, nor the desire, to own most of the movies they’d like to watch."

Scavelli cautions that if sellthrough pricing continues, "the rentalbusiness could go away, because studios, faced with revenue losses, could prematurely abandon video rental by shortening or closing pay-per-view windows or accelerating video-on-demand rollout."

Another potential downside to continued sellthrough pricing for DVD, Scavelli says, is that the big chains could slash rental ratesdramatically because their cost of goods is so much lower. "Once DVD rentals hit the 50% mark, you could see the big chains rentingDVDs for $1.49 and putting even more small dealers out of business than they are now," Scavelli says. "This could be a short-term benefit for the consumer, but in the long term, with fewer stores—and stores that may not have the appropriate selection for their community—the consumerloses."

Warner Home Video is the only studio actively pursuing revenue-sharing for DVD without a price increase. Lieberfarb is an outspoken advocate of sellthrough pricing, believing the home entertainment industry can reap incremental dollars instead of merely replacing one revenue source foranother.

Yet Warner is also concerned about the growing DVD rental market siphoning off dollars from higher-priced rental cassettes, so it is pitching revenue-sharing as a solution.

"We believe in revenue-sharing for DVD as well as VHS," says executive v.p. and general manager Jim Cardwell. "Revenue-sharing on DVD will provide additional copy depth and at the same time allow for affordablepricing."

How does Warner expect retailers to buy off on revenue-sharing for DVD if the low list price remains the same?

Cardwell won’t cite specifics, other than to say Warner is developing aprogram he believes will entice dealers to participate in revenue-sharing through low upfront costs and "a fair split of revenue."

"We believe there are ways to make revenue-sharing work, even with DVD remaining at an affordable price," Cardwell says.

Lieberfarb adds, "Central to Warner Home Video’s DVD strategy is to generate above-average growth rates for product and our shareholders,while at the same time treating our entire customer base fairly.

"A new win-win transaction for the rental trade is a prerequisite to this goal and that involves compromise by all.

"The 'big picture' issue for all is finding a way to assure home video’s place in the sequential distribution of movies."

For sellthrough retailers like John Thrasher of Tower Records and Video, revenue-sharing is a minor issue, because only 11 of the WestSacramento, Calif.-based chain’s 97 stores rent videos.

But he’s dead set against two-tier pricing or any kind of rental window. "It would seriously erode a growing element of our business — and not just Tower’s business, but the entire industry’s," Thrasher says.

"The growth of the business over the last five years has been all sellthrough. And even if you bump up the list price to $39 or $49, 80% of the people buying DVDs today are not going to be buying it at that price. If you want to tell all your market, Best Buy, Tower, Virgin, Circuit City, Target, that you don’t want their business, fine."

Thrasher finds it odd that studios are even considering two-tier pricing on DVD at a time when it appears they are phasing it out on the VHS side. "Really, two-tier pricing on VHS is a concept whose time has come and gone," he says, "as evidenced by the retreat from revenue-sharing and the lower cost of goods that’s happening out in the market on rental product."

Independent suppliers like Artisan Home Entertainment are on the fence when it comes to DVD revenue-sharing, with or without two-tier pricing.

"Who knows, at this point?" asks Jeff Fink, Artisan’s president of sales and marketing. "It really depends on the saturation rate ofhardware players and the conversion of rental customers from VHS to DVD."

For the time being, at least, Fink is inclined to maintain the status quo. "All things being equal, we’re watching to see where the marketplace is headed," he says.

"However, the current state of the business, is very beneficial to our economic and revenue-generation models. The opportunity to have product being taken in by all segments of our market, sellthrough and rental, simultaneously, has greatly added value to our ability to generate revenue from DVD."

Fink doesn’t believe revenue-sharing for DVD is viable unless there is an industry move toward two-tier pricing. Studios contemplating such amove, he adds, have to ask themselves some long, hard questions.

"You have to take into account how that would impact the sellthrough market that currently exists for DVD," Fink says, "and whether that’s a risk you want to take at this point in time in the marketplace."

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