The uncertain future of third party digital cinema funding in Europe - part II

...or, There's Gold in Them Thar Digital Hills, But It's Not the Propspectors That Will Profit From It.

This is the second installment of my thoughts about the role of third party companies in the digital cinema transition in Europe. Here I will attempt to set out what the implications are of third party players being effectively sidelined from financing the transition to digital for European cinemas, what role they could and should still play and well as taking a stab at who the likely winners in this process will be.

The worst thing that could happen for third party players would be for the European Investment Bank (EIB) to become involved in the digital cinema transition. Despite its name, it is not an investment bank in the traditional sense and as such is not presently involved in any financing discussions that I am aware of. As the Wikipedia page makes clear:

The European Investment Bank (the Banque Européenne d'Investissement) is the European Union's financing institution and was established under the Treaty of Rome (1957) to provide financing for capital investment furthering European Union policy objectives, in particular regional development, Trans-European Networks of transport, telecommunications and energy, research, development and innovation, environmental improvement and protection, health and education.

The EIB is thus not interested in the funding or conversion of one or more cinemas chains in a particular EU member state. Digital cinema conversion would have to be a European Union policy objective for the EIB to get involved. And as there is no country or organisation that is pushing it forward - UNIC is too weak and the Franco-German axis under Merkel-Sarkozy has other priorities - I do not see it happening.

What this means is that each country will have to find its own way to digital cinema. Some will do it better than others, some will do it faster than others, some will manage to 'save' smaller cinemas, while for others it will shake up the exhibition sector completely. What it also means is that there is potential for third party players to have different roles in different territories. I am not precluding that they will be part of the financing of some of the installations that will take place. But as I outlined in the previous post, I doubt that they will end up playing a large role in the roll-out once most European territories take a serious look at how to switch over all of their cinemas to digital. It is this solidarity approach that mainly precludes the participation of third-party players, as they will not be able to strike VPF deals that cover small and marginally profitable or even unprofitable cinemas.

Where does this leave third party players? For a start they still have a large potential role to play in the transition in terms of providing installation and support services. There are over 30,000 cinema screens i Europe. If we assume a five year transition, that will mean 6,000 screens converted per year or 500 a month. Such an exercise will require major logistical support from companies with experience. Here too, however, third party players will have to form strategic alliances with the manufacturers (in the US it is Christie rather than AccessIT in the Christie/AIX partnership that have driven the 'locust' approach of conversion, whereby teams descend on a town with multiplexes and convert all te screens in one go witgh insect like efficiency) and existing installation companies. Going your own way as Arts Alliance Media did when it ended the partnership with Sound Associates after the first phase of the DSN installation is risky because established installation companies have something that new third party players don't, which is well established relations with the cinemas. In in the exhibition relations, it is always personal.

However, installation will require hiring, training and using an army of engineers who will not be needed once the installations are complete, unless you move them to the next territory. While service of digital equipment appears to be at a premium of 30 to 40 per cent compared to 35mm, this will still not be a large enough business to sustain third party players or all those engineers in the long term, hence most installation work can be expected to be subcontracted.

This is also why third party players are branching out into mastering (Technicolor, AAM, XDC), satellite distribution (AccessIT), advertising (AccessIT, Technicolor), alternative content (AAM, AccessIT), software development (AccessIT) and other anciallary services. But the truth is that without VPF deals the third party players are financially doomed and it has everything to do with accounting practices and exist strategy. Here is how.

Take the UK Film Council's Digital Screen Network. This would seem to be a straight forward enough deal. The UKFC has £12m to spend on converting 240 screens. Cinemas apply to join and AAM are hired to carry out the installations and maintain the network. Cinemas that join the DSN apply for funding from the UKFC, pay that money to AAM who install the equipment. AAM then pays the vendors for that equipment. Except that's not how it works. AAM secures a loan with Barclay Capital which pays for the equipment. It then keeps the money from UKFC, paid via the cinemas, making sure that it pays interest on the loan each month. Read the fine print on the contract the cinemas sign with AAM and you will see that the equipment is collateral for the loan and legally belongs to Barclays, at least until the loan is paid off. What it means is that AAM now has a digital cinema network that they effectively run and control (or at least did, until they had to swap out the QuVis servers for Doremi, making it possible for anyone to distribute DCPs and KDMs directly to the cinemas) but more importantly, they have a war chest of around £10m to help fund future digital cinema plans.

It is important to stress that there is nothing illegal or un-ethical about AAM handling it this way. It is all strictly above board. In fact, it is the way that a lot of financial activity works these days. As long as they keep paying off what they owe Barclays everything is fine. I'm not telling you anything that isn't common knowledge in the industry. However, it also means that AAM cannot do anything with the QuVis servers they swapped out - because they belong to Barclays and not AAM! They cannot be sold, rented or dumped into a landfill. My guess is that they are sitting in a warehouse somewhere collecting dust. But the UKFC's DSN is not the standard way for financing digital cinema deployment. And this is where things get REALLY interesting.

Equipment such as digital cinema projectors and servers need to be paid for up front. Manufacturers don't like to be promised a share of VPF for however many years to come. So third party players like AccessIT and AAM do deals with banks and lenders such as GE Capital and RBS, who do similar deals for airplanes, truck fleets and other big capex projects. These deals are under written by the equipment and the VPF deal securing the loan. Over time the VPF deals are used to pay off the loan, with the third party player keeping a slice of the VPF deal above and beyond the additional maintenance costs, which is their profit. But where third party players make things interesting is where they start counting the VPF as income for the company. Not a fee that is used to pay off the equipment cost, but an income.

Your gut reaction will probably be that VPFs are not 'income'. And in one sense you would be correct. They are a time limited fee that distributors have agreed to pay towards the cost of the digital cinema equipment, facilitated by the third party player. But for accounting purposes they can be counted as an income to the company. And the reason for that is that the value of a company is determined in multiples of the annual revenue, as well as how profitable that company is. So if I'm Acme Digital Cinema and I have lots of VPFs passing through my account on paper I am very valuable. Which brings us to the exit strategy.

Leaving aside Technicolor, whose exit strategy is that they don't want to exit the market, Acme Digital Cinema has one of two exit options. The first is to get sold to another company or to float on the stock market. If you are already on the stock market, you want to increase your share value or even move to a better stock market (as AccessIT did when it moved to NASDAQ). When I joined Deluxe people were still speculating and asking me how long before Deluxe bought AccessIT, though most people seem to have accepted by now that Deluxe are sticking with its stated aim of not getting involved in deployment side of digital cinema.

So while mastering, advertising, etc. might provide a small profit to third party players, even put together these anciallary services are too small to increase the perceived value of the company as much as VPF deals do. There is thus no small irony that some of these niche pursuits might be more profitable than skimming off VPF deals, but they are still less interesting to third party players because of how markets work. Of course, any accountant going through the books of Acme Digital Cinema will spot that the VPF deals have a fixed end date. But Acme would argue that by this stage they will have grown the business through other means and be dominant through first move advantage. Prior to Enron and Sarbox accounting practices would have been much less transparent and more suspect.

I for one don't know what AAM or XDC's owners' ultimate goal is. But I suspect that they are not in this for the long haul, by which I mean more than 10 or 20 years. As investors or VCs they want to see a pay-off and an exit. And an exit is best when the company's share price peaks or it is at the height of its perceived value.

There is no reason for cinemas or anyone else to cry foul over this. In fact, cinemas should know this better than most. In the UK most cinemas right now are owned by investment vehicles. The loans that were raised to buy them were secured by real estate deals (ownership or lease of the properties they are in) and a guaranteed income based on content supplied by other companies, primarily blockbusters and advertising. But having a direct VPF deal in place means that the new (perceived) income goes towards increasing the (perceived) value of your investment, rather than someone else's investment in a third party player. Now you see why cinema owners resent the paychecks and share options given to the managers of the third party players get. It is not the VPF itself, of which the third part player will keep relatively little, that matters, but the flow of VPFs through the third party player that counts.

So what can and should the third party players do? Just as with any big infrastructure or IT project, such a computerizing patient records for all hospitals, once a governments decide that it needs doing, it will not do it itself but subcontract that work through open bidding. That's what the UKFC did with the DSN, awarding it not to the company promising to do it cheapest (the funding was fixed) but to the company they thought would do the best job. (And just for the record, I think that they absolutely made the right choice.) Third parties don't like open bidding and would prefer to do deals directly with distributors and cinemas but they may have no option but to go down this rout. And while many companies get rich off government contracts, it also introduces a whole new level of accountability and accounting limitations. It also means installing digital in those pesky and small unprofitable cinemas located in villages far off the beaten track that drive up installation costs and put a damper on profit margins.

Despite all this there is a role and profit for third party players to be had in the digital future. Unfortunately for them it is not what they think or are planning for. Over time, what was AAM's greatest success, i.e. securing the VPF deal, risks becoming an albatross around their neck. As I wrote earlier, the terms of funding digital switch overs in places like Norway (whose example I believe more and more European countries will follow, with variations for funding mechanisms) precludes AAM for implementing its VPF deal there. In contract, XDC are lucky enough (though maybe they themselves don't see it that way) not to have a similar VPF deal in place. Yes, there are many jokes being made about the number of times XDC's business model has switched. But in the Darwinian market place, having flexibility and being able to adjust to changing market conditions is a pre-condition for survival. Sooner or later XDC will get it right, because they have enough funding to keep trying got a long time yet. Staying the course with the VPF model, however, does not allow that sort of flexibility.

So if not third part players, who will profit from the digital switch over? Here I must declare an interest and not just because I always joke that the only people to make money from digital cinema are consultants and conference organizers, but because I had the privilege to work for two of the companies that I believe have steered the right course heading into digital cinema.

Essentially, it is the comapanies that ignore the lure of the VPF and focus on the ancillary services.

This means companies like Unique Digital, whose Norwegian sister company Unique Promotions recently became Unique Cinema Systems, after merging with two of Norway's largest cinema service, installation and consulting companies (check the link and, yes, she really works there, they didn't just get her to pose for the photo in the NOC). As far back as three years ago when I joined Unique we saw the writing on the wall that the future did not lie in selling digital screen advertising servers and a switch was made to supplying software and solutions that fit in around the cinemas and cinema advertisers' needs and worked with whatever digital set up they had in mind.

It also means companies like Deluxe, which stuck to what they do best, though even for them it could end up being a semi-Pyrrhic victory if they end up with a larger slice of a smaller pie for digital compared to 35mm. It means installation companies like Sound Associates, who will be essential to upgrading cinemas to digital and then keeping them supplied with spares and . The winner will thus be relatively small companies that stick to what they know and grow with the exhibition market and its changing needs.

In the California gold rush it was not the prospectors who got rich or built up a long term business, but the companies and men smart enough to sell them pick axes and shovels or even shipped their laundry to Hawaii. The cinemas and distributors know where the gold is and in the great rush to them thar digital hills they won't share this wealth if they can help it. But even if they are to prospect it themselves, they will still need to buy that shovel from someone.

The uncertain future of third party digital cinema funding in Europe

...or How I Stopped Worrying and Learned to Love State-Led Digital Cinema Funding Initiatives.

Having attended a number of national and international conferences and events around Europe there are growing signs that third party middle men are increasingly likely to be sidelined in Europe's digital cinema transition. I realize that this is a pretty strong statement, so here is the evidence that I have come across in as much detail as I can and am allowed to give.

Norway - I keep banging on about this one, I know, but given that they are still the likeliest candidate for being first in switching over all of their cinemas to digital they are well worth watching. With the government having pledged to support 50 per cent of the cost of the conversion, with 15 per cent coming from cinemas, 35 per cent from distributors and no cinema left behind, there is no room in this funding equation for any 3rd party financiers. The funding vehicle will instead be set up by FILM&KINO and in order to qualify, cinemas cannot dip into any other pot of money, be it from Arts Alliance, XDC or anyone else. This goes for municipally owned as much as for private cinemas. So far, so obvious, but what about the rest of the Europe that does not have such a unique cinema structure and big pot of money to spend on them?

Germany - A few weeks ago I attended and spoke on the 'Kino mit Zukunft' (Cinema with future') panel arranged with the FFA. What was interesting was the difference between what was said in public on the panel, which was detailed and interesting, and what people were prepared to tell me off-stage and off the record. Germany has far reaching plans for how to help the cinemas go digital and they are looking to apply the 'Norwegian model' but in reverse. I'm afraid that I can't go into more detail than that at this time, but I hope more will be revealed elsewhere soon.

This is very advanced thinking and the key is that the money is raised through the cinemas with upfront loans to pay for the cap-ex, but it would not involve third party financing. This was largely echoed at the IBC conference where at the D-Cinema Conference Day a presentation was given by Chris Koppelmeier (you can download it other IBC presentation for free as MP3 files here) left no room for third party funders in his overview of the German situation, even if it did not give the most up-to-date status of the plans. Having previously championed the 'Solidarity' model for conversion, it is perhaps no surprise that Germany should follow Norway's lead in planning for a conversion that would by state and exhibitor led, rather than by third parties and financial markets.

Remember too that German is still stinging from the media stock market crash that coincided with the bursting of the dot.com bubble that dragged down a lot of cinema and production companies only a few years ago. They have thus little wish to leave the digital transition to the vagaries of the market.

France - Another interesting presentation at the same IBC session was given by Lionel Bertinet from the CNC. Although he did not go into the level of financial detail and analysis that hid German colleague did, his message was all that more starker. On a slide titles 'The Answers and the role of the government' it stated that "A collective approach is needed." But this was followed by the even stronger statement "There will not be an answer from a third party financier." The means would be an adaptation of CNC public fund, if I understood him correctly. He did concede that pure public financing was not the answer either, but the tone had been set.
I tried to ask him and his German colleague what if any role, in that case, they saw for third party operators, such as those on the panel with him at IBC. The question effectively got swept under the carpet, but when I spoke to him afterwards he conceded that there wouldn't be no role, i.e. there would be some role, for the Arts Alliances, AccessITs and XDCs of this world. But the feeling was that they would not be driving the digitization of Europe. [What that 'other role' will be and the implications that has for third party companies I will get into a later companion post to this one].

UK - It is no small irony that when David Hancock gives his very good presentations of the digital cinema numbers around the world he qualifies the UK's lead by pointing out that it is a 'distorted' market because of public funding underpinning most of the deployments, which are the UK Film Council's Digital Screen Network. Unlike France, the UK is not known for state intervention, particularly when it comes to the film and cinema industry, which it sees as an 'industry' rather than as 'culture'. There was a feeling that now that the DSN is fully deployed and operating very weel, the UKFC had got the snowball rolling and could expect the industry to step in and finish what Pete Buckingham and Steve Perring had started. But that does not appear to be the case.

At the recent meeting of the UK Digital Cinema Group (now taken over by the DCMS from was the DTI) Pete Buckingham spoke ardently and passionately about the need for a digital switch over (DSO), whereby cinemas are migrated to digital much like terrestrial television is being switched to digital in the UK, rather than what he called digital deal making (DDM), whereby this third part operator does a deal with those cinemas and some distributors. Market failures would thus be remedied by a softly-softly public approach and assistance. This is in line with previous ideas that had been floated about the UKFC or a related entity facilitating the switch, much like the the Cinema Buying Group is preparing to do in the UK.

Third parties were already in danger of losing out in the UK because major cinema chains like Odeon-UCI, Vue and others are negotiating directly with distributors about a bilateral VPF deal that would not involve third parties. Given that most UK exhibitor operators are owned by banks or VC it should come as no surprise that they are not keen on other banks or VC getting in on the action.

But let's turn the situation around and look at it from the perspective of the third party companies themselves. Arts Alliance Media are currently top of the class, having announced Europe's first VPF deal at this year's Cinema Expo. But looks closer and talk to industry insiders and this claim-to-fame starts looking distinctly thin. It was set to be announced as far back as ShoWest and being pushed into announcing it with just two Hollywood studios and no exhibitor takers does not look like a position of strength. Remember that Christie/AIX had commitment from three studios within the space of one month and provisional deals with the others before the end of 2005 (yes, it really was two long years ago). I'm sure that AAM will get more distributors on board and sign up cinemas too, but unless they have a Carmike moment, their deal will not impress anyone for long. More importantly, they will have to explain how their 7,000 screen deal holds up on a country-by-country basis when territories start to fall of the road map as government initiatives are unveiled.

What then of AccessIT? Having said on stage several times that they would start international deployment before the end of 2006, they appear now to have changed plans and are focusing on the next 10,000 screens in the North American market instead. Internationally they are selling their software and possibly looking for partnerships, but are not out there signing VPF deals. This is a smart move, in my view. The international market is risky and costly, whereas they have a head start in the US and do well to consolidate this position before DCIP get rolling.

XDC meanwhile have the advantage of already being in Europe. In fact, in lots of European territories. And therein lies part of the problem. The company does not have any one territory where it is particularly strong. It's home market Belgium is out, as Technicolor snatched Kinepolis way from them (more on that later) and while they are big in German speaking territories such as Germany, Switzerland and Austria, this territory is so large that even big numbers do not add up to enough. If you discount Luxembourg XDC lacks critical mass in any given territory and is even getting dragged down somewhat by the e-cinema legacy of Sweden's Folkets Hus 1.3K deployment. XDC has a lot of funding and good will from their investors, so I would not write them off, but they too need some variant of VPF deal to prove that the digital cinema know-how that they have built up can be put to good use. (My sources also tell me that they are having 'issues' with the MPEG/JPEG hybrid server, so I'm sure a lot of focus goes into that at the moment).

Technicolor. More than a year has passed since Technicolor announced it's deal with Kinepolis to convert all of the Belgian exhibitors screens to digital. So far, no VPF deal has been announced and the deployment has been limited to 30-odd Dolby servers. Technicolor also appears to have lost the appetite to announce deals with any other exhibitors until it can sort out Kinepolis. Proud though they might have been to have got Kinepolis on board, I'm sure the Technicolor people recognise now that announcing an exhibitor deal prior to having a VPF deal is putting the carriage before the horse, Unless they want to fund the equipment and installation out of their own pocket, that it. So not only has Technicolor's Kinepolis deal stalled but at IBC word reached me that Denise Hsu, VP Business Development at Technicolor and in charge of the international digital cinema deployment plan has left the company (though if she really has left, then she appears not to have updated her LinkedIn page yet). One of her Technicolor colleagues working with her is said to have left as well. To have the key person responsible for international deployment (see my blog post about her speech at IBC last year) quit before it's even got underway means that she has either got an incredible job offer elsewhere, so good that it is worth giving up being in charge of the single greatest transformation of Technicolor's history, or that she lost faith in the task. Similarly to AccessIT, I'm guessing that Technicolor is focusing on the North American market but they cannot announce that they are walking away or have given up on the Kinepolis deal.

It thus seems that while none of the above companies are drowning, they appear to do little more than treading water in Europe at the moment. In my next post I will look more closely at the role they could still play in the deployment of digital cinema, but why this still spells bad news for them, as well as looking at who will really profit from state-led European digital cinema conversion plans.