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.