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November 21, 2007

Holiday DVD Sales Could Disappoint Investors

A significant risk for fourth-quarter earnings for the major entertainment conglomerates is an extremely crowded DVD release schedule. The risk is heightened by generally weak DVD sales for the past 18 months.

Early indications from the launch of several blockbuster movie titles are not promising, so investors should keep an eye on Disney (DIS) , DreamWorks Animation (DWA) , News Corp. (NWS) , Time Warner (TWX) and Viacom (VIA) for possible trouble.

DVD sales are critically important to the major movie studios. I have seen several analyst models in which the operating margin on DVD revenue is projected at more than 40%. Even for companies the size of Disney or Time Warner, the numbers are meaningful.

For example, a title such as Ratatouille might sell 25 million DVDs worldwide in its first release. At a wholesale price of $15, total revenue could be $375 million, and operating income could be north of $150 million. During the December quarter alone, Disney might sell 18 million units, generating operating income of over $100 million, which represents over 5% of projected operating income for the quarter.

During this holiday season, there are 16 movie titles set for DVD release that grossed over $100 million at the domestic box office. Several mega hits are for sale, including Ratatouille, Pirates 3, Shrek 3, Transformers, Spiderman 3 and Harry Potter 5. Crowding out is a definite risk, but it would not be so worrisome if DVD sales as a category were not already weak. According to Jessica Reif of Merrill Lynch, year-to-date DVD sales are down midsingle digits, the second consecutive year of flat to negative growth.

DVD sales peaked in 2005-2006 as penetration of DVD players into U.S. households reached saturation. For many years, DVD sales boomed, riding the wave of more players in more homes and the building of personal DVD libraries. A huge number of releases, including TV shows and movie catalogues, also boosted consumer interest and demand.

Growth ground to a halt as penetration of DVD players rose and early adopters finished building their initial libraries. Late adopters of DVD players naturally bought fewer DVDs. Adding to current sluggish sales trends is confusion over next-generation DVD technology (HD or Blu-ray) and initial developments in digital downloads.

Several Web sites track DVD sales and releases, including the-numbers.com and BoxOfficeMojo.com. According to sales data from early holiday season releases, the outlook for the rest of the quarter looks mixed.

Transformers (Viacom) got things off to a good start, selling over 8 million units so far, including a debut week of more than 5 million. Sales were not nearly so strong for Spider-Man 3 (Sony) or Shrek 3 (DreamWorks Animation). Spider-Man sold 2.4 million in its opening week and is at 3.4 million after two weeks in release. Ratatouille was the next major release, and it sold over 3.8 million units in its first week, a level variously described in trade publications as "very strong" and "as expected."

Shrek 3 was just released last week, so early sales have not been formally reported, but according to an article on VideoBusiness.com, sales are close to the Spider-Man level. This would translate to a disappointing quarter unless sales pick up considerably, given analyst estimates for 15 million to 20 million units.

Here is a brief look at the outlook for major studios this holiday season. Keep in mind that the holiday season is just starting, so it might be early to draw conclusions. Nonetheless, there is reason to be nervous based on early trends....

....Disney has three key films: Ratatouille, Pirates 3 and High School Musical 2. As mentioned, Ratatouille appears to be off to a good start in the U.S., but keep in mind that an unusually high two-thirds of the worldwide box office will have been generated overseas. High School Musical 2 is unlikely to have problems, so keep an eye on Pirates 3, especially in light of sluggish sales so far for the other $300 million grossing "threequels" released in May.

DreamWorks Animation has everything riding on Shrek 3. Initial indications of first-week sales are disappointing. With Bee Movie tracking well below most box-office estimates, it is not surprising that DWA shares have fallen 15% this month and are trading close to their August low.

News Corp. released Live Free or Die Hard this week, but the big action will come the week before Christmas when The Simpsons Movie goes on sale. The Dec. 18 release date positions the film as the perfect last-minute shopping gift. It is sure to get prime shelf space and plenty of advertising support, because the other blockbusters will have been in stores for one to six weeks.

Time Warner has already had a good year in home video thanks to 300, which sold over 8 million, and Happy Feet, with over 9 million units. The big holiday release is Harry Potter 5 on Dec. 11. For an upside, keep an eye on Hairspray, due in stores on Dec. 11. The film is getting a big push for a Best Picture nomination, it performed well in theaters, and its status as a remake of a popular musical gives it a built-in audience.

Viacom is already in good shape for the December quarter thanks to Transformers, which kicked off the DVD selling season in late October and has sold over 8 million units so far.

Posted by Steve Birenberg at November 21, 2007 12:22 PM in Media