Making Money in the Post-Production Services Industry

And Action! Making Money in the Post-Production Services Industry As commercial film production budgets continue to shrink, visual effects and 2D-to-3D conversion services are poised to become potential stars.

And Action! Making Money in the Post-Production Services Industry 1 Since late 2012, there has been one question on the lips of investors and managers in the post- production services industry: If the visual effects (VFX) giant behindTitanic —one of the most successful commercial films of all time—and many other blockbusters can sink, how can other VFX companies stay afloat? Titanic’s success was largely a result of its stunning visual effects but last September, just 10 months after going public, the film’s VFX creator, Digital Domain, filed for bankruptcy. The question of which VFX company might be next to collapse looms larger in the wake of Walt Disney’s recent acquisition of Industrial Light & Magic—arguably the biggest name in visual effects given its George Lucas heritage—and the more recent bankruptcy of Rhythm & Hues of Life of Pi fame.

The post-production services industry is at an interesting juncture. Driven by the squeeze in film production budgets in the United States, it has long faced low margins, slow growth, and operational complexity. Traditional post-production services such as audio and video editing, sound recording, and telecine have stagnated, causing overall market growth to stall in the low single digits (see figure 1).

Figure Growth is expected to remain sluggish for the post-production industry

U.S. post-production growth by services CAGR ( billion) +. % - . . +% . ~% . . . . . . . . . . . . . ~% . . . . .

. . . . . . . ~%

e e e e

D-to-D conversion Visual eects Other post-production services

Figures may not resolve due to rounding. Sources: IBISWorld, Motion Picture Association of America, Box Oice Mojo; A.T. Kearney analysis

In the past few years, however, the industry has been thrown two lifelines: VFX and 2D-to-3D conversion. While the overall U.S. post-production industry is expected to grow only slightly (about 3.5 percent) from its current $6.4 billion to $7.1 billion by 2015, VFX and 2D-to-3D conversion services are poised to gain momentum, albeit with some challenges (see sidebar: VFX and 3D: Making the Cut on page 4).

Investors, movie production houses, service providers, and other post-production stakeholders would be wise to pay attention to VFX and 2D-to-3D conversion as services that could make or break their fortunes. In this paper, we explore the challenges and opportunities for these conversion services from an investment and management perspective and discuss the success factors that will define each service’s future market leaders, or failures.

And Action! Making Money in the Post-Production Services Industry 2 The Special Character of Visual Effects Services Visual effects services encompass all processes involved in creating and manipulating visual imagery apart from shooting the film. The VFX industry has witnessed considerable growth in the last few years, spurred primarily by two factors: Audiences are welcoming movies of genres that have traditionally been VFX-heavy, such as action and adventure, and there has been a rise of VFX in movie types that traditionally have not been heavy on VFX, no doubt a result of production houses seeking to reduce costs.

More movie budget dollars are being allocated to VFX, which now garners 30 to 35 percent of production spending for the top 50 movies compared to about 25 percent four years ago. And the investment is paying off. High-quality VFX techniques have helped films such asThe Dark Knight and Alice in Wonderland become box-office hits (see figure 2).

Figure Top box-oice performers are traditionally heavy on visual eects

Global box-oice collections Performance of VFX-heavy ilms ( billion)

# Harry Potter and the # Transformers Deathly Hallows Part . billion % Other . billion % % Drama # Alice in Wonderland # Harry Potter and the % Thriller, suspense, billion Deathly Hallows Part % horror million % % Comedy # Avatar # Harry Potter and the % . billion Half-Blood Prince million

% Action Accounts for # The Dark Knight # Indiana Jones and the % more than billion Kingdom of the Crystal Skull percent million of global box-oice collections % Adventure # Pirates of the Caribbean: # Harry Potter and the % At World’s End Order of the Phoenix million million

Notes: VFX is visual eects. Rank based on global box-oice collections. Sources: Box Oice Mojo, the-numbers.com, Internet Movie Database; A.T. Kearney analysis

However, not all is rosy for the VFX industry. The same production budget restrictions that are bringing in more work are also resulting in significant price pressures and, consequently, lower margins. The VFX industry remains fragmented with more than 500 firms vying for a share of the pie. The industry is likely to remain fragmented despite intermittent consolidations because of low entry barriers and VFX artists’ preference for working in small teams alongside people with whom they have already done business.

And Action! Making Money in the Post-Production Services Industry 3 There is a clear segmentation among players, with the top five getting more than 50 percent of the work and the others competing aggressively on price and relationships. The middle tier studios largely play either supporting roles on large projects or important roles on smaller projects, drawing mainly from their specialized libraries; the bottom tier players work out of the “garage” focusing on low-budget films.

The leaders, thanks to strong connections and established capabilities, collaborated on more than 65 percent of the top 25 VFX-heavy movies between 2009 and 2011. For example, Industrial Light & Magic contributed to Pirates of the Caribbean, Technicolor brought to life both Harry Potter and Avatar, Double Negative was hired for 2012, Digital Domain worked on Transformers, and Weta Digital helped create X-Men.

In the middle tier, 15 to 20 companies typically specialize in select characters or scenes (for example, explosion scenes, animal sequences, credit sequences) and are sought by the major and mini-major film studios for their libraries. They also play supporting roles on large projects: Rhythm & Hues collaborated on The Wolf Man, Framestore worked on Prince of Persia, and Imageworks’ credits include Green Lantern.

The bottom tier is made up of more than 500 small firms, many with fewer than 10 employees. They focus on shorter projects and low-budget films, primarily from independent studios.

VFX and 3D: Making the Cut

Despite the substantial growth ing to enter the market and eat experience curve for 3D con- of visual effects in movies, VFX into the top players’ market share version, and offer reliable houses are feeling significant will need to build strong relation- delivery skills in terms of cost, margin pressures because of a ships with production houses, time, and quality. squeeze on movie production show significant progress in the budgets. The highly fragmented nature of the industry, while challenging, is likely to open up Figure interesting opportunities for The D market is expected to grow signiicantly both the top and lower-rung players. Cutting down on cost, primarily by developing an Number of D ilms produced in the United States offshoring model with a robust - pipeline, will be essential for Potential upside capitalizing on the opportunities. - Library conversions Other areas to explore include + % - New releases talent management, consultative services, and innovative cost- reduction avenues. Unlike past, short-lived 3D - trends, the current popularity of 3D movies seems to be here to stay. The continued release of new movies in 3D and the conversion of older movies to e Market potential 3D will spur the demand for 2D-to-3D conversion services Sources: Motion Picture Association of America, Internet Movie Database, industry experts; (see figure). New players seek- A.T. Kearney analysis

And Action! Making Money in the Post-Production Services Industry 4 Many also provide support to the top players, but infrequently, such as Mr. X (The Thing and Silent Hill) and Animal Logic (Planet of the Apes).

Breaking into the top tier is difficult, not only because these players have strong relationships with the major studios but also because they have a reputation for high-quality output, pushing breakthrough innovation in VFX techniques and creating movies with the industry’s most sophisticated visual effects.

Four strategies can help others rise to the top:

Offer specialized or low-cost services.Pricing pressure from customers and hyper- competition in the industry are likely to make surviving in this market difficult. Underestimating this challenge could be a mistake, as exemplified by the recent demise of Digital Domain. Forward-thinking players, especially the smaller ones, will focus on providing services that are either specialized (such as animatronics, specific animal libraries, or superior animation of hair) or low cost.

Consider offshoring.The focus on cost cutting, especially in the largest cost bucket of labor, is likely to intensify. Many players, including The Moving Picture Company (and indeed, the now-defunct Rhythm & Hues), have already tried to offshore work to countries where either labor is low cost, such as India and China, or tax incentives are high, such as Canada, the United Kingdom, Australia, and New Zealand (see figure 3). However, to reap all the benefits of offshoring, players will have to first ensure timely delivery and quality, something that has gone largely unaddressed but could be improved by taking a page from the IT industry, which has mastered the art of distributed delivery.

And Action! Making Money in the Post-Production Services Industry 5 Focus on innovative and consultative selling. Business-to-business consultative selling (engaging with studios from the early storyboarding stages to improve quality and “stickiness” of output) and innovative pricing and usage models for technology (balancing the need to stay up to date with managing capital expenditures) will become priority focus areas for VFX firms. Another crucial area will be talent management—finding innovative ways to engage talent and eliminate churn, such as revenue and ownership-sharing agreements.

Contemplate structural solutions, such as consolidation and equipment sharing. Consolidation becomes a viable option as smaller players find it difficult to compete, and equipment sharing is a possibility now that the major players all use similar technologies and platforms.

2D-to-3D Conversion Gains Converts Although 3D films first became popular in the 1950s, never before have they been produced on such a large scale (see figure 4). And while there have been similar growth spurts in the past, the current trend appears to be the deepest and most sustained acceptance of 3D content, due to the following factors.1

• More support from exhibitors. Exhibitors have been willing to invest—something that was a big point of contention in the past.

• More interest from directors and industry stakeholders. Big-budget blockbusters are being launched in 3D, including The Avengers, John Carter, The Amazing Spider-Man, and The Hobbit.

Figure The evolution of D ilms in the United States

Number of D movies

• More 3D ilms are launched post-war • 3D movies have color stereoscopic • Digitization simpliies ile distribution features and stereo sound • 2D-to-3D conversion is now possible • 3D movie screens and 3D TVs proliferate • Many 3D blockbusters are released

• Single-strip format arrives • Interest in 3D rises • IMAX and Disney improve 3D rendition to reduce eye fatigue • First 3D ilm in color appears

• The Great Depression • 3D ilms are low quality • 3D television via 3D glasses and World War II mean • Technology is a constraint fails to excite viewers less technology is used • Few exhibitors will invest in projectors • Most 3D ilms are low- or for movies mid-budget • Audience interest is unknown

Sources: Box Oice Mojo, Internet Movie Database; A.T. Kearney analysis

1 Source: Motion Picture Association of America

And Action! Making Money in the Post-Production Services Industry 6 • More interest in digitization. Digital file distribution and digital post-processing have helped 2D-to-3D conversion.

• More global demand. Admissions to 3D movies rose from 109 million in 2009 to 199 million in the United States in 2010. Although demand seems to have plateaued in the United States, 3D movies are becoming more popular in other countries. For example, China is becoming a substantial market for 3D films, rising from more than 20 million admissions in 2010 to about 64 million in 2011. In fact, the country contributed more than half of the total first-week non-U.S. box-office collections forTitanic in 3D.

• More 3D screens. In 2009, there were only 9,000 3D screens globally. Today, there are 43,000, pushing this format’s share of total theater screens from 7 percent to 35 percent.

• More 3D TVs. In 2010, there were just 1 million 3D televisions in the United States. That number has risen to 10 million and is expected to reach 30 million by 2015. The 2D-to-3D conversion market is likely to grow into a $300 million market by 2015.

Each year, about 100 movies have a budget of more than $30 million, out of which most are action and adventure films that can be released in 3D. However, there are constraints on the number of weeks available for exhibition. We expect more 3D movies on the horizon, rising from about 40 in 2012 to more than 65 per year over the next three to four years. Most are likely to be action and adventure, but animated movies will also make up a large portion, because the 3-to-17 age group is the largest 3D-viewing audience and this genre is comparatively easy to make in 3D. Adding to the total will be about a dozen 2D films re-released in 3D. Overall, we expect to see one 3D film released per week, with about five to ten extra released throughout the year, during peak moviegoing seasons.

Can purists spoil the party?

One post-production service that should get a boost from this 3D trend is 2D-to-3D conversion. Re-released 2D blockbusters in 3D format have been generating substantial returns for production houses.

As an alternative to native 3D shooting, conversion has found both dedicated followers and zealous critics. While some “purists” prefer shooting in 3D and believe that conversion is not up to the industry’s quality standards, pragmatists see the conversion’s benefits, including lower production costs and greater flexibility for visual representation and ease of implementation. Pragmatists also cite the inflexibility of currently available 3D rigs as a reason to shun native 3D. That said, animated movies are usually natively rendered in 3D. This rendering technology has been available with the major studios for some years now, and they seem to have honed it to perfection.

The pragmatists seem to be gaining ground. In 2011, for example, most 3D live-action releases were converted rather than natively shot, including The Green Hornet, Harry Potter and the Deathly Hallows: Part 2, Captain America, and Conan the Barbarian. It seems that 2D-to-3D

And Action! Making Money in the Post-Production Services Industry 7 conversion is here to stay, so the question among producers will not be whether to convert, but how much to convert. Even now, a natively shot 3D movie typically has about 30 to 50 percent converted content. However, as technology advances and better shooting rigs become available, the ball could fall on either side of the fence. We believe that the 2D-to-3D conversion market is likely to grow and become a $300 million market by 2015.

This growth could be much higher if 3D can penetrate the small screen—a development that appears to be a few years away. For viewers, 3D television has one particular drawback: the need for special glasses. Several manufacturers are working toward solving this problem. Toshiba launched a television in 2012 that does not require glasses, and Apple, Dolby, and MIT Media Lab are developing glasses-free 3D display screens. However, this new technology might give some viewers sticker shock as the cost can be high. Clearing these hurdles could spark explosive growth.

For existing business models, success will depend on strong relationships with movie studios, specific capabilities, and efficient workload distribution and integration management.

Additional growth drivers for the conversion market will become fairly important for sustaining audience interest in 3D. These include the potential to use the conversion experience to automate the process for cost and time advantages and a greater interest on the part of directors in including 3D as a storytelling tool rather than just a delivery medium.

What it will take to win

Unlike the fragmented VFX market, 2D-to-3D conversion is concentrated among five major players: Gener8, Legend3D, Prime Focus, Rocket Science, and Stereo D. Each had the foresight to spot the 3D opportunity early and consolidate its positions. Their strengths lie in their positions on the experience curve, including people skills, pipeline management, and strong relationships with the major studios. However, a squeeze in other areas of post-production could inspire more players to enter the conversion market, especially if the 3D trend expands to the small screen.

The key to entering this market will be an ability to forge relationships with the major production studios while being able to compete with the established competitors on price and skill. Similar to VFX, players that can offshore effectively are more likely to succeed because 2D-to-3D conversion is labor intensive. For example, it is estimated that converting Titanic to 3D took a staggering 750,000 hours. Most of the major conversion firms have already established an offshore presence and have developed an efficient system of pipeline management to ensure timely delivery. This gives the existing conversion firms a significant advantage. Other post-production players will need to act quickly if they are to capitalize on the expected market growth.

And Action! Making Money in the Post-Production Services Industry 8 Shooting for Success Although the post-production industry seems to have stagnated, VFX and 2D-to-3D conversion services are poised for growth. While VFX is expected to be one of the fastest post-production growth services, it is also a hypercompetitive market, where existing business models are unlikely to remain profitable. Success will depend more and more on strong relationships with movie studios, specific capabilities (and associated libraries of special effects), and efficient pipeline (workload distribution and integration) management to drive right shoring. The VFX industry landscape is likely to become somewhat polarized: VFX houses with strong relationships will be able to charge a premium and become co-creators of content, investing in R&D and innovation. Players with low-cost delivery or specific capabilities are likely to play the consolidation game, investing more in driving scale, and securing additional businesses and expansion or standardization of capabilities.

Relatively new, 2D-to-3D conversion services are capitalizing on the increasing demand for 3D content (dominated by the action and adventure genres), but the future is uncertain. The future of 2D-to-3D conversion depends on audiences’ interest in 3D and on the outcome of the intense debate between native 3D shooting versus 2D-to-3D conversion. The 2D-to-3D conversion market has currently been captured by five players, with other post-production players waiting on the fence and considering market entry. It will be crucial for incumbents and their investors to make the right investments in 3D conversion and maintain share, while challengers will do best to leverage existing VFX relationships with studios, especially on parts of films where they are already providing VFX.

Players that build up their capabilities in the next two- to three-year period are most likely to gain a larger share of the action over the long haul.

Authors

Debashish Mukherjee, Gaurav Gupta, partner, New Delhi partner, New Delhi [email protected] [email protected]

Rahul Bhasin, principal, Mumbai Pranjal Kumar, consultant, New Delhi [email protected] [email protected]

The authors wish to thank Sohil Bhagat for his valuable contributions to this paper.

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