Hollywood Meltdown

Why Paramount Had To Buy Dreamworks SKG

December 19, 2005

by Edward Jay Epstein

The Hollywood Economist

The numbers behind the industry.

The true brilliance of Paramount’s high-profile acquisition of Dreamworks SKG last week is that it will serve to divert from, if not totally hide, Paramount’s own failure to assemble a full slate of films for 2006-2007. Compared to the public-relations cost of revealing that managerial meltdown, the $1.6 billion price tag for Dreamworks SKG must have seemed a bargain.

Here is what happened, according to people at Viacom (Paramount’s corporate owner). In 2004, Sumner Redstone faced the prospect of a massive loss, one that would ultimately exceed $24 billion. The loss was not due to Paramount’s blunders but rather the falling values of Viacom’s Infinity radio stations and Blockbuster video stores. Someone other than Redstone, the CEO, or Viacom’s vice chairman Philippe Dauman, however, had to take the blame for the sea of red ink. Why not the heads of the movie division, who had already been criticized for a long string of box-office bombs in 2003? Following this logic, the studio heads Jonathan Dolgen and Sherry Lansing were axed.

The irony of this regime change was that Paramount’s movie division had consistently hit its profit targets. Although its movies had performed badly at the box office, the old regime, under Dolgen’s tutelage, had so perfected the art of the convoluted deal that 75 percent of Paramount’s movies, even those that appeared to be bombs to the outside world, made a profit due to the assiduous use of OPM, a.k.a. Other People’s Money. A term that includes the proceeds from “money for nothing” tax shelters, foreign production subsidies, and foreign pre-sales. Consider Lara Croft: Tomb Raider, for example, the acme of such deal pyramiding. Its budget was reported as $94 million, but, after the enterprising financial arrangements, it actually cost Paramount less than $7 million to make. While the art-of-the-deal formula didn’t always produce award-winning movies, to say the least, the studio under Dolgen and Lansing had a nearly 60 percent return on its invested capital. The disadvantage, for Dolgen and Lansing, is that such legerdemain works best when it’s invisible to outsiders.

Enter the new regime. When Brad Grey took over as studio chief in January 2005, he had a mandate from Redstone and Tom Freston, who now effectively headed Viacom, to totally revamp moviemaking at Paramount. To this end, he brought in McKinsey & Co to consult on the great reorganization. Grey let it be known that he wanted to make money through movies and not off-the-book OPM deals. When a senior executive outlined five off-balance sheet tax driven deals, which would have netted $50 million in bottom line profits, Grey aborted them, explaining to him, “We don’t do things like the old management.” The executive resigned the next day. One by one, Grey and his new management team cancelled almost every project already in process. He also forced out most of the executives who pieced together these deals. As a result, Paramount found itself with almost few viable projects in the pipeline—except for Tom Cruise’s Mission Impossible 3 (which Grey also came close to killing). It’s easy to terminate upcoming movies but it’s extremely time-consuming to package scripts with stars and directors. The studio, with rising overhead and falling morale, faced what one Viacom executive described as “a nuclear meltdown.”

Desperate for a slate of new product, Grey turned to Dreamworks SKG, which had about 30 movies in the pipeline for 2006-2007. The company had also been trying without success to sell itself to NBC-Universal. When Grey started negotiating with David Geffen—the “G” in SKG—Redstone “went ballistic,” as one of his associates put it, over the $1.6 billion price tag for Dreamworks SKG and had Grey pull out of any talks. Then, Spectrum Equities Investors, a private equity firm specializing in media and telecom deals, came to the rescue. It offered to put up about half the $1.6 billion price in return for the cash flow from the Dreamworks SKG’s library assets. This contribution allowed Paramount to justify the remaining $800 million outlay since Dreamworks SKG’s slate of movies in production and in the pipeline would fill the gaping holes in Paramount’s 2006-2007 schedule.

The value of these 31 projects was reckoned to be about $600 million. The remaining $200 or so million could be chalked up to “key money” or the price for getting the right to distribute the films of Dreamworks Animation (a separate company from Dreamworks SKG, headed by Jeffrey Katzenberg, the "K" in SKG)) and a relationship with the celebrated “S” in SKG, Steven Spielberg. However, the distribution fee of 8 percent that Paramount will receive on Dreamworks films is very low, indeed, a quarter of what Hollywood studios usually charge, and Spielberg is already doing Paramount co-productions, including such hits as Minority Report, Saving Private Ryan, and War of the Worlds. This is generous key money, even by Hollywood standards.

After Redstone gave his blessing to the acquisition, Spectrum found it could not accept some of the terms in the deal, such as the lack of the right to cancel Paramount’s contract to distribute the Dreamworks library, and Spectrum (at least temporally) withdrew its offer. Nevertheless, Paramount, assuming other private equity investors would take Spectrum’s place, went ahead with its “coup” (as the New York Times described it.). The offer prevailed because the other contender, NBC-Universal, was not in the same predicament as Paramount. It had a sufficient number of movies in its pipeline so it did not need Dreamworks’ future slate of movies. Bob Wright at Universal, unlike Brad Grey at Paramount, to spend $1.6 billion to buy his way out of looming failure. Because of this asymmetry, Dreamworks was worth much less to Universal, or any other Hollywood studio with a full slate of movies, than it was to Paramount. Indeed, only Paramount could internally justify a $600 million premium for Dreamworks’ pipeline of future movies.

When this deal closes, Paramount will essentially become, at least for the next two years, Dreamworks. Of course, many, if not all, of the people who work at DreamWorks will lose their jobs and the people at Paramount who created the near-meltdown will take credit for the slate of films they’ve acquired. But, as they say, that’s show business.

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