Redesign Business Model of Animation Films

In February 2013, DreamWorks Animation, the maker of highly successful franchises of “Shrek” and “Madagascar”, laid off 350 of its 2,200 employees. The restructuring was driven by disappointing results of Rise of the Guardians, which forced the studio to take $87 Million charge. The shocking news begs the question: what’s wrong with DreamWorks Animation Studio, or what’s wrong with animation film business in general? Animation film business has always been a hit-driven model. What happens when the streak ends and a hit becomes a dud?

Animation film industry has had a great run in the last 20 years. Pixar’s cultural phenomenon Toy Story (1995) marked the arrival of 3D animation. Since then several specialized animation studios have emerged and become dominant players in this space, such as Pixar, DreamWorks Animation, and Blue Sky (Fox). They have created some of the most recognized global brands from Hollywood, such as Toy Story, Shrek, Madagascar, Kung Fu Panda, and Ice Age. Pixar’s unbelievable streak of 13 hits in a row has become the stuff of legend not only in Hollywood, but also in the entire business world.

However, in recent years this once highly lucrative business seems to show some strains in its growth. Pixar’s Cars 2 (2011) was considered by most an artistic failure and Brave (2012) received lukewarm response from critics. Some CG service providers, like Digital Domain, almost went bankruptcy. Then came the news of the DreamWorks Animation’s massive layoff.

An analysis into the two leading animation studios, Pixar and DreamWorks Animation seems to suggest that the true financial return on major animation studios is not as stellar as it seems, once escalating production budget and prolonged development cycle are taken into consideration.

Redesign Animation Movie Studio Model

Exhibit 1 lists all the 13 Pixar movies with their reported production budgets. Since the first Toy Story (1995), which was made with only $30 Million, Pixar has been spending more and more on every subsequent film. The most recent five movies all carry a budget of north of $180 Million. Granted, they are all huge moneymakers, raking in receipts ranging from $500 Million to over $1 Billion (Toy Story 3). The worldwide total box-office numbers are summarized in Appendix 1. If we measure financial return in terms of Gross/Budget, the calculation shows that most Pixar movies had a multiple between 2.8X (Car 2) and 12.1X (Toy Story). Is this good enough? Not really if we keep peeling off the onion. Wikipedia provides some useful information on the development cycle of all the Pixar movies3, which shows that most of them took 4 – 6 years4 to complete (Appendix 1). Given the “investment horizon” and “total return multiple”, we can actually calculate the implied annualized IRR (Internal Rate of Return) for these movies, as indicated on Exhibit 1. The chart shows that the return for more recent Pixar movies are hovering around 25% - 30% on annual basis, and it seems to be on a downward trend lately. Pixar’s earlier movies, though produced with much smaller budgets, actually yielded much higher IRRs. If we use Silicon Valley’s VC investment as a benchmark, IRR of 25-30% is decent, but hardly earth shattering.

Redesign Animation Movie Studio Model

The same analysis on Pixar’s main competitor DreamWorks Animation points to similar trends and interesting facts, as seen on Exhibit 2.

  1. Production budget for major animation films keeps increasing. The most recent 14 movies all carry a price tag of at least $130 Millions.

  2. DreamWorks Animation’s performance is less consistent than Pixar’s. Occasionally it had a super achiever such as Shrek that had 8.1X multiple, but most recent films had multiples roughly between 1.2X and 5.1X.

  3. No wonder DreamWorks is so vulnerable to one movie’s failure – because it doesn’t really make that much extra profit in general. Nowadays major animation movies often require $80-$100 Millions in marketing. After splitting 50-50 with exhibitors, a movie that makes $300 Millions in worldwide gross receipt does not have much left to cover the marketing expense for the producing studio, as in the case of Rise of the Guardians.

Redesign Animation Movie Studio Model

While it’s becoming increasingly more expensive and taking longer to produce high-quality, profitable animation films in Hollywood, an emerging market on the other side of the Pacific Ocean just can’t get enough movies of any kind in general. As Exhibit 3 shows, China’s movie market has been growing explosively in recent years. It just surpassed Japan in 2012 to become the second largest film market behind US with $2.7 Billions in gross box-office. Its annual growth rate in the past four years has been at least 20% and as high as 140%6. During the same time, US’ box-office was trickling up and down around $10 Billions, with at most a nominal grow rate of 6.5% (2012). Global consulting firm E&Y in its Spotlight on China 2012 report predicted that by year 2020 China will overtake US to become the world’s No.1 movie market. My back-of-the-envelop calculation confirms this is not an outlandish claim. Based on 2012 numbers, if we assume China will grow at 25% annually (which is very conservative, considering the recent streak of record-breaking events in China) and US will grow 5% (which could be too optimistic), China’s gross box-office receipt will reach $16.1 Billions in 2020, edging US out of the top position.

Redesign Animation Movie Studio Model

Do we have enough reasons to believe China’s film industry will indeed sustain its current high growth rate? Some further comparison across major movie markets that on key indicators can reasonably justify this assumption. Exhibit 4 compares number of screens per million people. US is leading the world with 126.9 screens per million people; most of the western countries are in the range of 50 – 90; China’s Asian neighbors Japan and South Korea are between 25 – 40. China only has 9.7 screens, less than 10% of US7. While it’s debatable which country is the best benchmark of China, China will probably share a lot more in common with US with its population size, population dispersion, and geography. By US standard, China’s number of screens will have substantial room to scale up in the coming years, which will become a key driver to spur box-office growth.

Redesign Animation Movie Studio Model

Another comparison on admission per capita also supports the growth prospect of China’s movie market. Exhibit 5 shows this statistic across major film markets based on 2011 numbers. China’s admission capita was only 0.54, almost one- tenth of that of US (4.15). As China’s GDP grows, Chinese consumers will shift their focus from basic daily needs (food and housing) to more intellectually and emotionally enlightening activities such as watching movies. The government is also pouring more resources and capital into cultural industries as part of its “12th Five-Year Central Plan”. Therefore it is reasonable to expect Chinese consumers will exhibit similar cinema-watching behaviors as those in US and other western countries in years to come.

However, despite of the rosy outlook of China’s film market, Hollywood’s studios are having a hard time taking full advantage of the situation because foreign-produced films are subject to a quota system that the Chinese government has imposed. Every year only 34 foreign-produced movies can be released into China’s cinemas, and that covers not just US, but also European countries. The 34 movies include all genres like sci-fi, live-action, romantic comedy and drama. Usually only few of them are animation movies. So out of all the animation movies Hollywood has in a year (27, according to IMDB) that are expensively produced and craving for more box- office, only a few most well-known ones can tap into China’s vast market.

Therefore, the problem we have seen at a macro level, is a business model in Hollywood that is too hit-driven, getting too expensive and financially risky; at the same time, China’s fast-growing film market can’t get enough share of good quality animation films from Hollywood.

This situation calls for a creative solution that can turn a traditional hit-driven business model into a growth-driven business model with potential of hits. There are four key elements to this solution, code-named “New Co” for the sake of discussion.

  • First, New Co should make animation feature films with budget of $15 Millions instead of $150 Millions. Exhibit 6 provides breakdowns of a typical production budget for animation films between independent studios (New Co) and established major studios (Pixar, DreamWorks). Most of the production costs goes into animation, which includes art design, modeling, surfacing/texturing, grooming, rigging, etc. If New Co sets up its production/rendering team in China, it will be able to take advantage of the cheaper labor costs there and deliver the same effects with much lower budget.

Redesign Animation Movie Studio Model

  • Second, New Co should shorten the development cycle from the typical 4 – 6 years to 18 – 24 months. Established studios like Pixar and DreamWorks sometimes can get trapped in the perfectionist mentality and become a victim of their own past success. While that seems to be the norm of the industry, I think it is possible to avoid that by creating a new studio like New Co with no such legacy culture but execution-focused disciplines from day one. In the world of artist creation, it can be difficult to balance enhanced artist expression and marginal effort. Having said that, there are certain lessons New Co can learn from the past to embark on a light journey. For example, do not overkill on furs, which consumes way too much design labor and computing power. Also, let good story carry the movie, not the technical representation of the animation. Story should always be the most critical element of any successful movies, including animation ones. A studio culture can be built from day one so that animators don’t get too carried away with the movie’s technical achievement while scriptwriters have a stronger voice in the development process.

  • Third, New Co should aim to do wide-release (over 3,000 cinemas in US) of its movies in both China and US to fully tap into the market potential of these two countries. It can achieve this by setting up legal entity in China and position its China entity as a local studio producer so that its movies will not be subject to the annual quota of 34 foreign movies. At the same time its US entity will work with US distributors to release the same movie. Pleasant Sheep series is currently the most successful animation film franchise in China, even though its production quality and artistic appeal is appalling compared to those from Hollywood. Despite of its low-bar quality, it has been able to pull in impressive box-office numbers ($25 Million) year after year with each sequel, as Exhibit 8 shows. On a cost per minute basis, Pleasant Sheep is only $12 Thousands compared to $1.6 Million of a typical Pixar film, but its profit margin (measured by box-office divided by production cost) is 25X compared to Pixar film’s 3.3X. I believe there is room for New Co to arbitrage between high-end Pixar films and low-end Pleasant Sheep, where New Co can produce a decent quality animation film with only one-tenth of the cost of a Pixar film while enjoying a much higher financial return.

Exhibit 8: Cost, Return, and Production Comparison For Three Tiers of Players

Studio Cost/Minute Budget Boxoffice Margin Creative Team Location Production
Pleasant Sheep $12 K $1 MM $25 MM 25x China China
New Co $166 K $15 MM $150 MM 10x Hollywood China
Pixar Studio $1,666 K $150 MM $500 MM 3.3x Hollywood Hollywood
  • Last but not the least, New Co should assemble a global operation with the best talents from Hollywood and China and enable them to do what they can do best. Hollywood’s creative talents (directors, writers, animators and producers) are still the best in the world and they should still be the driving force of the animation movie production. China’s production quality for CG effects has been rising steadily over the years and there are abundant talents for low-to-mid range art designers and illustrators. China’s computing power, electricity utility, and labor all have significant cost advantages over Hollywood. New Co should leverage the best resources from both China and Hollywood and create a global process that enables open communication and smooth collaboration among branch offices that are geographically dispersed. Such global collaboration is certainly a challenge for any team, but that’s where the industry is going and sooner or later existing players and new entrants all have to adapt to this new way of artistic creation.

Redesign Animation Movie Studio Model

To sum up the proposed solution, by pivoting a new animation film studio like New Co in China for production and Hollywood for creativity, it is possible to turn the traditional hit-driven business model into a growth model with tremendous opportunities of hits. It will be a much more appealing model to the investors and enable animation film makers to develop high-quality films in larger quantity, shorter cycle, and lower budget. It’ll be a multi-win scenario for the market, for the investors, and for the filmmakers. (Exhibit 9 displays the relationships among the major groups of players in this space.)

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