It looked like a surefire hit. The producers of Used Guys had signed up Jim Carrey and Ben Stiller, as well as Jay Roach, the director of Austin Powers and Meet the Parents. The film was a futuristic comedy, set in a time when women have taken control and cloned men are bought and sold like secondhand cars; apparently it would have taken a wry look at contemporary gender issues. Millions of dollars had already been spent and sets constructed in Santa Fe, New Mexico. Then, last summer, 20th Century Fox abruptly pulled the plug on the project, leaving the writers and stars in shock. The budget had crept up to $112m (£54m) and the stars, as with most Hollywood projects, had cut lucrative deals for a share of the future revenues. An unnamed Fox executive told the New York Times that the economics had simply made "no sense".
It's a telling story about the current state of Hollywood. On the face of it, the film industry appeared to have a reasonably good year in 2006. The six major studios - Disney, Fox, Paramount, Sony, Universal and Warner - together reported about $36bn in revenue, roughly one-third of which came from their library of films. Cinema attendance was up after a poor 2005, even if there may have been some grumbling in the aisles about the number of sequels and remakes.
But the film industry is not a normal business. According to a recent report that is causing some uncomfortable shuffling in Hollywood, the combined release slate from the major studios last year (132 movies) is expected to lose $1.9bn by the time it has run through the five-year cycle of theatrical release, DVD, pay and free-to-air television, and every other source of income (a film's "ultimates", in movie industry jargon). The Fox decision to pull the plug on Used Guys now looks to have been a rare outbreak of good husbandry.
The report, Do Movies Make Money?, was put together by the Hollywood insider Roger Smith for Global Media Intelligence, part of the Screen Digest research firm, and is being hawked to American investors by the Wall Street bank Merrill Lynch. It will make difficult reading for the bosses of the big corporations that own the film studios.
The report suggests that a combination of spiralling costs (driven in part by the demands of star actors and directors), a sudden slide in DVD sales, and dipping or flattening revenues from television and the box office has left the studios dangerously exposed. The problem has been exacerbated by an influx of cash from outside investors such as hedge funds, which has left the business awash with money over which less and less control is being exercised. The result is a business model that appears to be broken. "The bottom line is that costs have risen in nearly every facet of the business, while revenues are flat or even down in every sector," Smith says. "Making movies has gone from a modestly profitable activity to one that now generates substantial losses."
The report suggests that the release slate for 2006 will go on to earn $23.7bn, down about 4.6% on 2004's releases, while costs have risen to $25.6bn, up 13.2% on 2004.
The problem, reckons Smith, is that Hollywood had gotten used to rising revenues and has become increasingly profligate. He suggests that the years between 1999 and 2004 may turn out to have been a golden age. During that time, DVD sales exploded, audiences flocked back to the cinema, and new pay-television channels appeared in markets around the world. Movies greenlighted during those years were based on assumptions that the upwards trend would continue.
The studios, perhaps not surprisingly, are unwilling to get drawn into public discussions about potential future losses, although some have dismissed Smith's calculations anonymously through the trade press. But even if his sums are not spot on, the trends that Smith highlights are undeniable. "It makes complete sense," says Terry Ilott, director of the Film Business Academy at the Cass Business School in London. "It confirms what quite a few people have thought for a couple of years. Everyone suspected that margins must be under pressure and that profitability must be an issue."
So where is the money going? Arguably the fastest growing costs have been participation and residual deals struck by talent and guilds, which give them a percentage of revenues on top of an upfront fee, and can earn top stars $70m to $100m even when a film fails to make any profit. Many in Tinseltown believe such a deal was behind the very public bust-up between Paramount's parent company, Viacom, and Tom Cruise last year. Cruise was reported to take 20% of the revenue from films he starred in. Participation deals are generally kept secret, but one studio, Disney, helpfully divulges how much it spends on the deals in its financial reports. In 2002, it paid $154m; that rose to $554m in 2006. A back-of-the-envelope calculation suggests to Smith that Hollywood paid out $3bn to its star names last year. If the movies are not necessarily making money for the studios, they are making a lot of money for a few individuals. Analysts compare the amount of money being paid to film stars during the boom years to the sudden influx of TV money that inflated footballers' wages.
Dade Hayes of the trade bible Variety says participation deals have become a cause of concern at the studios. "The star cuts are getting to be gigantic. A lot of projects have broken down because things were going down a track that ended up being too expensive."
In addition, the studios are involved in an arms race in marketing costs. The biggest marketing budget last year was $53.5m for Cars, according to TNS Media Intelligence, followed by $45.5m for Superman Returns. They are also spending more on spectacular special effects. "Can there be any industry other than film that has used digital technology to increase costs?" Smith asks. "Special effects were costly and you used to have two, three or four minutes in a film. Now they have 40-50 minutes of special effects at $2m a minute."
He says movie executives have allowed production budgets to soar, partly for fear of making a wrong decision. "The great fear is the Home Alone fear," he says, referring to the film that made a child star of Macaulay Culkin. "The film was being developed at Warner Brothers on a promise that it would be made for $14m. Well, the director came back and said the budget would be $17m. Warner said no. So he called Fox and said, 'Would you like the picture?' and in 20 minutes they said yes. Well, Home Alone 1, 2 and 3 went on to make an $800m profit contribution for Fox over the next 10 years."
According to the report, almost all of the main revenue streams have ground to a halt in the past two years. Box office takes have fallen by 8% since 2004 in the US and 10% internationally since 2004. American films are losing market share overseas (a record low of 55% in 2006). Revenues from TV are also looking a little wan. The growth in the number of dedicated subscription channels has slowed, while the free-to-air channels have begun showing fewer films in favour of their own programming.
But the biggest concern is DVD - the main engine of growth between 1999 and 2004. In the past two years, DVD revenues dropped by 11%, to $11.1bn. "It is undeniably true that DVD revenue, which had been responsible for the big boom that has happened in the past few years, has plateaued and now gone into decline," says Michael Gubbins of Screen International magazine. "And you can name any number of reasons for that: sticking DVDs on the front of newspapers has devalued them; piracy; but mostly because we have all got DVD players now and the big growth came when we were buying DVD players and replacing our VHS." GMI estimates that DVDs made $8.5bn of profits for the six major studios in 2004. By 2006, those profits had dropped to $6.9bn. The report suggests the fall has been caused by increased marketing costs, pressure from retailers to reduce prices, and, again, the escalating participation and residual deals secured by talent.
The massive increase in production budgets has been supported by the influx of hedge fund cash in the past couple of years. All of the major studios have signed "slate deals", whereby a specified number of films are co-financed by an outside investor. The additional cash has allowed the studios to ratchet everything up. "If a major studio has $100m to spend and then someone comes along and says, 'We will co-fund', then the studio says, 'You give us $75m and we will put in $75m', and it becomes a $150m film," says Ilott. "They think if we have that extra money it becomes more competitive." How successful those deals have been for the hedge funds and other financial institutions remains to be seen, but there have been suggestions in the financial press that some might have had their fingers burned. That could mean the hedge funds either renegotiating deals on better terms, or even walking away from future funding - something that would lead to a dramatic shake-up in the way films are made.
It is not immediately apparent where the revenue to replace slipping DVD sales will come from. It seems unlikely that consumers will pay the same amount for a download. Still, Gubbins thinks the current financial state of play will lead the studios to push more quickly into new forms of media. "I think we will see an acceleration into things like video on demand and downloading your own content. They are small at the moment and they have been ke pt artificially small. No one will risk the existing revenues when they can't yet be sure of new media. But I think that there will be a lot more attention and a lot more of a push to accelerate this new world and to make it happen."
In theory, it should not be too difficult to rein spending back in. There are few fixed costs in film - "You get the same Tom Cruise for $25m as you do for $5m," says Ilott. But the desire to do so must be there. "The studios look at gross, not profit. The kudos is taking $750m or $1bn at the box office. Nobody cares about making a profit for the parent company," Ilott says. "Generating revenue is not difficult. You can have George Clooney and Brad Pitt and make Ocean's 13 - but that doesn't mean you are going to make a profit."
But even if Smith's figures are correct, the studios are not about to go bust. Any losses would be cushioned by the profitable production and distribution of TV programming and the sale of DVDs from the film studios' back catalogues. The studios are also just single divisions of the likes of Time Warner, News Corporation and Viacom. The conglomerates have bought into the idea that the film business is volatile, delivering huge profits one year and losses in another. The corporate board can also be indulgent, says Smith, especially when the studio boss can introduce them to big-shot movie stars.
It will be difficult to work out whether Smith has done his numbers properly. When results are reported, they reflect production and marketing costs incurred in that quarter on current films, offset against revenue from titles that could be one, two or 10 years old. Hayes at Variety says Smith is well respected, but questions his assumptions. "The idea of projecting out the revenue for 2006 - you are extrapolating a lot. You also have to ask, how reliable is studio accounting? He is using studio figures to malign the studios. There is kind of a pretzel logic."
The only studios that win praise in the report for their more disciplined approach to costs are New Line (part of Time Warner) and Fox, the same studio that closed the shutters on Used Guys. "They made Fantastic Four for a mere $100m, which might sound a lot, but you compare that to Spider-Man 3, which cost maybe $300m," Hayes says of Fox. "You do have to applaud their restraint."