The Business
of Star Wars

A Citadel Conversation

Evan Ericson
Evan Ericson is a Veteran Consumer Analyst for Citadel Global Equities, focusing on Consumer Staples.
Evan Ericson
Stephen Parlett
Stephen Parlett is the Portfolio Manager for the Citadel Global Equities Communications, Media, Entertainment & Internet team.
Stephen Parlett
Joe Pasqualichio
Joe Pasqualichio is a Veteran Media & Entertainment Analyst for Citadel Global Equities.
Joe Pasqualichio
Steven Rosenberg
Steven Rosenberg is a Veteran Internet, Entertainment & Travel Analyst for Citadel Global Equities, focusing on the US & Asia.
Steven Rosenberg
The views expressed in The Citadel Conversation reflect those of the individuals being interviewed. These perspectives are neither endorsed by Citadel nor reflect our view on investments.

The Business
of Star Wars

"What do the markets have to do with my world?” We get this question a lot when touring campuses, and our answer, in a word, is “everything.” Our view is not just that markets touch every part of life, but that every part of life can be a way to find opportunities in markets. In this special edition of “Citadel Conversations,” we lift the veil on how members of our Global Equities team solve investment puzzles, even those that hail from a long time ago, in a galaxy far, far away….

Star Wars has entertained fans for nearly 40 years. What was your first Star Wars experience?
Stephen Parlett: I was 8 when the first Star Wars came out and it was the first time I got to see a movie for “grownups.” After I saw it, I remember trying to convince my parents that I needed every Star Wars t-shirt.
Evan Ericson: I was 12 or 13 when the originals were re-released in theaters. A few years later my friends and I were excited to see the prequels, but like a lot of people, we were pretty disappointed. Let’s just say Jar Jar Binks was not the greatest Star Wars character of all time.
Who is your favorite Star Wars character?
Joe Pasqualichio: Yoda. He would have made a great investor. He's wise, patient, has an extremely long-term outlook — I think he’d be able to find significant alpha!
What sparked your interest in covering entertainment?
Stephen Parlett: These are products and services we all interact with every day as consumers and fans. Of course that creates a risk of bias and it’s important to disassociate the analyst from the fan. Just because you like a movie doesn't mean the company’s stock is a good investment.
Joe Pasqualichio: As a consumer, I evaluate things very differently from how I do as an investor. Like any fan, I have my favorites, but it's important to eliminate your bias. The way you do that is through rigorous analysis of both historical and current data. People’s tastes may vary, but numbers don’t lie.

international Box office Revenues Double in 10 Years While Domestic Box office Stagnates

International vs Domestic Box Office
Few expected the original Star Wars to be a smash. How does Citadel calculate the likelihood of a “hit” and how do you change your models when needed?
Stephen Parlett: Our models are built to be dynamic and flexible. This enables us to make rapid adjustments. In the entertainment industry something can be a hit or a flop. The numbers can change rapidly and our flexibility enables us to react fast.
Steven Rosenberg: We perform a lot of proprietary research and data analysis. For example, we survey thousands of gamers every year to understand consumer trends, test hypotheses and gauge purchase intent.

Unsurprisingly, this year's video game analysis showed strong purchase intent for Star Wars: Battlefront. But if you dig deeper you discover interesting trends about how and where consumers plan to make their purchases. And that impacts gross margins.
Stephen Parlett: Not all revenues are created equal. Our job is to understand the revenue mix, the underlying costs and revenue sharing.
Joe Pasqualichio: Remember that the total revenue from a film includes more than the theatrical release. When a film is created, there is a major fixed cost in production. That production cost will be amortized over the life of the film based on how much it generates at the box office, in the premium TV window, in the basic TV window, consumer products and ancillary revenues.

Attack of the Clones: How Movie Studios use and Reuse intellectual Property

20th Century Fox was almost bankrupt before Star Wars, and then became one of the most successful studios in history. Is the industry today all about the value of intellectual property?
Joe Pasqualichio: The modern film studio is the content-generation engine of the bigger media conglomerates. Everything starts with the studio, whether they are creating something organically or monetizing intellectual property, from TV shows to toys, consumer products and theme parks. Studios look for these synergies that can make a modern media company successful. A good example is how Disney leverages Star Wars intellectual property across its studio, theme parks and consumer products.
How important is the intellectual property that a company owns? Presumably a franchise like Star Wars adds significantly?
Stephen Parlett: What's interesting is that Disney can effectively outbid anybody because they have so much experience in terms of acquiring intellectual property and so many outlets to leverage it. It’s hard to think of other places that can exploit and monetize as well as Disney.
Joe Pasqualichio: One of the things that studios do well is leverage intellectual property in ways that the original owner might not have been able to. So looking at Lucasfilm and the Star Wars franchise, you have more than 17,000 characters in this really rich world that spans over 20,000 years, so you have incredible opportunities to build additional properties. A trend we’re seeing is the development of secondary and tertiary characters into valuable properties, like Marvel’s Guardians of the Galaxy and Ant-Man movies.
Steven Rosenberg: The mobile gaming industry really demonstrates the value of intellectual property. There's a plethora of apps, and it's hard to launch and differentiate a new game and have it be discovered by users. Gaming companies have figured out they can leverage intellectual property to attract users, effectively lowering acquisition cost. A good example is The Simpsons intellectual property. Because it features The Simpsons, it attracts users. That means less need for marketing and greater profit potential.
Increasingly, gaming is an originator of intellectual property that can be leveraged across movies and other media.
It works the other way also: increasingly, gaming is an originator of intellectual property that can be leveraged across movies and other media. Activision | Blizzard is turning World of Warcraft into a movie. Not the most traditional idea at first glance, but gamers spent 12 billion hours playing their games. That’s a huge audience and valuable intellectual property.

The Droids You’re Looking For: Toys, Games and Merchandizing

How do toy and game companies use movie intellectual property, and how correlated are they to movie success?
Evan Ericson: There is fairly consistent demand for Star Wars related toys over time, even outside big movie years. You’ll see a significant lift in a movie year, but there are also collectors and life-long fans who buy products perennially. Other movies tend to drive spikes in toy sales during a release year, but support less consistent demand outside these windows.

The forthcoming Star Wars Trilogy will be released every other year. From a toy manufacturer's perspective, this could eliminate some of the boom/bust of a traditional release. We expect to see a lift in the current year, and then within six months to a year, we expect additional demand as we see hype build for the next movie.
There is a fairly consistent demand for Star Wars toys over time, even outside big movie years.
Joe Pasqualichio: This makes valuing Star Wars different, because if you look at the toy and merchandise data, Disney has made a lot of money off classic Star Wars merchandise. It's one of the most consistent categories other than the Disney Princess line. So while you'll have hits like Frozen or Avengers that add to growth during a particular release or film cycle, it's the classic Star Wars and Disney Princess lines that drive consistent revenues. That impacts valuations.
Are the toy and games manufacturers more dependent on the success of particular movies than the studios?
Steven Rosenberg: Electronic Arts has the rights to create Star Wars video games on PC, console, and mobile for the next 10 years. And it's not just the initial launch of the game – historically, game releases were more of a one-time sale model, but today we see a ‘games as a service’ model to extend customer engagement — games as ongoing networks that are programmed with content.

As we talked about earlier, Star Wars has a very rich canon, thousands of years of content, lots of characters and stories and worlds, all of which can be added to the games as digital downloads or extra content that consumers can get for free or purchase. This expands the monetization life and builds a pipeline of new releases for years to come. It also keeps consumers engaged which lowers customer acquisition cost.

“it’s a Trap!”: Movie Hits and Misses

There’s little doubt that Star Wars: The Force Awakens will be successful. How much impact can a hit movie have on a studio?
Joe Pasqualichio: A box office smash can have a significant positive impact. But it is important to manage expectations, which is exactly what Disney is doing. Everybody believes The Force Awakens is going to be a big hit, but you don't want to get expectations too far ahead of reality.
What about the movies that are big misses? John Carter of Mars was one of the biggest failures in history.
Joe Pasqualichio: There's a saying in Hollywood that “nobody knows nothing.” It’s hard to predict what's going to resonate and what's not. I think a studio would be happy batting .500, but it's important to get the big bets right. John Carter, a film with an approximate budget of $250 million lost around $200 million. Lone Ranger was another big miss.
There’s a saying in Hollywood that nobody knows nothing.
Box office flops happen, but the films that succeed, especially the ones with intellectual property backing them, should be enough to make up for the flops. That’s why you see studios move towards intellectual property and franchise films like Harry Potter, where eight films generated $7.7 billion. Those hits will absorb the John Carters. We’re seeing this ‘blockbuster’ strategy at studios where big ‘tent pole’ films — like Star Wars — generate sufficient profits to cover the misses and make the slate profitable.
Given the success of franchises, why take bets on unestablished movies?
Stephen Parlett: You can’t rest on your laurels. There aren’t enough reliable franchises so you have to take a shot at building new ones. Before Hunger Games we didn't know it would turn out four blockbusters. This industry is just as much art as science.
Joe Pasqualichio: We certainly expect to see more franchise films, more sequels, prequels and spin-offs, but studios will always comb through books and other intellectual property to find the next Star Wars, or Harry Potter.

Financing and the international Markets

Joe, you talked about risk tolerance. Can you expand on how films get financed and how financing has changed?
Joe Pasqualichio: Disney will release nine to 13 films each year across Marvel intellectual property, Lucasfilm intellectual property, Pixar, Disney Animation, Disney Live Action and others. They want to place big bets and take all of the risk and upside.

Other studios want to defray some risk, so they have added slate financing. They will find a partner with capital, but who doesn't necessarily participate in the creative process, to invest in a slate of films. Here’s a great example: Lionsgate has a slate financing deal with Hunan TV in China. However, Lionsgate isn't putting their Hunger Games franchise, Divergent franchise, or Twilight franchise into that slate because they know that those are somewhat guaranteed hits. Warner Brothers, similarly, hasn’t included Harry Potter in their deals.
Do these structures change the way you value studios?
Joe Pasqualichio: Well, there's a tradeoff. Somebody who's going to take on all the risk is likely going to have big swings in volatility. So to the extent that you as an investor have confidence about their success, you would be inclined to invest. On the other hand, if another studio owns many properties with uncertain prospects, you might prefer to see that studio opt for slate financing to smooth out some of the risk.
You mentioned Hunan TV in China. How are international audience trends changing and how does that impact how movies are produced?
Joe Pasqualichio: More than ever, films are being made for an international audience. That trend has really accelerated the past couple of years. The first three Star Wars made about twice as much at the domestic box office as they did internationally. The next trilogy, the ratio shifted to about 1:1. Given this trend, we estimate the next three films to make about twice as much internationally as they make domestically. Look at Transformers. In 2014, Age of Extinction had a ratio of 3.5 international box office revenue to domestic box office revenue led by China. Studios have embraced this and think about how their movies will be received internationally, from the very beginning of production.

Age of Extinction nailed authenticity. They didn't just add a scene in China or a mention of China — they cast a major Chinese actress, Li Bingbing. They found four Chinese citizens to be in the film through a reality competition. They filmed in Hong Kong and Shanghai.

A New Hope: What’s Next For the Movie industry?

What does the future hold for this industry?
Joe Pasqualichio: The industry is going to get more global, more focus on what does the Chinese and Latin American consumer want. A truly global blockbuster requires high production value, very recognizable intellectual property, and a plot that appeals to the entire globe.
Stephen Parlett: We’re studying the rapidly shifting landscape for content consumption – what consumers are willing to pay for, what they're not willing to pay for, and when and where they are watching. From an investment perspective, we are looking for companies and management teams that can adapt to rapid change. Adaptability and willingness to rethink old business models – those are pretty good features of any management team, in any industry.

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