Digital Cinema is coming

There have been some good reports out recently regarding the transition underway to bring movie theatres into the modern age. Both Genuity Capital Markets and Westwind Partners have focussed their respective research teams on the topic of late.

Westwind Partners looks at the space from the Cineplex (CGX.UN:TSX) vantagepoint :

In many respects, the current exhibition of film is a throwback to the old days. Film prints, which cost approximately US$1,500 per print, are transported to each venue, where only two different prints can be stored at any particular screen. In addition to the cost of production and transportation, film prints have a limited life and often need to be replaced during a film’s run. The high cost of prints creates limitations for exhibitors and distributors, as distributors often mandate two-week film runs.

The resulting system has not only created additional costs for film distributors but also, more importantly, it has handcuffed exhibitors from taking advantage of surprises in demand. Because print supplies are near-term fixed, break-out hits often appear in too few theatres while there are “excess” prints of titles that underperform expectations.

The New Digital Age

The movement to digital projection and transmission has been log-jammed with negotiations between the studios and exhibitors over which company would foot the bill. In addition, the security of electronic transmission remains a concern.

While digital offers a superior viewing experience, exhibitors are hesitant to increase ticket pricing with the entertainment market being so competitive. For the few digital venues already operating in North America, empirical evidence shows that consumers are not willing to pay extra for the digital experience. Exhibitors have no means to pass along these costs through premium pricing; therefore, they will not bear the incremental costs. For the studios and distributors, the move to digital was somewhat of a balancing act. On the positive side, the cost savings are significant:

???? Film reels cost about US$1,300–US$1,500 each and approximately 25% of these reels deteriorate during a run and need to be replaced. On a wide-release North American film screening at 3,000 venues (about 1.5 screens per venue), film prints cost about US$7 million per title.

The following concerns offset the reduction in print costs:

???? A number of different proposed technical standards were passed around, hampering the transition to digital, as studios did not want a revival of the Betamax experience.
???? The studios remained concerned about security breaches possibly accelerating piracy.
???? While the cost savings per reel are significant, the capex required to install the new digital projectors is US$70,000 (down from US$120,000 a few years ago), or some $2.6 billion across 37,000 screens in the U.S. alone.

A consortium of studios established JPEG 2 MB as the standard digital format. On the security front, the method of distribution is at the studios’ directive, but most have opted for delivery via an encrypted hard drive as they are not yet fully comfortable with satellite feed delivery systems. With standards established, equipment manufacturers stepped into the void to accelerate digital adoption by offering an equipment financing structure. Christie (a digital projection systems company based in Waterloo) and Access IT (software and transmissions; AIXD-Q, not covered) have crafted a working model that has been rolled out to exhibitors (with a similar but modified model likely to be used by National CineMedia).

Genuity Capital Markets looks at Dalsa’s (DSA:TSX) Digital Cinema business, which is more focussed on the movie set (cameras) than the theatre, of course:

Digital Cinema remains the key unknown for the company, where the path to profitability is hard to see at present. Still, CEO, Dr. Savvas Chamberlain, did throw out a big number for this division – more than US$200 million in five years, with margins better than the average seen in the Imaging division. This seems like a stretch, given that revenues in 2006 were just $1.5 million. The key underpinning belief is that traditional film cameras will be gone in five years in Hollywood, and that we are on the verge of a “hockey stick” for growth in Digital Camera adoption.

In short, DALSA continues to believe that we will soon reach that industry inflection point where the industry switches over to 4k digital cameras en masse. We had a chance to speak with incoming head of Digital Cinema, Rob Hummel, an industry veteran with time at Warner Bros, Sony, and Disney. A few key points emerged from that discussion.

Rob Hummel strongly believes in the quality of DALSA Origin camera, and this was the thing that swayed him to come to DALSA. When he joined, he was surprised at how good the dynamic range of the Origin was. Dynamic range is important in movies in scenes where cinematographers are trying to capture very dark elements and very bright elements simultaneously. For example, on Mel Gibson’s recent film Apocolypto, the digital cameras used could not handle the dynamic range in certain scenes – this made torches appear white in colour.

Things look better when you start in 4k. In seeing 4k films that were projected using both 2k and 4k digital projectors, the image quality is a differentiator. In other words, filming at 4k and then displaying on 2k was much better than filming in 2k and then displaying in 2k. At 4k, the picture quality is as good or better than 70mm film cameras, and is a direct result of the DALSA sensor, which is also featured in the Thomson Viper 2K camera.

Management is very excited about 2007, and is expecting a major production using Origin in H2/07. Rob Hummel’s excitement is important given the need to evangelize this technology in Hollywood, a place where industry contacts are important and film producers are generally very conservative. What makes Rob Hummel so confident that a production is in the works? He has had discussions with executives at studios such as Warner Bros. essentially telling him “when the cameras are ready, let us know.”

Why Origin is not yet ready for prime-time. As we have written about in the past, delivering a 4k camera into the industry is one thing, but having the complementary ecosystem is a completely different matter. Issues such as data storage and post-processing continue to be areas in need of development. Specifically, the post-production environment (provided by companies such as Ascent Media) for 4k films remains a work in progress. Rob Hummel noted that the technical guru who helped iron out problems on the Superman Returns production is very involved with getting the 4k workflow ironed out. The other issue that we believe Rob Hummel will be addressing is the need to “tether” the Origin camera, essentially providing a cable out the back of the camera to mass storage units. While this tether may be more of a psychological impediment for cinematographers, the fact that Origin currently does not support an all-in-one portable configuration is likely something that will need to be addressed.

Reaching a tipping point in F2007? Management continues to push the idea that, once a few productions start to use the Origin camera, then we will see a snowball affect in terms of adoption. This, we believe, remains to be seen, and the NAB show in April will provide us with a somewhat less biased view on this, given the opportunity to speak to post-production people and filmmakers. Once the Origin really takes off, Rob Hummel did note that he will aggressively look to expand the footprint of the device, expanding geographically to areas such as London, New York, and New Delhi (Bollywood), with the potential that they may allow other rental houses to rent out the Origin camera where a facilities investment does not make sense for DALSA.

In summary, we see Digital Cinema as the key overhang to the stock at present, with few tangible milestones or progress points demonstrated to date. We note that DALSA remains firmly committed to this initiative. On a positive note, the hiring of Rob Hummel does seem like a positive development, given his credibility within Hollywood. We do continue to have a few reservations regarding DALSA’s Digital Cinema initiative:

1. 4k tools and 4k workflow are still relatively immature, which would provide huge worries for generally conservative backers of major film productions;

2. Recall that 2k digital film development has benefited through key proponents within the industry – a list that includes Michael Mann (Collateral) and George Lucas (Star Wars) – as of yet, a big-name film producer has yet to back Origin; and,

3. Competition appears to be heating up within the 4k market. While Sony’s 4k camera development is apparently lagging by roughly three years, upstarts such as Red Digital’s $17,500.00 Red camera has currently seen a lot of interest and has booked over 1,500 reservations (each requiring a $1,000.00 deposit) pre-NAB. The low price of this camera (expected mid-2007) may limit DALSA’s ability to rent out the Origin.

In our view, we continue to believe that a lot of heavy lifting will be required before Digital Cinema can even book meaningful revenues, much less turn profitable. At this juncture, more partnerships with companies such as Sony may help to build important industry momentum – something that DALSA has been struggling with to date. In addition, an equity investment by a strategic partner would have the added benefit of assigning a positive market value for its Digital Cinema business – given its uncertain road to profitability, the market value of the Digital Cinema may be negative at present.

Each summary report leaves one with the impression that various firms are getting prepared for the transition to digital, but it is unclear what timeframe the consumer should be counting on.

If you think about HDTV, some analysts would have been putting out reports in 2003 suggesting that mass consumer adoption was right around the corner; and now you can buy a Rogers Cable digital cable box for $50, after store credits.

Perhaps digital cinema will become as omnipresent just as quickly, in an effort to combat the trend to wait for movies to come out on DVD.

MRM