The Fatal Allure of the Sexy Business

The tech site Engadget directed me to this article on Visual FX and CGI as a "must-read".  What I found was one of the odder economics and business hypotheses I have encountered lately.

The article begins by relating that VFX and digital effects specialty houses all lose money, even when they are providing effects for wildly profitable movies (e.g. Avengers) and purports to explain why this should be.  The author believes that this is a result of Hollywood purposely criticizing the artistry of VFX movies as a way to keep returns in the VFX companies down (and thus increase the returns of film producers).

As the debate surrounding what visual effects are worth rages on, it is clear that the studios themselves have an interest in perpetuating the myth that VFX are the product of clinical assembly lines and the results are equally lifeless and mechanical. Blaming computers for the dumbing down of movies has become a journalistic trope that is bandied about to squeeze the one part of the Hollywood machine that has no union or organizational skill to push back. The right hand asserts they are something not worth paying top dollar for, while the left lines up an interminable roster of VFX-based box office juggernauts for the foreseeable future.

The author goes so far as to say that Avatar was denied the best picture Oscar specifically to support the anti-VFX sentiment and keep returns of VFX companies down (emphasis added).

In 2010, James Cameron’s Avatar became the highest grossing film of all time just 41 days after its release, raking in an incredible $2.7 billion by the end of its run. Weta Digital, the VFX studio that created the majority of the visual effects, along with Lightstorm Entertainment, invested years in developing the tools and talent necessary to create Cameron’s almost entirely computer generated vision, with the cost of making the film rumored to be upwards of $500 million. Cameron had promised to show the world what visual effects could do and he succeeded. The results were universally lauded as visually stunning and unparalleled.

Yet, rather famously, the film and Cameron were snubbed that year at the Academy Awards, both for Best Picture and Best Director. The blame was laid at the feet of the critical success of The Hurt Locker. However, awarding Avatar the Academy’s highest honor would have been acknowledging visual effects as not only lucrative, but high art as well, worthy of its astronomical price tag. And that was a bargaining chip Hollywood was unwilling to concede to an industry it continues to hold hostage with threats of outsourcing to unskilled laborers around the globe.

This hypothesis seems outlandish, and in fact the author never really provides any evidence whatsoever for her hypothesis.   At least equally likely is that Hollywood insiders are snobbish and conservative and reject new approaches to film-making in a way that the public does not.  Or it could be that Avatar wasn't a very good movie (go try to watch it again today, you will be surprised what a yawner it is).  So why are VFX companies really losing money on profitable films?   Let's take a step back, because there is a useful business lesson buried in here somewhere.  I think.

This discussion is a sub-set of an age-old business problem -- how do rents in a supply chain get divided up?   Think of the billion plus dollars the new Avengers movie will make.  Everyone in the supply chain for making that movie, from the actors to the caterers to the VFX houses to the distribution companies believe their contribution has immense value, and that they should be getting a solid cut of the profits.  But profits in a supply chain are not divided up based on some third party assessing value, they are divided up by negotiation.  And the results of that negotiation depend on a lot of factors -- the number of competitors, the uniqueness of the service, regulatory rules, etc.  The most visible example of this sort of negotiation we see frequently in the news is in sports, where players and team owners are explicitly negotiating the division of the end revenue pie between themselves.

If we return to the article, the author actually gives us a hint of the true dynamic that is likely bringing down VFX profits.

The international subsidies-driven business model under which VFX companies operate has been well documented. In pursuit of tax rebates offered by various governments to produce films in their jurisdiction, studios insist that VFX companies open branches in these locations or reduce their bids by the amount of the subsidy in question. Even as studios, directors, and audiences demand the latest in cutting edge technology, VFX houses must underbid one another to get the work and many have been shuttered due to operational losses in the wake of explosive blockbuster budgets. The cost of research and development, shrinking schedules, and the unlimited changes that are the building blocks of every tentpole film, are shouldered entirely by VFX houses.

This is the best clue we get to the real problem.  Here is what I infer from this paragraph:

  1. This is a high fixed cost industry.  There are enormous up-front investments in research into new techniques and large investments in the latest technology, which presumably must be constantly refreshed because it has a short half-life before it is out of date.  The situation is worsened by government policy, which provides incentives for VFX companies to build extra capacity in multiple countries, losing economy of scale benefits from large concentrated production facilities.    One would presume from this that these companies' marginal cost of output, say 15 seconds of finished effects, is way way below their total costs.
  2. There is rivalry among VFX companies that seem to have excess capacity, such that bidding for work is very aggressive.  In such situations (think American railroads in the late 19th century) competitors lower prices down to marginal cost to keep their capacity and their trained people working.  Over time, of course, this leads to numerous bankruptices

I will add a third point which the author fails to cover.  To do so I will return to one of my favorite things I learned at Harvard Business School (HBS).  At HBS, in the first two days of strategy class, we studied two very different business cases.  The first was of a water meter manufacturer, a dead boring predictable unsexy business.  The second was a semiconductor company, which was hip and cool and really sexy.  It turned out that the water meter company coined money.  The semiconductor business was in and out of bankruptcy.

Why?  Well the water meter company had limited investment (made the same meters the same way for decades) and made most of its money off the replacement market, where it had no competitors since users pretty much had to replace with the same meter.  The semiconductor business had numerous shifting competitors and was constantly trying to scrape up enough investment money to keep up with shifting technology.  But there was one more difference.  By being sexy, tons of people wanted to be in the semiconductor business. They got non-monetary benefits from being in it (ie it was cool and interesting).  When there is an industry where lots of people are getting into the business for reasons other than making money, look out!  The profits are probably going to be terrible.   This is why most restaurants fail.  The business-for-sale listings are awash in brew pubs.   The aviation industry was like this for years, and I would argue this also suppresses rents in farming.

I don't know this for a fact, but I would bet that the VFX industry attracts a lot of people because it is sexy.  Yes, like a lot of programming, the actual work is detailed and dull.  But if the coding is detailed and dull, would you rather be doing it for Exxon's new back-office system or to put Ironman on the big screen (and have your name deep into the film credits, seen by the dozen or so people who hang around waiting for the Marvel Easter egg at the end)?

This is why I think a conspiracy theory to believe Hollywood is dissing the artistry of VFX movies as a way to keep VFX company rents down is silly.  It is totally unnecessary to explain the bad rents.  Had you told me it was a high investment business with huge fixed costs and much lower marginal costs and alot of rivalry driven by participants who piled into the business because it was sexy, I would have told you to stop right there and I could have immediately predicted poor returns and bankruptcies.

So what can VFX companies do?  I have no idea.  The first idea I would offer them is branding.  If you are buried deep in the supply chain and want to increase your bargaining power, one way to do it is to develop a brand with the end consumer.   If consumers suddenly latch on to, say, the CoyoteFX brand as being innovative or better in some way, such that they might be more likely to go to a movie with CoyoteFX sequences, then CoyoteFX now has a LOT more power in negotiations with producers.  Dolby Sound is a great example -- you probably don't even know what it is but movies used to advertise they had it.  Certain camera technologies like Panavision are another, where movies actually sold themselves in part on the features of one member of their supply chain.  As a digital house, Pixar effectively did this -- so well in fact its brand actually was bigger than Disney's (its distributor) for a while, and Disney was forced to buy them.  This does not happen just in movies.  I just bought a car that advertised it had a premium Bose sound system.  The car maker doesn't advertise who made, say, the fuel tanks, so my guess is that Bose, via branding, gets a better cut of the supply chain than does the fuel tank maker.

  • Richard Harrington

    I got my start in software 35 years ago at the third-largest VFX (it was just Computer Animation back) then companies. I was really surprised when this company bought out #'s 1 and 2. However, I wasn't surprised when this new conglomeration then went bankrupt.

    Computer animation is fun... Lots of really smart people like doing the work. And, guess what, that leads to over-supply.

    I think this industry is just a very large, lifestyle/hobby right now and probably won't make much money as long as the competition is there.

  • Daniel Barger

    With regards to the economies , profits and bankruptcies of such companies.....who cares. They do not provide anything
    that society needs therefore their success or failure, while relevant to investors, has no bearing on the daily life of 99% of
    America. If they choose to undercut each other to the point of failure so what. Another company will show up to pick up
    the slack and movie goers will never see even a hiccup in the number of films being produced.

    When these types of choices involve products and services that people rely on to survive then people will take notice.
    Usually this results in the hue and cry of 'something must be done', then politicians take notice. At that point the companies involved are doomed with a certainty.

  • drobviousso

    The reason animation houses are getting paid peanuts is because there's a reserve army of labor out there willing to do it at a price that's a nice, middle class income in south east Asia aka starvation wages in LA. And there are more workers flooding into the market every day. Everything else is just window dressing. There are a few places in US and Canada doing cutting edge R&D, and they make good fees because there are only a small sliver of people able to do that R&D. For the basic grunt work - rotoscoping and applying understood techniques - there's no real advantage to having that done in the US or Canada. All the data flies over our series of tubes, and the skills are all artistic, not technical.

  • LoneSnark

    What an awesome posting. I love these sorts of business analysis.

  • HoratiusZappa

    Correct. A VFX shop can set up almost anywhere, doesn't require technical aptitude, and - as Warren noted - is sexy. There are all the ingredients for labor oversupply and aggressive bidding wars.

    The other critical factor: the contracts are fixed-price and there are no objective criteria for "done", so the VFX companies die by what would be recognized as "feature creep" in software. When is a shot "done"? When the buyer decides it is good enough. How can that model possibly succeed over the long term?

    The result is lots of unpaid overtime in almost the only remaining non-unionized enterprise in the film industry.

  • FelineCannonball

    "When is a shot "done"?"

    I've heard from folks that work in in-house operations where there are many problems related to this -- often tacking on 300K edits because something tiny bothers a producer. The other aspect it seems to me is that some of the decision makers come in very late and decide to change major plot points or delete large sections. So there is extra effort at the end and wasted effort early.

    Anyway, it seems VFX is a salary generator, not a corporate profit generator and I don't see that changing. Necessary, but elastic and vague in the investment/profit equation and not generally rewarded with any premium because it's too far removed from box office. Maybe a bit like a research department.

  • progenitive

    Seems the question is why would investors repeatedly make the same error. From my experience in technology startups

  • Canvasback

    Your mama didn't raise an optimist, did she?

  • Daniel Barger

    No.....she raised a realist.

  • TMcolor

    Sure this is a sexy business but it has always been that way even when companies were making money. VFX folks have been more vocal about it but they are feeling the same pinch of technology that the rest of the post production industry has been going through for some time now.

    What's really happened is that technology has drastically cut the costs of VFX and post (e.g., my tool once cost $600K and required $100’s of thousands more in infrastructure - today the tool is free and runs on an iMac). Work that once required outside help can now be done in house. Producers no longer need a middle man with access to capital to build VFX or post houses. They can hire what they need directly. When they need manpower they turn to subsidized facilities or increasingly the cheap labor of China or India, but I suspect technology may soon reduce the need for even that. It’s a buyers market.

    A producer recently noted that 15 years ago post production on a commercial required 8 outside companies (and staff) but today a similar spot required 1 outside company and a few hours of time from some freelancers.

    Many companies have survived by changing from being suppliers to becoming producers themselves.

  • CT_Yankee

    Very likely not the same investers (there's a fool born every minute vs no fool like an old fool). An invester may hear or be presented information concerning a new method of producing an effect, believe this will be desireable and thus profitable. Then the high developement costs are only paid back until the next big idea hits the market. Think about the short life of a phone or tablet before something else knocks the market leader into the ditch. The product might well be innovative and fantastically trendy desireable for some glorious moments in the sun, but soon sinks into oblivion.

  • Canvasback

    True this. But musicians have known it for a long, long time.

  • progenitive

    Yeah, that helps. In tech, also, it can happen that VCs are happy, but the bulk of investors are screwed. I was with a company that surely generated negative cumulative profit over the past 15 years, but VCs were happy in 2000 at IPO...{"useLogScale":true,"range":"max","showPrePost":false}

  • marque2

    Well, because it can go both ways. Electronic Arts is fairly profitable and is considered very sexy by young programmers, so EA was able to coerce them into working very long hours for very little pay. California actually created an unfortunate set of laws to protect programmers (We are considered hourly if our pay is below $47 and some odd cents) from EA - however, because I get per diem a lot, my salary frequently is below that number, which means I have to be paid 1.5x if I work more than 8 hours in a day (again a CA law, all other states do OT at 40 hours per week)

  • marque2

    UAV's are considered sexy by programmers, and so companies like General Atoms tend to hire a lot of new graduates at below average wages. This is a big benefit for the company. It can work in the company's favor as well.

  • Mike Powers

    As to the initial article: "Avatar" didn't win Best Picture because, considered as a movie independent of technical achievements, it was garbage. It didn't win because it didn't deserve to when compared to the other films in the category.

  • Dan Wendlick

    The VFX studios are now learning the lesson that Walt Disney learned the hard way in the 1920s, and Pixar exploited in the period between leaving Lucasfilm and being purchased by Disney: you don't make money by making films for other companies. When the Disney brothers were making their Oswald the Lucky Rabbit shorts for Universal, they made money for Universal. When they asked for a bigger share of the pie, Universal pulled the production work from them, along with the rights to the character and much of the animation staff as well, almost bankrupting their fledgling studio. The lesson the brothers learned was to protect their interests, they needed to produce films under their own brand, owning the rights to the characters and eventually the distribution chain as well.
    In their independent years, Pixar made sure that they produced their own stories, with their own characters. that would enable them to have a sizable production fee, as well as a sizable chunk of the downstream residual income from the work. Sure,this approach was riskier than accepting journeyman work on a per frame or sequence basis, but it enabled them to build their own brand and differentiate themselves from the already crowded market.

  • Dan Wendlick

    and about that mention of Bose in the ads for the car: I think you have the situation reversed. It's more likely that Bose gives the carmaker a promotional or advertising credit for each time they mention Bose in print or on TV, at least in the case of the makers' high end models. By assosiating their in-car systems with the luxury and performance of high-end automobiles, they help build and extend their brand for their lines of home and office equipment.

  • bigmaq1980

    "why I think a conspiracy theory to believe Hollywood is dissing the
    artistry of VFX movies as a way to keep VFX company rents down is silly"

    Heard a similar conspiracy by pharmaceutical companies suppressing the cure for cancer, as they make more money selling current drugs. Many earnestly believe it. It falls flat with a little thought experiment...would all those science researchers just sit back and let their family members suffer and pass away knowing a cure was available. Given their salaries, it is highly unlikely they are paid enough, nor are psychopathic enough.

  • obloodyhell

    This hypothesis seems outlandish, and in fact the author never really provides any evidence whatsoever for her hypothesis.

    Yeah, it's ridiculous. It took Hollywood more than 20 years for them to give Spielberg an Oscar, for Saving Private Ryan, despite the fact that The Color Purple was a shoe-in more than 10 years earlier. On THAT, Spielberg was even snubbed, not even getting nominated despite the film itself receiving 11 nominations. The movie itself also got snubbed, not winning a single one of the 11 awards, one of the two biggest snubs in Oscar history. The film that won the BP? The inexpressibly boring "Out of Africa", probably the second most drearily boring picture to win since the MPAA started rating films in the 60s.

    Avatar had no chance not because of VFX but because Hollywood does not generally like it when "their own" are too successful. They think making lots and lots and lots of money is

    1) Sufficient reward of its own

    2) "Demeans" the art.

    And if there is anyone out there more successful than Spielberg, it's Cameron (and George Lucas). They will always face an uphill battle at Oscar time even if they made the perfect film and all the opposition was directed by fans and students of Harold P. Warren.

  • obloodyhell

    I would not go quite so far as to qualify it as garbage, but it was far from an amazing picture in terms of non-technical merits.