Is Starz Aligned?

New distribution channels could boost Starz in its biggest gamble: making movies
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Only hours into his job as head of sales at Starz premium movie channel in 2003, Bob Clasen was on a flight to Philadelphia, sent to broker a truce in a nasty dispute with Comcast Corp.

At issue between the cable giant and Starz parent Liberty Media were fees that Comcast inherited after buying TCI systems. Clasen, a cable vet who'd once worked at Comcast Cable, could have pushed the issue.

Instead, the former psychology Ph.D. student, known for being both soft-spoken yet strong-minded, played it cool and achieved a satisfying outcome.

When asked how he engineered the happy ending, he says, “I'm a good listener.”

Four years later, Clasen, the CEO of Starz, is now in search of a different kind of happy ending: a Hollywood one. Starz' latest—and biggest—business gamble is Overture, a brand new film studio begun entirely from scratch. And Clasen's got a supporting cast of a-listers already committed to make films at Overture including Al Pacino, Robert DeNiro, Dustin Hoffman and Emma Thompson.

With backing from cable pioneer John Malone and a buccaneer film producer named Chris McGurk, Clasen has built what he hopes will be an enviable model for film and TV success: Starz now produces films, animation and other television content with distribution on a number of its own platforms.

Granted, the wind-swept plain of Denver may seem an unlikely birthplace for a splashy new movie studio. The same can be said of Starz.

But Starz, once an also-ran pay-TV rival to HBO, has morphed into a $1 billion-a-year business with animated and live-action film and television production, domestic DVD and international television distribution and Web video sales through its Vongo unit. Its Starz and Encore premium cable services boast 16 movie channels.

The Starz movie service has 16 million subscribers—more than Showtime—while sister service Encore is the first premium service to have more than 30 million subscribers, surpassing HBO.

Starz and Encore have lingered in the shadow of entrenched incumbents because they previously focused solely on programming movies, only recently adding original programming. “They were much later getting into the pay space,” says SNL Kagan analyst Deana Myers, “[and] focused mainly on theatrical programming in the past, whereas HBO and Showtime have both done originals.”

Stepping up and out front

Now Starz is leading the way through vertical integration. CBS Corp., which owns Showtime, is following suit by launching a new film company that will produce four to six films a year with budgets of less than $50 million.

The action for Clasen's adventure began in September 2006 when he called a meeting with Liberty Media Chairman John Malone and CEO Greg Maffei. The topic: adding another piece to a growing portfolio of businesses under the Starz umbrella—movie-making. Sitting next to Clasen were veterans of the big studio business: McGurk, the former vice-chairman and chief operating officer at MGM, and former United Artists president Danny Rosett.

Clasen and McGurk were collaborating on an idea to build a new film studio from the ground up based on blueprints designed by McGurk. The key to their premise was securing the distribution first, which Starz could provide with its movie channels and the acquired properties, particularly the DVD business. “Controlling the distribution is much more important than controlling the production,” McGurk says, noting that distribution control provides tremendous leverage in the marketplace and ultimately attracts good material and good talent.

Clasen had known McGurk only a short time.They had met when Liberty Media acquired the studio production and film distribution units from IDT Corp. which would eventually become Starz Media, including Film Roman, which produces The Simpsons, and DVD distribution business Anchor Bay Entertainment. At the time, McGurk was a consultant for IDT on film production.

Liberty swapped cash and stock in IDT for these businesses, which fit Malone's strategy to make Liberty more of an operating company. The new properties would transform the premium movie channel into an integrated producer and distributor of live-action and animated content for film and television. By adding the film studio to the portfolio, Starz could also bolster its library with first-run titles. “The logic of buying films from yourself is inescapable,” Clasen says.

After Maffei and Malone peppered McGurk with questions about his business model for the new studio. Malone looked him in the eye and asked; “What makes you different than the 35 other people who have come in here trying to make movies in the past 25 years?”

“Well, I'm not going to tell you that I have the magic of picking movies,” McGurk replied, “and if anybody tells you that, check your wallet.”

Not that Malone's query wasn't justified: Countless companies have lost millions trying to make profits in the movie business. But under McGurk's plan, the new studio could absorb a few misses. The economic model McGurk devised for the studio resembles that of a unit at MGM that produced a high volume of small- to mid-budget films and yielded a return on investment of 30% over a period of six years.

The strategy of the new studio was to produce, acquire and distribute eight to 12 films per year with budgets in the $15 million to $20 million range. Drawing an analogy to a stock portfolio, McGurk says it makes more sense to spread the risk across a basket of films rather than make a bet on one big one. “It's a portfolio business, and you have to count on 30%-40% of the movies not working,” he says.

To test the theory for the presentation, they looked at random samples of 30 films in the $5 million to $30 million range. “The reality is, in that range, if you do enough of those movies, you will make money,” says Clasen. “And you will because you don't have that $100 million movie that does $20 million at the box office, and you have to write off $80 mllion.”

Smaller budgets also allow the studio creative flexibility, by focusing on specific audiences rather than betting big on a blockbuster with a general audience. McGurk says the spirit of the new studio is similar to that of United Artists; to be filmmaker-friendly and to keep the quality high. That's achievable under the economic model where the downside for any one film is limited. Bigger budgets, McGurk says, means less tolerance for risk and often result in formulaic filmmaking.

Sound of silence

The presentation didn't take long, and after fielding questions from Maffei and Malone, there was a pause in the room. “I remember he was very quiet,” Clasen says of Malone after the presentation. So Clasen put the question to him and asked Malone what he thought, to which the response was; “Sounds good to me.”

In many ways, the transformation was born of necessity. For years, Starz has been dependent on big movie studios for programming and on major cable and satellite operators for distribution. Starz was getting squeezed at both ends as higher programming costs and lower fees paid by affiliates trimmed operating income from $297 million in 2002 to $163 million in 2006.

Starz was launched in 1994 as a competitor to entrenched incumbents HBO and Showtime for first-run titles. Aggressive pursuit of studio output deals drove up the programming costs and started to rattle the company's financial results. By 2006, programming costs had doubled to $703 million from $358 million in 2002. Meanwhile, lower affiliate fees meant revenue was rising just marginally, from $945 million in 2002 to $1.033 billion in 2006. For the first nine months of 2007, it was $801 million.

“Even though we are adding a lot of subs, our affiliate deals continue to put a lot of pressure on us,” Clasen says, “We don't get as much for a customer as we used to get.”

The pressure is easing as big studios focus more on franchise productions and put out fewer films.That allows Starz to use the spot market to pick up independent titles on the cheap. “We can go and buy at 30%-50% of what we would have paid a few years ago,” Clasen says.

The shift is reflected in the numbers. Programming costs for Starz Entertainment dropped 9% to $483 million in the first nine months of 2007 from $532 million over the same period in 2006, and the company is forecasting costs to be between 6% and 9% lower for the full year 2007.

Whether the company can navigate the unpredictable waters of Hollywood hit-making is in question. Still, in the 18 months since Overture Films was green-lit, the fledgling studio has wasted no time in making waves in the Hollywood film community by striking key acquisitions and launching homegrown productions with top-flight names.

On Jan. 18, the Overture-produced film Mad Money, starring Queen Latifah, Diane Keaton and Katie Holmes, will be released theatrically. Other Overture projects coming up include Last Chance Harvey, starring Dustin Hoffman and Emma Thompson, and Righteous Kill, which pairs Robert De Niro and Al Pacino.

Overture also made a splash as a player in the film market in September by snatching up one of the most anxiously awaited screenings at the Toronto International Film Festival, director Tom McCarthy's (The Station Agent) second feature film, The Visitor.

The move exemplifies the clout of the distribution avenues available to the studio. Says McGurk: “We sat down with the filmmakers, and in very short order we were able to very crisply lay out why Overture was a better alternative. Because of all the assets we could line up behind our movies.”

In negotiations, Overture has the autonomy to green-light films within its financial model, meaning negotiators can sign the deal in the room without having to get clearance from the home office.

Of the films coming out of Overture, 60% are expected to be homegrown while the rest will be acquired titles. To date, Overture has green-lighted eight films and will have anywhere from 12 to 15 at various stages of production at one time.

In McGurk's eyes, the link-up with Starz and Liberty Media is the best scenario. “You want to look for a strategic partner rather than just a financial one,” he says. “You want a partner that will be there 10 to 20 years down the road and not just looking for a quick return.”

Starz Entertainment, which is driven by the premium movie channels, has seen its financial health improve over the past two years. While revenues have been fairly flat, Starz is improving its cash flow, which was 9% higher year-over-year in 2006 and was already 16% higher in the first nine months of 2007.

The company's operating income declined sharply from $297 million in 2002 to $105 million in 2005, but has risen steadily through 2006 and 2007. For the year 2007 through September, Starz generated $180 million in operating income, largely due to a reduction in expenses on the back of lower programming costs.

Starz Media, which includes the new business lines, is expected to generate losses for the next two to three years; Liberty will initially keep Media and Entertainment separate when it splits Liberty Capital into two tracking stocks. Media generated $195 million in revenue in the first nine months of 2007 but had $65 million in operating losses over the same period.

Clasen hopes to continue keeping costs under control by producing more content in-house. He plans to stay involved but under the radar. When asked if he will read scripts or hang around Overture sets, Clasen quips, “No, I'm just the suit.”

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