Fox the day after tomorrow
Peter Chernin knows that a digital revolution is underway - but he has faith that Hollywood will be Studio City forever.
By Marc Gunther, FORTUNE senior writer

NEW YORK (FORTUNE) - In 1903, an Eastern European immigrant and one-time street peddler named William Fox built a 149-seat movie theater in a penny arcade in Brooklyn.

W.F., as he was known, went on to build 1,100 theaters and a Hollywood studio; he became enamored of technology, audio in particular. His company patented a process for putting sound on film. His studio produced the first newsreel with synchronous sound. And he decided that all of his theaters, including the grand downtown motion picture palaces for which he became known, should be equipped for sound.

FOX's Peter Chernin
FOX's Peter Chernin
The big picture
Forget the dire predictions: The U.S. entertainment and media market is still strong.
 2005 (billion) 2009 projected (billion) 
TV distribution: Subscriber fees paid to cable and satellite networks $90.3 $109.0 
TV networks: Advertising revenues of broadcast and cable networks $57.3 $73.2 
Filmed entertainment: Box office, DVDs $37.2 $48.1 
Total $184.8 $230.3 
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A look at the folks who find the jobs, make the deals, and handle the media. (more)

This investment, on the eve of the Great Depression, proved ill-timed. W.F. went bankrupt, tried to bribe a judge, served a year in prison, and died a forgotten man in 1952. So much for happy endings.

Studios vs. technology

The Hollywood studios have had an uneasy relationship with technology ever since. They hated television. They went to court to try to outlaw the VCR. These days, they have to contend with digital piracy, Internet distribution, and TiVo boxes. They are keeping a wary eye on the user-generated content on YouTube and the dazzling new video game players from Microsoft (Research) and Sony (Research).

"I don't think it's an overstatement to say that it's been the most revolutionary period in the history of mass media," says Peter Chernin, the chairman and CEO of Fox, W.F.'s studio, as well as second-in-command to Rupert Murdoch at parent company News Corp. (Research)

Chernin gets no argument when he says there's a revolution going on - the debate is about what it means for Hollywood's future. Many people believe that digital technologies threaten the established order in much the same ways that digital music has rocked the foundations of the music industry and Internet news, blogs, and classifieds have taken readers and advertisers away from newspapers.

Put much of Wall Street in that camp: Fears of piracy, commercial-skipping, and audience fragmentation have weighed heavily upon the shares of the entertainment conglomerates, including News Corp., which have trailed the market for a couple of years. Videos, pirated and legit, are zooming all over the Internet, and a chorus of futurists warns that the explosion of distribution channels, which create practically unlimited viewing options, means the end of mass entertainment.

Chernin goes to work every day on the 54-acre Fox lot in Los Angeles that W.F. bought in 1928, so he takes a longer view. Much longer.

"Storytelling in two-hour forms has existed since the Greeks," says Chernin, who is 54 and a former book editor. Movies, he says, are merely a way to distribute stories. Yesterday "Oedipus Rex" in an amphitheater. Tomorrow "Dude, Where's My Car?" on an iPod.

Yes, distribution is becoming ubiquitous, Chernin says, but that's exactly why Hollywood's future is so bright.

"We are standing on the precipice of the most exciting time in the history of the media business," he says. "We now have infinitely more ways to tell our stories and connect them to the audience."

Putting money on it

You could dismiss this as a showman's hype if News Corp. weren't putting serious money behind Chernin's view. In the past decade or so, the Fox studio has created four new movie production companies and three new TV production units, each with its own budget and staff, to make movies and TV shows for big screens and small. Blockbusters like "X-Men." Offbeat movies like "Napoleon Dynamite." Teen flicks like "Transformers." Broadcast-TV hits like "24," and obscure cable offerings like "It's Always Sunny in Philadelphia." Even so-called "mobisodes" - for mobile phones.

Altogether, News Corp. will spend about $4.5 billion on the production and marketing of movies and TV shows this year.

So far, the investments have paid off. In fiscal 2006, which ends June 30, Fox's Filmed Entertainment, which is News Corp.'s biggest division, is expected to bring in about $5.8 billion in revenues and $1.2 billion in operating profit. Five years ago, Filmed Entertainment brought in $3.5 billion in revenues and $254 million in operating profit. A decade ago, revenues were $2.5 billion and operating profit was $112 million. That's a nice growth rate for a company that's been around since the days of silent films.

Fox and Warner Bros. (which, like FORTUNE, is a unit of Time Warner (Research)) are the biggest and best-run of the six major Hollywood studios - Warner made about $943 million in operating profit last year. The others lag behind. In their most recent fiscal years, Sony brought in $234 million, Disney brought in $207 million, and Paramount just $62 million. (NBC Universal does not break out results for its studio.)

What's most significant about these numbers is that despite the highly speculative nature of making movies and TV shows, many of which fail and lose money, all the studios are profitable.

They've survived by adapting to change, much of it technology-driven. In just the past five years, revenues from movie rentals have dropped drastically - that's why Blockbuster is struggling - but the lost income has been more than replaced by sales of DVDs.

Television viewing continues to migrate from broadcast to cable networks, but the studios make shows for everyone. In the unlikely event that viewing shifts to the Internet, the studios will be there too.

This is why Chernin is buoyant about the future, even if he can't predict where things are going. When I ask him how his three college-age kids will watch movies and TV shows 25 or 30 years from now, he says, "How will the content be distributed? I have no idea. Will they consume content that resembles what they are watching today? Absolutely."

A history of change

William Fox lived just long enough to see most of the elegant movie palaces he built go dark in the 1950s and 1960s. The culprit was television. People stayed home to see Uncle Miltie, the Tiffany Network, and later, HBO, must-see TV, and 300 channels of cable. These days, they are staying home to watch $15 DVDs, sold at Wal-Mart and Best Buy as loss leaders. A few download movies over the Internet for home viewing.

This trend is probably unstoppable. As movies become accessible through new distribution channels, and as big, high-definition, flat-screen TV sets proliferate - more than 30 million hi-def sets have been sold in the U.S. - people will more often choose to watch at home. There are no commercials, and the popcorn's a lot cheaper.

The phenomenal growth of home entertainment has already shaken up Hollywood's business model, sometimes in unpredictable ways. If you saw the movie "Office Space" when it opened in 1999, you were among the few. A sly workplace comedy starring Jennifer Aniston and directed by Mike Judge, who created "King of the Hill" for Fox's TV production unit, "Office Space" got so-so reviews and took in a disappointing $10 million, about what it cost to make. Judge described it as "the hugest turd of a movie."

His judgment was premature. In the years after its release, "Office Space" grew by word of mouth into what Entertainment Weekly called a "stealth blockbuster." It has sold nearly six million videotapes and DVDs. It has aired 56 times on Comedy Central. A character in "Office Space" has a peculiar attachment to his candy-red Swingline stapler; Swingline released a Rio Red stapler in 2002, and Fox put out a special edition DVD with the stapler included. That was a first.

Here's the point: Until the early 1980s, a movie had only two ways to reach audiences: theaters and broadcast television. Today, box office sales typically account for about 25 percent of a movie's revenues. Another 25 percent comes from pay television, basic cable channels, and broadcast TV, and fully 50 percent comes from home entertainment - meaning video rentals, DVD sales, and on-demand viewing via cable or satellite.

New distribution channels give movies and TV shows a longer life, and they unlock the value of libraries. Sony, Comcast, and private-equity firms paid about $4.8 billion last year for MGM, mostly to acquire its library of 4,000 movies and 10,000 episodes of TV shows.

More media means more markets

"You now have huge aftermarkets," Chernin says, "that have grown more important than the so-called primary markets."

The fact that people have so many ways to consume movies, Chernin believes, can actually serve as a buffer against piracy. The music business, he says, had an inflexible business model - one format, the CD, priced at $15 to $20 - that left some consumers feeling ripped off.

By contrast, you can watch a movie in a theater or at home on subscription pay cable, pay-per-view, basic cable, or over-the-air television. You can rent a video or buy a DVD. Prices range from $28 for four tickets at the multiplex to free for over-the-air television.

Still, piracy's a real problem, and it's growing. A new report from the Motion Picture Association of America estimates that global piracy costs the industry more than previously thought - about $6.1 billion a year. The global market for filmed entertainment in 2006 has been estimated at $97 billion by PriceWaterhouseCoopers.

The television business has been slower to change than movies, but it is now in upheaval. It's easy to forget that until the late 1990s the business of selling TV shows directly to consumers simply did not exist. Most people at the studios figured that people would not pay for TV shows that had been available for free.

Boy, were they wrong. Today, more than 5,000 TV series, from "The Abbott and Costello Show" to "Zorro," are available on DVD. Annual sales of TV shows on DVD have grown from just about zero in 1999 to nearly $4 billion in 2005. Viewers today also can buy TV shows on demand from cable and satellite operators, view them over the Internet on such platforms as Warner's In2TV (a godsend for fans of "Welcome Back, Kotter"), and carry them around on an iPod or a Sony PlayStationPortable.

News Corp. was the last big media company to get its shows onto Apple's iTunes platform because it decided to work out a revenue-sharing deal with Fox's affiliated stations first. The company has just launched 16 TV series from Fox and its cable networks on iTunes. Fox has permission from its affiliates to make as much as 30 percent of its primetime schedule available for downloads on a variety of platforms, from iTunes to fox.com to program sites like americanidol.com to, quite possibly, MySpace, News Corp.'s social-networking site.

Selling current TV shows directly to consumers turns out to have two benefits for the studios: It generates revenues, and it enables viewers to catch up with shows they missed. Fox has sold about 2 million DVDs of the first four seasons of "24" at a retail price of $35 to $45. People call Chernin to say, "I just got a DVD of season one, and I watched 13 hours this weekend." The show is enjoying its highest ratings ever this year, which is almost unprecedented for a TV show in its fifth season.

Fox also produces one-minute mobisodes called "24 Conspiracy" for cellphone users, mostly in Europe and Asia, that were sold to Vodafone for three times what they cost to produce. Chernin says: "What other television show in history has ever existed like that?"

New kinds of storytelling

Unless you are the kind of person who can't wait to watch TV on a cellphone, the most interesting question about all the new video distribution channels is this: How will they affect the ways stories are told? Most new technologies have spawned their own content. The late-night talk show was invented for broadcast television. Cable gave us MTV and Bill O'Reilly. Aristophanes never wrote a sitcom.

Some people believe that Internet video distribution will unleash a flood of user-generated TV shows and movies, just as the Internet has allowed blogs to flourish alongside established print media and garage bands to post their songs online. Digital camcorders and low-cost editing software mean that just about anyone can make a movie at a relatively low cost.

Many people do - so many that youtube.com, whose slogan is "Broadcast Yourself," recently imposed a 10-minute limit on most videos posted by users. The company says that 40 million videos are watched on the site every day. Hollywood has noticed - Weinstein Co. promoted a recent theatrical release, "Lucky Number Slevin," by running the first seven minutes of the movie on the site.

Chernin is a big believer in user-generated content. News Corp.'s MySpace is thriving. But he does not believe that there's a vast backlog of great unmade TV shows and movies that cannot connect with audiences because of bottlenecks in distribution. To the contrary, he and the other creative executives at Fox argue that the digital revolution will increase the value of high-quality, professional, branded content.

"If you don't have incredibly dynamic, exciting, frankly great content, you are toast," Chernin says. "In this world of infinite choice, mediocrity is finished." Evidently he missed "Big Momma's House 2." But he has a point.

In the old days, some broadcast-television programmers followed what was called the LOP theory of primetime: With one TV set in the home, families would make compromises and cluster around the Least Objectionable Program. That idea is long gone. Lately, the executives in charge of Fox's TV production unit have found that pleasing but inoffensive, middle-of-the-road TV shows are tougher sells than ever.

"You have to be creatively adventurous," says Dana Walden, who, with Gary Newman, runs Fox's TV unit. "Our business is about the top five or six shows that we produce," Newman says.

Content is king -- good content, that is

The chairmen of Fox's movie studio, Tom Rothman and Jim Gianopulos, also try to avoid the familiar.

"You can't keep making the same old movies," Gianopulos says. "They're boring."

Rothman sums up their strategy by saying, "We are fiscally conservative so we can be creatively reckless. And we marry very carefully the movie to a specific audience."

This can best be seen at Fox Searchlight, the first and most successful of the so-called "dependent" independent film units, which Rothman started in 1994. After Disney bought Miramax, all the studios set up subsidiaries to produce or acquire inexpensive movies with an offbeat sensibility, while exploiting the parent company's infrastructure and clout to get the movies distributed.

Searchlight releases about a dozen movies a year, some that it produces and others that it acquires, at a cost that rarely exceeds $15 million. It relies on reviews, film festivals, niche marketing, and word of mouth to promote them. By comparison, the average studio movie costs about $60 million to make and another $36 million to market, according to the MPAA.

"Sideways" is a notable Searchlight success. A buddy movie about two middle-aged men on a wine-tasting trip, it cost $16 million to make and opened on just four screens in the fall of 2004 with little buzz and no star power.

"There's no one in 'Sideways,'" says Peter Rice, Searchlight's president.

But after "Sideways" won good reviews, critics' awards, and two Golden Globes, Fox bought national TV spots and rolled it out to 1,800 screens. Eventually the film brought in $70 million at the domestic box office, $40 million overseas, and $75 million from DVD sales. It was sold to HBO and cable's Independent Film Channel, and it will earn revenues for years.

Fox still makes big bets on movies - $150 million in production costs for this summer's "X-Men 3: The Last Stand," $100 million for last summer's "Fantastic Four," $125 million for "The Day After Tomorrow," all of which had big marketing budgets as well.

"So-called middle movies that are just average movies for everybody - they are going to get way harder," says Rothman. "But movies that are either for a passionately devoted smaller audience or those that can be made into events for a larger audience are going to be of greater value, through all the coming forms of distribution."

"Ice Age: The Meltdown" has sold $594 million of tickets worldwide since its opening on March 31. High-risk, high-return projects will always be part of the movie business, Rothman and Gianopulos say.

From mega- to microhits?

But what if the Fox moguls are wrong? Chris Anderson, the editor of Wired, has written a book called "The Long Tail," which comes out in July, that is getting lots of buzz.

He argues that the digital-entertainment economy will be radically different from today's mass market because, as the costs of distribution and production fall and vastly expand choice, consumers will move from a relatively small number of hits to a huge number of niche products (which on a demand curve resemble a tail).

"Forget squeezing millions from a few megahits at the top of the charts," Anderson writes. "The future of entertainment is in the millions of niche markets at the shallow end of the bitstream."

His evidence comes from buying patterns at places like Amazon and Netflix. They have vastly increased choice - Amazon sells 3.7 million books, compared to 100,000 at the average Barnes & Noble store - and their consumers spend less on hits and more on niche offerings that until recently were hard to find. It's conceivable that a flowering of videos on iTunes, Yahoo!, and Google could lure viewers away from the broadcasters and the multiplex.

"You could have microhits and ministars," Anderson says.

That would be a nightmare for Hollywood. But even Anderson does not believe that mass-appeal TV shows and movies will go away. "You will always have hits and blockbusters," he says. "But how big?"

Our best guess? Pretty darn big. Recently I took a 20-minute drive from Fox's executive offices to a rented studio where a dozen singers, selected during try-outs held across America, had come together to compete for a record-company contract.

The live television show being broadcast that evening could be described as user-generated content - the singers had been unknown a few months before, and their performances helped draw a crowd to the studio and a far bigger crowd tuning in from home - about 30 million, watching "American Idol" on Fox.

There is a lot to say about "American Idol," but two things matter in this context.

First, it is in every important sense professionally produced content, so much so that when other networks and experienced producers have tried to stage talent contests they have not done nearly so well. It may look effortless to produce, but every detail has been thought through, from its aspirational appeal to the intimate camera work that captures the emotions of the singers to the way viewers get to vote, as many times as they like, for their favorite performer each week, giving them a stake in the outcome.

Second, it is a monster hit. Even though it has to compete with programs on 300 other channels, content on the Internet, and every other imaginable way that people can spend their time, the show has become a mass cultural phenomenon super-charged by a world of niches - local newspapers track the weekly results as if it were a sporting event; bloggers debate the merits of the performers; and songs that are showcased on the show zoom up the charts on iTunes.

The media climate has changed dramatically since the 1950s, but "American Idol" is the wholesome, gather-the-family-on-the-couch version of "The Ed Sullivan Show."

It occurs to me that W.F., who always thought sound would be a big deal, would be pleased.

FEEDBACK mgunther@fortunemail.com

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.