A fundamental shift has taken place in digital cinema lending patterns, affecting the activities of 3rd party digital cinema deployment entities. The structure of these entities was first contemplated by studios in the closing days of DCI’s business activities in 2005. (DCI stands for Digital Cinema Initiatives, a joint venture of the six major motion picture studios.) At that time, deployment entities were envisioned as a capital resource, either having cash on hand or having acquired the funds to purchase digital cinema systems, after which they would engage in equipment lending agreements with exhibitors. In turn, the deployment entities would receive “virtual print fees” (VPFs) to recoup their investments.
The one entity successful in executing this style of business is Cinedigm. The result is a company burdened with massive debt, with net interest expense equal to 33% of gross revenue. Once Wall Street caught on that the margin allowed a deployment entity is very limited, the stock fell dramatically. In truth, the cash flows in virtual print fee financing are healthy and backed by a solid industry. But the 3-way nature of these agreements – deployment entity, studio, and exhibitor – is complex, and that can spell risk to the institutional investor.
Additional risk is spelled out by the inability to value the equipment. The first test of secondary market value is now underway with Technicolor’s disposal of 300 screens-worth of digital cinema equipment. These systems were originally valued at around $90K per screen, and will probably get 1/3 of that price after 2-3 years of deployment. In part, that’s due to the lower cost of equipment today versus at the time of purchase. But the inevitability of accelerated devaluation is one of the risks of investing in technology assets.
Another risk is that of DCI Compliance. Four years after release of the DCI specification, no equipment sold on the market can proclaim that it fully meets the spec. The problem for banks is that DCI Compliance is a requirement of deployment agreements, which state that equipment in the field must be upgraded once DCI Compliant equipment is available. More damaging than accelerated devaluation, this spells obsolescence to the investor. It is difficult to get comfort from the technologists in this regard. DCI continues to revise its specification and test plan, causing manufacturers to frequently engage in retooling their products. (The latest activity in this regard is the ASM, explained in the SMPTE section of this report.)
It should be little surprise, then, that banks aren’t showing much interest in collateralizing loans with the equipment, and instead requiring exhibitors to provide guarantees. The result is that the original concept of the deployment entity is now flawed. The typical deployment entity is organized as a special purpose vehicle (SPV), protecting the parent company from bankruptcy. But the SPV is not holding assets that banks value. This complicates things for the exhibitor.
The exhibitor provides the financing and guarantees the loan, the studios provide the cash flow to recoup the loans, and the 3rd party deployment entity manages the cash flow. From the exhibitor’s point-of-view, the management of the 3rd party entity is a major risk factor. If the deployment entity misdirects funds, or fails in some other way, the exhibitor is on the hook to pay off the loan.
There are three ways to mitigate this problem: 1) the exhibitor buys from an entity that is self-financed and has other assets behind it (but be mindful of the inability to reach through an SPV), 2) the exhibitor takes a stake in the SPV to retain control (similar to DCIP in the US and DCIPA in Australia), 3) studios make payments directly to exhibitors. On the third point, Paramount and Fox offer such deals today. But without similar deals from the other studios, their offers aren’t of much value.