"Unlike any other business, where scaling up production focuses on replicating a standard existing product, duplication without modification, and then aggressively marketing it, a new product is required each and every time in the film business, with emphasis not on the marketing but on the manufacture and quality of the product." -- Subhash Ghai, chairman, Mukta Arts.

The risks associated with the film production business were aptly summarised by film-maker Subhash Ghai as part of the chairman's statement to shareholders in Mukta Arts' annual report for the year ended December 2002.

It is a complex business, and only venture capital comes close to it in terms of risk. The film industry launches hundreds of films every year, but in the end only a few of them prove profitable.

Like the 80:20 rule, which says that 80 per cent of the profits come from 20 per cent of the business, a handful of films contribute to the bulk of the industry's profits.

The imponderables are many, as the success of a film depends on its appeal to viewers whose tastes and preferences keep changing every time.

The Mukta Arts share - which has plummeted all the way from a 52-week high of Rs 130 to somewhere in the mid-forties now - bears ample testimony to the fickleness of film fans. It needs a blockbuster to pull it out of the rut.

In the United States and Europe, even large, reputed media houses have faced bankruptcy when their big-budget films flopped.

One classic example of bankruptcy among high-profile global film production majors is Carolco Pictures Inc, which was associated with blockbuster movies like Rambo, Terminator, Cliffhanger and others. Many of these movies grossed over $100 million.

But a few bad projects, like Lack Of Control and Cutthroat Island, led to record losses, wiping off the company's entire net worth. Another interesting case study is that of US-based Image Films Entertainment Inc. The company was associated with successful films like Kindergarten Cop and Parenthood, but went into bankruptcy in the last decade.

These examples of successful film production companies that ended up with huge losses underscore the risk of the business model.

Another reason cited for the bankruptcy of these companies was their inability to successfully scale up operations - which is essentially from the point of view of investors.

An investor looks for returns in the form of dividends and capital appreciation, which is only possible if the company is able to show sustained growth over a period of time. That's where Subhash Ghai was coming from.

In the Indian context, film production companies are becoming riskier as distributors are often unwilling to give minimum guarantees for territories and instead seek risk-sharing arrangements.

This has led some industry experts to suggest that it might be better for film production companies to avoid equity participation from retail investors and scout for investments from private investors.

"Specialised private funds and institutional investors who understand the business of film-making and have an appetite for high risk are better placed to invest in film production companies," feels Rabo India Finance's head of media and entertainment, Sunir Kheterpal.

This idea is further gaining acceptance as institutional investors can choose to invest in a particular project, or a slew of projects, instead of taking up equity in the whole company.

"It is essential to create or provide for an exit option to investors. Project-specific investment can have a defined exit route from the proceeds of the film upon its release," agrees Siddharth Das, chief executive officer, Pritish Nandy Communications, another listed film-maker which hasn't exactly set Dalal Street on fire.

On the contrary, if film companies were to become attractive investment options, they have to derisk their businesses through an integration across the value chain.

"Internationally, the distribution business is more profitable as compared to production and exhibition. Most of large studios in the United States have a well-developed distribution network to back their film production business," says Kheterpal.

Apart from this, production houses could diversify into related business like television software production. "Television software can provide much-needed stability in terms of a recurring flow of revenues," says Nihar Shah, research analyst, ASK Raymond James.

Although Mukta Arts has been planning a foray into the TV software business, it has not really taken off yet. Such steps will go far in making film production companies much more investor-friendly.

Corporatise or perish

The Indian film industry is one of the largest in the world, with over 1,200 movies released every year. Despite this, the industry shows a dismal performance in terms of profitability.

The industry recorded a loss of Rs 300 crore (Rs 3 billion) on gross revenues of Rs 3,900 crore (Rs 39 billion) last year, which itself was down 12 per cent from the previous year.

Mainstream Hindi films were worst-affected and accounted for almost 90 per cent of the industry's losses on gross revenues of Rs 1,650 crore (Rs 16.50 billion).

Hollywood, on the other hand, produced about 225 films and earned a handsome profit of $9.3 billion. So what really ails the Indian film industry?

Industry experts feel that the key reason for the dismal performance is its high cost of production and continued dependence on high-cost debt from private financiers.

The recent run of poor-quality content and lack of transparency in operations has kept institutional investors largely away from the film industry.

Though some institutions like the Industrial Development Bank of India and Bank of Baroda have earmarked Rs 100 crore (Rs 1 billion) and Rs 50 crore (Rs 500 million), respectively, for film financing, this accounts for a small fraction of the total debt requirements of the industry.

According to KPMG, the audit and consulting firm, the film industry could easily have reported a net profit of Rs 400 crore (Rs 4 billion) -- instead of a loss of Rs 300 crore -- if it had merely managed to curtail its losses by 12-15 per cent.

It points out that, on an average, artistes' fees and technician charges account for around 40 per cent of the total production cost, with significantly low focus on critical factors like pre-production planning and scripting.

In contrast to this, Hollywood studios spend about seven per cent of total outlays on pre-production planning, scripting and market surveys, which minimise the chances of time and cost overruns.

This is also an essential step to attract institutional investors. The KPMG report, authored by Rajesh Jain, executive director, corporate finance, also calls for moving towards a studio kind of set-up.

"Cost reduction could also be achieved through economies of scale by owning studio infrastructure and equipment and technicians, on the one hand, and distribution and exhibitors, on the other. Entities which adopt a professional and corporatised approach would be in a position to unlock value through a reduction in costs," Jain adds.

He feels that the Indian film industry will have to gradually move closer to the US studio model.

However, the 'studio system' of film-making will not be same as the pre-1960 scenario in India or the US where artistes and technicians were attached to studios and on the payroll.

"In the Indian context, it will mean that the film production, distribution and exhibition companies will vertically integrate," says Jain.

Unless isolated film makers expand their commercial interests across different business segments in the film value chain, they may not be able to cut costs effectively.