Friday, October 20, 2006

MGM Deal a Bold Miscalculation for Sony

The electronics giant took only a minority stake in the studio, then lost control of the prize it had fervently sought.
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By Claudia Eller
Times Staff Writer

October 20, 2006

When Metro-Goldwyn-Mayer Inc. went on the block in 2004, Sony Corp.'s Howard Stringer so lusted after the studio's coveted library that he told his boss he would resign if he didn't win a last-minute bidding war with Time Warner Inc.

Stringer, who at the time headed Sony's U.S. arm, figured the library's 4,000 film titles would give Sony more clout with DVD retailers and fuel the growth of its high-definition Blu-ray technology.

Stringer's resignation wasn't required: He engineered a clever deal to buy the storied studio for $4.9 billion with a consortium of investors that shouldered most of the financial risk.

But the deal that Stringer hoped would help cement his legacy has instead marred it.

In late May, amid rising tensions among the partners, MGM's board voted unanimously to dismiss Sony Pictures Entertainment as its domestic DVD distributor after it failed to meet performance goals. It was a humiliating blow for Stringer, who lost control of the very prize he was after. Sony now finds itself on the sidelines.

Stringer, who declined to comment, acknowledged the fiasco in July at Herbert Allen Jr.'s media retreat in Sun Valley, Idaho.

"Are you happy with the MGM deal?" goaded Michael Eisner, the former chief of Walt Disney Co., who was moderating a panel discussion.

Flanked by rival media moguls Rupert Murdoch and Barry Diller, Stringer made a rare concession for a chief executive: "We screwed up," he told the elite crowd of his peers.

How Sony lost control of MGM is a tale of corporate miscalculation, boardroom drama and power plays.

At a time when private equity firms are using their treasure chests to gobble up corporate assets, Sony's experience as a minority shareholder serves as a cautionary tale about the dangers of hooking up with investors motivated solely by quick financial returns.

The deal hasn't been a total wash. Sony remains a 20% investor in MGM and is sure to recoup its initial $250-million investment. MGM's commitment to Blu-ray remains intact, giving Sony an edge in a format war with Toshiba Corp.'s competing HD-DVD technology. And Sony Pictures gets to share in the proceeds of the James Bond sequel opening next month and a future installment of the popular spy series, which could mean hundreds of millions of dollars in additional revenue.

But being jilted as MGM's DVD distributor in favor of News Corp.'s 20th Century Fox movie studio cost Sony at least $50 million a year in future fees, not to mention public embarrassment in Hollywood and on Wall Street.

The first human casualty came last month, just as Fox officially took over as MGM's global DVD distributor. Sony fired the veteran president of its home entertainment group, Ben Feingold, who had been responsible for selling the MGM and Sony movie catalogs to the Wal-Marts of the world.

Sony Pictures CEO Michael Lynton acknowledges that losing the MGM distribution rights was a disappointment. He attributed the loss to several factors, including Sony's weakness in selling older library titles. "In the course of things, we discovered that distributing catalog was not a strength of ours — a situation we have since remedied," Lynton said in an interview.

The MGM debacle was particularly bruising for Stringer, who has been fighting battles on several fronts since June 2005, when he became the first non-Japanese chairman of Sony Corp. The 2-year-old Sony BMG music joint venture with Bertelsmann championed by Stringer has been plagued by internal power struggles. Apple Computer Inc., with its iPod, has claim to the most popular portable music device, one-upping Sony, which once had the lead.

Thursday, Sony dramatically reduced its earnings forecast because of the costs associated with a massive global recall of its computer batteries and a price cut in Japan for the new Sony PlayStation 3 game console.

The MGM deal was a bold move for Sony, which normally had approached Hollywood with caution, rarely making acquisitions. Under the deal structured by Stringer and Rob Wiesenthal, financial chief of Sony Corp. of America, the consumer electronics giant put up a fraction of the total purchase price, $250 million, but got control of domestic DVD sales. Sony would collect a hefty annual distribution fee, receive a stake in at least two new James Bond movies and retain the right to eventually buy out its private equity partners.

Yet Sony didn't get a majority stake in MGM. With a 20% holding, it had only three seats on the 13-member board, which includes representatives from MGM and the equity firms.

When DVD sales fell behind projections, a concerned Providence Equity Partners Inc., MGM's lead investor, persuaded the company's board to hire entrepreneur Harry Sloan.

Sloan, who had recently cashed out of a multibillion-dollar media company he had built in Europe, took over as MGM chairman last October. Almost immediately, he drove a wedge between Sony Pictures and the private equity firms, persuading the partners that MGM would be more valuable as a stand-alone studio than as a pared-down label inside Sony that had shuttered its production and distribution operations.

With Sloan's arrival, Sony's original plans for MGM were all but abandoned. In short order, Sloan announced that MGM would reenter the theatrical distribution business, take back worldwide home video and TV rights from Sony and set itself up as a global TV distributor. MGM now plans to co-finance big-budget sequels from the library, including "Terminator 4."

"It's gone in a very different direction," said independent media analyst Harold Vogel. "It was presented to the investment community as a library play that would enhance the position of the Blu-ray format."

At Sony, internal conflicts had erupted even before the ink on the deal was dry. In New York, while Stringer and Wiesenthal were lining up financing, not everyone at studio headquarters in Culver City was as gung-ho.

Feingold, a 15-year Sony veteran who had helped build the studio's lucrative DVD business, had strongly opposed the acquisition, said studio sources who didn't want to be identified because they were not authorized to speak on the record.

Feingold, who didn't respond to an interview request, had worried that the library, with such classic titles as "Midnight Cowboy" and "Dr. Zhivago," had been over-exploited.

"He thought the market had matured and [DVD] pricing had eroded and that therefore the library was overvalued," said a source familiar with Feingold's thinking. When they were considering buying MGM, Stringer and Wiesenthal had questioned whether the library was "a melting ice cube" but concluded it wasn't, said one Sony insider.

The value was uncertain partly because a small number of MGM titles — about 10% — accounted for 80% of the library's sales, according to people who have seen the figures.

For his part, Lynton, whom Stringer had recently hired to head Sony Pictures, thought the deal made strategic sense and enlisted cable giant Comcast Corp. as a last-minute investor to help outbid Time Warner.

But neither Lynton nor others at Sony realized how arduous integrating MGM would be. Sony said the transition — which included firing all but 400 of MGM's 1,500 employees — would take at least 18 months. Sony's private equity partners pressed for faster action.

Lynton said he quickly learned that the studio was better at selling new releases than older titles, which require more promotional finesse.

Sony's dreadful year at the box office in 2005 didn't help either. Flops such as "Bewitched" and "Stealth" meant Sony had no new releases popular enough to drive sales of older MGM or Sony titles.

To boot, the once-hot DVD market had suddenly cooled.

"The transition was more difficult than we anticipated, and it happened that at the moment we were having a particularly bad year theatrically, which was a distraction and didn't give us hits to drive the catalog," Lynton said, adding that the downward drift of the DVD market was an unexpected blow.

The MGM library's cash flow plunged by an estimated 25% to 30% under Sony's direction.

Sony's failure to hit its numbers infuriated the private equity investors, which had hired McKinsey & Co. to evaluate Sony's performance. The firm concluded that MGM had lost market share under Sony.

"The board meetings became increasingly uncomfortable," said one Sony executive who requested anonymity because the meetings were private.

Lead investors Providence Equity and Texas Pacific Group declined to comment.

Said a source close to the consortium who did not want to be named because of the sensitivity of the issue: "We were hoping Sony would be able to develop a higher level of catalog expertise, but that didn't happen. That was highly disappointing."

In May, MGM's board voted unanimously to exercise a clause in its contract with Sony that allowed it to drop the studio after one year if certain performance goals weren't met.

Fox made a play for the distribution rights, offering to pay a guaranteed $625 million over two years. At last count, Sony was generating less than $300 million a year from that business.

Sony turned down a chance to match Fox's guarantee and keep the MGM contract. Lynton declined to say why, although insiders said Sony lacked faith it could attain those financial results.

Sony's three MGM board members, including Lynton and Wiesenthal, even voted in favor of Fox's taking over.

Richard Greenfield, an analyst with Pali Research, said that though Fox had distinguished itself in DVD distribution, all studios could struggle next year, when, he predicted, DVD sales decline for the first time.

The upshot of the MGM ordeal was a bitter pill for Stringer.

In danger of losing the auction to Time Warner, Stringer had begged his boss at the time, Sony Corp. chief Nobuyuki Idei, for a nonrefundable down payment of $150 million that would help Sony take the lead. He had told Idei he would resign if Sony lost to Time Warner and had to forfeit the deposit.

Sony or partner Comcast could still end up owning MGM when private equity investors cash out. And getting a backer for Blu-ray was "important for Sony to swing the balance of power," Greenfield said.

But it remains to be seen whether the deal was worth the effort.

"You'd have to ask why Sony went through the exercise of buying MGM. What did they win? There are some benefits but also some huge costs," said Vogel, citing lost distribution fees, the time-consuming process of dismantling and integrating MGM's operation and the public relations liability.