THAT’S ENTERTAINMENT
The spirit of Silicon Valley is thriving in India, and it’s not about outsourcing.
By Charles Tan

If you gave Ashish Malushte the benefit of the doubt, you might be able to entertain the idea that the future of digital cinema lies in a restored warehouse in an industrial neighborhood in eastern Mumbai. Between servings of dhal and vegetable korma in this small private theater, the 32-year-old CFO of UFO Moviez enthuses about how the digital technology his company developed would not only make film reels a relic of history, but also change the way studios and theater owners make money. He motions to the projectionist behind, and out on the screen comes a series of clips with a slightly sharper image quality than at a typical movie house. This visual improvement, says Malushte, is just the sugar on top; beyond it is a business model that not even the American film industry, which pioneered digital cinema, has been able to build. “And there’s no reason why we couldn’t roll out the same in other countries,” he says.

This kind of ambition is not unique among India’s digital mavericks. In a country where ownership of television sets and personal computers is among the lowest in the world, companies vying to be at the cutting edge of digital entertainment are not hard to find. India is emerging as an unlikely proponent of the digital wave crashing on two shores. On one hand, thanks to its growing young population with rising disposable incomes, India is breeding a new generation of consumers who are quick to embrace new technologies and hungry for new forms of entertainment. By 2010, they will spend US$21 bn on movies, songs, and the like, up from US$10 bn last year, according to PricewaterhouseCoopers. On the other, foreign media and entertainment companies are finding that India’s wide pool of engineers and programmers can produce their products, from movies like “Finding Nemo” to games like World of Warcraft, for a fraction of the price.

The sector is getting noticed. In the first four months of the year, private-equity investments in the media-and-entertainment sector reached US$640m, dwarfing a combined US$302m in 2005 and 2006, according to auditing firm Grant Thornton. Much of these investments have so far gone to conventional film and television production, but investors are starting to look at more-innovative ventures such as gaming and animation. Last month, a British-led investor group applied to raise US$150m at the Alternative Investments Market in London for its India Media Fund. Reliance Entertainment, which has had a conventional media-and-entertainment fund since 2005, set aside US$100m last September to invest in online gaming and gaming cafés over the next three years.

This vibrancy is creating a new level of excitement akin to the early years of Silicon Valley. “In the United States, a lot of the VC opportunities now tend to be incremental; you’re just building a better mousetrap,” says Rahul Khanna, director at Clearstone Investment Advisors, a US venture-capital firm that invested US$5m last March in online-gaming operator Games2Win. “In India, the mousetrap doesn’t exist; you’re building a new category from scratch.” Or at least “new” in the Indian context. Many technology start-ups in the country are derivative: they use technologies invented, or business models that already worked, in the West or elsewhere in Asia. Clearstone, for example, has a stake in BillDesk, the Indian version of PayPal, the online-payment system owned by eBay. Draper, Fisher and Jurveston, a well-known VC in Silicon Valley in the US, has a stake in Seventymm, which runs an online video-rental service identical to NetFlix.

To be sure, not all of India’s new tech businesses in the country are adaptations of others’ successes. India, after all, is the land of emergent pride. The daring takeovers large Indian companies have pursued in recent years has had an infectious effect on budding players. Backed by a newly liberalized capital market, and a workforce with a can-do attitude, even small companies are thinking beyond national boundaries.

3D Generation

At Crest Animation Studios in Mumbai, the excitement is still running high. Last August, US-based investment and technology-development firm DE Shaw paid US$40m for 15% of Crest and 26% of its subsidiary, Rich Crest. That allowed Crest to move to a 45,000 sq f office, four times larger than before. More importantly, it boosted the company’s plan to evolve from an outsourcing-driven outfit to an original-content producer. That vision requires hiring more people, which make up 45% of costs, and buying more equipment, which accounts for 35%. “There’s big capital required for the speed of our development,” says CFO Pankaj Goswami. And there’s no time to waste. Just before DE Shaw came along, Crest had agreed to make three 3D-animation films with Lionsgate, the Hollywood studio that produced the 2006 Oscar-winning movie “Crash”. The first of these, “Sylvester and the Magic Pebble”, is to be delivered in 2008.

It was the first major realization of Crest’s ambition. Unlike its previous contracts, this is a co-production deal. That means Crest will provide half the funding for each film, and share all profits and intellectual property rights with Lionsgate. Crest will be in charge of the actual production of the films, using its creative team in California and computer-graphics facilities in Mumbai, while Lionsgate will market and distribute them across the US on 2,500 movie screens.

This is a new world for Crest, one that requires financing relationships with people in the know. While the company has no debt and is profitable, turnover from its existing operations – 231m rupees (US$5.7m) in nine months to December – is small. Nor would the size of its balance sheet allow it to borrow an amount big enough for an ambitious co-production deal. “Our traditional financiers are not well-versed with the recognition of the value of intellectual property,” says Goswami. “So the stake sale was a strategic move.”

Crest’s move toward becoming a producer of original content started in 2000 when it acquired Rich Animation, a small California studio headed by Richard Rich, an industry veteran who spent 14 years at Walt Disney and co-directed some of its classics such as “The Fox and The Hound”. Before then, Crest was an animator for the Indian market, and later, one of the first to do outsourcing work for foreign companies. In its first incarnation, Crest delivered more than 3,000 commercials and visual effects to local broadcasters and filmmakers. “We pioneered morphing – where you have a cheetah turning into a Kawasaki motorcycle – in the 1990s,” Crest CEO AK Madhavan recalls.

By the latter part of the decade, Madhavan saw an opportunity to take on work from foreign companies. “We decided to be in computer-graphics animation, because other Asian countries had already cornered the market for traditional animation,” he says. Not surprisingly, animators in South Korea, China, and Taiwan had also been building up their 3D skills. In 2000, Madhavan concluded that the outsourcing model wasn’t producing high enough margins; Crest had to own the contents it produced.

To do that, the company had to plant a stake near Rodeo Drive. “An indigenous folk tale with an indigenous character will not travel,” says Madhavan, “unless it’s designed for a global audience.” He adds: “Hollywood is what drives the global entertainment market, so that was where we had to look.” A mutual friend introduced him to Rich, who was then looking for a cheaper way of producing the stories he and his team create and sell to studios.

Animated

Two years after the acquisition, Rich Crest won its first contract with the US broadcaster PBS, to produce a 26-part half-hour television series called Jakers! Three months after the first season aired in 2003, the series earned an Emmy nomination, and later a BAFTA award, for best animation. Jakers! continues to air, and Crest now has shows in various channels such as FOX Kids and Cartoon Network, including Bratz, based on the popular dolls for tweens. It has also produced straight-to-DVD animation movies and children’s series, including Casper, Arthur, and Care Bears.

For now, India’s cost advantage is huge. Goswami reckons that wide-release Hollywood animated films cost US$50m to US$100m to make; he claims that Crest can do it with Lionsgate for US$20m to US$35m. As Crest in Mumbai gives Rich Crest in Burbank free rein in developing the creative aspects of its films, can it afford to go over-budget as typically happens in major studios? “We don’t have that luxury,” says Goswami. “Our budget would have to go through a lot of conservative pulls and pushes between a parent and the subsidiary, like a father telling a son, ‘This is your pocket money.’” Before signing Lionsgate, for example, Crest added only ten graphics machines. “We didn’t go out to buy 100 machines to build a studio; our overhead is not based on anticipation of a contract,” he adds.

It’s easy to understand such caution. But over time, Goswami realizes that Crest will have to fill the vacant seats in its expansive studio in Mumbai and that his operating costs will subsequently increase, not just because of a higher headcount, but also rising wages. To sustain its long-term EBITDA-margin target of 50%, Crest is focusing on enhancing productivity by investing in more-powerful machines, developing proprietary software, and training its staff. “It’s the CFO’s job to be cost efficient, and you do that either by slashing costs or improving productivity,” Goswami says. “We’re all for getting more out of every rupee we spend.” This, not wages, will give India the leg up on fellow Asian animators.

Can It Be Done?

Not five miles from Crest Animation, UFO Moviez has also set conquering the world on its agenda. The company converts films into digital format and delivers them via satellite to cinemas that run its servers and projection equipment. Since it started the business in 2005, UFO has swayed 650 theaters in India away from reels, making it the world’s largest digital-cinema operator, and the only one to use satellite to distribute films to theaters. In theory, digitization preserves the quality of the film, while satellite distribution curbs piracy and enhances the profits of producers, distributors, and cinemas. It may be too soon to tell if the system works as conceived, but UFO has already started pitching its services overseas. It made its first installation in Europe in March.

UK private-equity firm 3i invested US$22m in the company in January. CFO Aashish Malushte says that amount should be enough to fund UFO’s installation targets until 2008. By then, it aims to have signed up 800 to 1,000 theaters in Europe. UFO is now in talks with chains in the UK, France, and Italy. Likewise, it’s eyeing 300 theaters in countries with a sizable Indian population such as the United Arab Emirates, Sri Lanka, and South Africa.

What UFO Moviez has done is insert itself as a middleman in an industry that needed one – and in the process turn a reigning American business model on its head. In the US, cinema operators have been slow to switch to digital exhibition, since they are saddled with buying new projectors, which can cost as much as US$150,000 each. “There’s no business case for the theater owners,” says Sanjay Gaikwad, the company’s CEO. “Why should they buy expensive projectors?” Indeed, the obvious cost benefits of digital cinema go to producers and distributors. Filming a movie with a digital camera, having the finished movie saved in a hard drive, and then distributing it to theaters in the form of DVDs, hard disks, or via satellite – all eliminate the cost of analog reels.

UFO Moviez’s approach is different. On one end, it digitizes films at no cost to distributors, and then saves the files in its main servers, ready for distribution via satellite. On the other, it supplies theater owners, also free of charge, with projectors and servers, which receive the films via satellite. UFO Moviez makes money by charging 250 rupees from exhibitors and 200 rupees from distributors every time a film is run. It is able to track the play count because the movies are encrypted; exhibitors can only play them when they buy a decryption license. For a new big-budget movie, for example, the first decryption license will allow exhibitors to play the film 28 times, or an average of four shows a day for one week.

UFO Moviez’s “platform model”, says Malushte, works for distributors because they save on the cost of prints; each reel costs 70,000 rupees to make. A typical release will demand 200 prints at the outset and then many more thereafter. So distributing in 1,000 theaters eats away a typical production budget. It also works for theater owners, especially those outside major cities, because it allows them to run films on the same day they are released in Mumbai and Delhi. This boosts the revenues of theater owners because it beats piracy; in India, pirated copies often reach smaller cities long before the reels are handed down. The theater owners’ ability to store up to ten movies in their digital servers also gives them better control of what to show when.

Based on the fee UFO Moviez charges theaters and distributors per showing of a film, assuming a film is shown four to five times a day, Malushte reckons the company recovers costs on an average installation in less than a year. That’s not counting revenues from advertising. UFO Moviez also digitizes ads, which are sent via satellite with the movies each time a theater buys a decryption license. Currently, it charges 40 to 50 rupees per 60-second spot per theater. UFO Moviez then shares up to 30% of its ad income with the theater owners, who would otherwise have had to seek advertisers themselves. “When we bring our installations to 2,000 theaters,” he says, “we will be able to command a better premium from advertising. We may be able to get 200 rupees per spot.”

Will the model prove as promising in Europe? Malushte admits that the company won’t benefit from the same ad-revenue model there because of anti-advertising regulations in some countries. But he predicts higher revenues per film showing – thanks to the higher prices for film tickets in Europe. With its funding from 3i and internal cash flow expected to sustain its goal through end-2008, Malushte says UFO Moviez’s most immediate risk is competition. “Our single-biggest challenge is to ensure a fast rollout so that we are able to capture the market faster than our competitor does,” he says.
After all, no business model today can remain unique for long.