In part two of her investigation of the movie business, Karyn Scherer finds that the numbers are not what they seem.

It is one of Hollywood's oldest clichés that the most creative people in the film industry are the accountants. Such is their renown that "Hollywood accounting" even has its own Wikipedia entry.

If life really were a Harry Potter movie, these behind-the-scenes bean-counters would surely be the wizards known as the Unspeakables who beaver away at the Department of Mysteries, responsible only to their bosses at the Ministry of Magic.

Come to think of it, the Department of International Magical Cooperation bears some resemblance to the Motion Picture Association, the organisation that lobbies on behalf of America's major studios. And you could, if you were so inclined, extend the metaphor to the Muggles (Mugs, for short) and beyond. John Key for Muggle Prime Minister, anyone?

But back in the real world, the most appropriate analogy is probably a shell game - in which naive investors don't have a hope of tracing the money, because the studios have already stacked the odds.

New York-based investigative journalist Edward Jay Epstein has written two books about the hidden financial reality behind the movies, The Hollywood Economist and The Big Picture: Money and Power in Hollywood, and it astonishes him that so much coverage of the industry remains so superficial.

In 2006, the Economist estimated the major studios required an annual investment of US$1 billion just to remain viable. It insisted the business was a low-margin one.

Epstein concedes it's a difficult industry to analyse, given that Hollywood is notoriously secretive about its bottom line.

But according to him, the margins aren't so bad. "It's not as much as hedge funds, but they still make a fairly good 8 to 10 per cent return," he told the Business Herald.

The business is dominated by six main studios which are in turn owned by conglomerates who effectively cross-subsidise their movie-making with their other media businesses. Warner Bros, for example, is owned by media giant Time Warner.

Although Time Warner does not provide specific details, Warner Bros has consistently claimed to be the most profitable studio.

"If Warner Bros was a movie character, it would be Demi Moore in Indecent Proposal - sexy, successful, and with piles of money to roll around in," Elisabeth Rappe recently wrote on industry website

That said, studios these days have to market their products across a much wider range of platforms, including cinemas, public television, pay television, DVDs and the internet. The explosion of the electronic games industry has provided both another serious rival and another platform to consider.

In fact, the cinema business now makes up only 20 per cent of the studios' revenue. In 2007, the six studios took in US$17.9 billion from DVD sales alone, says Epstein.

As technology transforms the industry, the biggest squeeze is going on the actors, writers and directors who have been the most successful in ratcheting up their rates in recent years, and on production costs, he says.

In one of his books, Epstein cites the deal struck by Arnold Schwarzenegger for Terminator 3 as an example of start-of-the-art deal-making. Schwarzenegger's contract required no fewer than 21 drafts and ran to 33 pages. His base salary alone was a US$29 million "pay or play" fee, meaning he would be paid whether or not the movie was made.

While there are still plenty of contracts that would make local actors green with envy, studios these days are generally obsessed with the bottom line and have staff who query every single bill, says Epstein.

Even our own Sir Peter Jackson confirmed as much, in his review of the New Zealand Film Commission.

"The other reality is that all these companies are publicly traded, and have shareholders to whom they report," noted Jackson. "The studios attempt to save money at all times - every dollar in a production budget is picked over and questioned."

Epstein notes that studios have even resorted to shredding their old prints for their silver content - proving that bad movies can have a silver lining. But even in the case of extremely successful movies, government subsidies can also be very handy, he observes.

"As one producer put it, movies, like ladies of the night, go where the money is."

Lord of the Rings remains one of the most obvious examples of how studios can benefit from subsidies, says Epstein.

"New Line made enough pre-sales in foreign markets, and there were enough subsidies to pretty much cover their costs. New Zealand was not the only subsidy. There was also the British Commonwealth subsidy and the German tax subsidy in those days. New Line didn't have to put up any cash to make that movie."

While subsidies mean more profit and less risk, he says, exchange rates can be even more important.

"The New Zealand dollar has risen sharply since Lord of the Rings. So to make The Hobbit, they have to pay 30 per cent more. It has totally changed relations with Canada. The Canadian dollar used to offer a tremendous discount and the studios used to go to Canada a lot. But when the Canadian dollar started moving upward, the studios started to negotiate bigger subsidies. However, the state of Michigan found it was paying nearly US$200,000 in subsidies for every job that was created, which is basically idiotic."

While The Hobbit might look like the closest thing there is to a sure bet in Hollywood, you also have to take into account that directors such as Jackson don't come cheap, says Epstein.

"Peter Jackson demands, especially since Lord of the Rings and King Kong, a large percentage. In fact, he had a lawsuit over Lord of the Rings. You're going to pay a lot of money as a gross participant to Peter Jackson. So that also changes the reward part of the risk/reward ratio. And if the New Zealand dollar has appreciated, that also diminishes the reward part. So from their point of view they need to be pretty careful."

Some have indeed claimed that it was a bit rich for Jackson and co-producer Philippa Boyens to accuse the actors' union of playing hardball over The Hobbit, when his own company sued New Line over his compensation for Lord of the Rings. Jackson argued that he had been hoodwinked out of income from merchandising and electronic game sales from the trilogy.

Los Angeles-based entertainment lawyer and Hollywood Reporter contributing editor Jonathan Handel agrees that the end game these days is all about "the extraction of production incentives".

The film industry, Handel argues, is not as lucrative as it was.

"DVD sales have fallen off a cliff, and economically that's the tail that wags the theatrical dog. Movies like The Hobbit or Lord of the Rings still do a huge amount of theatrical as well, but speaking more generally we've just had studios finish their negotiations with SAG [the Screen Actors Guild], and their entire mantra was cost containment.

"In the past, they paid stars US$25 million against the back end of 20-25 per cent of the gross. That's pretty profligate. That's just throwing money around like pig slop, so the number of star-driven movies is in decline. Look at The Hobbit - who's the biggest star in that? Ian McKellen? He doesn't get US$20 million. So there's room for one big pay-day - and that's a movie that's going to make a huge amount of money across the world."

Epstein - who incidentally played a bit part in the Wall Street sequel which screened here last month - agrees most studios originally made most of their money from the exhibition business. These days it's DVDs, downloads and merchandising that help keep most afloat. With DVD sales declining, studios have had to get ever more creative to keep their shareholders happy, dabbling in arcane schemes such as copyright lease-back deals, and what are known as replication output deals.

According to Epstein, these deals have become part of Hollywood's "invisible money-making apparatus".

Paramount made nearly quarter of a billion dollars from just three deals, he claims: US$50 million for agreeing to release Titanic on DVD in time for Christmas, US$150 million for allowing Panasonic to take over video replication from another manufacturer, and US$50 million for agreeing to support the DIVX format. They also accepted US$150 million from Toshiba for supporting the HD-DVD format - which like DIVX, was soon dumped.

"Such windfalls, even if not visible to the public, are what assure studios a true Hollywood ending: bottom-line profits even when their films fail at the box office," he claims.

Another way studios subsidise movies is through product placement. The casting of cars goes back to the 1974 James Bond film The Man with the Golden Gun, whose producer, Albert "Cubby" Broccoli, made a deal to use American Motors vehicles in all the chase scenes in exchange for advertising dollars.

Even local movies sometimes resort to product placement, though it's hardly on the James Bond scale.

At an industry conference in Auckland last month, local producer Richard Fletcher noted one recent deal which was originally intended to provide the use of a car and $25,000 worth of advertising. "It ended up being $5000 because we didn't do number of placements they wanted," he noted. "It tends to be more television-focused than film-focused in New Zealand."

Meanwhile, the exhibition business is also undergoing a radical transformation. Following the advent of television, cinemas nearly died in the 60s and 70s, before multiplexes helped bring back audiences and restore profitability.

But as the line between the big screen and the little one becomes increasingly blurred, some executives worry that even the move to digital projection, and 3D, may not save the exhibition business.

In the past few years, blockbusters such as Avatar have revived the cinemas' fortunes. But in the US at least, many still lose money on the tickets they sell, Epstein claims. However, that's not really the business they are in, he argues. Most see themselves as retail outlets, peddling high-margin snacks to a captive audience.

As one executive happily tells Epstein in The Hollywood Economist, the most significant development for cinemas in recent times was seats with built-in cupholders. And as for popcorn - as we all suspected - what the cinemas are really selling us is the salt. Softdrink might not be healthy, but the margin certainly is.

Movies are inherently high-risk, so the movie business has a lot in common with venture capital. As in venture capital, logic should dictate that the most successful enterprises help pay for the vast majority which don't make any money.

But this is Hollywood, where behind the phony tinsel lies the real tinsel, as Oscar Levant famously said.

In July, someone leaked to a website the distribution reports for Harry Potter and the Order of the Phoenix, which appeared to show the movie lost US$167 million, despite grossing more than US$600 million worldwide. One of the main reasons for the loss was Warner Bros' "distribution fee" of US$212 million.

According to Epstein, Hollywood studios often dabble in double accounting, leaking an official budget to trade papers such as Variety and The Hollywood Reporter which is often markedly different to their own internal accounts. The latter budget, seldom seen by anyone outside a studio, takes into account the money the studio gets from government subsidies, tax shelter deals, product placement and other sources that greatly offset the amount of its own money a studio actually has to sink in to a film.

"When viewed from the outside, movies, which are almost always set up as separate off-the-books entities, rarely, if ever, show a profit. Nevertheless, when viewed from the inside, they serve as vessels for collecting and dispensing billions of dollars in fees."

Those fees are only paid once a production gets the green light, and once studios have run the numbers to make sure they have a good chance of covering their outlay, even if the film itself is unprofitable for others, he claims.

While researching his second book, Epstein couldn't at first understand why studios bothered bringing in outside investors, when they appeared to have plenty of capital of their own. A senior studio executive told him the reason: it was basically a con.

"Journalists all seem to buy - hook, line and sinker, and press release - the line that we need money," the person told him. "In my 30 years in this business I have never ceased to be amazed by this gullibility."

The real reason for pleading poverty, the person explained, was to help the studios negotiate better deals with stars and their agents. And the only reason for recruiting outside financing was to allow a studio to make an "asymmetric deal" with an outsider - meaning the outsider gets a smaller share of the total earnings than does the studio on an equal investment of capital.

Hedge funds have been traditional targets, and in his second book Epstein cites a note from JP Morgan Chase to hedge funds that shows it is not just the media that takes the studio bait.

"Despite compelling economic returns, major film studios are capital constrained and often must seek co-financing arrangements with other studios and other outside sources," the note reads. It goes on to offer "a unique opportunity to participate in the most profitable segment of the motion picture industry."

Between 2004 and 2007, some hedge funds were even offered a slice of the studios' internal rate of return - but what the funds didn't seem to appreciate was that the studio was taking a 10 per cent distribution fee.

According to Epstein, this remains true to the Hollywood tradition "of giving civilian investors the short end of the stick".

Or as Jackson and David Court put it rather more delicately in their review of the NZ Film Commission: "Some investors may relax their financial expectations, or accept risks they would ordinarily shun, because an investment pays off in other ways - the glamour of the association with the film industry, the chance to be part of something creative. We note that the Hollywood industry has been particularly effective in delivering these kind of benefits, thus reducing its cost of capital to rates well below what would be justified by the risk profile of the movie asset class."

If even the world's biggest movies with the biggest stars don't make money, what chance a little Kiwi flick with unknown actors?

Just like in Hollywood, a lot depends on how much you spend making the movie in the first place, and how well the marketing goes. But even spectacular successes such as Taika Waititi's Boy show how hard it is to make money from New Zealand movies.

So far, Boy has grossed around $10 million in New Zealand. However, it has been hard to sell overseas, so according to Fletcher, who was an associate producer on the film, it is unlikely to recoup its costs.

Many people buy the argument that it is important that we subsidise local films for cultural reasons. But given that so many studio movies are watched by so few, should so many be made in the first place?

And if a hugely successful movie like Lord of the Rings still needs taxpayer subsidies, then surely there is something fundamentally wrong with the industry's business model?

At an industry conference in Auckland last month, Australian producer Brian Rosen opined that there were probably far too many "dreary, drawing-room dramas" being made. Making a movie, he noted, was a "very expensive way to tell your personal story". Yet in this part of the world, projects tended to be driven by passion rather than popcorn.

The problem, said Rosen, was that it was very hard to predict which movies the public would lap up, and which they would ignore, largely because there were so many ingredients in the movie-making recipe that could potentially turn sour.

"The concept of an agency funding commercial films is the biggest myth there is. If I knew what a commercial film was, I wouldn't be sitting here. I'd be sitting in Hollywood, very rich."

Nevertheless, the local industry has occasionally complained that New Zealand is missing out on the profits that can still be made from international productions that choose to base themselves here.

In 2007 consulting firm LECG was asked to examine whether the Government should intervene to ensure New Zealand had even more skin in the game.

The report did indeed note that many of the movies and TV series being made in New Zealand were essentially fee-for-service productions "that will have little long-term benefit for foreign exchange earnings unless the industry is further developed."

It concluded, however, that movie-making was an extremely risky business best left to the international experts. "Although the bulk of any profits from international projects may go overseas, the large losses accrued if a project is a commercial failure also leaves New Zealand's shores."

It also noted that many people in the local industry were "able to articulate what they can do, but not articulate the value of the potential returns to investors."

Industry veterans acknowledge the local market has never fully recovered from the tax rorts in the late 80s, which have virtually ensured that anyone who invests in films attracts the full attention of Inland Revenue.

But even a clued up lawyer, and a very clued up accountant, may not save you if you fancy a flutter on the flicks.

Among those who have been burned is South Canterbury Finance.

In her recent biography of Timaru titan Allan Hubbard, A Man Out of Time, author Virginia Green recounts SCF's foray into films.

"The BNZ approached us to invest in Lord of the Rings and they indicated that the profits could be huge if it was successful," she quotes Hubbard as saying.

SCF invested $10 million in each of the three movies. However, New Line later produced accounts showing that instead of making a profit, the movies made "horrendous losses". According to Hubbard: "We found it surprising because it was one of the biggest box office success of all time."

SCF and several other high-profile investors attempted to sue New Line, writes Green, but soon got swamped by the process. Hubbard later discovered the US courts were packed with similar cases relating to films and plays "where unscrupulous promoters have presented an opportunity to naive investors", she says.

Apparently, Hubbard bought 100 shares in New Line and planned to go to the annual meeting and demand justice. "He was only restrained by the partnership's lawyers, who advised him against it," says Green.

It goes without saying that in recent years, money from hedge funds has also dried up. But that hasn't deterred the usual suspects from keeping an eye on the industry.

At the local producers' annual pow-wow in Auckland last month, Rosen revealed he was considering setting up a film fund that would package a portfolio of movies to intrepid investors.

According to Rosen, he outlined his pitch to an audience that included investment bankers such as Goldman Sachs, and revealed that his own study of mid-budget movies made in Hollywood between 2005 and 2008 showed that the total profit margin was only 10 per cent.

Unsurprisingly, animated films were the most profitable, returning on average three times their cost. But that meant many other movies made massive losses.

The reaction from the audience was predictable, he says. They wanted to know why on earth they should bother.

"And I said: 'But now watch what happens when I put the offset in.' Suddenly, the profit jumps from 10 per cent to 60 per cent. 'Now,' they said, 'that's a business'."

The "offset", in layman's terms, is the subsidy provided by the Government.

But Rosen didn't mention that Australian investment bank Macquarie has already gone there. According to the LECG report, investors in the Macquarie Film Corporation got back only 15 cents in the dollar when it was wound up in 2006, despite the Australian Government providing half the cost of production, as well as tax concessions. Of this, the bulk came from a single film which did moderately well at the Australian box office.

None of the eight films it financed made sales internationally, and most also flopped domestically.

At the same conference, Australian film financier Sharon Menzies admitted that some production companies were reinvesting in their own post-production.

"I think there is a limit to how much you can actually reinvest, but I don't think it's any secret that they are over-inflating their costs and over-inflating their budget and then putting that back in," she said.

Fletcher noted that many countries, including New Zealand, did not seem to mind. "I've been through several films with various agencies, and none of them have batted an eyelid. It's been very clear it wasn't a problem."

The lesson, according to Epstein, is that "things in Hollywood - and especially numbers - are not what they appear to be, proving yet again that in Hollywood, the real art of movies is the art of the deal."