Just 15%. Remember that figure as you listen to Hollywood representatives and trade press falling over themselves to laud the growth of Chinese cinemas.

At this year’s CinemaCon MPAA’s Chris Dodd marvelled at China’s USD $3.6 billion box office in 2013, representing a year-on-year growth of 27.5%, saying that “with China building 13 new screens every day more growth is coming.” The Hollywood Reporter breathlessly reported last week that  Chinese box office “first quarter revenues for 2014 have already exceeded the country’s full-year total for 2009,” and that it could surpass USD $4 billion for the whole year.

The opening of screens has also accelerated since Dodd quoted the 13 screens per day figure last month. “In the first quarter, there were 325 movie theaters built, for a total of 1,609 screens, which means an average of 18 new screens went up per day,” says THR. Thus, China presently has 20,007 cinema screens compared to the 40,000+ in North America.

There is just one problem with all this exuberance; if the rate of cinema openings outpaces Chinese box office growth, then it is not a boom but a bubble. Because we’ve been here before and it did not end well.

Gravity Defying No More?

Any news and analysis about China has taken place against the wider economic landscape of the mainland. Last week Reuters reported that ‘China economic growth slows to 18-month low in first-quarter‘ as China’s new leaders reign in credit and rule out major stimulus “to fight short-term dips in growth.” It is noted that “even three or fours years ago, growth of less than 8 per cent would have alarmed Chinese officials,” who have been used to double digit figures, but in January-March the economy grew just 7.4%. The housing market in particular was a source of worry. Keep that in mind.

Of course, there were plenty of pundits saying, “this time/one is different.” Yu Yongding, former President of the China Society of World Economics, wrote in the article ‘Fears of a Chinese crash are unfounded‘ that “the market is always in search of a story, and investors, it seems think they have found a new one this year in China,” noting that dire predictions about China’s economy have “abounded for the past 30 years.” He admits that “China’s real-estate price bubble is often named as a likely catalyst for a crisis,” but tries to assuage fears by pointing out that China does not have sub-prime mortgages.

Whether China’s economy as a whole is headed for a crash/slowdown/correction is beyond the scope of this article. But it should be noted that the property market is identified even by defenders of the economy as the weak point. Commercial real estate is more exposed than private housing and multiplexes balance most precariously on top of the countless, recently constructed, shopping malls.

But surely the Chinese middle class’ insatiable appetite for domestic hits, Hollywood blockbusters in 3D, giant Imax screens and popcorn ‘dyed in all colors of the rainbow’ and ‘coated with sticky sweet syrup’ (thanks Joel) will keep cinemas going? Statistics say ‘no’. Here is why.

The Worrying Piece of Data – 15%

While you wouldn’t pick up the worry about a Chinese cinema sector bubble from western media and trade press, the issue is debated fairly openly in the Mainland’s Chinese-language press. In an article originally titled ‘Perspective Hidden Behind the 20,000 Screens‘ [a reference to the total Chinese screen count] on CE.cn (source: Beijing Daily) author Lu Yang quotes:

“From the status of the overall development of the market, the growth rate of the domestic box office this stage and movie theater attendance is nowhere near the speed of construction, an increase of the ratio between the two is in an unbalanced state, which means that the national theater attendance is actually not ideal. “critic Liu Chang says.

Cultural Industry Research Institute of Peking University, the Beijing Daily reporter Chen Shaofeng pointed out, “statistics show that the average attendance was only 15% of the national theater. Oversupply in the market [means] the theater’s income will be diluted further. “

These are shocking and worrying admissions that should set alarm bells ringing. The 15% occupancy rate might be the norm for western multiplexes, but just like China needs a growth rate of above 7.5% to 8%, so too it cannot sustain its cinema sector with what passes for normal in the US and Europe. Consider the fact that IHS stated last year that in the UK “The average cinema has an occupancy rate of 20-25 per cent across the week.” So Chinese occupancy rate is way below a mature market like the UK that has gone through extensive consolidation.

Digging even deeper in the statistics should give further pause for thought for anyone who thinks that 13 or 18 screens opening per day is an unalloyed good thing. The article explains:

Last year, for example, the average national urban theater attendance was low overall; nearly 85 percent of theater seats [were] in an idle state. Nevertheless, last year the number of [new] screens nationwide, [was] still over 4000. Mr Zou, a Marketing Manager from a Beijing Cinema reluctantly told Beijing Daily reporter that especially in the last two years, with domestic box office market booming, many investors have poured into the film market, “as the cinema operator, as long as there is adequate financial support, it will be crazy ‘enclosure’ Even the current top five cinema operators in the country, would not claim that every movie theater is making money, because attendance to put in that annual real-grossing movie down, with your fingers can count them. No good movie means no attendance; no attendance is equivalent to no gain. ”

Mr Zou listed another example, “in terms of venue rental, for example, a few years ago, venue rental only takes up about 1/5 of theater cinema box office revenue, hence the profit margin was relatively large. But now we have to come up with about 50% -60 box office % to pay for the venue rental, if you include the daily expenses of utilities, equipment maintenance, and staff salaries, in the whole year, it would be an achievement if you manage to break even

So just as the lack of a Skyfall-size hit in the UK dragged down last year’s box office in UK, along with much of Europe, so a series of under-performing films in China could have a major knock-on effect on Mainland box office. Only this would take place in a cinema market that is not used to anything other than double-digit year-on-year growth. Even a growth of “just” single digits is likely to have a major sobering effect.

Underpinning this is a widely recognised imbalance in the building and saturation of coastal and Tier One cities in the PRC. In the resort city of Chengde (with a population of just over half a million) a cinema manager told the Beijing Daily reporter Liu bluntly:

“Now  the biggest problem facing the Chengde theaters is irrational development. Currently [within a] 10 km radius of the center [it] has four theaters, which for Chengde City is already regarded as high-density layout of the so layout. If it is in first-tier cities like Beijing, where the public consumer and market demand have reached a high level, but also to ensure the daily operations of the cinema, but for Chengde City it is extremely unreasonable. “

It also makes clear that things might not get better this summer. Even more than in Tier One cities, in second and third tier cities’ cinemas box office is “boosted most by the Spring Festival, during the ’11 and other holiday,” particularly by young people. So while Hollywood is hoping for a summer 2014 box office bonanza, China’s cinema “summer” may already have been and gone in the first quarter.

Box office in China is primarily driven by new cinemas, especially those offering 3D, Imax and the rival premium large formal (PLF) operator CFGS. But this put pressure on older cinemas, who can only compete by lowering their ticket prices, which will push down total box office. This adds to the pressure on new multiplexes, says Beijing Daily:

Construction of the new theater in terms of hardware, or including with surrounding restaurants, parking and other infrastructure, compared with the old theater has certain advantages. But in ticket prices, in order to recover the cost of the new theater, it is often higher. Zou told the Beijing Daily reporter: “In the past, in order to open the theater as much as 10 million yuan [USD $1.6 million] is enough, but now you want to open a general theater with at least one screen it will be a cost of at least 50 million yuan [USD $8 million]. In just five years it has increased nearly six-fold, so for the theater to recover the initial investment, even in the case of higher ticket prices it take at least five years. “

The suggestion is made for cinemas to make better use of their real estate by hosting business meetings and school classes. But as experienced exhibitors in the west will attest, this is at best a band aid in a situation where cinemas are hemorrhaging money.

Anecdotal Evidence of Existing Problems

Looking beyond the statistics, there is already plenty of anecdotal evidence of problems in the Chinese exhibition sector. Huayi Brothers Media Co. Ltd. recently published its earnings and while there was plenty to celebrate in its tourist portfolio, the company was being dragged down by its cinema investments. As reported in Money.163.com:

Above 23 show a negative correlation companies, the majority of investment in Huayi Brothers theater company. Huayi Brothers Cinema Investment Co., operating profit loss of 12.4028 million yuan, net profit of 14.1058 million yuan loss. Its establishment in Shanghai, Shenzhen, Harbin, Shenyang, Chongqing and other places theater management company net losses of RMB 1.592 million [USD $255,845], respectively, RMB 1.538 million [USD $247,167] RMB 245,200 [USD $39,405], RMB 5.5354 million [USD $889,577], RMB 6.5556 million ([SD $1,053,530]. How Huayi Brothers will handle the debt and net losses of affiliates is a concern.

Huayi is not one of the top cinema circuits, but they have invested aggressively. To complicate matters they have had to create a new legal entity for each city in which they have opened a multiplex. Speaking openly, this is a business that the company will no longer be aggressive in.

Wang Zhongjun said, Huayi Brothers involvement in the theater business, is “at the most expensive time in the market,” [putting it] bluntly “[there is] inappropriate intervention, and therefore the speed of development is not so fast.” “Now [we] find the whole concept of this big movie entertainment and theater are low-return, relatively asset-heavy, low rate of return, and the whole strategy Huayi Brothers deviation.” Theater investments by Huayi in the future, he stressed will be “very cautious, moderate development of the theater [business]. “

There is more evidence of a slow-down, away from the financial reporting of theatre investors.

Celluloid Junkie has previously highlighted the case of tax avoidance and under-payment by cinemas. The The State General Administration of Press, Publication, Radio, Film and Television, China’s movie watchdog, suspended or otherwise punished 15 cinemas and said that it would introduce a nation-wide electronic ticketing system to prevent future fraud. But what was less reported was that this fraud was only partly driven by greed and often by fierce competition resulting from over-building of cinemas.

We Have Been Here Before (on 9/11)

If any of this sounds familiar, it is because recent cinema history has an important lesson that seems to have been largely forgotten.

September 11, 2001 was not just the day the World Trade Center towers were brought down but also the day that the largest cinema chain in the US and the world, Regal Cinemas, filed for Chapter 11 bankruptcy protection.

The following years were no less dramatic and realigning for the US cinema sector than they were for the world as a whole following the Al-Qaeda attack, though the casualties were companies rather than people. Ultimately the sector emerged stronger, but only after several years of pain as many older multiplexes were closed, vendor contracts severed or re-negotiated and small chains going under or were bought up.

There are several striking parallels between the US exhibition at the turn of the millennium as with China in this the Year of the Horse:

• Major multiplex expansion fueled by easy credit and a shopping mall/real-estate boom;
• Entry of new players with little exhibition track record or experience;
• Costly investment in new must-have digital technology (Dolby Digital/DTS/SDDS digital audio);
• Surging box office on the back of a handful of outsize hits (remember “Titanic”)
• Failure to close older under-performing screens;
• ‘Multiplex madness’ over-capacity and ‘vanity’ location competition;
• Significant expansion in the number of Imax screens in multiplexes.

What is worrying is that the Chinese conditions are more stacked in favour of a crash than they were in the US 15 years ago.

• Chinese multiplexes are built in urban, rather than suburban shopping malls (or stand-alone) with higher rent and operating costs;
• Investing in new new digital cinema equipment now is more expensive than new 35mm projectors/platters were back then;
• Chinese cinemas’ concessions business is underdeveloped compared to the US, making theatre operators more dependent on the box office;
• Just as the US back then, China’s cinema advertising market is proportionally smaller than, say, the UK, offering less of a buffer;

What The Trades (Don’t) Say

Only one Hollywood trade paper has to-date injected a note of caution in all the exuberance about the Chinese cinema growth.

Writing in Variety on 1 April, Shirley Lau reported comments by Cheung Chi-sing, Vice Chairman of the Federation of Hong Kong Filmmakers, at the recent Filmart that a “bubble may be forming in the mainland Chinese film industry.” While mainly focusing on film production, with 700 films made but only 200 released theatrically, it also noted worrying signs in the theatrical business:

In terms of the movie theatre business, Cheung said mounting competition and rising operating costs in China today are eating up profit margins.

With the number of movie theaters rising by 5,000 last year to end 2013 with a total of some 18,000 screens, the growth in screens last year outpaced the growth in the box office.

“This means the average income for every screen is falling,” he said.

Trying to put a positive spin on it, Cheung said that developers should focus on Tier Three and Four cities, leaving unsaid what the fate of cinemas in Tier One and Two cities will be.

No such worry from the Hollywood Reporter, which instead seems to have made a cottage industry out of speculating when and how Chinese import restrictions on foreign (i.e. Hollywood) films will be eased.

Most recently it predicted that “China Film Import Quota Will Open Up in 2017, Says Top Local Producer” having previously told us that “China’s Foreign Movie Quota Set to Expand — For Arthouse Films“, after it trumpeted “China Mulls Upping Film Quota by 10 (Exclusive)“, which was only an ‘exclusive’ because it turned out not to be the case. But no word on the Chinese mainland multiplex bubble.

Prospects, Winners and Losers

It is too early to say whether Chinese cinema exhibitors are in for a hard crash or a soft landing, but a correction is now becoming overdue. It will not take a Black Swan event to bring it about, but a run of poor box office performers or simply a low quarter could have a ripple effect. If a larger economic crash comes, cinemas will be the least of the worry of China’s leadership, but they may be an early indicator.

It is worth remembering that Chinese cinemas are the top of a pyramid (or bottom, if you look at it inverted): the multiplex sits on top of the shopping mall (spatially and figuratively), which is perched at the top of commercial real-estate, which is resting on top of the property market, which is currently the most exposed part of the Chinese economy.

When the correction arrives there will be winners and losers. Again, we can draw lessons from what happened in the US, with major consolidation, the streamlining of businesses such as cinema advertising and distribution deals. In addition to cinema operators, suppliers, vendors and real estate companies, one of the major losers could again be Imax. While there is a difference between the US Chapter 11 regulation that allowed North American exhibitors to terminate expensive contracts with Imax, those differences are not in the Canadians’ favour when it comes to China looking to bail out its cinema sector. It could also spur a migration to the cheaper domestic CFGS large format operator.

At the risk of straying into the Hollywood Reporter’s crystal ball-territory, one of the beneficiaries of any correction or contraction could be Hollywood studios. While Chinese authorities want to promote domestic films above all, they could be forced to ease film import quotas in an effort to attract more people to the cinemas with more films.

There could also be an easing of censorship and a widening in the type of Chinese domestic films that get shown, much like what has happened in Indian multiplexes in the last decade. The success of Berlin Film Festival winner Black Coal, Thin Ice could be one such harbinger.

It is important to not be alarmist, but equally not to adopt the head-in-the-sand strategy that was all too common before the fall of Lehman Brothers in 2008. To keep reporting about the breakneck pace of new cinema screens opening in China without putting this into the larger context of an outpaced box office and major structural imbalances only helps inflate the bubble. China’s cinema correction need not be as dramatic as the one in the US a decade and a half ago, but only if the signs are heeded early enough.

Those who follow Chinese astrology should take particular note. An article from Hong Kong at the start of the years tell us, ‘Saddle up for a bumpy Year of the Horse, warn Hong Kong geomancers‘:

Hong Kong will face a difficult Year of Horse that is filled with chaos, disputes and a pessimistic economic outlook, according to Chinese Fung shui and Western astrology.

Fung shui masters say the Year of Horse is characterized by the elements wood and fire, with the latter being the dominant element – which is not a positive sign.

“The fire is so strong that it will cause an ‘explosion’,” said fung shui master Ma Lai-wah, citing as an example how this could mean “the economic bubble might burst, and the impact will last for a while”.

So even if you doubt statistics, listen to the Fung shui masters.