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interview: dennis mcalpine

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How large is the adult entertainment industry?

You can get estimates of a range from a billion dollars to $10 billion; nobody really knows. It's large. There's a lot of it that's almost invisible. There are some portions of it, like the paid TV side, where you've got public companies involved, Playboy and New Frontier, where you can get a fairly decent idea that it's maybe a billion dollars maximum.

Why are the numbers so different? Does anybody have anything to gain by making the numbers larger than they are? Why the divergence of opinion?

There's no reason for the adult entertainment companies to make themselves look bigger, unless they're a Playboy who would like to look bigger. Most of them would like to say, "Oh, we're just a small cottage industry. We're struggling to survive." ... They don't want the notoriety of how much money they've made. That's why you don't see most of them running around in the Rolls they keep that in the garage and take out on weekends. It draws too much attention to them. Then they're afraid that there will be investigations, and that some of the so-called public interest groups will come back and start going after them. "How can you let these people make these huge amounts of money by running filth on our screens?"

But the numbers you're saying are somewhat over-inflated in a way. The New York Times reported $10 billion. You read Adult Video News and the numbers go up to $14 billion. Are those numbers completely outrageous?

No, it depends on what you include in it. The adult entertainment side, the pay-per-view side, maybe that's a billion dollars. What the cable guys get, what Playboy gets, what New Frontier gets, maybe all in all that's a billion dollars. But then you've got the whole Internet. New Frontier, for example, is close to $20 million. Their pay-per-view, their piece of it, is only about $15 million. So it can be a lot bigger when you start getting things that you can't get your hands on, you don't see the money coming in.

Currently an analyst at Auerbach, Pollak and Richardson, an investment banking and brokerage firm, McAlpine has covered the entertainment industry for nearly two decades. In this interview, he offers an overview of the economics and business of the adult industry, including estimates of the revenue that AT&T Broadband generates from distributing adult programming through its cable operations. McAlpine also discusses the impact of video-on-demand for the adult industry and how adult video fueled the Internet's growth. This interview was conducted in August 2001.

Can you break down in general either the percentage of the pie that it is, or in rough figures what they seem to be?

The pay-per-view side -- again, using that because we can get some very decent numbers -- is probably close to a billion dollars. And this is the cable TV carriage. The Internet is probably, rough guess, two, three, four times larger than that. One of the problems with the Internet is you can't get much more than still pictures. Unless you've got a high-speed cable line, or a DSL line, you don't get good motion on the Internet. So you'll get still pictures, but that gets boring to a lot of people.

You've then also got the whole adult entertainment film business. That's a complete underground thing, even if you count the legitimate adult entertainment. And those are shown in the small theaters, or they show up on cable like Playboy or wherever else they may be.

What's the analysis of the adult video production? Where do we think that number lies?

I would think on the movie side, whatever they get out of the movie business, plus what they get out of home video, plus what they get out of pay-per-view -- it's probably somewhere between $5 billion and $10 billion.

And who's taking a big piece of that pie?

A lot of it is small producers out in Hollywood. They're setting it up. These movies don't cost much. You can do them for $5,000, $10,000, $15,000. Playboy does some stuff with, as they say, "great content." And they're spending $100,000, and that's considered outrageous by some of these companies.

For instance, "Barely Legal," a very popular series -- tell me how that brings a profit, from the point where they shoot it, to the point that it ends up in all the different possible venues that it might end up in.

The way you make the money is you're producing a show. It's not like you're doing "Star Wars." You're not spending $100 million on it. You're spending $5,000, maybe $10,000. You sell it for theatrical distribution, although that's pretty much gone now; there aren't too many of the adult theaters left. You sell it in home video.

And very often that will not show up in the home video rental store. Blockbuster, for example, Hollywood Entertainment, the chains, for the most part, will not carry adult entertainment on videos. They'll carry R or hard, but not the real pornographic-type stuff. So you have to go to the mom-and-pop stores for that. Then you got the whole chain of adult stores around the country. So each one of them supplies a little piece of it.

Besides the stores, you've also got pay-per-view. How does that work? Hustler, for instance, when they produce a series, where does their material go?

Most of the good stuff will go on either Playboy or New Frontier. New Frontier runs three channels. Playboy now is going to run about eight channels. And they will carry most of the adult entertainment programming.

They do not run the so-called XXX, because it's an area they don't want to get into. They don't want to test the laws for that. But they will run pretty close to that.

Tell me what X is, XX and XXX. What is it, content-wise?

There is no official MPA rating. They call Adult NC-17, and I'm not even quite sure what NC-17 stands for. But the XXX rating that you see on the old adult theaters was something that was gimmicked up by the exhibitor, who was trying to make the movie look bigger than it was. "Gee, come here and you're going to see Deep Throat and all of these things." There is no XXX rating.

There is a rating which is called Cable X, which has limits as to how far you can go in terms of explicitness, and how much has to be edited out. And then people have just gone from that, and said, "OK, we can go to XXX, which will cover everything.

Basically, what is the difference between XX, which you can get on video, on broadband, and XXX, which you need to go to a video store to buy? How are they different?

Typically, it will depend on what shots they will show. Bestiality, for example, I don't think anybody is touching that yet. That's XXX-plus. Lesbian, that's becoming more mainstream now, I think. You could probably get away with some of that. It went so far as to say, "How much frontal nudity? If you show 10 seconds, is that pornographic?" "No." "OK, how about 15 seconds?" "No." They keep testing the limits to see how far it can get.

What kind of pornography do you get on cable?

What you really get in most cases is a hard R, or a soft X.

On most of these channels, like the Hot Channel and stuff, you get insertion, you get anal sex, you get all that. That used to be considered pretty raw stuff. Has there been a mainstreaming so that the view of what's hard and what's not hard has sort of changed?

I think they've become much more liberal with it. And part of that is, as you show one area, that becomes accepted, so you go to the next one. And you go to the next one. And things that 10 years ago were not permissible now are accepted by society.

Let's talk about Vivid. Vivid was talking about the fact of possibly going public, and then was the downturn in the stock market and such. Can a Vivid go public at this point? Is that something that Wall Street is sort of ready for?

Apparently it comes down to, are they showing growth and earnings? Vivid has done a very good job for creating a niche for itself. They've separated themselves from the regular adult entertainment production companies by creating an aura about their girls. They have the so-called "Vivid girls." And that sets them apart from the tramp you pick up off the street. "This is a Vivid girl, she's good. She's just doing this because she's an artist." They've created that aura and it's worked for them.

The problem is that where they were getting a lot of the growth was on pay-per-view. Now they're selling that to Playboy, and the question is, where is their growth going to come from? If they're just doing home video and movies, then it's not as big a growth factor as it had been. It's still ... maybe $150 million in revenue. That's not a very big company.

The good thing it has going for it is that most of the people don't know what Vivid Video is. They know what Playboy Entertainment is. They say to investors, "I don't want to be involved in any of that smut, whether it is or isn't." And Playboy has been very careful to stay away from that. But probably a third of the investors will not buy a Playboy stock. They might buy Vivid because they don't know what's involved.

Has adult become mainstream enough that a hardcore video company can, in fact, come to Wall Street?

I think it would be very difficult. They could come to Wall Street. I don't think you'd see them do a public offering. You might see them do a private placement, where they go to select investors and say, "Here we're offering shares of Vivid Video." But to go to the general public and say, "We're offering Vivid, an adult entertainment producer," I'm not quite sure we're ready for that yet.

How much money is AT&T Broadband making from adult entertainment?

Probably a significant amount. They've got, give or take, 10 million subscribers. If you assume that 10 percent of those subscribers, or a million of them, buy one movie a month, at let's say $10, which is a high-end price -- that's $10 million dollars. They're getting probably 80 percent to 90 percent of that ... the remainder going to the program supplier. So they're getting $8 million to $9 million, minimum. They may be getting twice that on a very good month. So they could get $15 million, $20 million a month. That adds up over the course of a year to a good-sized amount of money.

How do we know those figures?

What we're guessing at is that we know that the particular buy rate for adult entertainment is somewhere between 5 percent and 10 percent. On some of the movies, you can assume that it's running closer to 20 percent. And that can be one person buying two times, or two people buying once a month. You just take that time and the price, and that's how you come up with that.

Typically, what happens is that the viewer will pay for a block of time. He may pay $5.95, or if he's watching something like Vivid, they're up to as much as $10.95 or $11.95 for the more explicit product. So he pays that amount, typically on an impulse basis. He pushes the button and says, "I want to see this movie."

Let's assume it's $10.95. That is split proportionately between the cable operator and the adult entertainment provider. That could be New Frontier, it could be Playboy, it could be anyone of these companies. Or, in the case of Vivid, they had their own channel, Vivid, and they were selling that separately.

How do we know how many hits they're getting, or how many times they're showing it?

We know anecdotally from various information that most cable systems are getting typically around a 5 percent to 10 percent buy rate. For the more explicit stuff, they're getting between 10 percent to 20 percent buy rate. The more technically advanced the system, the more higher the buy rate is.

How popular is this fare?

It's extremely popular. The consumer is now given a way of getting home video without going to the store and walking out with a brown paper bag with a title that he's afraid his next-door neighbor is going to see. He's getting that home video delivered to his home, and he thinks nobody knows that he's got it.

How do we know the figures? Do we just pick up an AT&T SEC document to sort of figure out the percentage that they're making off adult entertainment?

No, the only way you get that is anecdotally. If you talk to the Playboy people or New Frontier, or the Vivid people, or some of the cable operators, they'll tell you in general numbers what they're getting.

AT&T is a publicly held company. Why shouldn't we just be able to look at the records and see the profits?

It gets lumped into a category typically that's called "pay-per-view." And that includes boxing matches, it includes Wrestlemania, it includes adult entertainment, it includes concerts. You can't separate the whole bunch out.

Why not?

Nobody has got the exact numbers that they're willing to part with.

AT&T doesn't want to put down the figures that you can really understand what's going on?

My guess is that they don't want the suppliers to know how much money they're making off of each of the individual products, so that they're not going to get charged more for the stuff that's selling real well.

But is there an embarrassment factor here too? I mean, one of the things that AT&T seems to be saying in the past is, "The numbers of what we make off of the adult material is insignificant, such so that we don't break down our records that way." Is that true?

It can't be true, because AT&T has to pay the provider with the programming for each buyer that's made of his program, so they keep track of it.

So how does the profit that AT&T makes off of adult fare compare to everything else that they're making off of what they're selling on cable?

Typically, if you look at a cable company, they are charging the consumer $30 a month, and he's getting 50 channels or 100 channels or 200 channels. And they don't break it down from that. They have to pay a good portion of that in programming to the suppliers like CNN or Showtime, or whoever may be getting it.

The difference, when you get to the adult programming, is that New Frontier and Playboy supply the programming to the cable operator. The cable operator receives money directly from it. He will keep 80 percent, 85 percent, 90 percent of that money for himself, and give the rest to the supplier. So for him, adult is a source of revenue, and it has no cost against it. He doesn't have to pay for the programming, but he receives the money from it. So for him, it's an incredibly profitable operation, particularly in terms of profit and margin.

Why such a good deal?

Because the cable operator, in essence, has a monopoly on his subscriber. Until you get into DirecTV, or Dish TV, there was nobody else who could supply that. So if you were an adult programming person, you had to sell it to that cable operator to reach his audience.

How does pay-per-view or special payments compare to the other stuff that you can buy on cable, especially, for instance, looking at AT&T?

You can't tell about AT&T specifically because they, like any of the cable operators, won't break down their numbers as to how much they're making from each piece. But if you look at it, what are your options on pay-per-view? You've got adult, you've got first-run movies, sometimes you have concerts, sometimes you have wrestling, sometimes you have boxing. But the biggest piece of it is probably first-run movies. The second-biggest piece is adult.

If Hollywood Films is one of the offerings on AT&T Broadband or any pay-per-view, they make a certain percentage; adult makes a certain percentage. How surprising is how large that percentage is, and what is the percentage?

I would think, in general, on a pay-per-view basis, first-run movies coming from the major studios are probably generating 50 percent of the revenue. But the studios are keeping at least half of the revenue, and the middle guy is taking 10 percent. So the cable operator is probably keeping 40 percent of it.

Probably 25 percent to 30 percent of the revenue is coming from adult, but that's split -- 80 percent, 85 percent, 90 percent to the cable operator, the remaining going to the programming supplier. So the profit margins on adult are much higher for the cable operator, although the revenues may not be.

So, buck for buck, what are they making?

There are two ways of looking at it. At the low end, the hard R-rated, the relatively modest adult program, is probably selling for $5.95 for a block of programming. And the cable operator is probably keeping 80 percent, maybe 85 percent of it.

At the other end, on the more explicit, unedited programming, you're probably selling it for $10.95. The cable operator is keeping maybe 80 percent of it, but probably 85 percent, maybe a little higher. And the buy rate is probably two to four times higher for the explicit programming than it is for the R-rated.

If you start looking for AT&T or another cable company ads about coming stuff on the Hot Channel, coming attractions, the Spice Channel, you have some problems finding the information. Why is that?

The cable operators are a little afraid of the public opinion. There are a certain group of people in most communities who object to the programming. Even though they've never seen it and have no idea what it is, they object on general principles. It's pornography, it's smut, it's whatever. "How can we let our children see it?" And they will yell and scream, even though they've never looked at the programming themselves; they don't know what it is.

The cable operator has found that the viewer who wants that programming will find it. Much like kids finding kids' programming, adults who want adult programming will find it. So they don't need to advertise it a lot. What they do need to do is make it convenient for the buyer so that they just push a button, as opposed to calling up a phone and making a definite statement that they want it.

When you go to AT&T and ask for an interview or a statement, what you normally get is, "We don't talk about adult fare, because we don't want to advertise it. We think if the public wants it, we'll give it to them. But we don't go out and advertise and try to sell it, because we don't think that's right." Define that sort of policy and what that is.

That's sort of putting your head in the sand and ignoring what's going on. They know they're making a lot of money off adult programming. They just don't want to get the city councilmen upset and then breathing down their necks. So they say, "We're just doing it because we have to. It's freedom of speech. We can't control what's on the program."

We've been through all this, particularly in New York, with the public access channels. They had some stuff on public access that was probably worse a lot earlier than any of the adult programming was. They couldn't get rid of it because it was public access. You can do this, and say the same thing about regular adult programming. Yet you can't deny it. And if the people want to buy it, they should be allowed to, particularly now after we've gone through the whole Section 505 and the congressional hearings, and we don't have the so-called "bleedthrough" problem.

... One of these companies is sort of stating that they're a common carrier, so that they need to carry this stuff, and it's not really anything to do with them.

For them, it's a convenient excuse. They, the cable operators, are trying to stay away from the idea that they're running adult programming. All they're doing is making their facilities available to somebody and letting the consumer buy it if he wants to. But they're not forcing it on him; they're not advertising it to attract young kids, this sort of thing. They're just sort of a passive middleman taking 80 percent off the top.

So does their argument hold water?

Well, if it keeps the city council off the back of the cable operators, sure, it's holding water.

Why does an AT&T, a Ma Bell, get involved in this type of fare?

Every cable operator does, with one exception, to one extent or the other. It is a source of revenue, it is a big source of profit. It is a source of keeping their subscribers happy.

What about the legal risks to airing this?

The legal risk is if you push the envelope too far, when you cross that threshold from what's acceptable adult programming to what's pornography. The cable operator, the sound/light operator, clearly doesn't want to run pornography because then he's going to get into court. The Justice Department or someone, whoever tries that sort of case, is going to go after him. And he's going to be hung up in court spending lots of money on lawyers. He doesn't want to cross that threshold.

Now, you're drawing a line there by the term "pornography." Again, what we know is on the air is insertion, anal sex, girl-girl, boy-boy, multiple partners at once, oral sex. ... I mean, that used to be called pornography.

It used to be called pornography, but a lot of that has become socially acceptable now. So it has moved away from pornography. Or, looked at another way, a line of what is acceptable and what is unacceptable has moved a lot more to the explicit side.

But that depends on who's making the call. We've got a more conservative administration now in place. A lot of people around them, that advise them and such and talk to them, seem to be saying that the laws on the books state that pornography is defined as something that is maybe where the line was 10 years ago. So is there a concern that, as an administration changes, as politics change, that the line maybe moves? And maybe you're going to get caught on the wrong side of the line?

There is certainly a bit of concern on the part of the cable operator. But he's also got the advantage of having run this programming for, let's say, five years and nothing has happened, so it is acceptable, so he has an argument. It's a lot easier to get somebody when they first go over that line, than when they've been over that line for five years and nobody said anything, because that line has then been moved. As you keep moving the line and it becomes accepted, it's a lot tougher to go get them. ... Going back is a lot tougher to do. They can keep moving it forward. And the longer that nobody tries this in court, the more likely they've got a case that it is acceptable.

But that's OK for a Larry Flynt or a Bill Asher [president of Vivid Entertainment]. But is that scenario that you just defined there OK for a Mr. Armstrong at AT&T? When you're talking about a mainstream company, the pressures, the embarrassment, being brought into court to testify about your purchase of material from another company. ... There are lots of ways that you can be embarrassed or brought to the forefront. Is there a risk in that way for the mainstream? Even if they're not going to throw Armstrong or someone who runs direct television in jail, is there another aspect to the risk?

There's certainly a risk of it. Ten years ago, I think there was a case where a satellite operator was sued in Alabama, because somebody watched something that somebody considered pornographic. The case lost in court by First Amendment. It's a hassle; you don't want to get sued. You saw Playboy take a very cautious attitude when it first bought Hot Spice, by keeping that at arm's distance for several years.

So you have people who are going to stay away from it. Could you go in and sue a Michael Armstrong at AT&T and say, "Hey, you're running pornography"? I'm surprised that somebody hasn't done it, but it probably wouldn't hold water. The question is, how do you make money if you're going to sue? There's no reason to sue somebody if you're not going to make money at it.

Unless you're a special interest group that doesn't care about the money.

That's true. But they also have to look at the chances of winning.

In general, what's happened in the past 10 years regarding the mainstreaming of adult content?

Typically, adult programming has been the innovator of most new technologies. If you go back and think about it, girly magazines, a lot of that started out as adult programming, or what we'd consider adult programming. If you look at home video, the main reason for home video initially was to supply adult programming. If you look at pay-per-view, one of the initial reasons was adult programming. So adult programming, surprisingly, has driven the technology a lot more than people would give it credit for.

Tell me about the mainstreaming in the past 10 years. What's happened to this industry? How was it viewed 10 years ago? How is it viewed now? How more prevalent is it now, and why?

It's become much more open in the last 10 years, because you do have acceptable ways of delivering the programming. The consumer who's afraid that because they're a schoolteacher, that their next-door neighbor will see them coming out of a video store carrying Deep Throat, he's much more happy now that he can stay at home and order by pushing a button on his cable system, or his direct TV. He's much more willing to buy the programming than he used to be 10 years ago. I think we've seen a lot more acceptability.

So this term that's thrown around all over the place -- it's in every article -- "mainstreaming of pornography" or "mainstreaming of adult fare" -- what does that mean?

I think it means making the programming available, and not calling it pornography anymore but adult entertainment. That's that line that people don't want to cross. As long as you can keep moving that line out -- and people are certainly willing to pay more as you get close to that line, or move that line -- then they have a product back here.

It's sort of like the wrestling game. You have to keep coming up with something new. It used to be alright to push a guy out of the ring. Now you've got to make him land on a table. Once the people get bored with that, what are you going to do? Make him go through a chain fence or something. You've got to keep supplying more things to keep the consumer happy. And that's what you're doing with adult entertainment.

... What will video-on-demand do for adult entertainment? Are we talking about twice as much business, a quadrupling of the business? What could video-on-demand do for adult fare?

Video-on-demand will help adult entertainment if it provides more distribution for the product. If a consumer can go out and more easily buy the product, then he's alright. The problem now is that he doesn't get it as much as he would like.

For example, Playboy used to be on for 24 hours a day. Then because of some court rulings in a lot of cases, they cut back the hours. So it's only 10 or 12 hours a day. But the more you expand the availability, the better it is for the consumer who wants to buy that product. If video-on-demand becomes more adopted by the various providers of programming, you'll see more adult there, just because it will be more available to the consumer. The more broadly distributed it is, the more likely a consumer is to buy it.

Has there been any research on what it could do? Could this be sort of the next wave? Could this double sales? Is this going to be a very important move specifically for the adult producers?

No. I think probably the most important part for the cable operators, in particular, has been the dispersion of digital cable. Because that really makes the product unique to the consumer. There's no bleedthrough, there's no problem with kids seeing a product that they shouldn't see, or that the parents don't want them to see. As digital becomes more acceptable, you get a better picture, you get better quality. I think that is probably as important as video-on-demand. The thing that video-on-demand will do is make it easier for the consumer to buy that product.

Armstrong met with some religious leaders a while back -- I think it was last April. They were asking why he's providing the service on AT&T Broadband, and he sort of said, according to them, "I have to do it. It's a business decision. My competitors are doing it. I've got to do it. I might not want to do it, but I've got to do it." Does Armstrong have to do it?

There's been no case that says that a cable operator must carry adult programming. And, in fact, there is one cable operator, Adelphia, who has refused to carry adult programming and is not to this day, as far as I know, carrying programming of that sort. And, in fact, in cases where he's bought a cable system that carried adult programming, he's taken it off. So nobody has ever gone to court to force somebody to carry Playboy or New Frontier or Vivid Video. Could they? Nobody wants to test that.

Why?

It's going to generate far more negative publicity than it's worth.

... I'm trying to get at the bottom line again, of just how popular it is.

It's only if you're a subscriber to Adelphia and you want to see adult programming and you can't do it, then you've been shortchanged, so to speak.

If AT&T Broadband didn't carry adult, how much would it hurt them?

If you look at how much money is coming in from adult, remember there's virtually no cost to AT&T for carrying it. And if he's generating $10 million, $20 million a month, that's virtually all found money going into the bottom line. So it can be a significant amount. Twenty million dollars times 12 months -- that's a lot of bread.

How does AT&T pay Playboy for one of their channels? Do you know the workings behind that? Is it a one-time payment? Is it a per-viewing payment? You're saying it's 85 percent of each showing.

What AT&T does is they count the amount of money that gets generated from the programming. When the consumer pushes the button and says, "I want to see this program tonight, I'm paying $8 for it," AT&T keeps track of that. At the end of the month, or shortly thereafter, they go to Playboy and they say, "Well, you had X number of people watching the program, generate X number of revenue. Here's your piece of the revenue." And they split up the pie the way they're supposed to.

Typically, about six months later there is a reconciliation, where they go through the numbers and make sure they've got everything done the way that they were supposed to.

What about hotels? What percentage of business is adult on the pay-per-view hotel fares? How popular is adult in the hotels?

If we look at the family hotel, you're not going to see very much buys of adult programming there, for obvious reasons. But if you go to a businessman's hotel, you'll see a very high percentage of adult programming. In fact, it probably generates 80 percent of the profits of that system.

What does that mean for the hotel, in general? What's the bottom line?

If you're LodgeNet or On Command, you go to the hotel operator, and you make a deal where you agree to put in the equipment, in many cases including the TV set. The consumer orders a movie. Let's say they want to see an adult movie. They will get billed on their hotel bill whatever the amount is, $5.95 -- in fact, I think it's now up to $8.95 for either a first-run movie or an adult movie. The hotel operator keeps 5 percent to 10 percent of that revenue for himself, and remits the rest to the LodgeNet or the On Command.

Why do the hotels offer this service?

The reason the hotels offer this service, particularly in a businessman's hotel, is that it's an amenity that the consumer wants. He wants to be able to watch a movie of his choice in the privacy of his room. It might be a first-run movie or it might be an adult movie. In many cases, it's an adult movie. For the hotel, it's extremely profitable because there's no cost. They're getting 10 percent of the revenue. Whether you're watching an adult movie, or a first-run movie, or playing Nintendo, they're getting their piece of the revenue.

Again, the embarrassment factor -- does that cause a problem for these hotels?

In most cases, the hotel is staying way down to the left of that demarcation line that we talked about. They're running an R to R; they're not even an X-rated. ...

We went to Hilton Hotels and they weren't willing to talk to us. None of the others, either. Nobody wants to talk to us about it. Why?

The easiest answer is the old adage, "Let sleeping dogs lie." If there's no fear being caused by showing adult programming or any other kind of programming, why bring it up? "Just leave it alone. We're providing a service. The consumer likes it. We'll make some money off it, but we've kept the consumer happy. He's gotten what he wants, and we've gotten what we want."

For the buyers, when they look at the bottom line on these companies, and they see broadband carries the Playboy channels, is that a real big positive in the idea of purchasing this company?

No, I think the cable operator who's acquiring a cable system for somebody else is looking primarily at cash flow. He will look secondarily where it comes from. But he wants to see what that cash flow is, and how rapidly it's growing. To the extent that that's contributed to by carrying adult programming, that's a positive for the seller.

Let's talk about the importance of adult material to Internet companies, for example, AOL. Some people state that adult fare built AOL. What does that mean? How important to the beginnings of AOL was being able to get adult fare over their portal?

... Well, not just AOL but any of the Internet, in general. It was important because it created demand for the consumer. I want to get on the Internet. My next-door neighbor is seeing great racy pictures of whatever, or to see Pamela Lee Anderson and her new husband doing whatever. And that probably generated more Internet subscriptions than any other single event in the business. But that's the sort of thing that attracted people. So to the extent that it created interest on the part of the consumer, it was certainly positive for AOL or any other supplier.

So was AOL built on the back of adult fare?

AOL was built on the back of a very smart marketing program of distributing a bunch of floppy disks that got the consumer in and making it easy. I think the internet was built on the back of adult, but AOL went beyond that.

If, for instance, AOL had an ability to throw on software so that nothing in their chat rooms would be involved with porn -- that people would not be able to go to porn sites -- how would that affect now, or how would that affect AOL to begin with?

Anybody that got into the problem of censoring what was on the Internet is going to run their own risk of going to be dragged into court on a First Amendment right basis. So that's going to be more hassle than they wanted. The last thing AOL or any Internet supplier wants to do is be the guardian of the taste of its consumer. They want to provide the service to the consumer -- let them decide what they want to see.

What happened to Yahoo? They got involved a lot further than AOL in providing product basically. And then they pulled out completely. If you go on Yahoo now and you try to find anything of adult fare ... you can get onto other sites. But on their chat sites or looking for banners or whatever, there's nothing there. They've really pulled out. Why?

I think some of the suppliers got concerned of the publicity that they were getting, and they were going to be put into a category of being pornographers or adult entertainment providers, rather than just being a regular supplier of internet. Yahoo probably wanted to back away from that. AOL has stayed pretty much away from that. But I don't think anybody wants to get into the censorship of what they're carrying. It's like quicksand. You step in that, you're liable to be in court for years.

What was Yahoo after? Was there a pot of gold that they were looking at, that they saw that AOL didn't, or that they thought they could get at?

The bottom line in the whole thing is that sex sells.

Clearly one of the main reasons initially for getting on the Internet was sex. If you look at the words almost any one of the Internet suppliers has kept track of, you'll find that "sex" is probably the most frequent word used as they look for programming of any sort. So clearly, there is a desire to see it.

I think what Yahoo did was go one step beyond and say, "OK, my customers want to see sex. I'll make it easier for them, and I'll categorize it." And I think what they realized afterward was that they were taking a far more active role in supplying this programming than just making it available. "Here's bestiality, here's whips and chains, here's whatever." That was going into probably more active participation by Yahoo than they really wanted to do.

Does pulling away hurt Yahoo? And if so, how? Bottom line-wise?

If you buy the thesis -- and I think it's correct -- that a lot of consumers go to the Internet because they want to be involved in adult programming of one form or another, or toys or whatever else it may be, to the extent that Yahoo backed away from that, they probably didn't cost themselves a lot of money. But they probably did cost themselves some consumers. Somebody may have gone to Google or AOL, or somebody else who had a less restrictive policy because they found that they could get easier access to adult.

So is there any way to figure that out, number-wise, what effect that might have?

No, I think that's going to get lost. You could probably go back, and somebody who might have figured out the number of hits on adult channels could probably give you a better feel for it. But I would think that initially it was pretty big. It probably didn't hurt Yahoo or AOL specifically.

As a business decision, was it good or bad?

From Yahoo's viewpoint, I think it was probably a decent decision. They didn't make a lot of money out of it. They're doing it by supplying an overall service. They don't get direct money. ... They may have been making a profit from an adult supplier. But they were probably making a profit by running Coke banner ads when those were big. So percentage-wise, it's a very small piece for the overall thing. They're probably making much more on that $19.95 that they're charging -- whatever they get per month -- than they were off the percentage.

So the real concern is losing your clientele, losing your customers?

You're afraid that if you don't supply a service that the consumer wants, he's going to go find it someplace else, or somebody is going to tell him, "Hey, you know, I used to use Yahoo for my Internet," whatever it is that I'm looking for programming on. "But now I'm going to XYZ, because they give me all this great pornography."

So as someone who looks at how the companies are working and what the problems are and where they're coming from, does that decision look like a long-term decision to you? Or does this decision look like something that P.R.-wise which was right for now, but two years from now, 10 months from now, five years from now, it might go in a very different direction for Yahoo?

I think the way this goes in the future is going to be determined by what society says at that point. Five years from now, much as we've seen with the pay-per-view, what was not acceptable five years ago is acceptable today. You're probably going to see the same thing on the Internet.

The same situation as on the Internet?

Yes, that the envelope keeps getting pushed forward.

Let's talk about Playboy. What did Playboy make off of their adult channels last year?

Last year Playboy, on their so-called Entertainment Group, which is all of their programming, made roughly $25 million operating income.

And what does that say about what the distributors made?

That $25 million is probably 10 percent to 20 percent -- let's say it's 10 percent. That means that the distributor made $250 million minus the $25 million, or about $225 million. This year it will be about $40 million for Playboy.

Tell us the tale of Playboy buying back the Spice Channels. What happened back in 1998 first?

In 1998, Playboy acquired Spice Entertainment. Spice Entertainment at that point consisted of a couple of channels of adult programming. One was Spice, which was maybe a little more explicit than Playboy, but relatively mundane. The other was Hot Spice, which was maybe pushing the envelope a little bit at that time.

They decided they didn't want to be directly involved in Hot Spice, for the risk, I think, of maybe being sued or getting bad publicity. They sold it to another company, actually Vivid Video, and set it up in a joint venture. Vivid Video was adult programming, and they created pornographic product. However, when they sold it, they said, "Hey, you know, maybe things are going to change. I want an option to buy it back." And what they've done most recently is buy back those channels.

... The way it was reported was that Playboy passed up buying those channels and passed them off to Vivid. But is that indeed the case? Did they, in fact, keep a hand in the business?

What they sold them off to Vivid under this new company called Califa. Playboy kept a percentage of the revenues coming from Califa. They also had an option that gave them the right to buy back Califa at some point in the future. So, no, they kept it at sort of arms' length, but they didn't fully step away from it.

Why the subterfuge? Why play it that way?

Subterfuge, as much as they want to separate themselves from that channel. By keeping just a percentage, they could say, "We had no control over the product; that was done by Vivid. They programmed it, and in fact, created their own channel called Vivid TV. So they're the guys responsible for the programming. All we did was get a piece of it. And we're innocent bystanders. All we did was do Spice and Playboy."

Here's Playboy, who, for 50 years, has been synonymous with sex. And yet they seem to be very careful in how they deal with the harder content.

What you see at Playboy is that they are sort of like a lightning rod. If somebody wants to go after a pornographer, the first thing you do is go, "Playboy, they're a pornographer." It may have nothing to do with what they're doing. And, in fact, if you look at the magazine, if you look at the Playboy channel, their programming is somewhat mundane compared to a lot of the other stuff. It's a name that they've created, and a reputation that they've developed, which may not be totally justified. But it's an easy thing to go after.

Back then, why did they decide that they needed to go through this whole situation of creating Califa with Vivid, and Vivid taking control of it and all that? Why the need?

I think what happened, when Playboy bought Spice with its three networks including Hot Spice, Hot Spice was relatively new. It had not been accepted by the cable operators. They thought that it was pushing the envelope. I think they were a little afraid of it. The last thing they wanted to do was get involved in a suit saying that they could possibly be considered pornographers. They wanted to distance themselves from that possibility.

By leaving it over at Vivid or Califa for a couple of years, and there being no suit ... what we've seen is pushing that line over some more. And, in fact, it is now accepted, because after two and a half years, it's been available. Everybody's had a chance to see it. There's been no complaints. It must not be pornography; it's adult entertainment.

And we keep talking about this line being moved back. How much of that, to some extent, was due to sort of how the Department of Justice and obscenity law was practiced during the Clinton administration?

The bottom line was that, because DOJ or obscenity laws or local communities let the programming go without challenging it, basically people were able to move that line. If somebody had stood up and said, "This programming is bad, we're going to challenge it in court," it would have probably slowed the whole thing down. Part of this, I think, reflects the norms of society. They've become much more accepting of this type of programming.

One of the things that you've got to be concerned about, as you look at so-called adult programming, is not just the question of pornography, but it's the question of violence. And a lot of the adult pornography is violent, as well as having a lot of sex in it. The sex, I think, has clearly become acceptable. And you've seen the operators move far away from the violence. Playboy, Spice, Vivid -- they're not doing the violent side of it.

But you've got the Extremes and the others out there who, in fact, are taking up the slack.

Yes, they are doing that. There is probably a small but lucrative market for the violent product. And there are people who will step in and do that.

So the argument that the Clinton administration perhaps because of their liberal sort of view towards it -- how did that affect the business?

Whether it was Clinton or whoever, the absence of any challenge in the courts to what the product was, whether it was pornographic or not, basically meant that it wasn't pornographic. And as it created a history -- I guess the lawyer could probably tell you better about it -- would say that this is now an acceptable norm for society.

So if the Bush administration goes after pornography in the way that the Meese Commission had suggested, what does that do to the business?

Whether you can move that line back is going to depend on the ability of the lawyers to prevent it. I think once you've gone there, it's very tough to push it back. It's a lot easier to put a wall up and say, "You can't go past this." Or, once you move that wall over, it's tough to say, "We're going to push the wall back now." How do you do that and justify it?

When you talk to people in the industry, is this something that they're very worried about?

The easiest way to express it is the companies that I talk to that asked this question, one, they certainly don't want me to be concerned about it, so they're expressing no concern, and I have to believe that they don't have that concern.

Basically, the way it was reported was they [Playboy] spent a huge amount of money, $80 million or whatever the hell it was, for these channels, which two and a half years ago they passed up. It was a stupid idea. Bill Asher was a very smart guy on how it went. Basically, all he did was sell it back, because he thought the future was in the Internet anyway. What's the truth behind the numbers?

What you have is that Playboy was finding that, because of the availability of more explicit material, both in the adult programming side and the Internet, that Playboy and Spice was becoming more mundane. They had to get up with the times, which meant they had to develop more explicit programming. The easiest way to do that was to exercise the option and bring Califa and Vivid into the fold. And, as you notice, they're actually planning on building another channel called Spice Platinum Live, which will be another version of it.

They tried to come out with some channels before they decided to take back these channels. What happened?

I think Playboy said they were going to develop three new channels under the Spice Platinum name. The problem that they ran into, the best I can tell, is that the distributors, DirecTV, Dish, and the big cable operators, didn't want to put another adult channel on. You know, "One is enough. Let's not push the envelope too far. I've got one, I'm happy with it, I don't want two." So they were having trouble getting distribution. I think buying back Califa and Vivid gave them that distribution.

Let's go through the distribution chart one more time. ... The customer pays what the cable satellite company makes, what the network programming, Playboy, the New Frontier, makes, and then what the porn producer makes. If you can just clearly line it up from the customer to the producer creating that thing with actresses onsite. How does it work? Start with the customer.

Typically, the consumer, either on satellite or on cable, will pay a fee for a block of programming. That could run as little as $5.95 for a block of programming. And that's typically for well edited, maybe a Playboy type of product, to as much as $11.95 for virtually an unedited product.

Out of that money, depending on what the deal is with the cable operator or the specific satellite company, the satellite or cable operator will pick up 80 percent to 95 percent of that revenue. The remaining 5 percent to 20 percent will go to Playboy or the New Frontier or the program supplier. Out of that, the program supplier, such as Playboy, in some cases they'll produce their own programming. In a lot of cases, they're buying product from Vivid, or any one of a number of other suppliers will pay them for another flat fee. Playboy typically is paying $5,000, $10,000 flat fee, regardless of how much revenues they receive. So for them, the product is relatively cheap.

So who's making out here?

Everybody's making out. The guy who's producing the product, his talent isn't Julia Roberts. She's not making $20 million a movie. She's probably working on the scale of $500 to $1,000. So he's making money if he can get $10,000 for it. Playboy is making money if they're getting 20 percent or even 10 percent. The cable operator, or the satellite distributor, is making money because he has virtually no cost against it. And the consumer is happy. So everybody's happy.

One thing you said, which we need to define, is the "unedited version." What does that mean?

When you look at the programming that these people supply, we call it adult programming. "Unedited" means everything is there. "Edited" means you're cutting out frontal nudity so that it's only five seconds instead of 25 seconds. Or it's full penetration, but you're making it partial penetration. There's a whole bunch of things that you can do to make it edited as opposed to unedited, or explicit.

Lastly, let's go back to where we started out just one more time. A lot of people talk that this is a multi-billion dollar industry, $14 billion, $10 billion -- big bucks. How do we know, and how big is this industry?

We can see sort of like the tip of the iceberg. We know what Playboy is making, we know what New Frontier is making. Let's say that's $40 million dollars combined, and that's just on pay-per-view. If that's 10 percent of the total, that means their piece of the pie, that is the cable TV, direct satellite, is maybe $400 million. Then you've got the movies, you've got the home video, you've got everything else on top of it, and that's underwater; you really can't see how much that is. It's probably a lot bigger than what we're seeing.

So what is the best analysis and a total figure for it all?

It's certainly more than a billion. Is it $14 billion? I think it would be hard-pressed for anybody to disprove that it was $14 billion. On the other hand, I wouldn't want to have to try and prove it was $14 billion.

How hard a job is the one that you have? How difficult is it for you to analyze this industry compared to other industries?

There's certainly a prurient interest in the industry. And maybe we get some psychological benefits from it. But the main thing that we have to do as analysts is find stocks that go up. Fortunately, Playboy has gone from $9 to $35, back down to $9, back up to $20. So there have been movements in the stock, and that's the sort of thing that we want so that our clients can make money.

But as an analyst, you're somebody who looks at the bottom line, and looks at the numbers. This is an industry that's a difficult one to get a good grasp on, because so much of it is under the water as you define it.

The main things that we're concerned about in analyzing the industry is pay-per-view or satellite, and there, the numbers are available. We can see what's going on with those. We don't have to worry so much about what's going on in pornographic or Internet, because that's not part of the companies we're dealing with.

What's the future for this industry? What do you see happening in the next five, 10 years?

I think we're going to see a number of things change. One of the real concerns in the industry is, what is going to happen with streaming media? Will the internet become the preferred delivery mechanism? Once you get full motion video on the Internet, is a lot of this stuff going to migrate to the Internet? And it may. But that's probably long after I'm retired and won't have to worry about it.

How has the Internet affected the business as a whole?

The Internet has probably provided a big spurt in growth in the adult programming business. But it's only been, for the most part, still pictures. Whatever motion is available is fairly limited or awkward. As you increase the bandwidth and make high-speed video available, you're going to provide better quality programming on the Internet. And that will provide extra growth for them. That may cut into whether a Playboy or New Frontier or some of those guys are doing. On the other hand, they're now getting ready to provide that sort of service, so maybe it won't happen.

So who will be the chief beneficiaries of that future?

Ultimately, the chief beneficiary of that development of high-speed video is going to be the consumer, because he's going to have more sensibility to the product he wants. Maybe he can't get it on Playboy or his local cable system, and he wants to see it. He doesn't want to go to the video store. Maybe the internet is going to be a new way of supplying it.

But as far as the business side, on the producers and/or the providers -- who benefits on that side?

You're still going to see a substantial benefit to the existing suppliers if they adapt to the times, if they provide Internet programming. And you've certainly seen Playboy developing Internet programming with the Cyber Club, with its own type of movies. It acquired an Internet site called Rouse, which is aimed at younger viewers. So they're doing a lot to develop their own internet business. And the good thing for Playboy is that they have the brand recognition.

When you hear the name Playboy, rightly or wrongly, an image comes to your mind as to what that programming is. So they'll stand out from a lot of the den of 30,000 small adult programming providers. And I think they're good in that regard. New Frontier may have a problem, because they don't have that brand identity. So they'll probably get swallowed up or move back into a pack with everybody else.

Or get harder in content to compete against Playboy?

Even if they get harder in content, a New Frontier doesn't have the brand name. So it will have to compete against all those brand names we don't even know -- Sally Sin Factory, or whoever's doing it. The other guy who's going to benefit from this in the long run will be a company that's well organized, who has, again, differentiated themselves, like Vivid. The creation of something like the Vivid girls sets them apart from the average supplier of adult programming.

Why have we gone in this direction? Why has society been into it, agreed to it, allowed it?

What we've seen is society is accepting what is being spoon-fed to it. If you see a Jennifer Lopez wearing an outfit like she wore a few years ago, that's certainly pushing an envelope in more ways than one. But that's helping create the idea that all of this is good. Forget the morality of it. It's become accepted. You people will watch the Academy Awards to see what outrageous outfit the girls are wearing now. It's what the new outfit is, and how far you can push that envelope.

So what is the bottom line of all this?

The bottom line in the whole thing is that sex sells.

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