Flop!

June 17, 2005: The Bros Ambani split. And within a fortnight, Anil Ambani moves into entertainment. His newly formed Anil Dhirubhai Ambani Group (ADAG) swiftly snaps up Adlabs Films, built by filmmaker Manmohan Shetty, which produces, processes, and distributes films, and operates a multiplex chain.

Anil Ambani is impetuous while marking his territory. He pays Rs 360 crore for a 51% stake, valuing Adlabs more than eight times its revenue of Rs 86 crore (as on March 31, 2005). Shetty runs a tight ship and has a 25% profit margin. But if the valuation is slightly higher than what Bear Stearns paid for a 14% stake three months earlier, it is because Ambani has a dream: To build the largest entertainment conglomerate in India with a presence everywhere—from content to delivery—a bit like the way his father Dhirubhai had integrated his petrochemicals empire. Adlabs (renamed Reliance MediaWorks in 2009) is the first step.

Over the next few years, Ambani’s entertainment business builds a presence across radio, television, films, and the Internet; in Hollywood, it ties up with Steven Spielberg, Brad Pitt, and Julia Roberts; and some of the films he produces in partnership with Hollywood win a handful of Oscars. Big Cinemas, Reliance MediaWorks’ (RMW) multiplex business that rakes in more than two-thirds of its revenue, is tom-tommed as India’s largest multiplex chain.

Interval.

Cut to the present. The last time RMW releases annual financial data is September 2012. On a total consolidated income of Rs 1,255 crore, it reports a net loss of Rs 910 crore. Add to this a negative net worth of Rs 565 crore and outstanding debt of Rs 2,071 crore. Big Cinemas has been scampering for capital infusion, but no one seems interested. Recent quarterly results (period ending December 2013) indicate the slide continues—a loss of Rs 91 crore on an income of Rs 115 crore. The RMW scrip has been battered on the exchanges (see graph).

While the numbers raise questions on operational decisions, conversations with ex-employees, competition, and industry experts indicate serious strategic lapses. (Fortune India spoke to at least two dozen people for this story, most of whom declined to be named.)

Anil Ambani had never been hands on when it came to ADAG’s entertainment business. “That doesn’t absolve him, but entertainment has always been Amitabh Jhunjhunwala’s [the ADAG group managing director] baby. And he’s a finance guy,” says an ex-employee. He adds that RMW was mismanaged by a bunch of people who didn’t understand the business. For example, former CEO Anil Arjun, and the business development head for the exhibition business, Balaji Mudaliar, came from telecom backgrounds. Arjun cut his teeth at ICICI Bank, and after almost a decade joined Reliance Communications under Mukesh Ambani, while Mudaliar spent four years at TCS before joining Arjun at Reliance Communications. Arjun and Mudaliar refused to comment.

Speaking on phone from Los Angeles, Venkatesh Roddam, who joined RMW as CEO two years ago, avoided talking about his predecessors. But the banking, financial services, and tech veteran admitted that a few decisions hadn’t gone as planned. He defends the actions of the last few years as part of a conscious strategy. “We have grown rapidly and there is a need for consolidation,” says Roddam.

When Ambani bought the company, India’s Rs 23,400 crore entertainment sector was poised to grow at 21% till 2010, according to consultancy PricewaterhouseCoopers. In films, RMW was the only company that straddled all three segments—content creation, services, and platforms. Adlabs came with a history of successes such as Chakra (1981) and Ardh Satya (1983), and its film processing unit handled nearly 85% of all Bollywood movies. Being the only multiplex chain in Mumbai, Adlabs Cinemas was raking in money as well.

FLUSH WITH FUNDS FROM the split, Ambani didn’t just want to grow RMW’s existing businesses; he wanted to add new ones. A few months after the Adlabs buyout, RMW successfully bid for an FM radio licence—and launched a handful of startups such as Bigadda.com, a social media portal, and Bigflix, a movies-on-demand service. These were eventually spun off into separate entities. A former senior RMW exec says that between 2005 and 2009, at least 15 new businesses were started. Industry experts peg the amount of fresh investment upwards of Rs 2,500 crore. “I think the way he [Anil Ambani] looked at it was as a venture capitalist. Show me a plan and I’ll fund it—that was the approach,” the former senior RMW exec adds. In 2007, RMW ventured into TV programming through a majority stake in Siddhartha Basu’s Synergy Communications that produced superhit gameshows such as Kaun Banega Crorepati and Dus Ka Dum.

In the face of diversification, the film production and distribution businesses got more organised and focussed. “We used to do one movie a year, now we were working on four,” says another ex-employee. Later spun off into Big Pictures, it made box-office history distributing superhits such as Ghajini and Singh is Kinng.

The multiplex business grew at blazing speed as well. Former employees recall team meetings about creating a monopoly in the exhibition business. It seemed as if RMW wanted to build multiplexes wherever possible, Farmville style.

In 2006, the company added about 30 screens and by the end of 2007, that number was nearing 150. The big push came in 2008 with 220 screens being added in the U.S. and 51 in Malaysia. In India, the count was 260 across 80 cities, accounting for almost 10% of the box office collections. At its peak in 2010, Big Cinemas had almost 550 screens across India, U.S., Malaysia, Mauritius, Nepal, and The Netherlands.

In contrast, its biggest rival, Delhi-based PVR Cinemas, had grown to only 210 screens in 15 years. An ex-PVR employee says: “Big’s quick expansion put us under pressure. We were losing people to them and salaries were under pressure. But because we grew slowly, we’ve rarely had to scale back.”

The multiplex business works on principles similar to retail—location and rentals are key to success. Sumit Chandwani, managing partner at Arth Capital, and previously part of the ICICI Ventures team that had invested in PVR, says: “The biggest learning of the retail business is that scale doesn’t bring profitability. Every property has to be profitable, which means getting the right location at the right price.”

While PVR adopted the top-down approach choosing marquee locations in metros, such as Phoenix Mall and Juhu in Mumbai, and Saket in Delhi, and prime properties in cities such as Lucknow and Ludhiana, the senior management at Big Cinemas was busy tramping through middle India.

DEWAS IS AN ANCIENT TOWN in western Madhya Pradesh with a population of 280,000. Known for housing the government banknote press, Dewas had three single-screen cinemas until 2008. Big Cinemas leased two of these and converted them into two-screen multiplexes. “Of the 260 screens that came up in India, about 35% were in places similar to Dewas. You had multiplexes in Shivpuri (M.P.), Udgir, and Parbhani (both in Maharashtra)—most people don’t even know where these towns are located,” says a Big Cinemas ex-employee. Another says that the choice of locations was based on the idea that the high per capita income growth during 2006-07 would fuel the rapid development of tier III and tier IV towns.

Though the strategic direction wasn’t entirely off the mark, it wasn’t just the locations of multiplexes that proved a problem. It was the high price at which these properties were developed that made the whole business unviable. RMW apparently spent Rs 12 crore to develop the two leased properties in Dewas. That’s steep considering a typical cinema screen takes between Rs 1 crore and Rs 1.5 crore to set up.

Even re-developing an existing cinema didn’t make for smart business. Take the example of Metro Big Cinemas, one of the oldest cinemas located in tony south Mumbai, that RMW developed from a single screen to a six-screen multiplex. Wanting to preserve the vintage facade of the 68-year-old cinema as part of the city’s heritage, the company retrofitted the six screens inside the existing structure, making the re-development harder and costlier. The damages: Rs 15 crore.

While the steep development costs made overheads impossible to recover, what hurt more was the high rentals. “Other cinema chains such as PVR never paid more than Rs 60 a square foot in places such as Thane and Mulund. There have been instances where Big has paid up to Rs 120 a square foot in the same areas,” says an executive who consulted with PVR. “The counter party knows that you’re on an aggressive growth path and will exploit that.”

The expansion of Big Cinemas also coincided with the real estate boom, especially in the metros. Big kept signing deals, often on unviable terms. Most of Big Cinemas’ properties bled because they could never recover the high fixed costs, while the rentals eroded revenue. Between 2011 and 2012, RMW exited several such properties, including Dewas, Shivpuri, and Udgir, often paying exit penalties, a number of which feature as writeoffs in annual reports.

WHY BIG CINEMAS chose to set up cinemas in tier III and tier IV towns is as inscrutable as its strategy to enter the Malaysian exhibition business. In May 2008, Big Cinemas picked up 70% in Lotus Five Star Cinemas, a local cinema chain in Malaysia, for an undisclosed amount. A Big Cinemas ex-employee who was closely involved with the operations says: “Big Cinemas was supposed to cherry-pick from Lotus Five Star’s properties. They picked all the bad cherries.”

Lotus used the money from the stake sale to expand its exhibition business. “Even a college graduate would know that there should’ve been a strong non-compete clause to prevent such a situation. Weak contracts like these were a hallmark of most of the real estate deals that happened,” says the Big Cinemas ex-employee. Four years later, Big Cinemas sold the business to a private equity player, writing off Rs 27 crore.

Again, take the food and beverage (F&B) strategy—the core contributor to multiplex profits—at Big Cinemas. (Costs for running a multiplex include film hires, rentals, maintenance overheads, and manpower. It makes money from advertising and F&B sales mainly, and a marginal amount from ticket sales.) As Chandwani says, the key to a successful F&B strategy is a simple menu which has quick-to-serve meal combos, so the counter can cater to a larger number of customers.

That’s not a model Big Cinemas followed. In late 2009, moviegoers could choose between 12 flavours of popcorn (including wasabi and Cajun spice), kebabs, pastas, French fries, grilled sandwiches, burgers, and hot dogs. “The idea was to provide a gourmet experience,” says a former employee. It invested heavily in grills, fryers, and chillers—which only added to the already bulging overheads.

“F&B sales depend upon quick turnaround at counters during intervals. You have seven minutes to get through the queue and back to your seat. If the queue doesn’t move quickly, people don’t buy, and go back to the movie,” says a former PVR exec. So, as customers debated over grilled sandwiches, cheese or pepper popcorn, F&B revenues at Big Cinemas dipped severely.

But insiders say problems had started cropping up a lot earlier—from 2008-09, when RMW posted its first loss. “We kept altering the accounting year to dress up the performance,” says an ex-employee. A look at the company’s balance sheet indicates that accounting periods changed three times between FY06 and FY12—to June in FY07 (15 months), to March in FY08 (nine months), and to September in FY12 (18 months).

By 2011, even as cash flow was reducing and debt mounting, RMW announced that it had set up a 200,000 sq. ft. state-of-the-art studio in Film City in the northern Mumbai suburb of Goregaon. The company reportedly spent upwards of Rs 300 crore for the studio, which is not only built to technical specifications comparable to large Hollywood Studios, but also offers the entire range of post-production facilities for the movie and television businesses. A few months later, a 90,000 sq. ft. business process outsourcing centre for visual effects was inaugurated in Airoli, a suburb in Navi Mumbai. The BPO would cater exclusively to visual effects projects from Hollywood.

About the same time that RMW sold the Malaysian exhibition business, together with Chinese media partner Galloping Horse it made a $30 million (Rs 181.95 crore) purchase of the then bankrupt Digital Domain, a special effects company floated by Hollywood director James Cameron. “The idea was to bag big-ticket projects in Hollywood and outsource them to the 600-member team sitting in Airoli. In the last one-and-a-half years, we’ve done very little high-end work in India. Projects have also been slow to come by. As a result, a lot of artists have been on the lookout for jobs,” says a visual effects artist working at Airoli.

Apart from operational issues, what’s hurt RMW the most are high overhead costs. All expansions and diversifications were done with borrowed funds. In fact, according to Roddam, the reason for the net loss “is purely attributed to the interest burden that we carry, though at an operating level 100% of the businesses are profitable. Growing through debt has been a conscious action.” Roddam says that the interest burden will be taken care of by this fiscal’s performance. RMW has been looking at external capital infusion to bring down the debt as well as fund future growth.

RMW’s board first proposed a rights issue in August 2009 but couldn’t launch it until August last year. A former RMW senior exec points to the fight between the Ambani brothers over gas pricing that broke out in 2009, followed by the arrest of Gautam Doshi, a RMW board member in the 2G telecom scam in 2011. As a result, the rights issue dragged on and the company kept borrowing.

Roddam insists that the successful rights issue is a sign of things to come. “In my conversations with the promoters thus far, their stand is that we are in a comfortable position with formidable assets,” he says, adding that the last couple of years have gone in consolidating the business, like exiting unviable multiplexes which have streamlined the exhibition business. “Do we plan to split the company in three parts [namely, cinema exhibition, media and services, and TV production] to attract external investment? Yes, absolutely.”

But that may be easier said than done. According to market sources, RMW has been in conversations with investors and strategic partners for its exhibition business, but nothing has materialised so far. The market buzz is that the exhibition business may be on the block. “They’ve approached Cinepolis and PVR, but talks haven’t gone far,” says an RMW ex-employee. The claims could not be independently confirmed.

Roddam now wants the exhibition business to have a strong retail component. “We’re beginning to look at our properties or locations as social locations or social hubs, rather than just people going to the cinema to watch a movie,” he says. “Shopping is an area we’re exploring. The other is a tieup with a jewellery manufacturer for displaying its products across locations,” says Roddam. There are also plans of linking with food brands—both domestic and global. He cites the example of two standalone multiplexes in Mumbai—IMAX Big Cinemas and Metro Big Cinemas—which could be revamped into social hubs.

“Our objective for the next two to three years is to grow exponentially, and intelligently,” says Roddam. From the current network of 270 screens spread across 100 locations, RMW is now looking to grow through both the organic and inorganic routes. Although he doesn’t specify a target, Roddam says the focus is key metros where Big Cinemas is absent. “We’re also looking at smaller cinema chains with 20 to 25 screens.”

“RMW is strongly positioned for the next two to three years as the current year will take care of the interest obligations,” he adds. But here’s the catch: Within five months of the rights issue, RMW’s board approved a proposal to delist from the exchanges. Once the company moves away from public scrutiny, it’ll be hard to see whether Roddam’s strategy has played out.