Within the electronics industry, Warren Lieberfarb, president of Warner Home Video, is known as the “architect of the DVD,” the man who introduced a new CD-based format that delivers superior digital sound and picture.

Lieberfarb told an audience of Wharton students he became convinced ten years ago he had to create a new way of making movies available for home viewing. And the DVD (digital video disk) was an essential part of that. “Here I was, enjoying a nice life, running a billion and a half dollar business unit and reading that we were going to be put out of business,” Lieberfarb recalled.

What he was reading about, he said, was “the next generation of television” – improvements in bandwidth and interactivity that would make it possible for consumers to get movies-on-demand on their TV sets. Unlike pay-per-view, which offers only a small selection of films for viewing at specific times, movies-on-demand promise access to thousands of films, viewable whenever the consumer chooses. 

And when that happened, said Lieberfarb, who graduated from Wharton in 1965, there would no longer be any reason for consumers to go to video rental stores – the venue which currently provides “55%-60% of the total income” of Hollywood movie studios. There would be no need for Warner Home Video to supply video rental stores with Warner Brothers films.

“I decided that if we were going to compete, we had to change the rental model. My conclusion was you had to be able to sell movies at places where the customer does conventional shopping, like Wal-Mart, and make up in volume what you lose in margin. “

Selling rather than renting would be complementary to movies-on-demand, he said, because “there’s an emotional benefit to owning a movie; don’t ask me what it is. But tapes are too expensive. Movies on tape only sold to rich Wharton grads with money to throw away. I knew that to sell, the sound and picture quality had to be competitive with TV and the price half that of a VHS tape.”

Lieberfarb began investigating optical disk technology. In 1992, he said, Warner entered into a strategic alliance with Toshiba. “I remember the first meeting between Toshiba and Warner execs as Looney Tunes,” he recounted. “The Warner execs behaved like Hollywood characters – I leave that to your imagination. The Toshiba group looked like they were having a hard time staying awake. But then I asked Toshiba if they had made any advances in Mpeg compression. Did they think they could get 135 digital minutes? And they woke up.”

Lieberfarb said he convinced Toshiba that what was needed was a device that could handle video, music and films all in one. Toshiba invested $500 million and that was the beginning of the development of the DVD player.

Warner and Toshiba then asked Philips and Sony to become co-developers. “We laid out the specs for a single disk standard – the data capacity, wave length of laser, variable rate encoding, the physical structure. Philips and Sony agreed, but that turned out to be a subterfuge for delaying us and stealing our trade secrets. In 1994, Philips advised me that they and Sony were going their own way. They had a compact disk and if you wanted to use it, you’d have to get a license from them and any improvements you made belonged to them. They invited Matushita to join them. They were out to make it impossible for us to compete.

“I announced that we would bring action against them for collusion, conspiracy and violation of the Sherman anti-trust act. When you are betrayed, you have to get back at the betrayers, right?”

Lieberfarb did more than threaten to sue. 

“I wrote a letter to Philips seeking terms of licensing a single core patent they had going back to the sixties. ” And to make sure he got it, he sought help from the U.S. Justice Department, then headed by Janet Reno. “The Department issued guidelines for high technology on the misuse and abuse of a dominant patent portfolio to restrict competition.”

In addition, he said, “the executives of every studio except 20th Century Fox got together to enunciate disk specifications that would satisfy them as major producers of movies. These were not requirements – just a perfectly legal ’wish list.’”

Lieberfarb didn’t say that the wish list conformed to the Warner-Toshiba standard rather than the Philips-Sony standard. But probably so, because Philips and Sony caved and the Warner-Toshiba 4.7 gigabyte standard prevails.

“Twenty-five percent of U.S. households now have a DVD player, not including those in PCs and game players,” said Lieberfarb. “DVDs have caught on faster than did color TVs, cell phones or VCRs.” And just as he envisioned a decade ago, Warner Home Video is selling Warner movies on DVD as impulse purchases at Wal-Mart, Target and other mass merchandising stores.

That’s not the happy ending of the story because the story hasn’t ended yet. While Lieberfarb believes video rental stores are on the way out, Blockbuster, which controls 42% of the video rental market, is determined to prove him wrong. “Blockbuster is fighting for its survival by selling used tapes and disks at prices lower than Warner Video’s new movie DVDs at Wal-Mart,” he said.

What will happen now? “I don’t fully have the answer,” Lieberfarb admitted. “We’re playing a game of chicken.”

Indeed, according to a story in the Wall Street Journal earlier this month entitled “DVD Gains on Tape, but Economics Have Hollywood in a Tizzy,” Lieberfarb is thick in the middle of the debate over how best to take advantage of DVDs. Noting that North American consumers over the past four years have bought 31 million DVD players and are “snapping up” DVD versions of both first tier and second tier movies, the article cites big questions that remain over how to price these DVDs (Lieberfarb wants to price them low, to the dismay of some rival studios) and also how to balance the needs of those who want to rent films vs. those who want to purchase them. The Journal quotes Lieberfarb accusing Blockbuster of trying to “increase their margins at the expense of the studios,” and suggests that Blockbuster’s relationship with Warner Bros. “appears ready to come unglued as their deal to share revenue from videotape rentals expires this month…”

What has to be understood, Lieberfarb explained to his Wharton audience, is that “movies, TV, music and publishing are different from any other consumer product business. Despite all concept testing, all pilot testing, there is no accurate predictive tool to forecast revenues of a product that appeals to the heart and mind. Making decisions in that context is highly speculative and highly risky,” he said. “Seven out of ten movies lose money.”

He noted that when the VCR was introduced in the early 1980s, the Hollywood studios saw it as a threat. They believed the ability to record a movie from TV to tape would lead to pirating tapes and hurt box office receipts at movie theaters. Universal and Disney sued Sony claiming that by selling VCRs it was a party to copyright infringement. 

But [in 1984] the U.S. Supreme Court sided with Sony. And that, according to Lieberfarb, turned out to be fortunate for the movie business, he said. Video rentals were a bonanza for the studios because they not only added income from new movies, they recycled the value of the studios’ libraries of old movies. “Most of a movie’s cost is written off in two to three years. After that, except for royalties, income from rentals goes right to the bottom line.”

And the VCR did not hurt box office receipts. “It might seem logical to predict that no one would pay $7-$10 for a ticket when for $2 you can rent a movie or for $10 a month you can see several movies on HBO. But it didn’t work that way. Even though 80%-90% of American households now have a VCR, theater attendance has not gone down. It has stayed flat. “

Lieberfarb said that what he observed was that while the VCR was not seen as an alternative to movie theaters, it was seen as an alternative to TV watching. “In the 1990s when 70% of American households had VCRs, 40% of those households were renting three movies a week,” said Lieberfarb. “They were making trips to the video store in lieu of just turning on the TV. That is an extraordinary statement on the lack of diversity, quality and audience satisfaction provided by TV.

“In Europe, the opposite happened,” he added. “When television broadcasting was denationalized, Europeans liked the new programs they could see on TV and the video rental business collapsed. That only validated my belief that once U.S. consumers get what they want from TV, they will no longer rent videos. And, he added, TimeWarner Cable expects to be able to provide movies-on-demand by the end of this year.