Digital special effects, possibly more than any other industry, has been touted as the magic engine to power Los Angeles into the 21st century.

It has it all cutting-edge technology, high-paying jobs, a symbiotic link to Hollywood, and it's non-polluting to boot.

But there's trouble in paradise.

Two large, prominent special effects houses have closed down in the last three months, while others have been hit with layoffs.

Last month, Boss Film Studios, a 90-person effects house in Marina del Rey, closed its doors after 15 years as one of Hollywood's leading visual effects studios, with credits including "Cliffhanger," "Die Hard" and "Ghostbusters." Founder and owner Richard Edlund said the company could no longer afford to pay for current projects and overhead out of future profits.

Two months earlier, Time Warner Inc. announced it would close its 150-person Warner Digital special effects house in Burbank.

This summer, another one of the industry leaders, Venice-based Digital Domain, laid off 34 people, representing 10 percent of its staff.

"The dream is shattering in this industry," said Ralph Maiers, general manager and special effects supervisor for Santa Monica-based Digital Magic. "There used to be a lot of dreamers in this industry when it was brand new and burgeoning. Now people don't have the energy or money to be creative. That's all going by the wayside."

The current shakeout is being driven by falling profit margins in the industry. While margins traditionally have been low between 5 percent and 10 percent several forces have combined to push margins below 5 percent in recent months.

One traditional strategy for sustaining profit levels amid falling margins is to increase the volume of business.

That scenario was played out last month when Rupert Murdoch's 20th Century Fox digital effects subsidiary VIFX bought New York-based Blue Sky Studios, creating a major player with 250 employees.

The impact of that deal remains to be seen, but it does result in one less industry participant, a further manifestation of the shakeout.

Among the factors fueling the shakeout:

- A shortage of talented digital artists dramatically drove up labor costs, leading companies to hold onto talent even during seasonal down times.

- Increased competition among digital effects firms allowed film producers to play houses off each other, bidding prices down.

- Big-budget special effects films over the last two summers forced digital special effects houses to lay out huge expenditures in advance for labor and equipment.

- Disappointing box-office receipts for many digital effects-heavy films this summer led to a drop in the number of scripts featuring digital effects.

These trends, combined with high capital equipment costs (some digital effects computers cost as much as $1 million apiece) and the seasonal feast-or-famine nature of the business, are what's behind the industry shakeout, industry participants and consultants say.

"This is a difficult business with low margins," said John Weaver, a former special effects artist with industry leader Industrial Light and Magic of San Rafael, Calif., who now consults to the industry. "A lot of people got into the business because they loved it. But they did not pay attention to the bottom line. If costs shot up or they had a bad run, they could get into trouble easily."

The shakeout now under way is widely expected to continue.

Once the shakeout is complete, "there will be about a half-dozen major digital special effects shops in town and then you will see some boutique shops," Maiers predicted.

That would mean the demise of another one to three major L.A. digitial effects houses, along with many of the several dozen mid-sized and boutique houses operating in Los Angeles. The mid-sized houses are particularly vulnerable to extinction in the months ahead, industry sources said.

The shakeout now taking place in digital special effects is similar to the one that took place among post-production television shops in the late 1980s, Maiers said.

As for Boss Film Studios, founder Edlund said the company had been taking in an average of $20 million a year in revenues. But that money was going to cover overhead costs, leaving little or no profit to reinvest in the company.

Weaver said Boss Film had skirted financial disaster several times before Edlund finally pulled the plug.

"They lasted 14 years, which is a tribute to anyone in this industry. It just got to the point where it was one cash crunch too many," he said.

Unlike Boss Film, the executives at Time Warner decided to pull the plug on Warner Digital at a much earlier stage.

"Executives at studios turn over faster these days," Weaver said. "They saw that this was not a big money-making business and decided their resources were better spent in other areas, like distribution."

Also, according to Digital Domain CEO Scott Ross, there is a now trend away from studios owning their own digital effects houses. Originally, he said, studios jumped on the digital effects bandwagon because they feared that, with the rise of big-budget special effects movies, not having an in-house digital effects unit could leave them stuck with one or two outside digital effects houses serving the entire industry. But, as more special effects houses have sprung up, studios have been able to exercise their market power and strike good deals.

"(Studio executives) are all going to ask the question, 'Why are we in this business when we can do this more cheaply on the outside,'" Ross said.

Meanwhile, at Ross' own Digital Domain, the July layoffs, coupled with the company's work on the upcoming release "Titanic" which at $200 million is said to be the most expensive film ever produced have fueled speculation that the company is in dire financial straits.

Ross, acknowledging that the speculation is widespread and is being spread over the Internet, flatly denied Digital Domain is having financial problems.

"Our company is in decent financial shape," he said, also noting that IBM Corp. and Cox Communications have ownership stakes.

As for this summer's layoffs, Ross said the main reason was the lack of special-effects-heavy scripts coming out of Hollywood in recent weeks, as well as sharply higher labor costs. He said the layoffs were across the board, including nine digital artists, as well as several digital camera operators and people who worked in the finance department. The layoffs were timed for July, he said, to precede a major industry convention and allow the workers an opportunity to find other jobs.

"We plan no more layoffs at this time," Ross said. "Of course, a lot depends on what happens in the industry."

Ross said his company's work on the movie "Titanic" has been a "difficult process, as most films are." But he declined to comment on whether producing special effects for "Titanic" has hurt the company financially. He would only say that Digital Domain's work on the film is "extraordinary." (Ross' partner James Cameron is also the director of "Titanic").

Big-budget films like "Titanic" have been a contributing factor to financial problems at other digital effects houses.

"You have to hire like crazy for these big-budget films. In most industries, that is not a problem. But now, with the tremendous shortage of talented and skilled labor, all of us have a tendency to hold on to quality people even in down times," said John Hughes, president and chief executive of Rhythm & Hues, a Los Angeles digital effects house.

The labor crunch, while intense this summer, is expected to gradually ease as more digital artists enter the field. Also, with more than 100 digital artists laid off this summer, talented artists should be easier to find.

Capital costs have also started heading down, industry executives and consultants say. The highly specialized digital effects machines are costing less now as the computer platforms have become more common and easier to produce, Ross said.

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