Visual Effects Industry Does a Disappearing Act

Updated February 22, 2013, 2:50 p.m. ET

Visual Effects Industry Does a Disappearing Act

By BEN FRITZ

A split scene from the ‘Life of Pi’ shows a digitally-crafted tiger and ocean—and the studio where live action was filmed. Financial pressures forced the effects creator into bankruptcy.

The Oscar for best visual effects on Sunday is widely expected to go to Ang Lee’s “Life of Pi,” which uses a digitally created tiger so realistic that it serves as the main character’s sole companion for most of a journey across the Pacific.

But there may not be much celebrating at the El Segundo, Calif., offices of Rhythm & Hues Studios Inc., the 26-year-old company that served as lead effects producer for the film. On Feb. 13, just eight days after “Pi” won four prizes at the annual Visual Effects Society Awards, Rhythm & Hues filed for Chapter 11 bankruptcy. The same week it laid off 254 of its 718 employees in the Los Angeles area, according to court documents.

It is the second bankruptcy filing by a leading U.S. visual effects shop in the past six months, following Digital Domain Media Group Inc. DDMGQ +80.00% in September. The developments come amid skyrocketing use of computer-created robots, animals and sets in all kinds of Hollywood movies. Blockbusters like “The Amazing Spider-Man” and “The Hobbit: An Unexpected Journey” often have thousands of visual effects shots. Even dramas and comedies today can include hundreds of them. The Parisian backdrops in “Les Miserables” included many digital creations.

Despite such demand, the business of creating visual effects is getting less profitable, industry executives say. They blame a combination of factors, including generous tax credits in Canada, New Zealand and the U.K.; competition from low cost labor in developing markets; and ever-cheaper technology that is letting more competitors set up shop.

“We’re the ones who create the magic that allows billions of dollars to be generated for the movie industry and yet we’re at the companies that are going out of business,” said Eric Roth, executive director of the Visual Effects Society, an honorary organization that counts nearly 3,000 digital-effects artists as members. “How supremely ironic is that?”

Digital Domain said its bankruptcy occurred in part because it had taken on risky expansions, including original animation and a trade school in Florida. The company’s core effects business has since been acquired for $30 million by Beijing-based Galloping Horse Film Co. and Reliance MediaWorks Ltd.532399.BY +0.52% of India.

Few in Hollywood expected the more conservative Rhythm & Hues to find itself in the same predicament just five months later.

However, the delay of several anticipated movies left the company, which was also lead visual effects shop on “Snow White and the Huntsman,” without the funds to continue work on several movies for which it had contracts, according to bankruptcy court filings and interviews with executives.

“We made some bad investment choices that cost us a lot of capital and we did not book enough work to sustain the size of the company,” said feature film division chief Lee Berger.

Hollywood studios ready to make a movie typically solicit bids from visual effects shops like Rhythm, Digital Domain, Sony Pictures Imageworks, and Industrial Light & Magic (recently acquired by Walt Disney Co. DIS +0.15% as part of its purchase of Lucasfilm Ltd.), which attempt to complete the job for less than they’re paid.

That approach has never generated robust profits.

“A good year for us was a 5% return,” said Scott Ross, who co-founded Digital Domain in 1993 after serving as general manager of ILM. He left in 2006 after he and his partners sold the Los Angeles company.

Though it has accelerated in recent years, outsourcing to countries with lower labor costs has been a factor in the visual effects business for more than a decade. Rhythm & Hues opened its first of two offices in India 12 years ago, said Mr. Berger.

Some work previously done by large companies like Rhythm & Hues can now be handled by low-cost boutique shops that take advantage of plummeting technology prices. Rendering software that costs several thousand dollars per user just a few years ago can now be had for several hundred dollars, said Digital Domain creative director of software Doug Roble.

In its bankruptcy court filing, Rhythm & Hues estimated that tax credits, currency-exchange rates and labor practices gave other English speaking countries a between 35% and 60% cost advantage over Los Angeles. Tax credits available in California and other states are more limited.

Movie studios count on those benefits to keep down the growing budgets of their films, forcing California companies including Rhythm & Hues, Digital Domain and Imageworks to shift work to Vancouver.

Despite the tax benefits, opening offices in new cities is also costly.

“We have all had to endure substantially increased operating costs by setting up shops in locations where those local governments are providing subsidies,” said Digital Domain Chief Executive Ed Ulbrich.

The situation mirrors the “runaway production” phenomenon, where many movies and television shows are shot outside of California due to generous tax credits elsewhere.

Rhythm & Hues’ bankruptcy has prompted more discussions about what can be done to stabilize the business.

“Instead of making money on the making of a movie, how about aligning our interests?” said Digital Domain’s Mr. Ulbrich. To that end, his company serves as a producer for a coming adaptation of the science-fiction book “Ender’s Game.”

Rhythm & Hues has received court approval for up to $17.1 million in debtor-in-possession financing from two studios, allowing it to continue work on upcoming movies it was working on for them when it filed for Chapter 11: Twentieth Century Fox’s “Percy Jackson: Sea of Monsters” and Universal Pictures’ “R.I.P.D.” Fox, like The Wall Street Journal, is owned by News Corp. NWSA +1.13% Universal is owned by Comcast Corp. CMCSA -0.42%

In addition, Legendary Pictures LLC has agreed to pay the visual effects firm $5 million to complete work on its movie “Seventh Son.”

On Friday, Rhythm & Hues said it had engaged investment bank Houlihan Lokey Inc. to help it find a buyer and emerge from bankruptcy.

Even if the company gets back on its feet, it would face the same industry pressures. And its leaders don’t see any easy answers.

“Maybe if I knew, we wouldn’t be in this situation,” said Mr. Berger.