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Coinstar: Deep Value and Exceptional Growth

March 14, 2011 | About:
afardshi

afardshi

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Before I get into it, I would like to thank GuruFocus.com for all of its rocking and insightful content over the years. I have written this report as part of the Monthly Value Ideas Contest. For those who haven’t heard of this contest, please follow the link below:


http://www.gurufocus.com/news.php?id=119858


This report summarizes why I am bullish and long on Coinstar and why last month’s waterfall-like drop in the stock price provides a perfect entry opportunity to those looking to build a position in the name. All of the analysis disclosed below (and attached as a picture) is proprietary and based on my own research. This report is not posted anywhere else on the web. Some of the financial exhibits are complex and may come out fuzzy in this report. Feel free to message me if you would like me to email any of the exhibits or a PDF of this report to you.


Enjoy,

Amir (3/13/2011)




1.0 EXECUTIVE SUMMARY



Investment Highlights- Market leader in the in-home movie viewing space with 35% market share as of January 2011 (surpassing Netflix)


- Compelling unit economics; Redbox kiosks have a 3.5 year cash-on-cash payback (note: mgmt states 2.5 years, presumably pre-tax) and generate a 10-year IRR of 36%


- CSTR has grown revenue and EBITDA by 39% and 41%, respectively, over the past year and has plenty of room for additional growth through new kiosks and same-store sales growth; projected revenue and EBITDA CAGRs of 16% and 23% over the next five years


- Attractive valuation of 5.2x 2011E EBITDA / 5.8x 2010A EBITDA compared to its historical long-term average of 8.2x EV / LTM EBITDA. 2011 P/E of 13.8x, PEG of 0.61.


Secular concerns are overstatedConcerns over Q4 2010 “under” performance and long-term viability of the business model are overstated. Investors reacted negatively to the compression in gross margin and slowdown of comps to 12.5%. Given the revenue ramp of DVD kiosks ($35K, $50K, $55K), a slowdown in same-store sales % is not a result of shifting consumer preferences, but a result of average kiosk age (currently ~2 years). Gross margins, which underperformed by ~550bps in Q4, were another concern. DVD costs are a direct function of # of copies purchased for each new title, and management clearly over-estimated the demand for certain titles. This is not a long-term problem and should be filtered out of the financials by Q2 2011.


Long-term concerns around supplier relationship with studios and the threat of streaming are also ungrounded. Redbox proved in 2009 that it could live without studios by purchasing content from distributors after studios tried cutting Redbox out of the equation. This is why studios came back to the bargaining table in 2010, and although 3 studios instituted a 28 delay on new releases, they offered a lower purchase price on titles to make the effect ‘profit neutral’ for Redbox.


Streaming is a completely different business model that: 1. comes with an $8/month price tag vs. $1/movie from Redbox; 2. doesn’t offer new releases; and 3. requires a laptop or internet-enabled entertainment device. This is not the same consumer that values Redbox, which is why Rebox has gained share over streaming providers such as Netflix. This is all before factoring in Redbox’s strategy to offer streaming as well some time in 2011, perhaps in a bundled offering with its kiosk business.




Near-term CatalystsGross margin is key: with projected DVD revenue of $1.5bn, a 500bps GM% miss equates to $75mm of EBITDA. At a 7x multiple, this equates to $525mm of enterprise value, or ~$15 per share. Q4 2010 DVD costs per kiosk were $6.5K compared to the historical rate ~$4.5K. A reversion back to the average will drive significant EBITDA growth in the back-half of 2011;


Kiosk growth: CSTR expects to add 5,000 – 6,000 Redbox kiosks in 2011;


Announcement of streaming business: Management has made streaming one of its top priorities in 2011 and has stated that its offering will be truly unique; an announcement is expected some time this year; and


Liquidation of Blockbuster: Blockbuster continues to close down stores as it goes through bankruptcy; if the business is ultimately liquidated, that could lead to immediate market share gains for other brick and mortar players such as Redbox.


Business Summary

Coinstar (“CSTR” or the “Company”) operates two distinct segments: DVD Services ($193mm 2010 EBITDA) and Coin Services ($94mm 2010 EBITDA). The DVD Services segment operates ~30,000 Redbox DVD kiosks located in high traffic locations such as grocery stores, Wal-Marts, and convenience stores. A typical Redbox kiosk costs $15K on average, with a calculated after-tax payback of 3.3yrs and a 10-year IRR of 35.5% (see Section 4.1 for more information). The Coin Services segment operates ~19,000 Coinstar kiosks located inside grocery stores, which convert coins into cash for a transaction spread of 10%. Although growth opportunities in the Coinstar business are limited, the segment is a cash generator with $90-$100mm of EBITDA and only $10mm of annual maintenance capex (34% EBITDA margin / 30% cash EBIT margin).


The Company has historically traded at an LTM EV / EBITDA of 8.1x, but fell out of favor earlier this year when it pre-announced earnings on January 13th with year-end 2010 guidance that was below street estimates. The stock plummeted 27% from $57 to $41 that day and has seen a number of ebbs and flows since then as investors question the longevity of Redbox’s brick and mortar (“B&M”) business model vis-à-vis the threat of streaming content, video-on-demand (“VOD”) and the uncertainty around supply contracts with studios going forward. The short interest is currently 31%, so there is no shortage of haters on this name (pun intended).


As of March 11, 2011, CSTR’s share price was $42.48, its market cap was $1.55bn and its enterprise value was $1.65bn (assumes the $200mm of convertible notes are converted into equity). At this price, CSTR is trading at 5.8x 2010 and 5.2x 2011 EV / EBITDA, or 17.0x 2010 and 13.8x 2011 P/E. This is an extremely cheap valuation for a company with the leading market share in its industry (35% as per NPD in January 2011), 39% 2010 revenue growth and 41% 2010 EBITDA growth. A meticulous analysis of the Company’s financial model reveals that CSTR still has plenty of room for growth over the next five years. I project a 5-year revenue CAGR of 16% and an EBITDA CAGR of 23%.


The Company will face headwinds over the next quarter as it deals with: 1. overbought inventory from Q4 2010, which will pressure gross margins in Q1 2011; and 2. lower than expected Q1 comps as I believe all B&M businesses in the US to report disappointing comps due to the myriad snowstorms that hit the northeast for much of January and the beginning of February. However, I expect the stock to trade within a range of $55-$60 in the second half of the year as DVD gross margins stabilize around 60% and the number of kiosks and revenue per kiosk continue to grow. There is additional near-term upside if management provides further clarity surrounding its online streaming strategy. Over the next three years, I believe the stock will reach a valuation of $90-$110 as the DVD kiosk base grows from 30K today to 50K in three years and DVD EBITDA margins grow from 16.6% to 24.4% due to operating leverage. These returns represent a 40.0% IRR (assuming an exit at year-end 2013) or 2.6x MIC at the high end of the range.




2.0 COMPANY OVERVIEW



For those familiar with Coinstar’s business model and recent developments, you can skip over ahead to Section 3.


2.1 Rebox


Business DescriptionCoinstar’s DVD business, Redbox, seeks to provide customers with convenient access to a vast selection of movies, including new releases, for a fee of $1.00 per evening. This is a compelling offering in contrast to “mom & pop” movie rental stores or video-on-demand that can charge upwards of $5.00 per movie. Consumers will be charged an additional $1.00 for each additional evening that they hold on to a movie; after 25 days a customer is charged the maximum fee of $25 per DVD. This implied “sale value” of $25 to consumers is more than double the Company’s average cost of $11.20 per DVD (see Section 4.1 for details behind this calculation). Customers have the option of returning a DVD to any Redbox location regardless of where it was rented. Customers showed their appreciation for this convenience in Q4 2010 when 45% of DVDs were returned to a location different from the original point of transaction. Redbox kiosks are located in Wall-Mart, Kroger, 7-Elevent, McDonald’s, CVS and other high traffic stores.

Redbox was originally seeded by McDonald’s (first the Big Mac, then the Chipotle burrito, and now DVDs!). Coinstar bought a minority interest in the business in 2005 and acquired the remaining stake in 2009. Despite the limited operating history of the business, Redbox has already gained the lion’s share of the at-home movie-viewing market, rising from 30% in Q4 2010 to 35% in January 2011, eclipsing Netflix (source: NPD VideoWatch data) for the top spot.


CompetitorsThe competitive landscape can be bucketed into three main categories:




  1. Brick & More Rental Stores / Kiosks: Includes Blockbuster stores and blockbuster kiosks (built by NCR), Movie Gallery and independent rental stores. This segment currently has a ~20% share of the market, down 17% from its 2009 share of 37%. As Blockbuster and Movie Gallery (which are currently going through bankruptcy processes) continue to close stores, Redbox gains share as the only viable B&M alternative.
  2. Streaming / By-Mail Providers: Includes Netflix, Amazon.com, and other streaming providers. This segment represents ~35% of the market. Streaming content is still in its infancy stages as only older titles are offered online; Netflix offers ~70% of its library through its streaming service, with the absent 30% being comprised of all the new releases. While viewers have the ability to watch streaming content on their TV rather than a computer, this functionality requires specific hardware such as a video game system or an internet-connected Blu-Ray player.
  3. Video-On-Demand / PPV: VOD and PPV have been around for some time and provide the most convenient option for watching a movie on TV, but the selection is limited and prices tend to run between $5-$8 per title.


Relationship with Movie StudiosRedbox contracts with 7 movie studios in total. In late 2009, a number of these studios ended their relationships with rental service provides such as Redbox and Netflix in an effort to boost DVD sales. This strategy proved ineffective and in early 2010, Paramount, Universal an Warner studios re-negotiated terms with the rental services to provide them with new releases 28 days after those movies had been made available for sale to the general public. In exchange for accepting such terms, the studios agreed to supply new titles at a discounted rate such that the net effect of the 28-day delay would be neutral on profitability. I estimate the cost to have been reduced from ~$13.00 to ~$11.00 per title, which is based on two data points. First, Disney recently announced that “28 day” movies will be sold for $10 wholesale (so even lower than my estimate of $10.00). Second, new DVD titles are sold for ~$15 from retailers such as Wal-Mart, implying a wholesale cost of around $13 per title. Given the aim to make the impact of the 28 delay neutral on profitability, I have assumed that the wholesale price has been reduced by $2 to $11 per title.

Inventory purchases and management are imperative to maximizing profitability in this business. While management has historically done a superb job of driving gross margins at or near 60% as a result of effective DVD purchases, Q4 2010 was a misstep. Gross margins were down ~550bps from Q3 due to effects of the 28 day delay and over-purchasing of under-performing titles. Management continues to get smarter on the effects of the 28 day delay and how to adequately plan its inventory purchasing going forward.

Redbox Streaming ServiceThe Company has announced plans of launching its own streaming service through a partnership, most likely with an online brand-name. Amazon had been rumored to be in talks with CSTR as recently as February, but unilaterally launched its own streaming service shortly thereafter. CSTR’s management has stressed this issue as one of the primary focal points for the Company in 2011.

Although it would be premature to ascribe any value to this up-and-coming income channel, it is worth noting the potential optionality derived from this angle.

2.2 Coinstar

Coinstar kiosks provide customers with the option to turn their coins into cash. This is a high cash flow business, but has seen some tough comps over the past two years. Nonetheless, this is a $10bn market with CSTR only capturing $3bn of this market to-date; the Company is focused on closing the gap on the remaining $7bn of coins in circulation that do not go through Coinstar machines. Management has shown to be very analytical and data driven in their approach of operating the business, and have determined the single biggest deterrent preventing people form using Coinstar machines to be the 10% spread paid to the house. As such, CSTR has begun offering “fee-free” transactions by partnering with online retailers such as Apple and Amazon. Rather than receiving cash, customers are given a voucher for 100% of the transaction value to shop online at the retailer of their choice. In turn, CSTR is fully reimbursed for that amount of the voucher by the retailer. The benefit to the retailers is increasing visitor traffic to their site in hopes of drawing in shoppers to spend more than the voucher amount.

The kiosk base is currently 19,000 and prospects for footprint expansion are limited. Despite management’s efforts, I assume modestly declining EBITDA from this segment as there is little evidence to prove initiatives in the Coin segment will prove fruitful. That being said, the business has a solid market position and has shown stability with little marketing effort and support.

3.0 INVESTMENT THESIS

Unique business modelRedbox provides viewers with the ability to watch ANY movie for $1 per day, including new releases. This is an extremely unique offering for two reasons. First, even Netflix, which offers its streaming service for $8 per month DOES NOT offer new releases in this package. Only ~70% of its movie library is available via streaming; the missing 30% piece are all the new releases that you’d actually want to watch. Second, households are far more likely to watch a movie at a $1 price point through Redbox than $5 through VOD. The median US household income is $46,000, or $3,800 per month. Subtracting taxes and mortgage payments leaves $1,900 of discretionary income to be spent on 4 people per month. After deducting food costs and other bills, you can see how a $4 cost differential for a movie rental can go a long way.

In addition, Redbox’s geographic footprint allows customers to rent movies from convenient locations that they often frequent, with the ability to return a movie to any other Redbox location in the country. At the risk of sounding redundant, it’s worth re-iterating that 45% of Redbox rentals in Q4 2010 were returned to a different kiosk than their original point of transaction. The rental experience itself is also extremely efficient and takes less than 60 seconds if you know what you want. Lastly, Redbox is able to get new release titles to customers faster than Netflix since there is no waiting period for a movie to arrive by mail. Remember that Netflix also has a 28-day delay window with the same movie studios as Redbox.

Compelling Unit Economics Redbox’s DVD kiosks have a FCF payback of 3.3 years and a 10-year IRR of 35.5% (Note: management states the payback of a kiosk to be approximately 2.5 years, but this is probably on a pre-tax basis). These are outstanding returns when compared to benchmark returns across the retail space and form the crux of the investment thesis. FCF is negative in year 1, but reaches a cash-on-cash yield of 52% by year 2. These unit economics translate into a strong ROIC at the corporate level, which has grown from 12% in 2008 to 18% in 2010. Although such returns are not extraordinary today, they will continue to grow as the boxes mature; projected ROIC in 2011 is 21%.

Dominant market share Redbox has already gained the largest share of its market (35%), surpassing Netflix in January 2011 despite having only been around for only ~8 years (compared to 14 years for Netflix, which was founded in 1997). This is a testament to the effectiveness of Redbox’s unique business model. As Blockbuster and Movie Gallery close down stores, other competitors will continue to gain additional market share, the bulk of which would be expected to go to other B&M providers such as Redbox.

Barriers to Entry in the B&M SpaceRedbox’s barriers to entry fall into three large buckets: 1. relationships / partnerships; 2. operational expertise; and 3. geographic footprint.

First, CSTR has formed partnerships both in the Coinstar and Redbox businesses that are difficult to rival. In the Coinstar business, CSTR has partnered with Amazon and Apple to offer fee-free transactions (see Section 2.2). In the Redbox business, CSTR has strong supplier relationships with studios. Redbox clearly has some leverage in this relationship, as studios were unsuccessful in cutting them out of the equation in 2009 and were even forced to offer a price reduction in exchange for implementing the 28-day delay in 2010. Redbox should gain additional leverage in this relationship as it becomes the largest player in the at-home viewing market. CSTR also has strong relationships with retailers. Wal-Mart, Walgreen, Kroger and Mcdonald’s are its strongest partners today. Part of the value embedded in these relationships is knowing that stalwarts such as Wal-Mart rely on Redbox rather than launching a de novo rental business of their own.

Second, CSTR’s management has gained considerable experience in how to run a business of this complexity. Inventory management is one of the most critical factors in driving operating margins. Not only does the management team have to know the right titles and quantities to purchase, but they have to effectively re-stack the machines as customers rent DVDs from one location and return them to another. This is a very data-driven business, and no one has as much historical operating data as Redbox’s management team.

Third, Redbox’s 30,000 kiosk footprint cannot be replicated overnight. It would be far more difficult for a streaming content provider such as Netflix to mimic Redbox’s B&M model than it would be for Redbox to enter the online market. This footprint also provides customers with the convenience of renting and returning discs from more points than any other B&M competitor.

Attractive growth profileThe Company’s 2010 consolidated revenue and EBITDA grew by 39% and 41%, respectively. The DVD segment’s 2010 revenue and EBITDA 2010 grew by 50% and 89%, respectively. This is a high growth business that has plenty of additional room for growth. Management has identified ~60,000 tier 1 locations across the US, so Redbox could potentially double its footprint from its level today. Revenue growth will undoubtedly decelerate, but will remain in the double digits for the next five years. I project a 5-year revenue and EBITDA CAGR of 16% and 23%, respectively, assuming the Company grows to ~53,000 kiosks over the next five years.

High Free Cash Flow ConversionCSTR generated $170mm of actual FCF in 2010 (12% margin), or $100mm of run-rate FCF (7% margin) excluding NOLs and proceeds from sale of discontinued operations. These are impressive numbers considering ~$130mm was spent on new kiosks during the year. Both Coin and Redbox average $600K of annual maintenance capex per kiosk, implying ~$50mm of total maintenance capex (including corporate) annually. Excluding growth capex, Coin and Redbox reached FCF margins of 21% and 12% in 2010, respectively, and combined for $197mm of maintenance FCF ($6/share or 13% yield). This is an important metric that points to the cash generating ability of the assets if CSTR could no longer grow.

ValuationCSTR currently trades at 5.2x 2011E EBITDA or 5.8x 2010 EBITDA. This compares to a long-term average of 8.2x LTM EBITDA and a 3-year historical average of 8.5x LTM EBITDA. Assuming the Redbox business is worth at least 7.0x (which is more than reasonable given the aforementioned investment highlights), that would imply a Redbox value of $1.6bn and only $40mm of value ascribed to the Coin business! Going the other way, if we value the Coin business using a DCF (15% cost of capital), which implies a value of ~$400mm, that would imply $1.3bn of value, or 5.5x 2011 EBITDA, to Redbox.

I believe the Redbox business is worth 7.0–8.0x and the Coin business is worth 5.0–6.0x forward EV/EBITDA. Taking the mid-point of those two ranges implies a fair value of $58.17 today / 27% margin of safety.

Share Buyback Activity and High Short InterestManagement currently has a share buyback program active and recently announced a $50mm accelerated share repurchase. In addition, the short interest on the stock is currently over 30%. Any positive momentum could lead to the shorts covering their positions.

Optionality from Streaming Content and Fee-Free Coin Transactions

I do not ascribe any value to the potential streaming business, which management has constantly re-iterated is a top priority. An announcement related to this new business is expected some time in 2011. In addition, I have assumed that the Coin business declines over time. If the fee-free concept gain traction, CSTR may be successful at tapping into 70% unpenetrated coin market.

4.0 FINANCIAL PERFORMANCE

4.1 Unit Economics

Please see Exhibit A for a build-up of the Redbox unit economics. Some of the key assumptions are explained below:

- Investment: $15,000 (stated by management) + $6,720 of “start-up” DVD costs to fill the kiosk (600 DVDs * $11.20 per title)

- Revenue Ramp: $35,000 year 1, $50,000 year 2, and $55,000 in year 3 (stated by management on the Q4 call)

- Net DVD cost: The first step is calculating the run-rate number of DVDs purchased per kiosk (excluding the working capital hit of $6,720 in year 1). Based on the data I’ve tracked for 3 months, kiosks average 5.3 new titles per week. I’ve assumed 7.5 copies per title. This implies 2,048 DVDs purchased per year. However, some DVDs purchased from distributors (not studios) are then sold at the end of their useful life. Distributors supply 10% of Red Box’s inventory and I assume that 50% of these DVDS (5% of a Kiosk’s total inventory) are sold for $3.00. The net DVD cost works out to be $22,625 per annum, which is a constant figure annually since the number of DVDs purchased doesn’t change. This is why gross margin will continue to grow over time as sales per kiosks grow. In fact, this number is very conservative as you will see in my analysis of Redbox’s historical DVD purchases per kiosk in Exhibit C.

4.2 Redbox Financial Performance

Please see Exhibit B for Redbox’s financial model. In my opinion, the two most critical drivers that need to be modeled with precision are revenue and cost of goods sold to accurately project out the DVD business. The revenue build-up has three components: 1. current mature kiosks; 2. current ramping kiosks; and 3. new kiosks. Bucket 1 includes kiosks that are at least ~1 year old that will comp at a rate of ‘mature kiosks’ (see bottom of Exhibit B). Bucket 2 includes kiosks that were opened after Q1 2010 and have not yet fully matured. This group is only relevant for 2011. As each quarter in 2011 passes, the ramping kiosks that are older than one year are then included in the mature bucket to avoid double counting. The third bucket is revenue from new kiosks (calculated based on a revenue waterfall).

Cost of goods sold should be thought of on a per kiosk basis. Since this is a rental business, COGS is a function of the total inventory purchased, not inventory sold. COGS per kiosk in Q4 2010 were $5,000 compared to $4,444 in Q3. This is why margins were adversely impacted. This “over purchasing” is expected to spill into Q1 2011, but decline thereafter. See Exhibit C for my build-up of DVD costs and implied COGS (it is assumed that 98% of DVD purchases are amortized annually). Gross margins are projected to rise because the cost of DVD purchases per kiosk should remain flat, while comps gradually rise.

Because of the expected improvement in gross margin after 2011, EBITDA is expected to grow by $168 million, or 73%, in 2012 (sounds monstrous, but is still less than the 2010 growth rate of 89%). Almost 50% of this growth stems from the 450bps improvement in gross margin. See Exhibit D for a bridge of 2011 EBITDA to 2012.

4.3 CSTR Consolidated Financial Performance

For the consolidated performance, I have assumed flat revenue for the Coin business with declining EBITDA margins. See Exhibit E for the consolidated financial summary.

5.0 VALUATION


5.1 Historical Valuation


CSTR’s EV / LTM EBITDA multiple has historically traded above 8.0x, whereas today it trades at 5.8x (see Exhibit F). A P/E multiple valuation isn’t as relevant for CSTR since earnings are negatively impacted by non-cash interest expense related to the accretion of its convertible notes (i.e. cash earnings are under-stated).


5.2 Base Case Valuation


The Base Case assumes 22,500 new kiosks are deployed over the next five years and DVD costs per kiosk remain constant at $19,600 per annum after 2011. The projected share price is below. Note that the projected share price of $56.09 at year-end 2011 differs from the fair value of $58.17 because of the difference in net debt and share count (dilution from additional options issued over the remainder of the year).

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5.3 Downside Case Valuation

The Downside Case assumes only 5,000 kiosks are added over the next five years and DVD costs per kiosk rise to $22,500. Note that DVD costs per kiosk have never averaged above $20,000 in the past. Even under this case there is significant room for stock price appreciation.


6.0 RISKS AND MITIGANTS

Risk: Increasing competition from other kiosks and B&M vendors.

Mitigant: Blockbuster is the only other vendor that has attempted to enter the kiosk realm, with ~7,000 machines across the US. Unfortunately for Blockbuster, it has filed for Ch.7 and will either get liquidated or complete an asset sale to a consortium of hedge funds and private equity firms. However, even if Blockbuster is liquidated, NCR may continue expanding the footprint of its DVD kiosks even in the absence of Blockbuster. Blockbuster merely collects a royalty fee from NCR in exchange for the use of its brand, so it’s not critical to the expansion of NCR’s kiosks.

Risk: Extinction of kiosks as VOD and streaming gain market share.

Mitigant: Although many Redbox opponents make this argument, NPD market share data has suggested otherwise thus far, as Redbox has become the largest player in this space. Furthermore, VOD is not a new concept. Pay-per-view (similar to VOD) has been around for 20 years and has yet to be widely adopted. Although streaming has a more compelling offering than VOD because of the broader movie selection, studios have not made new releases available on a streaming basis (or these movies just cost too much for Netflix to offer them). Streaming is also a more “exclusive” offering that would be preferred by those that either prefer watching movies on their computers or those that have sophisticated enough in-home entertainment to stream movies to their TV. This is probably a different consumer than the Redbox consumer that loves paying $1 for a movie rather than $5 or $8 for a monthly subscription. In addition, Redbox is planning to launch its own streaming service in 2011 to make sure they don’t go the way of Blockbuster if kiosks do go away in 10-15 years.

Risk: Revenue concentration (60% of CSTR’s revenue is derived from 4 retailers alone).

Mitigant: CSTR continues to add new retailers to its list of partners (CVS was just added in January 2011). There is no reason to believe that any of these retailers are going disband their relationship with CSTR given the kickbacks they receive for minimal the real estate required for a box. In fact, a Redbox or Coinstar kiosk probably generate the highest revenue / sq. ft. in a store.

Risk: Studios will extend the 28-day delay or cease to contract with Redbox altogether.

Mitigant: Studious already attempted to boycott Redbox in 2009 in an effort to boost DVD sales. The incremental dollars generated from this decision were clearly not enough to offset the revenue lost from sales to Redbox, which is why they re-negotiated terms with the Company. Studios will supply Redbox as long as it is a formidable player in the movie rental space. As to whether the 28-day delay gets extended or not is uncertain, but since they provided a reduction in sale price to offset the delay, they would probably provide an additional reduction to offset any extension that takes effect.

Risk: Limited market size for DVD kiosks in the US with a ceiling of 60,000 locations.

Mitigant: Management’s stated potential market size of 60,000 only represents tier 1 locations. That being said, 60,000 is still double the number of Redbox kiosks currently in the market! Achieving that number will be a high-class problem to have. Management has already begun testing geographic expansion outside the US, with a number of locations in the UK under evaluation.

Risk: Inadequate management incentive since all options were struck below $30.

Mitigant: This data is based on last year’s proxy; this year’s proxy will be released next month and I’m sure options were granted to the CEO at a price that would be out-of-the-money today. Even beyond that, the management team should be incentivized by bonuses etc. to grow the business.

EXHIBIT A: REDBOX UNIT ECONOMICS

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EXHIBIT B: REDBOX FINANCIAL SUMMARY

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EXHIBIT C: REDBOX DVD COSTS AND COST OF GOODS SOLD

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EXHIBIT D: REDBOX EBITDA BRIDGE 2011E – 2012E

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EXHIBIT E: COINSTAR CONSOLIDATED FINANCIALS

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EXHIBIT F: COINSTAR HISTORICAL LTM EBITDA MULTIPLE

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Rating: 4.1/5 (21 votes)

Comments

tighanx
Tighanx - 3 years ago
"Both Coin and Redbox average $600K of annual maintenance capex per kiosk, implying ~$50mm of total maintenance capex (including corporate) annually"

How did you calculate that? Thanks

afardshi
Afardshi - 3 years ago


There are 3 components:





  1. Coin Kiosks: Management states maintenance capex is $600 per kiosk annually. Average number of coin kiosks outstanding in 2010 was 19,050. Total maintenance capex was $11.4mm.
  2. DVD Kiosks: Management says that $600 is a good proxy for annual maintenance capex per Redbox. Average number of DVD kiosks outstanding in 2010 was 26,300. Total maintenance capex was $15.8mm.
  3. Corporate: I backed into this number. We know total capex for the year was $171mm, which is made up of growth and maintenance capex. For coin growth capex, management expects to spend $7mm in 2011, so I assumed this figure was the same for 2010 since the kiosk base isn’t really changing. For DVD growth capex, I assumed $15K per new Redbox multiplied by 7,800 new locations in 2010, which totals to $117mm. So total growth capex works out to be $124mm. Total capex of $171mm less growth capex of $124mm leaves $47mm that was spent on maintenance capex. Back out maintenance capex related to coin ($11.4mm) and Redbox ($15.8mm) and that gets you to $20mm of corporate capex. [/list]
Toddius
Toddius - 3 years ago
One of the assertions you make is that Redbox has a different customer than the streaming business. That is probably true right now. You do need internet access to stream. However, most new dvd or blue ray devices have this capability. Long term - what if New Releases do become available? What if New Releases become available for $1, a la carte? Would you feel differently about Red Box then? It seems like the distribution costs of streaming are so much lower...companies could charge the same amount for streaming and make more. I could be wrong.

I agree that Red Box is viable now - but I worry about the future. No one can predict it, of course. Just my $.02.

Nice write-up.
adamcz
Adamcz - 3 years ago
I don't think movie kiosks will exist 10 years from now. Why would I want to leave the house not once but twice to watch a movie that I could stream instantly without leaving the couch? Streaming has to win out when the delivery economics are that much better.
afardshi
Afardshi - 3 years ago


Toddius and Adamcz,



I will respond to your comments in tandem since they both hit on the same point. The concern that you both raise is the most obvious criticism of the Redbox business model. It doesn’t help that Blockbuster, the once-upon-a-time industry leader, is now in bankruptcy, presumably because of the popularity of Netflix. The downfall of this industry guru has set the stage for critics to say that disruptive technologies will be the way of the future for home movie viewership.



It’s very easy to doubt a current trend when prevailing technologies are so “on the come”. Ten years ago I would have thought that brick & mortar vitamin / health shops such as GNC would cease to exist since it offers commoditized health products that every generic health website sells at a lower price! I also would have told you that digital cameras (and perhaps MP3 players) wouldn’t exist since cell phones would combine all those functionalities into one. On the contrary, none of these trends have come to fruition. For one, GNC just priced its IPO today and is a stronger company than it has ever been before (it is now by far the most dominant player in its industry). As for digital cameras and iPods, they are still very much in existence today (you could argue that the iPod’s success was essentially the stepping stone to Apple’s turnaround over the past 10 years). Without digressing too much, the point is that we can try to hypothesize what the future has in store 9 different ways to Sunday, but none of these theses mean anything without facts to support them. In reality though, the facts thus far point to a sustainable business model for the “foreseeable” future. There are three facts / trends to look at when evaluating the sustainability of the Redbox business model:



1.Market share is the single most important data point. I’ve mentioned it numerous times in my report: Redbox has gained the largest share of the home movie-viewership market as of January 2011. Not only is the trend for Redbox positive, but they are now the largest player in the category. Some skeptics will point to decline (but still positive) same-store sales growth. This argument is completely flawed: Redbox’s kiosks are only 2.5 years old, on average. This means that stores are still in the maturation phase, so comps are bound to slow down. This isn’t to say the comps were bad (12.5% last quarter), but they aren’t going to stay at 20%+ forever. Okay, so the market share argument should tell you that this business model clearly works today and probably for the next 2 - 3 years, but what about “10” years from now? (I think now is a good time to give kudos to Adamcz for having such a long investment horizon, his 401K must love him).



2.Redbox offers consumers both value AND convenience (hold on to your hats, I’ll explain). You need to appreciate the difference in offering a rental for $1 versus $5. An on-demand movie costs 5x the amount of a kiosk rental! The total dollars may not seem like much, but consumers are clearly more cost conscious since 2008 as they continue to de-lever their personal balance sheets. My report breaks down the average income for a family and how this cost differential influences their decision. In 10 years from now if this price difference still exists, then you can be certain that there will be a market for rentals that are priced for only 1/5 of the cost of on-demand movies. “But what about couch potatoes who want to stream instantly without even getting up??” If Redbox’s business model required people to get up and make a trip to the local kiosk solely for the purposes of renting a movie, then the business wouldn’t exist today. Redbox’s biggest retail partner is Wal-Mart (20% of sales). The average investor may look at this number and see a risk related to customer concentration. But this isn’t a customer concentration issue (Wal-Mart isn’t the customer). If anything, this is a very telling statistic about the value of the Redbox model: I can assure you that movie renters aren’t hopping in their cars and driving to Wal-Mart for the sole purpose of renting a movie. On the contrary, Redbox rentals are impulse transactions made by consumers at the tail-end of another transaction, whether it be at Wal-Mart, CVS, Safeway, etc. Consumers rent movies from Redbox because whatever errand they were running required them to step foot into a high traffic location, which just so happens to have kiosk right there. What’s even more interesting about this purchase is that in all likelihood, consumers who rent movies from Redbox probably didn’t even plan on renting a movie that night at all. In other words, they don’t weigh the cost / benefits of Redbox vs. streaming. They simply see an easy opportunity to have some form of entertainment for $1 that evening and make an impulse transaction. As for returning the movie, they can return it to any Redbox location they want! That’s why 45% of the rentals in Q4 were returned to a different kiosk. Again, the return process shouldn’t require the viewer to hop in their car for the sole purpose of returning the movie. So now the question becomes “well what if Netflix offers new movies online for $1 a la carte?”



3.First of all, that’s not even Netflix’s business model. NFLX prides itself on its 20mm subscriber base. To switch to an a la carte streaming model becomes a very different business. That being said, Toddius’ point is definitely a risk worth mentioning. Assuming that Netflix can offer new movies through streaming for $1 would imply that all the various players within the supply chain, particularly the studios, would be willing to just let go of DVD / BluRay sales and “subsidize” the rental market. It’s just not that simple. Netflix isn’t even allowed to offer new movies (it’s not a matter of cost) because studios don’t want to jeopardize new DVD sales. There is an array of revenue streams on which studios rely on, and home movie sales are a big part of it. You may have heard that Time Warner recently struck a deal with Facebook to offer streaming movies. The first pilot movie is Dark Knight, which was a great movie 2 years ago. But this highlights the industry’s reluctance to make new content accessible for a small fee. You have to appreciate the “depreciation curve” of a movie’s revenue trajectory. A movie is most valuable at its onset, so studios implement perfect price discrimination (pricing a movie high at first, and lowering it with time). There’s actually a good article in last week’s Economist that talks about this subject in-depth.



So Toddius, if new rentals were to become available for $1 on an a la carte basis, then there would certainly be cause for concern. But if we suspend all the “what ifs?” in our head (believe me, I have a ton of them) and just rely on the facts in front of us today, then it’s hard to see how this business goes away in the foreseeable future. I won’t quantify what “foreseeable” means. I am comfortable with what I see today and will re-evaluate as more industry data comes out over time.



I hope this helps,

Amir

adamcz
Adamcz - 3 years ago
For me this brings to mind to Buffett's joke about the auto industry. (paraphrasing) You didn't know which automobile manufacturer would come out on top, but it would have been nice to short horses. I don't know who will win the digital delivery game - could be Netflix, Apple, Amazon, Microsoft, Walmart, Hulu, or any number of new players - but I feel confident that digital delivery will win in all mediums like it already has with music.

Printing 1s and 0s onto plastic discs and shipping them by truck is inefficient and wasteful. How can redbox possibly maintain a long term price advantage over sending those same 1s and 0s through fiber and copper? To clarify, I'm not just predicting that Redbox's days are numbered - I'm also saying that Blu Ray will be the last optical format.
superguru
Superguru - 3 years ago


Amir has good points.

Redbox has been perfect. I now on average rent one movie almost every weekend from redbox. They are new movies and I chose and rent only when I like something.

Also I agree with Amir on impulse renting. The redbox near my home is outside Ralph's grocery store and I often stop in front of the redbox kiosk to just browse what is there before/after grocery shopping. I have done 1 impulse rental so far.

And I do not have cable in home and I used to watch like 3-4 movies a year before redbox.

Many times I cannot go to return next day and keep movie a day extra, $1.00 is hardly a cost I care about..

When I can get similar service at similar price via internet will I move to it, I sure will.
grover432
Grover432 - 3 years ago
Given that Redbox is investigating a streaming service, it indicates that they know the physical media delivery model has reached its peak and will be dropping off in the near future. If you look at the Q1 results, same store sales increases are continuing to drop off (12.5% in Q1 2011 vs 2010, which is half the increase - year over year for the 2101/09 comparison in Q1). This shows just how quickly the sales are slowing in the DVD rental business.

A recent interview with the CEO of Netflix (Reed Hastings) covered Netflix's latest results. Mr. Hastings indicated that the next quarter would be the first one in Netflix's history in which Netflix would actually see a decline in DVD rentals. I don't think you can attribute this to their streaming service as you have pointed out that Netflix's business is in streaming old library titles while the B&M stores and Redbox specialize in new content. In addition, with the closing of Blockbuster, you would expect Netflix to pick up at least some of the Blockbuster business, yet the CEO of Netflix predicts a drop in DVD rentals.

Your whole analysis of Coinstar/Redbox's value ignores what "foreseeable future" means or how it is defined. Does it mean the next quarter? The next 3 quarters? 2 years? this is the critical question after the basic questions of whether the business model is currently profitable and whether there are extraordinary expenses around the corner that would impact EBITDA.

My personal opinion is that the DVD rental business on it's own has a life of a maximum of 3 - 4 years. I think we can expect to see declining sales during the period, so we will see drops in same store sales and pressure on the stock price as soon as the same store sales start dropping (or flatten).

With the introduction of video game rentals, same store sales might stabilize for a time, but if the majority of business is in DVD rentals (say 70%) and the games maintain the total revenue, but the DVD revenue drops to 60%, I think the main business model with tank unless game rentals become the next big thing in Redbox kiosk sales.

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