CSTR’s COIN business has established itself in a niche market and should continue to represent a steady source of cash flow for the foreseeable future. In addition, Redbox has established itself as the primary vendor through which physical media (movie/video game/TV series rentals) is distributed in the aftermath of the business contributing to the complete disruption of the traditional movie-rental storefront business model once dominated by Blockbuster. However, we believe that this business model has matured as the home-media market continues to transition to digital distribution.
While we recognize that this view is clearly reflected in the market’s current valuation of the company (see comparables below for context), and that there may be potential opportunity for attractive appreciation if this perception is currently overstated, we do not feel confident that this valuation overstates the transition to digital distribution sufficiently to make the stock an attractive buy when considering its potential appreciation on a risk-adjusted basis.
It’s worth noting that assuming a 10% WACC using the EPV valuation methodology applied to normalized earnings in 2015e, our model calculates a fair-value stock price of between $64 and $67; however, due to the long-term prospects associated with a transition to digital media distribution, our target prices incorporate a rate of decay of approximately 4%, which effectively applies significant negative pressure to our perception of underlying value.
It is this long-term element of negative growth coupled with a substantial required margin of safety given the company’s risk and uncertainty surrounding its future prospects for earnings power that we conclude that the stock is not worth buying at its current levels. Moreover, we believe this long-term shift justifies valuation multiples more in-line with competitors suffering from the same trends facing “brick & mortar” retailers such as Best Buy (NYSE:BBY) and GameStop (NYSE:GME) – albeit not to the same extent considering the lower levels of efficiency associated with operating full storefront retail operations rather than CSTR’s more efficient kiosk model.
Key Investment Issues
CSTR management has positioned the company as one geared towards disrupting other traditional storefront retail market segments, and has been investing in identifying new areas through which it can replicate the success it has achieved through Redbox. However, given the company’s history of investing in relatively unsuccessful ventures geared towards similar business models that it has subsequently sold or terminated, we do not find sufficient evidence to believe that there is sufficient value in the option to have exposure to Redbox’s digital initiatives or the portfolio of startup kiosk ventures being developed/rolled-out through the company’s New Ventures business segment. In other words, we do not consider innovation to be a competitive advantage that isolates CSTR as an investment likely to generate superior risk-adjusted returns. In fact, we believe that as management struggles to find new ways of generating growth, it will continue to invest cash generated through COIN and Redbox in projects that are likely to detract value from the company rather than be accretive.
We have identified a number of key issues existing in the company that we consider to be central to our investment analysis, including:
§ Shifting Consumer Preferences/Growth in Digital Distribution: There has been a trend of consistently declining rentals per kiosk recognized in the Redbox segment, which may represent a shift in consumer preference towards accessing media through Netflix and digital distribution through Netflix as well as other major competitors such as Apple’s iTunes, Amazon, etc.
§ Retailer relationship concentration: CSTR’s top three retailer relationships represent nearly half of the company’s consolidated revenue with Walgreen Co., Wal-Mart Stores Inc., and The Kroger Company representing 16%, 16% and 11% of total 2012 revenue, respectively. CSTR’s agreements with these retailers offer very little security protecting the company from termination of the agreement; while these are long-term established relationships that seem to have offered value to the retailers through increased traffic, it is possible that any one of these retailers might conclude that they have the ability to monetize the function offered by CSTR on their own and therefore terminate their relationship with the company, which would result in almost immediate double-digit declines in revenue.
§ Geographic Expansion: CSTR is currently rolling out kiosks in Canada through locally established retailers and existing retailer relationships such as Wal-Mart (Wal-Mart Canada). This may be an attractive source of value for the company and a key area of the company’s future activities and performance to monitor in evaluating its value prospects.
However, while Canada represents a rational geographic region for expansion due to having relatively similar consumer preferences as the U.S., we are concerned about the CSTR’s ability to leverage its established competitive advantage from the perspective of matching kiosk inventory to consumer preferences and demand in countries with significant cultural differences that CSTR management may not be in a position to be responsive to in attempting to replicate the success in distribution it has achieved in the U.S.
§ New Ventures: Similarly to a number of other media distributors (e.g. GameStop) that have established business segments dedicated to investing in risky new ventures with the hopes of effectively positioning themselves to benefit from the likely future transition to digital distribution, CSTR’s New Ventures segment represents a tricky component of the business. From a value investor perspective, we would consider the most conservative approach here to be considering this segment as a value-destroying segment of the operation.
However, in combination with its equity-investment partnerships such as Redbox’s relationship with Verizon, there may be some value in considering ownership of CSTR as having option value to effectively offset the segments current cash-burning performance.
In addition, the company’s rollout of kiosk-distributed coffee is a venture that is already showing promise and would be worth watching carefully in the near term as it may represent a significant source of growth. If the market is slow to respond to this segment continuing to show signs of growth, the company might be an attractive buy at its current trading multiples.
Financial Projections Overview
Our projections assume a declining rate of revenue growth from approximately 19% seen in 2012a year over year to a revenue decline of 2.5% in 2015e representing a 5.7% CAGR over the forecast period, which is significantly below the 24% or higher four-year CAGR recognized from 2009a through 2012a. This revenue decline is the result of the mature COIN business remaining relatively flat combined with a maturing of the Redbox business due to a plateau in terms of its ability to grow through adding additional kiosks and a slow decline in the revenue levels generated by each kiosk.
A base-case scenario does not anticipate revenue growth levels in the New Ventures business significant enough to offset these unfavorable trends in the established COIN and Redbox segments. While the company has the potential for operating leverage from an EBITDA standpoint, its heavy capital investments in adding kiosks, investing in content and other capital expenditures associated with systems and other technology will have a “snowball” effect on the D&A line – thus offsetting the dynamic of revenue growth outpacing growth in cash operating expenses.
Moreover, CSTR has benefited from NOLs throughout most of its history thus far and is now at a pivotal point where it is expected to begin paying taxes, which will have meaningful negative impact to its bottom-line earnings.
Our financial projections incorporate the following expectations pertaining to the future prospects of CSTR’s Redbox segment:
§ Two offsetting factors could impact the net revenue per rental at Redbox kiosks:
o Tailwinds associated with management’s emphasis on focusing more on the higher-revenue media formats it saw benefit from in 2012 including Blu-Ray DVDs and video game rentals
o Headwinds resulting from pressures relating to the general shift towards digital and mail-order distribution resulting in pricing pressures.
§ We anticipate an increase in rentals per kiosk in 2013 resulting from the redesigned kiosk technology that the company has begun to roll out; while we expect this to have a favorable impact continuing in the outer years as well, we have projected declining rentals per kiosk in 2014e and 2015e of 4.3% and 5.0%, respectively, due to shifts in consumer preference coupled with a slight unfavorable impact associated with some cannibalization in certain areas that may be somewhat oversaturated with kiosks.
§ We have projected a 17% increase in average number of active kiosks in 2013e due to the continued replacement of acquired NCR kiosks with Redbox kiosks as well as management’s guidance of new kiosk installations of approximately 2500 (a number significantly below the number of installations seen since 2008); management has acknowledged a shift in its Redbox growth strategy from growing kiosks to managing the profitability of existing kiosks, which we have incorporated into the model by increasing new installations by 1250 (half of the guidance level for 2013e), which will be combined with the completion of replacing NCR kiosks. In the “steady-state” year (2015e) we assume that there will be no new kiosk installations – we would expect this to be the result of gradual continued expansion in Canada fully offset by eliminating unprofitable kiosks located in certain U.S. locations.
§ Our model considers two primary expense lines directly associated with the Redbox segment – Direct Expenses and Marketing (G&A and R&D were modeled on a consolidated basis because we are skeptical with the way in which management has allocated these central expenses among the business lines):
o We have projected relatively consistent direct expenses (as a percentage of segment revenue) for Redbox, with a slight increase resulting from our perceived negotiating leverage held by studios/content providers over the company and negotiating leverage of retailers for purposes of revenue-share arrangements; however, we do not expect this expense to increase by more than 100bps over the projected period as the company will continue to benefit from increased efficiency associated with newly designed kiosk technology.
o We anticipate Redbox to rely increasingly on marketing costs to retain its existing customer base and replace customers it loses to alternative distribution channels. As a result, we project marketing costs to equal the average of the trailing four quarters in each quarter of 2013 plus 5 basis points (equating to marketing equal to 1.2% in 2013e up from 1.1% in 2012); we then project a more rapid increase in the outer years with the expense representing 2.5% of revenue in 2014 and 4.5% in 2015
§ We have projected average transaction size to remain flat from 4q12a throughout 2013 and the outer years as we see no rational basis for this to fluctuate given the nature of the coin-counting function
§ Average transactions have been steadily declining, with year-over-year decreases of between 3% and 4% in 2010a and 2011a; this trend slowed in 2012a to a decline of approximately 1%, although year-over-year declines towards the end of the year re-accelerated. On the other hand, we believe that an element of this trend is the result of COIN customers (most notably lower and middle-income households) selecting to avoid paying the transaction fees within the context of a challenging economic environment. Thus, we have projected a slowing declines of 3.50%, 3.00% and 2.75% in 2013a, 2014a and 2015a, respectively
§ Management has indicated it will very gradually install additional COIN kiosks, which is reflected in the model with the installation of approximately 900 kiosks over the forward-looking three-year period. This projection/guidance has a sound basis given the consistent decline in number of transactions per kiosk suggesting somewhat of a potential shift in consumer preference offset by an expected offsetting tailwind resulting from an improving economic climate in the outer years.
§ Average transaction fee as a percentage of gross value of transactions are projected to improve slightly as a result of two offsetting drivers:
o Management initiatives to partner with vendors (e.g. Apple and Amazon) to monetize the value of coins without a transaction fee in exchange for the equivalent of gift certificates that can be used at select retail vendors
o Partially offset by pricing pressure as consumers identify alternative channels (e.g. banks) through which they can exchange coins
§ Similarly to Redbox, we have limited our segment-specific projections for COIN to Direct Expenses and Marketing
o There has been a consistent increase in Direct Operating expenses as a percentage of COIN revenue in recent years, which is somewhat surprising. As a result, we have projected a continuation of this trend at a diminished rate.
o As a mature business, there should be a decreasing need for COIN marketing expenses, although there may be a continued need based on the changing dynamic through the growing number of partnerships through which customers can spend the value of their change. In addition, in an effort to offset the declining revenue stream associated with the business management may attempt to offset this with marketing initiatives. As a result we have projected a slight increase as a percentage of revenue in the projected period.
§ We have based our base-case New Ventures revenue projections on the trailing four-year CAGR seen in the (successful) Redbox segment. Since there is a high degree of uncertainty here and a lack of obvious acquisition growth opportunities, offset by the greater ease associated with growing a small revenue stream, we have assumed New Ventures revenue growth to essentially equal three-fourths of the 70% revenue CAGR recognized in Redbox.
§ In addition to Direct Operating and Marketing expenses, we have also modeled R&D in the New Ventures division based on the greater significance of this expense line in the New Ventures segment.
o We have projected Direct Operating expenses to stabilize as a percentage of revenue from 236% in 2012a to 125% in the normalized 2015e period.
o We anticipate marketing expense to be a critical driver in the success of some of the New Venture product lines (e.g. coffee kiosks) and therefore project a stabilizing level of marketing as a percentage of revenue that falls off more gradually than Direct Operating expenses (falling from approximately 130% to 115% in 2015e).
o R&D represents the largest component of the New Ventures expense structure. While we would expect management to spend less as a percentage of revenue as they look to transition to generating positive cash flow from these ventures, we expect it will continue to be a major component of this segment by nature; thus, we project R&D to fall from well over 500% of revenue to 400% in 2015e.
Additional Key Assumptions Related to Financial Projections
§ Central expenses.
o Management has been relatively irresponsible with G&A expenses as these costs grew at the same rate as revenue in 2011a and almost double the rate of revenue growth in 2012a; we have projected this trend to come under control over time with consolidated G&A growing 29%, 8%, and then eventually declining 3% (as revenue also declines) in 2013e, 2014e and 2015e, respectively
o We expect R&D to continue to represent a key driver (from management’s perspective) of maintaining their growth trajectory (despite our lack of confidence in them successfully being able to generate returns in excess of those required on these invested funds). As a result we have projected R&D (separate from New Ventures) to hover around $6 million in each of the forecast annual periods.
§ Based on management’s guidance regarding proactive share buyback initiatives, we have conservatively assumed 50% of the cash we anticipate to be used for buybacks is distributed to shareholders in the form of dividends (to avoid uncertainty regarding future stock price swings).
o This cash has been discounted back using the assumed 10% WACC and factored into our target share price valuation.
§ We have also projected cash investment in Redbox content to grow as a percentage of revenue from 2% in 2012a to 3.5% in 2015e.
Expanded Consideration of Fair Value & Risk
The following summarizes the normalized earnings and valuations calculated by segment:
As noted earlier, the valuation levels depicted in the exhibit above suggested a share price of approximately $64. However, our investment thesis is based on the assumption that there will be a negative perpetuity growth rate in normalized earnings in the steady-state period; in addition, due to the high historic growth and uncertainty surrounding the future prospects of the company we would require a minimum margin of safety of 35% — ideally 50% to 65% — before considering CSTR to be an attractive investment opportunity. We have assessed the sensitivity of share prices for various discount rates (10% cost of capital with negative growth rates effectively increasing the perpetual cost of capital) and various margin of safety levels — both with and without our value estimate for the New Ventures segment.
 It’s worth noting that we believe that the market may be overstating some of these key trends – with BBY and GME likely being undervalued while Netflix and Amazon are likely overvalued; while this would seem favorable for CSTR given its market multiples currently trading much closer to BBY and GME, we reiterate the notion that we do not feel comfortable with the lack of margin of safety associated with CSTR and also recognize that there are other factors impacting these competitors as there is a substantial variance among business models of each of the comparable companies shown in the exhibit above.
 After modeling these expenses on a consolidated basis, we re-allocated them using a combination of management’s reported allocations and our own methodology for remaining unallocated expenses for purposes of determining segment valuations
 Adjusted in projected periods to control for excess cash
 See Appendix for supporting detailed calculations