May 29, 2012 LONG: Coinstar (CSTR) Price; $60 Market Cap: $1.9 bil Enterprise Value $1.9 bil Average Daily Volume: 1.2 mm shares THESIS Coinstar trades at 4.4x EBITDA and roughly 10x earnings, net of cash, despite strong underlying growth trends in the business today and opportunities for significant growth in the coming years. This valuation is driven by negative sentiment that the company s two businesses, DVD rental kiosks and coin exchange kiosks, are dying. Our 3-year price target is $147 per share including cumulative excess cash, based on 7x 2016 EBITDA, for upside of 150%. BUSINESS DESCRIPTION The company s financial results are dominated by the Redbox kiosk DVD rental business which accounted for 85% of consolidated revenue and 80% of consolidated EBITDA in 2011. There are more than 36,000 Redbox kiosks at 29,000 merchant locations in the United States. These locations have high levels of traffic, high frequency of visitation, and a middle-income demographic. The largest merchant partners are Walgreens, Wal-Mart, Kroger, 7-Eleven and CVS. The company recently announced an expansion into the dollar store format with Dollar General and Family Dollar and is also in process to acquire almost 10,000 Blockbuster kiosks which will buy them a presence into new merchants on the west coast. The unit economics of a Redbox kiosk are compelling. A new kiosk costs roughly $15,000 and is depreciated over 5 years. Each kiosk holds 600 disks broken down into roughly 120 titles: 85-90% DVDs, 5-10% Blu-ray, and 3-5% video games. Across the system the kiosks are averaging almost 21,000 transactions per year at an average revenue rate of $2.56 per transaction in the latest quarter. Management amortizes each disk over 26 weeks with a disk turning about 30x before its end of life. This leaves the 263 Glenville Road, Greenwich, CT 06831 www.glenvillecapitalmanagement.com T 203. 542.7608 F 203. 531.0666
company earning close to $40 per disk over a six month period at a cost of $15-20 for each disk. The net result is a mid-to-high 50% gross margin rate on an average revenue base of $47,000 per kiosk. That equates to $26,000 of gross profit on inventory against $3,000 of machine depreciation and less than $14,000 of servicing costs. And these are average figures. At maturity a kiosk is likely to generate $55-60,000 of revenues against similar expense figures. We believe the pretax ROI for each machine exceeds 65%. As more store locations are added to the kiosk network, the density increases and network benefits grow. Increased points of presence lead to greater brand awareness (more than 300 million people walk by a Redbox kiosk every week) and greater convenience. The network has been designed to maximize both walk-by frequency and convenience of return, with the company allowing customers to rent from one location and return to any other. The increased convenience of return removes a key hurdle to the purchase transaction which typically is an impulse response to seeing the kiosk. The positive network effects can be seen in kiosk revenue results that have exceeded the original business model. Another benefit to increased density is improved leverage of the field operations staff. The average cost to service a kiosk fell 1% from 2009 to 2011 even as the network grew 58% and kiosk utilization increased. Since the kiosks throw off more revenue over time, the cost of field operations has fallen from 32% of revenue in the first quarter of 2010 to less than 27% in the first quarter of 2012. Once kiosks are installed in a location, the freshness and desirability of titles in the kiosk becomes a key operational consideration for management. As a result, management has three separate models for managing disk inventory through the inevitable lumpiness of new title releases throughout any given year. The company has entered into long term content deals with two-thirds of its studio content suppliers. These deals require Redbox to purchase an assortment of releases, rather than allow them to stockpile a hundred copies of the hottest new title in a single kiosk. The appropriate purchasing and distribution of inventory has become a complex process which can lead to some quarterly variability of results relative to Wall Street s preference for linear growth patterns.
Despite the lumpiness of new title releases, management has powerful levers to drive sales. The company has accumulated an email list that exceeds 39 million customers and an additional 3.4 million text subscribers. Management is constantly testing various promotions through email and text to drive consumers to the kiosks and increase basket size. Ultimately, the Redbox business is competitively advantaged in that it couples a direct marketing model with low cost distribution and excellent service. Its success in the market has been recognized by consumers who have given it a Net Promoter Score in the high 80s and 84% brand awareness. The strong customer affinity was proven out recently when the company imposed a 20% price increase with broad acceptance by the market. The company also operates Coinstar coin machines which allow consumers to exchange loose change for cash vouchers or gift cards. There are more than 20,000 kiosks deployed across the United States and Canada, mostly in the grocery channel. The five largest merchant partners in 2011 were Wal-Mart, Kroger, Supervalu, Delhaize, and Ahold. Recently the company announced a renewed partnership with Safeway. Coinstar machines historically offered a convenient service at a high price. People not wanting to pay Coinstar fees could alternatively roll their own coins and exchange them for cash at banks for free. In addition, some banks have similar coin machines to which they offer access as a free service for existing clients. For many years Coinstar charged an 8.8% fee for the use of its machines and in 2010 they raised the fee to 9.6%. The fee increase led to a drop in transactions but an increase in total revenue. Coin kiosk economics are attractive as well. The average kiosk does roughly 4,000 transactions per year. The average transactions is about $38, generating revenue to Coinstar of $3.74. Gross margins, including the cost to service the machines and pay rent, are 50% and there is little overhead. EBITDA margins have been in the mid-to-high 30% range in recent years. The company shares its revenue with its retail partners.
More recently, management has begun to improve the value proposition to customers by offering a number of no-fee options. This includes gift cards to third party retailers such as itunes, Lowe s, and Old Navy, as well as in-store debit cards to be used at the retailer where the machine is located. Retailers love this option as it keeps the exchanged money in the store, and they have further discovered that these customers spend more than the average ticket. Coinstar processes roughly $3 billion of change annually which is about one-third of the available market. In the past two quarters revenue growth has accelerated although gross margins have declined as recent store contract renewals have come with higher rents. Management has not commented on whether or not they are paid the same rate for gift cards as they are for cash. Finally, Coinstar is investing in a number of new vending machine concepts to support the long term growth strategy of the company and diversify its revenue streams. These investments are suppressing the underlying profitability of the DVD and coin businesses. In 2012 these investments are likely to cost the company almost 50c per share of EPS. SHORT THESIS REFUTED The DVD Rental Business is in Rapid Decline So Redbox Will Soon Hit a Wall The DVD rental business has sustained significant revenue shrinkage in recent years as the high cost bricks and mortar model has been disrupted by Netflix and Redbox. For instance, while Blockbuster generated 90% of sales from new releases, it kept large and expensive stores stocked with a deep catalog of titles. The cost of the store base required the company to charge high fees. Netflix entered the market with a lower cost, lower priced, higher convenience option: DVD by mail. Netflix has long claimed that 70% of its DVD rentals were catalog rather than new release, and their use of centralized warehousing allowed the company to drive significantly higher inventory turns on the DVD library while also maintaining lower costs to store the inventory. The
Redbox business, with its more limited inventory selection, targets the new release market. Its expansion throughout the mid-to-late 2000s was the death knell for Blockbuster as it attacked the heart of its business with better convenience and lower pricing. At its recent analyst day, Redbox management revealed that from 2007-2011 the retail square footage for physical DVD rental across the industry declined by 69% while unit volume declined by only 3%. These figures match our own estimates and we believe they exclude unit rentals of DVD by mail. When mail units are included, we believe unit rentals have grown over this period. DVD player unit sales in the US have declined in recent years as the market has been saturated. However, penetration rates are still increasing, with a 4% lift in 2011 to 91%. 1 With HDTV penetration also growing, there is clearly a strong desire for home movie watching. Redbox s share of the DVD rental market remains below 40%. As the company continues to fill out its geographic footprint and the kiosks mature, there is an opportunity for this business to grow another 50-100% before reaching maturity. Investors have confused revenue declines for a general market decline in DVD rentals. If anything, we believe the disruption by lower cost business models has extended the life of the DVD market. Streaming Will Kill the DVD Rental Business Outside of piracy, movie streaming is not a direct competitor to Redbox. Streaming focuses on older content while Redbox is primarily focused on new releases. The economics behind streaming make it likely that it will remain a catalog offering for the foreseeable future. Studios have an interest in protecting the enormous revenue stream provided by new movie unit pricing. Streamed movies allow distributors to provide unlimited views at a flat rate. Therefore a move towards streaming new content would impair studio business models. 1 Centris Research: http://www.homemediamagazine.com/blu-ray-disc/centris-blu-ray-player-householdpenetration-reaches-26-26721
In addition, high speed internet penetration in the United States remains below 40% 2. Penetration of households that have both high speed internet and a connected internetready television is well below that figure. Therefore, the streaming market has limited access to the consumer today although its penetration rate will likely increase over time. As a side note, Redbox has formed a joint venture with Verizon to offer a bundled DVD/streaming subscription package that should hit the market in the second half of 2012. This will provide Coinstar an opportunity to profit from the catalog streaming opportunity, although it is unclear at this point if the offering will be differentiated enough to succeed in an already crowded marketplace. Video on Demand Will Kill the DVD Rental Business Unlike streaming, video on demand (or pay per view) has superior economics to the studios relative to DVD rentals. It is also an important revenue source to the cable and satellite providers. However, the dual mark-up of this business makes it a higher cost offering to the consumer. In fact, the studio mark-up alone creates a situation where video on demand remains price uncompetitive for over-the-top services such as Vudu and Amazon. Clearly video on demand will continue to grow. However, this is not an existential threat to DVD rental since lowest price always has a place in the market. Falling video on demand prices would pose a competitive threat to Redbox. However, the studios are unlikely to lower pricing because it would result in a significant loss of profits. Time Warner claims a video on demand transaction is 7x more profitable than a rental transaction. But given that the video-on-demand revenue is shared with the distributor, it does not appear that the studio could lower content prices enough to close the price gap with Redbox. Even heavily discounted offerings from Vudu and Amazon are almost 3x more expensive than a one-night rental through the kiosk. Finally, as with streaming, penetration of VOD capable digital television is roughly 35% of homes passed which means much of the market does not even have access to this service. 3 2 NCTA industry data: http://www.ncta.com/statistics.aspx 3 Ibid
Studios Will Extend the Delay Window on Movie Releases to Rental Kiosks Time Warner claims a DVD sale is 20x more profitable than a rental. In a typical year the home entertainment business brings in more revenue than the theatrical release business for the studio industry. To protect this profit pool, studios have sometimes implemented a delay window between the time a DVD is released for sale and the time it is available for rental. However, there is a legal construct known as the first sale doctrine that permits rental companies to purchase DVDs wholesale or at retail and then rent them out. Therefore, if the studios push too hard on this, Redbox can simply purchase their inventory indirectly and rent it out at the same time the DVDs are released for sale. In fact, this is currently going on with Warner Bros. releases as the two companies were unable to agree to an appropriate rental window. Today, roughly two-thirds of Redbox content is available at the same time the DVDs become available for sale. The rest is available on a 28 day delay and Redbox receives a discount on the content costs in exchange for the delay. Studios are experimenting with other options, including concurrent VOD and theatrical release. In that case they have charged a very high price (reportedly $50-60) for the opportunity to see a brand new movie at home. However, at that price a family might as well go out to a theater and enjoy the night out. Ultimately, the studios have other partners to manage: the movie theatre companies who will try to retain exclusively on new titles, and the retailers who sell DVDs for profit (or some, like Wal-Mart, who sell at a loss to drive traffic). This complex ecosystem of distribution partners limits the flexibility of the studios to experiment with new pricing models. Studios Dislike Rental Distribution and Will Look to Disintermediate Redbox There is some tension between Redbox and the studios as the movie industry wants to do everything possible to preserve the DVD sales revenue stream. Unfortunately, DVD sales do not represent a compelling value for the consumer so this is likely to be a losing battle for the industry. In fact, we may have gotten to the point where the whole movie-going experience is facing a price-driven decline. From 1997 through 2010 ticket prices inflated at an average rate of 4.2% across the country, for a cumulative increase of almost 80%. Unit ticket sales peaked in 2009 and have declined for two consecutive
years. Ticket sales in 2011 were the lowest in 16 years. It may not be a coincidence that the industry did not raise prices in 2011. The rapid growth of large HDTVs as well as the almost complete penetration of DVD players in the home (not even counting DVDs on gaming consoles and personal computers) has created an alternative lower-cost viewing option for consumers. Redbox is a beneficiary of this trend. In terms of studio economics, rentals are less attractive than DVD sales and video-on-demand, but more attractive than streaming. Presumably, the studios will try to drive more consumers to video-on-demand over rentals by lowering those costs. But as discussed above, Redbox is priced well below video-ondemand so it s not clear that there is enough room to drive demand elasticity from lowering VOD pricing. That said, this remains a competitive threat that requires monitoring. MANAGEMENT Coinstar s CEO is Paul Davis. He joined the company as chief operating officer in 2008 after stints at such packaged foods companies as Kettle Foods, Barilla, Starbucks, and Frito-Lay. Davis was hired after a series of poor capital allocation decisions by prior management. From 2004 through 2007, the company paid more than $250 million for e- payment and money transfer businesses, as well as skill-crane/bulk vending machines. Under Davis stewardship, Coinstar disposed of these businesses for nominal value while also taking its ownership stake in Redbox from 47% to 100%. Total consideration paid was $162 million. In 2011 Redbox generated pretax operating profit of $169 million. We consider these to be a series of excellent capital allocation decisions made during Davis tenure as COO and CEO. FINANCIALS AND VALUATION Our calculations reveal a return on invested capital in the high 30s driven by the compelling unit economics discussed above less stock compensation, corporate overhead, and investment spending on new ventures. The company was not free cash flow positive until 2010 due to the accelerated rollout of Redbox kiosks. That expansion has slowed and the cash is now flowing. Management has projected 2012 free cash
flow of $130-155 million which equates to a 7-9% yield on enterprise value. Capital spending remains inflated as the company continues to invest in kiosk growth, new kiosk software to improve close rates and average ticket, and a company-wide ERP system. This spending, and the nearly $0.50 per share being spent on new venture concepts, masks after-tax operating profits of at least $5.50. On this basis the enterprise value is selling for roughly 10x profits. However, the company s earnings power is materially higher than that. Once the kiosk network reaches maturity, the business as currently constructed will generate roughly $485 million of free cash flow. At this level of cash generation the stock has a 27% yield on enterprise value. Therefore, if the kiosks were to simply reach maturity and sustain that level or begin a slow multi-year decline, the security would be attractively valued today. However, there remain significant growth opportunities ahead. Coinstar will soon close on a deal to acquire the Blockbuster-branded DVD rental kiosks from NCR, adding almost 10,000 machines to the network. Beyond this, Redbox has another 10,000 locations of growth before appropriate density is reached, not to mention the Redbox-Verizon joint venture, new initiatives at the coin machines, new venture concepts, and international expansion. Assuming a 3 year growth rate of 12% and a target multiple of 7x EBITDA the stock has an IRR of 45% at current prices. Alternatively, if we are 100% wrong about Redbox and the business begins a rapid decline beginning in 2013, we believe that cash generation plus the residual value of the coin business will be worth more than the current stock price in three years.