Coinstar, which is better known for its solid, deep-moated coin processing business, is now driving quite a bit of shareholder value with its Redbox unit.  Short Sellers believe that physical distribution of DVD/Blu-ray is a dying technology that will be replaced by some manner of digital distribution.  While new may be better, old doesn’t go away overnight, and sometimes ‘old’ can still prosper within a niche market segment.  I believe that Redbox’s niche service is innovative enough to extend the life of physical distribution of entertainment content.  Coinstar shares don’t fully price in the value of this Redbox Unit, which for reasons I will lay out, is a longer tail business than short sellers currently realize.

In short, the market is overpricing the value of new digital distribution, while under pricing the value an old but innovative physical distribution model.

The Redbox Value Proposition:

Redbox takes low productivity “4^th-wall” retail space and turns it into money making, traffic generating space.  Redbox pays a small percentage of revenues to the retailer, who also benefits from the boost in traffic.  Aside from price, Redboxes are conveniently located everywhere, with 68% of Americans living within 5 minutes of one of their 33,000 units. Customers may rent at one location and return to another, creating a network effect of growing convenience, and a barrier to upstart competitors.  The company also has an iphone/ipod/ipad app, which allows customers to browse inventory and reserve movies in real time.

Redbox is also something of a ‘retail’ experience.  Its one thing to have a movie queue and patiently wait, it’s far better to have instant gratification.  Many Redbox customers weren’t “planning” to rent, they were out for groceries or other chores when the machine caught their eye.   A Redbox machine is an advertisement, it has “microgravity”.

Industry:  In the physical disc rental space, Redbox competes directly with NCR’s Blockbuster branded kiosks, brick and mortar rentailers (Blockbuster et al), and lastly Netflix.  Redbox has found a competitive and sustainable niche as the lowest cost physical distribution model.  To understand where and what Redbox’s wedge is in the product value chain, we must analyze the release schedule of a typical movie.  Traditionally, movies are released first in cinemas (first run). A DVD/BD release follows some months later (second-run). Later still the movie is released through pay-per-view television and digital download; then premium cable networks and internet streaming; and finally free-to-air television. This staggered release schedule gives each distribution channel an exclusive "window" in which to profit from the film.

So after a few months in theatres, the studios sell the film as a DVD/Blu-ray (BD).  Studios love the for sale DVD market, as studio’s typically take 70-80% of the $15-20 retail price.  Blockbuster, currently charges $4+ for a new release DVD rental and pays out about 60% to studios.  Enter Redbox, who used to offer new release DVDs for $1 rental the first day they were available for sale.  They exploited the ‘First Sale’ Legal Doctrine that protects the rentailer from suit for renting out the title to multiple parties.  Redbox’s $1/day DVD rental proposition was so successful that studios felt it threatened to undermine the for sale market.  Last year, certain film studios took action by embargoing certain wholesale shipments, causing Redbox staff to ‘work around’ by buying many new titles at retail stores.  The ultimate resolution was to create a 28-day rental delay, in exchange for some modest discount on future titles.  This only applies to a little over half of Redbox’s DVDs, as not all studios went along.   Blockbuster was permitted to continue to rent new titles within that window at the “premium” rental price with the studios getting a big cut.  But with the ongoing shutdown of virtually all Blockbusters, the 28-day window will largely become a ‘buy-only’ 28-day window. 

Digital distribution begins for most films on the same day the DVD/BD is available for sale.  But new releases are priced at a premium price to rent ($3-$4), or to download a digital copy ($10-$20).  After several months the content may come up as a discount rental (99cents) and after a year or more becomes available to be streamed or watched on demand on cable.  It is important to note that Video on Demand is a premium service that is charged in addition to a basic movie package.  Something should become apparent about Digital vs. DVD/BD:  Digital follows a similar time-price tiering as the physical market.

Theatrical Release: First 6-12 months

                                                Digital                                                              Physical

DVD Release:   $4 PPV Rental/$15 Download                            $4 Blockbuster Rental/$15 Disc for sale

28 days later:                                                                            $1/day Redbox Rental; Netflix Rental

Months Later:    $3 Rental, Cable, VOD

Years Later:      $1 Rental, Netflix/Amazon Streaming

The studios will continue to window simply because it’s a better business model than simultaneous release.  The big studio’s invest a lot in talent and promotion, making what’s in theatres part of people’s current events culture.  The idea of having to ‘go somewhere’ generally ‘with some one’ is an experience with social value.  In other words, studios maximize the value of their content by creating an initial buzz and exclusivity. However, the value of the content declines with the buzz, and customers need to be enticed with cheaper and more convenient sources as the content ages.  The competitive threat is clearly less about windowing and more about new distribution methods such as internet streaming that compete horizontally.  Let us compare and contrast all these competing ‘second run’ distribution methods.

“2^nd Run” Industry Analysis:

• Brick and mortar is dying as a form of distribution

The dirty secret of the brick and mortar rental approach is that the new release wall generates about 3/4 of the movie rental store’s total revenue.  The rest of the square footage simply doesn’t pull its weight.   By comparison, the 12 square feet of a mature Redbox generates annual revenues north of $4,000/square ft, which is just a tad more than the Apple store on 5^th Ave.  The Redbox kiosk has nil occupancy costs, and runs that revenue at a nearly 20% operating margin from a machine that only costs $15k (excluding content).  Blockbuster is in slow moving liquidation regardless of what business strategy the new parent (Echostar) takes.  Even with a 28-day window, a Redbox simply puts a big enough dent the nearest rental store’s gross profit to kill it.  Blockbuster is now down to 1500 locations and I give the rest only a few years at best. The robots are literally taking over!

• Digital is not the threat shorts think it is

The biggest potential competitive threat to Redbox would be the ability to download or stream a copy of a video right to the television/laptop/mobile.  Digital is so much more convenient, but they will always make you pay for that convenience.  Case in point is Pay Per View, which has been around since the 1980s.  The studios have kept the price at par or premium to rental.  Of course, you need a cable box to buy via Pay Per View, which cuts off just under half of households.   And when we look at internet rental distribution (iTunes), again Pay Per View pricing!  Not to mention that not every one has broadband, and the slower DSL connections (particularly rural ones) are currently inadequate to for streaming. These rural and ‘unplugged’ folks will make up a sticky core audience who will continue to patron the machines as a long tail.

Still, over time, as streaming technology improves there will be a continuing trend to order rentals with a remote instead of a disc from a store or kiosk.  I anticipate that digital’s impact will grow, but at a slow enough pace that allows Redbox to generate far more cash than what its currently being valued at.

• Netflix is becoming less competitive

Netflix announced that beginning in September it was unbundling video streaming and DVD Rental.  It will now cost $16/month compared to $10 previously for both disc delivery and streaming video ($8 each).  Currently, 82% of Netflix subscribers will be affected and many will increase their usage of Redbox.  Estimate are that as many as 40% of Netflix subs might opt for streaming only, and for them, Redbox might be the best way to see the newer films.  Under the old pricing, the Netflix sub who signed up for the streaming for $8/month only had to pay $2/month more for DVD delivery.  Looked at from the perspective of the streaming customer, the dvd mail option was underpriced.   Over time, as Netflix’s streaming product continues to mature, you will see more of their subs dropping physical delivery and using Redbox as the stop-gap.  Interestingly, we now have a factor driving digital streaming users back to physical disc.

• NCR may be looking to exit

Redbox competes directly with NCR, who licensed the Blockbuster name and rolled out the Blockbuster Express kiosks.  NCR probably didn’t realize that there is more to this business than setting up the machines as they are still not profitable.  Recently they had to ‘redeploy’ about 500 machines, which reflects poorly on their location analysis. Location and service play a big role and the NCR machine’s integration with the dying retail chain is poor at best.  Management indicated that NCR may take strategic options with the business.  Chances are, the market really isn’t ‘big enough for the both of them.’  NCR exiting would only be a positive, but their continued presence really only brings in the market saturation point for Redbox.

Industry Saturation & Firm Strategy:

The company believes the market can handle between 45K and 60K locations.  Coinstar currently has 27k location (33k machines total, counting duals), and competitor NCR has about 9k locations.  So using the lower end of that range, there is at least another 25% growth to come.  The runway may in fact be longer.  From 2004 to 2009, rental revenues for the whole disc rental industry were relatively flat.  During this time market share shifted from 90% brick and mortar based, to now less than 10% today.  Because the stores charge 2-4 times per rental what Netflix/Redbox charges, disc rentals have actually been taking off, not declining during the shift.  And should that surprise any one?  Video stores were a poor way to distribute films because of high occupancy and labor costs.  Netflix and Redbox found innovative ways to bring the price down dramatically, and not surprisingly, they grew the market.   I am amazed that 1500 Blockbuster are still left, and it should be clear that the DVD/BD has at least a decade or more left.  However, when saturation approaches management will doubtfully not over expand as they’re very realistic and disciplined with the roll out.

The economics of an individual machine is eye-poping.  The machine costs about $15K (excluding inventory) and will do about $30K, $40K, $50K of annual revenue in its first 3 years and covers its costs in about 24 months. Because of startup losses on new kiosks, the stable and optimized margin is not clear to investors.  With some massaging of the financials we can easily back into 23%-25% Ebitda margins for mature kiosks.  Therefore, as growth begins to slow, firm margins and profitability expand as the low margin new kiosks mature.  Additionally, Redbox is now rolling out video games at substantially all locations, and currently take up about 5% of a given unit’s inventory while generating more gross profit dollars (albeit at a lower margin). 

Redbox is also experimenting with price hikes in several markets, currently testing 3 new price points ranging from $1.10 to $1.25.  For some time now, NCR has been trying $2 and $3 for new releases.  With Netflix raising prices nearly 60% for dual users on September 1st, there may be some new room for pricing power.  And with Redbox operating margins currently in the high teens, a 10 or 15% price hike would be substantial.  My base case model assumes no pricing power.

The company’s strategy is to keep building out Redbox as it continues to make sense, but what does a post-saturation world look like for Redbox?  When revenues begin to go the other way, it will not lead to sharply eroding margins.  Remember, Redbox killed the video star…err video store precisely because of its dramatically lower fixed costs.  Assuming variable costs (content, commissions, credit card fees) is about 50% of revenues, and that Redbox has little room to cut fixed costs, Redbox would have an EBITDA to revenues leverage ratio of only 2.5.  Said another way, Redbox’s revenues can decline about 40% from model peak before breaking even.  Again, the tail is likely long and revenue declines are probably no where to be found for years.

Cashflow usage going forward will be for buybacks and possibly a new venture if one proves out.  The firm just completed a $50 mil buyback, and has authorized a further $250 mil, so shareholders can expect the cash to be put to good usage at these levels.

The Market’s View:

With a short interest in CSTR of 32%, there is clearly a bearish thesis floating around.  The bear case is pretty straight forward: DVDs will be replaced by digital distribution.  Thus, we ought to apply a secular decline PE multiple in the mid-to-high single digits (ala, Gamestop).  Bears draw an analog to how iTunes and Amazon killed off the record store.  But music had no history of release windows, and by contrast almost all music is available online.  MP3s could even be easily distributed over slow internet connections.  As mentioned earlier, there exists a core group of ‘unplugged’ consumers who do not pay for cable, nor have adequate broadband.  While that group may not seem large, they will be renting discs for a decade or more.   And when revenues do begin to decline, the low fixed costs of the Redbox machines will keep them flowing cash at much lesser revenue rates.   

Valuation: 

The base case DCF contemplates pessimistic assumptions, but still gets us to a valuation of about $60.  The assumptions are:

• Kiosk growth at 20% a year until maxing out at 45K in 2013
• Kiosk SSS that initial annual growth of 10%, and decelerates linearly to -15% by year 10
• Optimized EBITDA margins peak at 23%
• Operating leverage reduces EBIDTA at 2.2-3.0x decline in revenues during decline phase
• Terminal value in year 10 of only ~$175 mil
• Coin business at 7.5x 100 mil EBITDA

It is likely that CSTR performs above expectations on at least some of these factors.  Lastly, here is a link to my DCF: https://sites.google.com/site/idamiena/110807_CSTR_DCF.xls?attredirects=0&d=1

expanding margins & potential pricing power, strong buybacks, Netflix price hike unleashed Sept 1, high short interest