Coinstar (CSTR) is a perennial VIC favorite, having been written up 7 times since 2003.  Since that time, its market cap has increased from $330 million to $1.5 billion, yet its EV/EBITDA remains at less than 4X. Coinstar suffers from poor performance on several key metrics over the past few quarters which seems to confirm critics’ perception that it is in secular decline.

Over the next few quarters several of these metrics should reverse, and Coinstar could move to a substantially higher valuation.  In 2012, Coinstar purchased the Blockbuster movie kiosk rental business from NCR for $100 million.  Over the past year, the company has been replacing these kiosks with Redbox units. This transition has imposed significant costs on Coinstar, including a $6.9 million loss in Q1, and has reduced comparable kiosk sales.  The final NCR kiosk was removed in April. After Q2, Redbox will see no more NCR transition costs.  In addition, new kiosks typically ramp up significantly in the second and third years.  Over 20% of kiosks will move into the comp base over the next year, which should boost the favorite metric of most retail analysts.

Coinstar has made several other moves which hurt reported profitability in the short run, but which could benefit the business in the long run.  Last year Coinstar entered a joint venture with Verizon to provide streaming content.  This project is now in Beta.  Coinstar expects the JV to be self funding in the second half.  I look at this as a relatively low cost option. At March 31, 2013, Coinstar had invested $38.5 million for its 35% share in the JV.  While the joint venture is expected to show a loss of $9 to $11 million in Q2, the company is estimating no additional capital investment in the second quarter, and breakeven in the second half.

Another low cost option is Coinstar’s investment in new kiosk formats.  The most promising new format, Rubi, is a coffee kiosk which dispenses Seattle’s Best Coffee (a Starbucks brand). Rubi currently has 100 units in operation in 6 markets, and is expected to roll out 1,000 to 2,000 kiosks in the remainder of the year.  Coinstar has announced that is disposing of Orango, an electronics recycling kiosk.  At this point, the new venture kiosks are best viewed as R&D projects.  In valuing Coinstar, I don’t expect any return from the new ventures, but I also don’t expect management to squander large sums of money.

Business Overview

Coinstar has three business segments – the Coinstar coin counting business, the Redbox movie rental business, and a group of six new kiosk ventures, including the Rubi coffee kiosk as well as a joint venture with Verizon to provide movie streaming. 

The original Coinstar coin counting business is a mature business which generates steady cash flow of around $100 million per year.  Capital expenditures for the coin segment are estimated to be between $27 and $30 million in 2013 ($13 to $15 million is for 800 to 850 new kiosks, the remainder is for maintenance).

                                                                           Coins ($M)

                                                            2009      2010      2011      2012

               Revenue                                 259        276        282        291

               Segment EBITDA                    103          96        101          99

The Redbox business has shown strong growth  driven by additional unit growth, and the demise of brick and mortar rental options such as Blockbuster. That growth is now slowing, and Redbox expects to add only 2,000 to 3,000 kiosks in 2013.  In 2012, CSTR purchased NCR’s kiosk business, eliminating its only real competition in the movie kiosk business.

                                                                           Redbox ($M)

                                                            2009      2010      2011      2012

               Revenue                                773       1160      1562      1909

               Segment EBITDA                   102          191       285        387

As shown in the table below, the Redbox business has benefitted from strong growth in the number of kiosks, increasing sales per average kiosk and an increasing operating margin.

                                                                                            Redbox ($M)

                                                                              2009      2010      2011      2012

               Ending # Kiosks                                  22,400   30,200   35,400   43,700

               Revenue/ Avg. Kiosk                           43,047   43,571   47,150   48,800

               EBITDA  / Avg. Kiosk                             5,665     7,167     8,575     9,944

               EBITDA Margin                                      13.1%    16.5%   18.2%   20.3%

Why is Coinstar cheap?

The value of Coinstar is clearly driven by Redbox. Redbox is viewed by investors as an old technology business that is at risk of being replaced by streaming.

The movie rental business has been a graveyard for many retailers, most notably Blockbuster. Streaming is clearly growing at a rapid pace and taking share from physical discs. Netflix has been transitioning its subscribers from physical disk delivery to streaming for several years. Same store sales for Redbox were down 4.2% in the fourth quarter and 11.8% in the first quarter of 2013.  On a unit sales per kiosk basis, sales were down 17% in the third quarter, 13% in the fourth quarter, and 17% in the first quarter of 2013.  These numbers have not gone unrecognized by the bears.  As of April 15, approximately 13 million shares out of the company’s 28 million outstanding shares were sold short.

Same store sales were favorably impacted by an increase in standard rental rates from $1.00 to $1.20 which was implemented in October 2011.

Management attributed the drop in same store sales in Q3 to fewer DVD releases and reduced viewing caused by the Olympics and the decline in Q4 to a combination of a change in renters’ habits caused by the Olympics and a weaker theatrical release schedule in Q3, which impacted Redbox’s offerings in Q4.  (Where Redbox has agreements with the studios, movies are generally available on Redbox 28 to 45 days after DVDs are placed on sale. In other cases, Redbox will purchase DVDs to use in its kiosks.) The softness in Q1 was partly due to the strong release schedule in January 2012, when 23 movies were released.  Only 12 new movies were released in January 2013.  Management indicates that rental performance in March was in line with March 2012. 

The acquisition of the NCR kiosks in June of 2012 has also impacted Redbox’s results. Of the 6200 Blockbuster kiosks initially acquired, 3100 were removed and 2800 were replaced with Redbox kiosks as of March 31, 2013.  The remaining 300 kiosks were removed in April. According to Coinstar’s 10-K, the NCR kiosks had revenue of $22 million in 2012, and lost $14.5 million.  If we attribute this revenue solely to the 1900 kiosks that were operating for the full six month period, average annual revenue per NCR kiosk would be around $22,000 which is less than half the $48,800 that the average Redbox kiosk generated in 2012.

Redbox kiosks typically show a significant ramp from year 1 to year 2.  First year sales historically average around $35,000 and move close to $50,000 in year 2 and $55,000 in year 3.  While the converted NCR kiosks may not follow the typical maturity curve of a new Redbox, the poor performance under the Blockbuster brand presents a significant opportunity as these 3,000 kiosks enter the comp base.

Even at modest multiples, CSTR offers potential for a significant increase from today’s level. I have treated both the Verizon joint venture and the new kiosk initiatives as failures. A success by either of these investments could provide substantial additional upside.

With slower growth, management has shown a willingness to repurchase stock. The company repurchase $46.5 million of stock in Q1 and had $341 million of authority for repurchases remaining. CSTR raised $350 million of debt in Q1, which will enable it to retire its remaining $132 million of convertible de

Risks

Declining Redbox comps could be the result of a secular shift away from DVD rentals.

Management could overspend on streaming or new ventures.

Improved comps due to normalized release schedule, easier comparisons versus last year’s Olymipcs influenced numbers and 8,000 new 2012 kiosks moving into the comp base.

Elimination of the losses from the NCR kiosks.

Reduced expenses for the Verizon streaming JV.

Successful introduction of the Verizon streaming JV or the Rubi coffee kiosk.