Description

Coinstar (Ticker: CSTR / $39.52)

Event Type: Value Catalyst / Contrarian

Trade Recommendation:

• Long CSTR equity, currently trading at 5.4x FY10 EV/EBITDA (price $39.52), ahead of the completion of Movie Gallery's liquidation and in conjunction with Blockbuster's Chapter 11 filing (filed 9/23/10).
• Bedrock346 did a great job of presenting this opportunity when the stock was trading in the mid $20's in late 2009, but we would argue that despite the stock price being higher, the opportunity is more compelling now and offers a similar opportunity in terms of upside with more certainty and less downside risk.
• Entry price offers $20-$40/share or 50%-100% of upside utilizing conservative market share and kiosk life assumptions over the next 3-6 months.
• Four significant catalysts over the next 2 months provide a clear event path on a left-for-dead growth equity that generates $100+m in free cash flow (and growing) with minimal capex/fixed cost requirements post 2011. Catalysts, discussed in more detail, are as follows:

1. Blockbuster Chapter 11: filed September 23

2. Movie Gallery Chapter 7 liquidation: October 29

3. Online strategy announcement: mid/late October

4. Strong earnings: late October/early November; share repurchase and/or debt paydown

Situation Overview:

Coinstar has two distinct businesses - a coin collecting/cashing business (~ $100m 2010 EBITDA, $60.7m YTD) and Redbox, the dvd kiosk business ( ~ $200m EBITDA 2010, $130m EBITDA YTD).  You either love Coinstar or you hate it. Clearly, with 7.8mm shares sold short, there are a lot of haters (per Bloomberg, but chart doesn't show up on VIC). 

And for good reason, Redbox, will not exist at some point in the future. If you are short, and can wait it out as the ice cube melts and pay the cost to borrow for the next # of years (only 75bps as of September 15th according to various primer brokers), there is probably $15-25 to make depending on your future borrow cost assumptions. Using a straight-forward death-spiral Redbox valuation (assuming 100% y-o-y kiosk declines + 10% y-o-y reduction in revenue/kiosk), this $15-25/share assumes that the Redbox kiosk business disintegrates to $0 in the next 6 years.  To put this sensitivity in context:

• Various industry estimates call for ~ 2% p.a. growth in the physical DVD market over the next 5 years.
• The two largest dvd chains are closing thousands of stores, a large portion of this share transfers to Redbox.
•         Movie Gallery is in the process of shuttering its 3,400+ stores.
•         Blockbuster, which filed for Chapter 11 on 9/23/10, is expected to close 800-1,000 stores (and potentially more).
• Over the last 2.5 years, CSTR has grown its kiosk footprint by 264% while maintaining stable revenue per kiosk (+0.6% per kiosk) (compare vs. NFLX at 78% sub growth over the last 2.5 years with a -10.6% decline in revenue per sub over the last six quarters).

Based on the multiple positive catalysts ahead, the IRR on a short doesn't seem compelling at this level. In fact, after further due diligence, CSTR once again, seems like a tremendous long opportunity with limited downside.  Please see prior CSTR write-up from Bedrock346 on November 20, 2009, which provided over 100% return at a time of tremendous uncertainty.

Some Background:

• Redbox versus Hollywood: Redbox has settled their litigious battles with the movie studios (no more workaround), and has removed the major overhang on the stock price.
• The new management team, under Paul Davis, has successfully undone the bad habits of the prior team and is appropriately reinvesting in Coinstar and Redbox.
• Redbox's first mover advantage over NCR continues to improve via new kiosk partnerships such as Ez-Mart and CVS (as an aside: many NCR shareholders would like to see them throw in the towel in the entertainment space)
• Coinstar has shed its non-core, non-contributing (via growth or margin) E-Payment and Money Transfer business.

Overview of Potential Catalysts:

• Movie Gallery Liquidation - October 29
• Blockbuster Chapter 11 and inevitably will follow same downsizing path as Movie Gallery - filed on September 23 with agreement from its senior secured bondholders
• New Redbox Kiosk roll-outs (recently announced Worsley Companies and CVS)
• Short Covering (24% of float is short, up ~ 1. 2m month-over-month).
• New Online Partnership announcements: speculation regarding improving relationship with Apple
• Accelerated Share Repurchase: CSTR has the ability to buyback ~2mm shares (~ 7% shares outstanding) via free cash flow alone and/or repurchase debt (the Company is levered 1.1x FY10 EBITDA).
• Expansion of blu-ray discs (at all locations this fall at a higher price point, not included in our estimates = $0.50 or 50% increase in revenue per rental - much of which will flow to EPS).

Value of Coin Business:

The coin business will do $85 -$100m in EBITDA each year without much investment.  In addition, only ~ $5m of maintenance capex is required to run the business.  It's worth mentioning that this "dying" business has generated in excess of $25m in EBITDA per quarter for the last eighteen quarters.

Value of Redbox:

Assumptions: $250 - $300m of EBITDA in 2011 (excluding Blockbuster Chapter 11 store closures, Movie Gallery liquidation and incremental uplift on blueray penetration). Note: all of the debt resides with the coin business.

$250m Redbox EBITDA - conservative case

• Using a 3x EBITDA multiple = $750m / 32.7m shares = $22.94/share
• Using a 5x EBITDA multiple = $1.25b value / 32.7m shares = $38.23/share

$300m Redbox EBITDA - likely case

• Using a 3x EBITDA multiple = $900m/32.7m shares = $27.52/share
• Using a 5x multiple = $1.5b / 32.7m shares = $45.87/share

Using a 50% discount to NFLX multiple (50% of 15.9x); $300m of EBITDA = $73/share.

Sum of the Parts:

Range of Values: $31 - $93 per share.

We believe (with the understanding that Redbox is a "melting ice cube" sometime in the next 4-12 years) that today's fair value is $60 - $70 per share. Can the stock price get to $93 or our high end?  The answer is yes, as most controversial situations overshoot to the downside and to the upside.

Catalysts to realize $60 - $70 per share:

Move Gallery Chapter 7 Liquidation:

On October 29, 2010, Movie Gallery will finally be put out of its misery.

Quick background: Movie Gallery filed for bankruptcy protection on Feb. 2 for the second time since 2007, saying it planned to close "a significant number" of stores. In May 2010, they decided to file for Chapter 7 liquidation. Before the first bankruptcy Movie Gallery had 3,500 stores. This time they are shutting down 2,415 stores. The confirmation hearing for approval of the plan is set for Oct. 28. We believe a similar scenario holds true for Blockbuster despite the involvement of Carl Icahn. Blockbuster discussion to follow... Below is a simple Movie Gallery market share analysis and the opportunity for Redbox:

In summary, the Movie Gallery liquidation should create value of $7 per share.

Blockbuster Chapter 11 Reorganization:

On September 23, 2010, Blockbuster filed for Chapter 11 after reaching an agreement with 80.1% of its senior secured bond holders.  Under the plan, the bondholders will convert their holdings into equity; subordinated holders and existing equity holders will receive no proceeds.  The plan calls for a $125m in DIP facilities which will be the only debt in the structure post implementation.  We assume that Redbox captures 45% of the Blockbuster market share based on an initial 800-1,000 store closures (again, the WSJ has reported there could be more closures).

In summary, the Blockbuster Chapter 11 should conservatively create at least $4 of value per share. In total, the Movie Gallery and Blockbuster catalysts should create at least $11 of value ex any margin expansion. I don't think it's necessary to discuss the various levers for margin expansion (pricing, blue ray, online partnerships, etc) as that is all upside option value.

Total Market Share Grab Sensitivity:

Conservatively, Redbox will hold a sustainable >20% market share, and at least 17.5% EBITDA margins (more likely 19%), leading to EBITDA of $268 - $364mm within the next 12-18 months.  In total, with the coin business, there is ~ 68% upside assuming de-minimus operating leverage.  Note: Piper Jaffray estimates that Redbox will have 27.5% market share in 2012.

Why Redbox Isn't Movie Gallery / Blockbuster:

First, let's take a look at the evolution of the physical DVD market and its competitors.  Mom and pop rental chains and supermarkets ceded control of the market to big box players Blockbuster, Movie Gallery and Hollywood Video who garnered significant studio and marketing clout. Blockbuster and Movie Gallery then pursued the smallest of the big three, Hollywood Video, in which Movie Gallery eventually paid over $1.3bn (and levered its balance sheet to pay for it).  Blockbuster acquired the divested stores from the Movie Gallery-Hollywood Video transaction and in turn leveraged its balance sheet.  Enter Redbox and NFLX.  The hunters, now saddled with heavy debt loads, became the hunted.  Redbox and NFLX, not hindered by debt and costly lease arrangements, were quickly able to undercut the big box players.  A simple table illustrates the slow demise of Blockbuster and Movie Gallery.

We aren't debating a similar fate for Redbox - eventually, the physical DVD market will give way to streaming/digital/VOD distribution.  However, industry estimates still call for ~ 2% p.a. growth in physical DVD markets for the next 5 years, and those estimates don't need to be achieved for this thesis to work.  A growing market only expands the Redbox opportunity beyond the natural gain share as Blockbuster pares its store portfolio and as Redbox expands its own kiosk distribution network.

Summary:

In total, applying conservative assumptions to the near term redbox opportunity yields 50-100% upside, with downside protection afforded via highly stable and entrenched coin-business.  Excluding the potential upcoming soft catalysts (share repurchase announcements, debt pay-down, online strategy roll-out), the demise of Blockbuster and Movie Gallery yield at a minimum $11/share of upside. Even under the current depressed CSTR multiple the market has given us another asymmetric investment opportunity in Coinstar for value investors.  While this is not NFLX (it's not trying to be), it certainly isn't Blockbuster and Movie Gallery either.   

Catalyst

• Blockbuster Chapter 11: filed September 23
• Movie Gallery Chapter 7 liquidation: October 29
• Online strategy announcement: mid/late October
• Strong earnings: late October/early November; share repurchase and/or debt paydown