Description

Coinstar has a monopoly position in the US coin counting business. The company has 11,000 machines in supermarkets in the US, UK, and Canada. Coinstar collects an 8.9% fee and kicks back 1.0% to the supermarket partners as rent for the service of converting loose change into a cash voucher that shoppers cash at the store. This business looks deceivingly simple. The reality is that while Coinstar now enjoys high operating margins, it took years to get its current scale and to prefect a system of field repair and collections that enables it to enjoy EBTIDA margins that now approach 40%. The stock is at multi-year lows, but has several catalysts which could drive it materially higher.

The short argument against Coinstar has always been why pay a 9% fee when banks do it for free. Banks (with the exception of CBH) actually only do it for free if the coins are sorted and rolled. Even if you have a machine that does this service it still takes time and effort. In addition, there is the convenience factor. The average American visits a supermarket 2 times a week. The average American does not go to a bank during teller hours nearly as often. Also, banks often have long lines that Coinstar machines generally do not have.

Coinstar has several options for the fee adverse. One of the most popular is the charity option. Coinstar gives several charity options, often tailored to local charities. The company is also a large processor for UNICEF during their Halloween drive. The charity pays the fee and the donor gets a 100 cent on the dollar tax deduction. The average charity has about 50 cents of expenses for every dollar it collects. Coinstar costs the charity only 8.9% and is thus one of the most cost efficient and effective fund raising tools around. The bottom line is weather or not you think people should use the service, millions of people do and have been with increasing frequency which is why the company has gone from negative EBTIDA to $65mm this year in 5 years.

The other knock on Coinstar is that growth is limited. But with at least 16,000 viable locations in the US alone, not including Wal-Mart, this is not true at this stage in its life cycle. In addition, the machines are networked, so other services like prepaid wireless and phone cards could be sold for added revenue.

Valuation

I have valued the company under three scenarios. The first is based on this year’s cash flow. The second is based on an estimate of cash flow in four years when the network is built out to 15,000 machines. The final scenario is an adjusted book value calculation on the replacement value of the network. Most of my revenue growth assumptions come from a combination of the increased machine placement and increased trial. Penetration right now hovers at just less than 10%. Most of the marketing efforts have been focused at increasing trial with a fair amount of success. In addition, I give no revenue or profit contribution from any of the company’s growth initiatives which included prepaid wireless and phone cards, which have been quite promising sources of new business in trials. The company’s vision is to use its valuable machine and networked platform to offer services to the 40mm Americans who are unbanked. The cost of a new machine is $12,000 and that is capitalized. The $250 a machine per year in maintenance capital spending is expensed.

Assumptions (all $ in millions except per share calculations)
Machine Count at beginning of 2003: 10,706
Machine Count in 2007: 14,831
Fully diluted share count at end 2003 adjusted for buybacks: 22mm

Beginning 2003 Net Cash: $5
Value of Tax Asset: $59
Machine New Build CapX: ($50)
Other Initiative CapX: ($50)
EBITDA 2003-2007: $506
Cash Taxes: ($150)
End of 2007 Net Cash: $320

2003 2007
Sales 184 308
EBITDA 66 140
DA 27 30
EBIT 39 110
Interest 0 5
EBT 39 115
Taxes 0 (46)
NI 39 69
EPS $1.77 $3.13
CapX 20 5
Cash/NOL 64 320

Valuations:
PE @
10 $17.70 $31.30
15 $26.55 $46.95
20 $35.40 $62.60

EBITDA @
6 $20.91 $52.72
8 $26.91 $65.45
10 $32.90 $78.18

EBIT@
10 $20.64 $64.54
12 $24.18 $74.54
14 $27.72 $84.54

Adjusted Book Value
Net Cash and NOL: $64
Replacement Value of 10,706 machines @ 12k: $129
Cost of replicating the investment in technology and infrastructure: $150
Total Adjusted Book Value: $343
Adjusted Book Value per Share: $15.59

This investment has a large margin of safety as evidenced by the adjusted book value calculation. The stock is currently trading at book value. Presumably a bank, Catalina marketing, or some other entity would at least pay this amount to get into this high margin business.

As for the cash flow calculations, the question boils down to where a monopoly business with high amounts of free cash flow should trade. The current earnings are exaggerated by the large NOL so P/E is not that helpful. An 8x EBITDA valuation seems reasonable for this type of business though I could argue for 10-12x given the growth rate. At these levels, the stock should trade at almost $27 which I think is fair. If you want to give the business an LBO type multiple of 6x, the stock should still be trading for $21 per share or a 40% gain from here. What is truly exciting about the business is that since most of the costs are fixed, and the machine universe should be at least 15,000 (my sources tell me it is more like 17,000), the $140 in EBITDA in 2007 should not be that hard a target to achieve. In addition, the company should have about $14.55 in cash on the books by then which almost equals the current share price. If the company where to trade at a no growth 6x EBITDA multiple in 2007, the share price should reach almost $53 for a 29% compound annual return from $15. This calculation gives no value to the millions in marketing and brand building that the company has spent over the years.

The stock is cheap for a variety of reasons that have nothing to do with the company and everything to do with false rumors and a jittery market. The first was an Off Wall Street short report, which knocked the stock down from the mid 30s (where I was not a holder) to the mid 20s. The stock was in the hands of momentum funds and they bailed on what was a timely but inaccurate report that the company was about to end its growth. Next the CFO quit, which knocked the stock from the mid to low 20s. While I have great respect for the former CFO, she was not very polished in her communications with Wall Street. I believe she was pushed out by large shareholders who were unhappy with the share price performance. Finally, there was a rumor that Safeway was going to kick the company out of its 1,000 stores. This rumor sent the stock down to $15. This rumor was grounded in a kernel of fact. Safeway Arizona, which has never been a Coinstar client, is running a trial of 3 machines from a competitor called Scancoin. The test has gone on for almost a year and has yet to be rolled out to the 100 Safeways in Arizona, much less the 1,000 stores in the US. It is worth pointing out the Coinstar was very unprofitable at only 1,000 machines. It is unlikely Safeway would do any better in a business that is not core.

Catalyst

There are three near term catalysts to drive the stock higher. First, the Safeway rumor will be disproved as the company continues to retain Safeway as a client. Second, the company continues to grow same machine sales and expand – hitting its numbers. Finally, a new CFO is hired putting confidence back into the numbers and getting the story out to the street. Finally, a longer term catalyst is the sale of the company. Coinstar has a few large and long term shareholders who have already forced out the founder and the CFO. At one point, the company was put up for sale about 2 years ago and bids came in around $20 a share (which were rejected). These holders would not hesitate to auction the company again. I think it could go for at least the mid 20s.