Description

I am recommending the purchase of Coinstar Inc. (Symbol CSTR).  In addition to dominating the coin counting machine market (the market for which CSTR is best known), the company has a near 50% investment in a company  (Redbox) which is dominating the incredibly fast growing self serve DVD kiosk market.  CSTR has a few other businesses that fit within their “fourth wall” strategy which include entertainment machines, e-pay, and money wires.  However, it is the first two business opportunities that I believe make CSTR a very compelling investment opportunity.

CSTR has a 90% market share of the coin counting market. The economics of this business are very compelling, with higher than expected growth given their strong cash flow generation.  Redbox has been growing very quickly and, as will be discussed below, is within 18 months of a likely IPO which should value CSTR’s share of the business at over $240 million.  So when you back out the value of the Redbox stake that CSTR owns, I believe you get a very attractive business, in a market that CSTR dominates with 90% share, for a ridiculously low valuation; near 5 x’s normalized free cash flow.

Overall Business Strategy

The individual business lines will be discussed below but I would, very briefly, like to discuss CSTR’s overall strategy.  The company is attempting to dominate the products and services that are sold on what is referred to as the “fourth wall” of super markets and retailers such as Wal-mart.  The fourth wall is near the exits, past the check out counters. This wall is historically space that is under utilized by super markets.  It is where you will find the coin counting machines, gumball machines, kiddie rides, DVD Kiosks, money transfer stations and the like.  CSTR has products and services that are placed in this area that historically had been “dead” space for the stores but which CSTR has helped make very profitable floor space for the markets.

Coin Counting Business Normalized

CSTR manages a network of machines that count loose chance that customers have accumulated. After the change is deposited into the CSTR machine, the customer has the option of receiving a cash voucher or a stored value card.  If the customer chooses cash value they are charged an 8.9% transaction fee.  If the customer chooses a stored value card, the customer pays no transaction fee.  But the economics are the same to CSTR as the 8.9% fee is charged to the retailer that is providing the stored value card.  The stored value cards can be redeemed at top retailers such as Amazon, Starbucks, Borders, iTunes and many more.

CSTR dominates this market.  They have a 90% share. The company currently has an installed base 14,000 coin counting machines.  On 22 different occasions they have had customers stop using CSTR’s service in an attempt to implement the service themselves.  21 of these customers have returned to CSTR.  (Safeway is the one company that they lost that has not returned.)

Each new machine costs CSTR between $10,000 and $12,000 to install.  But after maturity, which occurs at approximately 3 years in service, each machine generates $17,000 to $18,000 in revenue to CSTR with a 30% EBITDA margin.

The company depreciates machines over a five year period but in the history of the company they have not retired any machines. The average machine in the field is between 5-7 years old. They still have machines in the field that were installed 13 years ago, at the beginning of company history.  Once installed the machines have a long life and are cash cows.

Unit level economics are very compelling and it would be very difficult for a potential competitor to reach the critical mass that CSTR has already achieved.

In 2008 the company has guided to coin EBITDA of $150mm.  Currently the company is spending much money on CapEx.  This money is largely being spent to put new units in the field (as they should) because of the great economics of each machine as I discussed above.  In the third quarter alone the company spent $64mm on CapEX.  However, the lion’s share of this was installing new machines across the different business lines.  In fact only $4.7mm of last quarters CapEx is what you would deem as “maintenance CapEx”.  If we are to annualize that number we can assume that if CSTR was to stop growing, CapEx would be in the neighborhood of $20mm per year. (Actually the company guides to a number lower than this for maintenance CapEx, but to be conservative we will use the $20mm number.)

Using those normalized numbers, if CSTR was to stop growing, which I am by no means suggesting, the company would generate approximately $130mm per year in free cash flow.

Coin Counting Business – Growth Opportunity

Part of the bear story on CSTR is that the coin business is slow growth and that older machines are near maturity and have stopped growing.  I think the evidence will show that this is not the case.  Machines that are 3 to 8 years old are “comping” between 5 and 7.5%.  Older machines still continue to comp in the low single digit range.  So, their oldest machines are not seeing the declines that some bears had predicted.

More importantly, there is much growth opportunity in the installed base.  In 2004 they acquired an entertainment company (gumball machines, skill cranes, kiddie rides, etc) called American Coin Merchandising, Inc.  This acquisition has largely been blamed for recent problems that the company has had (more on this below), but with this acquisition they were afforded their largest growth opportunity going forward.

American Coin had a relationship with Wal-Mart; at the time of the acquisition CSTR did not.  Since the acquisition the Coin machines have been installed in 400 Wal-Marts.  Wal-Mart has 4,000 total stores CSTR has the opportunity to move into a significant number of these stores.  Additionally, CSTR has 60,000 total locations where at least one product (coin, entertainment, e*pay etc) is installed and only 7,000 of these have more than one product.  This allows for much potential cross selling of their products.

Furthermore, 75% of the people in the U.S. haven’t ever used a CSTR machine.  So there is still growth potential as consumers become more aware and accepting of the coin counting machines.

So, not only are the machines still “comping” positive, there is still much room for unit expansion within existing customers.

Redbox – Background

Redbox manages a network 6,000 DVD kiosks that feature new releases of popular DVD titles.  Customers are able to rent these DVD’s for $1 per day.  Their purchase is on their credit card and if they keep the movie for a second day, they are charged an additional dollar.  This continues as long as they have the movie.  If the customer doesn’t return the movie within 25 days, they are charged $25 as a replacement cost; about how much it would cost the customer to purchase the movie themselves.  These kiosks are also located on the forth wall of large retailers. This new product is a perfect cross selling opportunity for CSTR.

CSTR originally invested in Redbox in the beginning of 2005.  The other strategic investor in Redbox is McDonalds.  Both currently are 47.3% owners of Redbox.  Between 12/31/2007 and 12/31/2008 CSTR has the option of purchasing enough Redbox to get their ownership stake up to 51%.  This option would cost CSTR $4.8mm to acquire the 3.7% from McDonalds.  For it to be worthwhile for CSTR to purchase this option they would have to believe that Redbox is worth at least $130mm.

The fact of the matter is that Redbox has been much more successful than expected and the value of Redbox is well north of $130mm (more below) and there is no doubt that CSTR will exercise this option.  Part of the reason it has been more successful than expected is that CSTR sales people have been very successful at cross selling this product.

As a condition to this option that CSTR has, McDonalds has the right to force a liquidity event if CSTR exercises the option.  McDonalds will force this liquidity event once CSTR exercises their option so CSTR will make sure that Redbox is ready for an IPO before they exercise this option.  CSTR has only to the end of next year to make this happen, which in turn would lead to McDonalds forcing a liquidity event.  So we can expect a Redbox IPO within the next 12 to 18 months.

Redbox – Valuation

Wall Street analysts are expecting Redbox to have 10,200 units (from 6,000 now) at the end of 2008.  The total market is somewhere in the neighborhood of 50,000 units and Redbox is clearly in the lead of the competition.  Currently installed units are “comping” at over 30% on a year over year basis.  Revenue expectations for 2008 are expected to be approximately $300mm with EBITDA margins in the neighborhood of 20%.

In a business growing as quickly as Redbox (both organically and with new installed units), I think a conservative valuation for an IPO would be approximately 8x’s EBITDA.  Using the numbers I gave you above, we can estimate that Redbox’s total valuation at IPO would be $460mm.

[ ($300mm Rev * 20% Margin) =  $60mm EBITDA * 8 times = $460mm ]

CSTR would own 51% of this so we can conservatively estimate that CSTR’s stake in Redbox at the time of the IPO would be worth approximately $230mm.

CSTR Valuation

As I type CSTR trades for just under $30 per share with 28mm shares outstanding for an equity value of $840mm.  The company has $224mm of long term debt and cash of 161mm.  (Much of this cash is not available for operational purposes as it is in the machines or being processed, but it is CSTR’s cash none the less.)

Putting these numbers together you get an enterprise value of $903mm.

If we subtract out the value of Redbox which I derived above at $240mm we are left with an enterprise value of $663mm for CSTR’s core businesses.

Using the normalized free cash flow number from above of $130mm for the coin business we see that in essences you get the very good coin business, of which they control 90% of the market, for only 5 times multiple of free cash flow.  This seems ridiculously cheap to me for a business that has such good economics that has created a moat from competition.  CSTR is a near monopoly business that has seen 21 of 22 customers who have left them return to CSTR because it was impossible for them to manage the business on their own.  The company is still “comping” positive even on its oldest machines and has much growth potential from cross selling and deeper customer penetration; all for a 5 times multiple of free cash flow.

With the growth potential in the core coin business I don’t think it is unreasonable to think that  the core business trade a 10x’s multiple of free cash.  This would imply a share price of over $50.

Equity Value = [Enterprise value of (10 multiple * $130mm) + $240mm (redbox)] - $224 debt + $161mm cash

Equity Value = $1,477mm

Share Price = $1,477mm/ 28mm shares

Share Price = $52.75

 

Entertainment

In this write up I have ignored many of the products in the fourth wall strategy.  I have done this largely because I believe that the interesting part of the story lies in the strong cash flow nature of the core business and the implied “kicker” of the RedBox business.

However, it is important to point out that the stock sold off after the third quarter report largely because of disappointing results in their entertainment division.  This division does the kiddie rides, the gumball machines, and the skill cranes.  The company attributed this weakness to the broader forces that are affecting all retailers in this market; lower consumer spending.  Additionally, the Chinese lead paint scare that hurt many toy manufactures over the last 6 months also affected CSTR’s skill crane business.  CSTR had no issues with lead paint in any of their toys, but the consumers definitely had a negative sentiment to this type of toy.

This business long term is a 9 to 10% margin business that even in this bad quarter didn’t lose money for CSTR.  Additionally, this is the business that opened the door to Wal-mart so it is providing business in other ways.

Other Business

The other businesses in the four wall strategy are showing the early stages of success.  E* pay is profitable and doing well and money transfers, their newest business, is about to break even. 

Recently it was announced that CSTR was piloting an automatic coffee machine in partnership with Starbucks that would also be located on the fourth wall.  This is in the very early pilot stages obviously, but could provide upside in the future.

Lastly, the company has been piloting change machines in banks.  If they company is able to get traction in banks it could make the growth opportunity even bigger.

Catalysts:

• The most obvious catalyst is the Redbox IPO.  This should occur within the next 18 months and is likely to value CSTR’s share at near $250mm.
• Continued growth of the coin business on both a “same stores” basis and the new unit basis.
• Penetration of the coin machines into the banking system.

Summary

In a nut shell, a purchase of CSTR gets you an investment in the dominate provider of a niche market with great business fundamentals for 5x’s normalized free cash flow.  Additionally, you get an equity kicker in a business that is growing very fast that is showing tangible results that should be recognized through a monetizing even within the next year and a half.

Ultimately, I think CSTR would be a good investment without Redbox.  With Redbox I think it becomes an outstanding opportunity to see capital appreciation over the next 12 to 18 months.

 

Catalyst

* The most obvious catalyst is the Redbox IPO. This should occur within the next 18 months and is likely to value CSTR’s share at near $250mm.
* Continued growth of the coin business on both a “same stores” basis and the new unit basis.
* Penetration of the coin machines into the banking system.