A song made famous by The Buggles, called "Video Killed the Radio Star," recalled how television, a new form of entertainment, had eclipsed the longstanding format of radio. Could we be witnessing the same phenomenon with physical DVDs as tablets explode in popularity?
On February 7th, 2013, Coinstar (CSTR) issued guidance for Q1 2013 that was significantly below Wall Street estimates. Prior to the earnings release, Wall Street expected CSTR to have revenues of $623mm. Coinstar guided revenues between $568mm and $593mm; the midpoint of guidance was a very large 6.8% below Wall St. estimates. Pro-forma earnings (don't count the streaming investments to ward off competitive threats) were also guided to come in below expectations at between $0.77 and $0.92 for Q1. The midpoint of earnings guidance was 31.8% below Wall Street's estimates of $1.24 before this guidance came. Clearly, relative to sell-side expectations, the business model is not performing to its capacity in the beginning of 2013. Why?
I think tablets are causing a shift in media consumption that is impacting CSTR dramatically. CSTR's performance on an average kiosk basis is deteriorating rapidly.
As one can see, consumers rented 12.9% fewer DVDs per kiosk in Q4 2012 versus the prior year. While some will want to blame this poor performance on the movies on offer at the kiosks, the downward trajectory first appeared in Q4 of 2011 and has accelerated meaningfully since. That is an incredibly long-time period on which to blame box office cadence. After all, Q2 2012, Q3 2012, Q4 2012 revenue results and Q1 2013 revenue estimates all missed analyst expectations markedly (they missed by 2.5%, 3.6%, 2.8% and 6.8% respectively).
On the other hand, before they increased price in Q4 2011, we can estimate DVD volume per kiosk based on revenue per kiosk because pricing was constant. (There is some effect based on Blu-Ray but that was such a small percent of their business until recently it would have a negligible impact.)
As one can see, despite them adding a huge number of kiosks on a year-over-year basis, revenue per average kiosk was relatively steady and slightly increasing! If we use the disclosed 2010 average revenue per DVD rented of $2.17 for 2008 and 2009, we can estimate the DVD rental volume prior to its disclosure. Here is what that looks like:
Something clearly changed in late 2011. Anyone arguing there has not been a change to the business model is not looking at the data.
So, what changed? I have a simple hypothesis: tablets went mainstream around this time. And since tablets provide a substitute media consumption platform, their widespread adoption put pressure on the DVD rental market. There are just so many things to do on a tablet (Facebook, games, email, apps, books, streamed TV, streamed movies, etc.), they absorb people's time. People are simply less likely to drive 5 minutes to go pick up a DVD when they own a tablet.
When we plot the contraction in DVDs rented / kiosk / month vs. the trajectory of tablet sales, we clearly see there is an obvious visual correlation of when tablet prices dropped and tablet volumes ramped, to when CSTR started seeing a dramatic slowdown in rentals per kiosk.
[Actual DVD volumes not disclosed by CSTR until 2010].
It seems clear to me that tablets are having a substantial negative impact on CSTR's DVD rental volumes. While tablets get credit for decimating the PC industry, it is quite likely their huge growth is having massive impacts on other sectors, especially those tangential such as entertainment and gaming. This is not likely widely accepted or acknowledged by CSTR sell-side analysts or company insiders.
In fact, company insiders have given guidance projecting a massive turnaround in rental volumes per kiosk. The following spreadsheet lays out my calculations of future revenues and volumes based on the midpoint of management's recent guidance for 2013.
What this shows is that management is projecting an incredibly aggressive turnaround in DVD rentals per kiosk over the next 4 quarters. Visually, their guidance appears as follows:
At this point, I do not believe this is achievable. I think management has not confronted the fact that there are new substitute products taking huge share in the market for media consumption. Instead, management has tried to heap blame on an uncontrollable factor such as "movie quality" and the box office of DVDs flowing through their kiosks.
If management's aggressive projections do not pan out, the profits of CSTR will fall precipitously. The kiosks have a very stable cost structure, pointing to an extremely heavy ratio of fixed costs for the kiosk operations (on a per kiosk basis). Here is a graph of the operating costs per kiosk per month for Redbox other than movies since it was broken out by CSTR in 2010.
As one can see it is remarkably stable. It averages about $1,760 per month per kiosk. Movie costs are more variable but nevertheless average $1,650 per month and are almost always above $1,500 per month per kiosk.
So, if we add these two amounts (with a discount to minimum movie costs), we can see that Redbox fixed costs ($1400 + $1,760) are about $3,160 per month per kiosk. Bulls may argue that movie costs are entirely variable. However, how much of an entertainment destination is Redbox going to be if they cut the number of titles in their kiosks by 1/3? There would be sell-outs of hits and very little variety, frustrating consumers massively. Simply, there is a minimum amount they have to put into the kiosks to drive any traffic. So, given these huge fixed costs, we see that when revenues decline, almost all the shortfall hits the bottom line.
In sum, CSTR's guidance implies Q1 Revenue / Kiosk of about $3,867. If we use that as a benchmark, and say this number falls a further 7% in 2014 to $3,600 per kiosk for the year, using our average expense numbers ($1,760 + $1,650) we get EBIT per kiosk per month of $190 (3,600 - 1,760 - 1,650). If we have 46,000 kiosks in 2014, that means EBIT for Redbox is $105mm. That compares to $238.7mm in 2012, or down 56%. Any further deterioration in the DVDs rented per kiosk is going to have disastrous financial results for the company.
CSTR admittedly looks cheap when using last year's numbers or management's guidance. However, we have shown that such guidance appears incredibly aggressive. Moreover, we have shown that the possible downside to earnings are huge if tablets really are eating away at the Redbox business.
A very intelligent and highly regarded shareholder of CSTR, Mario Cibelli (@mariocibelli), tweeted yesterday, "im also convinced middle america doesnt have room to up its entertainment budget." I wholeheartedly agree! I think Middle America discovered tablets - which comes out of that entertainment budget - and is giving more of its time and money to tablets vs. Redbox.