Coinstar and Netflix: Two Shorts on Movie Rentals

|
 |  Includes: NFLX, OUTR
by: Ryan Edward

Sometimes good stocks are run up too far. Sure, you may take a look at Coinstar (CSTR) and Netflix (NASDAQ:NFLX) and see all the positives. Netflix's main competitor Blockbuster (BBI), is teetering on the edge. With Blockbuster out of the way, Netflix should be able to pick up a huge amount of market share without even trying. Coinstar's Redbox and DVDXpress units saw sales at DVD machines installed at least a year leap 52% last year. It plans to increase Redbox's installations by about half this year.

So what's the problem? Not much, but lofty expectations usually result in huge corrections if expected earnings aren't met. Looking at both both Netflix and Coinstar's valuations, they have high expectations indeed.

The Case For Shorting Netflix:

Sometimes it's not a bad thing to go against the crowd, and by shorting NFLX, you most definitely are. Its current P/E stands at a mountainous 33x earnings. Sure the company is growing quickly, but it may not deserve such a high valuation.

In today's economy, people are cutting back on non-essentials. I would say having DVDs sent to your house to watch every night may qualify as a want for many families. The USPS, responsible for delivering Netlix movies, is considering reducing the mailing week to only 5 days a week, down from 6. This would severely hurt Netflix's customers, as it would interfere with their schedules.

One of the reasons for NFLX's high valuations is that it is working hard to get into the over-the-internet movie industry. The company has been a front-runner in getting movie titles available online, watchable not only on computers, but on TVs through the use of Blu-Ray players too. The problem is that investors seem to think NFLX is the only player in this market. Netflix's business will eventually turn from movies-by-mail to movies-by-internet, where it will face stiff competition. Their moat will disappear quickly, as giants such as Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Hulu and Blockbuster move into the arena.

Publishers such as Dreamworks (NASDAQ:DWA), Universal, and Fox have no alliances when it comes to distributing their work. They have no reason to deal exclusively with Netflix, so they will distribute to multiple companies, including Netflix's competition.

I don't necessarily think Netflix is a bad stock, but I do think it's time for its investors to get serious. Netflix is already showing some pain, increasing Blu-Ray subscribers' bill by $1 a month. I expect these problems to get more serious, and for NFLX's stocks valuations to fall back to earth. At just a tad under its 52 week high, I think NFLX is due for a correction.

The Case For Shorting Coinstar

Another great, yet overvalued company in the DVD business is Coinstar. It operates not only Coinstar machines, but also DVD vending machines such as Redbox. Their DVD vending machine business grew to 6% of the $8.2 billion movie-disk rental business last year from 1% in 2006. They have even more room to grow as they are rolling out expansion plans for more machines in numerous locations. Although these are great signs, I do not think it justifies a double in its stock price YTD or a multiple of 44 times estimated 2009 earnings.

Although they have seen stupendous growth, this will eventually slow due to at least two factors. The first is that its new Redbox kiosks will eventually cannibalize their old machines sales. Also, competitor Blockbuster is planning on rolling out new DVD vending machines this year.

Another reason to dislike the stock is that one of its main markets is running dry. To help offset the costs of carrying publishers' content, Coinstar sells its used DVDs. Not only have resale prices declined, but Redbox's inventory has slowly been growing.

With profit margins of under 2%, Coinstar has little room for error. Due to higher competition, rising costs, and lower sales, CSTR's stock should see a correction until expectations are more in line with current conditions.

Disclosure: I hold no positions short or long in any of the stocks mentioned.