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Executives

Rosemary Moothart – Director of Investor Relations

Paul Davis – Chief Executive Officer

John Harvey – Chief Financial Officer

Gregg Kaplan – President and Chief Operating Officer

Analysts

Eric Wold - Merriman Curhan Ford & Co.

John Kraft - D. A. Davidson & Co.

Robert Evans - Craig-Hallum Capital

Nathan Brochmann - William Blair & Company, L.L.C.

Steven Rees - J.P. Morgan

John Kraft - D. A. Davidson & Co.

Simeon Gutman - Canaccord Adams

Alan Robinson - RBC Capital Markets

Coinstar, Inc. (CSTR) Q2 2009 Earnings Call August 4, 2009 5:00 PM ET

Operator

Good day, ladies and gentlemen. Thank you so much for standing by and welcome to the Coinstar, Inc. second quarter 2009 earnings conference call. (Operator Instructions)

As a reminder the conference is being recorded today on Tuesday, the 4th of August, 2009. I will now turn the conference to your host, Miss Rosemary Moothart, Director of Investor Relations. Please go ahead.

Rosemary Moothart

Thank you, Michael. Good afternoon everyone and thanks for joining us today. The speakers on the call will be Coinstar’s CEO Paul Davis, and our CFO John Harvey. Before I turn the call over to Paul there is important information I need to review with you.

During this call, various remarks that we make about future expectations, plans and prospects for the company, constitute forward-looking statements for the purposes of the Safe Harbor provision under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from expectations, plans and prospects contemplated in these forward-looking statements as a result of various factors, including those discussed in our previous 10-K’s and 10-Q’s filed with the SEC.

In addition, during this call we are referencing both GAAP and non-GAAP financial measures. Definitions, a note about the importance of these measures to investors and a reconciliation between GAAP and non-GAAP financial measures are available in the press release announcing second quarter financial results that is posted in the About Us section of our Investor Relations website on Coinstar’s website at www.coinstar.com.

For the call today we have posted a slide presentation that Paul will reference during his remarks. You will find a link on the home page of the Investor Relations website. The slide presentation as well as the webcast of the call will be available on the website for approximately one year. Also posted and filed as an 8-K is the new investor update. It includes the 2009 guidance John will refer to, as well as some historical financial information.

You may have noticed that we are not posting a script and will not be using financial slides. Complete financial statements were included with the press release issued today, and additional historical information, as I mentioned, is available on the investor update.

And now I’d like to turn the call over to Paul.

Paul Davis

Thank you, Rosemary. Good afternoon and thank you for joining us on the call today. We are very pleased with our results in the second quarter, as we exceeded both our revenue and EPS guidance.

Once again our strong performance was driven by our core businesses at DVD and Coin. After John reviews the second quarter results, I want to talk about how we intend to leverage our core competencies and our position in the marketplace to drive future success.

John, I’ll turn the call over to you.

John Harvey

Thanks, Paul, and good afternoon everyone. As Paul mentioned, we are very pleased with our top and bottom line performance in the second quarter, which exceeded both our revenue and EPS guidance. For the quarter, net income was $7 million, a 160% increase compared with $2.7 million a year ago. GAAP EPS on a fully diluted basis was $0.23, exceeding the guidance of $0.14 to $0.20. Last year, GAAP EPS on a fully diluted basis was $0.09.

EBITDA was $50.8 million, an increase of 34% year-over-year. Consolidated revenue was $314 million, up 43% on a year-over-year basis, exceeding the guidance of $300 to $310 million we provided last quarter. This increase was driven primarily by continued strong growth in our DVD business, which increased 110% year-over-year to $188.9 million. We continue to expand our installed kiosk base, and at the end of the quarter we had 17,900 kiosks installed compared with 9,600 a year ago. For the second quarter, DVD same store sales were up 33%.

Coin and entertainment revenue was $96.8 million, down 4% year-over-year. Breaking down the segment, coin revenue was relatively flat at $64.9 million, largely due to declining foreign exchange rates. If rates had been constant year-over-year, coin revenue would have been up 4% or approximately $2.5 million. For the quarter, there was no net change in the number of installed coin kiosks which was 18,400. For the full year 2009, we reiterate our guidance of 800 to 1,000 net installed. Coin same store sales were down 4.3% for the quarter.

Entertainment revenue was $31.9 million, down 11% from a year ago. The decrease was primarily due to the reduced number of entertainment machines deployed at Wal-Mart and other retail partners, as well as less foot traffic at the retail partner’s locations.

Money transfer revenue was $22.2 million compared with $23.8 million year-over-year, a decline of 6.7%, largely due to a decrease in the average amount per transaction from approximately $590 to roughly $510. E-payment services revenue was $6.1 million compared with $5.8 million a year ago.

Turning now to expenses, direct operating expenses were $224.2 million, an increase of 49% year-over-year, reflecting continued investment in and growth of our DVD business. As a percentage of revenue, direct operating expenses were 71.4%, approximately 300 basis points higher than a year ago. This was primarily driven by increased DVD product costs resulting from a decrease in DVD salvage value.

Marketing expenses increased 50% year-over-year to $5.7 million, but remains relatively flat as a percentage of revenue. The absolute dollar increase is mainly due to increased marketing expenses for DVD as we continue to deploy additional kiosks in new locations.

G&A expenses were $34.1 million, up 38% year-over-year, reflecting the growth of the business. As a percentage of revenue, G&A was slightly down as we continue to leverage our infrastructure to support additional growth in our business overall.

Depreciation other expenses increased primarily due to the installation of 1,900 coin kiosks and 8,300 DVD kiosks over the last four quarters. And finally, amortization expense was relatively flat year-over-year.

Turning now to income from operations and segment operating income and loss, for the second quarter consolidated income from operations was $20.8 million, up 34% year-over-year. Reviewing segment operating income and loss, which is the same measure we use for reporting results in our SEC filings and is defined as segment operating income prior to depreciation, amortization and stock comp expense, segment operating income for the coin business was $23.9 million, which equates to a 37% margin compared with $24.7 million or a 38% margin in the prior year period.

Entertainment had a loss of $1.8 million, which equates to a negative 6% margin compared with the loss of $2.7 million or a negative 7% margin in the prior year period. Segment operating income from the DVD business was $31 million, which equates to a 16% margin compared with $19.2 million or a 21% margin in the prior year period. As mentioned previously, this decline in margin percentage is primarily due to increased DVD product costs.

Money Transfer had a loss of $2.3 million, which equates to a negative 10% margin, compared to the loss of $4.1 million or a negative 17% margin in the prior year period. The margin improvement is due to $1.5 million in write offs in the second quarter of last year, largely related to acquisition costs. Excluding the write offs, margin for the Money Transfer segment would have been negative 10.9% in the second quarter of 2008.

And finally, our E-pay segment was neutral for the period as compared with segment operating income of $1.5 million or a 25% margin in the prior year period. The 2008 results reflect the impact of the InComm settlement. Excluding the InComm settlement, the E-pay segment would have generated a $630,000 loss or negative 11% margin in the second quarter of 2008. Please note that in determining segment operating income and loss, we include an allocation of the direct operating and general and administrative costs for services shared among the business lines. This allocation is based upon management’s estimate of the proportion of shared services supporting each segment as of the beginning of each year, and thus is subject to change.

Turning to below the line, foreign currency losses improved compared with a year ago due to unfavorable movement in foreign exchange rates in our overseas subsidiaries during 2008. As expected, interest income decreased due to lower interest rates, and interest expense increased due to the higher debt balance primarily related to our acquisition of Redbox as discussed in detail during our last conference call.

Our effective tax rate for the quarter was 43.5%, which is down from 49.7% reported in the first quarter. Our effective tax rate for the second half of the year is expected to be approximately 45%. The improvement in the tax rate is due to a U.S. tax election that allows certain foreign operating losses in the UK to be deductible against U.S. taxable income. While the reported tax expense in the quarter was $5.3 million, cash taxes paid in the quarter were only $505,000 due to the use of federal bonus depreciation and net operating loss carry forwards.

Turning to the balance sheet, at quarter end we had cash and cash equivalents of $58.4 million compared with $66.4 million at the end of last year. Cash and machine or in transit was $48.7 million compared with $34.6 million at the end of last year. And cash being processed was $81.8 million compared with $91 million at the end of the year.

During the quarter, we repaid $92.3 million on the notes related to the acquisition of Redbox. As of June 30, we owed a final installment of approximately $10.8 million, which we expect to pay this quarter. Also as of June 30, our outstanding revolving line of credit and term loan balance combined were $430.5 million. Total CapEx for the quarter was $40.8 million. We continue to invest significantly in DVD where we spent $32.8 million, and we also invested $5.4 million in coin kiosks that we expect to install by the end of 2009.

Before I turn to guidance through the end of the year, I’d like to take a minute to discuss the recent Sony announcement. As we disclosed via an 8-K filed on July 17, we entered into a copy depth agreement with Sony whereby Redbox anticipates paying Sony approximately $460 million for DVD purchases during the term of the agreement. In addition, we granted Sony 193,000 shares of restricted stock that will vest over the term of the agreement. Assuming fully diluted shares outstanding of $30.5 million, the impact on EPS for this stock expense will be approximately $0.01 per quarter for the second half of 2009.

Looking ahead, we are providing guidance for the full year 2009 that we summarized in an investor update that we filed in an 8-K earlier today. Allow me to share the highlights. For the full year 2009 we expect consolidated revenue from $1.225 to $1.3 billion, a narrower range than we previously provided. By segment, the revenue ranges in millions are Coin $255 to $270, DVD $750 to $780, E-pay $20 to $30, Money transfer $80 to $90, Entertainment $120 to $130. On a consolidated basis we are raising EBITDA guidance for the year and now expect EBITDA between $200 and $210 million. We are also issuing full year GAAP EPS guidance of $0.80 to $0.86 on a fully diluted basis. For the year, we expect shares outstanding between 30 and 31 million and an effective tax rate of approximately 45%.

Turning to kiosk installations for the year, we reiterate net coin kiosk installs in the range of 800 to 1,000 and we are increasing net DVD kiosk installs to a range of 7,500 to 8,500. Due to the increased kiosk installations at Redbox, we are increasing full year cap guidance to $165 to $175 million.

In closing, our performance was very strong in the second quarter and we remain committed to growing both revenue and earnings, thus increasing shareholder value.

Now I’d like to turn the call back over to Paul as he shares our vision for Coinstar and the future.

Paul Davis

Thanks John. I’d like to spend some time talking about what our focus will be over the next few years. As I’ve explained during our last two conference calls, we’ve been spending a lot of time digging deep into our business, identifying which product lines would deliver the highest return for both our retail partners and our shareholders.

As we examined our business, we partnered with Bain and Company, a name that many of you know, to help us dissect our various businesses and identify our core strengths. We believe we’ve landed on something pretty exciting. Turning to Slide 3, it’s clear to us that our core strength is in the area of automated retail, which is the delivery of retail products and services to consumers, DSL service, interactive kiosks. Using a few slides, I will explain why automated retail is an attractive and growing category, why we’re uniquely positioned to win in this category, and why our core DVD and coin provides a solid foundation to build long term shareholder value.

As you look at Slide 4, we’ve framed up the four reasons why automated retail is a terrific space for us to concentrate on. The combination of retailer demand, consumer adoption, our core competencies and opportunities for innovation all point to this as being a sustainable platform for future growth. Let’s explore each.

Looking at Slide 5, retailers need solutions that reduce costs and at the same time increase traffic. Automated retail is a very attractive option for several reasons. First, automated retail improves the consumer’s shopping experience by providing speed, flexibility and convenience, which many consumers require. Satisfied consumers are more likely to return for repeat business. Second, automated retail appeals to retailers that want to be positioned as leaders in innovation. As pace setters, these retailers expand their consumer base by offering goods and services that competitors are under delivering due to inadequate convenience and/or value.

Third, kiosks are turn key solutions that can improve the retailers’ bottom line. Retailers can select products and services that complement their businesses without significant outlays of time and money. Fourth, automated retail reduces shrink, which is a significant problem that our retail partners consistently tell us they’d like help on. And finally, automated retail reduces labor costs by shifting labor and sensitive practices to a self-service solution.

As you look at Slide 6, you’ll see that the second driver of strong growth in automated retail is consumer adoption. Recent research indicates that 97% of consumers will use self-service with several key factors driving that demand. First, self-service gives consumers what they want, convenience and control. A recent study indicated that 86% of consumers are more likely to do business with companies that offer the flexibility of self-service. Second, immediate gratification. Today’s time starved consumers are looking for quick and simple solutions that satisfy their immediate needs, something automated retail allows them to accomplish.

Third, lower costs. Consumers have grown accustomed to this lower cost alternative. In fact, banks, retailers and airlines often charge additional fees for human assistance when a self-service alternative is available. And finally, consumers are comfortable paying with credit cards for self-service, which is both widespread and convenient. One needs to look no farther than your own gas station when you pay at the pump.

On Slide 7 you’ll see that the third driver of growth in automated retail is the opportunities for innovation as both the industries it serves and the benefits it provides to consumers to expand. In fact, forecasts indicate that self-service transactions will grow from $775 billion in 2009 to $1.6 trillion in 2013, a compounded annual growth rate of 20%. Behind this growth will be innovation that increasingly impacts and changes consumer behavior. Imagine the multitude of services that could be handled via self-service. You could point to numerous examples where consumers either don’t like the time that’s required standing in line, or the inconvenience of a special trip for a product or service they need that we could satisfy by offering that product or service where they go every day, grocery stores, convenience stores, gas stations and drug stores. These channels alone point to thousands of locations for an automated retail solution.

In fact, based on our current footprint of kiosks, approximately 150 million consumers pass by one of our kiosks per week, something that many entrepreneurs would envy as they think about how to get their great kiosk idea in front of millions of people.

Turning to Slide 8, we feel that our core competencies uniquely position us to succeed in this space. We have an amazing relationship with our consumers. Both Redbox and Coinstar brands that are recognizable and meaningful. Consumers associate these brands with convenience, simplicity and efficiency. As you know, we also have very strong retailer relationships. We have deployed kiosks with some of the best known chains in the world such as Wal-Mart, Walgreen’s, 7Eleven, McDonald’s, Super Valu, Ahold and Delhaize to name a few.

Yesterday you probably read that we announced that we are expanding our relationship with Kroger, where we’ll be deploying over 2,600 DVD kiosks over the next year. We also have a proven track record of taking great kiosk ideas and quickly scaling. Redbox will deploy between 7,500 and 8,500 kiosks this year alone, which is nearly one every hour. And we will have deployed over 14,400 in the last two years. Our deployment capabilities are unmatched.

And lastly, we have a proven ability to manage the automated retail infrastructure. As an example, Redbox software built over the last several years allows for tremendous capabilities and scalability. We are now processing over 70 transactions per second on busy weekends. This is comparable to Amazon’s peak processing during the Christmas shopping season.

Further, Redbox repairs over 80% of its machine related issues remotely via the web. This is only possible with highly sophisticated software that’s been developed over years of trial and error. In my opening remarks, I told you that DVD and coin continued to drive our strong performance. Redbox provides consumers with quick and easy access to very affordable entertainment that gives them exactly what they want, when they want it.

Let me take a few minutes to highlight why Redbox is such an attractive solution. Turning to Slide 9, you’ll see that our offering wins on multiple fronts. Low, simple price, $1 per day with no late fees and no membership fees. Convenient locations, we are where people go every day. Speed, the entire process takes less than a minute. Redbox provides titles consumers want. Each kiosk has over 500 DVDs across 200 plus titles with new releases delivered to kiosks every Tuesday. Redbox also offers the convenience of online reservations where consumers order through the Internet and pick up their selections at their convenience. And finally, a very important advantage for consumers, they can rent and return at any kiosk.

DVD continues to drive significant revenue and segment profit as we grow in size and relevant market share. On Slide 10 there are four charts, annual revenue, number of kiosks, annual segment profit and market share, with remarkably similar growth patterns from 2006 to 2009.

Annual revenue for DVD has grown from $49 million to a projected range of $750 million to $780 million in 2009. Annual segment profit has increased from $4 million in 2006 to $73 million in 2008, with first half 2009 results of $58 million. The financial performance reflects the increase in deployed DVD kiosks as well as their revenue growth during the same period, from approximately 2,000 to a range of about 21 to 22,000 projected for 2009. This translates to an increase in market share from less than 1% in 2006 to approximately 13.8% the end of the first half of 2009. The incredible growth of Redbox has been driven in large part by the increasing loyalty of our consumers.

On Slide 11 you can see that we’re now renting over 30 million DVDs per month. At the same time, our net promoter score has grown to more than 80%. We’ve continued to get these high scores because we’re delivering to the consumers what they want, value and convenience.

Slide 12 highlights some of the characteristics of our coin business that underscore its value in the marketplace. Since 1992, Coinstar kiosks have been the hassle free way to turn coins into cash, saving time and eliminating a trip to the bank. As we recycle 50 billion coins per year, new coin production decreases which lowers environmental inputs and preserves natural resources.

Our patent protected network makes our service turn key. The same as DVD, we are where consumers want us, in supermarkets, mass merchandisers, drug stores throughout the U.S. We also have a broad footprint in the UK, Ireland, Canada and Puerto Rico.

Consumers are offered a choice as they turn their coins into cash. One option is a cash voucher for immediate gratification and they are also given the option of loading or reloading a gift card. The service is free to the consumer when they change coins into a gift card or e-certificate which is a real advantage, especially in a difficult economy. We believe the fee free feature represents an underdeveloped market opportunity which we plan to focus on over the next couple of years.

As you look at Slide 13, coin has generated steady revenue and segment profit over the past two years. Revenue has grown from $230 million in 2006 to an expected range of $255 to $270 million for 2009. Segment profit has grown from $71 million in 2006 to $99 million in 2008, with first half 2009 results of $45 million. At the end of second quarter we had 18,400 coin kiosks deployed which is the same net number we had at the end of 2008.

As we discussed on the Q1 call, we are focused on optimizing the network and we have redeployed nearly 100 locations year-to-date. We will continue to evaluate each location. At the same time, we will hit our commitment of 800 to 1,000 net new locations in 2009. And lastly, we expect to process over $3 billion in coin this year.

Turning to Slide 14, you’ll see that while $3 billion is impressive, we still have a tremendous untapped opportunity as this number represents less than 30% of the coin in circulation. Research tells us that the single biggest reason for consumers not using our coin service is the fee. Research also indicates that 89% of consumers are unaware that Coinstar offers a fee free option. We consider fee free a great opportunity for us to drive even higher adoption and market share. As we expand the fee free options and consumer adoption increases, we expect the level of coin processed will grow through our existing kiosk base. And as I’ve said, if we can drive just one more transaction per kiosk per day, we’ll see about $13 million drop to the pretax line.

In order to enhance our leadership position and leverage the market opportunity for automated retail, it’s critical that we optimize our core businesses. Turning to Slide 15, at Redbox our plans have several key components. First, we clearly understand the importance of fostering collaborative relationships with the studios. Just two weeks ago, we announced a long term partnership with Sony and we continue to have positive conversations with other studios along similar lines. Secondly, we plan on testing different pricing models, all the while preserving our core value proposition. Third, we will continue to expand the footprint of our DVD kiosk and increase market share. The retailer and consumer demand has been incredible, so we plan on continuing to strengthen our significant leadership position. And fourth, we plan to extend the current product offering by testing video games, Blu Ray and a broader title base.

As for our coin line of business, we will focus on a number of very important initiatives. As I mentioned, we believe we have a great market opportunity among consumers who resist fees and those unaware we offer fee free conversion options. We’ll be testing numerous ways to increase consumer engagement, including special website offers, kiosk offers and value added promotions. We will also expand our fee free consumer options. And lastly, we’ll continue to redeploy underperforming units to higher value locations. This year our target is to redeploy 250 units and next year we’ll likely focus on redeploying another 200 to 300 units to better locations.

On Slide 16, you’ll see our plan for innovation which is essentially the process that was originally used for incubating Redbox. The key message is we will use a thoughtful and rigorous process for growth and innovation. Automated retail is a space that’s right for innovation, so we built a dedicated team that’s focused on delivering the next set of new product ideas that will enable the company to continue to grow and prosper for many years to come. At any point in time, we’ll have five to seven ideas we’ll be testing on a small scale basis, and once we’re satisfied we’ll be ready to scale. We’ll likely not talk a lot about them until they pass our own set of internal hurdles.

For a number of months we have said that we were evaluating strategic options for the entertainment business. Today I’d like to share with you that based on our deep dive over the past few months, we’ve decided to pursue strategic alternatives for two additional businesses, money transfer and e-pay. Each of these is a great business. However, we have concluded that they do not leverage our core competencies. This process will likely take some time so we ask for your patience as we start down this path.

On Slide 17, in summary, we’re excited about our future in automated retail. We believe that we have a solid foundation based on our core businesses of DVD and coin, that we will leverage to generate growth. As we move forward, we are confident that our strategy will generate growth on both the top and bottom line, thus increasing shareholder value. Our approach is holistic in that we plan on developing a company in which consumers love our services, one that retail partners love to do business with, one that employees love to work for and one that shareholders want to invest in.

With that, I’d now like to open the lines for questions.

Question-and-Answer Session

Operator

All right. Thank you sir. (Operator Instructions) Your first question comes from Eric Wold - Merriman Curhan Ford & Co.

Eric Wold - Merriman Curhan Ford & Co.

First question, I guess a question on the Sony deal and the studio deals in general. I don’t want to get into the weeds and them, but if you think about in general where you were prior to a deal such as Sony, where you’ll be after a deal such as Sony, should we think of those kind of deals to be, you know, beneficial to margins long term? You know margins are going to be neutral. And then secondly on that, before you’ve given kind of a 14 to 16% DVD EBITDA margin guidance for the year. Is that still the same?

Paul Davis

Yes. Let’s start with the Sony question. Obviously we wouldn’t do deals that we didn’t believe were margin dollar positive at the end of the day, and we are not providing specific line of business guidance. However, we have increased our EBITDA guidance for the year. We’ve kept revenue fairly flat, thus EBITDA margins have gone up. And as we all know, Redbox is a significant contributor to Coinstar’s overall performance.

Eric Wold - Merriman Curhan Ford & Co.

And then just a follow up question on the video game roll out, can you give a better sense of timing of that? Whatever data you can throw out. How many machines it might encompass this year? Any thoughts on economics?

Paul Davis

Yes. Good question. We won’t share a lot of details because we’re, as we go out and do these tests we don’t want a lot of fanfare around them because, you know, we want to make sure they pass our internal set of hurdles. But what you likely, I mean if you happen to land in the market where we’re actually testing, we will test our kind of a couple of paths. One is dedicated machines just for rental, and then also ones where we integrate with our DVDs. So when I say dedicated to rental, I mean both the video games as well as our DVDs.

Operator

Your next question comes from John Kraft - D. A. Davidson & Co.

John Kraft - D. A. Davidson & Co.

In regards to coin, obviously this remains a focus for you guys. When do you expect we’ll see positive same store sales? Is that possible this year with still another 800 or so to ramp?

Paul Davis

Well, I think a couple of points. The first one is on the good news is that we did get the first positive improvement, at least a little better than the past two quarters, so that’s moving in the right direction. That said, we have said all along that we believe the same store sale comps to be heavily related to our Wal-Mart installations last year. We did just over 2,200 Wal-Mart installations last year, 84% of those installations will anniversary in the second half of this year. So more to come on that.

John Kraft - D. A. Davidson & Co.

And then shifting gears back to the Sony contract. You had discussed that going forward Sony titles would represent roughly 20% or so of the Redbox. What has the market share been? I know that we’ve seen some industry data that implied that they’re sort of 14 to 15% overall, but specific to Redbox users, is it about the 14 to 15 or is it closer to the 20?

Paul Davis

I want to say for this year that 20% was Sony relative to Redbox.

Operator

Your next question comes from Robert Evans - Craig-Hallum Capital.

Robert Evans - Craig-Hallum Capital

Sorry if I missed this, but can you elaborate a little bit more in terms of the Sony deal in terms of, I know there’s an out on the deal. How much is committed to in terms of the, is that a contractual commitment, in terms of the $460 million, or is it a general estimate of what you think you will pay?

John Harvey

The $460 million is based upon sort of a matrix that is in the contract that’s based upon kind of our assumed kiosk growth and certain minimum buys per kiosk. So it kind of grows over the five year period. With respect to the two year out, what you’re referring to that’s at Sony’s discretion at the end of year two.

Robert Evans - Craig-Hallum Capital

Again just to get your perspective as it relates to copy depth deals, you’re having discussions with most of the industry, is that correct? And is that, is the structure I guess of the Sony deal would you say is the standard for the industry?

Paul Davis

That’s a good question. I mean we, as you might imagine we’re talking to the studios all the time. And we like the structure of a copy depth deal. We think it’s a clear win-win because we’re able to buy it at a lower price, all the while destroying the bulk of the previously viewed videos. So we have operated under that arrangement with a couple of the studios for some time. We just never have formalized that agreement. We’re working on that, but it’s hard to predict exactly where this will go. But those are the kinds of discussions that we’re having with all the studios.

Robert Evans - Craig-Hallum Capital

As it relates to your strategic alternatives, I think money transfer and entertainment are pretty clear, e-pay sometimes has been considered a better business. Can you just give us a little bit more perspective there in terms of strategic alternatives on e-pay?

Paul Davis

Yes. Good question. I mean I think e-pay is a great business as is actually money transfer, but as we look at the position in the marketplace, I mean we’ll look at, Bob, a number of different possibilities. So you shouldn’t go all the way to thinking, you know, just selling the business is the only possibility. That’ll be one of multiple considerations. But we look at our market position. We also look at our core competencies. And when we went back and really found a mirror we thought that we really need to focus on improving shareholder value there. So I’d say more to come. You know we don’t have a lot of detail, because it’s early in the process. But give us some time and as we, you know, get closer to some decisions we’ll be sure to share that with everyone.

Robert Evans - Craig-Hallum Capital

I know it’s hard because processes can always change, but do you have any sense of timing internally that you’d like to see this occur by to be able to make decisions?

Paul Davis

Difficult to comment on, Bob, because you never really know because some of this is a little bit out of our control. But we’re starting it. We’re working on it right now.

Operator

Your next question comes from Nathan Brochmann - William Blair & Company, L.L.C.

Nathan Brochmann - William Blair & Company, L.L.C.

Hey, I wanted to talk a little bit in terms of, you know, we’ve always talked about Coinstar in terms of the fourth wall provider and bundled solutions, etc. It sounds like the new strategy might be a little bit more piecemeal and a little bit more individualistic in terms of the targets towards convenience stores or grocery stores, etc., depending on the different product needs that they might have. Can you kind of walk us through a little bit in terms of that, whether that’s departure or not?

Paul Davis

I think it’s instead of maybe characterizing it as a departure, I’d say it’s maybe a bit sharper focus. We still believe that the fourth wall, I mean the fourth wall was really good for opportunities to sell multiple products, cross sell with the customers that we have relationships with. Automated retail is not exclusively for supermarkets or convenience stores. You know we have great relationships with mass merchandisers, with drug stores, with C stores, with supermarkets, etc., etc. And we believe that there is an automated retail sort of self-service solution, you know, possibility across multiple channels.

So when we really went back we said what are we really good at? You know, where’s the bulk of the money made? And where do we see the sort of best long term shareholder value operation? It’s really that circle around automated retail.

Nathan Brochmann - William Blair & Company, L.L.C.

Just to kind of follow up with that, do you think there will still be then leverage across products and cross selling within the same channels?

Paul Davis

Absolutely.

Nathan Brochmann - William Blair & Company, L.L.C.

Second question is maybe if you could just give us a little update on the competitive front in terms of what you’re seeing on the DVD side. Obviously there’s been some announcements there. And we haven’t heard really anybody moving too fast in that area, and it sounds like you guys are still moving the fastest. Just maybe a little update on your perspective.

Paul Davis

It’s difficult to comment on what our competitors are doing. We haven’t heard much either. I mean we’ve read a lot of the press releases on the plans, but to date have not heard or actually seen in the marketplace a lot of activity. There are some isolated tests that are actually happening with a couple of chains. It’s been well documented. At this point in time though I mean we are aggressively pushing forward. There is a tremendous demand, you know, from our retail partners and we’re doing everything we can, you know, just to keep up with that demand and do what we know how to do best.

Nathan Brochmann - William Blair & Company, L.L.C.

And so in other words I would assume that would lead us to believe that there’s still a pretty solid pipeline of new opportunities with new partners out there that you have facing you as well.

Paul Davis

Yes. You know, the balance of the year is already sold in. It’s done. We’ve already got that business. But now we’re in the process of just executing it, which implies that the team’s already working on 2010. So there are no shortage of opportunities. We’re just trying to be prudent in thinking about how do we use, you know, the cash available to manage the capital outlays. But there’s no shortage of opportunities.

Operator

Your next question comes from Steven Rees - J.P. Morgan.

Steven Rees - J.P. Morgan

So 2009 has been a significant year of acceleration for the DVD business. And can you talk about, you know, how much of this year’s growth in unit has been in new markets versus existing markets? And maybe how this year’s accelerated pace has impacted the volumes of the kiosks in your existing markets? And if this at all changes your previous view for sort of the 50,000 run rate by year three.

Paul Davis

Good question. What we talked about in the past was a ramp rate of 30,000 that by year three eventually gets to 50,000. Candidly we just don’t have a lot of kiosks that are much older than three years and I think we will next year have better insight to those 50 and go beyond that. We don’t have enough information to project beyond that.

But if you look to the map of our locations, I mean we have, I mean we’re filling in across the country. You see strong, strong East Coast presence and then starting to develop, you know, a real strong West Coast presence. But the thing that I always go back to is if you look at our most penetrated market, which is Salt Lake City, we have one kiosk per 3,000 people, where our average is obviously much, much higher than that.

If you extrapolate that across all of the U.S. the numbers are, you know, significantly higher than where we are today. And it sort of goes back to support what a study that we did a couple of years ago said that, you know, the range of possibility is 60 to 90,000. That should not be misconstrued, but that’s, you know, we would go that far or be that aggressive.

But in terms of white space and opportunities, you know, a lot of the share’s coming directly out of brick and mortar is going to kiosk. But there’s no shortage of white space there.

Steven Rees - J.P. Morgan

And then just a follow up on the pricing strategy that you said you would be testing. I guess I would just be curious to hear a little more color behind what’s driving this. Is this just more of a desire to have more of a market based approach to pricing? Or is it things you’re seeing from the emerging competition or new deals with the studios that could require higher price point over time? Or do you just want to gauge sensitivity of the customer to pricing?

Paul Davis

Yes, I mean it’s, you could say all of the above. Any prudent business person should always, at least in my opinion, should always look at price elasticity. And we would never do anything to jeopardize our value proposition that we have with our loyal consumers. So if we have the opportunity to go out and start to test that, we’ll do it in small pockets across the country. Really don’t want to add a lot of color as to what the different pricing points will be, but you can imagine that we’ll look at a lot of different scenarios. And I think more to come. You know, give us time to go out and test this and if it looks like it’s a prudent next step, then we’ll make sure we communicate it [clearly].

Operator

Your next question comes from John Kraft - D. A. Davidson & Co.

John Kraft - D. A. Davidson & Co.

I guess specifically referring to the Universal situation, I’d love an update on what’s going on there. But also specifically, I’ve noticed that it’s about a two day delay for you to get the titles into the kiosks for the Universal titles. Can you quantify the impact that it has, that two days?

Paul Davis

Yes. With respect to Universal, obviously ongoing litigation so we have no comment. There’s been no update. We have not shared because it is ongoing litigation any specific numbers with respect to what incremental costs would be for the work around Universal. Suffice it to say though that those numbers are baked into our guidance for full year 2009.

John Kraft - D. A. Davidson & Co.

And then my understanding is that on the used DVD side of things, you’re not selling very many if any through the kiosks. But I guess my question is, what percent have you been selling back roughly to the distributors? It sounds like you already had some deals with some studios that precluded you from doing that.

Paul Davis

Yes. There’s like three answers to that question. The first one is relative to the kiosk. It’s a very, very small percentage of our total revenue is actually sold at the kiosk. I think it’s less than 1%. So it’s not a big number. As it relates to previously viewed, it goes back into the market. We, you know, we don’t like really being in that business either. So in fact we’re very aligned with the studios. All the more reason that we are trying to secure copy depth deals on a going forward basis. And as I’d mentioned but I didn’t give a lot of specifics that, you know, we do have copy depth deals with a few of the studios and that’s, you know, where we’d like to eventually get to.

Does that answer your questions?

John Kraft - D. A. Davidson & Co.

Yes. I guess so. I mean you specifically did mention, though, that the gross margin was affected by, you know, declining retail values, that presumably they’ve been hit pretty hard lately and that’s not on all the DVDs that I guess you’re buying, but.

Paul Davis

That’s correct and hopefully as we add other long term agreements similar to Sony and we announce what percent of our business we do with those companies, you’ll be able to back into that math appropriately.

John Kraft - D. A. Davidson & Co.

And then I guess if I could sneak one in, the restricted stock for Sony, can you tell us a little bit more about that? Is that restricted for a certain amount of time or what?

Paul Davis

It’s restricted stock, five year vesting period and, you know, again the way we run the math it’s going to be an extra penny per quarter drag on the P&L through the end of the year. But other than that I mean it’s about as standard as it gets.

Operator

Your next question comes from Simeon Gutman - Canaccord Adams.

Simeon Gutman - Canaccord Adams

Kind of on a similar, a little bit to that previous question, you know, if you kind of had your druthers about the supply or source of the DVD, I mean would you go 100% towards copy depth? I know, you know, if you kind of had your way in assuming a normal supply without copy depth, and just factoring in resale pressure, would you still go 100% towards copy depth?

Paul Davis

Yes we would. I think if we could do that and eliminate the need to, you know, find a home for the previously viewed and buy it initially at a lower price, the answer is yes, we would do that all day.

Simeon Gutman - Canaccord Adams

And I gather that the Sony disclosure as a percent of the Redbox network, that was by virtue of the agreement because I was going to ask you if just directionally you can kind of lay out what some of the other percentages are. Or if, you know, if you can, are there any customers that are larger than that on an individual basis to Coinstar?

Paul Davis

We’re not providing that information at this time.

Simeon Gutman - Canaccord Adams

And then on the coin business, I think you mentioned at least on a single year basis the comp did take a slight positive turn in the right direction. And I don’t know if you look at it on a two year basis, I don’t know if it’s relevant for this business or not, but if you do look at it on a two year basis, the trend got a little worse, you know, and I’m just kind of layering all those factors you put in in terms of the Wal-Mart roll out. But if you look at it on that basis, you know, at least that bottoming does seem like it’s kind of coming soon. Would you concur with that? You know, if so, that means things could slowly get better but at least on a sort of one year positive basis. It could take several more quarters.

Paul Davis

Yes. You know we said all along that we think the Wal-Mart installations heavily cannibalized our same store sales on the coin front. At the same time you’ve got some overriding macroeconomic conditions. Quite candidly, it’s really hard for us at this point to tell you it’s Wal-Mart, it’s macroeconomic. I think it is interesting that Q2 we did improve from negative 5 to negative 4.3, and about 16% of our Wal-Mart installations anniversaried in Q2. So we seem to be headed the right direction and knowing that again 83, 84% of them anniversary in the second half of this year, you know, we think we’ll have a much better feed by Q3 and Q4 as to whether it was Wal-Mart or whether it was the economy as a whole.

John Harvey

Yes. The other thing to add is, you know, there’s this natural lift you get by obviously, you know, the first year anniversary once you start comping. We also think there’s, and I go back to a point you heard in the script, great opportunity to just improve our through put kind of on a same store for the 18,400 we have out there. So all the things that we’re testing in the second half of this year is really designed to improve the through put, so we’re not dependent upon anniversaring some new placements. And we’ll start sharing the data as we learn more from these tests.

Simeon Gutman - Canaccord Adams

And I guess given some of the consumer data you have or the research you’ve done, you know it does sound like it’s somewhat economic related, somewhat cannibalization. But on the economic side, you know, where are the customers? Are they not redeeming them or are they doing it themselves? And then this might even be harder, you know, how do you predict where the customer’s going to you know vote when things start to get better? Are you starting to see that in some markets, in some machines already?

Paul Davis

Yes. In general, coin and circulation so people aren’t cashing in coins as much as what they were, say, just a year, a year-and-a-half ago. So I think there is, well we know that there’s a real tight correlation between consumer confidence index and the performance of our comps. So we’ll see that as the general economy improves, coupled with what we’re doing at the machine to drive awareness, as well as at the web, you know, all those things I talked about, improving our current offerings, we think could come together and really help that business out.

Still, it’s a wonderful business with great margins that kick off a lot to the bottom line. So, you know, we love the business.

Operator

Your next question comes from Alan Robinson - RBC Capital Markets.

Alan Robinson - RBC Capital Markets

Could you give us some insight into how your overall growth strategy has changed in the wake of your decision to explore alternatives for your three non-core and non-DVD business lines. I mean specifically does this signal your shifting to preferring to build new businesses rather than to buy them going forward?

Paul Davis

Good question. I think the answer is yes. You’ll see that, first of all, there’s nothing that we can do outside of the core that’s as strong as driving Redbox and coin at this point in time. However, we think there’s a lot of white space in this automated retail sort of circle that goes well beyond where we are today. And given the choice of growing it organically or buying, we will grow the organic path. We think that’s the more prudent approach, where we go out and test on a small scale basis. We have real strict hurdles internally and once we clear those hurdles, based upon the requirements we’ve put in place, then we’ll, you know, we’ll continue to grow it to the point where we’re ready to scale.

Now that’s not to imply that we would never make an acquisition. I think if there is an acquisition out there that would fit into our space, that is, you know, on strategy, then we would absolutely look at that.

Alan Robinson - RBC Capital Markets

And then my follow up, I guess, can you give us some commentary on how the quality of the titles out there in the previous quarter impacted your DVD rentals, either positively or negatively compared to the same quarter last year?

Paul Davis

If you look at an overlap on a comp basis, remember a year ago we were overlapping the writer’s strike so you see extraordinarily high comps a year ago. So we think a 30% scrape, that number will start to come down, you know, some as our install base gets larger and larger. But specifically addressing the titles which was a year ago, you know, I’m actually not prepared to answer that right now, so.

John Harvey

I don’t have that data either. And the one thing that I want to throw out there about people looking at Redbox comp same store sales, one I think 33% any retailer would love to have in this macroeconomic environment. Two, Paul’s absolutely right. That number we fully expect will drop over time just as the proportion of newer machines that ramped very quickly entering the calculation falls relative to our installed base. And then finally, Redbox is a very young company and it’s been a very fast growing company. And because of that, it’s really hard to draw any definitive conclusions from a minimal amount of data points. And that’s really what we have at this point. We’re not like the coin business that’s been around for a long time and is a very stable business. So, you know, all that considered, I think we’re quite pleased with our Redbox same store sales in Q2.

Operator

Your next question comes from Eric Wold - Merriman Curhan Ford & Co.

Eric Wold - Merriman Curhan Ford & Co.

Just kind of getting a little bit further on the topic of exploring new product areas and channels you’re looking at, when you get to a new area that might be attractive, does the question become do you want to spend capital on that new product at the expense of capital you may have already planned for, you know, coin, Redbox? Or would you lever up to roll out a new product area while keeping the same capital spending plans for the other ones in place?

Paul Davis

Yes. You know at the end of the day that’s a great question and one we’re constantly looking at. I mean when we look at new products and new opportunities, you know, we’re running projected numbers, we’re looking at net present values, internal rates, rates of return, are they clearing our [rack] or are they clearing our hurdle rates? And then we’re basically stack ranking the priorities relative to our cash flow and our ability to fund.

You know, going forward right now we’re working on creating a long term capital structure that we believe is in the best interest of this company. We have relied very heavily to date on the commercial bank market and we are very grateful to the commercial bank market, but my background being from the airline side of the house is one in which you probably ought to have some sort of longer term financing in place because it matches your longer term assets. And it’s always good to have what I call a rainy day fund, which means you probably don’t use your revolver as a working capital fund which we’ve done to date.

So we’re going to be addressing our capital structure going forward, but again whatever we do with respect to new business it will be done prudently and it will be done in line with whatever credit metrics we’ve outlined in our free cash flow profile.

Eric Wold - Merriman Curhan Ford & Co.

Assuming that the ’09 guidance, you know, obviously includes the impact from the Sony deal that was signed, should we assume, or I mean I don’t want to assume, does the ’09 guidance assume any additional Sony type deal signed before year end? Or would those all be additive or change the model once they’re signed?

John Harvey

The guidance does indeed assume Sony economics through the end of 2009. As Paul mentioned we do have a couple of informal arrangements in place. The guidance assumes those as well. Anything incremental to that, obviously we’d have to run through the model.

Operator

Your next question comes from Robert Evans - Craig-Hallum Capital.

Robert Evans - Craig-Hallum Capital

Operating margin percent for the DVD business this quarter? Sorry if I missed that but.

John Harvey

Yes. Segment operating for DVDs this quarter was 16%.

Robert Evans - Craig-Hallum Capital

And the sequential down, is it just basically number of units installed?

John Harvey

Well again what we’ve seen taking place this year and we have factored into the numbers in the guidance for the first part of this year, declining sale back has really accelerated as that number has dropped recently. So you’re seeing a lot of that impact flowing through the numbers.

Robert Evans - Craig-Hallum Capital

So that would be the biggest component?

John Harvey

Oh yes. Without a doubt.

Robert Evans - Craig-Hallum Capital

And in the past I think the comment that was made by the ramp up of the DVD sales, year three 50k plus. I think those units have been still comping double digit positive. Does that trend still hold?

John Harvey

I would have to look to see specifically what year three comps are doing. I know we, myself I, have never given specific guidance on individual same store sales.

Paul Davis

Gregg, do you know the answer to that? Gregg Kaplan?

Gregg Kaplan

I don’t. I don’t. We’d have to check.

Robert Evans - Craig-Hallum Capital

Is it fair to say right now, I think you touched on this but you’re still trying to see where machines peak at?

Paul Davis

Oh yes. Oh yes. I mean the vast majority of our installations if you think about it are under three years. So we still have a lot of white space going forward, without a doubt.

Robert Evans - Craig-Hallum Capital

And that’s prior to any impact of you get into new categories like video games and so forth?

Paul Davis

Yes. From the Redbox perspective we just don’t have a lot of data points beyond three years where I’d be willing to come out right now and say year four does this or year five does that.

Robert Evans - Craig-Hallum Capital

Do you have a ballpark idea of how many duos you have in the field?

Paul Davis

Well there’s some teams right now. I think it’s about.

John Harvey

It’s probably up, Paul, about 1,500 or so with the plan to be around 2,000 by year end.

Paul Davis

Maybe around 10%. Just under 10% of year end number will probably be duo.

Operator

All right. Thank you and that does conclude our question-and-answer session. At this time I’ll have management please continue with any closing remarks you may have.

Paul Davis

Well, I appreciate everyone’s time and attention this afternoon. We are really excited on the quarter. I think we’re also equally excited about, you know, our future and the team that we’ve assembled here. And we’re really confident that, you know, we’ve got a great plan. So thank you very much and have a great day.

Operator

All right. Thank you. Ladies and gentlemen, this concludes the Coinstar Incorporated second quarter 2009 earnings conference call. This conference will be available for replay after 4:00 PM Pacific Daylight Time today through tomorrow at midnight. The conference replay can be accessed by dialing 1-800-406-7325 or 303-590-3030 and then put in the access code, 4120533. We thank you very much for your participation and you may now disconnect. Have a very pleasant rest of your day.

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Source: Coinstar, Inc. Q2 2009 Earnings Call Transcript
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