There are plenty of articles detailing why Netflix (NFLX) is a good short. These articles make some great points, and Netflix may very well be a good short, but in our opinion it is primarily a valuation short.
Coinstar (CSTR), on the other hand, faces many of the challenges that Netflix faces, but has no subsciber base and no streaming strategy. RedBox is a business that will ultimately be rendered obsolete. The traditional coin business is also in secular decline, which the company has offset with price increases (higher percentage take on the coin kiosk) for the time being, but the secular tailwinds that caused such bullishness around Visa (V) and MasterCard (MA) (the move to a cash/coinless society) create secular headwinds for the coin business.
Coinstar’s primary growth engine, the RedBox DVD rental business, dominates an industry that is fast becoming obsolete – physical content delivery. As movies-on-demand and internet streaming of media become more and more prevalent, the DVD industry will accelerate its secular decline. Coinstar is currently priced like a growth stock and garners the correspondingly high multiple because it has been a strong growth story by taking significant market share, albeit in a slowly dying medium. As the company saturates the market, its organic growth will slow, and as the industry’s secular trends accelerate, this will become overwhelming. Ultimately, the obsolescence of DVD will cause sales to plateau, then decline, resulting in a significant multiple contraction.
- There is a strong secular headwind as DVD will inevitably be rendered obsolete by video-on-demand, web streaming, and digital media.
- Obsolescence, in our opinion, is likely to happen sooner and faster than the 10 to 20 years physical DVD rental companies would like to believe.
- In the meantime, new competition within the space from NCR’s Blockbuster Express kiosk, which is considered to be a more advanced technologically with digital download and point of sales capabilities, could reduce Coinstar’s ability to grow its footprint.
- Content providers dislike the rental market in general and should look for ways to dis-intermediate RedBox.
- Coinstar does not have long-term contracts with its two largest RedBox customers (WMT and MCD, at 21% and 11% of sales, respectively).
- Installing and maintaining the machines is somewhat capital intensive, the business has and will continue to have limited ability to create and harvest free cash flow.
- The DVD life expectancy is really a minimum of 10 years, potentially longer.
- Brick and mortar bankruptcies increase the addressable market for DVD kiosks.
- The company could have the ability to raise prices in the interim.
- Coinstar is able to develop and transition the RedBox brand to a successful web/video on demand strategy.
- Content providers are unable or unwilling to pursue a more comprehensive streaming/video on demand strategy.
Risks to the Short:
- Coinstar continues to take share in a declining market, growing faster than expected.
- Coinstar is able to find another profitable use for their RedBox units or successfully pursues and profits from other kiosk ventures: health & beauty, coffee, and the “ecoATM” (a cell phone recycling unit that pays the seller cash for their old phone).
The price target of $31.50 is based on a discounted cash flow analysis, giving the company full credit for growth that is expected to occur the remainder of this year into 2011 and 2012, from which I have modeled sales growth in 2012 of 10%, declining to 0% in 2014. After that I applied a terminal value of 8x to those earnings, comparable to GameStop (GME), another business retail content provider deemed by the market to be going obsolete. This, plus discounting interim cash flows, results in a price of $31.50, $20.00 of which is driven by the terminal value, which is arguably high given the very real risk of obsolescence.