Why I'm Maintaining My Long Position in Coinstar

| About: Outerwall Inc. (OUTR)

On February 25th, JPMorgan downgraded Coinstar (NASDAQ:CSTR) to neutral with a $42.00 price target, citing competition from streaming video companies such as Netflix (NASDAQ:NFLX), increased costs from Hollywood studios which could pressure margins, and the fact that Coinstar is forced by studios to wait 28 days before releasing new DVD titles. They believe that these concerns make for negatives on both the revenue and margin sides of the business. While I share some concern with regards to Hollywood studio fees increasing, as well as the 28 day hold, I believe that JPMorgan may be making too much of these factors while overlooking some other important issues.

Not everyone streams movies on laptops or watches on their TV through Wii (OTCPK:NTDOY). Personally, I do not own a Wii or any other device with which to watch movies streaming on my TV, nor do I want to watch movies on my computer. I do not believe that I am alone. Here in the Dallas area, I see steady traffic at Redbox movie kiosks, particularly in lower income areas. These consumers likely do not want to have the burden of, or perhaps cannot even afford, a Netflix subscription. They may not even have a credit card through which to run the subscription. However, $1.00 for the occasional movie rental is well within anyone's budget.

Blockbuster (BBI) is dying on the vine. Whether it is sold or is liquidated, there will be a massive number of store closings. There have already been a great deal of store closings announced and last night came word that the Justice Department wants Blockbuster liquidated. Per Home Media Magazine (see here):

Tracy Hope Davis, a United States trustee for Region 2, filed the motion Feb. 28 with U.S. Bankruptcy Court in New York regarding Blockbuster’s attempt to begin an asset auction sale with a $265 million bid from a group of senior lenders. Davis, in her filing, said Blockbuster’s proposed auction process will only benefit senior lenders and leave little or nothing for the Dallas-based rental icon.

“Based on the monthly operating reports and other information, it appears unlikely that there will be any balance to be paid to [Blockbuster following a sale],” Davis wrote.

As a result of insufficient operating funds post sale, the Justice Department is urging a Chapter 7 liquidation. That's right... Blockbuster would totally vanish from the landscape, leaving no physical media choice other than Coinstar, the occasional independent video store, or Netflix by mail subscription.

I believe this substantially changes the competitive landscape. When the only option for physical media is via mail with Netflix by subscription or Redbox for a one time $1.00 rental, the 28 day hold before release period will matter less in the equation.

Additional fees imposed by the Hollywood studios may be less of an issue if Blockbuster ceases to exist. Studios still need to release their titles to the public. I believe the position of Hollywood studios to force higher fees from Coinstar or Netflix might be somewhat less with Blockbuster out of the picture. I know if I were in charge of a major studio and I saw a substantial part of my distribution channel disappear before my eyes, I might think twice about squeezing what players remain.

Of course there is always the possibility that Coinstar itself could enter into a major streaming relationship in the very near future. Coinstar has said repeatedly that it is in talks with big players on such an arrangement. While I am not sure how this would immediately affect margin dynamics, the excitement over such an announcement is sure to cause a considerable pop in the stock price.

And that possibility brings us to the final point. According to ShortSqueeze.com, as of March 1st there were about 9.7 million shares of Coinstar held short against 31m shares outstanding. An almost 30% short interest! Any material news could create a massive short squeeze in Coinstar given such a high short interest. I would not want to be short Coinstar on any positive news.

Disclosure: I am long CSTR.