We Know Netflix Is Doomed: What About Coinstar?

| About: Outerwall Inc. (OUTR)

Things have gone from bad to worse at Netflix (NASDAQ:NFLX) over the past few months, and the stock has crashed from over $300 to its current trading range in the mid-$60s. This disaster could be spotted a mile away by knowledgable investors (and was highlighted on SA many times). Netflix had an unsustainable business model and could not pay for both DVDs and content costs at a $9.99/month price point (for 1 DVD at a time). But when the company tried to fix this by raising the price for this service to $15.98, outraged customers left Netflix in droves. The anger increased when Netflix announced that it would split into two companies, forcing the company to abandon that idea. Subsequently, Netflix has endured multiple downward guidance revisions, culminating in the most recent news that it will be unprofitable for all of 2012, forcing the company to raise cash by diluting existing shareholders.

At least initially, analysts predicted that Netflix's woes would be very good news for Redbox owner Coinstar (NASDAQ:CSTR). However, the stock has lost a solid 20% since the Netflix announcement. (Data from Yahoo Finance) The vast majority of this loss has come since the company's earnings report on October 27. In that report, Coinstar announced that it would be raising prices on Redbox DVDs from $1 to $1.20. This price increase was designed to offset expected increases in debit card fees related to the Durbin Amendment. The stock's difficulties since that date have been largely attributable to 1) fear that the price increase will drive away customers; and 2) fear that the debit card changes will permanently damage gross margins, as evidenced by Coinstar's lower-than-expected guidance for Q4.

Neither of these challenges should be more than a very temporary setback. With regard to the price increase, it's true that there's something alluring about selling something for just a dollar. $1.20 DVD rentals doesn't provide the same kind of marketing panache. That said, this is not the kind of increase that will drive customers away en masse. While Netflix's claims that the $6/month increase was equivalent to "a latte" and that the service was still an extremely good value proposition failed to soften the blow, Redbox has a much smaller mountain to climb. Netflix had to convince customers to part with an additional $72 a year. Redbox users would only spend an additional $72/year if they rented a Redbox DVD every night of the year. Due to its business structure, Redbox caters more to occasional DVD watchers. Since there really is no lower-price option relative to Redbox, I expect these customers to gladly part with a few extra dollars per year.

With respect to the debit card fee worries, one analyst opined last week that fees will fall in the future as Coinstar negotiates agreements with debit card processors. I agree that this is the likely outcome. Redbox processes such a large number of transactions that Coinstar probably has the leverage necessary to get a better deal on debit card fees. With this sort of arrangement, the price increase would lead to better gross margins than previously and a significant uptick in EPS.

Coinstar is a business that still offers strong growth opportunities, and yet it trades at a forward P/E ratio of only 11. There are lingering concerns about whether the DVD will go out of fashion and be replaced by an all-streaming model of video consumption. However, thus far no competitor has successfully challenged the low-cost video rental model Coinstar pioneered with its Redbox kiosks. With nearly ubiquitous kiosks, the inconvenience of going to pick up a DVD at Redbox is minimal, and well worth the savings compared with online services like Netflix and video-on-demand services that providers such as Comcast (NASDAQ:CMCSA) offer. Any downside is easily outweighed by Coinstar's upside potential, and the stock is a good buy candidate. I would look for an entry point around $40 if the stock market pulls back this week.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.