After having a bull run since 2009, 2012 might finally present a great opportunity to take a short position in Coinstar (CSTR). This will be especially true, if the following catalysts pan out:
- Short: Coinstar
- Current share price: $61.00
- Potential Return: $15 to $20 however shares may trade up approx. $8 in the short term
- Market Capitalization: $1.88B
- Cash: $260M; Total Debt: $347M
- Shares Outstanding: Approximately 31M
- Sector: Services Industry: Specialty Retail
- FCF/Share:$7.32; P/E:19x
- Trading timeline: 15 to 18 months
Important timeline: 3Q-2012
- Main Catalyst: Content costs, Studio relationships, Marginally declining business, Interchange fees, Heavy competition, mispriced JV
- Inflection points: Continued decline in organic revenue growth rate, outcome of interchange fee negotiations in 2012, details in 2012 of Verizon JV and of synergies on recent acquisition
- How might I trade: Start a very small tracking position and build a short in the second half of 2012 (2H-2012)
2H-2012 might present a great opportunity to take a short position in CSTR. This opportunity might sound contradictory because CSTR reported an average 30% increase in YoY revenue since 2009 and its largest segment, Redbox, which constitutes 85% of the total CSTR revenue and also its biggest growth driver reported average revenue growth of 14% since 2009. Moreover, EPS for the firm has grown over 100% since 2009. So why do I make a case for a short? Because there are two major parameters that drive CSTR's share price and give it an advantage in my opinion - revenue growth and low pricing strategy. However there are couple of reasons due to which CSTR's growth might slow down and its pricing advantage may eventually disappear and therefore investors who might be bidding up CSTR shares might want to pay attention to.
First is the substantial increase in content costs and potentially intense competition. Just analyzing the financial statements from 2010 to 2011 alone, the payout to studio's for 2013, 2014 and 2015 has increased 45% while revenues have increased approx. 30%. This substantial cost increase comes in addition to increase in recent interchange fee and heavy competition.
Second is the potential rift with studio's that might unravel materially impacting the firm. Warner which constituted 15% of CSTR's total DVD's did not renew its contract in 2012. Universal studio's contract, another major content provider, was up for renewal and was renewed on 29th- Feb-2012 with “Amendments to revenue sharing agreement”, details of which have not been disclosed.However, looking at the 45% YoY increase in studio payouts, the numbers don’t look very encouraging. Both studios were involved in very similar legal battles with CSTR back in 2008-2009.
Third might be the fact that CSTR's 30% revenue growth since 2009 might have come at the expense of the firm already installing its most marginally profitable kiosks in the most populated locations. Marginal analysis performed on these additional kiosks shows the current business model based on revenue growth and low cost might not be sustainable. This is especially concerning due to CSTR's dependency on revenue growth as the major driver of its stock price. Retail partners constituting 50% of CSTR's revenues have a combined total of approximately 31,000 stores in the US while CSTR has 35,000 DVD kiosks in operation at approximately 30,000 locations. I believe that further expansion through more kiosks might not be marginally profitable and CSTR might lose its pricing advantage in the medium term due to increased competitive pressure and rising costs, making the continued assumption for high revenue growth in the near term less credible.
Another major segment, the coin counting business, which reports higher operating margin of the two, has also been slowly in decline and now only constitutes a mere 15% of total revenue- a reduction from 46% in 2007. Redbox has been given rave reviews by the street, however, if the above factors were to pan out, CSTR might be poised for a slowdown in the next 12 to 15 months putting material stress on its stock price. The last cause of concern is the major uptick in the stock price after announcement of Verizon JV and NCR acquisition. Low on details, I do not believe Verizon JV will be very beneficial to CSTR shareholders in the future. However, the NCR acquisition might give a short term upside in the share price presenting an opportunity to short the firm.
Understanding Coinstar - Little History
Coinstar which initially started as a coin counting business went public via an IPO in July 1997. The firm has grown through a series of M&A starting in 2005. After starting as an operator of coin counting machine, CSTR entered into the DVD kiosk market by providing DVD express in 2005. Few months later, in November 2005, CSTR invested $20m for a 48% ownership in Redbox which operated 400 DVD kiosks at that time and was owned by McDonald. Then in January 2008, CSTR took a majority ownership in Redbox to 51% for another $5m and in February of 2009 acquired the rest of the remaining 45% from GetAMovie (GAM) for cash and stock totaling approx. $140M according to some industry reports and paid further $20M for minority interests, thus completing its ownership of Redbox.
CSTR also ventured into other businesses which it finally got out of. For example, in May 2006, CSTR acquired money transfer business operating in approx. 142 countries. This business was further grown by acquisitions made in 2008 however the operation was discontinued in second quarter of 2010 and sold in June 2011 to GroupEx Financial. Also in 2010, the E-Pay Business was also sold to InComm Holdings, Inc for $40M. In addition, CSTR also excited the entertainment business in 2009. These divestitures left Coinstar operating under two primary businesses - Redbox and Coin Counting.
CSTR's Redbox segment operates DVD kiosks in every state, as well as Puerto Rico. These kiosks are installed primarily at leading grocery stores, mass retailers, drug stores, restaurants and convenience stores including Wal-Mart (WMT), Walgreens (WAG), Kroger (KR) and McDonalds (MCD). Four of these retailers constitute approximately 50% of Redbox's sales. The kiosks act like traditional video rental stores, where consumers use credit cards to rent movies. Redbox has no membership fees. According to some court documents, a single kiosk may contain up to 700 DVD with 70 to 200 different titles. Redbox charges a flat fee plus tax for one night and same fee for additional nights. This fee was recently increased by 20% to $1.20 per DVD per day with consumers able to pick and drop movie at any location - a patent which expired in 2010. Redbox also sells video games and blue ray disks however, according to CSTR's own admission; Blue rays have negative impact on margins even though they bring in more dollars.
Business Drivers -
Redbox is the major driver for CSTR constituting 85% of the total revenue. The major factors that affect revenue are: 1) access to number of titles released every year, 2) Increasing kiosk footprint, 3) pricing policy 4) number of days from the movie release to the titles made available to Redbox customers,5) content costs and, 6) product mix.
QoQ revenue has been volatiles because titles released every year or quarter varies. The number of titles released and the success of those movies determine how much additional revenue CSTR can generate. Furthermore, Redbox only has access to limited number of titles, mostly new ones. Since the release schedule depends on the studios and not with the firm, it makes the revenues volatile The firm has tried to start new ventures to potentially negate revenue volatility but hasn't had much success yet and revenue concentration with the Redbox segment remains a concern. The concern is further exacerbated by my belief that most of the low hanging fruit in terms of capturing marginally lucrative markets might have been already captured by the firm, giving it 30%+ YoY growth over the last three years. Therefore, even if the firm increases the number of kiosks, they might not be as much incrementally profitable as the previous ones. However, the firm to its credit has taken some steps recently such as recent JV and acquisition; but it has been short on details. From what I do know, I believe the JV will not compensate for the potential marginal decline in future revenues, especially when CSTR is trying to compete against the likes of Netflix, Amazon and Hulu - firms that have more resources and own more content than CSTR.
Fourth point alludes to the title availability to clients, an important factor to retain and increase client footprint. Currently, CSTR has arrangement with certain studio's to release DVD's on street date, the same day DVD's are made available to retailers. However, Redbox's low pricing policy costs the studios and undercuts their margins. It's because studios that release DVD's to retailers earn approx. $3 -$4 per title as opposed to Redbox which only charges an average of $1-$2 per title. Therefore, incentive for studios to maintain Redbox's 28 day window is high. In January, 2012, Warner, one of the major DVD providers to Redbox (15% of total DVD's) decided to not continue its relationship with the firm, because it refused to reduce the number of days related to its DVD release to Redbox clients. This forced CSTR to acquire titles from outside thereby increasing its costs for DVD acquisition.
As content costs rise in the future and CSTR dependence on low pricing policy remains its major differentiator, future capability of the firm to satisfy customer demands while still maintaining its current cost structure remains a major concern. Rising prices makes demand for Redbox inelastic. Supporting this thesis is the recent 20% price hike for DVD rentals due to increase in interchange fee and content cost. Lastly, the firm has tried to diversify its product offering by offering games and blue ray DVD's which constitute 4% -6% and 7%-8% of total Redbox sales, respectively. By the firm's own account, even though Blue-rays bring in more dollars to the firm, they are not accretive to the firm's margins. With major drivers potentially under stress within the next 12 -15 months, it might be difficult for CSTR to justify its current share price.
CSTR originally started as a coin counting business with the installation of the first Coinstar unit in 1994. CSTR is a leader in the self-service coin-counting services market in the U.S. and own and operate the only multi-national, fully automated network of self-service coin-counting machines across the U.S., Canada, Puerto Rico, Ireland and the UK. CSTR owns approximately 20,200 coin-counting machines (approximately 12,100 of which offer a variety of stored value products to consumers) in 19,900 locations. The firm provides service to retailers such as Kroger and Wal-Mart. The revenue is generated through transaction fees which currently is 9.8% of per transaction, of which certain percentage is shared with the retailer. Consumers feed loose change into the machines, which count the change and then dispense vouchers or, in some cases, issue stored value products.
Business Drivers -
Coin went from being 46% of the total revenue in 2007 to 15% in 2011. Despite the reduction in the total revenue contribution, Coin still reports higher operating margins of the two: 25% for Coin and only 11% for Redbox. The major driver for this segment is the volume of coins people choose to count. The firm estimates that at any one time, there is $7B to $10B worth of coin sitting idle. Despite high number of idle coins, Coin revenues have only increased from $250M in 2007 to $280M in 2011. The relatively anemic growth in the business can be partially explained by the competition the firm faces from the likes of banks that are offering free coin counting services to their clients. Another reason is the reduction in the coin counting volume by customers due to CSTR's price increase from 8.9% to 9.8% this year. Moreover, coin counting patent for the firm expires in September 2012, creating further downside pressure on this segment as competition expands into this space. Another concern is the low pricing power that the firm has. If consumers elect to have a stored value product issued instead of a voucher, the transaction fee normally charged to the consumer is charged instead to the card issuers such as the retail stores. In recent month, retailers have increased pressure on the firm to give them the greater share of its revenue or to make other financial concessions to win or retain their business. With patent expiration, intense competition from banks and incremental revenue sharing pressure from retail partners, this segment even with its higher operating margins may potentially come under stress within the next 12 to 15 months.
Studio relationships and increased content costs may directly impact profits and CSTR's pricing policy -
Redbox's business model revolves around its relationship with movie studio. This relationship is most crucial to Redbox being able to maintain its pricing advantage. Traditionally, businesses such as CSTR that rent movies in physical formats, such as DVDs, have enjoyed a competitive advantage. After the initial theatrical release of a movie, the major studios generally have made their movies available on physical formats for a 30- to 45-day release window before release to other movie distribution rental channels, such as pay-per view, video-on-demand, basic cable, and others.
This release window has been beneficial to firms such as Redbox which have in certain cases enjoyed the first mover advantage in providing movies to customers before they become available through other mediums. However, this trend is changing as certain studios are making their content available to other media channels before the release window in addition to selling it in DVD format. Furthermore, over the last few years, certain studios have implemented or announced their intention to implement policies to lengthen the time that certain video retailers such as Redbox must wait following their initial release on DVD. This 28-day delayed rental window negatively impacts Redbox. The delay makes sense for the studios who can earn as much as $4.00 a title via immediate release of DVD's to certain retailers as opposed to Redbox which rents out these movies for $1.20 a title. But to remain competitive, its essential for Redbox to have access to all new movies immediately so it can continue to increase its client footprint.
To assure access to titles immediately, Redbox in 2008 and 2009 took Universal Studios, 20th Century Fox and Warner studio's to court. But CSTR could not win and later reached a settlement and withdrew its cases. The cases related to studio's demanding 28-30 day delayed window for release of new DVD titles. One of those three studio, Warner which constituting 15% of total CSTR DVD volume, decided not to renew its contract in 2012, thereby impacting Redbox's cost basis for acquiring DVD's. Universal Studio's was exactly in similar lawsuit with CSTR in 2008 and its contract which was up for renewal on 21-April-2012 was renewed on 29-Feb-2012 However, it came as a cost. Firm stated that it renewed these contracts after “amendment to the revenue sharing agreement”, however firm did not provide any further details. However the apparent 45% YoY increase in studio payouts are likely to impact Redbox's bottom-line in the next 3 to 4 quarters. Another studio, 20th Century Fox, which has already once asked wholesalers to stop selling DVDs to Redbox in 2009 before reaching an agreement, has an option to rescind its contract in April 2013. Studios hold a lot of pricing power as they are major providers of content and will apparently only compromise with Redbox at a cost. Even though CSTR has been able to reduce the 28 day window with certain studios, its payments to them from 2013 to 2015 have increase by 45% YoY ($3 per share after tax in 2013) in 2011 - time when it settled with or extended contracts with studio.
Another major issue is Redbox's relationship with wholesales. When Redbox buys 15-30 titles of the same movies, wholesalers usually sign a simultaneous contract to buy certain amount of titles back from Redbox. These contracts directly affect margins of Redbox's DVD services business in part by their ability to negotiate favorable sell-back terms for DVDs at the end of their rental life. According to the firm, the price at which CSTR can sell back DVDs under these arrangements has declined in recent periods thereby increasing Redbox's cost basis. Furthermore, Redbox entered into certain studio licensing arrangements that require the destruction of certain DVD titles at the end of their rental life. If the relationships with studio's are not renewed, then not only CSTR has to acquire DVD's at a higher cost, but it also risks dissatisfying its clients and making its inventory obsolete as it may not able to sell the acquired titles and replace them with new ones in time. With revenues in previous years increasing 30% YoY and poised to grow at a slower rate, increase in content costs will become a major catalyst that will drive's the firms bottom-line. Given the trend in increasing content costs and my assumptions about decline in firm's revenue growth rates, it does not bode well the CSTR shareholders in the medium term.
Increase interchange fee negatively impacting the bottom line -
When CSTR reported 4Q results, it stated that one of the reason for a 20% increased prices it charges to customers is due to increase in interchange fee. In the case of Redbox, every extra day a customer keeps a DVD, a separate transaction is charged and for every transaction, Redbox is obligated to pay an interchange fee to the credit card companies such as Visa and MasterCard. Since Redbox's sales are directly related to the transactions it processes substantial increase in the interchange fee might have a material impact on CSTR. CSTR has spoken about moving to a single transaction system, but the details are not out yet. Furthermore, full impact of the increase in interchange fee, estimated to be $0.22 a transaction, has yet not been felt, since the company was able to negotiate a temporary reprieve with credit card companies for the last 2 months of 2011. One of the major catalysts to maintain low interchange fees will be the volume of transactions and the sales CSTR can generate in the future. However, if the firm cannot sustain substantial growth and negotiate a long term contract to lower interchange fee in 2012, it will create further downside for the shareholders.
Marginal Analysis shows an unsustainable business model -
Lot of people speak about what has happened - a.k.a., a great revenue growth, JV with Verizon, increased footprint, recent acquisition and major contracts with retailers. However, marginal analysis paints a different picture. Marginal analysis leads me to believe that the 35% increase in the stock price over the last year may not be sustainable in the future because CSTR's low pricing strategy in addition to increasing costs are putting stress on its existing business model. Why in the world did I spend so much time doing this marginal analysis? One, I did not find it anywhere else and it was fun! Marginal analysis looks into the profitability of every extra kiosk that Redbox deploys. More importantly, it shows what the incremental value of Redbox's growth is to shareholders.
This analysis reveals that the revenue growth, CSTR's most important share price driver might not be sustainable! Results indicate that incremental revenue per kiosk has been volatile. Since 2007 the incremental revenue per machine remained flat at approx. $52,000 to 55,000 per machine. Although operating revenue per machine has improved partially due to higher revenue, major credit goes to lower expense including options expense, lower amortization expense and lower R&D. Furthermore, since FY-09, incremental rental of DVD's per day for every extra kiosks installed have remained volatile with total rental per machine per day remaining almost flat at 13 titles a day. Moreover, comparing QoQ numbers on a yearly basis, meaning 2Q-10 compared to 2Q-11, the total incremental rentals per extra machine installed have remained flat or slightly declined since FY-10. Furthermore, if we average the number of times a DVD has been rented out, it remains flat at 7 times a year since 1Q-10. The business seems to marginally decline or be flat despite installation of 10,600 extra kiosks since 1Q-10. It means that the numbers have grown because Redbox installed more kiosk, however, every kiosks installed has not been marginally profitable to the firm.
The story with the coin counting business remains more or less the same, however, the coin counting business does enjoy higher operating margins. Given the recent increase in rental pricing, recent increase in content costs and if assumption that most of the marginally profitable business has already been captured were to be true, it does not bode well for shareholders. These numbers do raise some serious concern about the profitability of the existing business model over the next 4 to 6 quarters
Competitive space might force CSTR to question its low pricing strategy -
As I mentioned earlier, it's in the interest of studios that provide content to CSTR to delay the release of their DVD's via Redbox since it undercuts their profits by a wide margin. If the studios succumb to CSTR demands than they will demand higher payouts which CSTR will eventually have to pass on to consumers. Moreover, studio's have recently experimented with releasing titles early to consumers through pay per view and other channels which might pose threat to Redbox. In addition, CSTR's biggest retail partner, Wal-Mart (WMT), recently signed a deal with "Ultraviolet", a program backed by several studios where the retailer agreed to help its customers digitize movies and store them in the cloud. Some reports said that WMT might charge an extra $2 for the service which might demotivate people from digitizing movies.
However, with time, as costs come down, this library of content can pose a threat to Redbox. Netflix (NFLX), one of CSTR's biggest competitors is already negotiating agreements with certain cable companies and Apple. Netflix that is already streaming content online enjoys viewership from 30% of Redbox's consumers while 20% of Netflix consumers use Redbox. Other firms are also trying to crowd this space, including Intel's attempt to come up with online TV. In its efforts to bring programming online Intel recently hired a guy from British broadcasting who is heading a team in London. Others efforts to enter the space have been from the likes of Samsung, Sony, Microsoft and Google. The concern is that most of these players have way much more dry powder, a.k.a cash to acquire content and compete in this space. Big tech firms might also have the technology to devise ways to bring content online at prices competitive to those of Redbox.
Verizon JV and NCR acquisition may be priced in but not understood -
On 03-Feb-12, CSTR announced an agreement between Redbox and Verizon to launch a nationwide "over-the-top" video distribution service which will provide consumers with access to video programming content delivered via broadband networks and offering rental of physical DVDs and Blue-ray Discs from Redbox kiosks. The stock price jumped substantially after the announcement; however, there are some things that need to be noted. One, Redbox is initially acquiring a 35% of the JV and will make an initial capital contribution of $14M. If Redbox contributes its pro rata share of the first $450M of capex to the JV, Redbox's interest cannot be diluted below 10.0%. The service is suppose to be subscription-based, meaning consumers will pay a fixed fee every time period to avail this service - a revenue model in which Netflix and Amazon currently dominate.
A new addition to the list is Hulu which has made considerable inroads with consumers. In addition, Verizon (VZ) holds the decision making power in this JV. In my view, if the JV were to remain competitive it might be required to acquire additional content at a higher cost. If they chose to do so, I believe Redbox will opt out of the JV when it can. Additionally, Redbox only controls 35% of the JV and hence the incremental revenue that the firm will get from this venture still remains to be seen.
Another major event was the 03-Feb-12, agreement to acquire approximately 10,000 NCR's DVD kiosk for $100M, or $10,000 per kiosk. Additionally, Redbox intends to enter into a strategic arrangement with NCR for manufacturing and services during the five-year period post-closing for a guarantee of another $25M. This transaction is expected to close in 3Q-12 giving a temporary bump to CSTR's top line and hence might give a floor to he stock price. However, when asked how many of these 10K kiosks would have originally qualified as per Redbox requirements, the management did not have an answer! Moreover, all these kiosks, according to some reports need to be remodeled to suit Redbox, adding incremental costs to the firm. Once the affect of this acquisition wears off and more details emerge about the JV, I believe it will be hard to justify a substantial increase in the share price of this company.
Fundamentally overvalued -
The Company currently has $260M available on the balance sheet while total debt remains at $374M. For FY-11, company reported a total revenue of $1.8B, an increase of $401M. Of the $401M, the company stated that $206M came from same store sales while $196M came from installation of new kiosks. The firm also mentioned that some of the main drivers of the operating income were due to lower interchange fee negotiated for 2 months ending December, 2011, better that expected elasticity to price increase, R&D benefit from lower spend, less income tax expense and lower amortization costs. Although debt is not a current concern, but if the firm's convertible debt gets converted, it can be material to the firm. CSTR generated $227M in FCF in FY-11.
CSTR's new credit facility matures in 2016 while the convertible debt matures in September, 2014. The firm currently seems to be in compliance with its covenants. If CSTR is valued using SOTP analysis and comparative analysis by using Revx; EV/EBITAx; FCFx and Forward P/E multiples, it yields prices in the range from $35 per share to $53 a share. Sensitivity analysis leads to the conclusion that any change in revenue affecting CSTR's bottom-line will put major stress on the firm. Having said that, CSTR shares may rise in the short term (probably next 2 quarters), due to NCR acquisition and Verizon JV. Additionally, CSTR has $262M allocated to share buybacks. However, sources of stress in the medium term far outnumber the positives thereby ultimately causing the stock price to come down from its current valuations.