What Jim Chanos Is Missing On Coinstar

| About: Outerwall Inc. (OUTR)

Jim Chanos mentioned on CNBC on the morning of 4/12/12 that he is short Coinstar (NASDAQ:CSTR). The rather obvious thesis was that streaming would someday supplant DVD rentals. He put Coinstar in the bucket of companies threatened by technological obsolescence.

Fair enough, someday in the future it is likely that streaming overcomes physical distribution of media for movie rentals. But, that day is very far into the future.

There are a few things that Mr. Chanos is missing in his analysis. Given the seeming similarities, Mr. Chanos is likely using the MP3 vs. CD analogy as justification for his belief. I believe that the fundamentals of the movie and music businesses are drastically different, thus altering the pace of obsolescence of physical media for the DVD rental market.

Let's look at the simple fact that movies are often rented. Were CDs rented? No. Why would billion dollar businesses be built around the rental of movies, but not around music? Doesn't that point to a significantly different consumer usage model, and thus partly discredit the MP3/CD vs. movies analogy? I think so.

CDs cost $13.99 or so when MP3s came on the scene, while pulling up two new Redbox releases, Iron Lady and The Descendants on Amazon, shows they can be acquired for $14.99 (or you can buy the digital version for $14.99 on iTunes). So, the upfront cost of the movie is roughly the same as a CD. However, one typically views a movie once or twice, whereas one may listen to an album 20-30 times, or even more. So, on a price per unit of time basis, music is enormously cheaper. Hence, there is a rental market for movies where there was none for music (consumers effectively "share" the purchase of the movie via a rental market). This value relationship is unlikely to change, therefore, I believe that it is a certainty that we can count on a rental market for movies in the future.

Why is this important? Admittedly, physical DVD purchases will be cannibalized more quickly by their digital counterparts (similar to MP3s once bandwidth improves and storage devices become mainstream). But, it is unlikely that the rental market will move that direction at a quick pace. How come? Well, there is this Supreme Court ruling often called the "First Sale Doctrine".

Very importantly, for our purposes here, it only applies to physical media. It effectively caps how much a company (like Redbox or Netflix) has to pay for the physical media version of a movie. For, if the studios try and charge too much to Redbox or Netflix for the physical media, Redbox or Netflix can legally buy a physical copy at retail or through wholesale channels and rent that version. This is not relevant for the digital version of the same movie. Hence, there is a massive difference in the pricing structure for physical vs. digital in the rental market for DVDs. The studios can price the streaming version wherever they want, whereas there is a cap of the retail price for the physical version. That's why right now Netflix will send you this week's new releases, The Descendants or Iron Lady, but good luck finding them on Netflix's streaming service. It's also why Redbox will rent those movies to you for $1.20 a night, whereas a 48-hour rental on Amazon.com3) or 24-hour rental on iTunes will cost you $3.99. Yes, it is 3.3X as expensive to rent the digital version vs. the physical version at Redbox. Amazon isn't known for their price gouging, so it is likely that the studios are charging Apple and Amazon somewhere near $3.50 for the digital version (per stream) that Redbox pays about $.60 for per rental night. In other words, there is a massive price difference in digital vs. physical for movie rentals that is not likely to change anytime soon.

The studios have zero incentive to lower the price of a rental stream, especially of new releases, which are the bread and butter of the physical DVD rental market.

  1. The studios rely on sales of the movie to consumers (digital or physical) for a large chunk of profits. Making rentals streams too cheap would cannibalize this very profitable segment of their business.
  2. The studios don't want to provide an unlimited streaming option of new releases to streaming providers (like Netflix) as again that would take away their profit on movie sales (especially in the new release window when they do the bulk of their sales volumes).
  3. As is, they are able to charge a fortune to Netflix and Amazon and Google for their old library content that doesn't include their new releases. Don't expect the studios to cut prices on rental streams anytime soon. And, until that pricing difference changes, expect Coinstar to do just fine, and physical DVD rentals to remain a prominent feature of the market.

There are other factors that point to the continued success of Redbox and a slow transition to digital in the rental market:

  • Verizon teaming up with Redbox. Due to the First Sale Doctrine, and the essential monopolization of new release content by physical DVDs, Verizon knew their only chance to make an impact in the streaming video market was to team up with Redbox. Consumers want new and fresh content. Outside of buying Netflix, Verizon knew a JV with Redbox would be the best way to get consumer share of mind for their streaming endeavor. Without access to new releases, their streaming venture would have no competitive advantage versus all the others. Their only other alternative was to pay studios $3.50 per stream to "rent" new release content to consumers and charge $35 per month to make it work. Something tells me the consumer adoption of that model at such a price would be approximately 0. Given Redbox's positioning with consumers, and the desire of many companies to enter the streaming market, don't be surprised if Verizon ultimately pulls the trigger and buys Coinstar to solidify and bolster their competitive position. It would give them the most differentiated offering out there and essentially provide consumers a full-fledged alternative to the old physical+streaming Netflix. Many people who fled Netflix after the pricing gaffe, will probably flock to this alternative.
  • Redbox's recent 20% price increase had a negligible impact on volumes. If there was going to be a transition away from physical DVDs, this should have greatly accelerated that move. It hasn't, which doesn't surprise me. After all, remember the pricing umbrella for a streaming rental is still 3.3X. Volumes in Q4 stayed strong after their pricing move, showing that the physical DVD rental market has much more underlying support than Mr. Chanos believes.
  • If the physical market was really going to evaporate for rentals, wouldn't Apple have already made a bigger impact, more than four years (MacWorld Expo 2008) after they started renting movies on iTunes (and six years after they started selling movies)? They already have millions and millions of people accustomed to downloading content. They have a strong presence with devices like the iPad, making the viewing on non-traditional formats enticing. Frankly, it is very telling that Apple's movie rental service is not widely discussed despite Apple's dominance of all things digital and media related. Four years in and it still hasn't had a meaningful impact on Redbox. (Hint: it's likely because the prices are too high relative to Redbox. Apple would change that if it could, but it simply can't!)

In summary, using a physical to digital transition for rented movies modeled on MP3s and CDs is like comparing apples and oranges. It is based on false logic, as the movie rental market is completely different from the CD purchase market because of the First Sale Doctrine. Connecting the two is sloppy, as it completely overlooks the true structures of these markets. Sorry, Mr. Chanos, but I am pretty sure you can count on Redbox to see continued success with their enormously profitable model.

Disclosure: I am long CSTR.