Cashing-In With Coinstar Inc.

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Shares of Coinstar Inc (NASDAQ:CSTR) rose 14% Tuesday after the owner/operator of Coinstar and Redbox kiosks reported earnings that beat analysts' bottomline expectations by 36%. According to the company's report, earnings were $1.00 per share for the quarter, a 47% increase from the fourth quarter of 2010. The strong results were largely attributable to a 40% increase in Redbox revenue which rose to $446 million during the period.

Coinstar Inc has turned Redbox into a household name as the demise of movie rental stores left a void in the market. Now, Coinstar Inc operates 35,400 Redbox kiosks which charge around $1.20 per night for standard DVD rentals. For the full year (2011), Coinstar Inc's revenues increased 29%, margins expanded, and earnings per share rose nearly 78%. Additionally, free cash flow more than doubled from the fourth quarter of 2010 to over $100 million. As noted by the company's CFO Scott Di Valerio, the fourth quarter results indicate that Coinstar Inc has been adept at increasing profitability while generating free cash flow.

On the surface, there are a few things to be concerned about regarding the company. First, it might be argued that as consumers increasingly opt for electronic payments, the need for automated coin-counters may diminish. However, despite the fact that the company is named for its coin-counting kiosks, the coin business accounts for only 14% (around $74 million) of net sales. Coinstar Inc. is primarily an entertainment company. Revenue from the coin business is just 'icing on the cake,' to use a well-worn metaphor. As a side note, same-store sales in the coin business actually grew during the fourth quarter.

A more pressing concern is the shift away from physical DVDs as consumers increasingly opt for streaming online content. This trend is likely to speed-up as so-called 'smart TVs' find there way into a greater percentage of homes. Additionally, if Apple (NASDAQ:AAPL) incorporates AppleTV into its Apple-branded television which is set to launch later this year, streaming content could become so seamlessly integrated into consumers' sets that leaving the house to rent physical DVDs simply would not make any sense. On Monday, Coinstar Inc stepped-up to the plate to answer this challenge by announcing a new joint venture with Verizon (NYSE:VZ) in which the two companies will invest in a new streaming business that will compete directly with Netflix (NASDAQ:NFLX). Verizon and Coinstar Inc plan to begin offering the service as early as the second quarter--Coinstar will reportedly have a 35% stake.

Another problem facing Coinstar is the possibility that other studios will go the way of TimeWarner (NYSE:TWX) and extend the waiting period that Redbox must suffer before it gets the latest releases. Recently, TimeWarner doubled the waiting period (from 28 to 56 days) to which Coinstar Inc is subjected. What TimeWarner didn't expect was that Coinstar Inc would immediately call the studio's bluff. Coinstar Inc announced it would simply buy the titles from third parties and make them available to renters immediately. This type of issue is unlikely to surface again soon as the company "recently signed deals with Sony (NYSE:SNE) and Viacom's (VIA.A) Paramount, and the only contract expiring soon is with Comcast's (NASDAQ:CMCSA) Universal Pictures" according to the Wall Street Journal.

Having said all of this, there are some significant risk factors to consider before purchasing shares of Coinstar Inc. First, and perhaps most important, is the fact that the company is being forced between a rock and a hard place regarding the move into streaming content. On the one hand, failure to get a foothold in the streaming market could cause an entertainment company to fall hopelessly behind the times. On the other hand, jumping into the streaming business could very well be the beginning of the end regarding profitability as high fees make streaming a low margin business--just ask Netflix which actually lost money on its streaming unit last quarter if you factor in results from its international operations.

Second, it is unclear how Coinstar's margins might be affected should it be forced (via studios' extension of waiting periods) to purchase a majority of its DVD's and games from third-party suppliers. As the Wall Street Journal notes, purchasing titles from third parties is obviously "more expensive than buying titles from a studio directly." It is possible then, that the company's margins could be under pressure from both the move into streaming content and from the increased cost of buying DVDs and games from third party suppliers. This might spell trouble given that the company's operating margin was only 11.4% in 2011.

With all of this in mind, I still believe shares of Coinstar Inc can go significantly higher over the next year. At $57.53 the stock trades at just 15 times analysts' consensus estimate of $3.90 per share for 2012. By comparison, investors are paying $127.50 per share for Netflix which is expected to lose money in 2012. As a final note, the company guided above what the Street was expecting regarding full-year earnings for 2012 meaning the stock may actually be even cheaper than it appears. As long as investors keep the above-mentioned risk factors in mind, Coinstar Inc. seems like a good bet.

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

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