|Shares Out. (in M):||32||P/E||13.0x||11.5x|
|Market Cap (in M):||1,300||P/FCF||15.0x||10.0x|
|Net Debt (in M):||150||EBIT||142||183|
Coinstar, which is better known for its solid, deep-moated coin processing business, is now driving quite a bit of shareholder value with its Redbox unit. Short Sellers believe that physical distribution of DVD/Blu-ray is a dying technology that will be replaced by some manner of digital distribution. While new may be better, old doesn’t go away overnight, and sometimes ‘old’ can still prosper within a niche market segment. I believe that Redbox’s niche service is innovative enough to extend the life of physical distribution of entertainment content. Coinstar shares don’t fully price in the value of this Redbox Unit, which for reasons I will lay out, is a longer tail business than short sellers currently realize.
In short, the market is overpricing the value of new digital distribution, while under pricing the value an old but innovative physical distribution model.
The Redbox Value Proposition:
Redbox takes low productivity “4th-wall” retail space and turns it into money making, traffic generating space. Redbox pays a small percentage of revenues to the retailer, who also benefits from the boost in traffic. Aside from price, Redboxes are conveniently located everywhere, with 68% of Americans living within 5 minutes of one of their 33,000 units. Customers may rent at one location and return to another, creating a network effect of growing convenience, and a barrier to upstart competitors. The company also has an iphone/ipod/ipad app, which allows customers to browse inventory and reserve movies in real time.
Redbox is also something of a ‘retail’ experience. Its one thing to have a movie queue and patiently wait, it’s far better to have instant gratification. Many Redbox customers weren’t “planning” to rent, they were out for groceries or other chores when the machine caught their eye. A Redbox machine is an advertisement, it has “microgravity”.
Industry: In the physical disc rental space, Redbox competes directly with NCR’s Blockbuster branded kiosks, brick and mortar rentailers (Blockbuster et al), and lastly Netflix. Redbox has found a competitive and sustainable niche as the lowest cost physical distribution model. To understand where and what Redbox’s wedge is in the product value chain, we must analyze the release schedule of a typical movie. Traditionally, movies are released first in cinemas (first run). A DVD/BD release follows some months later (second-run). Later still the movie is released through pay-per-view television and digital download; then premium cable networks and internet streaming; and finally free-to-air television. This staggered release schedule gives each distribution channel an exclusive "window" in which to profit from the film.
So after a few months in theatres, the studios sell the film as a DVD/Blu-ray (BD). Studios love the for sale DVD market, as studio’s typically take 70-80% of the $15-20 retail price. Blockbuster, currently charges $4+ for a new release DVD rental and pays out about 60% to studios. Enter Redbox, who used to offer new release DVDs for $1 rental the first day they were available for sale. They exploited the ‘First Sale’ Legal Doctrine that protects the rentailer from suit for renting out the title to multiple parties. Redbox’s $1/day DVD rental proposition was so successful that studios felt it threatened to undermine the for sale market. Last year, certain film studios took action by embargoing certain wholesale shipments, causing Redbox staff to ‘work around’ by buying many new titles at retail stores. The ultimate resolution was to create a 28-day rental delay, in exchange for some modest discount on future titles. This only applies to a little over half of Redbox’s DVDs, as not all studios went along. Blockbuster was permitted to continue to rent new titles within that window at the “premium” rental price with the studios getting a big cut. But with the ongoing shutdown of virtually all Blockbusters, the 28-day window will largely become a ‘buy-only’ 28-day window.
Digital distribution begins for most films on the same day the DVD/BD is available for sale. But new releases are priced at a premium price to rent ($3-$4), or to download a digital copy ($10-$20). After several months the content may come up as a discount rental (99cents) and after a year or more becomes available to be streamed or watched on demand on cable. It is important to note that Video on Demand is a premium service that is charged in addition to a basic movie package. Something should become apparent about Digital vs. DVD/BD: Digital follows a similar time-price tiering as the physical market.
Theatrical Release: First 6-12 months
DVD Release: $4 PPV Rental/$15 Download $4 Blockbuster Rental/$15 Disc for sale
28 days later: $1/day Redbox Rental; Netflix Rental
Months Later: $3 Rental, Cable, VOD
Years Later: $1 Rental, Netflix/Amazon Streaming
The studios will continue to window simply because it’s a better business model than simultaneous release. The big studio’s invest a lot in talent and promotion, making what’s in theatres part of people’s current events culture. The idea of having to ‘go somewhere’ generally ‘with some one’ is an experience with social value. In other words, studios maximize the value of their content by creating an initial buzz and exclusivity. However, the value of the content declines with the buzz, and customers need to be enticed with cheaper and more convenient sources as the content ages. The competitive threat is clearly less about windowing and more about new distribution methods such as internet streaming that compete horizontally. Let us compare and contrast all these competing ‘second run’ distribution methods.
“2nd Run” Industry Analysis:
The dirty secret of the brick and mortar rental approach is that the new release wall generates about 3/4 of the movie rental store’s total revenue. The rest of the square footage simply doesn’t pull its weight. By comparison, the 12 square feet of a mature Redbox generates annual revenues north of $4,000/square ft, which is just a tad more than the Apple store on 5th Ave. The Redbox kiosk has nil occupancy costs, and runs that revenue at a nearly 20% operating margin from a machine that only costs $15k (excluding content). Blockbuster is in slow moving liquidation regardless of what business strategy the new parent (Echostar) takes. Even with a 28-day window, a Redbox simply puts a big enough dent the nearest rental store’s gross profit to kill it. Blockbuster is now down to 1500 locations and I give the rest only a few years at best. The robots are literally taking over!
The biggest potential competitive threat to Redbox would be the ability to download or stream a copy of a video right to the television/laptop/mobile. Digital is so much more convenient, but they will always make you pay for that convenience. Case in point is Pay Per View, which has been around since the 1980s. The studios have kept the price at par or premium to rental. Of course, you need a cable box to buy via Pay Per View, which cuts off just under half of households. And when we look at internet rental distribution (iTunes), again Pay Per View pricing! Not to mention that not every one has broadband, and the slower DSL connections (particularly rural ones) are currently inadequate to for streaming. These rural and ‘unplugged’ folks will make up a sticky core audience who will continue to patron the machines as a long tail.
Still, over time, as streaming technology improves there will be a continuing trend to order rentals with a remote instead of a disc from a store or kiosk. I anticipate that digital’s impact will grow, but at a slow enough pace that allows Redbox to generate far more cash than what its currently being valued at.
Netflix announced that beginning in September it was unbundling video streaming and DVD Rental. It will now cost $16/month compared to $10 previously for both disc delivery and streaming video ($8 each). Currently, 82% of Netflix subscribers will be affected and many will increase their usage of Redbox. Estimate are that as many as 40% of Netflix subs might opt for streaming only, and for them, Redbox might be the best way to see the newer films. Under the old pricing, the Netflix sub who signed up for the streaming for $8/month only had to pay $2/month more for DVD delivery. Looked at from the perspective of the streaming customer, the dvd mail option was underpriced. Over time, as Netflix’s streaming product continues to mature, you will see more of their subs dropping physical delivery and using Redbox as the stop-gap. Interestingly, we now have a factor driving digital streaming users back to physical disc.
Redbox competes directly with NCR, who licensed the Blockbuster name and rolled out the Blockbuster Express kiosks. NCR probably didn’t realize that there is more to this business than setting up the machines as they are still not profitable. Recently they had to ‘redeploy’ about 500 machines, which reflects poorly on their location analysis. Location and service play a big role and the NCR machine’s integration with the dying retail chain is poor at best. Management indicated that NCR may take strategic options with the business. Chances are, the market really isn’t ‘big enough for the both of them.’ NCR exiting would only be a positive, but their continued presence really only brings in the market saturation point for Redbox.
Industry Saturation & Firm Strategy:
The company believes the market can handle between 45K and 60K locations. Coinstar currently has 27k location (33k machines total, counting duals), and competitor NCR has about 9k locations. So using the lower end of that range, there is at least another 25% growth to come. The runway may in fact be longer. From 2004 to 2009, rental revenues for the whole disc rental industry were relatively flat. During this time market share shifted from 90% brick and mortar based, to now less than 10% today. Because the stores charge 2-4 times per rental what Netflix/Redbox charges, disc rentals have actually been taking off, not declining during the shift. And should that surprise any one? Video stores were a poor way to distribute films because of high occupancy and labor costs. Netflix and Redbox found innovative ways to bring the price down dramatically, and not surprisingly, they grew the market. I am amazed that 1500 Blockbuster are still left, and it should be clear that the DVD/BD has at least a decade or more left. However, when saturation approaches management will doubtfully not over expand as they’re very realistic and disciplined with the roll out.
The economics of an individual machine is eye-poping. The machine costs about $15K (excluding inventory) and will do about $30K, $40K, $50K of annual revenue in its first 3 years and covers its costs in about 24 months. Because of startup losses on new kiosks, the stable and optimized margin is not clear to investors. With some massaging of the financials we can easily back into 23%-25% Ebitda margins for mature kiosks. Therefore, as growth begins to slow, firm margins and profitability expand as the low margin new kiosks mature. Additionally, Redbox is now rolling out video games at substantially all locations, and currently take up about 5% of a given unit’s inventory while generating more gross profit dollars (albeit at a lower margin).
Redbox is also experimenting with price hikes in several markets, currently testing 3 new price points ranging from $1.10 to $1.25. For some time now, NCR has been trying $2 and $3 for new releases. With Netflix raising prices nearly 60% for dual users on September 1st, there may be some new room for pricing power. And with Redbox operating margins currently in the high teens, a 10 or 15% price hike would be substantial. My base case model assumes no pricing power.
The company’s strategy is to keep building out Redbox as it continues to make sense, but what does a post-saturation world look like for Redbox? When revenues begin to go the other way, it will not lead to sharply eroding margins. Remember, Redbox killed the video star…err video store precisely because of its dramatically lower fixed costs. Assuming variable costs (content, commissions, credit card fees) is about 50% of revenues, and that Redbox has little room to cut fixed costs, Redbox would have an EBITDA to revenues leverage ratio of only 2.5. Said another way, Redbox’s revenues can decline about 40% from model peak before breaking even. Again, the tail is likely long and revenue declines are probably no where to be found for years.
Cashflow usage going forward will be for buybacks and possibly a new venture if one proves out. The firm just completed a $50 mil buyback, and has authorized a further $250 mil, so shareholders can expect the cash to be put to good usage at these levels.
The Market’s View:
With a short interest in CSTR of 32%, there is clearly a bearish thesis floating around. The bear case is pretty straight forward: DVDs will be replaced by digital distribution. Thus, we ought to apply a secular decline PE multiple in the mid-to-high single digits (ala, Gamestop). Bears draw an analog to how iTunes and Amazon killed off the record store. But music had no history of release windows, and by contrast almost all music is available online. MP3s could even be easily distributed over slow internet connections. As mentioned earlier, there exists a core group of ‘unplugged’ consumers who do not pay for cable, nor have adequate broadband. While that group may not seem large, they will be renting discs for a decade or more. And when revenues do begin to decline, the low fixed costs of the Redbox machines will keep them flowing cash at much lesser revenue rates.
The base case DCF contemplates pessimistic assumptions, but still gets us to a valuation of about $60. The assumptions are:
It is likely that CSTR performs above expectations on at least some of these factors. Lastly, here is a link to my DCF: https://sites.google.com/site/idamiena/110807_CSTR_DCF.xls?attredirects=0&d=1
expanding margins & potential pricing power, strong buybacks, Netflix price hike unleashed Sept 1, high short interest
|Subject||Any thoughts on the quarter?|
|Entry||07/28/2012 12:18 AM|
I think management lost some credibility and I honestly don't know what to think of the stock at these levels. Any opinions would be appreciated.
|Subject||RE: RE: RE: CSTR|
|Entry||09/27/2012 06:19 PM|
I have finally gotten around to digging in on this one. And I actually think that capital allocation is extremely important, maybe the most important thing to consider with this one. I used the DCF provided in the original writeup here, updated it for 2012, assumed they would top out at about 50K kiosks, and lowered the discount rate to 10%. I further assumed that the Coin operation was worth 10x FCF or about 5.5x EBITDA. After converting the convertible to equity, I get to about $52.00 per share in value. Today's price is a discount to the theoretical DCF value but not a mouthwatering one. I was pretty surprised that even a conservative DCF would indicate that the Redbox business was worth only about 2.5x EBITDA, but that seems to be what the math says. I guess the combination of declines in revenue/EBITDA assumed to start in 2014, significant capex, limited terminal value and full taxation add up.
While compounding at 10% with conservative assumptions is pretty good in today's environment, I am also left unsure if my assumptions are conservative enough. After all, this still assumes that in 2022 Redbox does over $700M in revenue and $53M in EBITDA.
Anyway, I am pretty sure they could return 10% or greater to shareholders if they simply distributed the cash they earned from counting coins and renting DVDs, but this is anathema to a growth-oriented public company. Instead they are sinking huge sums into new kiosk concepts, new ventures and investments. If these go poorly the company could easily be worth less than the DCF value.
To put it in perspective, the model I am looking at shows about $440M in operating cash flow this year. They used $100M of this to buy the Blockbuster kiosks. I tend to think this is a good investment, but it's hard to be sure until we see the decline curve of the DVD business (and recall that the DCF suggests that the DVD business could be worth only 2.5x EBITDA vs. the 3x a previous poster said the effectively paid).
Further, they invested about $28M in their Verizon streaming venture. They are going to invest more in the back half of the year, let's call it $50M for a total of $78M this year. I am highly skeptical that the world needs another streaming service and think the competition with Netflix and Amazon will be tough. They are committed to spending up to $150M on this JV, which could all be money down the drain.
In terms of capex, they are investing about $110M in installing 4,500 new Redbox kiosks and converting 2,700 of the Blockbuster kiosks. There is probably about $20M of maintenance and corporate capex. Yet they guided to at least $250M of capex this year. Where is the other $130M+ going?
On a notional "discretionary" FCF to equity holders basis this looks very juicy. However, starting with $440M of OCF less $78M of Redbox streaming investment less $100M NCR acquisition less $110M Redbox growth capex less $130M of "other" growth capex leaves you with a mere $22M of FCF accruing to shareholders in the form of buybacks or buildup on the balance sheet.
Maybe a simpler way to state this: If they can maintain $400M+ in operating cash flow and $20M in maintenance capex for the next three years, they basically cover up the market cap. However, this year they are basically spending all of that on growth initiatives. If these fail, the theoretical DCF value evaporates and the shorts will be right.
How do you get comfortable that their redeployment of the operational cash flow is beneficial to shareholders?
|Subject||Same store sales|
|Entry||09/27/2012 06:25 PM|
BTW, is it crazy to think the decline of the Redbox kiosks is already starting? According to the company, SSS growth for Redbox was 16.5% in Q2. This is probably a similar number to the Y on Y benefit from the pricing increase implemented in October of 2011, so units per machine installed over a year may have been flattish. It appears that Q3 could be the first quarter since Q2 of 2010 where we see a Y on Y decline in average revenue per kiosk (not SSS). While this metric has recovered in the past, SSS growth has never been negative, and I think it could be in Q4 after they have lapped the price increase. This supports the idea that an overall revenue decline for Redbox could start in 2014.
|Entry||09/28/2012 01:15 PM|
Thanks for pointing me to that Finn. It looks like maintenance capex is a little over $40M for the Redbox segement alone and probably around $65M for the whole company. That still leaves around $100M of mystery growth capex, about $50M of which seems to be going into hardware and software development of new kiosk concepts which could also be though of as R&D expense.
When you look under the covers, the Redbox trends look a little scary. SSS growth of 16% last quarter is similar to the uplift they should have gotten from prices. Rental volumes are down. Revenue per kiosk will go negative Y on Y next quarter despite the pricing uplift. How positive will SSS be once they have lapped the pricing increase? To me this all points to the possibilty that Redbox revenue will start declining in 2014. One big wild card is how well the company will be able to maintain margins when revenue starts declining on a per-kiosk and then overall basis.
CSTR still seems like a risky short to me, but I am starting to better understand why more shorts aren't covering despite the stock price decline. Staying short seems to entail a two-headed risk around capital allocation, one that they are successful with one or more of these growth initiatives and the other that they get more disciplined and start returning cash more aggressively.