Coinstar Falls, But Isn't Broken

By Tom Gibbs - July 28, 2012 | Tickers: AAPL, CSTR, NFLX, VZ | 0 Comments

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Coinstar (NASDAQ: CSTR) has taken a big hit late in the trading week of July 23 following the release of its second quarter 2012 financial results.  With the shares falling by more than 25% during this month alone, could they possibly be ripe for the picking?

What has Happened?

Although the kiosk-operating corporation was slightly shy of average analyst expectations, the Q2 results were not shockingly negative on the surface.  Coinstar reported revenues of $532.2 million for the quarter, a 22.2% increase as compared to the same period in 2011.  Net income of $36.9 million -- $1.11 per share – was up 38.2% from last year’s earnings of $25.7 million -- $0.83 per share. 

Revenues were short of the consensus estimates by $14.6 million (2.7%), and due to acquisition fees and other special items related to Coinstar’s $100 million purchase of NCR’s DVD assets this past February, earnings missed average expectations of $1.18/share. 

Coinstar’s Redbox division, which has contributed around 86% of its top line over the past four quarters, also experienced meaningful growth.  Redbox-based revenues jumped to $457.97 million in the quarter, up nearly 26% as compared to Q2 2011.  Operating income in the division grew faster than revenues – up 31.7% year-over-year to $61.39 million – due in part to a slash in marketing costs and efficiency gains in the direct operation of the kiosk fleet. 

The growth does appear to be less impressive when considering the changes Coinstar has made to its Redbox division since 2011’s second quarter, however.  In acquiring NCR’s 10,000 Blockbuster Express kiosk assets, Coinstar experienced the largest single quarter jump in its DVD-rental fleet (although only around 40% are currently reported in this quarter’s results).  Likewise, Coinstar also initiated a 20% price increase on its daily DVD rental fees – from $1.00 to $1.20 – and rolled out higher priced Blu-ray and video game rental options for consumers as well.  Unlike its competitor Netflix (NASDAQ: NFLX), which failed at its own price increase initiative, Coinstar was able to boost total disc rentals and the average prices per rental since the increase.

So the DVD is Dead, Right?

Coinstar has been able to enjoy slightly higher rental volume and higher average prices due to the larger kiosk fleet and the higher-priced rental fees.  When looking at the longer-term trends in its performance metrics, however, it does appear that utilization at each of its DVD kiosks is slipping.

Coinstar has always had a degree of seasonality in its rental business.  With generally better weather coming in April/May and with daylight savings time, consumers have always tended to pursue other outdoor activities in the corporation’s second quarters.  Likewise, due to the beginning of the school year and the launch of the new television season in September/October, there tends to be another skip in Coinstar’s business in the latter half of the year. 

Seasonality seems to have made quite a larger impact in 2012 than in prior years thus far, however.  The total number of disc rentals for Q2 did hit 179.23 million, up 7.4% compared to the 166.89 million rented in the same period of 2011.  This is the first time in the past two years that year-over-year disc rentals have fallen to single digits.  Likewise, as the chart above illustrates, the most recent quarter was subject to the largest quarter-over-quarter swing over the past ten quarters.  Whereas the second quarters of 2010 and 2011 experienced 5.5% and 3.0% drops compared to each years’ Q1s, respectively, there was almost a 13% change in disc rentals between the first and second quarters of 2012. 

Coinstar has a huge short interest, with nearly one-third of the outstanding shareholders betting against the stock’s growth.  One of the primary theses shared among these shorts is the fact that Coinstar’s Redbox division – until its upcoming streaming video JV with Verizon (NYSE: VZ) begins in late 2012 – is 100% driven by the popularity of the physical DVD.  Similar to its CD counterpart in the music industry, the DVD will eventually be phased out as the use of the digital alternative becomes more widely accepted.  Does this quarter’s slow down in DVD rentals indicate that such a shift has begun?

What many people do not appreciate is the fact that digital music sales have just surpassed CD revenues for the first time in history – more than a decade after the release of Apple’s (NASDAQ: AAPL) iTunes and iPod were released.  Because the number of significant competitors in the digital video streaming business is still relatively low – at least when compared to the number of competitors offering digital music – the same gradual shift can be expected in the industry.  The DVD might see dramatically lower retail sales over the next several years, but a troublesome drop in rentals is not likely to happen anytime soon, especially with DVD and Blu-ray players having 90+% and 25+% penetration rates in U.S. households, respectively.

Strong Movie Slate

It should also be noted that Coinstar’s Q2 results were likely to be affected by the strong movie slate released thus far in 2012.  Some of the largest blockbusters seen in years were launched in the past quarter:

• Hunger Games (released end of first quarter, spilled into second quarter): $405.3 million domestic gross
• Marvel’s The Avengers: $615.4 million
• Snow White and the Huntsman: $152.8 million
• Madagascar 3: $208.4 million

2011’s major titles were largely released at the end of Coinstar’s second quarter, or even third quarter, of last year:

• Transformers: Dark of the Moon: $352.4 million domestic gross (released June 29, 2011)
• Harry Potter and the Deathly Hallows Part 2: $381.0 million (released July 15, 2011)
• Captain America: The First Avenger: $176.7 million (released July 22, 2011)
• Cars 2: $191.5 million (released June 24, 2011)

It can be argued that more entertainment options available within the quarter have also dissuaded consumers from renting in higher volumes during the period. Penny-pinching consumers will understand that one needs to forgo 10+ movie rentals to watch one of this year's blockbusters at the theaters. 

Now What?

Coinstar updated its 2012 guidance for $4.60 - $4.90 EPS in 2012, which is below the original analyst expectations of $4.74/share.  With shares tanking by as much as 14% during the day after Coinstar’s Q2 financial results announcement, shares now trade for around 10.7x the median EPS projection for 2012, significantly below the firm’s past five year P/E average. 

It is unlikely that the DVD rental business will experience a significant slow down over the next several years, and by still generating a large amount of free cash flow ($260.8 million over the past four quarters), Coinstar has ample ability to fund future projects.  On the horizon are several initiatives that will continue to diversify Coinstar’s business away from DVD rentals – the upcoming video streaming service with Verizon, and an upcoming joint venture with Starbucks’  Seattle’s Best brand to roll out as many as 15,000 coffee-brewing kiosks over the next several years. 

Being treated like a company with a broken business model and no future prospects on the mid-term horizon, investors should definitely use the recent drop as an opportunity to take a closer look into Coinstar shares.   

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