News Analysis date published New: 
Friday, August 5, 2011 - 13:00
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Friday, August 5, 2011 - 13:00
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Friday, August 5, 2011 - 13:00

Forget Netflix, Buy This Stock Instead

Friday, August 5, 2011 - 1:00pm

We're coming up on the one-month anniversary of Netflix's (Nasdaq: NFLX) fateful decision to sharply boost its monthly pricing. The sudden jolt led many customers to vent their disapproval, and the video-rental service eventually conceded it will lose a chunk of customers in coming months.

A large portion of those customers will migrate to lower cost rental services such as the one offered by RedBox, a supermarket-based DVD kiosk business run by Coinstar (Nasdaq: CSTR).

You would think the Netflix news would be grounds for joy among Coinstar's shareholders. But since the Netflix news hit the tape on July 12, shares of Coinstar have actually fallen nearly 25%. This is what happens in a lousy stock market. All kinds of stocks get dumped, regardless of company-specific events. The selloff in Coinstar gives investors that missed the Netflix-related news a chance to belatedly profit.

A history of detractors
To understand where shares of Coinstar are headed, you need to know a little about its past. The company has been public for nearly 15 years and has periodically seen its shares pummeled as short sellers questioned the company's staying power.

For much of the early part of the past decade, shares were heavily shorted as investors predicted the company's business of providing coin-counting machines at grocers and other retailers would soon hit a peak. Yet throughout the rest of the decade, the business kept growing as more machines were put in place and rivals failed to steal market share.

The short sellers' basic contention was correct, but very premature. Growth would (and eventually did) slow, which is why the company moved to partner with McDonald's (NYSE: MCD) to enter the DVD rental business through a then-pilot program known as RedBox. Coinstar bought a half-interest from Mickey D's in 2005 and the rest of the business in 2009. This turned out to be a wise move. Coinstar invested less than $300 million to acquire and develop Redbox, and now reaps significant cash flow from the division.

Just as short-sellers predicted the coin-counting business would eventually flop, they've more recently focused on the Redbox DVD business, citing industry predictions that video streaming would eventually replace DVDs. This prediction has actually been in place since cable companies first started offering video-on-demand about a decade ago. Yet DVD rentals have turned out to be a far larger business than anybody would have guessed back then.

Fast-forward to today, and Redbox is a $1.5 billion (in annualized sales) business, dwarfing the coin counting business' $260 million sales base. (The coin counting business throws off ample cash, generating 27% operating margins, according to analysts at Needham.)

Thanks to Netflix, Coinstar's DVD business will thrive for even longer than some short sellers had predicted. This is because it's increasingly apparent that Redbox looks set to take some market share. Simply put, it's a better deal for customers.

Netflix's new pricing plan entails an $8 monthly streaming plan, or $16 to have access to both streaming and DVD by mail. Those who choose the "streaming only" option will discover that the vast majority of coveted titles simply can't be streamed yet on Netflix, due to licensing issues with movie studios.

In contrast, RedBox rents movies -- including new releases (that have been embargoed) for 28 days) -- for just $1 a day. How can the company make a profit on such a small price? It can't. The profits come from customers that keep movies out for additional nights. Redbox is testing price hikes at a few kiosks, and if demand is not impacted, the price hikes will expand nationwide. But management can also opt to keep the movies at the $1 per night price to take market share from Netflix. Either way, this business looks set to generate higher cash flow as we head into 2012.

What now?

OK, so the DVD business will eventually mature, just as the coin counting business did. In response, management is using the expertise of kiosks-within-stores to roll out other concepts. For example, consumers can now rent video games from kiosks, and in coming months, look for test trials to expand with kiosks offering Seattle's Best Coffee and kiosks that accept used electronic devices for store credit.

Retailers like having these boxes in their stores because they generate impromptu foot traffic. The charm of the model is the company already pays someone to stock and service its machines, and this person can handle any new kiosks that are placed in-store as well.

Admittedly, Coinstar has a perception problem with investors. The company tends to deliver a great quarter and then a weak quarter the next time around. Management doesn't seem to do a very good job of tracking short-term revenue and cost gyrations. The focus instead should be on annual growth, which has been -- and should continue to be -- quite impressive. Sales and earnings per share (EPS) have grown at least 19% in each of the last three years. Growth is expected to be even more robust this year (26% sales growth and 50% profit growth). This is a business model with clear operating leverage: sales are expected to rise another 15% in 2012, with profit growth approaching 25%.

Action to Take --> The DVD business will eventually mature, though not before a Netflix-inspired spurt in the next 12 months. In coming years, new kiosks ideas should augment those cash-flow rich mature businesses of coin-counting and DVD rentals. Analysts have been raising their estimates, even as the share price continues to fall. At just 12 times next year's projected EPS, shares discount Coinstar's still-robust growth that lies ahead.

P.S. -- Few investors realize that a 20-year energy agreement between the United States and Russia is about to expire. This deal supplies 10% of America's electricity. As broke as our government is, the situation is so serious that President Obama is asking for $36 billion to avert this crisis. And Republicans support him. Here's what's going on…

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.