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Coinstar (CSTR) is a leading provider of automated retail solutions, offering convenient products and services that benefit consumers and drive incremental guest traffic and revenue for merchants across the country. The company’s core businesses include the Redbox-branded DVD division, where consumers can rent movies from self-service kiosks (located primarily in supermarkets and drugstores) for as little as $1 a night, and the older coin operations, where consumers can convert their loose change to cash or stored value products at coin-counting machines.

Some Background

Coinstar, along with its volatile stock (down more than 15% year to date), has had a bumpy ride of late, as the Redbox segment has recently been hampered by higher wholesale prices for some DVDs, clumsy inventory management, and sluggish demand following the company’s transition to a new 28-day rental delay policy (the result of a negotiated legal settlement between Coinstar and a handful of Hollywood studios). The current difficulties ought to be fairly short-lived, however.

Indeed, the DVD rental business should regain its lost luster by mid-year, thanks to improved inventory practices, stepped-up advertising for Blu-ray movie titles (they rent for $1.50 a night), and further market-share advances at the expense of traditional “brick & mortar” outfits, like bankrupt rental chain Blockbuster. Moreover, we see the company entering a whole new growth phase, as it looks to leverage the value-oriented Redbox brand and take on sector heavyweight Netflix (NFLX) by rolling out a new digital strategy.

Coinstar’s Move into Streaming

Netflix has a big head start over Coinstar, for sure, when it comes to the rapidly expanding world of online video streaming. In fact, Netflix already has over 20 million subscribers to its Internet movie service. And it is poised to gain more share in the coming quarters by supporting additional handheld devices, inking new licensing deals with content creators, getting into original programming and television streaming, and attracting young, disenchanted consumers that are looking for a cheaper alternative to satellite and cable TV.

That said, we believe that there is plenty of room in the online video space for Coinstar to launch a competitive product that will grab at least some of Netflix’s thunder (and customers). Rather than go it alone, Coinstar plans to offer digital downloads on a subscription basis in conjunction with one or more partners. This approach seems prudent, since it will enable the company to penetrate the market quickly, and save money on buying content rights and building a new online distribution platform.

Though no potential online partners have been specifically mentioned by the company (it has acknowledged being in discussions with multiple parties), a few retail heavyweights stand out as possible choices. Among these is Internet giant Amazon.com (AMZN), which has slowly been developing its own digital download strategy to persuade more customers to join its Prime membership program and help it better compete with Apple’s (AAPL) popular iTunes platform.

Amazon Prime has been pretty successful since launching in the U.S. in 2005, offering members, for a $79 annual fee, unlimited free two-day shipping on all purchases (and discounts on one-day shipping) and the option to instantly stream roughly 5,000 movies and TV shows. But some Amazon users have been reluctant to sign up for the pay service, because they lack the necessary equipment for streaming video through their TVs, and because of the still-limited library of content available. The added ability to rent movies and TV shows from Redbox kiosks nationwide could be just the incentive these finicky consumers need to finally come into the Amazon Prime fold. What’s more, a subscription-based product offering combining Amazon’s digital programming with Redbox’s DVD inventory and coast-to-coast retail footprint could well give Netflix a decent run for its money.

Other potential partners are Sonic Solutions, a provider of streaming services to the likes of retailers Sears (SHLD) and Best Buy (BBY), and mass merchant Wal-Mart Stores (WMT - Free Wal-Mart Stock Report), which has expressed an interest in pushing deeper into the digital realm. Notably, Coinstar already has close ties with Wal-Mart, adding credibility to a possible joint venture between the two companies. In fact, Wal-Mart-based Redbox kiosks now account for approximately 20% of Coinstar’s revenue mix.

There is also the chance, however remote, that Coinstar may be acquired by Netflix. Such a preventive strike would give Netflix valuable access to the retail channel at a time when competition from Apple and Google (GOOG) appears set to heat up. It would also help the firm maintain its blistering growth rate, which has been called unsustainable by many Netflix detractors on Wall Street.

All told, we believe that Coinstar is now in the right place at the right time. If it’s not acquired (at a nice premium), the company should be able to find a suitable online partner and make profitable inroads in the video streaming arena. The stock, meanwhile, looks reasonably valued relative to year-ahead earnings and the firm’s long-range growth prospects. Consequently, we think that patient investors with a 3- to 5-year view would do well to build positions in this mid-cap issue.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.