Coinstar-Time Warner Deal Removes a Major Uncertainty in Their Business Model

With yesterday’s announcement of new terms with Time Warner’s (TWX) Warner Brothers studio, Coinstar (CSTR) has removed one major uncertainty in their business model. Coinstar’s Redbox division, which operates self-service DVD rental kiosks, has been locked in legal battles with movie studios regarding terms for the availability of their films. The problems arose from Coinstar buying large quantities of DVDs on the day of release at wholesale prices and offering them for rental for $1 per day.

This situation was unacceptable to the studios as this threatened a key source of revenue: initial sales of popular movies. This is especially critical to studios as DVD sales have already been in decline for some time. So, the studios refused to sell at wholesale to Coinstar, and forced Redbox to invent a “workaround”. Essentially, they would send employees to buy as many copies of new releases as possible from big-box retailers. Even though this was less cost effective, there were few alternatives to filling the company’s 22,000 kiosks. However, a recent limit on quantities by retailers sent Coinstar back to the drawing board, and was a major cause of concern for investors.

Coinstar’s new deal with Time Warner has a 28-day window in which Redbox will have to wait after a new release. Furthermore, Redbox has agreed to destroy the DVDs after their popularity slows rather than sell the used DVDs at a huge discount. In exchange, Redbox will get sufficient supplies for each film at wholesale prices. This is a very similar deal to the one that Time Warner made with Netflix (NFLX) recently, although Netflix has the added ability to offer streaming rentals on some titles. Both sides are heralding this as a win-win and this may provide a roadmap to settle the ongoing disputes with other studios.

As for our valuation on these companies, we have CSTR as Undervalued and TWX as Overvalued. We consider this as a more significant deal on CSTR’s end because Redbox, their fastest growing and most promising business line, had become very strained by the legal battles with studios. This breakthrough has caused at least one analyst to upgrade the stock, and in general the analyst community is bullish on CSTR. For example, the analyst at Merriman Curhan Ford said that the stock may be worth $59 to $77 in a note penned following this deal.

At Ockham, we have a positive outlook on Coinstar shares also, and based on the market’s historical valuation we think it could reach the high $40’s. For example, in the past the market has been willing to pay between 7.9x and 13.9x cash earnings, while the current price-to-cash earnings is only 5.3x. Similarly, price-to-sales is currently only .72x, which is well below the historically normal range of 1.15x to 2.07x. It is clear that recent legal standoffs have held the stock down and made it fall out of favor with the market, but now there is a light at the end of the tunnel. We expect the other studios to follow Warner Bros. lead and soon Redbox can put the capital it was using on legal fees towards growth. The market is ripe for this solution, as it presents an alternative to disappearing bricks-and-mortar stores and it requires no monthly fee like rent by mail options. Competitors such as Blockbuster-licensed kiosks owned by NCR Corp. (NCR), but Coinstar’s Redbox has the lead on them and will look to expand on that.

Coinstar and Time Warner Strike a Deal on DVD Rentals

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

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