Last summer, when Netflix (Nasdaq: NFLX) was messing with its pricing plans, alienating its customers in the process, I spotted a clear opening for rival Coinstar (Nasdaq: CSTR), which runs a kiosk-based DVD distribution system.
As I wrote then: "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."
Six months later, Coinstar is now posting stellar results, and its shares are up more than 40%. In fact, a just-announced deal with Verizon (NYSE: VZ) to enter the streaming video market has led some to conclude that Coinstar's run has only just begun.
Yet a deeper look behind Coinstar's income statement, along with an unvarnished look at that Verizon deal, implies that the stock's run is almost done. If you own this stock, then it may be time to take profits. And for short-sellers, a case may slowly build in coming quarters.
A good but not great quarter
Shares of Coinstar surged nearly 20% on Tuesday, Feb. 27 on the heels of a blowout quarter. Sales of $520 million were roughly $20 million ahead of forecasts. Earnings per share (EPS) of $1 were far ahead of the $0.64 consensus forecast. This will spike a stock any time. Most of that gain, however, came from lower-than-expected overhead, a reduction in credit card transaction fees, and a lower-than-expected tax rate.
Make no mistake: The $520 million in sales is the direct result of rising market share. There are more Redbox kiosks in service (up 17% from a year ago), and each one is seeing higher utilization rates. So the 33% year-over-year quarterly sales jump, the best showing in five quarters, shouldn't be discounted.
Yet it's worth noting that the rate of new kiosks put into service will sharply slow in 2012, simply because the market is getting close to saturation. So Coinstar will only be able to count on rising utilization rates for further growth. This explains why analysts at Needham see sales growth slowing later this year. By the fourth quarter of 2012, they predict sales will grow just 8% (to $561 million) compared with the just-completed quarter.
Of greater near-term concern, Coinstar's blowout results were partially attributed to a heavy slate of new releases. Yet in the current quarter, there is a big drop off of new releases. And a current deal with Universal Studios may expire as soon as April. Universal is ratcheting up prices for new releases, and Coinstar may simply decline to stock Universal's new releases, according to analysts.
Streaming to the rescue?
Frankly, many investors have been predicting the demise of physical DVDs for quite some time, and they predicted that Coinstar would be posting shrinking sales by now. They were wrong. But the long-term migration to downloadable content is inevitable, which is why Redbox needed to ink this deal with Verizon.
Verizon will own 65% of the joint venture, with Coinstar owning the rest, with costs shared on a commensurate basis. And oh boy do these two firms have costs ahead of them. Consider this: Netflix sends $2 billion a year to movie studios and others to secure the rights to content. By this math, Coinstar/Verizon will need to shell out huge sums of money just to build up a storehouse of licensing agreements that Netflix already has in place.
Amazon.com (Nasdaq: AMZN) hasn't disclosed what it spends to secure the rights to stream various titles, but as a customer, I can tell you Amazon's selection in its Prime catalogue is very limited. Most movies I'd like to see are unavailable, although you have the option of paying extra for more current titles.
Another thing to consider is YouTube, which is owned by Google (Nasdaq: GOOG). The video website offers some titles for $2 or $3 and is already established. So the Coinstar/Verizon joint venture may find itself as the fourth horse in a four-horse race.
Coinstar's management anticipates that the development of the streaming service will create a $19 million drag on profits in the near-term, with a total potential capital commitment of $157 million. This implies the joint venture will spend a little under $500 million developing the platform and securing the rights to content this year. It's simply unclear how costs will be that low in light of what Netflix must spend for its streaming rights, let alone the upfront development costs already in place.
Coinstar/Verizon may look to develop a more rudimentary streaming service that only serves up films that are far beyond the "new release" time frame when studios charge top dollar. This may not strike much of a chord with consumers. As analysts at Dougherty & Co. note, "Without more details on the scope and pricing of the offering, it is tough to judge whether or not Verizon/Redbox can effectively compete with Netflix and Amazon in the over-the-top market." In a worst case scenario, Coinstar pours a lot of money into the effort, but still badly lags Netflix and Amazon in terms of market share.
Risks to Consider: It's best to let the dust settle before looking to potentially short Coinstar. Shares could extend this week's gains as some analysts speak of the company's prospects in a very bright light.
Action to Take --> Coinstar has done an extremely impressive job of capitalizing on Netflix's miscues. But Netflix appears to have regained its footing, as seen by recent robust quarterly subscriber growth. Moreover, Amazon has announced plans to ramp up its streaming video efforts sharply in 2012. For that matter, other streaming sites such as Hulu.com also appear to be building a strong following.
As a result, Coinstar's strong start to 2012 may peter out. That makes this a good time to start to examine the potential downside of this business model and book profits.
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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of GOOG, VZ in one or more if its “real money” portfolios.
This article originally appeared at www.streetauthority.com.