Coinstar Shares Look Very Cheap After Guiding Down Earnings Expectations

Consumers should know¬†Coinstar (CSTR)very well as the maker of coin counting machines found at grocery stores and more recently the owner of the Redbox DVD rental kiosks found in even more retail locations such as McDonald’s and Wal-Mart. I believe the stock, which has gotten hammered lately after an earnings miss for the fourth quarter, represents tremendous value. CSTR gives investors a rare combination of value and growth potential.

At around $39 per share (down from $67 late last year), Coinstar stock fetches only 6 times trailing cash flow. To put that in perspective, Microsoft sells for 7 times, Cisco for 8 times, and IBM for 9 times. Investors are clearly getting a valuation that is otherwise reserved for larger, slower growth businesses. This despite the fact that the company just reported that 2010 revenue soared 39% on the heels of a 50% jump in DVD rental sales (the more mature coin counting business grew by 7%). Despite giving more conservative guidance going forward after the company missed Wall Street’s fourth quarter expectations, Coinstar expects 2011 revenue to jump by about 24% with cash flow rising by 18%, as it continues to invest in growing the business. If management can deliver on these numbers this year (and after an earnings miss we should think they might give out forecasts they feel quite confident in reaching), the stock trades at only 5 times current year cash flow, unheard-of for a company growing like Coinstar.

Now, as with any investment, expectations and forecasts of future growth and valuation are not the only things to consider. Analysts would be quick to argue (and I would not disagree) that movie rentals are moving from disc-based to cloud-based, with the emergence of Netflix and other streaming platforms. Any market share gains that Coinstar’s Redbox kiosks might see with the pending bankruptcy of Blockbuster could very well be negated by more and more people signing up for Netflix streaming.

However, I still believe that the market for Redbox kiosks is bright, for two main reasons. First, with nearly 25,000 kiosks installed in grocery stores and retail outlets across the country, the convenience and cost ($1 a day) of Redbox rentals will make them attractive to both cost conscience movie watchers (if you only watch a couple movies per month you will likely opt for Redbox over an $8/month Netflix streaming plan) and those who enjoy the convenience of grabbing a movie on their way out of McDonald’s, Wal-Mart, or their local grocery store (just picture how easy children can convince mom and dad to get a movie for $1 before they leave the store).

The second reason I think it will be years before physical disc rentals will become completely obsolete is that there are still millions of Americans who are afraid of technology to a large degree (either due to things such as identity theft, or simply out of not being comfortable with operating high tech toys such as wi-fi enabled DVD players). To illustrate this point, let me share an encounter I had with a woman a couple of weekends ago.

After noticing that several Blockbuster locations were being liquidated near where we live, my fiancee and I decided to stop by and see if we could land any ridiculous deals (they were literally selling the store’s shelves as well as the DVDs sitting on them). Everything was for sale, and if you had a spare $350 sitting in your bank account you could buy the giant gum ball machine from your local Blockbuster store (we saw one being carried out by a man as we entered the store).

As I was perusing the aisles I helped explain the pricing structure to a woman in her 50’s or 60’s who was confused. We got to talking and she was mostly rambling about how disappointed she was that this store was closing because all of the other DVD rental places had also closed and now there was nowhere for her to go. I mentioned Netflix and she immediately dismissed it as a viable option “because you need a credit card for the box.” She was clearly confusing Netflix with Redbox, but the fact that she refused to use a credit card to rent a movie told me that Netflix would not be any better in her mind.

I bring this up because I think people like this woman are exactly the ones who will shun new technology like Netflix streaming. Eventually she will have to cave and start using Redbox for movie rentals most likely, and think about how many people like her there are out there. Not only that, but even if she felt comfortable using the Internet to order movies by mail (I don’t see her using Netflix mail order anytime soon, given that her explanation for why that wouldn’t work for her was that her printer has been broken for months and she can’t figure out how to fix it), I really don’t think she would proactively adopt such a technology when there are other “lower-tech” ways of getting a DVD such as Redbox (granted, a credit card will still likely be required).

In short, I think there will be room for both technologies for several years to come. While I subscribe to Netflix and have never actually used a Redbox kiosk, there are plenty of middle aged and older Americans who will. Not only that, but the Redbox kiosk in the grocery store I visit is often crowded with college kids as there are several universities in the area. Cost is probably the main factor there, as young kids can certainly operate Netflix streaming movies, but more likely lack the discretionary income to afford an expensive box with wi-fi and a monthly plan. So, there is definitely a market for Redbox with younger people too.

With Blockbuster in liquidation, Redbox should continue to grow, although Coinstar’s current stock price seems to not fully be factoring in such strong demand for their kiosks. I do not see any reason CSTR shares should not fetch 7-8 times cash flow, which makes a stock price of $60 quite a reasonable expectation.

Full Disclosure: Long CSTR at the time of writing but positions may change at any time