This Movie Rental Company Will Survive

Source: Outerwall.

In April 2014, SEC filings revealed that hedge fund Jana Partners has reduced its stake in Outerwall  from 8.4% to 4.9%. Outerwall owns Redbox, the largest operator of DVD rental kiosks in the U.S., and Coinstar, a leader in consumer coin-counting and conversion.

Given the maturity of these businesses, are there any concerns about Jana Partners's stake reduction? Also, is Netflix a better investment choice? It's worth analyzing Outerwall at the product, business, and company levels to have a better understanding of its prospects.

Product-level: DVDs
Many people are calling the death of the DVD rental business. This is premature for two key reasons.

Firstly, DVDs rentals have a pricing advantage over other competing alternatives. Based on Outerwall's internal estimates as of January 2014, it costs approximately $5.99 and $4.99 to rent a new movie release on cable video-on-demand and iTunes, respectively. In contrast, the average bricks & mortar store will charge about $4.00 per new release rental.

Moreover, Redbox's DVD rental services are significantly cheaper than both bricks & mortar stores and e-tailers, at prices ranging from $2.40-$2.95 per DVD. In May 2014, Netflix announced it will increase its monthly streaming plan by a dollar to $8.99 for new members. This will further enhance Redbox's price competitiveness vis-a-vis its competitors.

Secondly, convenience is relative. About 70% of Americans remain within a five-minute drive of a Redbox kiosk. In comparison, a 2013 study conducted by Pew Research Center indicated that 30% of Americans don't have access to broadband at home.

For those without broadband access, they aren't able to enjoy the "convenience" associated with video streaming services offered by Netflix. Instead, a Redbox kiosk serves the same purpose of granting access to movies, which are literally a stone's throw away.

Source: Outerwall.

Business-level: Redbox
Both Outerwall and Netflix have overlapping business areas. Outerwall has Redbox Instant, a video streaming service, while Netflix still retains its legacy physical DVD rental business, where DVDs are rented and returned via snail mail.

In the physical DVD rental business, Netflix drove its former competitor Blockbuster out of business, because it simplified the DVD return process. Unlike Blockbuster customers, who had the hassle of returning DVDs at the physical stores, Netflix's customers could simply mail the viewed DVDs back.

Recently, Redbox kiosks have gained popularity at the expense of Netflix and brick & mortar rental stores. The numbers speak for themselves. In the fourth quarter of 2013, Redbox owned half the market share of physical movie rentals.

With respect to the video streaming business, Redbox Instant is still a newcomer, having started in 2012. It currently offers more than 8,000 digital movies from its library and supports more than 25 devices. In comparison, Netflix already boasted a library of more than 100,000 titles in 2009. However, initial results have been positive. Outerwall has commented that it has seen "increases in time spent and frequency in viewing" on a monthly basis.

More importantly, Redbox (physical rental) doesn't have to beat the video streaming guys like Netflix to grow. It is estimated that kiosks and bricks & mortar shops split the share of the physical movie rental market almost equally among themselves. Redbox has the potential to gain further market share from other physical distribution channels such bricks & mortar (the old Blockbuster model), notwithstanding the fact that the physical market is ceding ground to online streaming.

Recent trends validate this view. Other forms of physical movie distribution such as bricks & mortar and mail have seen revenues decline from $5.1 billion in 2009 to $2.5 billion in 2012. In contrast, the rental revenue contribution from kiosks doubled over the same period to reach $1.9 billion in 2012.

Company-level: Outerwall
A company with maturing businesses isn't the issue; one that splurges cash on value-destroying ventures is the real worry. Outerwall acknowledges that its core businesses have matured. Coinstar's top line has remained flat for the past five years, while Redbox's revenue growth has slowed considerably in 2013. To address shareholder concerns, Outerwall has put in place a series of shareholder-friendly actions.

Firstly, it has committed to return 75%-100% of its free cash flow to shareholders. In February 2014, Outerwall announced it will spend $350 million on share buybacks via a tender offer.

Secondly, Outerwall will keep capital expenditures to a minimum to conserve free cash flow. While it has historically spent in excess of $150 million a year in capital expenditures, it has guided for capital spending to be capped at $125 million this year.

Thirdly, it discontinued new ventures that weren't doing well, such as Rubi, Crisp Market, and Star Studio.

Foolish final thoughts
I have no idea how long it will take before physical DVD rental is completely replaced by video streaming. But Outerwall should continue to be a good investment candidate, because it has a pricing advantage and has market share expansion opportunities in the physical movie rental market. In addition, its capital allocation policies should assure investors that cash isn't deployed to value-destroying initiatives.

Viewed from the perspective of valuation, Netflix has all of its growth prospects factored in, trading at a lofty 64 times forward P/E. In comparison, Outerwall sports a forward P/E of 7.6 and looks very attractive as a cash-flow rich value stock with moderate growth prospects.