Can Redbox Leverage Its Retail Network to Streaming Success?

Outerwall's automated-dispensing machines average roughly 12 square feet in size. These machines are probably the world's smallest retailers, primarily offering the company a way to market DVDs and coin-counting services to its millions of customers. These machines also make Outerwall a valuable partner for grocery and mass-merchandiser landlords, which get to share in a revenue stream that would otherwise be lost. While Outerwall's Redbox unit has heavy competition from video-streaming companies, the business is the top dog in the DVD rental and coin-counting kiosk businesses. So, should investors change their tune?

What's the value?
Outerwall's origins are in the automated coin-counting segment, which is still a highly profitable business. The company generates the vast majority of its current revenue from its Redbox DVD rental segment, which it acquired in stages from restaurant giant McDonald's starting in 2005. The company's market share in the DVD-kiosk business is pegged at around 50%, aided by its 2012 acquisition of NCR's DVD-kiosk unit, which had approximately 6,200 machines. The move was designed to eliminate a major competitor, which was validated by Outerwall's removal of most of the machines from active service over the past year.

Outerwall's top line has held steady in FY 2013 with total revenue up 2.6%. The company's profitability has been hurt by losses from its push into new areas like beverages and electronics. In addition, declining productivity in the Redbox segment negatively affected the company, with comparable-store sales down 9.9% for the period. However, the unit's operating margin remained above 20%, as its larger installed base of machines drove efficiencies in administrative and maintenance costs.

Protecting the moat
Video streaming continues to drain sales from the physical DVD market. Data provider IBIS World reported a 13.7% year-over-year decline for the physical-rental market as of August. Outerwall has countered the threat by partnering with telecommunications giant Verizon in its Redbox Instant by Verizon service, which went into beta launch in March. The service's $8 monthly subscription fee, comparable to Netflix's monthly fee, includes unlimited streaming of movies from its library as well as four free monthly DVD rentals from its kiosk network.

Naturally, investors are worried about competitors in the space, specifically Netflix . The company has built a 38-million strong global subscriber base by following its domestic script in its international markets, with a willingness to operate at a substantial loss in order to generate critical mass.

Netflix has also been improving its value to customers though valuable features. The new Profiles function allows individual customers to create personalized "profiles" based on their viewing history or favorite lists, which allows Netflix to provide better recommendations and improve users' experiences.

In FY 2013, Netflix has been riding its larger subscriber base to better financial results and a sharply higher stock price. For the period, the company has reported increases in revenue and segment operating income of 19% and 46.1%, respectively, versus the prior-year period.

Netflix's higher segment operating margin, 17.3% in 2013, has been a function of growing its customer base faster than expected. Many customers are probably attracted to the company's stable of original content, including Emmy-nominated shows House of Cards and Arrested Development. Netflix also continues to leverage its subscriber base to win exclusive deals, like its recent multi-year content agreement with the Weinstein Company that begins in 2016.

Also on the competitor threat list is Amazon.com and its Prime Instant Video service. For $79 per year, the service provides unlimited streaming from its video library, as well as unlimited two-day shipping on purchases and a monthly free book rental from its Kindle lending library. While the company doesn't divulge Prime-subscriber numbers, a Morningstar report estimated the total at 10 million back in March.

Like Netflix, Amazon is trying to increase its value to customers. The company's Video Finder feature creates recommendations based on a user's viewing history or list of favorite preferences. In addition, the company is similarly using its size and financial strength to procure original and exclusive content, with recent CBS and PBS deals to be the exclusive online home for its Under the Dome series and Downton Abbey series, respectively.

The bottom line
Investors seem to want to put Outerwall out to pasture, based on expected further declines in its DVD-kiosk business, but they may be missing the point. While the company has moved into the streaming business to protect its DVD-kiosk sales, it really is an automated retailer story with a periodically changing product mix, including its latest foray into used electronics through its ecoATM acquisition. With a low net-debt position and profitable franchises, Outerwall has a favorable risk/reward ratio for investors.

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The article Can Redbox Leverage Its Retail Network to Streaming Success? originally appeared on Fool.com.

Robert Hanley owns shares of Outerwall, Netflix, and Amazon.com. The Motley Fool recommends Amazon.com and Netflix. The Motley Fool owns shares of Amazon.com and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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