Newsletter: Movie Rentals Gross Millions

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Movie Rental Industry

Key Redbox releases this year (with domestic box office total in millions from

o 12/3: The Smurfs 2 ($71), The Mortal Instruments: City of Bones ($31)

o 12/10: Man of Steel ($291), Turbo ($83), Battle of the Year ($9)

Key Redbox releases last year (with domestic box office total in millions from

o 12/4: Men in Black 3 ($179), Hope Springs ($64), Sparkle ($24), The Apparition ($5)

o 12/11: The Odd Life of Timothy Green ($52), Savages ($47), The Watch ($35)

Over the next two weeks, there are five rental releases that grossed over $50 million in domestic box office compared to three last year. DVD rentals for the upcoming two-week period should be roughly flat with the same period last year due to the release of The Dark Knight Rises last year, which was the second highest grossing film of 2012. Last week, Outerwall (NASDAQ:OUTR) updated investors on its operations review and capital structure initiatives. Outerwall will discontinue three New Ventures — Rubi, Crisp Market, and Star Studio — and expects to be substantially done winding them down by the end of Q1:14. The units will be reported as discontinued operations beginning in Q4:13. While we expected a reduction in New Ventures, we were surprised by the closure of Rubi as Outerwall management had seemed committed to the business. Outerwall will continue to invest in its ecoATM business, and will continue with a limited investment in SAMPLEit ($1 samples).

We expect ecoATM to be accretive to EPS in 2014. Outerwall added $350 million of new debt, primarily for share repurchases, allowing it to move to its previously announced target net leverage range of 1.75 – 2.25x net debt to core adjusted EBITDA in Q1:14. The company will reduce costs by roughly $22 million annually beginning in 2014, primarily through workforce reductions. It has reduced its workforce by 251 positions (8.5 percent), suggesting that the savings will easily be captured. We were surprised by the magnitude of the restructuring, and believe that it has positioned the company to substantially grow EPS in 2014. We believe that the recent purchase of ecoATM gives the company a growth vehicle, which could drive its multiple higher, but it is difficult to assess the potential of used phone trading.

We expect Netflix (NASDAQ:NFLX) to eventually hit a ceiling on its growth, and although we acknowledge that the service is sufficiently sticky to allow the company to substantially raise prices, we do not believe that the current valuation is warranted, even if a large price increase drops to the bottom line. As a hypothetical, assume that Netflix was able to raise prices by $4 per month per subscriber; assume further that subscribers were so satisfied that none quit the service; finally, assume that content providers were sufficiently complacent that none would seek an increase in fees for their content. If we were to annualize Q3 profits, Netflix would deliver $128 million in net income. If it were to raise prices by $4 per month for its 40 million subscribers, its profits would rise to around $1.362 billion, or approximately $22/share.

On December 13, Netflix stock closed $368.97/share, reflecting a valuation of 16.8x this hypothetical EPS figure. We submit to rational investors that Netflix is unlikely to raise pricing by $4/month any time soon; if it were to do so, we believe that a significant number of subscribers would terminate the service, although we acknowledge that the service is sufficiently sticky that price elasticity would likely be less than 1.0. In our survey completed in October, 79 percent of subscribers said that they would not accept any price increase; notwithstanding their protestation, we think that fewer than 25 percent would actually quit if prices were raised.

We cannot say the same for content providers. If Netflix were to become wildly profitable, we would expect content providers to seek higher fees for content, in a manner similar to movie studio deals with theatrical exhibitors. The studios share in ticket sales, irrespective of ticket price, although minimums are set for film rent. We think that Netflix’s current content deals reflect minimums, and believe that if Netflix were to increase prices, content costs would rise in lock step.

Exhibitor Industry

We expect Q4 domestic box office to end down roughly 3 percent from a strong release slate last year, causing difficult comps. Q4:12 experienced year-over-year increases in the box office each month of the quarter. We believe the week later Thanksgiving in 2013 and the quicker rollout of wide-release films in October 2012 compared to 2013 will drive year-over-year box office declines for Q4:13. Q4 is trending down 1.9 percent through December 15. October was down 6.7 percent, while November was down 2.3 percent.

We expect a very active M&A market to continue in 2014 as the industry continues its consolidation. The transition to digital, IMAX (NYSE:IMAX), and 3D screens is helping to drive consolidation. Approximately 85 percent of screens have been converted to digital, and, while most circuits have some portion of screens converted, a significant number remain unconverted. The recent S-1 filed by AMC suggests to us that it may enter the fray, and we expect prices for screens to rise as competition for acquisitions increases.

Michael Pachter is an analyst at Wedbush Securities.

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