Analyst: DVD Rental Business Is Not in a State of Persistent Decline

netflix remote

The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.

Movie Rental Industry

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

o 9/17: World War Z ($202), Epic ($108)

o 9/24: Iron Man 3 ($409), The Great Gatsby ($145)

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

o 9/18: The Cabin in the Woods ($42)

o 9/25: Battleship ($65)

Over the next two weeks, there are two 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 underperform the same period last year, as this year’s DVD releases grossed less than last year’s at the box office.

Earlier this month, Outerwall preannounced lowered guidance due to worse-than-expected performance of its Redbox business. Once again, Outerwall ((NASDAQ:OUTR)) management was overly optimistic about its growth prospects, and once again, the company disappointed investors by preannouncing negatively. We have covered the company since 2009, and this is the seventh time that management has either preannounced negatively, preannounced positively, or provided guidance that was significantly lower than or higher than expectations. We think that the company’s management is generally poor at forecasting its business, leading to significant beats and misses, and leading to increased share price volatility as confused investors hate uncertainty.

Had we seen this preannouncement coming, we likely would not have added OUTR to the Wedbush Securities Best Ideas List, and would have waited for the inevitable correction the preannouncement brought. However, our confidence in the Outerwall story is largely unchanged, as we do not believe that the DVD rental business is in a state of persistent decline. Our addition of Outerwall to the Wedbush Securities Best Ideas list was predicated on four factors: 1) a stabilization of Redbox revenues; 2) the launch of ecoATM; 3) the continuation of the company’s share repurchase program; and 4) the reduction in spending on new ventures. We gained confidence for each of these factors with this month’s preannouncement, and our conviction is even greater today.

In June, Wedbush completed a survey composed of the responses of 1,000 domestic Netflix (NASDAQ:NFLX) subscribers. The survey included 29 questions, with an emphasis placed on content and pricing. The survey results reinforce our belief that Netflix faces a difficult balance as it attempts to contend with ever-increasing content costs, while satisfying the demands of its customers for ever-increasing content. We believe that Netflix must choose between maintaining low prices and seeking higher profits. We expect Netflix to continue to offer low prices (which should drive its subscriber numbers higher) and generate minimal profit, but should it hope to boost its profitability, it will be required to raise prices.

Should it choose to increase prices, however, the survey responses suggest to us that Netflix runs the risk of alienating a significant portion of its subscriber base. In our view, the survey responses suggest that any price increase will drive high churn, potentially negatively impacting revenue growth (and hence profitability) if fewer subscribers at higher pricing fail to make up for the revenue lost from price-sensitive subscribers quitting the service. The survey makes it clear that low pricing is the key draw for many Netflix subscribers, and not content quality. However, content quantity is clearly important to subscribers, as a large percentage focused on content as a reason for joining or quitting the service.

Exhibitor Industry

We expect Q3 domestic box office to end up roughly 8 percent from a strong release slate and easy comps. Q3:12 experienced year-over-year decreases in the box office each month of the quarter. We believe the larger number of blockbuster releases will drive year-over-year gains for the quarter, similar to Q2:13’s performance. Q3 is trending up 7.6 percent through September 29.

We expect a very active M&A market to continue in 2013 and 2014 as the industry continues to consolidate. The transition to digital, IMAX (NYSE:IMAX), and 3D screens is helping to drive industry consolidation. Approximately 85 percent of screens have been converted to digital, and while most circuits have some portion of screens converted, a significant number (around 6,000, or 15 percent) remain unconverted. The recent S-1 filed by AMC suggests to us that the company, once public, may enter the fray, and we expect prices for independent screens to rise as competition for acquisitions increases. As IMAX’s largest customer, the increased capital could also lead to further penetration of the IMAX format.

Michael Pachter is an analyst at Wedbush Securities. 

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