By Mark Basham
Shares of Coinstar (CSTR ) sold off in recent weeks -- which we at Standard & Poor's attribute more to market factors than company-specific news. And that presents an attractive opportunity for investors. We expect Coinstar, which carries S&P's highest investment ranking of 5 STARS (buy), to realize superior near-term gains from rising earnings as it realizes significant economies of scale in its business.
Coinstar owns and operates the only network of self-service coin-counting machines installed in supermarkets across the U.S. and in Canada. It has relationships with 19 of the 20 largest supermarket chains (excluding mass merchandisers) in the U.S. As of Mar. 31, 2002, Coinstar had about 9,500 units installed in North America.
And the company is entering new markets. In May, 2001, it announced plans to roll out its coin-counting service in Britain, and it reached agreements with Asda Stores Ltd. and Sainsbury's Supermarkets Ltd., two of the three largest British supermarket chains, to begin installing additional machines in their stores. As of Mar. 15, 2002, Coinstar had installed over 250 machines in Britain.
Coinstar's coin-counting machine, about the size of an ATM, is highly accurate, easy to use and service, and capable of processing up to 600 coins per minute. It accepts consumers' loose change and then prints out a voucher listing the total number of coins counted by denomination and dollar value, less the company's processing fee. Consumers may then apply the vouchers to their retail purchases or redeem the vouchers for cash. Coinstar receives an 8.9% service charge from customers who turn in coins. Customers receive the net amount, and the stores receive profit sharing of 1%.
Overall revenue growth is primarily dependent on the growth in coin-processing volumes over Coinstar's installed base and, to a lesser degree, the rate of new installations. Historically, volume per unit has generally increased with the length of time the machine is in operation.
All of Coinstar's devices are connected to the company's central data processing center, which allows it to service and empty its machines at optimum times. Together with important coin-recognition technology covered by patents, this keeps the machines operating nearly error-free and minimizes maintenance costs. S&P expects that Cointar will continue to realize significant operating leverage due to the relatively fixed costs of installing and maintaining each machine.
We think Coinstar has substantial opportunities to fully exploit the coin-counting service. And it's highly likely that its investment in its national network can be leveraged to offer additional services -- with minimal additional capital spending.
S&P believes that consumer awareness of the Coinstar service is still relatively low, suggesting that usage rates may be easily boosted. For example, field trials have shown that a new Coinstar unit with a backlit display makes consumers feel more trusting of the machine (i.e, that their coins will not be undercounted). Coinstar has done little marketing up to now, as well. It remains uncertain what the return on a well-thought-out marketing campaign would be.
The trial of a new backlit machine resulted in a volume pickup of about 10%, and Coinstar has begun rolling the retrofitted machine in select markets. The new units will also ease the introduction of new services, such as a trial of a new prepaid MasterCard that has been put on hold. The decision to delay the launch was caused by failure to agree with the card issuer on terms of the arrangement, not by less-than-successful results of the trial. Other services, such as making utility payments through the machine, are also being considered.
S&P estimates that revenues will increase 18% in 2002, with earnings coming in at 67 cents a share, compared to the 8-cent per-share profit reported in 2001. Higher projected revenues are being driven by further maturation of the existing Coinstar machine network and installation of additional machines, including in the relatively new British market. S&P hasn't assumed much in the way of additional 2002 revenue from new services.
Fueled by the expected introduction of new Coinstar services, revenues in 2003 are projected to rise 23%, leading to EPS growth of 97% over 2002 levels to $1.32. S&P projects Core Earnings in 2003 of $1.10, which adjusts for our forecast of implied stock-option-grant expense of 22 cents per share (vs. expected 17 cents in 2002).
Although Coinstar's balance sheet is relatively leveraged, with long-term debt as a percentage of capital of 62% at 2001 yearend, S&P believes that the company's finances are sound in light of the significant cash-generating nature of its business and a recent refinancing that reduced its cost of debt.
S&P expects robust cash flow and earnings growth over the next five years to drive superior compound annual price appreciation, compared to the S&P SmallCap 600 Index. Our assumptions are that free cash flow will increase at double-digit rates for the next five years and gradually trail down to a probable sustainable growth rate of 2% to 3%. Discounted cash flow analysis using these assumptions results in an intrinsic value for the shares in the $38-$40 range.
And based on another measure, the shares, trading at 19 times our 2003 EPS estimate of $1.32 a share, are relatively inexpensive, given Coinstar's expected higher growth rate, based on a ratio of its 2003 p-e to growth rate of about 0.95, compared to an estimated ratio of 1.1 for the S&P SmallCap 600.
Analyst Basham follows small-cap and emerging growth stocks for Standard & Poor's