Margin’s Ugly Call19 Sep, 2013 By: Erik Gruenwedel
Outerwall said margins at subsidiary Redbox would fall below expectations in the second half of the year as consumers rent movies for fewer days, among other issues.
By definition, margin is the difference between the cost and the selling price of something. For Redbox, the selling price would be the number of nights it can charge $1.20 for a particular disc at a kiosk. Outerwall’s profit margin in the first half of 2013 shrunk to 6.2% from 8.2% in the same period of 2012. And it’s expected to fall further.
Culprits include Redbox promotions and a shorter rental period per disc, according to CEO Scott Di Valerio. He said the kiosk vendor would report increased revenue in the third quarter, including record rentals in July, but the profitability (margin) of those rentals is lower.
That’s because while more people are renting movies from kiosks, they're returning them the next day, instead of days later. With the margin on a nightly $1.20 rental razor thin, Redbox makes its money through volume (renters) and extended rental nights. Previously, the average kiosk rental generated more than $2 in revenue. When a consumer returns a disc in less than 24 hours, that revenue (and margin) falls.
Pitfalls of Teaser Pricing
Redbox (and streaming services such as Netflix) has shifted the rental paradigm, transforming the $3.99 video store transaction into a low margin commodity. Kiosks and subscription video-on-demand services have reduced the cost of the rental transaction, replacing it with a big-volume business model predicated on the belief that if a movie/TV show rental is priced at next to nothing, people will flock, rentals or subscribers will balloon and profit will follow based on increased volume.
If you’ve ever had someone ask you at McDonald’s, "Would you like a drink with that?," then you get the idea. Redbox is silently asking customers, "Would you like to keep that another night? It’s only $1.20 more." And Netflix every month is cajoling, “It’s only $8 a month. Isn’t the entertainment we provide each month worth that?”
This mindset has been a boon to the consumer, but it’s a delicate balancing act for Redbox and the home entertainment industry. Studios and media companies loudly herald the incremental revenue SVOD is generating via multimillion dollar license deals. Redbox, too, is paying select studios hundreds of millions to secure street date releases.
Yet, this business model is dependent upon SVOD and Redbox continually growing their subscriber bases and/or maximizing the time a disc is gone from the kiosk and in the home. Any deviation from these prerequisites, and the bubble bursts.
“Unfortunately, this demonstrates the leverage in the Redbox model, but on the negative side,” said B. Riley & Co. analyst Eric Wold. “The more you can push customers to multiple nights, larger baskets, etc., the more you leverage that cost.”
Analysts say Redbox needs to adjust its promotional strategies going forward to offset the single night shift and negative margin hit. Consensus suggests Redbox is not operating on the margin fringe as much as it is operating a business model that requires a certain level of risk predicting disc demand ahead of time, which doesn’t always pan out correctly.
“They make outsized profits when revenue is higher than budgeted and lower profit when revenue falls short. It’s a tough model to predict, but I think they need to manage a bit more conservatively,” said Wedbush Securities’ Michael Pachter.
As for Netflix, as long as they can grow their subscriber base and leverage their ballooning stock price, the party will continue. However, someday the music may stop,