There is no doubt that DVDs will lose market share to Internet video streaming services. However, that doesn't imply that Netflix (NASDAQ:NFLX) is a better investment than Outerwall (NASDAQ:OUTR). Factors such as the rate of decline for the DVD industry and the relative competitive advantages of companies play a big part in choosing a stock as well.

Economics 101
Streaming a video online from Netflix costs as much as four to five times that of a DVD rental from Redbox, Outerwall's DVD rental business. In other words, you can rent about five DVDs for a single video streamed online. From an economic viewpoint, Netflix has to provide five times the benefits of Redbox. The equation isn't that straightforward, however, because movies are experience goods. Consumers only know if they like the movie after they have watched it. Neither the cast nor the story act as a perfect proxy for movie quality. Therefore, most consumers are likely to either to pay the same amount for more movies (to spread the risk of a picking a bad movie) or pay less for a single movie. This adds tremendously to the attractiveness of the lower-priced DVDs.

Convenience, another key benefit of online streaming compared to physical DVD rental, is also debatable. While physical distribution can't match up to electronic distribution perfectly, it isn't far behind. According to research from Spatial Insights in July 2011, a Redbox kiosk is within five minutes walking distance for more than two-thirds of people in the U.S. Furthermore, unlike the old Blockbuster model that was limited by rental store locations, a Redbox DVD can be borrowed and subsequently returned at any Redbox kiosk.

While people view the DVD business purely as a battle between electronic and physical distribution, there are many ways to distribute a physical copy of a DVD. In fact, kiosks currently have only about half the market share of the physical movie rental business. As the DVD rental market cedes ground to online streaming, there is still potential for Redbox to gain market share in the physical market at the expense of other inefficient physical distribution channels such as rental shops.

As a result of these factors, the decline in the DVD may be much slower than expected. This may provide respite for Redbox's DVD business.

Distribution channels
Both Netflix and Outerwall (through Redbox) are in the business of distributing movies. The key difference lies in the mode of distribution: physical and electronic. While electronic distribution is more efficient for both companies and consumers, it also reduces barriers to entry. Redbox boasts of a broad footprint of more than 40,000 kiosks in U.S. and Canada and an active customer base of more than 40 million customers based on unique credit card rentals. Any new entrant will have to commit significant fixed cost investments to build a network of kiosks to rival redbox. Moreover, the best locations have been already been occupied by Redbox's kiosks.

For example, while Netflix still has its legacy physical DVD rental business, its customers rent and return DVDs by mail. However, this form of physical distribution is losing market share to kiosks over the past few years. According to research by SNL Kagan, revenues from DVD rental via kiosks have doubled from $0.9 billion in 2009  to $1.9 billion in 2012. Comparatively, revenue contribution from other forms of physical DVD distribution have fallen from $5.1 billion to $2.5 billion over the same period. It is clear that Redbox kiosks are becoming the preferred model for DVD rental. 

Given that it is much easier and cheaper to start a online video streaming business, it is not surprising that Netflix faces stiff competition from a host of competitors in the electronic distribution business, including Amazon (NASDAQ:AMZN). Amazon offers its on-demand video services through Amazon Instant Video in the U.S. and LoveFilm in the U.K. and Germany. In June of last year, Amazon sealed a licensing deal with Viacom, bringing its viewers well-liked kids programs like SpongeBob SquarePants. This occured after Netflix didn't renew its contract with Viacom.

Hedging your bets
I don't dispute the fact that DVD will go the way of the dinosaur one day. But as of now, there is still money on the table when it comes to kiosk DVD rental. Hence, Outerwall isn't ready to exit the Redbox business anytime soon, given that there is still a lot of potential market share gain from other forms of physical DVD distribution. However, Outerwall is already hedging its bets with Redbox Instant, its own video streaming service. As customers slowly transition from physical DVD rental to online streaming, Outerwall is well-prepared to capitalize on any resulting growth opportunities.

Foolish final thoughts
I don't disagree with the fact that on-demand video streaming will be the dominant distribution channel of the future for movies. However, the rate of decline in the DVD rental business could be much slower than expected because of the trade-off between price and convenience. Furthermore, Redbox faces relatively lesser competition in its physical distribution business as compared with Netflix and its digital competition. With all the negative expectations built into Outerwall's DVD business, the odds are for Outerwall to surpass these expectations.

So where should you look for growth?
They said it couldn't be done. But David Gardner has proved them wrong time, and time, and time again with stock returns like 926%, 2,239%, and 4,371%. In fact, just recently one of his favorite stocks became a 100-bagger. And he's ready to do it again. You can uncover his scientific approach to crushing the market and his carefully chosen six picks for ultimate growth instantly, because he's making this premium report free for you today. Click here now for access.

Mark Lin has no position in any stocks mentioned. The Motley Fool recommends and Netflix. The Motley Fool owns shares of 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.

Compare Brokers