How critical is competitive advantage? Just ask Coinstar (NASDAQ:CSTR), the outfit behind those coin-counting kiosks at your local supermarket. Today, Coinstar was clipped some 28% (and is still falling) after losing Safeway (NYSE:SWY) as a distribution partner. Safeway, a partner for nine years, accounted for 10% of Coinstar's revenue.
The company issued a press release blandly stating that the former partners were unable to reach "mutually acceptable economic terms." Previous terms had included an 8.9% fee to Coinstar, with supermarket partners getting a 1% cut for housing the kiosks in their stores. Apparently, Safeway wanted more, and Coinstar was unwilling to bend.
The possibility of a Safeway defection had long been rumored due to trials of a competitor's product by Safeway Arizona, who had never been a Coinstar client. It's too early to say whether Safeway has intentions of rolling out the competing product on a larger-scale, but Coinstar's dominance is clearly at risk. Furthering those worries is the news revealed on today's conference call that Kroger (NYSE:KR), a 23% revenue client (Coinstar's largest), has also been pilot-testing a competitor's machines in 10 locations.
This is a classic case of juicy profit margins attracting competition. Over the past three years, Coinstar's free cash flow margins have averaged 10%, even while the company has aggressively expanded its kiosk network (over 10,000 machines at last count). Once the expansion slows, free cash flow margins could easily reach 20% or more. But only if Coinstar can maintain its current economic terms, which are obviously at risk.
Until Coinstar can prove that this risk is unfounded, the stock is vulnerable. At today's market cap of $294 million, Coinstar is valued at roughly 1.7 times projected 2003 sales. A normalized 10% free cash flow margin implies a price-to-free cash flow multiple of about 17. Even after today's 28% haircut, that's not yet cheap enough given the competitive risks. A price closer to 10 times free cash flow might offer a reasonable margin of safety.
