In the digital era, there's not much left to prop up DVDs, aside from Redbox kiosks. Can anything prevent them from tipping over?
Perhaps surprisingly, physical DVDs still account for the majority of U.S. home-video entertainment spending, with an estimated $7.3 billion in sales and $4.2 billion in rentals in 2014, according to research and analysis firm IHS Global. The combined $11.5 billion is more than the $8.6 billion from all digital subscription services like Netflix and on-demand services like Apple's iTunes, IHS estimates. Those figures don't include pay-TV channels like Time Warner's HBO and Starz.
The physical category has been in decline for nearly a decade as consumers embraced a variety of digital alternatives. The only growing segment within the DVD category has been revenue at kiosks, namely those operated by market leader Redbox, a unit of Outerwall.
Now, even kiosks appear to be in trouble. After reporting two consecutive quarters of Redbox revenue declines, Outerwall announced Monday it would raise prices. For regular DVDs, the daily rate will be raised to $1.50 from $1.20; for Blu-ray, the price will rise to $2 from $1.50.
Outerwall is convinced the move will work. In an interview with CNBC Digital, CEO Scott Di Valerio said the company had run test price increases over a period of several months earlier this year to determine whether the move made sense. While volumes may decline as a result of the price hike, the net impact is expected to be higher revenues. He also pointed out that box office results have been weak in 2014, and a better slate in 2015 could give Redbox a boost as well.
The big question is how many customers will forgo Redbox rental and instead choose video-on-demand services. According to IHS, the typical on-demand movie sold through a set-top box costs $6.46. A digital rental through an Internet service like iTunes is a bit cheaper at $4.19, IHS said.
While those options appear to be far more expensive than a one-day rental from Redbox, consumers tend to keep movies for a couple of days. At $1.50 or $2 per day, the price of a Redbox rental will generally be cheaper so long as a DVD is returned within three days.
Redbox probably made the right move this time. Given that many costs are fixed, much of the new revenue from the price hikes will flow through to higher earnings. Wedbush analyst Michael Pachter estimates the price increase will lead to a 21 percent increase in Outerwall's operating income. That helps explain the 10 percent rise in Outerwall shares since Monday.
Will customers stick with Redbox in the longer term? Certainly, there are some people who don't have cable or Internet-connected TVs. Redbox DVDs can be watched multiple times if consumers decide to hang onto them. And DVDs have other benefits, like being shared easily with friends.
But digital competition is only getting tougher. The most precise replacement for new releases on Redbox are on-demand rentals and purchases, which are available in roughly the same time window a few months after theatrical release.
Digital purchases, which are more expensive, are sometimes even available slightly sooner. Studios love digital purchases because the margins are extremely high—even better than DVD sales. While the absolute numbers remain low, digital sales appear to have traction. In the first nine months of 2014, electronic sales of movies and TV shows rose 33 percent, according to The Digital Entertainment Group, which reports figures collected from studios.
Among the Internet players, competition will likely remain fierce. While Apple has been in the game for a long time, others have come in aggressively. Anthony DiClemente, an analyst with Nomura, points out that Amazon's movie catalog is as deep as any Internet rival. The e-commerce giant is known for keeping prices as low as possible so it's hard to imagine a significant hike anytime soon.
For movie lovers who can wait a bit longer, there are even more alternatives. The likes of HBO and Starz get movies from major studios about six months after DVD release. HBO also plans to launch a standalone service in 2015 and Starz has signaled similar plans. CBS's Showtime may also launch a similar service next year, though it focuses more on original series than new films.
Even Netflix, which tends to focus on older movies, has some relatively new releases from Viacom's Paramount, MGM, and Lionsgate through a deal with premium TV network Epix. It will also pick up Disney titles for theatrical titles beginning sometime in 2016. Disney titles currently go to Starz.
Outerwall has become a serious battleground stock. Some 35 percent of the company's shares outstanding are sold short by investors betting against it, according to FactSet. At the same time, Outerwall is buying back shares aggressively. In the third quarter, for instance, the company spent $71 million on share repurchases. During the period, it generated $30 million in free cash flow.
While Outerwall has likely bought itself some time with a smart price increase, its longer-term problems show no sign of fading.
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