Download Outerwall (OUTR)

Outerwall (OUTR) - Long Thesis
from 2014 Annual Meeting
July 21, 2014
DISCLAIMER
Before making an investment decision, investors are advised to
read carefully the Offering Memorandum, including the
description of the risks, fees, expenses, liquidity restrictions and
other terms of investing in the funds. Performance data has not
been prepared to meet any specific requirements applicable to the
presentation thereof and should in no event be viewed as
predictions or representations as to actual future performance.
Investment may involve a high degree of risk and should be
considered only by investors who do not require access to their
capital and can withstand the loss of all or part of their
investment. Return targets in this document are subjective
determinations and do not reflect either actual past performance
or a guarantee of future performance. Referenced benchmarks
may fail to provide a meaningful comparison. Forward looking
statements are based upon assumptions which may differ
materially from actual events. This information should not be
relied upon in making an investment decision.
Investment Strategy – Brief Summary
•
Focus on out-of-favor Stocks
 Out-of-favor
stocks that are mispriced due to uncertainty
or fear, misunderstanding or obscurity; conduct
significant due diligence to overcome those hurdles; invest
only at a deep discount to intrinsic value
 Limited to 10 to 15 best ideas
•
Preserve Capital
 Achieved
by focusing on stock with poor scenarios built
into the stock so risk of permanent loss is low
•
Minimize taxes
 Focus
on long-term gains over short-term gains and
capital growth over income
Two Types of Investments
•
Pillar stock – will hold a long time
 Durable competitive advantage
 Trustworthy management
 Industry we understand with favorable characteristics
 Available at a deep discount
•
Work-out – shorter time frame & catalyst driven
 No durable competitive advantage required
 Trustworthy
management
 Industry we understand
 Available at an even deeper discount
 Near-to-medium term catalysts required
Where we look for ideas
•
We look for companies with specific issues:









•
Turn-around situations
Spin-offs
Post-reorganization equities
Debt covenant concerns
Recently lowered guidance
Hidden or unappreciated assets
Misunderstood business model
Recent negative headlines unfounded, short-term in nature, or unrelated
to the actual operations of the company
Out-of-favor industry or country (best source for pillar stocks)
No particular market cap or sector focus

Thorough understanding of the industry and sufficient liquidity required
•
Increasingly looking abroad for ideas
•
Special situations will arise regardless of overall market
Volatility Is Our Friend
•
Volatility is a measure of the price swings in a stock
•
Modern portfolio theory assumes greater volatility means greater risk to
the investment

•
Only risk that matters is the permanent loss of capital

•
Short-term fluctuations in the stock price in no way indicate
probability of permanently losing capital
Since we focus on out-of-favor stocks, our investments often go down
further after we invest before eventually rising to our valuation

•
Nothing could be further from the truth
We invest into negativity and negative sentiment can increase in the
short-term, but eventually cooler heads prevail
Increased volatility means we have a greater chance of buying a stock we
like at even lower prices
In-Depth Analysis
Profile
•
Outerwall (ticker symbol: OUTR) is U.S. leader in automated
retail
 Self-service, stand-alone kiosks in heavily trafficked
locations
•
Founded in 1989 as Coinstar
•
Changed name to Outerwall in 2013
•
$1.1B market cap
•
Over 100 patents
Brands
•
Flagship Brands – cash cows
 Redbox
 Coinstar
•
Developmental Concepts – growth stage
 ecoATM
 Coinstar
Exchange
 SampleIt
 Redbox
Instant by Verizon
Available at very low multiples
•
Stock selling <7 times 2013 free cash flow & for <6 times
expected 2014 free cash flow
• Despite the fact that free cash flow is still growing
• Capital expenditures to decline substantially over next
few years
• Highly variable cost structure
•
Available at less than 50% of revenue despite high
margins
•
•
Revenue still growing
Margins expected to grow even faster
Opportunity
•
Maximum negativity from market due to Redbox
 Face of the company
 Seen as another Blockbuster-in-waiting
•
Very high short interest
 44%
of float shorted – 10 days to cover
•
Shifting investor base from growth to value-oriented
•
Market cap down 37% YTD
 Down 25.5% in last 2 months solely on negative analyst
reports
•
Work-out investment
 Expect company to beat lowered market expectations,
overcome market’s fear, & likely cause short squeeze
Automated Retail
•
Self-service, stand-alone kiosks in heavily trafficked areas
•
Strong role in future of retail
•
Allows convenience for fulfilling immediate need at lower
costs than traditional brick-and-mortar retail, even lower
cost than e-commerce
•
Limited overhead
 No large rent expense (take up 12 square feet of space)
 1 part-time employee can service multiple kiosks
Outerwall Rules Automated Retail
•
No competitor can come close to matching Outerwall
•
Outerwall has prime real estate no competitor can get
 Ex. just about every Wal-Mart has a Redbox and Coinstar
 It does not make sense to have a second kiosk from
competitor in same location offering same service
Lends itself to natural monopoly within a store
•
Long-term relationships with major retailers throughout the
country creates high barrier to entry for competitors
 Wal-Mart,
Walgreens, Kroger, Target, malls, gas stations
 Retailer receives percentage of revenue
 Drives foot traffic to store
 Automated
retailer of choice for any new concept
Redbox
•
86% of Outerwall revenue in 2013
•
Kiosks offering physical DVD, Blu-ray, & video
game rentals
•
43,000+ kiosks in U.S. and Canada
 68% of U.S. within five minute drive of a
kiosk
•
Only option available in most areas for physical
rentals
Bear Thesis
•
Can be summed up by one brief paragraph:
 Pacific Crest negative report note on July 1, 2014:
“Total DVD/Blu-ray rental volume in the U.S. has
declined for six consecutive years. We have found no
physical format in the past 40 years that has stabilized
after five or more consecutive years of decline, which
makes a stabilization at Redbox seem highly unlikely.”
Faulty Reasoning
1.
Physical DVD/Blu-ray volume declined mostly due to extensive
retraction in supply as opposed to demand
 B&M
stores going bankrupt but Redbox has continued to grow
rental volume throughout this period
2.
One format emerged previously because single device could
only play one format (VHS vs Betamax, HD vs Blu-Ray)
 Many
devices used to stream movies can also play DVD or Blu-
ray
3.
Generally new format was better quality – DVD over VHS
 Blu-ray
quality exceeds anything possible via streaming today
or near future while DVD has same quality as streaming
4.
Ignores sustainable and growing price difference in physical
versus streaming rentals and new release availability
Bear Thesis Dissected
“Total DVD/Blu-ray rental volume in the U.S. has
declined for six consecutive years. We have found
no physical format in the past 40 years that has stabilized
after five or more consecutive years of
decline, which
makes a stabilization at
Redbox
seem highly
unlikely.”
•
Paints the picture of a free fall at Redbox – revenue and
margins tell a different story…
Revenue Growing
in millions
12+%
Operating
Margins
$2,000
$1,500
26.4% CAGR
$1,000
$500
$2009
2010
2011
2012
2013
Revenue per Kiosk Stable
in dollars
$50,000
$47,610
$47,500
$45,000
$48,263
$45,029
$44,110
$42,853
$42,500
$40,000
$37,500
2009
2010
2011
2012
2013 decline due primarily to Canada expansion
2013
Market Share
Should only increase
Slide from Outerwall 2014 Analyst Day
Can still take market share from brick-and-mortar
Home Entertainment
Slide from Outerwall 2014 Analyst Day
How to think about competitive
landscape
•
Natural urge to compare Redbox to Netflix or Amazon
Prime because each offers movies, but that is a mistake
•
Netflix and Amazon Prime do not get new releases for some
time and must maintain large and growing library of older
movie titles and TV shows plus original content
•
Redbox focuses primarily on new releases and does not
carry any TV content
• Result is little to no content overlap with subscription
services
•
Proper comparison is Redbox vs. Amazon Instant Video,
iTunes, and Cable Video on Demand (CVOD)
Redbox vs Streaming
•
Advantages
1. Sustainable Price Gap
2. New Releases
3. Higher Quality
•
Disadvantage
1. Convenience
Price Advantage
Slide from Outerwall 2014 Analyst Day
Upward Pricing Pressure
•
Redbox – no price increase since 2010 yet maintaining
margins
•
Amazon, iTunes, & CVOD have all raised standard video
on-demand prices at least $1 since then
•
Studios retain ownership of digital content and have
significant say in price charged for video on-demand
 Want to maximize revenue by selling DVD or digital copy
instead of renting
 Think highly of the value of their content
•
Redbox has far greater control over pricing due to First-Sale
Doctrine
First-Sale Doctrine benefits Redbox
•
Enables distribution of legally purchased copyrighted
material
 Once sold, copyright holder (i.e., studio) has no say in
what purchaser does with product as long as purchaser
does not reproduce material (i.e., create additional copies)
•
Allows Redbox to purchased DVD or Blu-ray and rent it out
at whatever rate it and as soon as it desires in the absence of
a contract with the studio
•
Court rulings within the last decade determined that FirstSale Doctrine does not apply to digital copyright material
 Results in studios maintaining significant control in
streaming pricing
New Release Advantage
•
New Releases usually available at Redbox well before
subscription services Netflix, Amazon Prime, Hulu, etc.
 Studios want to maximize revenue by selling or renting
individually for a time
•
Amazon and iTunes sometimes do not have new release
available for rent immediately
 Only able to buy at higher price
 Studios concerned about hurting sales
•
Redbox has all of the new releases either the day of release or, at
most, 28 days after release
 First-Sale
Doctrine prevents studios from stopping Redbox from
renting DVD’s, so sign agreements with Redbox, giving discount
 2nd
or 3rd largest source of DVD revenue for Studios
Blu-ray – Higher quality
•
Blu-ray is higher quality than HD streaming
 Only available in physical format and at fraction of the cost
•
Only costs $0.30/day more at Redbox than DVD rental
 HD
•
is $1 more than standard on streaming
Blu-Ray at Redbox introduced in 2012
 Currently 17% of Redbox revenue
 Expected to grow to 25% by 2015
 Higher margin than DVD
Not So Inconvenient
•
Only 12% of purchases reserved online
 Very easy process with app or website
•
45-50% of DVD’s returned to different kiosk
•
Indicates an impulse transaction as leaving grocery store or
getting gas
 Prominent kiosk display near front door grab attention
 Greatly reduces “convenience” advantage of streaming
High Frequency Renters
•
Rent 4+ DVD’s/quarter on average
•
25% of customers
•
60% of revenue
•
Core customer base
 “Movie night”
 Want new releases and/or Blu-ray
•
Would take long time to erode this base
Growth Initiatives
1.
VMZ – expanded capacity & inventory efficiency in kiosks in
2013 – added equivalent of 4,000+ more kiosks
2.
New CRM & customer understanding
•
Increased interaction with customer via e-mail and app already
paying dividends
3.
Increased Blu-ray mix
4.
Increased video-game mix ($2/night vs $60 for new game)
•
Only 2% of revenue currently
5.
Expansion into Canada – new market
6.
Potential rate increase
•
Currently testing in a few markets
Coinstar
•
13% of Outerwall revenue in 2013
•
Kiosks that convert coins into cash
•
20,000 kiosks in 4 countries
 U.S., U.K., Ireland, and Canada
•
80% market share, excluding banks, in U.S.
 33% when including banks
•
Counted four times as many coins as processed
by U.S. mint in 2013
•
91% of population within 5 miles of a kiosk
Clear Advantages
•
Prime real estate and retailer relationships
•
No threat from e-commerce
•
Even banks are beginning to put Coinstar kiosks in their
branches
•
Raised price from 9.0% of transaction amount to 10.8% and
consumers did not bat an eye
 Exceptional pricing power
Retailers Love Coinstar
•
50% of cash received from converting coins is spent in store
kiosk is located in
•
Customers have option for gift card to store in lieu of cash
 Retailer pays the fee instead of customer in this instance
Mature but some growth initiatives
1.
Possibility for future fee increases
2.
Expand bank presence
3.
Considering variable pricing by region or transaction size
4.
New ways to deliver funds
• PayPal
• Blackhawk
• Charity Donation
• Gift Card
Slow and Steady Revenue Growth
$310
20+%
Operating
Margins
$300
3.7% CAGR
$290
$280
$270
$260
$250
$240
$230
2009
2010
2011
2012
2013
Coinstar Exchange
•
New kiosk concept in test phase
•
Exchange gift cards for cash
 Many retailer gift cards accepted
 Gift cards are then sold by Blackhawk to other partners
• Blackhawk takes a fee and remits rest to Coinstar
• Difference between what Coinstar receives from Blackhawk
and pays to customer is recorded as revenue
•
Only 440 kiosks at end of Q1 2014
 Expect
700 by mid-year 2014
•
Benefit from Coinstar brand
•
Revenue and profitability not released
ecoATM
•
1% of Outerwall revenue in 2013
•
Kiosks give customers cash for used electronic devices
 Phones, tablets, MP3 players – 4,000 devices allowed
•
Devices sold wholesale to other companies
•
Over 30 patents issued or pending
•
Invested in 2009 when concept won Outerwall best
idea contest
•
Acquired remaining interest in July 2013 for $263M
•
900 kiosks in Q1 2014
 Expect 2,000 by 12/31/14
ecoATM Opportunity
•
370M devices sitting idle in U.S. alone
 Only 59M recycled in 2013
•
Recycled device market $1.4B in 2013
 Expected to grow to $7.6B and 174M devices by 2018
•
Trade-in at store most popular option, typically buying newer
device
 Only receive store credit
•
Online trade-in requires shipping in product and waiting for
cash or owning a PayPal account to receive amount, subject to
later adjustment
•
ecoATM only option for instant cash
 Could serve as best option for unbanked and underbanked
In Roll-Out Phase
•
Unprofitable currently but expect Redbox-type operating
margins at scale
•
High capex during rollout phase eventually settling to
maintenance levels
•
Expect to grow from 1% to 12-15% of total revenue by 2015
•
Expect 6,000 kiosks in U.S. at maturity
 Predict $600M-$720M in revenue and $120M to $182M in
operating profits
•
Given it is mostly unproven at this point, we assume concept is
drain on free cash flow in both upside and downside valuation
Redbox Instant by Verizon
•
Couples movies-only streaming service by Verizon with rentals
from Redbox into subscription service
•
Redbox is 35% owner in the JV with Verizon
•
$157M capital commitment, of which $63M already spent
 Unproven concept, so we deduct entire amount of required
future investment from both upside and downside valuation
 OUTR can put interest to Verizon if certain subscribers levels
not reached by March 2015 – recoup some costs
Other Concepts
•
SampleIt
 Kiosks offer $1 samples of products in skincare, fragrances,
health & wellness, hair, cosmetics, & household categories
 Retailers like it because gives insight into consumer
 Earliest stage concept – immaterial
•
SoloHealth
 Outerwall owns 10% of company
 3,500 kiosks nationwide offering free health and wellness
screening
 Services 130,000 customers daily for free – paid via
advertising, referrals, other
 Not yet profitable or material to OUTR
 Example of continued search for next great kiosk concept
Recent Shareholder Friendly Moves
•
Disposed of 4 unsuccessful concepts in December 2013
 Reducing headcount 8.5%
 $40M in total annual savings
•
Took on debt at reasonable rates to buy back 20% of stock at
below our assessment of intrinsic value in March 2014
•
Committed to returning 75-100% of free cash flow to investors
via buybacks going forward
•
New, more conservative approach to new concept testing
Solid Balance Sheet
•
Debt issued previously to fund growth and, more recently, to
buyback stock
•
Debt easily manageable
 Leverage ratio = ~2.0
• Target is 1.75-2.25
 Net debt to free cash flow = ~4.0
• Ratio declines as capex settles to lower maintenance level
•
No pension or unrecorded liabilities
•
Current ratio ~1.0 due to low cash conversion cycle
 Outerwall receives cash from customers about the same time the
cost of the product is due to the vendors and payroll due to
employees
 Rent expense based on percentage of revenue, so not paid until
after cash received from customer
Sum of Major Growth Initiatives
1.
ecoATM
2.
Coinstar Exchange
3.
Redbox Canada expansion
4.
Redbox Blu-ray expansion
5.
New Redbox CRM and customer understanding/targeting
6.
Potential Redbox rate increase
7.
Recent Coinstar price increase
8.
Expanding Coinstar bank presence
9.
Automated Retail of choice for any future high potential kiosk
concept
Cash Cow
Operating cash flows – in millions
$500
$464
$416
$400
$208
$300
$200
$306
$179
$158
$171
$325
$125
$256
$166
$135
$200
$-
2010
CAPEX
FCF
$237
$100
$324
• 18% avg. FCF
yield
• 25% FCF yield
at maintenance
CAPEX levels
2011
2012
2013
2014*
* Low end of 2014 guidance – high end is $240M in FCF
Sustainable & Improving Free Cash
Flow
1.
Discontinued 4 test concepts Dec. 2013 – saving $40M in annual expense
2.
Highly variable cost structure
Minimum guarantees for Redbox only material fixed cost
 Rent, credit card fees, marketing either based on revenue or adjustable

3.
Recent Coinstar price increase and potential Redbox price increase
4.
Blu-ray expansion
5.
Substantially reduced CAPEX for Redbox from 10+% of revenue to 1 - 2%
of revenue
6.
Potential for ecoATM profitability – currently cash drain during rollout
7.
Limited working capital requirements – current cash conversion cycle
around 0 days
8.
Limited advertising required (~0.5% of revenue) – rely on point-of-sale and
word-of-mouth
Risks to Consider
1.
E-commerce threat – factored into assumptions, particularly
for downside valuation
2.
Major retailer (Wal-Mart) deciding to offer same service and
kick out Outerwall
 Highly unlikely due to Outerwall scale advantages, business
complexity, and the fact that retailer already profiting from
service via Outerwall
3.
Studios deciding to eliminate DVD all together
 Highly unlikely because too large a revenue stream
Valuation Methodology
•
Valued using two methods
1. Projecting company-wide financials to determine free cash
flow
2. Sum of the parts analysis
•
Completed upside and downside valuation
 Upside
conservative
 Downside aggressive to incorporate worst case scenarios
Valuation
Upside Analysis
Method 1
Method 2
Intrinsic Value
$115
$94
Stock Price
$55.32
$55.32
Upside
108%
70%
Downside Analysis
Method 1
Method 2
Intrinsic Value
$46.95
$46.05
Stock Price
$55.32
$55.32
Downside
15%
17%
Invest based on the lowest number for both upside and
downside
Back of the Envelope Calculation to
Support Valuation (1 of 2)
•
Should understand investment well enough to be able to
calculate a rough valuation using simple methodology
 Used
•
as a sanity check for valuations calculated on previous slide
Key Data points:
 Starting
 Avg.
•
OCF/Revenue last 4 years = 19.7%
Redbox began establishing dominant position in 2010
 Avg.
•
revenue of ~$2.3B
CAPEX/Revenue last 4 years = 9.5%
Project next 5 years average free cash flow - assumptions:
 Upside:
no growth, lower margin (higher tax and interest, no credit
for higher rates), less capex (still well above maintenance level)
 Downside:
35% revenue decline, even lower margin (high variable
cost structure limit margin decline), slightly higher capex
Back of the Envelope Calculation to
Support Valuation (2 of 2)
• Project average cash flows over next 5 years and apply
appropriate multiple based on business risk
Key Data Point
Upside
Downside
Revenue
$2,300
$1,500
OCF/Revenue
16.0%
12.0%
CAPEX/Revenue
3%
4%
Free Cash Flow
$299
$120
Multiple
8
8
Valuation
$2,392
$960
Market Cap
$1,100
$1,100
Upside/(Downside)
117%
(13%)
• Key is capital expenditures – elevated for Redbox rollout
and currently for ecoATM rollout
• Strong boost to FCF as settles at maintenance level
• Not appreciated by market at all
Catalysts
In descending order of probability:
1.
Primarily beating lowered expectations
 Short
2.
squeeze
Positive surprise from ecoATM
 Either
3.
ignored by market currently or viewed negatively
Buyout by private equity firm
 Beaten
down cash cow in the under $2B range hits the private
equity sweet spot
Near-term Expectations
•
Redbox to some degree reliant on popularity of new releases
 Fluctuates from quarter to quarter
 Evens out over time
•
Next earnings release July 31, 2014
 Not a great quarter for new movie releases
Expectations already so low, so hard to predict how market
would react to one quarter
 If stock drops further, we will be happy to add assuming no
drastic change in fundamentals
Volatility is our friend
UPDATE: Proven correct subsequent to annual meeting – terrible
quarter for new releases & market initially down on the news
before finishing up
Appendix
About the Managers:
Jonathan Booth, CFA, CPA/ABV
•
Passed CPA exam, ABV exam, and all 3 CFA exams on first attempt
•
2006 Elijah Watt Sells Award (top 10 CPA exam score in the world
out of 50,000+ test takers)
•
2008 Baton Rouge Business Report “Top 40 Under Forty” Award
•
B.S., Accounting and M.S., Accounting from Louisiana State
University
•
3+ years of auditing experience with two of the Big 4 accounting
firms
Exceptional performer every year & early promoted
• Lead senior of Fortune 500 audit client
•
•
Former Assistant Director of State Economic Competitiveness
under Governor Jindal
•
Accredited Member magazine and SeekingAlpha.com contributing
author
About the Managers:
Kevin Laird, CPA
•
7 years of accounting and auditing experience with
•
KPMG – Big 4 accounting firm
•
Postlethwaite & Netterville – largest accounting firm in
Louisiana
•
The Edgen Group – Manager of Financial Reporting
•
Edgen-Murray Corporation – Assistant Controller
•
B.S., Accounting from Louisiana State University
•
M.B.A. from Southeastern Louisiana University
•
Louisiana Society of CPA’s Business & Industry Committee
•
2012 AICPA Leadership Academy – one of 36 selected from
across the nation for prestigious 4 day event
Contact Information
Booth-Laird Investment Partnership
9005 Westlake Avenue
Baton Rouge, LA 70810
(225) 767-1439
Website: www.boothlaird.com
Blog: www.boothlaird.com/boothlairdblog/
Twitter: http://twitter.com/#!/BoothLaird
Jonathan Booth, CFA, CPA/ABV
Chief Executive Officer
Cell: (225) 978-1532
[email protected]
Kevin Laird, CPA
President & Chief Operating Officer
Cell: (225) 229-6567
[email protected]