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Why Outerwall Still Has Plenty of Gas Left in its Tank

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Outerwall (NASDAQ: OUTR  ) operates in the rather stodgy business of renting out DVDs. Many investors have been overly critical of the company, suggesting that its Redbox DVD rental business could be close to breathing its last breath. Investors have not been particularly impressed either by the company's late entry into the video streaming business, where the likes of bigger and better-heeled competitors such as Amazon and Netflix (NASDAQ: NFLX  ) will ostensibly give it a snowball's chance in hell. A famous unapologetic investor recently termed Outerwall's Redbox Instant project as a ''Hail Mary'' me-too product play. From the unfavorable comparisons being drawn between Outerwall and its more illustrious peers, Netflix in particular, you would be forgiven for thinking the company's DVD business is in the same doldrums as Dell's or HP's PC business. But nothing could be further from the truth.

Outerwall's Redbox's DVD business might be old-fashioned and boring; its cash flow and profit margins certainly aren't. The company's free cash flow is in fact one of its strengths. Take a peek at the graph below to compare Outerwall's FCF with Netflix's:

Outerwall expects its FCF in the current fiscal year to be around $211 million-$227 million. Its price-to-free-cash flow multiple of 8 is the lowest among its peers.

If you are probably thinking that Outerwall is no better than buggy whip companies then your reasoning is faulty. Although most technologies but the very primitive, such as fire, lasts forever, DVD technology will probably disappear slower than most. There is still considerable demand for DVDs and Blu-ray's, video streaming notwithstanding. In the last two years that Netflix has been streaming video, Outerwall managed to record 30% revenue growth, and net income grew by an incredible 53%. Mind you this happened in a backdrop of intense competition from Netflix, which seems to have recovered from its fiasco and is growing its subscriber base by about 600,000 new subscribers every quarter.

It's quite clear that even in this age of video streaming, there are a sizable proportion of US customers who still want to watch their DVDs while enjoying other streaming services. Redbox recently released estimates that 20% -30% of its customers have subscribed to other competing video streaming services such as Netflix. Consumers still love the immediate gratification of renting a Redbox DVD from the local Walgreen or Wal-Mart store, instead of waiting for two days for a Netflix delivery.

Demand for Redbox's DVDs continues to be robust. Outerwall managed to rent out a staggering 74 million DVDs in July, 2013, from its 43,700 self-serve store kiosks. July turned out to be the company's best DVD rental month in its history. The lower revenue guidance that was issued by the company's management was pinned on heavy discount coupons that it has been issuing to lure more customers. The bait has been working, albeit lopsidedly since Redbox's customer base has been growing, but the average rental period has gone down. It is this lower rental period that led to lower revenue guidance.

Coinstar business' rock solid margins
Outerwall derives 87% of its revenues from Redbox while the rest comes from Coinstar. But Coinstar's operating margins are far higher than Redbox's: 34% vs. 22%. Coinstar has been consistently profitable and provides a downside assurance whenever the Redbox DVD business suffers from the occasional hiccup. In fact, many analysts believe that Coinstar's super-high margins not only make it almost impossible for Outerwall to lose money, but also let the company take chances in newer ventures. The only time Outerwall returned an operating loss in the last decade was back in 2007. Coinstar remains a very important business segment for Outwerwall and critical to the firm's future success.

Netflix overvalued
Netflix remains Outerwall's, biggest competitor. The company recently released blowout third-quarter results that revealed how its global subscriber base has already crossed the 40 million mark. The biggest concern for Netflix investors, however, remains its growing cost of original content as a percentage of total costs and, of course, its extremely pricey valuation.

Despite a stellar third-quarter, investors are advised to be wary of the firm's share price that has remained in the stratosphere. The stock, which has been the S&P 500's second-biggest gainer this year, tumbled a jaw-dropping 9.2% on Oct.21, to trade at just $322.52 after having soared to a dizzying height of $396.98 hours after third-quarter results were released. Bank of America said that Netflix's price is ''difficult to justify'' and the firm would have to reach a subscriber base of 140 million to justify a $400 price.

Bottom line
Outerwall is not the falling knife it has been labeled as by some of its detractors. Although the recent weakness being experienced in the firm's DVD business could raise a red flag, it is more likely just the usual comeuppances that all companies have to deal with every now and then. The recent entry into the scene of activist investor Jana Partners increases the options available for the firm's investors. Outerwall and its investors set look to continue thriving even as video streaming continues growing in popularity.

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