Outerwall Is Not a Buggy Whip Company

Outerwall (NASDAQ: OUTR  ) naysayers have been dismissing the company's future prospects based on fears of the imminent demise of DVD and Blu-Ray technologies. Some have likened this DVD rental company to buggy whip companies that were put out of business after Henry Ford, the maverick Model T inventor, found a perfect formula to mass produce automobiles. In this age of video streaming, few investors expect Outerwall to compete favorably with bigger and better-heeled companies such as Netflix (NASDAQ: NFLX  ) , Hulu, or Amazon.com (NASDAQ: AMZN  ) , which will ostensibly give the company a snowball's chance in hell. Not even Outerwall's video streaming service, Redbox Instant, is commanding favorable reviews, with some investors terming it a Hail Mary, me-too project.

Outerwall shares currently have a consensus recommendation of 'Buy' with an 'Industry Outperform' rating. The mean price target for the shares is $73.80, representing a potential 9% upside from current price. Some analysts, such as B.Riley, think the shares could go as high as $103.00.  Apparently, most equity analysts do not share the unmerited pessimism surrounding the company. Outerwall's current P/E ratio of 14 times 2012 earnings is far below its 10-year historical average of 36. Its low 0.66 PEG ratio is a reflection of investors' low growth expectations.

DVD business in the pink of health
Many tech companies such as Cisco, Dell, and HP, among others, are facing headwinds in their respective businesses. They have fallen out of favor with investors as they continue to undertake drastic internal restructuring. Many are struggling to find a regular cadence of revenue growth, as Cisco's recent first-quarter earnings call proves.  However, to say Outerwall's DVD business is in the same doldrums as these companies would be to stretch the truth too far.

Redbox, the Outerwall segment that deals in DVD rentals, is doing just fine. Outerwall grew its revenue by 30% and its bottom line by an even faster clip of 53% in the two years Netflix has been streaming video.

The healthy DVD business has given Outerwall cash to burn, and it currently enjoys better cash flow than Netflix.

Redbox's stellar performance only goes to prove that there is a sizable class of consumers who prefer renting a Redbox DVD alongside their regular video streaming service. Outerwall estimates that 20%-30% of its customers have subscribed to a video streaming service. Granted, no technology lasts forever, and DVDs will one day go the way of the dinosaur. Video streaming might be a more utopian entertainment concept than DVDs right now, but with so many companies competing for a share of the pie, it will most likely become almost banal in a few years' time.

Although demand for DVDs has been robust throughout this year, Redbox has been facing a few headwinds. The company issued lower income guidance for the third quarter not because customers are no longer renting out Redbox DVDs, but rather due to the coupons which offer heavy discounts that the company has been giving its customers to lure them into its 43,700 self-serve stores. This has resulted in some degree of margin compression. The rental period has also gone down a bit, and this has also led to slightly lower revenue than expected.

Returning money to shareholders
Outerwall returns about 75%-100% of its free cash flow to its investors every year, mainly through share buybacks since it does not pay dividends. This year, it planned to achieve that through share repurchases totaling $195 million. Outerwall share buybacks in the first three quarters hit $95 million, and the remaining $100 million worth of shares is expected to be purchased in the fourth quarter. The company plans to purchase a further $50 million worth of shares in the first quarter of 2014. Total share repurchases in the fourth quarter of 2013, and the first quarter of 2014, amount to 8% of total outstanding shares. Investors are therefore likely to see the value of their shares rise by a similar margin through the buyback effect alone.

Coinstar business solid margins
Redbox accounts for 87% of Outerwall's revenue while Coinstar, the firm's automated retail machines seller, accounts for the rest. Coinstar acts as a superb hedge for Outerwall mainly because it enjoys a very high operating margin: 34% for the segment compared to Redbox's 22%. Many analysts believe that Coinstar has been pivotal in Outerwall's stellar run of consistent profits in the last decade, as the only time the company returned an operating loss was in 2007.

Video streaming competitors
Video streaming does not necessarily provide direct competition for Redbox DVDs, since Outerwall revealed that a sizable proportion of its customers rent DVDs and subscribe to a streaming service at the same time. The growth in popularity of video streaming does not seem to be coming at the expense of DVD rentals as we have seen above.

Amazon's video streaming service goes by the name Amazon Instant. The service is relatively new compared to Netflix. Amazon Instant operates an a-la-carte system where subscribers pay per video rental, with another option of $79 per year for unlimited access. Although Prime has a smaller subscriber base than Netflix, there is a considerable degree of overlap: about 10% of consumers who have subscribed to a streaming service use both Amazon Prime and Netflix.   Morningstar estimates that Prime currently has 10 million subscribers, and expects the number to grow to 25 million by 2017. Amazon Prime is a very important segment for the company, and contributes a third of its overall profits.

Netflix announced it had finally surpassed 40 million subscribers during its blowout third-quarter earnings call. The stratospheric valuation of the shares remains a point of concern. Bank of America revealed that the company will have to grow its subscriber base to 140 million to justify a $400 share price

Bottom line
Outerwall certainly isn't the falling knife that many think it is. The shares could be grossly undervalued, and they might rise considerably in the coming year. DVDs look set to be around a lot longer than most initially thought.

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  • Report this Comment On December 25, 2013, at 12:24 PM, duuude1 wrote:

    Hey Joseph,

    Merry Christmas. Great article. Kids are playing so I get to surf the Fool articles :)

    I commented on Chad Henage's article a couple months back which was similar to yours in recommending Outerwall over Netflix (or Amazon):

    http://www.fool.com/investing/general/2013/11/16/are-netflix...

    I didn't use the buggy whip analogy, but instead equated Outerwall to Lexmark who bought IBM's Selectric typewriter business (and initially rocketed up 1000%). I'm sure business was cranking many years after Lexmark bought IBM's business. With 20/20 hindsight, you can now see that investing in electric typewriters at the start of the PC and desktop publishing era was a fool's errand, right? Well that hindsight doesn't help with Lexmark, but it does help with similar situations - like Outerwall.

    What Lexmark (then) and Outerwall (now) investors are doing are exactly the same thing - vigorously denying the march of technology.

    Investing in a business is not just about the finances - looking backwards at prior quarter's or year's performance - which can be great or Outerwall. Investing is also trying to look forward into the murky future - is the light blazing bright for Outerwall? The future is always hazy, but I believe it is brighter for Netflix than Outerwall.

    That said, Netflix's current valuation is certainly a valid concern - but I bought Amazon a couple years ago despite the huge runup on very poor earnings and crazy valuations for the exact same reasons. Future prospects.

    Best of luck,

    Duuude1

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