There is no doubt about it. The DVD rental business is shrinking. Outerwall (NASDAQ: OUTR ) , owner of Redbox, is the last known survivor in the industry. Its stock price suggests that the market is anticipating zero earnings growth for the company. However, Outerwall has multiple growth segments that may have been missed or discounted by many investors. Outerwall's new ecoATM business and Netflix- (NASDAQ: NFLX ) challenging partnership with Verizon (NYSE: VZ ) could help propel its stock price significantly higher over the next few years.
What are these growth segments, and how much growth are we talking?
The fact that Outerwall has a relationship with 35 million Redbox users could help the company grow its top and bottom line. The presence of the kiosks enables the company to easily advertise its new ventures to existing customers.
On July 23, 2013 Outerwall completed an acquisition of ecoATM. The new venture could generate a lot of profit in the future. The ecoATM is a kiosk where customers can instantly trade mobile phones, tablets, and mp3 players for cash. These machines cost the company around $35,000 to develop, but return $100,000 to $120,000 in revenue per year. Management believes the kiosks will generate around 20% operating margin once they are fully scaled. Currently the ecoATM is the company's main focus.
Started in 2012, Redbox instant is a joint venture between Outerwall and Verizon. The service costs subscribers $8 a month. In exchange for their subscription fee, subscribers gain access to a library of streaming movies and TV shows, and videos on demand. Each subscriber is allotted four credits per month that can be used to rent videos from Outerwall's Redbox kiosks. Although the two firms thought the venture would have gained more traction by now, its growth potential is still overwhelming.
Outerwall recently created Coinstar Exchange--a series of kiosks where customers can trade gift cards for cash. Currently there are 440 Coinstar exchange kiosks and Outerwall plans a significant expansion over the next few years. Once it is fully scaled, this segment will supply the cash needed to grow its other business segments.
Redbox might be doing better than you think
Similar to Netflix's DVD rental segment, Outerwall's Redbox business is shrinking. But not in the way you might think. The company is dismantling hundreds of Redbox kiosks, however Redbox revenue continues to increase. This is due to management's efforts to make the segment more efficient.
The company has found that 45% of discs are rented in one location and returned to a different one. Recently field merchandisers have started rebalancing the kiosks. This has prevented outages and subsequently increased Redbox's revenue.
The company is also gaining a better understanding of its customers' rental patterns. This has enabled Redbox to decrease its numerous discounts and promotions previously used to get customers to rent movies.
Although statistics on home entertainment suggest a large shift toward online entertainment, the DVD rental business is still very significant. Millions of consumers still go to Redbox for new-releases.
The company is catching the demand for both new-releases through its Redbox presence and older content through its Redbox Instant service. As the CEO put it at the J.P. Morgan Global Technology, Media and Telecom Conference "Redbox is the outside walls of the video rental store, while Redbox Instant is the shelves in the middle".
What about the competition?
Now that Blockbuster is finished, Outerwall doesn't face much competition in the DVD rental business. Netflix is pretty much the only other player left. Since customers have to wait a few days to receive Netlfix DVD's in the mail, Outerwall is virtually uncontested in the instant DVD rental industry. DVD streaming is a different case.
The ecoATM segment faces competition from phone retailers such as Apple. Many phone retailers give customers a higher trade-in value for their cell phones than the high-tech ecoATM kiosks pay out in cash. However, Outerwall's CFO believes the consumers' love of instant cash will make the ecoATM a significant profit-generating segment of Outerwall Inc.
What does all this mean for investors?
The price-to-earnings ratio of Outerwall is less than ten times its trailing earnings. Which is significantly lower than the Standard & Poor's average of over fifteen times trailing earnings.
It seems like the market is anticipating that Outerwall's earnings will grow at a lower than average rate. For investors, finding investment opportunities before the market does is the key to achieving above-average returns. So, if you believe OUTR will be able to leverage its growth opportunities as outlined above, Outerwall's stock may make a good value investment for your portfolio.
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