3 Reasons Why Outerwall Is in Trouble

The management of Outerwall (NASDAQ: OUTR  )  seems to constantly be in search of the next big thing. For a while it appeared the company would pin its hopes on the Rubi coffee machine. The Rubi was a self-serve coffee machine that sold Starbucks' Seattle's Best Coffee. Outerwall envisioned opening thousands of these machines. However, the Rubi wasn't the jewel the company hoped for, and if investors are hoping the ecoATM will pick up where the Rubi left off they could be disappointed.

The past
Outerwall is ultimately a retailer at heart. Whether it's renting videos in DVD or Blu-ray format, games, or change conversions, it deals with customers. The largest division of Outerwall by far is the Redbox division. In fact, almost 86 % of Outerwall's revenue comes from Redbox.

Redbox is in the difficult position of attempting to rent physical DVDs and Blu-rays in an age when streaming video is becoming more commonplace. With both Netflix (NASDAQ: NFLX  ) and Amazon.com (NASDAQ: AMZN  ) fighting for a piece of the streaming pie, Redbox almost isn't a player in this industry.

It's true that Outerwall has Redbox Instant, which is a partnership between Outerwall and Verizon, but the fact that management rarely mentions the service says a lot about how well this venture is performing.

With Netflix adding millions of new customers every quarter and Amazon increasing the attractiveness of Amazon Instant Video, it's hard to see how movie rentals from Redbox kiosks will continue to grow well into the future. In the last quarter, while Netflix increased its revenue by 24 %, Outerwall's overall revenue increased by just 4.7%, and Redbox did even worse with a 1.5% increase.

Given that Redbox plans to close between 500 and 700 Redbox kiosks in the US and open between 250 and 450 kiosks in Canada, customers will have fewer Redbox kiosks to rent from because of the net change. The first reason why Outerwall is in trouble is that the company's largest division is posting sub-par revenue growth and will have fewer kiosks by the end of 2014.

The future
The second reason why Outerwall is in trouble is that the company seems to believe that its future lies with the ecoATM business. The problem is that this business makes up a very small part of Outerwall, and if investors want fast growth this won't be enough to move the needle for the company.

Outerwall plans to open at least 1,000 ecoATMs during 2014, which would more than double the size of the business. However, the ecoATM business generated less than 3% of Outerwall's revenue in the current quarter. Even if the business doubles to 6% of revenue this year, that is nothing to write home about.

By comparison, both Amazon and Netflix have growth opportunities with significantly more importance to their revenue than what ecoATM offers to Outerwall. Netflix's international streaming members represent 25% of the company's members, and Amazon's Web Services business already makes up more than 6% of its consolidated revenue.

The point is that Amazon and Netflix both have thriving businesses with much more significance to their earnings streams than Outerwall's ecoATM business.

The balance sheet
The third reason Outerwall is in trouble is that the company continues to spend money it doesn't generate to buy back shares. Though share buybacks can be positive if the company is using excess cash flow, Outerwall is damaging its balance sheet to make these shares disappear.

This is similar to what Netflix did a few years ago when the company had been repurchasing shares and then decided it didn't have enough money for expansion and decided to borrow funds. Amazon doesn't buy back shares, but the company has also taken on long-term debt to fund its expansion.

Outerwall has retired more than 14% of its outstanding shares in the last year, but the company's net long-term debt has ballooned from just over $300 million last year to more than $660 million this year. What makes this an even harder pill to swallow is that the company's most recent repurchase occurred when the stock was at more than $70 a share. With the current price in the 50s, to say this is a questionable use of cash is an understatement.

The bottom line is that Outerwall's main business is struggling and its fastest growing business doesn't mean much to the company's top line, much less the bottom line. In addition, Outerwall is pillaging its balance sheet to buy back shares that have fallen far lower than the buyback price. If investors are looking for a sign of a turnaround, they need to look elsewhere.

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