Can ecoATMs Change the Negative Perception Surrounding Outerwall?

For many investors, Outerwall (OUTR) is an old-fashioned company that deals in nearly obsolete DVD technology. Some have even gone as far as comparing it to buggy-whip companies that Henry Ford, the eccentric Model T inventor, helped put of business. Few expect it to remain relevant in the face of streaming video technology from the likes of Amazon.com (AMZN 0.77%) and Netflix (NFLX 3.49%). Short interest in the company shares remains unusually high, with around 30% of the float sold short. Although the current short interest is lower than the 40% it hovered around last July, it's still too high.

The recent huge insider sale by Jana Partners, one of the firm's foremost investors, hasn't made the negative perception surrounding the company any better. Jana sold 54% of its 13.5% stake in Outerwall, effectively bringing its stake down to just 6.2%. But is all that pessimism and negativity justifiable? Let's look at how the business has been performing, and if there's something investors might be missing.

Fiscal 2013 results
For fiscal 2013, Outerwall reported an overall revenue of $2.3 billion, a modest 4.9% improvement over the previous year. Of that amount, $1.97 billion, or 85.7%, was from Redbox, the DVD rental business, while the rest came from Coinstar, whose machines convert coins to cash vouchers or gift cards for a fee. Coinstar revenue crossed the $300 million mark for the first time, while Redbox finished the year with more than 775 million DVD rentals. Earnings per diluted share shot up 46.9% from $4.99 to $7.33, mainly because of a decrease in income tax expenses. However, the company's operating margin slid 140 basis points from 12.7% to 11.3%, mainly because of heavy ecoATM capital expenditures. ecoATMs allow users to recycle their mobile electronic devices for cash. 

While 4.9% revenue growth is hardly the hallmark of fast-growing business, neither does it signal a dying platform. Outerwall expects its RedBox and Coinstar businesses to grow at around 4%-7% through 2015. Looking at the latest quarter's results, Redbox saw its revenue increase 1.7% over the previous year's comparable quarter, while its gross margin shot up 460 basis points to 58.5% as the company adjusted its content purchases to better align with customer needs.

Some analysts argue that the company has only managed to keep growing by opening more DVD kiosks. That's one way of looking at it. Another valid way is that the company has not yet saturated the market, and there's still more room to run.

Furthermore, Outerwall says that as many as 30% of its customers already have streaming service at home. If that's so, it seems that many people still prefer the convenience of a Redbox DVD instead of having to wait two days for a Netflix delivery.

New ventures and ecoATMs
Outerwall has also been investing in new ventures to supplement its core businesses, and perhaps to mitigate against the decline in DVD rentals when it finally happens. The company realized a revenue of $16 million from new ventures in the fourth quarter of 2013, up sharply from $0.3 million in Q4 of fiscal 2012.

The company's new ventures include SampleIt, which are kiosks that sell $1 samples of various items such as cosmetics, skin-care products, detergents, and snacks, and Coinstar Exchange, where people cash in their unused retailer gift cards. Overall, the company's new ventures, led by ecoATM, contributed 3% to its top line in the last quarter. The company wants to push up that figure to 9%-12%, or at least triple 2012's revenue share.

The opportunity for ecoATMs is bigger than most people might imagine. Even though the recycle rate for mobile devices is still low in the United States, used mobile device trade-ins in the U.S. generated $1.4 billion last year, and that figure is expected to reach $7.6 billion by 2018. Moreover, despite their relatively small installed base of about 900, ecoATMs have recycled 2 million devices so far. ecoATM President Maria Stipp says ecoATMs can recycle 4,000 different devices, and those devices are resold to both U.S. and international buyers, with about 60% of the recycled items sold to international buyers. The company hopes to have 2,000 ecoATMs by the end of fiscal 2014.

ecoATMs face competition from eBay, Best Buy, and several wireless carriers that recycle used phones. But ecoATMs arguably provide the best customer experience, and the most convenient way to safely dispose of a used phone for some cash.

The potential for Coinstar Exchange is also huge. Gift cards worth $110 billion were sold in the U.S. in 2013 (more than $4 billion from Starbucks alone), and $8 billion went unspent. Coinstar President Jim Gaherity is confident that the company can establish first-mover advantage in this space, since currently no other company is working in this niche. Coinstar Exchange is still in its infancy, with about 200 kiosks deployed.

Peers in comparison
Netflix's DVD business has been on a steep decline, which of course minimizes the competitive risk for Redbox. Last year, its DVD segment declined 17%, while Redbox managed to hold its own and saw 2% growth. That's quite bad for Netflix, considering its DVD segment has more than double the operating margin of the video streaming segment, at 50% vs. 20%.

But its video streaming business is in the pink of health, and adding subscribers at a blistering pace.

Amazon, meanwhile, recently announced that its Amazon Prime membership had reached 20 million -- or about 45% of Netflix's 44 million global subscribers. Amazon also recently raised the fee of its popular Amazon Prime from $79 to $99, a 25% increase. There has been a lot of hue and cry over this move, with many analysts fearing that it will lead to an attrition of its subscribers. But that might not happen. Costco has raised its membership fee three times in recent years, yet its membership base continues to grow admirably, as I pointed out in this article.

Bottom line
The excessive pessimism surrounding Outerwall is based on speculations that the DVD might be dying soon. But many people said the same thing about the PC, yet analysts are now predicting that PC sales are close to hitting a bottom, after which they will start growing again.

No technology lasts forever, and DVDs are no exception to the rule. But the DVD might be around longer than many people think. Outerwall's new ventures, such as ecoATMs, will also contribute to its top line in a big way in the future, and perhaps help investors to see the company in a different light.