Outerwall Inc (OUTR): The Little Redbox That Could by Aeternitas Investing
Reprinted below is the section from the JRW Financial Q2 2015 Management Commentary in which I detail some of the thinking behind our long thesis for Outerwall, Inc..
I like to highlight one of our investments in each of these quarterly letters to give a bit more information as to what we look for in our research, how we analyze the businesses we own, and what our outlook for the future is for our holdings. Last quarter’s letter went into depth about our position in World Wrestling Entertainment. This quarter I would like to highlight our position in Outerwall.
Outerwall is a provider of automated retail solutions offering convenient products and services that benefits consumers and drives incremental retail traffic and revenue for retailers. Most notably, Outerwall owns the Redbox self-serve movie and video game rental kiosks located outside many retail stores and gas stations. Outerwall also owns Coinstar (previous name of the company), the coin-counting kiosks usually found in supermarkets and other retail stores.
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Outerwall enjoys a monopoly on providing automated retail services through Redbox and Coinstar in all of the properties in which it retails. Retailers are unlikely to have multiple kiosks providing the same service taking up valuable floor space. Thus, the fact that Redbox and Coinstar are significantly ingrained into many of the most popular and ubiquitous retail chains, including Wal-Mart, CVS, Walgreens, and Target, inhibits competition and makes it unlikely that a competitor will enter the market to provide the same service.
The biggest risk to Outerwall, and the fundamental reason why short interest in the name is exceedingly high (47% of the float as of June 15, 2015), is the threat of digital streaming of movies. Netflix is a primary competitor, along with Amazon streaming, and cable operators such as Comcast and Verizon also compete through their digital streaming options. The argument is that people will just choose to browse through their cable boxes and digitally purchase a movie, rather than go out to a store (a large reason why Blockbuster and other movie rental retailers went out of business). Physical rental volume of DVDs and Blu-ray discs continues to decline over the years, and offers little reason to expect stabilization.
While the physical DVD rental market is in secular decline, we believe the decline to be plodding at worst. Outerwall has a dominant position based on its kiosk footprint. We believe the market for low-cost DVD rentals will not decline precipitously and the convenience of widespread kiosk locations cannot be overstated. Outerwall recently experimented with price increases to stem the tide of revenue stagnation with great success. The ability to raise prices and keep demand steady is the sign of a truly advantaged business.
Returns on invested capital are consistently above average. Current return on invested capital is 28.24%. Over the past 5 years, returns have consistently exceeded 17%. The company has committed to returning 75-100% of free cash flow back to shareholders through share buybacks and dividends. The business is not capital intensive and requires minimal maintenance capital expenditures each year. Thus a capital allocation policy of returning the lion’s share of free cash flow to shareholders is very prudent.
From a valuation perspective the company’s shares are very attractive. At the time of writing, shares in Outerwall trade for $80.02. Based on current total enterprise value, the shares yield a very attractive 12.30% (remember that we look for EBIT yield in excess of 6.5%). On a free cash flow to market capitalization basis, the company yields 17%. Prudent capital allocation continues to reduce the outstanding share count, thus increasing our portion of earnings and free cash flow generated by the company. On valuation, Outerwall is one of the most attractive opportunities in our universe.
Based on the company’s shareholder friendly capital allocation policies, we believe there is a significant margin of safety built into the shares at current levels. We believe also that the competitive advantage enjoyed by Redbox in the low-cost, on-demand DVD rental kiosk space more than makes up for the slow secular decline in physical DVD rentals. The company continues to look for other ways to innovate as well, including its Coinstar division and its EcoATM division, a technology recycling kiosk service that continues to attract attention.
With above-average returns on invested capital, extremely attractive valuation, and an adequate margin of safety, we are confident in our ownership of Outerwall over the long-term.
Disclosure: The author owns shares in Outerwall, Inc. in his personal account and for clients at time of publication.