Outerwall Inc (OUTR), Buybacks, And Activists
Outerwall is a stock that has been struggling as the cash flows from Red Box are drying up much faster than investors have expected. Not only that, but Outerwall management has had the troubling habit of throwing good money after bad by “investing” in things like ecoATM–kiosks that allow you to turn in your old cell phones for cash, a concept that doesn’t seem to be gaining traction.
This spending on business lines that were unlikely to succeed was all in an effort to extend the life of the company. Extending the life of a company is not always the best way to maximize value for shareholders. One thing I’ve observed is that dying businesses (or more euphemistically, businesses in “secular decline”) almost always turn out to be bad stock market investments. I think money can certainly be made from a cash cow like Red Box (even if the cash flow eventually will be $0), but not if the cash flow stream is attached to a public company. This is because of the inherent conflict of interest between a management team and the owners of the business. The owners of the business want to see the cash. The management team wants to continue getting a salary.
Of course, this is why activists have become so interested in Outerwall, and other companies that throw off copious amounts of cash.
Focusing on Stock Price vs. Running the Business
[drizzle]But here is a slightly different problem I’ve observed. Activists are much more interested in driving the stock price higher in the near term than they are in improving the long term value of the enterprise. A couple years ago, an activist (who failed in his attempt to get the company to sell itself) succeeded in driving the stock price of OUTR from around 60 to 80, where he was able to unload his stock. The stock now trades around 30.
After initially failing to get the company to sell itself, this activist was able to convince the company to take on a sizable amount debt to finance a massive share buyback program. This financial engineering tactic worked in getting the stock price up, but did the owners of the company (the shareholders who were left) benefit? Absolutely not. They loaded a dying business with massive debt, which hindered the ability of the company to deliver cash back to shareholders.
To me, this tactic of loading a company with debt to finance huge buybacks (in order to allow the activist to exit the stock at a (oftentimes short-lived) higher price) is not much different than the “greenmail” strategies that the activists used in the 1980’s.
I recently came across a video from a few years ago where Buffett was talking about Apple in 2013 when a few investors were pressing for Apple to return some of its massive cash to shareholders. Tim Cook had just recently taken over the reins from Steve Jobs, who always had a habit of ignorning Wall Street and focusing on the business at hand (a wise strategy for any executive). Buffett’s advice for Tim Cook was simply: Ignore the activists.
“The best thing you can with a business is run it well. If you run it well, the stock behaves fine over time… …I would run the business in such a manner as to create the most value over the next 5 or 10 years. You can’t run a business to try and run the stock up everyday.”
This is obviously the way Buffett has run his own business for the past 50 years. Despite 4 separate occasions where BRK dropped 50%, Buffett said: “We just kept focusing on building value.”
Wall Street’s Obsession with Buybacks
While I almost always think Buffett is spot on with his advice for management, it’s not necessary to always agree with his stock picks. Buffett also mentioned IBM in that interview. I noticed the share price of IBM was around $200 at that time and the share price of Apple was around $62 (split-adjusted). I looked at IBM a while back. Ironically, I felt that they were much more focused on pandering to Wall Street and the analyst community (with the previous management’s focus on share buybacks and the infamous “Road Map” that had a $20 EPS target that the current CEO finally had to walk back).
Buybacks are great in certain cases, but a management team who is trumpeting buybacks as a key business strategy is probably not entirely focused on running the business. Buybacks aren’t a business strategy, they are a capital allocation policy. Buybacks were an afterthought for Steve Jobs, and also for Warren Buffett himself. Buffett has mentioned buying back BRK stock here and there, but like Jobs, he was focused on running his business. I’m somewhat wary of CEO’s who are trumpeting buybacks and putting together glossy investor presentations that prioritize these capital allocation strategies above business strategies.
Now, I know buybacks are very popular among value investors. I too like buybacks, but buybacks don’t exist in a vacuum. Automatically and routinely using free cash flow to reduce share counts without any consideration given to price paid doesn’t automatically mean that value is being created. Like spending on R&D, marketing, capex, or any other capital allocation decision, buybacks don’t always create value. Companies often perform buybacks routinely as if it’s always value accretive. They would be much better off approaching it opportunistically, like when Jobs was considering it, or when Buffett talks about the price he would pay for Berkshire Hathaway shares. Buy it when it’s cheap, don’t just make buybacks a habit.
We obviously have the benefit of hindsight, and I am in no way making any predictions on IBM, but I will say that I think Apple was (and is) much more focused on running its business for the long-term than IBM is. Which is why I’m surprised that Buffett bought IBM.
Nevertheless, I think his general advice is—as usual—outstanding. Focus on running the business, don’t focus on the stock price.
I’d like to point out that David Einhorn was one of these activists back in 2013 calling for Apple to return cash. I respect Einhorn tremendously, and I wouldn’t put him in the category of activists who I consider modern day greenmailers. Einhorn is a much more thoughtful, much more owner-minded. He has engaged in activism, but is generally on the side of long-term shareholders (he himself has been a shareholder of Apple for a few years now).
And Apple did eventually institute a sizable buyback and dividend program, but in that case, it was probably warranted, and it didn’t come at the expense of marginalizing the balance sheet or distracting management from focusing on running the business.
Tying this All Together With Outerwall
It might be too late for Outerwall to correct its course, and because of the large debt, there are limited options to maximize the shrinking stream of cash flow. Ideally, the company would have focused solely on paying dividends to shareholders initially, running the business to maximize cash flow, keeping a clean balance sheet, and minimizing investments in long-shots. But again, management wants to keep their jobs and activists want a quick buck.