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Shareholders in Outerwall (OUTR), the company formerly known as Coinstar, are reacting cautiously optimistic after the company announced the strategic acquisition of ecoATM last week.

The strategic deal, which expands Outerwall's operations into electronics to be sold through vending machines, diversifies Outerwall's operations. Furthermore, the revenue and cost synergies should result in earnings accretion going forward. Yet I remain cautious on the back of threats to Outerwall's long term business model.

The Deal

Outerwall announced that it has entered into a definitive agreement to acquire ecoATM for $350 million in cash. This includes transaction costs and payoffs related to ecoATM's debt.

As Outerwall already holds a 23% stake in the business, the effective transaction price will come down to about $270 million.

ecoATM operates automated self-serve kiosk systems in which consumers can buy used mobile phones, tablets and MP3 players. The real-time trade in solution is sophisticated and allows consumers to easily sell their electronics on the secondary markets for good prices.

ecoATM has a sizable market potential, with some 175 million mobile devices being sold per annum in the US alone. Merely 20% of these mobile phones are collected, with the majority being discarded or stored. Growth in emerging markets is a major driver behind demand for refurbished mobile phones as well.

CEO Scott Di Valerio commented on the rationale behind the deal, "With ecoATM, Outerwall will advance its evolution into multiple automated retail businesses and increase our exposure to the growing demand for refurbished products and mobile devices across the globe. As evidenced by our growing investment in ecoATM over the last four years, we are confident that ecoATM's innovative, environmentally minded business model will continue to resonate with today's technology savvy consumers."

Neither of the companies released any additional financial details regarding the transaction. Outerwall did mention that it expects the deal to be accretive to earnings per share in 2014, and to yield a positive return on invested capital in the coming years. The deal is expected to close in the third quarter of this year and is subject to normal closing conditions as well as regulatory approval.

Valuation

Outerwall ended its first quarter with $506.5 million in cash and equivalents. The company operates with $692.8 million in total debt and capital lease obligations, for a net debt position of around $185 million.

For the year of 2012, Outerwall generated revenues of $2.20 billion, up 19.5% on the year before. Net income rose by 30.7% to $150.2 million in the meantime. Trading around $62 per share, the market values Outerwall at $1.75 billion. This values the company at 0.8 times annual revenues and 11-12 times annual earnings. Outerwall does not pay a dividend at the moment.

Some Historical Perspective

Outerwall, or better Coinstar, has created a lot of value over the past decade for its shareholders. Shares have tripled, rising from $20 in 2004 to levels around $62 at the moment. Shares hit upon all time highs around $70 back in 2012.

Between 2009 and 2012, Outerwall has more than doubled its annual revenues to $2.20 billion. Net income tripled in the meantime to $150 million over the past year.

Investment Thesis

Investors in Outerwall reacted cautiously optimistic to the latest deal. The net investment is roughly equal to 15% of the company's current market capitalization.

Outerwall knows ecoATM well, being an early investor in the business. With its larger resources and expertise in the field, Outerwall hopes to accelerate the rollout of ecoATM's across the nation. Currently, ecoATM has an installed base of 400 machines across 24 different states.

The recycled electronics market is growing rapidly as people get more environmentally conscious about the impact of obsolete technologies and their devices. Many consumers want to make some cash disposing their unused gadgets as well. Potential cost synergies could emerge as well if Outerwall is able to offer multiple products at the same locations.

Outerwall had a tough first quarter as revenues rose by merely 1.1% to $574.7 million, after the company doubled its operations over the past three years. Net income fell by 58% to $22.6 million as the cost base was growing faster than overall revenue growth.

Yet Outerwall remains optimistic about its prospects as it used a lot of cash to retire some 13% of its outstanding shares over the past year. During the first quarter, the board of Outerwall authorized an additional $250 million share repurchase program, sufficient to retire almost one out of every six shares outstanding at current prices.

It is promising that the acquisition of ecoATM is already accretive to next year's earnings, and the unit will undoubtedly report faster growth compared to the overall company. Significant revenue and cost synergies could make this strategic deal quite important for Outerwall.

Yet I remain a bit cautious as I don't think the historical growth rates can be extrapolated into the future. The shareholder friendly financial strategy has already resulted in year to date returns of 20% in 2013.

This is while revenue growth is slowing down as the physical distribution model will come under pressure from online content providers of movies and possibly games like Netflix (NASDAQ:NFLX). Furthermore giants like Amazon.com (NASDAQ:AMZN) could compete more effectively for physical distribution, if and when it starts same-day delivery.

The valuation remains fairly cheap at current levels, yet the company is now screaming on the back of uncertainties about the very long term business model. For the future I would expect that more content and products would be delivered online.

I remain on the sidelines.

Source: Outerwall - Strategic Deal With EcoATM Offers Diversification And Growth