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Shares of Outerwall (OUTR) took a plunge in after-hours trading on Monday after the company lowered its third quarter and full year guidance.

Unanticipated negative impacts from the revised pricing guidance are taking a large chunk out of revenue growth, and consequently earnings, causing selling panic in Monday's after-hours trading session.

I think this is more a temporary issue as weakness is induced by poor marketing decisions, not necessarily changing competitive pressures. Outerwall has already indicated that it has reduced promotional activity to address the shortfall of the strategy.

Yet the long term prospects remain not great to say the least. In the meantime, management keeps trying its best by allocating capital in a profitable manner while repurchasing shares with freely available cash flows.

I remain on the sidelines as I don't have a great clue how quickly changing competition could impact Outerwall's business.

Third Quarter Update

Outerwall updated its third quarter and full year outlook on Monday after the close.

Third quarter revenues are now seen between $569 and $589 million, which compares to a prior revenue estimate of $604 to $630 million. This means that the midpoint of the revenue guidance has been adjusted downwards by 6.2%.

Adjusted EBITDA is seen between $101 and $109 million, which compares to earlier guidance of $129 to $139 million. Diluted earnings per share are seen between $0.82 and $0.94 per share, compared to an earlier guidance of earnings between $1.36 and $1.51 per share.

The company is set to release its third quarter results on the 24th of October. Note that consensus estimates for third quarter earnings stood at $1.43 per share, on $612.6 million in quarterly revenues.

Full Year Update

Full year revenues are now seen between $2.274 and $2.339 billion, which compares to a previous guidance of $2.372 to $2.475 billion. The outlook implies that fourth quarter revenues are seeing substantial weakness as well.

Adjusted EBITDA is seen between $451 million and $471 million, compared to previous guidance of $507 to $538 million.

As a result, core earnings are seen between $4.72 and $5.12 per share, which compares to a previous guidance of $5.76 to $6.26 per share.

Summer Update

Redbox saw a 13.4% and 15.7% increase in rentals for July and August, respectively. Actually, July was the best month ever with 74 million rentals.

The promotional strategy drove rental frequency, while unique debit and credit card usage rose 11% on the year before as well. The promotional strategy still impacted revenues more than anticipated as customers trended toward single night rentals.

Rental growth is expected to slow down to 5% in the first half of 2013. Net revenues per rental are expected to improve in the fourth quarter compared to the third as the company adjusts the promotional strategy. Even then the fourth quarter will still include more single-night rentals than previously expected.

The greater capacity per kiosk remains on track, to be completed halfway through the fourth quarter. By then 39,000 kiosks should have greater inventory capacity allowing Redbox to keep more titles on stock without incurring additional product costs.

Revenue growth in the Redbox business is expected between 4% and 7% through 2015. The company will align the cost structure to reflect the growth and focus on maximizing cash flows.

Valuation

Outerwall ended the second quarter with $380.2 million in cash, equivalents and short-term investments. The company operates with $604.2 million in short, long and convertible debt as well as capital lease obligations. This results in a net debt position of around $224 million.

Revenues for the first six months of the year rose by 2.6% to $1.13 billion. Net earnings fell by 23% to $69.5 million. Core adjusted EBITDA for the period totaled $228.7 million.

Factoring in a 20% sell off in after-hours trading, with shares exchanging hands at $45 per share, the market values Outerwall at $1.3 billion.

This vales operations of the firm at roughly 0.55 times annual revenues and roughly 9 times annual earnings.

Outerwall does not pay a dividend at the moment.

Some Historical Perspective

Despite operating in a sluggish, old-fashioned industry, Outerwall has created a lot of shareholder value for its holders over the past decade. Over the past decade, shares have quadrupled from $15 in 2004 to highs around $60 between 2010 and 2013.

The correction following the updated guidance has sent shares back toward $45 per share.

Between the calendar year of 2009 and 2012, Outerwall has more than doubled its annual revenues from $1.03 billion toward $2.20 billion. Net earnings almost four-folded toward $150.2 million in the meantime.

Investment Thesis

Back in 2008, Outerwall acquired Redbox, which ever since has become the primary business of Outerwall. Yet the recent discounts at the business has undesired consequences. While rentals rose, so did the customer base. Yet revenues are under pressure and expected to come in below expectations as average rental periods are falling.

Worse for the fourth quarter, many expected to be released movies are going to be released later in the quarter, or even in 2014. This is negative effect is partially offset going forward by an increase in inventory space per kiosk.

The company is working hard to re-adjust the trade off between discounts and higher sales. The company remains focused on the acquisition of ecoATM, boost operating cash flows, and return free cash flows to shareholders. As a result, the company will repurchase another $100 million worth of common stock, sufficient to retire 7%-8% of the current share base.

Back in July of this year I last took a look at Outwerwall's prospects when it acquired the remainder of the shares in ecoATM for a total deal value of $350 million. I concluded that the deal offered both diversification and growth. I though the strategic deal was nice given the potential for revenue and cost synergies.

At the time I concluded to be cautious given the strong momentum in 2013 already. I also thought that historical growth rates couldn't be extrapolated in the future, especially as Outwerwall faces stiff competition from Netflix (NFLX) which continues to grow its customer base, and from giants like Amazon.com (AMZN). The latter is especially true if Bezos might offer same-day delivery across the nation after running pilot-projects.

I concluded at the time that the valuation was cheap at current levels around $60, but the company was no obvious buy given the uncertainties regarding its long term business model. Shares have sold off some 25% ever since, but I have to reiterate my stance.

While the current sales growth erosion does not appear to be triggered by a changed competitive landscape, but rather results from poor marketing decisions. Irrelevant of the pressure in the short term induced by these marketing decisions, the long-erm business model will undoubtedly face pressure at some point in time as the physical distribution model will come under pressure.

Based on current metrics the company looks cheap, and while I have to give management credibility for building the business in a solid way in recent years, the long-term overhang remains.

Shares will continue to trade at cheap multiples until things go wrong, and it remains a guess how long this "niche" market might exist in the current form. Alternatively, Outerwall could prove me wrong and report years of modest growth figures, making today's levels a screaming buy.

As I'm not in the guessing game, and are a bit bearish on the long-term prospects for the business, I remain on the sidelines.

Source: Outerwall: Investors Throwing Shares Out After Poor Price Initiatives