Great investors are often a wonderful source of investment ideas and opportunities-imagine capitalizing on a great Buffett idea like Coca-Cola (KO) in the late 1980's. However, blindly following an elite investor can have disastrous consequences-think following Bill Ackman into J.C. Penney (JCP). Valuentum helps you sort out the good ideas from the bad.
Still, when an investor with a superb track record takes a sizable stake in a troubled company, we tend to pay attention. Barry Rosenstein's Jana Partners has trounced the S&P 500 since its inception, achieving annual compounded returns of 12.7% versus 1.7% for the S&P 500 over the same time frame. Jana is known as an activist shareholder that focuses on extracting value from special situations.
Outerwall (OUTR), formerly known as Coinstar (under the ticker symbol CSTR), has become Jana's latest target. In a recent 13-D, Jana revealed a 13.5% stake in the DVD-rental firm. More importantly, Jana noted that it would have a conversation with the company, writing in the 13-D filing:
"The Reporting Person intends to have discussions with the Issuer's board and management regarding: a review of strategic alternatives including exploring a strategic transaction, selling or discontinuing certain businesses, or pursuing a sale of the Issuer; the Issuer's capital structure including providing for a significant return of capital to shareholders; improving the Issuer's capital allocation policy; and cost cutting opportunities."
We doubt this signals an end to the Redbox kiosk business. In spite of the firm slashing its fiscal year 2013 full-year revenue, earnings, and free cash flow guidance in September, recent commentary suggests traffic at Redbox kiosks continues to grow and fend off competition from streaming services like Netflix (NFLX) and Hulu. Rentals in July and August grew 13.4% and 15.7% year-over-year, respectively, and the service continues to offer low cost rentals for the newest movies.
It seems that no matter how compelling Netflix's streaming TV lineup becomes, it cannot simply provide the same movie choices that are available at Redbox. Since Netflix has clearly prioritized TV shows, in our view, Redbox should be able to achieve the low-end of its 4-7% revenue guidance for the business. Further, in order to maintain revenue growth, promotional activity has weighed on profitability. Year-to-date, Redbox's operating income has declined 14% year-over-year, with the potential for further deterioration possible.
Outerwall originally made its mark as a coin-to-dollar bill kiosk in grocery stores and convenience stores across the United States. However, the explosion of bank branches offering a competing free service has created stiff competition, so the business is no longer growing. Year-to-date, segment revenue of $139.9 million is essentially flat year-over-year, while the segment generated $27 million in operating income (resulting in an operating margin of 19.4%).
Though this number isn't too shabby, we think Jana may have some interest in divesting the relatively small segment in order to invest more heavily in the firm's new business, ecoATM (an electronics recycling kiosk). Selling the business could fetch a decent price since its cash flow generation remains stable, which brings us to a more likely possibility...
Outerwall Increases the Share Buyback
Event-driven investors have little incentive for a larger quarterly dividend because periodic dividends provide returns of capital over a longer time frame. Buybacks, on the other hand, can often provide a short-term boost to earnings per share and a subsequent rise in the share price (given the firm's active market participation in buying shares). A quick increase in the share price might be just what Jana wants to happen.
Because betting on ecoATM and continued strength in Redbox seems like a risky proposition, we believe Jana will push for a share buyback to inflate earnings per share expansion. However, at current share price levels, a buyback would be value-neutral to shareholders (on the basis of our fair value range). But more importantly (and perhaps cause for concern), a hefty share repurchase program could cause the firm to carry a lower net-cash balance, making the company vulnerable to failure in the event of a shift in the competitive landscape.
While it is hard to argue with Jana's historical track record, we're having a difficult time seeing the value in Outerwall over the long run. Redbox may be insulated from competition in the near-term, but a new video streaming service with a superior movie portfolio may arise, eliminating the kiosk's last remaining competitive advantage.
ecoATM seems like a great concept, but it remains a small business that has generated just $2.5 million in revenue year-to-date as a portion of Outerwall. Admittedly, Outerwall has struck gold twice before in the kiosk space, but we aren't as confident in ecoATM given the amount of competition for purchasing used electronics (particularly smartphones) that includes Wal-Mart (WMT), GameStop (GME), and Best Buy (BBY).
Based on the firm's updated fiscal year 2013 guidance range, the current forward free cash flow yield is 7.5-8%, which is a strong number that could decline materially going forward. At this time, we think shares of Outerwall look fairly valued, and we aren't considering adding the firm to the portfolio of our Best Ideas Newsletter. Financial engineering won't be enough to sustain share price appreciation if fundamentals continue to decline, in our view.