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Outerwall Inc. (NASDAQ:OUTR)

Q4 2013 Earnings Conference Call

February 6, 2014 05:00 PM ET

Executives

J. Scott Di Valerio - CEO and Director

Galen C. Smith - CFO

Karla Olson - IR

Analysts

Steven Dyer - Craig-Hallum Capital Group

Andy Hargreaves - Pacific Crest Securities, Inc.

Darren Aftahi - Northland Securities

Steven Frankel - Dougherty & Company

Paul Chung - J.P. Morgan Securities LLC

Operator

Welcome to the Outerwall Inc. 2013 Q4 Earnings Conference Call. My name is Robert and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Please note that this conference is being recorded.

I’d now like to turn the call over to Ms. Karla Olson. Ms. Olson, you may begin.

Karla Olson

Thank you, Robert. Good afternoon and welcome to Outerwall's 2013 fourth quarter and full year earnings conference call. Our call today will be hosted by CEO, Scott Di Valerio; and CFO, Galen Smith. Scott and Galen will make introductory remarks and then open for Q&A.

In terms of Q4 documents, the earnings release and prepared remarks are posted on the Investor Relations section of Outerwall's website, outerwall.com. The supplementary slides are in Appendix B in the prepared remarks. And finally, our 2013 10-K is available in the SEC Filings section of our IR website.

During this call, Scott and Galen may reference non-GAAP financial measures. A reconciliation of differences between GAAP and non-GAAP financial measures is provided in Appendix A of the earnings release, which is posted on the Investor Relations website.

Also during this call, various remarks we may make about future expectations, plans and prospects for the Company constitute forward-looking statements for the purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ material from expectations, plans and prospects contemplated in these forward-looking statements as a result of various factors, including those discussed in our latest 10-K and subsequent 10-Q filings with the SEC.

And now, I'll turn the call over to Scott. Scott?

J. Scott Di Valerio

Thanks, Karla. We appreciate everyone joining the call. We are opening 2014 with several important announcements, including our financial results, executive leadership appointments and plan for a tender offer, all of which position the Company for further success, growth and value creation. Outerwall is committed to value creation through strong and effective leaders managing our business. The new leaders for Redbox, Coinstar and ecoATM fit the bill.

We’ve been actively searching for the right person to lead Redbox and we’re confident we found that person in Mark Horak. Mark appreciates Redbox brand with its value, simplicity and convenience. He also recognizes the value of our relationships Redbox has developed with consumers, retail partners and studios. Mark will leverage all that Redbox has to offer to drive the business forward in the changing landscape, enabling Redbox to grow its role in the home entertainment ecosystem.

Mark brings a significant amount of experience to Redbox, including this most recent role as President of the America at Warner Home Video. Mark’s background in the entertainment and media industry and the relationships he has developed over the many years are valuable resources as Redbox pursues its mission to be America’s number one choice for movies.

And turning to Redbox President -- excuse me, turning to Coinstar President role, I would first like to thank Mike Skinner for his leadership and many contributions to the Coinstar business and Outerwall over the past nine years. Mike has chosen to leave to pursue an opportunity at a private equity fund and we appreciate that he will remain to ensure a smooth transition as Jim Gaherity takes over as Coinstar President on March 10.

Jim has work side by side with Mike as Senior Vice President responsible for worldwide operation, helping to drive operational efficiencies throughout the Coinstar network. Jim has more than 25 years experience building teams as well as developing and executing long-term strategies and operating plans and we believe he is the ideal candidate for the role.

Maria Stipp is now serving as Outerwall’s Chief New Ventures Officer and Interim President for ecoATM and will now permanently assume the role as ecoATM President. Maria’s background in growing businesses and leading global teams, including sales, marketing, finance, supply chain and human resources, provide a solid foundation as she focuses on scaling the ecoATM business. ecoATM will be the key driver of growth and free cash flow of Outerwall and Maria is well suited to drive this future pillar of our automated retail platform. I’m pleased that we have these talented leaders taking on these important roles at Outerwall.

Outerwall remains a strong company and we’re confident in our future and our ability to continue ensuring our investments provide the highest risk adjusted returns. Managing our business to drive greater profitability and free cash flow and optimizing our capital allocation strategy to increase shareholder returns.

Now I’ll turn it over it to Galen to talk about our financial results and the tender offer we announced today.

Galen C. Smith

Thanks, Scott. We made several decisions in Q4, as we announced on December 10. One of those decisions was to discontinue the Rubi, Crisp Market and Star Studio businesses and as a result the financial impact of these three ventures as it move to discontinued operations. Including that change, this quarter we generated approximately $594 million in consolidated revenue, up 5.4% year-over-year.

At Redbox we had rental growth of 2.2%, with both rentals and revenue per kiosk up year-over-year as we lapped the heavy installs completed in the second half of 2012. Furthermore, with the adjusted level of promotional activity coming out of Q3, 2013, net revenue per rental increased from $2.46 in Q3 to $2.58 this quarter. We also saw growth in Blu-ray as it represented 16.3% of Redbox revenue in Q4, up from 12.4% in the same period a year-ago.

At Coinstar, the price increase help drive revenue to $80.7 million allowing the business to surpass $300 million in total revenue for the first time. New ventures results, which now consist of ecoATM and SAMPLEit totaled $16.6 million in revenue. We generated $137.3 million in core adjusted EBITDA from continuing operations and a $1.68 of core diluted EPS from continuing operations.

Core adjusted EBITDA from continuing operations benefited from lower bonus accrual and continued focus on driving profitability along with a $7 million benefit from lower comps and amortization that we expect to reverse in Q1, 2014. Redbox achieved a gross margin of 58.5% in the quarter, which was up 4.6 percentage points from Q4, 2012, driven by the teams focus on aligning purposes with expected revenue.

In addition to these items, core diluted EPS was impacted by several additional factors, including a lower tax rate in the quarter, which added $0.10 to EPS, a reduced share count which added $0.02 and higher than expected interest income of $0.04. We generated a $142.6 million of free cash flow in the quarter, driven primarily by working capital changes bringing the total for 2013 to $166.4 million, a $24 million cash tax benefit we had expected to receive in December, shifted to January 2014, benefiting 2014 free cash flow.

In Q4 we repurchased approximately 1.5 million shares for $100 million through an accelerated repurchase program. And in January we repurchased an additional 736,000 shares for $50 million. For the year we repurchased $195 million of common stock, exceeding our goal of returning 75% to 100% of free cash flow for the shareholders.

Today we announced several actions to further enhance shareholder value, a new repurchase authorization from the Board, increasing our total available authorization to approximately $650 million and our intent to purchase $350 million of Outerwall stock through a modified Dutch auction tender offer at a 5% to 20% premium to today’s last reported sales price.

These actions reflect our long-term confidence in the business as well as our expected growth, our ability to continue to generate strong cash flow and the attractiveness of the current stock price. These steps also demonstrate our focus on returning 75% to 100% of free cash flow to shareholders as well as our commitment to optimizing our capital structure by moving to a target net leverage ratio of 1.75 to 2.25 times. To that end, we raised an additional $350 million of debt capacity in Q4, $200 million of which was funded on December 31 through a term loan.

Turning to guidance, there are several factors impacting our expectations for Q1, including the impact of the Winter Olympics, which we expect to be in the range of 4 million to 5 million fewer rentals, the reversal of the $7 million benefit received from lower content amortization in Q4, investments to build out the ecoATM early in the year, which we did not have this time last year and we do not expect to release of an accrued liability as we received in Q1, 2013.

For Q1, we expect consolidated revenue between $570 million and $600 million, core adjusted EPS from continuing operations between $93 million and $108 million. Core diluted EPS from continuing operations between $0.77 and $0.97. For full year guidance, we expect the year to be second half loaded from a revenue and profitability perspective due to the Winter Olympics in Q1 and improved promotional strategy in Q3 relative to Q3, 2013 and the growth of ecoATM throughout the year as we scale the business.

As a reminder, it's important to note that the $80 million of savings benefit we identified from the shutdown of three new ventures is included in our 2013 results. Therefore we do not expect any additional savings in 2014 with the discontinuation of these ventures. However, we do expect to generate $22 million of annualized savings beginning this quarter from the restructuring actions we announced in December to better align our cost structure with expected revenue.

It's also important to remember in 2013 we benefited from the changing content amortization, which we expect to be a headwind in Q1 and Q2 as I mentioned before. In addition to these items core diluted EPS will be negatively impacted by a higher tax rate of 39% relative to the actual tax rate in 2013 of 29.7%, which by itself accounts for $0.72 to $0.88 of EPS headwind.

We also have amortization of the intangibles related to the ecoATM purchase price accounting and lower interest income as the note receivable for Sigue was paid in full in Q4. In addition, while we had included the benefit from share repurchase so far in Q1, 2014 in our quarterly guidance, we’ve not forecast the benefit from any additional share repurchases we may complete including the tender offer announced today.

Finally, we expect free cash flow of $200 million to $240 million with the biggest headwind being an increase in cash taxes, which we expect to be between $105 million and $150 million. We are keenly focused on maximizing shareholder value by driving profitability and cash flow, while making the right investments for the future of the business. Our two core businesses combined with the strong potential we see for ecoATM, provide a significant opportunity for Outerwall to continue to deliver superior value creation.

With that, we will turn it over to Q&A.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions) And our first question comes from Steve Dyer from Craig-Hallum. Please go ahead.

Steven Dyer - Craig-Hallum Capital Group

Thank you, Good afternoon, gentlemen. If I could drill down a little bit on the ecoATM side of things, the deployment this year of 1,000 to 1,200 kiosks seems maybe a bit light, I think of at least my expectations in the thought process there. Can you give a little color as to your thought process and maybe when you’d expect one of these mass merchant pilots to turn into a more full deployment?

J. Scott Di Valerio

Yes, I mean we’re actually -- we’re pleased with the progress we’re making with ecoATM as we talked about, we’ve the kiosks in the mall channel and we began testing them out in a pilot fashion in the mass merchant channel and those pilots are going quite well and we’re continuing to expand those pilots out in a number of kiosks in the marketplace. The number of kiosks that we put this year for ecoATM was in line what we had expected when we acquired the business and they’re right on track from that perspective. And as I said earlier, we’re very -- we’re pleased with how the mass merch tests are going and as in our partner in that, our mass merchant partner in that.

Steven Dyer - Craig-Hallum Capital Group

Okay. Could you give us kind of a ballpark as to how we can think about kind of the loss for that segment this year just roughly?

J. Scott Di Valerio

So as we think about that segment, obviously we’ll be making some investments early in the year Steve to help build up that business. Later on the year we would expect it to be positive EBITDA as we grow the business. We also still have some limited investments for SAMPLEit, but again the -- obviously it's going to be of a significant reduction in the loss in that segment this year.

Steven Dyer - Craig-Hallum Capital Group

So turning positive EBITDA sometime later this year?

J. Scott Di Valerio

On the ecoATM side yes. But obviously we’ve also got the investment in SAMPLEit.

Steven Dyer - Craig-Hallum Capital Group

Got it, okay. Any additional color on Redbox Canada and how sort of the rollout progresses there?

J. Scott Di Valerio

Yes, we were pleased to get 1,100 kiosks in the ground and as we finished up 2013, as we go into 2014 we expect to add about 250 to 450 kiosks, and we’re really concentrating those in key geographies such as Vancouver and Toronto. We think concentrating the installs will allows us to get the network effect of the rent return anywhere similar to what we have in the U.S. And we’re pleased overall with either the awareness that it's continuing to increase. It's up eight percentage points in the last four months which is an important indicator they’re beginning to kind of track the brand recognition. So we’re continuing to focus and get those kiosks in the ground. We’re targeting to get them in the ground earlier than later through the year, and then be able to build the rest of the kiosks as we’re able to do that a ransom return anywhere becomes a bit more of the reality for our folks in Canada.

Steven Dyer - Craig-Hallum Capital Group

Okay, great. I’ll hop back in the queue. Thanks.

J. Scott Di Valerio

Thank you, Steve.

Operator

Our next question comes from Andy Hargreaves from Pacific Crest. Please go ahead.

Andy Hargreaves - Pacific Crest Securities, Inc.

Thanks. First just a couple of clarifications. Galen, on the buyback, did you say the Dutch auction is included in the guidance but not anything that you would do after that?

Galen C. Smith

So what we’ve included in guidance, Andy, is the $50 million that we repurchased in January under a 10b-5. We have not included in our guidance any impact from the parts that we do under the tender or any additional repurchasing we may do throughout the year. So that’s not in our guidance.

Andy Hargreaves - Pacific Crest Securities, Inc.

Following just ideally though you, in terms of changing the plan to stick with the buying back 75% to 100% or the target leverage ratios are there?

Galen C. Smith

No that’s correct and in fact again because we thought about the best way for us to return capital to shareholders, we chose to do it through a tender offer to buyback essentially 18.1% to 20.6% of our outstanding shares on the price range we’re providing tomorrow.

Andy Hargreaves - Pacific Crest Securities, Inc.

Okay. And then one more just clarification, you mentioned the $7 million benefit in Q4, is that from the accounting change that was made in Q2?

J. Scott Di Valerio

Yes, that’s correct and so as we look at -- as we look at the title level, we see some benefit depending on the value of those discs and the kiosks at the end of the year. It was a little bit greater value than what we expected and so we didn’t see as much amortization in the quarter. Obviously it's simply timing, so we expect to see that flow through in Q1.

Andy Hargreaves - Pacific Crest Securities, Inc.

Okay. Thank you very much.

Operator

Our next question comes from Darren Aftahi from Northland Securities.

Darren Aftahi - Northland Securities

Hi, guys. Thanks for taking my questions. Just a couple so, I haven't got through all the prepared remarks but, so what's the expected ramp in 2014 for Redbox, and then in conjunction with that, what sort of impact are you seeing you’ve implemented all the VMZ’s?

J. Scott Di Valerio

Right, well again we’re not expecting a large ramp other than what we talked about in Canada for Redbox in 2014. We’re really focusing 2014 around continuing to refine our CRM processes in order to drive more value out of each kiosk and more value out of each of our consumers. And so that’s going to be the focus as well as continuing to build out our Blu-ray penetration. So in 2013 we’re pleased with the increase in our Blu-ray penetration getting it to 14.2% of our movie rentals. As we go into 2014, we’re looking at that to increase to 14% to 17% of the rentals which has taken advantage of more than 72 million U.S. homes that have Blu-ray players and the 55% or so of our Redbox customers are now on Blu-ray compatible devices. But that’s the focus that we’re going to be having as we go into 2014. And then your question around was …

Darren Aftahi - Northland Securities

The impact that you’re seeing from VMZ’s?

J. Scott Di Valerio

Yes, the impact from VMZ we completed that rollout in October, so that’s all about 39,500 kiosks now which is allowing us to provide the content in the box wander so that consumers can get -- we can get additional rents out of it with the same product cast. Also in ’14 we’re beginning the rollout of smarter, what we call smarter re-bouncing or I’d call it dynamic re-bouncing. So because of the work we do with the VMZ and the software we can now, out field team as we merchandize the kiosks can move discs into the right spot in a much more efficient and effective way. So since 50% or so of our discs are rented in one location and moved somewhere else and an additional different kiosks, now we’re going to be able to get our inventory balance much more efficiently with what we’re doing and we expect low single digit increase in rents due to the combination of those two things.

Darren Aftahi - Northland Securities

Got it. And just a couple of more; Galen if you clarify your comment on cash taxes, was the range $105 million to $150 million for 2014?

Galen C. Smith

$115 million.

Darren Aftahi - Northland Securities

$115 million. And then the last one, does your eco ramp contemplate anything international and is that the sort of long-term strategy to parallel domestic ramp or can you kind of give us some general strategic thoughts about how you plan to ramp eco long-term? Thanks.

Galen C. Smith

Yes, we’re continuing to look at the channels and test the channels out that we think will be positive and a good place for eco to go in the U.S. as well as evaluating moving across internationally. We believe that this is a good international play and that we’ll move international at a lower saturation point than what we have with our other kiosk products or automated retail products. So again we’re still evaluating them, but the ramp that we are talking about now is in the U.S. and in new channel’s other than the mall channel and those are moving along well and then we do see ourselves moving international at the right point in time.

Operator

(Operator Instructions) And our next question comes from Steven Frankel from Dougherty & Company. Please go ahead.

Steven Frankel - Dougherty & Company

Good afternoon. I wonder if you might drill in a little bit to the locked iPhone issue that you alluded to in your comments.

J. Scott Di Valerio

Sure, Steven. One other thing that occurred as new iOS systems came on is a default to Find My Phone. And when a phone is sold with a Find My Phone on, it basically is what we call brick. So it's not able to be utilized or again recycled to be able to be used by another consumer, in fact ends up having to get sold for parts which is significantly lower price. So, one other thing that we did very quickly once that became discoverable as the new iOS came out is we added a step, a few steps into the user interface into the ecoATM which walks our consumers through being able to turn and go back up into iCloud and turn off the Find My Phone feature which allowed us to being able to get more phones in that were not bricks, so which increases the overall value of the phones obviously that you have. As well as increase the confidence of our buyers of our phones that they’re getting phones that are going to be able to be utilized in the ways that they want to be able to utilize as oppose to having to be sold for parts. So, again the team did a very nice job of making that change really quickly, and we’re pleased with the number of phones that we’ve been able to get in that are operable phones as well has the ability to get confidence with our buyers in the backend which increases the overall price point. So we’re able to give to the phones.

Steven Frankel - Dougherty & Company

And what is the move towards lower end android handsets due to the economics at ecoATM; see as you look out maybe at a year or two from now?

J. Scott Di Valerio

Yes, I think that this business is a dynamic business and always evolving, and even in the shorter time that we’ve been associate with it and again prices move up and around and consumer’s preferences move up and around and we’ve been pretty successful of being able to anticipate that and also react to it where we’ve been out of position. So we’ll continue to monitor that Steven and look at it, but we don’t believe it has a -- it's going to have a significant impact on the overall viability of the business nor on the metrics that we expect out of the business from the revenue per kiosk and the ability to continue to grow out the business at the right margins.

Steven Frankel - Dougherty & Company

Okay. And then the last one, when do you think we might get some material information on what's going on with Redbox Instant?

J. Scott Di Valerio

Well, we’ve -- Redbox Instant it continues to move through and as I think we’ve talked about in prepared remarks, and before 2013 was really focused around getting the CE devices onboard, in fact we’ve been able to bring more CE devices onboard in the first year of operation Redbox than any of our competitors in a particular year. So the team has done a very good job there as well as continuing to work the interface to better merchandize the product over 8000 titles, additional titles that we have in Redbox Instant as well as the 200 or so titles that are available in the kiosk. And we’ve been seeing reasonable results where and some momentum around subscriber ads, time viewing or screen hours viewing as well as an increase in digital ramps or transactional ramps on the system. So, we’re making progress there and are going to continue to focus on making progress at the right levels as we move through 2014 add to specific numbers of subscribers and those types of things really we’ll work close with Verizon at the right time to begin to write more details around that, but it's obviously something that we have to work with Verizon to be able to do.

Steven Frankel - Dougherty & Company

Okay. Thank you.

Operator

Our next question comes from Paul Coster from J.P. Morgan. Please go ahead.

Paul Chung - J.P. Morgan Securities LLC

Hi. This is actually Paul Chung for Paul Coster. Thanks for taking my question. So the last reported market share you guys provided in 2Q was around 51% for Redbox. Do you have an update there or has it stabilized at that level?

J. Scott Di Valerio

So Paul, we’re still looking at finding providers, as we talked about last quarter. We didn’t have a lot of confidence in the numbers we were receiving from our current provider as they were understating our rentals by a significant amount. We’re hopeful that we’ll be able to bring a new measure out in the coming quarters.

Paul Chung - J.P. Morgan Securities LLC

Okay. But it's not materially different from what it was in 2Q you think?

J. Scott Di Valerio

We’re just looking for the right source field provided. I think, as you think about what's happening in the industry overall, we’re -- the place where America goes to get new release movies. And so I think our opportunity is to continue to grow that share over time.

Paul Chung - J.P. Morgan Securities LLC

Got you. And I know there is little detail on Redbox Instant, but I was wondering what percentage of the overall rentals are the users that find out are not being used at the kiosk or is that a material number at all?

J. Scott Di Valerio

So that’s something we haven't talked about publicly because again it's something we’re seeing building out and maybe some we provide down the road for more insight. Interesting for us from an economics perspective, right as we get paid on a per-sub per-month basis and so if there are -- if there are rental rights that aren’t used and we get the benefit of that in our P&L.

Paul Chung - J.P. Morgan Securities LLC

Got you. Okay, thanks.

Operator

(Operator Instructions) And we have no further questions at this time. I would now like to turn the call back over to CEO, Scott Di Valerio for closing remarks.

J. Scott Di Valerio

Thank you. Thank you for joining the call today. We are pleased how we finished 2013 and our position to drive successful 2014 and expand Outerwall’s leadership position in automated retail. Thank you and have a good rest of the day.

Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

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