By Jason Seo
Beating the market can be difficult when picking stocks on your own. One common source of alpha can be focusing on small cap stocks, which tend to outperform larger peers over time. Another source of alpha can be following the smart money, by mimicking the trades of professional investors. Our research has shown that, by combining these two approaches - buying the most popular small-cap stocks recently purchased by hedge funds - one can outperform the market on average (read the details here).
A slew of hedge funds accumulated shares of Outerwall Inc. (NASDAQ:OUTR) during the fourth quarter of 2013, among whom the largest purchasers were Barry Rosenstein of Jana Partners (its largest shareholder with around a 13.5% stake), Dinakar Singh of TPG-AXON Management and Alec Litowitz of Magnetar Capital (whose purchase was a new position initiation). Joshua Nash, Clint Murray, and Kenneth Squire are also among Outerwall shareholders.
Outerwall is a $1.8 billion market capitalization company that operates 43,700 Redbox kiosks for DVD rentals and 20,300 Coinstar kiosks for coin-counting and other self-service concepts in the automated retail space (such as recycling machines for electronics). Essentially, the company is using the cash flow from its mature Redbox and Coinstar businesses to fund investments in new ventures (such as its purchase of ecoATM, a producer of kiosks for recycling and trading-in electronics, in July 2013), opportunistic acquisitions and share repurchases.
Jana Partners is a very active activist investor with big positions in Ashland (NYSE:ASH), Oil States International (NYSE:OIS), Equinix (NASDAQ:EQIX), and Walgreen (WAG). It began to purchase the shares in the third quarter of 2013, probably after the stock dropped 17% in mid-September due to lowered guidance for 2013 amid disappointing results in its Redbox business.
In early October, the hedge fund disclosed a 13.5% stake and stated it would press the board to review strategic options, including a sale of the entire company, divestitures of certain businesses, management changes and changes to its capital structure. The campaign worked, as three weeks later, along with an in-line earnings release for the third quarter of 2013, OUTR announced it would return 75-100% of its free cash flow to shareholders, including $100 million in the fourth quarter of 2013 and $50 million early in the first quarter of 2014. For reference, management expects to generate $200 million -240 million of free cash flow in 2014, implying $150 million -240 million of share repurchases (or 8-13% of its market capitalization) for the year. At this pace, OUTR's outstanding share count would be roughly 30% lower in three years. According to media reports, Jana believes this is a positive first step, but will continue to explore a strategic review of the company.
The stock rallied 45% from its mid-September low through the end of 2013 and has risen a further 5% in 2014 so far after reporting better-than-expected results for the fourth quarter of 2013. Despite the rally, its valuation is not too demanding, trading at forward P/E and EV/EBITDA multiples of 4.5X and 12.2X, respectively, while its free cash flow yield is an attractive 7.6%. With high profit margins, a manageable debt load (especially after extending its debt maturities) and approximately $15 per share in cash, OUTR should continue to work as long as it sticks to its plan of investing in new ventures in a disciplined manner while returning any excess cash to shareholders. An initiation of a dividend would not be out of the question, in our view. Finally, any further developments by Jana on its push for strategic options would be greeted positively by the market.
Disclaimer: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article is written by Insider Monkey's writer, Jason Seo, and edited by Meena Krishnamsetty. They don't have any business relationships with any of the companies mentioned in this article and they didn't receive compensation (other than from Insider Monkey and Seeking Alpha) to write this article.