Outerwall posts a Valuentum Buying Index score of 4, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and bearish technicals.
A score of 4 is not great, and we don't have any plans to include the firm in either the Best Ideas portfolio or the Dividend Growth portfolio.
Why write about the company then? Well, we think an independent view supported by in-depth analysis is valuable. Our analysis also helps frame the "short" thesis.
Outerwall (NASDAQ:OUTR), formerly known as Coinstar, is the owner of the Redbox kiosks that one sees in front of most Walgreens (WAG) stores or inside most Wal-Mart (NYSE:WMT) stores. Recent reports indicate that the firm will be uninstalling over 500 of such kiosks in the US this year as online streaming and original TV programming provide heightened competition. Though we have little interest in the shares given the competitive landscape, let's run them through the Valuentum process for the benefit of holders of the equity.
But first, a little background to help with the understanding of some of the terminology in this piece. At our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Outerwall posts a Valuentum Buying Index score of 4, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and bearish technicals. A score of 4 on the index is a relatively unattractive score (we prefer 9's and 10's), so it should not be a surprise that Outerwall is not included in the Best Ideas portfolio. The score also reveals that the "new money" (incremental investor) isn't too fond of the firm, at present. Let's continue with the analysis.
Outerwall's Investment Considerations
- As we mentioned previously, Outerwall is the parent company of the Redbox movie and video game rental kiosks and the Coinstar coin-counting kiosks. It operates over 42,000 Redbox DVD kiosks and over 20,000 coin-counting kiosks.
- Outerwall's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders, with relatively stable operating results for the past few years, a combination we view very positively.
- Outerwall has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 7.9% in coming years. Total debt-to-EBITDA was 1.7 last year, while debt-to-book capitalization stood at 60.4%.
- Investors should be aware that Outerwall is one of the most heavily shorted stocks, with nearly 40% of its float held short. The sustainability of the firm's business model remains the biggest question fueling the bear argument. Though there are many places to check the short ratio on your stocks, the easiest place is on Yahoo here.
- Though cash flow was robust during Outerwall's first-quarter results, the company's net income barely moved higher on a year-over-year basis, while revenue growth came in at just over 4%. This is hardly strong year-over-year improvement.
- Redbox same-store sales only increased 1% in the first quarter of 2014. The company will uninstall 500+ units in the US this year.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Outerwall's 3-year historical return on invested capital (without goodwill) is 54%, which is above the estimate of its cost of capital of 10.4%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Outerwall's free cash flow margin has averaged about 11.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Outerwall, cash flow from operations decreased about 16% from levels registered two years ago, while capital expenditures fell about 12% over the same time period.
Our discounted cash flow model indicates that Outerwall's shares are worth between $57-$85 each. Shares are trading at roughly $68 each at the time of this writing. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $71 per share represents a price-to-earnings (P/E) ratio of about 9.7 times last year's earnings and an implied EV/EBITDA multiple of about 5.2 times last year's EBITDA. These are relatively low multiples, all things considered, but the market, as evidenced by the short interest, seems to be factoring in some pretty aggressive business declines beyond the next few years (which could make these multiples reasonable).
Our valuation model -- whose fair value estimate ($71) roughly approximates its current share price ($68) -- reflects a compound annual revenue growth rate of 5.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 17.1%. Though we're factoring in revenue growth slowing over the next five years, the market's expectations may be much more punitive.
Our valuation model reflects a 5-year projected average operating margin of 10.3%, which is below Outerwall's trailing 3-year average. The company's operating margin was just shy of 10% in the first quarter of 2014, for reference. We think removing underperforming kiosks and engaging in efficiency improvements will allow the firm to hold the line in terms of profitability (margin) for the next couple years.
We think our DCF analysis is most informative to short investors at this juncture, as to achieve Outerwall's current stock price via our valuation, we'd still have to embed both top line growth and resilient margins over the long haul. This can strengthen the short thesis if investors consider this to be an "optimistic" case. The DCF model has myriad uses, and understanding what is embedded in a variety of scenarios is one of them.
Beyond year 5, we assume free cash flow will grow at an annual rate of 1.4% for the next 15 years and 3% in perpetuity. For Outerwall, we use a 10.4% weighted average cost of capital to discount future free cash flows. The relatively low growth rate and slightly higher-than-average discount rate are consistent with our expectations of the firm's long-term growth potential and risk profile.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Outerwall to a number of "specialty retailer" peers, though it's worth noting that there really is no pure peer.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $71 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Outerwall. We think the firm is attractive below $57 per share (the green line), but quite expensive above $85 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Outerwall's fair value at this point in time to be about $71 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Outerwall's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $102 per share in Year 3 represents our existing fair value per share of $71 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.