Outerwall (OUTR) Erik E. Prusch on Q3 2015 Results - Earnings Call Transcript

| About: Outerwall Inc. (OUTR)

Outerwall, Inc. (NASDAQ:OUTR)

Q3 2015 Earnings Call

October 29, 2015 5:30 pm ET

Executives

Rosemary Moothart - Director-Investor Relations

Erik E. Prusch - Chief Executive Officer & Director

Galen C. Smith - Chief Financial Officer

Analysts

Mike J. Olson - Piper Jaffray & Co (Broker)

Eric Wold - B. Riley & Co. LLC

Andy R. Hargreaves - Pacific Crest Securities LLC

Paul J. Chung - JPMorgan Securities LLC

Operator

Good afternoon, ladies and gentlemen. Welcome to Outerwall's 2015 Third Quarter Earnings Conference Call. My name is Tracy, and I will be your host operator on this call. Please note that this call is being recorded today, Thursday, October 29, 2015, at 2:30 PM Pacific Time. A replay will be available after the call ends today, through November 12. Details on how to access the replay are available in Outerwall's earnings press release.

I would now like to turn the meeting over to your host for today's call, Rosemary Moothart, Director of Investor Relations at Outerwall. Please go ahead.

Rosemary Moothart - Director-Investor Relations

Thank you, Tracy. Welcome to Outerwall's 2015 third quarter earnings call. The call today will be hosted by our CEO, Erik Prusch and our CFO, Galen Smith. Erik and Galen will make introductory remarks, and then we'll open up for Q&A. The earnings press release and prepared remarks are posted on the IR website at ir.outerwall.com. The Q3 10-Q has also been posted in the SEC filings section.

During the call, year-over-year comparisons we make will be Q3 2015 versus Q3 2014, unless we state otherwise. In addition, Erik and Galen may reference non-GAAP financial measures. Definitions and reconciliations of differences between GAAP and non-GAAP measures are provided in Appendix A of both the earnings release and the prepared remarks.

Also during this call, various remarks we 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 materially 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.

I'll now turn the call over to Erik.

Erik E. Prusch - Chief Executive Officer & Director

Thanks, Rosemary, and thank you for joining our call today. I am pleased to have joined the Outerwall team. I joined the company as CEO because I recognize that it has a strong base of assets and I believe there are opportunities to leverage them, building on the company's long and successful history to reinvigorate growth and create value for shareholders.

I've spent the past three months diving deep into our businesses and gaining a better understanding of what differentiates us from others. Specifically, we have very strong brands with both Redbox and Coinstar in leadership positions in their markets. The company has over 60,000 points of distribution, far more than any well known retail brand and a scale that is unparalleled in automated retail. We have longstanding relationships with retailers and provide them with solutions that create some of the most profitable real estate in their stores. We generate predictable traffic, revenue and profit for retailers.

Consumers value our products and services. Customer lifetime value across all our brands remains strong. We have continuously demonstrated our ability to create efficiencies in our businesses, manage expenses and drive profitability, and our business continues to generate significant and attractive cash flow.

Understanding what differentiates us is imperative to the direction we are heading. I'd like to address two important questions, first, what are we doing to improve, and second, where do we have new opportunities. We are committed to leveraging our assets, core brands, value to retailers, consumer relationships and financial strength to prudently and profitably grow our business and build for the future. When I talk about growth, I'm talking about pragmatic growth, disciplined growth, profitable growth.

Let's first spend some time discussing Redbox. We have spent many years optimizing the ecosystem that is Redbox, but we still have further to go. First, we need to continue delivering a high-value and a high-quality experience for customers, making certain we have convenient, great and timely content at affordable prices.

We expect to improve the experience with customers by making sure we have a highly interactive and frequent connection. We expect to deliver greater value through tailored customer understanding and improve content algorithms to anticipate their needs.

One of our initiatives at Redbox is video games, where the industry is currently undergoing a transition to new generation formats. We believe Redbox can drive revenue, as we provide both value to our industry partners and customers through our $3 a night video game rentals. Redbox has reached agreement with several of the leading game publishers that will allow us to increase the number of units in the kiosks to meet the growing consumer demand for new generation games.

Redbox is increasing its investments in video games in the fourth quarter. The greater depth of content is necessary to generate consumer awareness and interest among Redbox consumers to enjoy a video game rental. We believe this is a natural extension to the success we've had in movies and it creates a unique customer proposition, whether it is a try-before-you-buy proposition or a try-and-then-buy proposition. We can take advantage of the growing proliferation of new gaming platforms, the growing demand for games, high sticker prices for games in an inefficient and fragmented rental market.

Moving to Coinstar, we are executing a test, land and expand strategy. We are currently planning several international tests in Western Europe. We've been successful in Canada, Ireland and the UK and have identified two countries for limited tests in 2016 with modest investments as we prove the kiosk economics.

I want to emphasize these tests will be small and will measure the value proposition to consumers. If we are able to generate profitable results in new countries to that in North America, you should expect that we will expand pragmatically with a key focus on ROIC.

International markets are attractive because many countries largely reflect the same economic dynamics we experience in the countries where we operate today. For the two countries we plan to test, our current technology requires no modifications to assess these new markets.

Now turning to ecoATM. Our focus is on getting to profitability as quickly as possible. We plan to do that with our existing install base of kiosks, as well as our kiosks currently in inventory. The key is making sure we deploy these assets in the right locations. We continue removing underperforming kiosks and redeploying them in locations that satisfy our productivity thresholds, mostly in malls and mass merchants. We've also been doing limited testing of ecoATM in several international markets; and although it is early, the results have been very promising due to less competitive market dynamics in the e-commerce space.

Additionally, today, we are announcing the signing of a definitive agreement to acquire certain assets and liabilities of Gazelle. Gazelle will enable ecoATM to gain critical mass, provide margin revenue uplift opportunities and leverage a direct-to-consumer channel for collected devices. We're excited by the addition and we look forward to updating you on the combination after we close the transaction and integrate the assets.

One area of opportunity across all of our lines of business is our relationships with consumers. With our over 60,000 kiosks, we are able to reach consumers across almost every retail channel; and we're currently investing to expand our consumer knowledge and analytic capabilities to serve them better. With ongoing investment, we have a unique opportunity to further deepen our understanding of consumer needs and behavior patterns and leverage that to increase revenue and profitability for Outerwall and our retailers.

To summarize, we're moving quickly to generate growth and new opportunities. I continue to be optimistic about where we can take Outerwall, where we can stretch, and the value we can create for both our shareholders and our retail partners. We will share more on our strategy in coming quarters.

Now I'd like to turn to our revenue performance in the third quarter. Redbox revenue was lower than we expected, at $395 million. The business was challenged by the lowest box office in four years and there were additional factors that pressured rentals and revenue, including higher impact from secular decline in the physical market, lower demand due to the price increase which was exacerbated by the weak content, and fewer Blu-ray titles.

What is important is what we are doing to address those challenges. Redbox is a strong brand with millions of loyal customers that have generated more than 4.5 billion cumulative rentals. So there is a solid foundation to keep building on. In the near-term, we are investing in broader and deeper movie content to get customers back to the kiosk.

While we expect the content in Q4 to hit closer to historical averages, we are still cautious because 20 titles have shifted out of Q4 and into the first half of 2016, versus our prior expectations. We have significant work to do to make sure we are maximally effective. We also are expanding video games content, as I mentioned earlier. And we are increasing promotion to reengage customers who may not have rented this past quarter due to the lack of content in Q3.

The Coinstar segment revenue finished Q3 just under $86 million and it represented an increase of $600,000 over the prior year. Same-store sales increased 3% and average transaction size continued to grow. We expect the business to continue to perform well and deliver on its commitments. While this is not a high-profile business, the business model is solid and continues to resonate with retailers and customers.

The ecoATM segment revenue was $31 million. While it was the highest ever quarterly revenue, we're not where we should be yet as it relates to revenue on a per kiosk basis. And we continue to look for ways to drive the top line, including optimizing the user experience and making it easier for customers to transact with us. With the Gazelle assets, we expect to accelerate our progress to profitability.

In summary, I believe that we can position ourselves for additional opportunities that provide value to our customers and partners and drive top and bottom line growth for Outerwall.

The significant amount of cash flow we generate allows us to both reinvest in our successful brands and return a meaningful amount of cash to shareholders through dividends and share repurchases as we maintain our commitment to return 75% to 100% of annual free cash flow to shareholders. We will continue on that path until we have a higher and better use for the cash we generate.

Each of our businesses faces headwinds, but we have the assets and financial strength to work through the challenges and improve our performance. We will sharpen our focus going forward as we look for opportunities to create additional wealth for our shareholders.

I'd like to turn the call over to Galen, who will discuss our financial results and updated guidance. Galen?

Galen C. Smith - Chief Financial Officer

Thanks, Erik. For Q3 2015, we generated consolidated revenue of $512 million. Core adjusted EBITDA from continuing operations grew 3% to $120 million, driven by our continued focus on expense management and profitability despite a year-over-year decrease in Redbox revenue.

Core diluted EPS from continuing operations grew 32% to $2.21, reflecting our increased profitability and lower share count. We generated $66 million in free cash flow in Q3, an increase of more than 116% year-over-year, bringing the year-to-date total to $207 million. We continue to return capital to shareholders, repurchasing more than 938,000 shares for $61 million, paid another quarterly dividend of $0.30 per share, and lowered our total debt outstanding by $38 million as a result of our balanced approach to deploying capital.

Turning now to Q3 2015 segment operating results. Redbox produced year-over-year segment operating margin improvement for the fifth consecutive quarter. In Q3, segment operating margin increased 260 basis points to 23%, reflecting improvements in direct operating, marketing and G&A expenses as Redbox continues to improve profitability and cash flow, while facing the challenges of weak content, with seven fewer releases and a box office down 45%, as well as the higher impact from secular decline in the physical market. Gross margin improved 150 basis points to just under 59%, despite the revenue decline as we continue to refine our content purchases with demand.

Turning now to Coinstar, segment operating income grew 3% to $34 million; and segment operating margin increased 100 basis points to 40% as we continue to find ways to increase productivity and reduce costs. In regards to ecoATM, as Erik discussed, we're focused on getting to profitability as quickly as possible and make progress since Q2 in a number of key operational areas.

Sequentially, we saw improvements in both value devices sold per kiosk and revenue per kiosk. Q3 benefited from higher seasonality as well as increased collections of higher value devices approaching the iPhone 6S release. In addition, our active redeployment of 180 underperforming kiosks also contributed to improving per kiosk productivity.

Segment operating loss also improved sequentially, reflecting efforts to reduce expenses across the business with particular success in cost related to servicing and supporting the kiosk network.

Turning now to guidance, we've updated our 2015 annual guidance to reflect Q3 actuals and our current outlook on the business, including our lowered expectations for Redbox based on the significant shift in expected releases out of Q4 and into 2016 relative to what we expected in July.

Our EPS guidance includes the impact of share repurchases executed in Q3. For the full year 2015, we expect consolidated revenue in the range of $2.205 billion to $2.24 billion. Core adjusted EBITDA from continuing operations between $490 million and $510 million. And core diluted earnings per share between $8.82 and $9.52, which does not include the impact of any additional shares we may repurchase this year.

We expect Redbox revenue in the range of $1.79 billion to $1.815 billion, reflecting slightly lower revenue in Q3 and a substantial change in expected Q4 content releases. 20 titles have moved out of Q4 to the first half of 2016; and we previously expected them to generate over $60 million of revenue in Q4. The shift in titles makes 2015 the lowest annual box office for Redbox titles since 2011.

The box office in Q4 is expected to be 7% higher than last year. However, there are nine fewer titles and four of the titles were percent $1.8 billion or nearly half of the total box office. While sequentially Q4 box office is up substantially, we're coming out of a period of exceptionally weak content that disrupted normal rental frequency patterns and we need to reengage consumers with the improved content.

As Erik discussed, we're doing that through messaging and a number of targeted promotions. In addition, to help increase traffic and frequency of rentals, we're planning to purchase more content than we normally would in Q4, giving us higher copies out in the kiosk for certain titles, similar to our strategy in Q4 2012 used to reengage consumers.

While this will have an impact on Redbox margins in Q4, we believe the additional content is critical to consumers returning to more normal rental patterns. We also expect a significant increase in video games revenue this quarter as we focus on operating the latest new-gen platform content at a great value.

We expect ecoATM revenue in the range of $100 million to $105 million, a tightening of the range from our guidance in July. We'll continue to take action to bring the business to profitability, looking to drive efficiency in the business, while repositioning assets to drive better performance. We expect free cash flow to be in the range of $252 million to $282 million, up from our prior guidance due to the increase in expected core adjusted EBITDA and lower CapEx as we look to drive cash flow across the enterprise.

We remain focused on driving the financial performance of the company, managing expenses and improving profitability to both reinvest in the business and drive the bottom line. While we faced headwind in a number of our businesses, given our strong brand and financial strength, we'll continue to execute and return capital to create shareholder value.

We'll now open up the call to Q&A.

Question-and-Answer Session

Operator

Your first question comes from the line of Mike Olson with Piper Jaffray. Your line is now open.

Mike J. Olson - Piper Jaffray & Co (Broker)

All right. Thanks. Good afternoon. Just a couple of questions. It sounds like you're expecting a solid slate in the first half of 2016 because of some titles getting shifted from Q4 into the first half. In general, do think we're at a point where a strong slate can improve the growth profile of Redbox or is the kind of the situation more that the secular decline is just too powerful to offset at this stage in Redbox's life for the title slate to really have much of an impact?

Galen C. Smith - Chief Financial Officer

So we definitely have, as we talked about, a number of titles shifting out to first half of 2016. Q1 should have good content. But as you know, as we've seen even this quarter, content tends to shift at different times. To your question, Mike, I think we do have opportunity to leverage strong content to help offset the secular decline. We're doing everything we can to engage consumers. And I think the thing that's important for us to continue to be out there and to tell our story is, we provide the best value for new release entertainment, right. This is the best place to get the latest movies, the latest games, and we want to continue to tell that story well and we think that will help offset secular decline.

Mike J. Olson - Piper Jaffray & Co (Broker)

Okay. And then along those lines on the games front, it sounds like you're going to get more aggressive there. Do you have evidence to suggest that there is demand for more video game content in a Redbox kiosk? For example, are you able to see like how many queries you got for certain content that you didn't have in stock or anything like that?

Galen C. Smith - Chief Financial Officer

We don't actually see it that way, but what we do see is again an increase in demand for video game titles. So we're seeing more people want to come and rent. And really this has been a time of transition, right, where for us, it's how do you get to the right level of the installed base for PS4 and Xbox One that connects with our consumers. And then it's how do you get that right level of content. And the team has made a lot of progress in the last four, six, eight weeks in terms of getting us to the right level of output deals with our video game partners to try to get that new release content in. So we made a lot of progress. Q4 is a big time in terms of new releases and we're looking forward to providing that to consumers.

Mike J. Olson - Piper Jaffray & Co (Broker)

Okay. And then just lastly for ecoATM you mentioned deploying the kiosks you have in inventory. Does that mean that you aren't planning on developing more kiosks at this point?

Erik E. Prusch - Chief Executive Officer & Director

Mike, it's Erik. We are focused on getting eco to profitability and we think that the shortest path to profitability is making certain that we leverage the assets that we've already got. So our first and foremost focus is making certain that the assets that we've deployed or have in inventory right now are deployed effectively and that we position them in the exact right places, which really is around mass merchant malls.

Mike J. Olson - Piper Jaffray & Co (Broker)

Okay. Thanks a lot.

Erik E. Prusch - Chief Executive Officer & Director

Thank you.

Operator

Your next question comes from the line of Eric Wold with B. Riley & Company. Your line is now open.

Eric Wold - B. Riley & Co. LLC

Thank you. A couple questions. One, not sure what all you can say about Gazelle at this point, but you can maybe discuss some of the main advantages of acquiring Gazelle other than either removal of a competitor offering cash for devices kind of targeting somewhat the same consumer as you? And then two, is Gazelle currently cash flow positive or EBITDA positive at this point?

Erik E. Prusch - Chief Executive Officer & Director

So Eric, this is Erik. As far as Gazelle is concerned, what we saw attractive about it was: one, was the direct-to-consumer channel; two, was the fact that they bring additional critical mass for us; and three, there is the uplift in margin potential in terms of complementing the existing ecoATM business. Recognize that they're online and eco is physical with kiosks. So we think that the combination of these two give us greater breadth in the marketplace, give us greater depth in terms of critical mass. Now we're not going to comment yet on the cash flow profile of the business, but we do think that this is a good acquisition and it is very complementary to what we have.

Eric Wold - B. Riley & Co. LLC

And then just on the existing ecoATM business, obviously you're in a point where you're kind of deinstalling or redeploying. But thinking about the kiosks that have been installed in one location for 12 months or more, can you give us an idea of what the average revenues of those kiosks are versus the total average or total number, and then kind of what percentage of those are profitable at this point at the unit level?

Galen C. Smith - Chief Financial Officer

We don't break that out Eric, but we were pleased in seeing, as I talked about in my comments, just the improvement in per kiosk revenue generation. So we're making good progress. Part of that as to what you mentioned, is those 180 that we redeployed out of underperforming locations to better locations. As we continue to do that, we put them in the mall and mass channels, as Erik talked about, that will help us continue to improve there. And we've seen a lot of improvement over the last couple of quarters as we've come out of a very challenging Q4 last year.

Eric Wold - B. Riley & Co. LLC

Okay. Last question, any guidance in terms of what the – I know you're talking about more on Gazelle, but the price being paid, is it in cash?

Galen C. Smith - Chief Financial Officer

What we filed in our Q today is we paid $18 million, and we'll pay $18 million for the assets and it will be cash deal.

Eric Wold - B. Riley & Co. LLC

Perfect. Thank you.

Operator

Your next question comes from the line of Andy Hargreaves with Pacific Crest. Your line is now open.

Andy R. Hargreaves - Pacific Crest Securities LLC

Thanks. Still I'm just looking at the numbers, even though movies are just shifting out of Q4, it looks like you are expecting I don't know maybe the strongest sequential increase in rental volumes for Q4 that we've seen. Is that right? And, I guess, why it's such a strong sequential growth period if movies are shifting out?

Galen C. Smith - Chief Financial Officer

One of the things that's driving that, Andy, is that you have such a dearth of content in Q3. And if you go back and you think about what's kind of happened in the last three quarters, right, each quarter has been a sequential decline in box office. So all of a sudden as you get into Q4, right, you are up to a lot more titles, right? You are up to over $3 billion in content, right?

You've got a number of blockbuster titles that we talked about, four of them present $1.8 billion. You've got a very heavy November release slate that's coming out; and we've really built up over the last couple of weeks a number of very good titles that have come. And so it's really how do we get consumers to come back to that. And we feel that we've got the right level of range and again coming out of something that we hadn't seen in four years in terms of the content release schedule, we think this is the right expectation for those numbers.

Andy R. Hargreaves - Pacific Crest Securities LLC

Okay. And then just on getting people to come back, sorry, there has been sort of an elevated level of promo activity early in the quarter, can you comment at all just on what the responses for those have been? And now that we're a few weeks in are we starting to see some volume return in response to promos?

Erik E. Prusch - Chief Executive Officer & Director

This is Erik. So one of things to consider is that more of the content is back-end loaded, but we're definitely increasing the spend. We've done this before. We're expecting that will have positive results for Q4. But it is going to be more back-end loaded and it's too early to tell.

Andy R. Hargreaves - Pacific Crest Securities LLC

Okay. And then the last question I had is just given – you've referenced in sort of the strategy being similar to what we saw I think in 2012. Was that sort of an indication of what you would expect margins to look like as well, or was that just directionally saying we're going to spend more to try to make sure that people have in stock?

Galen C. Smith - Chief Financial Officer

Yeah. No, it's more directional in terms of the strategy behind it. I think we did want to note the fact that it will have an impact on margins this quarter just as people work through their models. For us, it was really what's important to consumers and it's getting that content in their hands. And after you go to the box a couple times and don't put there's something interesting to rent, it's what Erik talked about, how do we advertise and get them to realize that there's something good. And then when they come to the box, you make sure that they have that content there. So it's much more directional in terms of the strategy behind what we're trying to do to drive behavior.

Andy R. Hargreaves - Pacific Crest Securities LLC

Got it. Thank you.

Operator

Your next question comes from the line of Paul Coster with JPMorgan. Your line is now open.

Paul J. Chung - JPMorgan Securities LLC

Hi, guys. Thanks. This is Paul Chung on for Paul Coster. Thanks for taking my question. I have a question on...

Erik E. Prusch - Chief Executive Officer & Director

Hi, Paul.

Paul J. Chung - JPMorgan Securities LLC

Hey, how are you? A question on Redbox revenues, there have been several levers that have driven growth whether it be installs, market share grains, Blu-ray percentage, but those levers are less effective at the moment. My question is price increases seem to be the most viable lever moving forward, when can we expect another price increase to drive growth?

Erik E. Prusch - Chief Executive Officer & Director

Certainly, the last price increase we had was very effective at driving revenue thus far this year. I think the reality is we're going to make certain that we've got the right content; we've got the right strategy to go after at the next series of growth objectives.

We will continue to evaluate our pricing and our value proposition. We still think that we're extremely advantaged in the marketplace, as Galen alluded to earlier, but that's really an ongoing assessment of what we'll do in the future. But for now, we're concentrating on content, we're concentrating on the experience and making certain it's a deep, good quality experience for our customers.

Paul J. Chung - JPMorgan Securities LLC

Got you. Thank you.

Operator

There are no further questions at this time. I turn the call over to Mr. Erik Prusch, Outerwall's CEO.

Erik E. Prusch - Chief Executive Officer & Director

Thank you. As I close the call today, there are several important ideas that underlies the thoughts I shared with you regarding our performance and our business. First, Q4 is going to be challenging quarter for us, but we're focused and we expect to deliver on our commitments.

Second, we're centered on driving top and bottom line growth whether it is through brand expansions, adjacencies or new opportunities. Third, when we innovate, we'll do it pragmatically. We'll be patient for revenue, but inpatient for profitability. And lastly, I'm excited to be here and lead this effort. I have a very high set of expectations for the team and myself. We will improve and I expect to succeed in reinvigorating growth in the top and bottom line, and I look forward to updating you on our progress.

Thank you for your support. And thank you for joining us today.

Operator

This concludes today's conference call. You may now disconnect.

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