Outerwall (OUTR) Erik E. Prusch on Q4 2015 Results - Earnings Call Transcript

| About: Outerwall Inc. (OUTR)

Outerwall, Inc. (NASDAQ:OUTR)

Q4 2015 Earnings Call

February 04, 2016 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

Darren P. Aftahi - ROTH Capital Partners LLC

Paul J. Chung - JPMorgan Securities LLC

Operator

Good afternoon, ladies and gentlemen. Welcome to Outerwall's 2015 Fourth Quarter and Full-Year Earnings Conference Call. My name is Sharon and I will be your host operator on this call. Please note that this call is being recorded today, Thursday, February 4, 2016 at 2:30 PM Pacific Time. A replay will be available after the call ends today through February 18. Details on how to access the replay are available on Outerwall's earnings press release. Following the company's remarks, we will conduct a question-and-answer session; instructions will be provided at that time.

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, Sharon. I'd also like to welcome all of you to our Q4 earnings call. Outerwall's CEO, Erik Prusch, and CFO, Galen Smith, will host today's call. Erik and Galen will make introductory remarks and then we will open up for Q&A.

The Q4 earnings press release and prepared remarks are posted on the Investor Relations section of our website at ir.outerwall.com. The 2015 10-K is also posted in the SEC Filings section. During the call, the year-over-year comparisons we make will be full-year 2015 versus full-year 2014 or Q4 2015 versus Q4 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 press release and the prepared remarks.

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.

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

Erik E. Prusch - Chief Executive Officer & Director

Thanks, Rosemary. Thanks to everyone for joining us and for your ongoing interest in Outerwall. Outerwall has a solid financial foundation as evidenced by our 2015 results, with $249 million in free cash flow and record core EPS of $8.77. This solid foundation is a great testament to our unrivaled network of more than 60,000 network kiosks and millions of loyal customers.

We have long-standing relationships with retailers, and provide them with automated solutions that create some of the most profitable real estate in their stores. We are committed to leveraging our assets, strong brands, value to retailers, consumer relationships, and financial capabilities, to strengthen our businesses, extend them with modest investments and deliver sustained value to our stakeholders. It's this strong foundation from which we will address the top-line headwinds at Redbox.

Frankly, I am not satisfied with our recent performance. I made a conscious decision in December to change the leadership at Redbox, and as Interim President, I have the opportunity to dig into the Redbox business with a different lens and assess opportunities for the brand by focusing on the fundamentals and managing for profitability and cash flow.

Managing expenses is a fundamental part of how we run the businesses across the company. We continually look for ways to cut cost, increase productivity, and operate the kiosks more efficiently to align cost with revenue.

Similar to my experience for finding our approach at ecoATM, we dug in to identify opportunities for improvement and minimized expenses, which resulted in expanded revenues and margin uplift. Simply put, we are committed to executing better.

Redbox revenue was $407 million for the quarter and $1.76 billion for the year, in line with our revised guidance. While a lack of hit titles hurt second half performance, secular decline is also impacting Redbox at an accelerated rate.

We are facing challenges from changes in the marketplace and how consumers access content in various formats. Levers that worked in the past, such as investing in more content or certain marketing promotions are no longer sufficient as a counterweight.

However, there is another side to Redbox that cannot be overlooked. As evidenced by more than 587 million physical movie and game rentals in 2015, millions of everyday consumers rely on Redbox as the new release market leader as a best value. In fact, the vast majority of our customers use Redbox as a complement to, not instead of digital alternatives.

Another key factor to our business strength that is often overlooked is the fact that our movie and games studio partners rely on physical disks as a key part of their window and revenue maximization strategy. This would be very difficult to replace. To that end, we signed a new multi-year agreement with Universal Studios Home Entertainment that will continue to make their movies available at Redbox locations nationwide.

This deal underscores our ongoing commitment to deliver affordable and timely access to new release movies. While we recognize that Redbox may become a smaller business over time, we believe that it will remain a compelling business in its ability to continue providing new release movies and games to millions of consumers at a great value for many years to come.

Turning now to Coinstar; the business had another solid year in 2015 and generated nearly $319 million in revenue. As mentioned last quarter, we are moving forward with limited tests in two Western European countries, France and Spain, based on our past success in Ireland and the U.K. Expansion will proceed only if we're able to generate the returns comparable to what we achieved in existing markets.

With respect to the ecoATM line of business which includes Gazelle, the business generated $114 million in revenue for the year. Our focus is on getting the ecoATM business to profitability this year. And based on early indications with Gazelle, we believe that this asset acquisition will accelerate our progress.

We closed the transaction in the fourth quarter and have made significant progress integrating the two businesses and their teams. The combination with Gazelle provides the ecoATM business with a direct-to-consumer channel for collective devices and capabilities, reinforcing our commitment to deliver convenient customer solutions.

Additionally, we are focused on increasing revenue and profitability for our retailers. For example, an estimated 60% of Redbox' kiosk customers shopped in store when visiting the kiosk and a majority of Coinstar kiosk users spend more than half their cash voucher in the store, helping fuel more spending with our retail partners.

We maintain strong relationships with retailers and provide them with solutions that create some of the most profitable real estate in their stores. I am optimistic about where we could take Outerwall, as we remain focused on strengthening our businesses, controlling costs and creating efficiencies, while continuing to return significant free cash flow to investors.

With that, I'd like to turn the call over to Galen, who will discuss our financial results in more detail and provide guidance for 2016. Galen?

Galen C. Smith - Chief Financial Officer

Thanks, Erik. Our 2015 results demonstrate our ability to manage businesses for profitability and cash flow and deliver strong financial results, despite the challenges in Q4 that impacted consolidated results and caused us to lower our guidance during the quarter.

For the full year, we generated consolidated revenue of $2.2 billion. Core adjusted EBITDA from continuing operations of $485 million, down $12 million, despite a $98 million decline in revenue. Core diluted earnings per share from continuing operations of $8.77 and $249 million in free cash flow.

We identified and actively managed expenses, cutting $38 million of overhead throughout the year to better align with our revenue. We continue to return capital to shareholders, repurchasing approximately 2.5 million shares for approximately $160 million, and paid $21 million in quarterly dividends. In addition, in December we opportunistically repurchased and retired $41 million in face value of our outstanding 2021 senior notes for approximately $35 million in cash.

For the fourth quarter, we generated core adjusted EBITDA from continuing operations of $96 million, primarily reflecting lower Redbox revenue and higher content purchases, core diluted earnings per share from continuing operations of $1.43 and free cash flow of $42 million.

During the fourth quarter, we completed restructuring activities that resulted in approximately $2 million in one-time lease termination and severance costs related to organizational changes at Redbox and ecoATM. We also had the opportunity to settle our remaining $15 million NCR purchase commitment for a one-time charge of $8.5 million. These costs have been allocated to the lines of business and are included in segment restructuring and related costs.

Turning now to Q4 2015 segment operating results; Redbox gross margin of 52% was largely driven by a short-term misalignment of content purchases and demand. We increased content purchases and promotions to reengage consumers after several quarters of weak content, but rental did not meet our expectations.

We began to adjust purchases for Q1, as we saw preliminary November results, but the amortization from the Q4 overbuy is expected to impact Q1 margins by 410 basis points. The increased impact from secular decline has made it more challenging to optimize our purchases, but we will continue to refine them based on changes we see in the business.

Redbox segment operating margin was 15%, a decrease from 26% in Q4 2014, with the largest impacts from the lower gross margin, higher marketing expense, and allocation of the one-time restructuring and NCR settlement costs. Without the one-time charges, segment margins would have been 17%.

We remain focused on managing the Redbox business for profitability and generating cash flow through discipline expense management, while making targeted strategic investments to extend the business. We plan to continue to aggressively attack the cost structure in relation to the trajectory of the business, as we look at adjusting the number of kiosks to be in line with demand, refining content agreements, improving supply chain and reducing operating expenses.

Turning now to Coinstar; segment operating income decreased $2 million to $31 million. The decrease reflects higher G&A related to increased technology costs as well as the allocation of $2 million in restructuring-related expenses, partially offset by the increase in revenue.

For ecoATM, with the acquisition of Gazelle, we'll report the performance of the two brands as one segment. We closed the transaction in Q4 and have provided detail on the accounting for the acquisition in our prepared remarks and our 10-K.the

ecoATM segment results include approximately $900,000 in one-time costs related primarily to organizational changes and Gazelle acquisition fees. As we move forward, we expect to create efficiencies and consolidate overhead expenses that will benefit margins and profitability. ecoATM segment operating loss in Q4 improved $1 million year-over-year, despite the one-time charges, reflecting our focus on controlling expenses and creating efficiencies.

Turning now to guidance; last year we began to provide annual guidance only and we expect to update it as appropriate when we report the financial results each quarter. Due to the difficulty in forecasting, as a result of the content release schedule, accelerating secular decline as well as our focus on profitability and cash flow, we are not providing revenue guidance for 2016.

We'll continue to provide guidance for core adjusted EBITDA from continuing operations, core diluted earnings per share from continuing operations, and free cash flow. There are several factors that influence our 2016 expectations, including the new release schedule and strength of content, Redbox's ability to reengage consumers to rent, the integration of Gazelle, the redeployment of previously manufacturing ecoATM kiosk, and ability to further align costs with revenue.

For the full-year 2016, we expect core adjusted EBITDA from continuing operations between $340 million and $380 million, reflecting the impact of rental decline on Redbox revenue and profitability; Core diluted earnings per share between $5 and $6.30 impacted by the lower expected EBITDA, partially offset by lower depreciation from fully depreciated kiosk. This range does not reflect any share repurchases we may complete during the year; Free cash flow between $140 million and $190 million, driven by lower EBITDA and a negative impact to working capital, partially offset by lower capital expenses. In 2016, we reduced our expectations for capital expenditures to $45 million to $55 million from the $75 million in 2015.

Our guidance includes our current view of the release schedule for Redbox in Q1 2016 and expectations for how titles might be released for the remainder of the year. Our visibility is limited as the theatrical release schedule will evolve, and the performance of titles in theaters is difficult to predict.

Based on our estimates, 2016 box office for Redbox titles is expected to be $10.2 billion, an increase of 3% from 2015, with eight more titles, including 11 more titles in the first half of the year and three fewer in the second half of the year. Redbox expects nine more day and date titles, which generally drive higher rentals, but are lower-margin percentage titles. In Q3 2016, we expect the lowest box office and number of releases during the year, due to the Rio Summer Olympics.

Historically, studios do not release new titles during the summer games, which impacts rental volume and momentum at Redbox. In addition, in Q4, we expect some level of impact on rental demand from the presidential election in November.

The Q1 2016 box office is expected to be $3 billion, 23% below Q4 2015, with eight more titles, seven of which are delayed. Year-over-year, Q1 2016 box office is up 16% or $406 million from Q1 last year, with eight more titles. For the year, Q4 2016 is expected to have the highest box office, followed by Q1 2016, Q2 2016, and Q3 2016. Consistent with historical patterns, we expect stronger seasonality in the first and fourth quarters of 2016.

We also expect that our continued focus on operational efficiencies and network optimization will help to partially offset rental declines in 2016. We continue to collaborate with our retail partners to improve kiosk productivity at existing locations and remove unproductive kiosks.

We expect to remove 1,000 to 2,000 kiosks in 2016, helping to improve revenue and profitability for kiosk, while lowering content and servicing costs due to a smaller install base. We estimate a 15% to 20% decline in rentals from secular decline in 2016, which is an increase from what the business experienced in 2015, as consumers ship to other forms of entertainment.

For 2016, with our focus on moving ecoATM to profitability, we'll continue to redeploy underperforming kiosks and inspect to install 50 to 100 net new kiosks in the mall and mass channels. Since these kiosks are manufactured in previous years, we expect a significant reduction in capital expenditures for ecoATM.

Despite an expected decline in Redbox segment results, Outerwall has a solid financial foundation, and we believe we can continue to generate a significant amount of EBITDA and cash flow in the years ahead. Capital allocation has been and will continue to be at the forefront in how we manage the business and look to create value for the shareholders.

As we manage the business for profitability and cash flow, we're focused on continue to create value by returning 75% to 100% of the annual free cash flow to investors through share repurchases, dividends and senior note repurchases.

We will now open up the call for Q&A.

Question-and-Answer Session

Operator

Your first question comes from Mike Olson from Piper Jaffray. Please go ahead.

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

Hey, good afternoon. Couple of questions on the cost structure. I guess you mentioned it a little bit, what kinds of things can you do to reduce costs more rapidly as secular decline continues or potentially accelerates I guess? And I guess along those lines, do you see or envision EPS or free cash flow growing again in the future or is it more about just kind of managing the pace of decline with those metrics?

Galen C. Smith - Chief Financial Officer

As we think about the Redbox business Mike, there is a number of opportunities that we are looking at. First, we buy our content on a per kiosk basis, and so our opportunity is to take a look at what's the right network for the level of demand that we have. So, it will be a (19:11) kiosk that we talked about. That obviously also provides opportunities besides taking down content costs, to also reduce your servicing costs so you lower your supply chain costs.

We'll look at overhead, we'll look to other direct OpEx, so there is opportunity to continue to refine that as we go forward. Our focus is on driving profitability and cash flow, but we look for opportunities to do that. We're only providing guidance for 2016. But we will look for ways to improve those two measures as we go forward.

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

Okay. And then you said I think the combo of ecoATM and Gazelle will be profitable this year, is that correct? And do you expect to expand the ecoATM footprint at this point or just focus on the current footprint and making that profitable?

Erik E. Prusch - Chief Executive Officer & Director

So, Mike, this is Erik. First off, yes, our objective this year is to get ecoATM/Gazelle profitable in 2016, and we're committing a lot of effort in order to do that. We are also – and I think we mentioned this on the last call, we're not building out any additional kiosks. We're going to deploy whatever kiosks that we have in inventory. And we believe with the existing portfolio of kiosks that we have both in inventory and deployed that we can get the business to profitability.

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

All right. Thanks very much.

Erik E. Prusch - Chief Executive Officer & Director

Thank you.

Operator

Your next question comes from Eric Wold from B. Riley and Company. Please go ahead.

Eric Wold - B. Riley & Co. LLC

Thank you. It's a question around Redbox. Obviously, you've got the secular decline, and it's difficult to deal with and something you can't directly change. You've only raised prices twice in 13 years. Why not take a more proactive approach to price increases? There's still a very big delta between $1.50 at Redbox and $6-plus at VOD and you've got a dedicated group of customers, I know there is a hesitancy to kind of piss them off and kind of maybe increase that decline more, but I think there is a definite ability to raise prices to more than offset any additional impact to rentals. Do you have any thoughts on an annual increase there?

Erik E. Prusch - Chief Executive Officer & Director

Yeah, Eric, this is Erik. We're going to continue to look at price as one of the levers that we have with the business. I think it's imperative for us to make certain. We've got tests going on. We know what results we're going to achieve in a nationwide rollout well in advance of actually doing the rollout. But it is one of the levers. We'll continue to monitor it. We see the increase that we did at the end of 2014, having been accretive overall to revenue. So, the offset of the decline in rentals versus the price increase, the price increase more than offset that.

So it is something that we're going to continue to monitor moving forward. And we'll let you know as we get closer to it or as we see some results in our tests.

Eric Wold - B. Riley & Co. LLC

Okay. Thank you.

Erik E. Prusch - Chief Executive Officer & Director

Thank you.

Operator

Your next question comes from Darren Aftahi from ROTH Capital. Please go ahead.

Darren P. Aftahi - ROTH Capital Partners LLC

Thanks, guys. Just a few here. So, if we look at obviously 2015, rentals around 19%, but the second half of the year was closer to 25%. Can you kind of walk me through some of the details behind your 15% to 20% year-on-year decline? And then how much of not really having that much visibility in the second half of the year plays into that? And I've got a couple of follow-ups.

Galen C. Smith - Chief Financial Officer

So, on secular decline, if we go back to 2015, as we talked throughout the year, we really saw very little impact from secular decline as we started out the year. And as we went throughout the year, we saw some signs of it increasing. As we talked about in our Q3 call, we talked about seeing a higher impact from that. With all – with the strategies we deployed in Q4 to help consumers get back to the kiosk, which included buying more content, promoting more by trying to drive the consumer behavior that we expect, particularly coming out of weak content and a stronger content, we thought we'd see different level of behavior and we just didn't see that.

And so, again, we've seen this greater impact over the last two quarters from increase in secular decline. So we thought about 2016, it's really that continuation of that trend. Now, again, we talked a bit about content, content is up 3%; so it's roughly flat. So, again, I think more that – as Erik said and talked about in his remarks, we can't counterweight or offset in the same way there we used to. And so again, we'll look for every lever we can pull to drive the maximum amount of profitability, but it's definitely more challenging than it's been in prior periods.

Darren P. Aftahi - ROTH Capital Partners LLC

So to that point and I think Erik's comments earlier, if buying more content isn't the right strategy anymore, how do you guys think about historical gross margins in the Redbox business? I know they've been kind of in the mid to sort of high-50%s. I mean does that hold true and what are the mechanics you're going to use to get people to come back at the boxes?

Erik E. Prusch - Chief Executive Officer & Director

So there's a number of factors that are impacted, right. So in my remarks, I shared that what we did in Q4 will impact Q1 margins by 410 basis points. So that's definitely a factor, particularly on it (24:38) it's about a full point for the full year that we expect in terms of the impact. In addition to that, right, we are trying to expand in other areas that have lower margin percentage, but higher dollars; so think Blu-ray, think video games. And those are the ways that we think that can drive more profit dollar, but will have an impact on margin percentage.

And so again, what we'll look to do is optimize. Now, there may be periods of time where you have a disconnect between the number of kiosks in demand, and that's where we've got to try to manage very well, right. So as we look to attack cost structure, it's how do we get that as closely aligned at the right time. But you're not always going to have that. So, again, we'll attack it, we'll go after it. But we won't have the same benefit we did in 2015, when you had the benefit of the price increase the entire year.

Darren P. Aftahi - ROTH Capital Partners LLC

And it's my last one. Did you guys break out anywhere what the Gazelle revenue contribution was in 4Q for the eco segment?

Erik E. Prusch - Chief Executive Officer & Director

We do, it was just over $13 million for Q4.

Darren P. Aftahi - ROTH Capital Partners LLC

Okay. Great. Thank you.

Operator

Your next question comes from Paul Coster from JPMorgan. Please go ahead.

Paul J. Chung - JPMorgan Securities LLC

Hi. This is Paul Chung on for Coster. Thanks for taking my question. Can you talk about your high-frequency renters? First, what's causing the decline besides the secular decline? And second, how can you combat this, whether it'd be more promotions like Play Pass, et cetera or would you expect this percentage to really stabilize?

Erik E. Prusch - Chief Executive Officer & Director

Yeah, Paul. So, in Q4, our HFR customers represented about 47.3%. That was a decline from year ago of 54% and a slight sequential improvement from Q3 where we were 46%. So what we saw was with the content in Q3, our HFR customers came down and kind of hit a trough in Q3. So we do think that there is a correlation between the content that we've got.

At the same time, secular decline is going to impact that customer base. And we're seeing, as we've kind of mentioned in the prepared remarks, we see our physical strategy as a nice complement to others from a digital standpoint. We can maybe improve that as we go along. We've got to work harder from a promotion standpoint. We've got to make certain that we're delivering key value. We've got to make certain that we've got the right content in the box that's available for those customers.

And lastly, and I think this is perhaps one of our best tools that we've been successful with, is our Play Pass. And we did grow Play Pass during the course of the quarter. That grew about 15.7% to 3.2 million customers. There were about 10% of uniques. So, we're doing the right things, but we've got to reengage customers. We weren't as successful with it in Q4 as we'd like, and we're going to put more in action in 2016.

Paul J. Chung - JPMorgan Securities LLC

Okay. And I think the Redbox has a limited TV offering? Do you have any intentions of offering more TV titles? It seems like industry viewing, consumer trends or Netflix is really changing behavior shifting to more binge TV viewing. Why haven't you guys capitalized on that? Thanks.

Erik E. Prusch - Chief Executive Officer & Director

Well, first, we are the new release movie business. That is our core strength, that's our value proposition, and of course, we're the best value in new release movies. So we're going to stay focused on what we do best. We have added games obviously. We've also looked beyond theatricals into direct-to-video and we've manage that business pretty well over the course of the last year. I think that our ability to deliver greater value to customers is going to be consistent with our core strength and that's where our focus is going to be.

Paul J. Chung - JPMorgan Securities LLC

Okay. Thanks.

Erik E. Prusch - Chief Executive Officer & Director

Thank you.

Operator

We have no further questions at this time. I will turn the call over to Mr. Erik Prusch, CEO.

Erik E. Prusch - Chief Executive Officer & Director

Thank you very much. In summary, with over 60,000 network kiosks, there are actually more Outerwall kiosks worldwide than Starbucks and McDonald's location combined. Few companies have that kind of reach and influence on people's lives. With our beloved brands coupled with millions of consumers who value our products and services, we are resolute in pushing the business to drive stakeholder value through discipline capital allocation, managing expenses tightly, pragmatically investing in modest brand extensions and international growth. We look forward to updating you on our progress in future calls. Thank you.

Operator

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

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