... "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." - Outerwall CEO on the Q4 2015 Call
I've never personally had much attraction to the Outerwall (NASDAQ:OUTR) thesis - I thought that most bulls' revenue forecasts failed to account for an acceleration of the shift from physical rental to streaming. This fear was validated by Q4 results that can only be described as "awful" - Redbox revenue was down 17% from $490 million to $407 million, with underlying rental volume declining even further (25%).
Despite my lack of immediate interest in the thesis, I've been following it from a distance as several value investors I respect - most notably Allan Mecham of Arlington Value - have been involved in the name. Unfortunately, I think the only thing the company really has within its control is its ability to alter its capital structure - and on that front, they seem to be taking the wrong path. With that, even though Outerwall is statistically very cheap, I don't think this falling knife is one investors should try to catch.
Is There Anything Management Can Do?
One of the factors management attributed the poor results to was weak content and the need to increase marketing and promotions to offset this. In the company's defense, they were up against a movie slate in-theaters that included Star Wars, but unpredictability in release schedules is the name of the game in their industry, and this is not a "one-time" item.
Redbox President Mark Horak was sacked along with the announcement, and CEO Erik Prusch made all the usual statements on the call about focusing on the fundamentals. I think the firing, however, is more optics than substance - what levers can management really pull here? Increase pricing and you'll drive down demand; decrease pricing and you'll sacrifice profitability to arrest the decline in demand.
I'm not convinced that the company has anything left to try that it hasn't already tried. Yes, any business can always be managed better - but the problem at Redbox does not, fundamentally, seem to be bad management. I rented a DVD from Redbox just the other weekend. There really wasn't anything they could have done to made the experience better. The checkout process is easy and the movie selection is fine. The fact remains that streaming/Netflix (NASDAQ:NFLX) are much more convenient than having to make two trips to a kiosk to pick up and return a movie. Even if you are already at the store, picking the movie up, having to drop it off the next day is a hassle. Why not just watch something on Netflix? Unless you really specifically want to watch a certain piece of content that isn't on Netflix, there's no reason to go to a Redbox.
And thus, while management points out that Redbox still has value to studios, the problem is that neither studios (nor management) have control over consumers' increasing proclivity to go online for content.
Debt Could Become A Major Concern
As of the end of the year, Outerwall had $845 million in "net debt" excluding overseas cash. This represents 1.7x trailing adjusted EBITDA, and 2.3x the midpoint of forward EBITDA ($360MM at the midpoint). If you include overseas cash and ignore repatriation taxes, you're looking at $670MM of net debt. It's an interesting question how to account for the accounts payable, but we will just work with the number most favorable to Outerwall for now. (If you're looking into the company, however, really digging into what the exact "net debt" number should be is an issue you should certainly spend some time on.)
Against this, the company expects to generate between $140 million and $190 million of free cash flow in 2016; at the midpoint, it would take the company 4 years to repurchase its debt if FCF held steady (which it almost certainly won't). I think it's a valid question to ask if that is too long: next year's free cash flow, at the midpoint, is expected to be two-thirds of this year's, while adjusted EBITDA is expected to decline by 25% despite management's plans to remove the big profitability drag from ecoATM.
Even if you model Redbox revenue declines of only 10% a year going forward - which, honestly, seems fairly optimistic in light of the Q4 print and management's own expectations of a 15 - 20% rental decline - things start to get dicey. Coinstar's $120MM in standalone EBITDA (momentarily ignoring corporate costs and ecoATM losses) is hardly close to being able to support, let alone pay down, a $690 million debt load. That cash flow will need to come from Redbox.
And yet the company's capital allocation leaves something to be desired, from my perspective. I hear zero urgency to bring down the debt load, nor do I see any in the numbers. For example, during the fourth quarter of 2015, the company repurchased $36MM worth of shares at an average price of $53.89. Normally I think it's very bad sport to get angry at management teams for buying their shares back prior to a price decline - they don't have a crystal ball more than any of the rest of us, and you can't blame them for repurchasing shares at what seemed like a reasonable valuation. In this case, however, management clearly knew that the quarter was not going at all the way they wanted it to, and yet they were still repurchasing shares rather than waiting until they'd updated the market on how badly things were going.
Going forward, the company is planning to spend 75 - 100% of FCF repurchasing shares, paying dividends, and buying back Senior Notes - but again, the first two seem like a bad idea to me. The dividend is a ~$20MM annual burden, and while you can make the argument for repurchasing shares if you're a bull, it's a little reflexive. A bigger piece of a pie that's worth nothing is still, well, worth nothing - and there is a very real scenario here where Redwall declines fast enough for the debt load to become unmanageable.
Management could very easily lower risk here by devoting all of FCF to debt paydown; if they could get it to say $400 million within two years, things would still be tight if Redbox continues to decline at the rate that it currently is, but Coinstar and a much smaller Redbox could still feasibly support something in that level.
In the company's defense, I should note that Outerwall will get a little bit of help from its ability to purchase its $600 million of Senior Notes (2019 and 2021 maturities) at a discount to face value - in December, the company purchased $41 million of the 2019 notes at a 15% discount to face value, for example.
Wrapping It Up
On whatever metric you pick, Outerwall looks very cheap. Unfortunately, the brutal decline of Redbox rentals in Q4 - and very weak guidance for next year - shows the risks of being invested here. (Plenty of people thought it was cheap before the >50% decline.)
If Outerwall doesn't take a significant chunk out of its debt this year - or if Redbox declines continue to be greater than expected - the company could very quickly find itself in a bad spot. I honestly don't think there is enough within their control here for investors to feel confident in them stemming the declines; Outerwall at this or any price is really a math problem.
How rapidly do you think consumers will shift to streaming? If you want to make a bet on that, go ahead, but make sure you're running your numbers right - and be conservative, because the debt load doesn't leave much room for error.
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