An Open Letter To Engaged Capital And The Outerwall Board

| About: Outerwall Inc. (OUTR)

Summary

Engaged Capital makes several good points in its letter and presentation, but does not address Outerwall’s ultimate issue, which is revenue growth.

Growth can be achieved by removing distractions, and adopting features of other pricing models - what does Outerwall have to lose?

Going private today leaves money on the table and won’t solve Outerwall’s challenges.

To Engaged Capital and Outerwall:

Engaged, in your recent press release about your intentions on Outerwall (NASDAQ:OUTR), you suggest shareholders voice their concern directly to the Outerwall Board. Outerwall, you mention in your statement that you welcome the opinion of your shareholders and remain open to constructive input toward the goal of enhancing shareholder value. So here it is:

Engaged Capital is the latest private equity fund to try and create fundamental change at Outerwall. In its recently posted letter and presentation, Engaged makes the argument that Outerwall has:

  • Significantly underperformed the market, and that its currently depressed valuation is a direct result of the Board's failed strategies

  • Allocated capital poorly, on poor acquisitions and initiatives, and effectively squandered approximately $1.2 billion of shareholder capital in doing so.

Engaged has put together a cogent, compelling letter and article, and both provide reasonable points for the issues that Outerwall is dealing with. Frankly, the analysis is straightforward and technically correct, but simplistic, and comes across no differently than the output of an MBA class on activist investing. There are certainly elements Engaged gets right - but ultimately their stated goal, of a sale of the company to private equity, leaves money on the table. Instead, if the Outerwall Board and management can get courageous, it has the opportunity to alter the trajectory of Outerwall's prospects in a significant way.

What Engaged Gets Right

It is fairly easy to Monday morning quarterback Outerwall today, and see with perfect vision that the diversification strategy, of owning the physical space near its Redbox and Coinstar and/or creating or acquiring orthogonal businesses, has failed to produce the same kind of growth driver that Outerwall initially had with both Coinstar and Redbox. That's the reality of Outerwall's business. It is unlikely to find another opportunity like its most successful ones, and it should stop trying. To Outerwall's credit, it focused on the largest consumer markets (e.g., coffee, fresh food, etc), and if the fish are not biting, it is time to pack it in. So it is clear that throwing good cash after bad is not the answer. Outerwall should preserve its capital and shutdown everything but Redbox and Coinstar.

What Engaged Gets Wrong, Mostly

Engaged's proposal of ending share repurchases make sense, because while shareholder friendly, buybacks do not put cash back in the shareholder's hands. But is a large, immediate dividend the right answer? if Outerwall is not able to increase its revenue, Engaged's proposal is simply to harvest Outerwall's capital and profits. This approach is obviously short term focused. While this is a typical tactic for activist investors, it may not be best use of capital.

Engaged also makes the argument that Outerwall has squandered significant capital in its business forays. If the company's stock is any measure, Outerwall did fairly well, up to a point. An investment in Outerwall and Netflix in early 2011, four years later, produced a nearly identical return. And most everyone would agree that Netflix has been a star performer. Only since the beginning of 2015 have Netflix and Outerwall diverged so significantly.

OUTR Chart

Growing Revenue

Without the ability to grow revenue, simply harvesting diminishing cash flows is not a good investment thesis for a new investor in Outerwall. Why buy Outerwall stock, instead of an MLP or Dividend Aristocrat? if one believes that the DVD business, as it currently exists, is not sustainable, why invest? there would be no good reason. Outerwall should focus on growing revenue in its Redbox first. With strong revenue growth, all kinds of things are possible.

Here are three approaches Outerwall should implement immediately to grow revenue.

#1. Surge Pricing and Surge Availability during the First Week of a New Movie Release.

Outerwall should take a page from Apple and Uber's pricing models and implement pricing tiers and surge pricing. For example, when renting The Martian from Redbox, why is it $1.50, and not $3.00 for the first week of release, when everyone wants to rent the movie? A consumer would likely pay $3.00 because it is still less than the $6 paid to rent the movie on Verizon Fios and iTunes. And why is it that when I want to rent the new release, it is sold out at Redbox and never available during the first weekend? Redbox should fill up the boxes entirely with the new release. For example, when Star Wars:The Force Awakens hits Redbox, why not fill up the entire box with the new release and all of the other Star Wars movies? It is pretty much a sure thing that Redbox could achieve higher revenue by charging more for new releases, and having many more rental units available. Then, after the initial surge Redbox could implement an iTunes-type pricing model, whereby newer more popular releases get a higher price, but eventually get priced down.

#2. Buy Original Content and become like Netflix and Amazon Prime.

With the capital on hand today, and the 2016 guidance of approximately $140-190 million in free cash flow, Outerwall should stop buybacks and dividends and immediately get in the business of licensing rights to original content, using social media and an internet presence to promote it. Netflix became more than a distribution channel when it distributed original content like Orange is the New Black and House of Cards. Outerwall has the opportunity to leverage its capital into a number of new shows annually. By doing this, Outerwall could differentiate its offerings from Netflix and Amazon Prime. With the cost of content fairly well described, Outerwall could invest in multiple different series. By acquiring original series with multiple episodes, Outerwall can create a more durable revenue stream, less dependent on movie hits it does not control. In order to drive adoption, Outerwall could implement creative pricing models to drive more rentals of its original series.

#3. Partner with Amazon Prime to distribute Amazon's Original Content by DVD.

Amazon Prime is locked in a death match with Netflix as the two major suppliers of online streaming of both their own content and content of others. Outerwall should seek a partnership with Amazon to distribute Amazon's original content by DVD, further flanking Netflix in their head-to-head battle. In addition, Outerwall could offer Amazon Prime the streaming distribution rights to Outerwall's new original content, in a revenue-sharing deal. This might be particularly important since Outerwall ended its joint venture with Verizon.

With these three approaches, Outerwall has the best opportunity to grow revenue and create a durable, sustainable enterprise. Rather than simply cash out for a dividend check and selling the company low, Outerwall's shareholders would benefit from its management and board taking courageous risks, which have the opportunity to create enormous reward. As an investor, having the opportunity to take the ride can be more fulfilling than investing in the DVD equivalent of an oil well.

Disclosure: I am/we are long OUTR.

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.