July 21, 2014
Outerwall (OUTR) - Long Thesis from 2014 Annual Meeting
Before making an investment decision, investors are advised to read carefully the Offering Memorandum, including the description of the risks, fees, expenses, liquidity restrictions and other terms of investing in the funds. Performance data has not been prepared to meet any specific requirements applicable to the presentation thereof and should in no event be viewed as predictions or representations as to actual future performance. Investment may involve a high degree of risk and should be considered only by investors who do not require access to their capital and can withstand the loss of all or part of their investment. Return targets in this document are subjective determinations and do not reflect either actual past performance or a guarantee of future performance. Referenced benchmarks may fail to provide a meaningful comparison. Forward looking statements are based upon assumptions which may differ materially from actual events. This information should not be relied upon in making an investment decision.
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Out-of-favor stocks that are mispriced due to uncertainty or fear, misunderstanding or obscurity; conduct significant due diligence to overcome those hurdles; invest only at a deep discount to intrinsic value
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Investment Strategy – Brief Summary
• Pillar stock – will hold a long time
Durable competitive advantage
Trustworthy management
Industry we understand with favorable characteristics
Available at a deep discount
• Work-out – shorter time frame & catalyst driven
No durable competitive advantage required
Trustworthy management
Industry we understand
Available at an even deeper discount
Near-to-medium term catalysts required
Two Types of Investments
• We look for companies with specific issues:
Turn-around situations
Spin-offs
Post-reorganization equities
Debt covenant concerns
Recently lowered guidance
Hidden or unappreciated assets
Misunderstood business model
Recent negative headlines unfounded, short-term in nature, or unrelated to the actual operations of the company
Out-of-favor industry or country (best source for pillar stocks)
• No particular market cap or sector focus
Thorough understanding of the industry and sufficient liquidity required
• Increasingly looking abroad for ideas
• Special situations will arise regardless of overall market
Where we look for ideas
• Volatility is a measure of the price swings in a stock
• Modern portfolio theory assumes greater volatility means greater risk to the investment
Nothing could be further from the truth
• Only risk that matters is the permanent loss of capital
Short-term fluctuations in the stock price in no way indicate probability of permanently losing capital
• Since we focus on out-of-favor stocks, our investments often go down further after we invest before eventually rising to our valuation
We invest into negativity and negative sentiment can increase in the short-term, but eventually cooler heads prevail
• Increased volatility means we have a greater chance of buying a stock we like at even lower prices
Volatility Is Our Friend
In-Depth Analysis
• Outerwall (ticker symbol: OUTR) is U.S. leader in automated retail
Self-service, stand-alone kiosks in heavily trafficked locations
• Founded in 1989 as Coinstar
• Changed name to Outerwall in 2013
• $1.1B market cap
• Over 100 patents
Profile
• Flagship Brands – cash cows
Redbox
Coinstar
• Developmental Concepts – growth stage
ecoATM
Coinstar Exchange
SampleIt
Redbox Instant by Verizon
Brands
• Stock selling <7 times 2013 free cash flow & for <6 times expected 2014 free cash flow
• Despite the fact that free cash flow is still growing
• Capital expenditures to decline substantially over next few years
• Highly variable cost structure
• Available at less than 50% of revenue despite high margins
• Revenue still growing
• Margins expected to grow even faster
Available at very low multiples
• Maximum negativity from market due to Redbox
Face of the company
Seen as another Blockbuster-in-waiting
• Very high short interest
44% of float shorted – 10 days to cover
• Shifting investor base from growth to value-oriented
• Market cap down 37% YTD
Down 25.5% in last 2 months solely on negative analyst reports
• Work-out investment
Expect company to beat lowered market expectations, overcome market’s fear, & likely cause short squeeze
Opportunity
• Self-service, stand-alone kiosks in heavily trafficked areas
• Strong role in future of retail
• Allows convenience for fulfilling immediate need at lower costs than traditional brick-and-mortar retail, even lower cost than e-commerce
• Limited overhead
No large rent expense (take up 12 square feet of space)
1 part-time employee can service multiple kiosks
Automated Retail
• No competitor can come close to matching Outerwall
• Outerwall has prime real estate no competitor can get
Ex. just about every Wal-Mart has a Redbox and Coinstar
It does not make sense to have a second kiosk from competitor in same location offering same service
Lends itself to natural monopoly within a store
• Long-term relationships with major retailers throughout the country creates high barrier to entry for competitors
Wal-Mart, Walgreens, Kroger, Target, malls, gas stations
Retailer receives percentage of revenue
Drives foot traffic to store
Automated retailer of choice for any new concept
Outerwall Rules Automated Retail
• 86% of Outerwall revenue in 2013
• Kiosks offering physical DVD, Blu-ray, & video game rentals
• 43,000+ kiosks in U.S. and Canada
68% of U.S. within five minute drive of a kiosk
• Only option available in most areas for physical rentals
Redbox
• Can be summed up by one brief paragraph:
Pacific Crest negative report note on July 1, 2014:
“Total DVD/Blu-ray rental volume in the U.S. has declined for six consecutive years. We have found no physical format in the past 40 years that has stabilized after five or more consecutive years of decline, which makes a stabilization at Redbox seem highly unlikely.”
Bear Thesis
1. Physical DVD/Blu-ray volume declined mostly due to extensive retraction in supply as opposed to demand
B&M stores going bankrupt but Redbox has continued to grow rental volume throughout this period
2. One format emerged previously because single device could only play one format (VHS vs Betamax, HD vs Blu-Ray)
Many devices used to stream movies can also play DVD or Blu-ray
3. Generally new format was better quality – DVD over VHS
Blu-ray quality exceeds anything possible via streaming today or near future while DVD has same quality as streaming
4. Ignores sustainable and growing price difference in physical versus streaming rentals and new release availability
Faulty Reasoning
“Total DVD/Blu-ray rental volume in the U.S. has declined for six consecutive years. We have found no physical format in the past 40 years that has stabilized after five or more consecutive years of decline, which makes a stabilization at Redbox seem highly unlikely.”
• Paints the picture of a free fall at Redbox – revenue and margins tell a different story…
Bear Thesis Dissected
Revenue Growing
$-
$500
$1,000
$1,500
$2,000
2009 2010 2011 2012 2013
in millions
26.4% CAGR
12+% Operating Margins
Revenue per Kiosk Stable
in dollars
$42,853
$44,110
$47,610 $48,263
$45,029
$37,500
$40,000
$42,500
$45,000
$47,500
$50,000
2009 2010 2011 2012 2013
2013 decline due primarily to Canada expansion
Market Share
Can still take market share from brick-and-mortar
Should only increase
Slide from Outerwall 2014 Analyst Day
Home Entertainment
Slide from Outerwall 2014 Analyst Day
• Natural urge to compare Redbox to Netflix or Amazon Prime because each offers movies, but that is a mistake
• Netflix and Amazon Prime do not get new releases for some time and must maintain large and growing library of older movie titles and TV shows plus original content
• Redbox focuses primarily on new releases and does not carry any TV content
• Result is little to no content overlap with subscription services
• Proper comparison is Redbox vs. Amazon Instant Video, iTunes, and Cable Video on Demand (CVOD)
How to think about competitive landscape
• Advantages
1. Sustainable Price Gap
2. New Releases
3. Higher Quality
• Disadvantage
1. Convenience
Redbox vs Streaming
Price Advantage
Slide from Outerwall 2014 Analyst Day
• Redbox – no price increase since 2010 yet maintaining margins
• Amazon, iTunes, & CVOD have all raised standard video on-demand prices at least $1 since then
• Studios retain ownership of digital content and have significant say in price charged for video on-demand
Want to maximize revenue by selling DVD or digital copy instead of renting
Think highly of the value of their content
• Redbox has far greater control over pricing due to First-Sale Doctrine
Upward Pricing Pressure
• Enables distribution of legally purchased copyrighted material
Once sold, copyright holder (i.e., studio) has no say in what purchaser does with product as long as purchaser does not reproduce material (i.e., create additional copies)
• Allows Redbox to purchased DVD or Blu-ray and rent it out at whatever rate it and as soon as it desires in the absence of a contract with the studio
• Court rulings within the last decade determined that First-Sale Doctrine does not apply to digital copyright material
Results in studios maintaining significant control in streaming pricing
First-Sale Doctrine benefits Redbox
• New Releases usually available at Redbox well before subscription services Netflix, Amazon Prime, Hulu, etc.
Studios want to maximize revenue by selling or renting individually for a time
• Amazon and iTunes sometimes do not have new release available for rent immediately
Only able to buy at higher price
Studios concerned about hurting sales
• Redbox has all of the new releases either the day of release or, at most, 28 days after release
First-Sale Doctrine prevents studios from stopping Redbox from renting DVD’s, so sign agreements with Redbox, giving discount
2nd or 3rd largest source of DVD revenue for Studios
New Release Advantage
• Blu-ray is higher quality than HD streaming
Only available in physical format and at fraction of the cost
• Only costs $0.30/day more at Redbox than DVD rental
HD is $1 more than standard on streaming
• Blu-Ray at Redbox introduced in 2012
Currently 17% of Redbox revenue
Expected to grow to 25% by 2015
Higher margin than DVD
Blu-ray – Higher quality
• Only 12% of purchases reserved online
Very easy process with app or website
• 45-50% of DVD’s returned to different kiosk
• Indicates an impulse transaction as leaving grocery store or getting gas
Prominent kiosk display near front door grab attention
Greatly reduces “convenience” advantage of streaming
Not So Inconvenient
• Rent 4+ DVD’s/quarter on average
• 25% of customers
• 60% of revenue
• Core customer base
“Movie night”
Want new releases and/or Blu-ray
• Would take long time to erode this base
High Frequency Renters
1. VMZ – expanded capacity & inventory efficiency in kiosks in 2013 – added equivalent of 4,000+ more kiosks
2. New CRM & customer understanding
• Increased interaction with customer via e-mail and app already paying dividends
3. Increased Blu-ray mix
4. Increased video-game mix ($2/night vs $60 for new game)
• Only 2% of revenue currently
5. Expansion into Canada – new market
6. Potential rate increase
• Currently testing in a few markets
Growth Initiatives
• 13% of Outerwall revenue in 2013
• Kiosks that convert coins into cash
• 20,000 kiosks in 4 countries
U.S., U.K., Ireland, and Canada
• 80% market share, excluding banks, in U.S.
33% when including banks
• Counted four times as many coins as processed by U.S. mint in 2013
• 91% of population within 5 miles of a kiosk
Coinstar
• Prime real estate and retailer relationships
• No threat from e-commerce
• Even banks are beginning to put Coinstar kiosks in their branches
• Raised price from 9.0% of transaction amount to 10.8% and consumers did not bat an eye
Exceptional pricing power
Clear Advantages
• 50% of cash received from converting coins is spent in store kiosk is located in
• Customers have option for gift card to store in lieu of cash
Retailer pays the fee instead of customer in this instance
Retailers Love Coinstar
1. Possibility for future fee increases
2. Expand bank presence
3. Considering variable pricing by region or transaction size
4. New ways to deliver funds
• PayPal
• Blackhawk
• Charity Donation
• Gift Card
Mature but some growth initiatives
Slow and Steady Revenue Growth
$230
$240
$250
$260
$270
$280
$290
$300
$310
2009 2010 2011 2012 2013
3.7% CAGR
20+% Operating Margins
• New kiosk concept in test phase
• Exchange gift cards for cash
Many retailer gift cards accepted
Gift cards are then sold by Blackhawk to other partners
• Blackhawk takes a fee and remits rest to Coinstar
• Difference between what Coinstar receives from Blackhawk and pays to customer is recorded as revenue
• Only 440 kiosks at end of Q1 2014
Expect 700 by mid-year 2014
• Benefit from Coinstar brand
• Revenue and profitability not released
Coinstar Exchange
• 1% of Outerwall revenue in 2013
• Kiosks give customers cash for used electronic devices
Phones, tablets, MP3 players – 4,000 devices allowed
• Devices sold wholesale to other companies
• Over 30 patents issued or pending
• Invested in 2009 when concept won Outerwall best idea contest
• Acquired remaining interest in July 2013 for $263M
• 900 kiosks in Q1 2014
Expect 2,000 by 12/31/14
ecoATM
• 370M devices sitting idle in U.S. alone
Only 59M recycled in 2013
• Recycled device market $1.4B in 2013
Expected to grow to $7.6B and 174M devices by 2018
• Trade-in at store most popular option, typically buying newer device
Only receive store credit
• Online trade-in requires shipping in product and waiting for cash or owning a PayPal account to receive amount, subject to later adjustment
• ecoATM only option for instant cash
Could serve as best option for unbanked and underbanked
ecoATM Opportunity
• Unprofitable currently but expect Redbox-type operating margins at scale
• High capex during rollout phase eventually settling to maintenance levels
• Expect to grow from 1% to 12-15% of total revenue by 2015
• Expect 6,000 kiosks in U.S. at maturity
Predict $600M-$720M in revenue and $120M to $182M in operating profits
• Given it is mostly unproven at this point, we assume concept is drain on free cash flow in both upside and downside valuation
In Roll-Out Phase
• Couples movies-only streaming service by Verizon with rentals from Redbox into subscription service
• Redbox is 35% owner in the JV with Verizon
• $157M capital commitment, of which $63M already spent
Unproven concept, so we deduct entire amount of required future investment from both upside and downside valuation
OUTR can put interest to Verizon if certain subscribers levels not reached by March 2015 – recoup some costs
Redbox Instant by Verizon
• SampleIt
Kiosks offer $1 samples of products in skincare, fragrances, health & wellness, hair, cosmetics, & household categories
Retailers like it because gives insight into consumer
Earliest stage concept – immaterial
• SoloHealth
Outerwall owns 10% of company
3,500 kiosks nationwide offering free health and wellness screening
Services 130,000 customers daily for free – paid via advertising, referrals, other
Not yet profitable or material to OUTR
Example of continued search for next great kiosk concept
Other Concepts
• Disposed of 4 unsuccessful concepts in December 2013
Reducing headcount 8.5%
$40M in total annual savings
• Took on debt at reasonable rates to buy back 20% of stock at below our assessment of intrinsic value in March 2014
• Committed to returning 75-100% of free cash flow to investors via buybacks going forward
• New, more conservative approach to new concept testing
Recent Shareholder Friendly Moves
• Debt issued previously to fund growth and, more recently, to buyback stock
• Debt easily manageable
Leverage ratio = ~2.0 • Target is 1.75-2.25
Net debt to free cash flow = ~4.0 • Ratio declines as capex settles to lower maintenance level
• No pension or unrecorded liabilities
• Current ratio ~1.0 due to low cash conversion cycle
Outerwall receives cash from customers about the same time the cost of the product is due to the vendors and payroll due to employees
Rent expense based on percentage of revenue, so not paid until after cash received from customer
Solid Balance Sheet
1. ecoATM
2. Coinstar Exchange
3. Redbox Canada expansion
4. Redbox Blu-ray expansion
5. New Redbox CRM and customer understanding/targeting
6. Potential Redbox rate increase
7. Recent Coinstar price increase
8. Expanding Coinstar bank presence
9. Automated Retail of choice for any future high potential kiosk concept
Sum of Major Growth Initiatives
Cash Cow
$135
$237 $256
$166 $200
$171
$179 $208
$158 $125
$-
$100
$200
$300
$400
$500
2010 2011 2012 2013 2014*
CAPEX
FCF
$464
$325
Operating cash flows – in millions
* Low end of 2014 guidance – high end is $240M in FCF
$306
$416
$324
• 18% avg. FCF yield
• 25% FCF yield at maintenance CAPEX levels
1. Discontinued 4 test concepts Dec. 2013 – saving $40M in annual expense
2. Highly variable cost structure
Minimum guarantees for Redbox only material fixed cost
Rent, credit card fees, marketing either based on revenue or adjustable
3. Recent Coinstar price increase and potential Redbox price increase
4. Blu-ray expansion
5. Substantially reduced CAPEX for Redbox from 10+% of revenue to 1 - 2% of revenue
6. Potential for ecoATM profitability – currently cash drain during rollout
7. Limited working capital requirements – current cash conversion cycle around 0 days
8. Limited advertising required (~0.5% of revenue) – rely on point-of-sale and word-of-mouth
Sustainable & Improving Free Cash Flow
1. E-commerce threat – factored into assumptions, particularly for downside valuation
2. Major retailer (Wal-Mart) deciding to offer same service and kick out Outerwall
Highly unlikely due to Outerwall scale advantages, business complexity, and the fact that retailer already profiting from service via Outerwall
3. Studios deciding to eliminate DVD all together
Highly unlikely because too large a revenue stream
Risks to Consider
• Valued using two methods
1. Projecting company-wide financials to determine free cash flow
2. Sum of the parts analysis
• Completed upside and downside valuation
Upside conservative
Downside aggressive to incorporate worst case scenarios
Valuation Methodology
Valuation
Upside Analysis Method 1 Method 2
Intrinsic Value $115 $94
Stock Price $55.32 $55.32
Upside 108% 70%
Downside Analysis Method 1 Method 2
Intrinsic Value $46.95 $46.05
Stock Price $55.32 $55.32
Downside 15% 17%
Invest based on the lowest number for both upside and downside
• Should understand investment well enough to be able to calculate a rough valuation using simple methodology
Used as a sanity check for valuations calculated on previous slide
• Key Data points:
Starting revenue of ~$2.3B
Avg. OCF/Revenue last 4 years = 19.7%
• Redbox began establishing dominant position in 2010
Avg. CAPEX/Revenue last 4 years = 9.5%
• Project next 5 years average free cash flow - assumptions:
Upside: no growth, lower margin (higher tax and interest, no credit for higher rates), less capex (still well above maintenance level)
Downside: 35% revenue decline, even lower margin (high variable cost structure limit margin decline), slightly higher capex
Back of the Envelope Calculation to Support Valuation (1 of 2)
Back of the Envelope Calculation to Support Valuation (2 of 2)
Key Data Point Upside Downside
Revenue $2,300 $1,500
OCF/Revenue 16.0% 12.0%
CAPEX/Revenue 3% 4%
Free Cash Flow $299 $120
Multiple 8 8
Valuation $2,392 $960
Market Cap $1,100 $1,100
Upside/(Downside) 117% (13%)
• Project average cash flows over next 5 years and apply appropriate multiple based on business risk
• Key is capital expenditures – elevated for Redbox rollout and currently for ecoATM rollout • Strong boost to FCF as settles at maintenance level
• Not appreciated by market at all
In descending order of probability:
1. Primarily beating lowered expectations
Short squeeze
2. Positive surprise from ecoATM
Either ignored by market currently or viewed negatively
3. Buyout by private equity firm
Beaten down cash cow in the under $2B range hits the private equity sweet spot
Catalysts
• Redbox to some degree reliant on popularity of new releases
Fluctuates from quarter to quarter
Evens out over time
• Next earnings release July 31, 2014
Not a great quarter for new movie releases Expectations already so low, so hard to predict how market
would react to one quarter
If stock drops further, we will be happy to add assuming no drastic change in fundamentals Volatility is our friend
UPDATE: Proven correct subsequent to annual meeting – terrible quarter for new releases & market initially down on the news before finishing up
Near-term Expectations
Appendix
• Passed CPA exam, ABV exam, and all 3 CFA exams on first attempt
• 2006 Elijah Watt Sells Award (top 10 CPA exam score in the world out of 50,000+ test takers)
• 2008 Baton Rouge Business Report “Top 40 Under Forty” Award
• B.S., Accounting and M.S., Accounting from Louisiana State University
• 3+ years of auditing experience with two of the Big 4 accounting firms
• Exceptional performer every year & early promoted
• Lead senior of Fortune 500 audit client
• Former Assistant Director of State Economic Competitiveness under Governor Jindal
• Accredited Member magazine and SeekingAlpha.com contributing author
About the Managers: Jonathan Booth, CFA, CPA/ABV
• 7 years of accounting and auditing experience with
• KPMG – Big 4 accounting firm
• Postlethwaite & Netterville – largest accounting firm in Louisiana
• The Edgen Group – Manager of Financial Reporting
• Edgen-Murray Corporation – Assistant Controller
• B.S., Accounting from Louisiana State University
• M.B.A. from Southeastern Louisiana University
• Louisiana Society of CPA’s Business & Industry Committee
• 2012 AICPA Leadership Academy – one of 36 selected from across the nation for prestigious 4 day event
About the Managers: Kevin Laird, CPA
Contact Information
Booth-Laird Investment Partnership
9005 Westlake Avenue
Baton Rouge, LA 70810
(225) 767-1439
Jonathan Booth, CFA, CPA/ABV
Chief Executive Officer
Cell: (225) 978-1532
Website: www.boothlaird.com
Blog: www.boothlaird.com/boothlairdblog/
Twitter: http://twitter.com/#!/BoothLaird
Kevin Laird, CPA
President & Chief Operating Officer
Cell: (225) 229-6567