Outerwall (Nasdaq:OUTR), the maker of Redbox and Coinstar automated kiosks, seriously reduced its third quarter and full-year revenue and earnings outlook September 16. Its stock tanked the next day on the news. Although it gained back some of its early losses, it still finished September 17 down 11.6%, very close to its 52-week low.
Is this a falling knife or a time to buy? I'll have a look.
The Bad News
On July 25 as part of its Q2 earnings release it projected 2013 full-year core diluted earnings of at least $5.76 per share. Less than two months later it reduced its 2013 outlook; it now expects full-year core earnings of $4.72 per share, an 18% cut to its number. Never a good thing, CEO J. Scott Di Valerio said the following: "Although both rentals and revenue for Redbox increased significantly in July and August over 2012 levels, they were not to expectations. In addition, heightened promotional discount activity, which added new customers during the quarter, had an adverse impact on the expected average transaction size and we believe drove consumers toward more single night rentals."
Translation—they gave away the store in order to gain market share. It's no different then a clothing store ramping up discounts to boost sales; something has to give and it's usually gross margins.
Normally, if you discount heavily, revenues should increase. That's not happening here. Outerwall expects revenues at the low-end to be $2.27 billion, down $100 million from its July outlook. How could this happen? Well, as the CEO mentioned, its discounting brought in lots of single-night rentals but not nearly enough multi-night customers reducing the size of the average transaction. It's simple mathematics.
Outerwall's definitely got some side bets going on: Rubi, its automated coffee machine serving Seattle's Best Coffee, Starbucks' (Nasdaq:SBUX) other coffee brand; Crisp Market, its self-serve food kiosk; Redbox Instant by Verizon (NYSE:VZ), its own version of Netflix (Nasdaq:NFLX) or Amazon's (Nasdaq:AMZN) Prime; and ecoATM, the automated kiosk that trades used cell phones for cash. That last one it paid $263 million for the remaining 67% it didn't already own. The potential for one of these to be bigger than Coinstar is certainly possible.
However, its Redbox kiosks still represent 86% of its overall revenue. If that doesn't go right—the entire company's on faulty ground.
The Good News
It's not very fun when you have to admit to investors that your business model just went cockeyed. How else do you explain an 18% reduction in annual earnings? It's inexplicable, really. But it happens. It's better to know what's happening ahead of time than to find out when it normally releases its Q3 results—utilizing the "rip the band-aid off" solution. Take your lumps and move on.
There's a lot to like about the company despite the near-term problems. For instance, it still expects free cash flow in 2013 to be between $211 million and $227 million. At its September 17 closing price of $49.49, you're looking at a price-to-free-cash flow multiple of 6.4, which is lower than most, if not all, of its peer group. In addition, its net debt is just $471 million or less than one times' EBITDA and that's after accounting for the $100 million borrowed on its revolving line of credit as well as the use of $162 million in cash in order to pay for its acquisition of ecoATM. It's in a pretty enviable cash position. Not to mention it's seriously undervalued.
I've already mentioned that it trades at an extremely low multiple to free cash flow. Its enterprise value is currently $1.77 billion or 4 times EBITDA, which is also low. But take into account the ecoATM deal and its adjusted EBITDA guidance for 2013 and the multiple drops to 3.6. In addition, while its Coinstar business only generates about 13% of Outerwall's overall revenue, its operating margins are rock solid at 34% in Q2, 12 percentage points higher than Redbox. As a result of Coinstar's consistent profitability, it's virtually impossible for Outerwall to lose money, which provides some downside assurance for investors when Redbox isn't quite firing on all cylinders. It also allows the company to take some chances on its New Ventures division as it can afford to absorb a reasonable amount of losses. It's critical to its future success.
On only one occasion in the past decade has Outerwall suffered an operating loss; $13 million in 2007. During that year the mid-point between its high and low was $29.83. Today it trades just $20 higher yet its operating income is higher than its ever been and its revenues are four times greater. The last time it traded below $50 was December 2012 and January 2012 before that. It hasn't traded below $40 since April 2010; you'd have to go all the way back to December 2008 for a trade below $20.
There are some definite red flags with its recent Q3 and full-year guidance. Fortunately for existing shareholders the damage September 17 was limited to an 11% haircut. It's possible that Outerwall continues its retreat in the days and weeks ahead. For deep value investors that's a very good thing. Personally, I've always liked its business—I just wish it had a normal name.
I'd buy some now and wait to see if you can get more below $40. I wouldn't characterize Outerwall's stock as a falling knife. Rather, I view it as a reasonably stable business that slipped up. All good companies get their comeuppance. Outerwall's turn just happens to be now.
Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.