Why This Little Company Will Change the Concept of Retail

Adrian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Outerwall (NASDAQ: OUTR) is the company behind well-known Redbox movie and video game rental kiosks and the popular Coinstar kiosk, a $1.71 billion company in the business of offering automated retail solutions to make retail more convenient for both customers and sellers. The company has seen EBITDA (earnings before interest, taxes, depreciation, and amortization) from its Redbox unit grow from $50 million in 2008 to over $400 million expected in 2013. 

However, the company's market capitalization is yet to reflect this growth: while the stock price has risen over 80% since 2008, the fact that investors are still concerned over the long-term viability of Outerwall's business may be playing against the stock. Is Outerwall sustainable as a business? And more importantly, is Outerwall about to change the concept of retail in the United States?

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The bull case

Let's start with what the bulls think about Outerwall. Bulls are excited about two things:

1) Outerwall's cash cow: Redbox, a kiosk with the ability to reserve discs online and via mobile devices, with more than 2.5 billion discs rented to date. Nearly 68% of people in the U.S. live within a five-minute drive of a Redbox location, making the kioks as popular as grocery stores and convenience stores. 

2) What Outerwall can do with the cash derived from Redbox business (the "New Ventures" segment).

Redbox is definitely not going anywhere. According to the latest earnings call, the product already has 50.6% of market share in the U.S., as rentals have been up year-over-year, driven by growth in Blu-ray and video games. The company expects between $2.05 billion to $2.14 billion in Redbox revenue for the year, the biggest component of revenue by far (Coinstar is expected to bring $292 million-$300 million, and New Ventures $30 million-$35 million).

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Source: Outerwall Investor Relations, 2013Q2 Presentation Slides

Now, some investors are worried about the future growth prospects of Redbox because there are already plenty of them available in the United States. The advantage of Redbox is that installing a kiok is pretty straightforward and doesn't require too many expenses. That advantage may become a disadvantage now that Redbox is quite ubiquitous. Is there further room for growth?

Well, Outerwall's solution seems to rely on using the strong cash flow from Redbox to expand the business in Canada and to fund new ventures. Further expansion of Redbox in the U.S. and Canda could add positive net present value in the future, but how about these new ventures? Will they become important revenue components, strong enough to sustain the current growth rate of the company, or they are just a waste of money, as Adam D. Wyden (Managing Member of ADW Capital Partners, an institutional shareholder) mentioned in a public letter to the company? That's the main difference in thinking between bears and bulls. 

The bear case

Bears acknowledge the importance of Redbox's cash flow, but they think the new ventures won't be able to sustain the company's growth. In other words, they think Outerwall is a one-hit wonder, and should be priced as so.

Take, for example, a look at Redbox Instant, a partnership with Verizon through which Outerwall is able to expand its kiosk business model to online streaming (Verizon would pre-install the service onto all of its services), where giants like Amazon (NASDAQ: AMZN) with its Amazon Prime platform or Netflix (NASDAQ: NFLX) are engaged in a ruthless competition for market share and size of premium content. The ambition to become a tier three player in the hyper-competitive streaming video-on-demand space is indeed admirable, but way too risky. Can Outerwall bring substantial premium libraries and commit substantial financial resources to this war?

Amazon is committed to succeed in this space and isn't afraid of spending money to improve its premium content libraries. The company just paid more than $200 million to give its prime members unlimited instant streaming access to popular kids' programming along with top-rated shows from MTV and Comedy Central. By now, Amazon's Prime Instant Video library has more than 41,000 titles, an amazing growth rate considering that less than two and a half years ago, the library only had 5,000 titles. 

With 2.7 million net new subscribers so far this year, Netflix, on the other hand, isn't going to make things easy for Amazon. Although Netflix lost some important content from Viacom (that is, no more programming from Nickelodeon, BET and MTV for Netflix users) in April, it will not hesitate in spending a great amount of the $1.07 billion per quarter it generates (at least that's what it made in the latest quarter) to protect its cash cow. In 2010, acquisitions costs rose 106% (from $257 million to $530 million), and in 2011, another 354% (up to $2.41 billion)! The downside to this is that Netflix's margins have been hurt severely; net income plummeted in 2012 and during the first half of 2013.

If even Netflix is barely able to compete against Amazon Prime, how can Outerwall manage to compete in this fierce field, where content amount and quality is everything, without having its cash flow and margins wiped out?

My take

Well, Outerwall is definitely aware of the risks that video streaming involves. That's why the company is also involved in other ventures. An example is EcoATM, recently purchased for roughly $270 million in cash. EcoATM allows people to turn their old devices into instant cash by paying them for recycling old-phones, tablets and mp3 players. There are about 650 kiosks installed so far, which have recycled more than a million devices. But it's too early to know if this business will become a cash cow or not. In the very long run, recycling will probably play a fundamental part in human's lives, so I'm  optimistic about this business. 

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What I like about the company is the fact that it knows what problems it has and management is taking concrete steps to solve these issues. "Redbox's future growth is in danger? Let's go for some ventures. The online video on demand partnership with Verizon is too risky? Let's diversify by purchasing ecoATM." That kind of thinking is constructive and eventually should bring Outerwall some rewards because it was by using this philosophy that Outerwall managed to get its current cash cow, Redbox, in the first place.

In the meantime, there's plenty of rich harvest to reap. The company has a pretty clean balance sheet with shareholder equity of $505 million, trades at a forward P/E ratio of just 11 and remains substantially under-levered. How can this not be a buy?

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Adrian Campos has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Netflix. The Motley Fool owns shares of Amazon.com and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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