Outerwall is the consumer-services company I mentioned in last quarter’s letter. I’ve been paying attention to Outerwall for a number of years but I hadn’t found an opportunity until 2015. During 2016 we’ve made a significant investment in the unsecured bonds of the company (the 6% notes of 2019 and the 5.875% notes of 2021).
Most of you will be familiar with the company’s DVD rental kiosks (Redbox) and coin-redemption kiosks (Coinstar) located in thousands of retailers across the country. Redbox is the largest segment and gets the most attention. To that end, everyone knows that DVDs are going away in favor of Netflix and other streaming/over-the-top media, although the rate of decline and the ultimate amount of cash it generates are the key topics of debate. The decline rate in the DVD business did accelerate in the second half of 2015 before moderating slightly in the first three months of 2016. The decline exceeded my expectations (more on that below) and highlighted many long standing strategic and governance problems at the company. When operating results deteriorated in the 3rd and 4th quarters of last year the stock plunged, and partly due to the company’s performance and partly due to pressures in the high-yield market the bonds fell in sympathy through February of this year, despite a much more stable credit profile.
During 2016 the company’s direction has shifted. It has settled with an activist investor (who owns 15% of the company and now has board representation), and at that investor’s urging the company is considering “strategic and financial alternatives” – i.e., a sale of the company. And selling would make sense, particularly to a private buyer. As a profitable but shrinking enterprise the company is unlikely to get an attractive value in the public markets but its prodigious cash flow should appeal to buyers who have better uses for it. If we had the resources I would gladly buy the entire company at recent prices. The company’s equity value would be roughly double its current level, in my opinion, had management simply avoided the mistake of investing hundreds of millions into a speculative venture (its failing ecoATM segment). The mechanical approach to buybacks regardless of price also wasted substantial capital. Looking forward, I think a new owner could make an outstanding return over time by intelligently allocating the company’s cash to more productive ventures.
In the meantime there is a renewed focus on cost reductions and cash flow generation. On the capital allocation front, the share buybacks have stopped and the disastrous foray into a third business segment is hopefully nearing an end. Most important to us, the company is using its prodigious cash flow to buy back its bonds in the market. In the first quarter the company repurchased $57 million of outstanding notes for $45.3 million and reduced total debt by 9% to approximately $830 million. In the prior quarter the company repurchased $41.1 million of outstanding notes for $34.5 million. The opportunity to reduce its leverage is substantial given my estimate of $150 to $200 million of free cash flow in 2016 alone.
In 2016 the bonds have traded at significant discounts to par, ocassionally with yields-to-worst in the low- to mid-teens. I believe the Coinstar business by itself – which is stable and producing at least $85-90 million of operating income per year by my estimate, with minimal capital requirements – covers most if not all of the debt. Redbox, while in decline, is still profitable and generating cash on the way down. I did misjudge the rate of decline during 2015 – part of it was a poor year for movie releases, part of it was strategic missteps by the company, and part of it was a shift away from movies as an entertainment choice – but some stabilization in the business and two major contract renewals in the third quarter of this year will go a long way toward better financial results. Even at a DVD rental decline rate that accelerates unexpectedly from here I think our bonds are well covered – Redbox will likely remain profitable and cash flow positive, all on top of Coinstar’s contribution.
If the company is sold we have a change of control provision that redeems our bonds just above par. If the company is not sold in the near future I would likely sell our equity investment unless there is some unexpected positive development. I think the bonds are attractive in most scenarios but I would want to see continued stability at Coinstar, a manageable decline at Redbox, and sensible capital allocation. Given management’s history and the inevitable challenges of a declining business there is no point in overstaying our welcome.
The above commentary is excerpted from the 2Q16 quarterly letter of Anabatic Investment Partners LLC. The fund’s Managing Principal and Portfolio Manager is Philip C. Ordway. Please note that the complete text of the disclaimer included with the fund’s quarterly letter is also reproduced below.
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