Kerrisdale Capital Investment Case Study Competition

Kerrisdale Capital Investment Case Study

Competition:

Find a Zero: Which Billion Dollar Company Will be

Bankrupt by 2020

Team Name & University:

University of Colorado

Rick Brubaker Everett Randle Iana Stoytcheva

February 2015

Tables of Contents

1. Investment Thesis ……………………………………………………………… 3

2. Business Description …………………………………………………………… 4

3. Key Thesis Factors ……………………………………………………………... 5

a. Failed New Ventures …………………………………………………… 5

b. Redbox on the Decline …………………………………………………. 7

c. Competitive Pressures for Additional Segments …………...……….. 10

4. Financial Analysis …………………………………………………….………. 13

a. Debt & Obligations ……………………………………...……………. 13

b. DCF Analysis ……………………………………………………..…… 14

5. Appendix ………………………………………………………………………. 16

The Next Billion Dollar Company to go Bankrupt: Outerwall Inc. (NASDAQ:OUTR)

Investment Thesis

Outerwall operates an outdated and quickly declining business model in its Redbox division, and possesses no sustainable competitive advantages in its CoinStar or ecoATM segments which make the firm vulnerable to increased competition from banks and telecom companies that create similar services. The firm’s search for a new source of growth has been unsuccessful, as their two most recent ventures – Redbox Instant and Redbox Market Profile Closing Price (2/19/15) ($USD) $66.57 Canada – both failed within two years of launch due to a Avg. Daily Volume 714,535 Shares Outstanding (millions) 18.97 lack of demand coupled with operational miscues. As Market Capitalization ($B) $1.3 Revenue ($mm) $2,303 P/E (LTM) 12.8x Outerwall’s current business segments continue their P/B (LTM) 13.0x Debt/Equity 9.7x transition from cash cow to dog status, the firm becomes more desperate to find a new venture to provide much needed growth. This will lead Outerwall to sink cash into R&D and other investment related expenses, just shortly after management refinanced the firm’s debt raising its total long-term borrowings close to $1 Billion. If the firm is unable to find a new star venture – and all evidence points to them being unable to – Outerwall will not be able to meet its principal repayment obligations from 2019-2021. Because of these factors, OUTR will file Chapter 11 bankruptcy by 2020.

Business Description

Outerwall Inc. (“OUTR” or “the Company”) is a provider of automated retail solutions that offer products and services that benefit consumers and drive incremental retail traffic and revenue for retailers.

Business Segments

Redbox - OUTR owns and operates 43,680 Redbox kiosks, in 36,140 locations across the U.S. where customers can rent or purchase movies and video games. Kiosks are installed primarily at leading grocery stores and convenience stores such as Kroger, Walgreens, and Walmart. Kiosks require ten square feet and allow the customer to efficiently rent a movie or video game via debit or credit card. Return of products is allowed to any Redbox location. The Company pays retailers a percentage of their revenues generated at the machine and obtains movie licensing through revenue sharing and licensing agreements with studios.

CoinStar - OUTR owns and operates 21,340 CoinStar kiosks in 20,250 locations. Consumers feed loose change into the coin-counting machines, which count the change and dispense vouchers redeemable for cash, gift cards, or store credit. Revenues are generated through transaction fees charged to customers and product partners.

“New Ventures” - The Company is exploring other self-service concepts to build their business.

The main growth product in this area is ecoATM which provides an automated self-service kiosk where consumers can recycle mobile phones for cash and OUTR generates revenues from this venture by selling the recycled phones to third parties.

Past performance

In February 2009 Outerwall purchased Redbox from McDonalds for $175M to end their previous joint venture (McDonalds and OUTR both owned 47% of the company). Since the acquisition, sales growth has exploded from $766M (with around 20,000 Redbox kiosks) in

Redbox revenues to over $1.9B in 2013 with 43,000 kiosks in North America while the stock price has risen nearly 100% during the same period. However, though total kiosk growth has been robust, OUTR has struggled over the last two years with declining same store sales growth, total kiosks, average revenue per kiosk, and total revenues.

Key Thesis Factors

Failed New Ventures:

Obsolescence of Physical Rentals Shows in Canada

Redbox recently announced that they were abandoning their Canadian operations with an associate loss of $1.5 million. A quote from the company’s Redbox Canada website states

“unfortunately, demand just didn’t meet our expectations.” The company will be moving the 1,400 rental kiosks from Canada back to the United States, where they will be distributed to new locations. In an interview with a local newspaper, a Regina, Canada resident named Chris said of the Redbox closing, “I really don’t know a lot of people who have used them because a lot of people I know

5 go through Netflix.” Chris’ comments reflect a larger consumer trend taking place not only in

Canada, but in the United States. The primary selling point of Redbox when it was founded in

2002 was to give consumers greater place utility by offering a quick and easy way to rent new releases while visiting the grocery store, or fast food establishments. When examining the current marketplace for movie rentals, this utility has been completely outdone by brands like

Netflix, Hulu, and Amazon. These firms have taken the same principle of place utility that fueled

Redbox’s original success, and brought it to the next level. Now, consumers don’t have to leave their homes (more specifically their couches) in order to enjoy a movie rental, and often at a comparable price. Online renting also eliminates the responsibility of keeping track of DVDs and ultimately returning them to their source.

Redbox Too Late on Addition of Online Rentals/Streaming

In March 2013, Outerwall launched Redbox Instant, a partnership with Verizon that offered four one-night movie rentals per month as well as unlimited video streaming. The move followed in the steps of rival Netflix, and was designed to carve Redbox a sizeable share of the online rental market. Ultimately, Redbox entered the market too late with too weak of a value proposition to steal any significant market share from the dominant players Netflix, Hulu, and Amazon. The service operated at a loss for a year and a half until Outerwall shut it down in early October of

2014. A lack of demand coupled with security issues related to customer’s credit card information led to the poor performance of the service. A Redbox spokesman commenting on the closing said that “the service had not been as successful as either partner hoped it would be.”

Internal Distress

On January 18th, 2015, Outerwall CEO Scott Di Valerio resigned from his position and also stepped down from the company’s board of directors. Di Valerio’s resignation came in the wake of a decision to raise the daily rental prices of DVDs and Blu-ray Discs in their Redbox segment, which the firm stated would have an “adverse impact” on rental volumes. Analyst reports after the decision predicted that the move would shift rental market share further away from Redbox.

While the Outerwall board continues to insist that Redbox is “well-positioned for success,” Di

Valerio’s abrupt departure shows that the company may be in more turmoil than they’d like to admit.

Redbox on the Decline:

Macro Factors & Consumer Preferences

Over the last ten years, the movie rental industry has experienced a remarkable change in customer preference and distribution channels. In 2005, the United States physical video rental spending was over $8 billion. This spending is estimated to have been near $4 billion in 2014; a

50% decrease in consumer spending through this medium over the last decade. While the physical DVD rental market has been diminishing, online streaming/renting of movies has been growing exponentially. According to IHS Screen Digest Broadband Media Market estimates in

2012, the paid consumption of movies online had nearly $1 billion more transactions than the physical rental of movies in 2012, and is projected to account for twice as many transactions as physical rentals in 2016. This increase in online movie streaming has led to the emergence of new market players such as Netflix, Hulu Plus, and Amazon. Currently, these three companies are the main competitors for Outerwall’s kiosks, but on a higher level, it is the online rental market as a whole that represents the biggest threat to the firm, not any individual competitor.

Competitive Factors

Hulu, Amazon, and iTunes are the most direct competitors in the movie rental industry. To compare price points, the DVD rental market can be standardized in 48 hour periods. Redbox currently charges $3.00 ($1.50 per day) for physical rentals. Amazon charges $3.99 - $5.99 for a digital rental, and iTunes commonly charges $0.99 - $4.99. Collectively, Hulu, Amazon, and iTunes represent a large market share within the online streaming market. With competitive pricing, and additional place utility, these online channels represent an attractive alternative to physical movie rentals.

The products provided by iTunes, Hulu Plus, and

Amazon Video are direct substitute goods for the

DVDs provided by Outerwall’s kiosks. As economic principles suggest, if the demand for a substitute good increases – as it is projected to grow exponentially - the demand for the primary good will decrease. Given the historical and forecast projected increase within the online streaming industry, the physical rental market is projected to face steep decreases in demand.

Operational Evidence

Redbox has begun to see the macro effects of shifting consumer preferences in their segment operations. Since 2012, the average revenue per Redbox kiosk per quarter went from $12,000 in

2012, to an estimated $9,800 for 2015. Redbox was able to offset this decrease in average revenue per machine for a few years by building out more kiosks, but in 2014 the market appears

8 to have become saturated, and Redbox was no longer able to continue purchasing growth. This trend is projected to continue in a large way in 2015, where total Redbox revenues are projected to decrease by 5-10%.

PP&E Offers Little Value in Divesting Scenario

Outerwall currently holds 43,680 Redbox kiosks. The kiosks are designed specifically for the business and cannot be quickly repurposed for other uses. Due to this specialization, the kiosks are not easily transferable to other business segments, which limits their liquidity for potential sale in the future. Market research suggests that one kiosk has an approximate value of $3,500.

Using this estimation, Outerwall owns approximately $152,880,000 in kiosk equipment. Due to the declining business demand for the Redbox segment, it is likely that in the near future

Outerwall will be forced to liquidate some of its kiosks, and because of their illiquid nature, those sales will have to come near scrap value, and will not provide a significant amount of cash for the firm.

Competitive Pressures for Additional Segments:

CoinStar vs. Banks

Outerwall’s CoinStar segment provides 13% of the company’s total revenues. The segment was founded in 1991 and has grown to over 21,000 locations. For a long time, CoinStar faced little to no competition in the coin counting market, but that has changed drastically over the past few years. The division now faces competition from traditional banks such as TD

Ameritrade, JPMorgan Chase, and Wells Fargo. TD Ameritrade’s Penny Arcade platform has over 1,300 machines and allows current TD Ameritrade customers to exchange their coins to bills for free and charges other customers a Coin Counting Market: Company: # of Locations: Fee: 6% fee (3.8% less than CoinStar). Chase and 21,340 9.8% or Gift Card

Wells Fargo allow customers of the bank to Free (TD Customers) 1,300 6% Other exchange their coins for free. Additionally,

CoinStar faces competition from grocery Over 5,000 Free for Customers stores who purchase coin counting machines Over 5,000 Free for Customers from ScanCoin, a private competitor which charges competitive rates.

Overall, the future outlook on CoinStar isn’t promising. Stagnant revenue per machine has been being masked by total segment revenue growth due to additional kiosk openings. This capability to purchase growth will soon cease to exist as the market becomes increasingly competitive with a presence from both new private upstarts as well as large financial institutions.

Lower coin-exchange rates for non-customers from banks also threatens to compress CoinStar’s margins as it’s forced to compete on price. These competitive factors create considerable uncertainty for the future viability of CoinStar operations.

10 ecoATM vs. Telecom

Outerwall’s “New Ventures” segment - which is primarily comprised of its ecoATM kiosks - generated $94 million in revenue in 2014 while operating at a $30 million loss. The ecoATM division faces direct competition from major wireless companies and retailers. AT&T, Verizon,

T-Mobile and Sprint all have buyback programs that value the customers’ phone online, provide a free shipping label, and exchange the phone for credit towards a new one. Best Buy and

Amazon also feature trade in programs for phones, tablets, computers and more in exchange for company credit. The most popular trade-in platform is a start-up company, Gazelle, who already has 2 million total trade-ins for phones, tablets and other devices. The company allows customers to trade in their phones for cash and also resells refurbished phones on the same website. While the market for buying back phones and other mobile devices is set to grow exponentially in coming years, Outerwall is going to have a hard time capturing market share.

Outerwall is competing in a market where wireless companies can offer additional incentives such as discounts on new phone models when a customer sends in their phone in addition to the store credit provided. Retailers like Best Buy offering trade-ins for additional products such as tablets and gaming consoles makes it especially difficult for this “new venture” to take off and blossom into the star that Outerwall desperately needs.

BCG Portfolio Analysis

The easiest way to bring together all of the research on Outerwall’s segments is to create a

Boston Consulting Group Matrix, a tool used by firms to observe current product positioning and identify possible future investment strategies. The general idea is that a firm should use their cash cow operating units (high market share, low market growth rate) in order to fund new ventures that become stars (high market share, high market growth rate), before those cash cows become dogs (low market share, low market growth rate). Outerwall has been trying to complete this process, but as our BCG analysis illustrates, the firm has had been unsuccessful in bringing two question marks (low market share, high market growth rate, where most new ventures start), to star status. Instead, the ventures quickly became dogs and were harvested. As time goes on, and

Redbox and CoinStar continue to make their shift from cash cow to dog, it becomes more and more vital for the firm to find a venture that can become a star. Right now, the firm is counting on ecoATM to be that star. As our previous analysis suggests, though, the probability of that happening is marginal. If ecoATM is unable to make the transition to becoming a star, Outerwall will be in an extremely vulnerable position as all of its segments slide into becoming dogs. This positioning would leave little opportunity for the firm to generate cash without raising more debt, an option which is restricted by protective covenants present in the firm’s current notes.

Financial Analysis

Debt & Obligations

Current Obligation Overview

The company maintains two senior unsecured loans due at 2019 and 2021 (callable) with coupon rates of 6.000% and 5.875% respectively. The bonds are non-investment grade and have an S&P rating of BB-, meaning the business is less vulnerable in the near-term, but faces major ongoing vulnerabilities toward financial and economic conditions. OUTR also entered into a senior secured revolving line of credit with repayment in 2019 and convertible to 2018 if the 2019 bond is still outstanding.

Debt Covenants

The Company must comply with its Amended and Restated Credit Agreement governing their

Credit Facility and the indentures that govern the Senior Notes due 2019 and 2021. These covenants state that the company cannot incur any additional debt without lender approval

(limiting liquidity if the company is short on cash), is restricted in the ability to liquidate assets and engage in M&A, pay dividends, or make investments into capital expenditures. Finally,

OUTR must maintain certain leverage and interest coverage ratios or they risk the threat of default. While all of these covenant agreements appear to be standard, the company has addressed them as a significant risk to the firm as they state in their 2014 10-k filing, “If we do not comply with the covenants in the Amended and Restated Credit Agreement that governs our

Credit Facility, the indentures that govern our Senior Notes due 2019, or our Senior Notes due

2021, respectively, we may not have the funds necessary to pay all of our indebtedness that could become due.” The significant debt burden that OUTR holds coupled with its questionable future

13 profitability should be considered a major risk when considering the future viability of the company.

DCF Analysis

Equity is Essentially Worthless

After running a discounted cash flow analysis, it becomes evident that OUTR’s business model is not sustainable and that the firm’s equity is essentially worth nothing zero. The assumptions we use in our model include a 5% year-over-year (yoy) decline in total revenues driven primarily by the decline in Redbox sales, and the lack of significant growth in “New Ventures.” We also factored in a yearly 0.5% margin compression factor for net income to reflect increased R&D expenses associated with the new ventures and general compression of margins due to decreasing revenues. Depreciation and amortization were projected based on a five year historical average (D&A as a % of sales) and capital expenditures were calculated based on a five year historical average as a percentage of D&A. Projected interest expense was generated by examining the coupon rates of the company’s two outstanding bonds to generate an annual interest payment. Unlevered free cash flows were generated based on a discount rate of 10% with a terminal growth value of zero (using the perpetuity growth method). This yielded an enterprise value of $732.5M. With net-debt currently at $731.0M, the model yields an equity valuation of nearly zero, illustrating that with slight revenue and margin declines in coming years, Outerwall equity is essentially worthless.

Appendix A: New Venture Revenues vs. Total Number of Kiosks

Source: Investor Relations

OUTR has a “New Ventures” business segment that participates in the development of various kiosk concepts. Currently the company has ecoATM as the primary product from this category.

Revenues have increased from nearly $500,000 and have grown to almost $100 million in annual revenues. The trend can be traced with the total kiosk growth as well with the segment having just fewer than 2,500 kiosks. In 2014, the company also discontinued four product lines in this business segments including Orango, Rubi, Crisp Market, and Star Studio. The operating results of these segments have been moved to other comprehensive income and are not included in reported segment results.

Appendix B: CoinStar Kiosk Growth & Sales vs. Operating Income

Source: Investor Relations CoinStar has added around 2,500 kiosks in the past five years. During the same period, revenue has grown at a CAGR of 2.7% while operating profit has grown to $120M. While revenues have operating profits have gone up, revenue per kiosk has actually declined during the same period.

Appendix C: Redbox Segmented Data

Source: Investor Relations

The Redbox business segment experienced considerable top line growth from 2010-2014 primarily driven by the large increase in kiosks in 2010 – 2012. However, total Redbox kiosks have stayed completely stagnant since 2012 and even declined by 1% year-over-year to 43,680 total units. The decline was coupled with a tumultuous 2014 for the business segment; same store sales growth was negative for 3/4 quarters during the year with revenues declining $81 million.

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