The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.
Before the market opened on Tuesday, Outerwall (NASDAQ:OUTR) — formerly Coinstar –announced it agreed to acquire ecoATM for $350 million in cash. The purchase price includes the payoff of certain indebtedness and transaction costs. As Outerwall already has a 23 percent ownership stake in ecoATM, we estimate that the total net cash payment will be roughly $270 million. The transaction is expected to close in Q3.
Outerwall expects ecoATM to be accretive to EPS in 2014 and to yield a positive return on invested capital in the coming years. We believe Outerwall has sufficient cash and credit to complete the transaction without requiring additional capital, and we believe that the company’s cash flow is sufficient to allow it to end the year with its balance sheet intact and positive net cash.
EcoATM operates self-serve kiosks that evaluate and buy back used consumer electronics (including mobile phones, tablets, and MP3 players) for cash. In a typical transaction, the user places the device in the ecoATM test station and the device is examined. The user is then provided with the highest price that ecoATM can find in the worldwide secondary markets, and if the user agrees to the price, he receives cash from the kiosk. Most of the devices purchased are “pre-sold,” meaning ecoATM has contracts with aggregators who agree to purchase whatever inventory ecoATM can attract at a set price. This enables ecoATM to offer a fair price to the consumer and ensure that it will generate a reasonable return.
Outerwall expects the acquisition to increase its exposure to growing worldwide demand for refurbished products and mobile devices. According to Tuesday’s press release, 175 million new devices are sold in the domestic mobile device market annually, with only 20 percent of used devices being collected and more than 50 percent stored or discarded. Outerwall will compete with GameStop (NYSE:GME), which generated mobile revenue of $184 million for the fiscal year ended January with an additional 30 to 40 percent of growth expected in FY:13 (implying $239 to 258 million) at an estimated gross margin of 30 percent or more.
We estimate ecoATM generates approximately $100 million in sales from 500 kiosks, and that the business has the potential to double over the next two years and to deliver margins similar to GameStop margins. At $100 million and 20 percent operating margin, the ecoATM business would generate approximately $12 million in net income, or approximately $0.40 per share.
Wednesday is the first day of trading for Outerwall under its new name and ticker, OUTR, after formerly being known as Coinstar. We are not encouraged by the change to Outerwall, as we think that the new name reinforces management’s intention to grow the company by introducing new lines of business. Instead, we think most investors prefer the company to sell its coin business, retire all debt, buy back convertible shares, and rename the business as Redbox.
Our estimates remain unchanged. Although the acquisition is expected to be accretive in FY:14, we are maintaining our FY:14 estimates for revenue of $2.82 billion and EPS of $6.50 until the company provides guidance or more specifics around the financial impact of ecoATM. We are also maintaining our FY:13 estimates for revenue of $2.56 billion and EPS of $5.60 versus guidance for revenue of $2.385 billion to $2.545 billion and EPS of $5.05 to $5.55.
Maintaining our OUTPERFORM rating and 12-month price target of $78, which reflects a multiple of ≈ 12x and our 2014 EPS estimate of $6.50. This is a discount to its historical valuation to reflect recent rental demand declines, increasing competition for the Verizon (NYSE:VZ) JV, the negative impact of the NCR kiosk acquisition so far, uneven profitability, and long-term technology challenges. After the ecoATM transaction closes and we have greater visibility, we will revisit our estimates.
Investment thesis: Ultimately, we think that Outerwall is a value story with solid recurring revenues from its coin and DVD rental business, and modest growth prospects from brand extensions such as gift card exchange and ticket sales. These ventures require modest capital investment, limited inventory risk, and appear to be natural extensions of the company’s core businesses. The company’s other new ventures are far more ambitious in scope, and although we remain optimistic about the coffee business, we are skeptical that any of the others will meaningfully contribute to revenues over the next several years.
We think that Outerwall management would be better served by focusing on harvesting cash flow. Once the company is able to establish that its core businesses are stable and not in decline, we believe investors will embrace modest expansion into new ventures. Until then, we think current investors must accept that the company’s earnings and cash flow growth will be more modest as management chases new opportunities. This will likely depress Outerwall’s multiple to a below-market multiple.
Risks to attainment of our share price target include changes to movie release timing, the effects of competition – from other video rental companies including Blockbuster and Netflix (NASDAQ:NFLX) and other forms of entertainment — variability in consumer demand for video rentals, changing macroeconomic factors, and debt repayment and refinance risk.
Michael Pachter is an analyst at Wedbush Securities.
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