Outerwall Shorts May Get Slapped

Kiosk tech company Outerwall is one of the most shorted stocks around, with the majority of investors and analysts firmly of the belief that DVD rentals, whether they are in low-cost kiosks or not, are pending extinction.

It's not an unreasonable thesis by any means, but there is more to Outerwall's business.

Near the end of the summer, activist fund ADW took a stake in the company and wrote a public letter illuminating what it thought could propel the company higher and disprove the shorts. Now, another activist is on board -- Jana Capital Partners with a 13.5% stake. Jana, too, made clear what it wants from Outerwall.

Are these activists about to prove a whole lot of shorts wrong?

Complaint list
ADW and Jana have plenty of qualms with Outerwall, which owns both Redbox DVD rental kiosks and Coinstar change-conversion kiosks (as well as some developmental-stage products). But they fundamentally believe the company has some unexposed value to shore up. This fact, in and of itself, should be most important to investors as Outerwall's short interest is nearly 10 million shares strong. The company has just 27.3 million shares outstanding.

The basic argument is that Redbox, the company's bread and butter, is doomed to go the way of the dinosaur as people switch to digital delivery methods. ADW takes issue with the company's capital allocation practices and claims Outerwall's third-party deal with Verizon, in which it provides on-demand content to their cable subscribers, is one that pays far too little to Outerwall. Moreover, services like Netflix, Amazon, and Hulu have tremendous competitive advantages in the streaming world.

Jana has taken its position and plans to sit with management to discuss options. One of them, according to a Bloomberg article, includes the potential breakup of the company. Both Coinstar and Redbox are high-cash-generating businesses, but some of that cash flow is masked by the company's New Ventures segment, as well as the Verizon deal. Other possibilities include the usual turnaround efforts -- cost-cutting and bigger stock buybacks. Essentially, these activist firms are seeing the impressive cash flows achieved by Outerwall, but are bothered by where it's going.

For the retail investor
Current and prospective investors in Outerwall are likely aware that the company trades at cheap valuations, especially compared to other high-tech peers. The market believes things aren't going to go so well for Outerwall in the long run. The investment strategy here is a value-oriented special situation. One of the questions investors should be asking is if the breakup value of Outerwall is superior to its current price. According to some analysts, the answer is no. This is the belief that better capital allocation and value-uncovering is not enough to offset the fact that Redbox (more than 80% of the company's revenue) is facing a coming demand crisis. On the other hand, a slimmer, more shareholder-friendly Outerwall could allow investors to see the fruits of the company's still strong cash flows.

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The article Outerwall Shorts May Get Slapped originally appeared on Fool.com.

Fool contributor Michael Lewis 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.

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