Outerwall Is Not a Buggy Whip Company

Outerwall naysayers have been dismissing the company's future prospects based on fears of the imminent demise of DVD and Blu-Ray technologies. Some have likened this DVD rental company to buggy whip companies that were put out of business after Henry Ford, the maverick Model T inventor, found a perfect formula to mass produce automobiles. In this age of video streaming, few investors expect Outerwall to compete favorably with bigger and better-heeled companies such as Netflix , Hulu, or Amazon.com , which will ostensibly give the company a snowball's chance in hell. Not even Outerwall's video streaming service, Redbox Instant, is commanding favorable reviews, with some investors terming it a Hail Mary, me-too project.

Outerwall shares currently have a consensus recommendation of 'Buy' with an 'Industry Outperform' rating. The mean price target for the shares is $73.80, representing a potential 9% upside from current price. Some analysts, such as B.Riley, think the shares could go as high as $103.00.  Apparently, most equity analysts do not share the unmerited pessimism surrounding the company. Outerwall's current P/E ratio of 14 times 2012 earnings is far below its 10-year historical average of 36. Its low 0.66 PEG ratio is a reflection of investors' low growth expectations.

DVD business in the pink of health
Many tech companies such as Cisco, Dell, and HP, among others, are facing headwinds in their respective businesses. They have fallen out of favor with investors as they continue to undertake drastic internal restructuring. Many are struggling to find a regular cadence of revenue growth, as Cisco's recent first-quarter earnings call proves.  However, to say Outerwall's DVD business is in the same doldrums as these companies would be to stretch the truth too far.

Redbox, the Outerwall segment that deals in DVD rentals, is doing just fine. Outerwall grew its revenue by 30% and its bottom line by an even faster clip of 53% in the two years Netflix has been streaming video.

The healthy DVD business has given Outerwall cash to burn, and it currently enjoys better cash flow than Netflix.

Redbox's stellar performance only goes to prove that there is a sizable class of consumers who prefer renting a Redbox DVD alongside their regular video streaming service. Outerwall estimates that 20%-30% of its customers have subscribed to a video streaming service. Granted, no technology lasts forever, and DVDs will one day go the way of the dinosaur. Video streaming might be a more utopian entertainment concept than DVDs right now, but with so many companies competing for a share of the pie, it will most likely become almost banal in a few years' time.

Although demand for DVDs has been robust throughout this year, Redbox has been facing a few headwinds. The company issued lower income guidance for the third quarter not because customers are no longer renting out Redbox DVDs, but rather due to the coupons which offer heavy discounts that the company has been giving its customers to lure them into its 43,700 self-serve stores. This has resulted in some degree of margin compression. The rental period has also gone down a bit, and this has also led to slightly lower revenue than expected.

Returning money to shareholders
Outerwall returns about 75%-100% of its free cash flow to its investors every year, mainly through share buybacks since it does not pay dividends. This year, it planned to achieve that through share repurchases totaling $195 million. Outerwal

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