Outerwall, Buybacks, and Activists

Posted on Posted in Case Studies, General Thoughts

Outerwall is a stock that has been struggling as the cash flows from Red Box are drying up much faster than investors have expected. Not only that, but Outerwall management has had the troubling habit of throwing good money after bad by “investing” in things like ecoATM–kiosks that allow you to turn in your old cell phones for cash, a concept that doesn’t seem to be gaining traction.

This spending on business lines that were unlikely to succeed was all in an effort to extend the life of the company. Extending the life of a company is not always the best way to maximize value for shareholders. One thing I’ve observed is that dying businesses (or more euphemistically, businesses in “secular decline”) almost always turn out to be bad stock market investments. I think money can certainly be made from a cash cow like Red Box (even if the cash flow eventually will be $0), but not if the cash flow stream is attached to a public company. This is because of the inherent conflict of interest between a management team and the owners of the business. The owners of the business want to see the cash. The management team wants to continue getting a salary.

Of course, this is why activists have become so interested in Outerwall, and other companies that throw off copious amounts of cash.

Focusing on Stock Price vs. Running the Business

But here is a slightly different problem I’ve observed. Activists are much more interested in driving the stock price higher in the near term than they are in improving the long term value of the enterprise. A couple years ago, an activist (who failed in his attempt to get the company to sell itself) succeeded in driving the stock price of OUTR from around 60 to 80, where he was able to unload his stock. The stock now trades around 30.

After initially failing to get the company to sell itself, this activist was able to convince the company to take on a sizable amount debt to finance a massive share buyback program. This financial engineering tactic worked in getting the stock price up, but did the owners of the company (the shareholders who were left) benefit? Absolutely not. They loaded a dying business with massive debt, which hindered the ability of the company to deliver cash back to shareholders.

To me, this tactic of loading a company with debt to finance huge buybacks (in order to allow the activist to exit the stock at a (oftentimes short-lived) higher price) is not much different than the “greenmail” strategies that the activists used in the 1980’s.

I recently came across a video from a few years ago where Buffett was talking about Apple in 2013 when a few investors were pressing for Apple to return some of its massive cash to shareholders. Tim Cook had just recently taken over the reins from Steve Jobs, who always had a habit of ignorning Wall Street and focusing on the business at hand (a wise strategy for any executive). Buffett’s advice for Tim Cook was simply: Ignore the activists.

“The best thing you can with a business is run it well. If you run it well, the stock behaves fine over time…  …I would run the business in such a manner as to create the most value over the next 5 or 10 years. You can’t run a business to try and run the stock up everyday.” 

This is obviously the way Buffett has run his own business for the past 50 years.  Despite 4 separate occasions where BRK dropped 50%, Buffett said: “We just kept focusing on building value.”

Wall Street’s Obsession with Buybacks

While I almost always think Buffett is spot on with his advice for management, it’s not necessary to always agree with his stock picks. Buffett also mentioned IBM in that interview. I noticed the share price of IBM was around $200 at that time and the share price of Apple was around $62 (split-adjusted). I looked at IBM a while back. Ironically, I felt that they were much more focused on pandering to Wall Street and the analyst community (with the previous management’s focus on share buybacks and the infamous “Road Map” that had a $20 EPS target that the current CEO finally had to walk back).

Buybacks are great in certain cases, but a management team who is trumpeting buybacks as a key business strategy is probably not entirely focused on running the business. Buybacks aren’t a business strategy, they are a capital allocation policy. Buybacks were an afterthought for Steve Jobs, and also for Warren Buffett himself. Buffett has mentioned buying back BRK stock here and there, but like Jobs, he was focused on running his business. I’m somewhat wary of CEO’s who are trumpeting buybacks and putting together glossy investor presentations that prioritize these capital allocation strategies above business strategies.

Now, I know buybacks are very popular among value investors. I too like buybacks, but buybacks don’t exist in a vacuum. Automatically and routinely using free cash flow to reduce share counts without any consideration given to price paid doesn’t automatically mean that value is being created. Like spending on R&D, marketing, capex, or any other capital allocation decision, buybacks don’t always create value. Companies often perform buybacks routinely as if it’s always value accretive. They would be much better off approaching it opportunistically, like when Jobs was considering it, or when Buffett talks about the price he would pay for Berkshire Hathaway shares. Buy it when it’s cheap, don’t just make buybacks a habit.

We obviously have the benefit of hindsight, and I am in no way making any predictions on IBM, but I will say that I think Apple was (and is) much more focused on running its business for the long-term than IBM is. Which is why I’m surprised that Buffett bought IBM.

Nevertheless, I think his general advice is—as usual—outstanding. Focus on running the business, don’t focus on the stock price.

I’d like to point out that David Einhorn was one of these activists back in 2013 calling for Apple to return cash. I respect Einhorn tremendously, and I wouldn’t put him in the category of activists who I consider modern day greenmailers. Einhorn is a much more thoughtful, much more owner-minded. He has engaged in activism, but is generally on the side of long-term shareholders (he himself has been a shareholder of Apple for a few years now).

And Apple did eventually institute a sizable buyback and dividend program, but in that case, it was probably warranted, and it didn’t come at the expense of marginalizing the balance sheet or distracting management from focusing on running the business.

Tying this All Together With Outerwall

It might be too late for Outerwall to correct its course, and because of the large debt, there are limited options to maximize the shrinking stream of cash flow. Ideally, the company would have focused solely on paying dividends to shareholders initially, running the business to maximize cash flow, keeping a clean balance sheet, and minimizing investments in long-shots. But again, management wants to keep their jobs and activists want a quick buck.

The latest activist in Outerwall (Engaged Capital) correctly points out that there is no law that says that buybacks automatically create shareholder value. They also correctly (in my opinion) point out that a business like Outerwall is much better in the hands of a private owner than in the public, because a private owner can cut costs, reduce debt, and allow the company to slowly die while siphoning off the still large (but declining) stream of cash flow. So these are good points. But then they have a few slides basically saying that if Outerwall paid a big dividend, the share price would skyrocket.

OUTR-Outerwall Dividend 1

OUTR-Outerwall Dividend 2

While I have nothing against short-term focused investors, I’d say the main objective for most activists is not improve business operations or create lasting value for shareholders, it’s to get the stock price higher as quickly as possible. As these slides point out, what could be quicker than simply declaring a massive dividend?

Maybe this works, but if it does I’m almost certain it will only accomplish what the previous activist investor did—get the stock price higher and dump the shares to another investor at a higher price (akin to greater fool theory). I personally find it to be a difficult game trying to get the timing right by jumping in and out of stocks. I’ve noticed the same arguments are being made for OUTR at $30 as were being made when OUTR was at $60. Maybe buying at $30 will allow you to sell out at $45. But those who bought at $60 using that same thesis are out of luck. So you have to a) know for sure there is a bottom, and b) time the bottom pretty accurately.

Also, one other point I would make is that dividends aren’t necessarily return on investment. Sometimes, they are return of investment (returns of principal). I understand that in this case, Outerwall is in fact generating sizable cash flows. But the cash flows are depleting. It’s not much different than an oil well that sees sizable cash flows in the first couple years followed by precipitous declines.

So a 10%, or even a 15-20% yield wouldn’t necessarily be unwarranted for a declining business. After all, if the denominator in the P/E ratio (or the numerator in the dividend yield) is declining rapidly, then the seemingly “cheap” ratios could be warranted or even not discounted enough. P/E’s of 3 aren’t necessarily cheap if multiple years’ worth of (declining) cash flow is needed to pay off debt.

Three General Takeaways

I don’t have a dog in the Outerwall fight. I have good friends (who are very smart investors) who have owned the stock in the past. Allan Mecham—an investor I respect tremendously—still owns (as far as I know) a large position. I think the best possible outcome (the only one I see resulting in profits) for shareholders is to get the company sold as quickly as possible. Let the private equity guys figure this out.

I do think watching this unfold in real time has been an excellent case study. There are specific things that could be discussed in much greater detail related specifically to the Outerwall situation, but my general takeaways:

  • Rarely have I seen intrinsic value (long-term shareholder value) increased as a result of a company taking on massive debt to buy back stock. While it might successfully drive the stock price higher in the short term, in the long-term the debt—in the best case—takes a disproportionate share of the future cash flow away from shareholders, or—in the worst case—ends up compromising the financial condition and stability of the company.
  • Shareholders are rewarded by companies with management teams who focus on running the business, rather than focusing on the stock price, or Wall Street demands, or short-term results.
  • Seemingly cheap price to free cash flow valuations on companies with depleting streams of cash flows might make attractive private equity investments, but almost always make poor stock market investments due to the inherent conflict of interest between a management team and the owners (shareholders) of the business.

There are exceptions to these of course. One exception could be if the management team themselves happen to have ownership positions that dwarf their annual salaries/bonuses. But generally speaking, I have seen these three points hold true much more often than not.

Disclosure: Long AAPL, BRK-B

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com

13 thoughts on “Outerwall, Buybacks, and Activists

    1. Sure, there certainly can be good activists. And my point wasn’t to say that all activists are bad. I think there can definitely be a place for activism at firms that are destroying value. But I find that the solutions that many activists bring to the table are variations of: cut costs and buyback stock. Most of the time this doesn’t create lasting value for the long-term owners of the business. It might succeed in getting the stock to jump 20%, but rarely will this result in a higher lasting value over time. I think some activists have succeeded in taking a long-term approach and permanently changing value. But these are few and far between. Most activists today are hedge fund managers that have no idea on how to run a business, and so they suggest the same capital allocation solution to an operating business problem in the hopes for a quick score…

  1. Great post John. I respectfully inquire your opinion of what technology companies that generate significant amounts of free cash, such as IBM, should do with that money? I believe that IBM has generated significant amounts of cash to use for buybacks and has not greatly expanded their debt load to achieve repurchases.

    If, as you suggest, they shouldn’t use it for stock buybacks, then the other alternatives are : to internally reinvest the cash back into the business, acquire new subsidiaries, or increase the dividend even faster than they already have? Had IBM not used money for buybacks they conceivably could’ve used that free cash for acquisitions in the last few years. However, that is a bit complicated, because the acquisition prices for companies that neatly fit into the scenarios IBM is looking to add were likely more expensive to acquire just a few years ago. The decrease in general investor sentiment for early stage companies has actually allowed IBM to make acquisitions at theoretically more favorable terms. In terms of reinvesting in their business organically, I don’t believe that there that many high ROIC projects that are available to most companies to plow money back into. On this level, I actually appreciate the humility that IBM brings to the table by basically admitting this conundrum.

    Most other tech companies endlessly plow money back in to their business with very spurious actual results on that investment. I acknowledge Apple is an outlier so far.

    It’s as if they IBM Is saying:

    “Look, the business as we see it is still throwing off lots of cash, but that software based, on-premise business is slowly evolving. We want to shift to a cloud based business that serves the most mission critical of industries (Banks/ Airlines/ Governments) and we believe that analytics (Business and Healthcare) will be a huge new business for the new IBM, but we need to build that out. In the meantime we have the responsibility to share this cash bounty with you as owners and we take the responsibility of investing wisely into our future very seriously. And because of that, we will be aggressive in pursuing our acquisitions when the prices for those are appropriate. Although stock buybacks are not as perfect as simply increasing the dividend only, we feel committed to using both of these options. We acknowledge this isn’t perfect but, not everything in life is.”

    The key question in my analysis of IBM is “Will IBM be a trusted partner in the future and is the need for that trust increasing in value”? My answer is yes. But only time will tell.

    Full disclosure, I have a position in IBM.

    1. Hi Achit,

      Yeah I am not necessarily saying IBM is making a poor decision to do the buybacks. It’s certainly easy to look back in hindsight over the past few years and say that dividends would have certainly been far better for shareholders than buying back stock at significantly higher prices than the current share price. Unless the stock ends up significantly higher in the next couple years, it seems unlikely that those stock buybacks were the right use of excess cash, but we’ll see. Stock markets, and stock prices are volatile. So maybe it’s too soon to judge that. But my main point was not directed at IBM specifically, but rather at the idea that buying back stock at any price, with no consideration made to the intrinsic value of the company, is not a good practice in my view. Unless the company is a true compounder and the share price is continuously undervalued, it is not optimal to just allocate excess cash to buybacks without any thought given to the price of the shares. Capital should be allocated to the place where it achieves the highest possible return. Sometimes that might be internally via R&D, growth capex, or acquisitions. But those are done based on opportunities that become available, not automatically each quarter like companies often do with buybacks. I think buying stock should be viewed with the same thought process as making an acquisition or really any other capital investment.

      The bottom line is that buybacks are only a good use of capital if they are done at a price below intrinsic value. If they are done above intrinsic value, you are destroying value. So that’s really the question IBM or any other management team should be asking when they are doing buybacks.

      But for IBM’s sake, and for the sake of BRK, I certainly hope it works out well in the end!

      Thanks for reading Achit.

      1. John,

        As a BRK holder as well, I hope for the best too! Your article reinforced some recent thoughts I had about “compounders” and franchise type businesses. It’s truly stunning how valuable they become over a longer duration. Thanks again for another thought provoking article.

  2. Great article.

    Love that you also brought up Allan Mecham. I respect him tremendously as well, but I can’t fathom the Outerwall holding for the same reasons you mentioned.

    He’s also holding DNOW if I’m not mistaken, which is on my watch list. Run by the former boss of NOV, it could do very well when oil prices recover. BUT it’s not making any profit right now and I remember Lynch’s warning about before buying a stock, make sure it has earnings!

    Then again, as WB says: “you pay a high price for a cheery consensus”.

    Thanks for writing.

    Respectfully,

    Anthony

  3. Nice summary thoughts, I agree OUTR has been a great case study to learn from. I have no intentions of investing but I follow it just for that reason. ZINC is another one of recent that I’ve learned a lot from just by following the story.

  4. Calculating intrinsic value is essentially an “external investor” point of view. It would be very unusual for an entrenched management team to be able to figure the intrinsic value of their firm (I think most of them would think it to be very high…management is paid to believe in the company and act accordingly).

    Regular buybacks by management is similar to a dollar cost averaging strategy wherein the assumption is that we don’t know what the “intrinsic” value is but by buying over a long period of time we should be OK (sort of how most salaried people buy an index fund in their 401k). Besides other factors like sending a signal of confidence to the market, improving eps.

  5. Very interesting and insightful post.

    Do you know of any other companies in secular decline that would be good takeout candidates? I agree that management and activists can have incentives that don’t necessarily align with all or long-term shareholders, so a privatization by a firm that intends to run the business into the ground (but collect FCF along the way) eliminates those risks.

    Do you have any insight as to how much cash flow Outerwall can generate over the coming years? It is possible they crash faster than expected, making it a potential terminal short.

    Cheers

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