Why Investing Like This Activist Could Make You Look Smart

Activist investing: When hedge funds and other investment managers publicly disclose new holdings after normal trading hours, some investors can be caught off-guard. Last Friday, activist Barry Rosenstein's Jana Partners reported a 13.5% stake in Outerwall Inc (NASDAQ:OUTR) minutes before the market’s close and shares were up almost 9% after hours. Due to the promising potential of hedge fund piggybacking (discover how investors can beat the market), we’ll take a look at this move.

Barry Rosenstein JANA PARTNERS

To start this week, Outerwall’s stock finished Monday up another 4% as investors pondered if Jana could instigate meaningful change. In its original filing, the hedge fund mentioned plans to initiate a “review of strategic alternatives” at the automated kiosk company, including a whole or partial sale of some assets, and a potential capital return program.

A buyout or breakup

Aside from the obvious attractiveness of introducing a dividend and share buyback plan, Jana’s desire to explore a breakup or buyout is intriguing. Acquisition rumors have circled Outerwall before, most recently when Providence Equity Partners lost a takeover bid last summer.

As the Wall Street Journal reported last month, Outerwall’s Redbox division did not meet the company’s expectations this summer, though it’s difficult to think it would shed the movie rental business that makes up most of its revenues. Any Redbox sale would likely be a part of an Outerwall merger with a larger bidder.

A partial sale, on the other hand, could involve any one of Outerwall’s other kiosk segments, including Coinstar and ecoATM. The company also has a few experimental projects, including: 1) Star Studio photo booths, 2) SoloHealth health monitoring stations (partial stake), 3) Alula gift card-to-cash exchange machines, and 4) Rubi kiosks that serve Seattle’s Best coffee. If Jana thinks Outerwall could be best served by focusing only on core operations, multiple divestitures would be reasonable.

The valuation

While it’s unclear exactly what Jana’s eventual aim will be, there’s no denying that Outerwall’s business is priced very cheaply at the moment. The company is expected to hit $2.5 billion in annual revenue by 2014, yet it trades at a market capitalization below $1.7 billion. Sell-side analysts expect earnings to grow by 20% a year over the next half-decade, but the market is valuing this growth at a paltry PEG of 0.7—lowest amongst Outerwall’s specialty retail peers (with at least $1 billion in market cap).

To be fair, the stock trades at low multiples for a reasonable secular concern. Outerwall’s doubters assert Redbox cannot survive in a world of digital streaming dominated by Netflix, Inc. (NASDAQ:NFLX) and Amazon.com, Inc. (NASDAQ:AMZN). Broader-thinking bears, meanwhile, argue that a future where customers would want to pick up different types of items at individual kiosks is wishful thinking.

In many pessimistic scenarios, the advantages of Outerwall’s vast system of retail partnerships are simply overlooked. Wal-Mart Stores, Inc. (NYSE:WMT), for example, has agreed to feature Redbox kiosks in over 3,500 of its stores through at least 2014, while Walgreen Company (NYSE:WAG) and The Kroger Co. (NYSE:KR) are a couple other names that offer similar high-quality kiosk placement. Regardless of if the company’s new ventures take hold or not, it’s this partnership network that appears to be the key driver behind Wall Street’s bullish forecasts.

The combination of Outerwall’s solid growth prospects at a very reasonable valuation warrants any investor’s attention, and Jana’s stake is just icing on the cake. Any buyout would place a premium on the company’s current share price, and divestitures would likely place a higher multiple on Outerwall’s core business.

That’s not all

In addition to Outerwall, Jana Partners also advanced its activist campaign at Safeway Inc. (NYSE:SWY) last month (see the full recap here), and now owns 6.2% of the food and drug retailer. Unlike the scenarios discussed above, it doesn’t appear that Jana is seeking a sale at Safeway. According to the filing with the SEC, the hedge fund is focused on potential cost cutting measures, capital return programs (likely in the form of dividends or a buyback), and a review of executive compensation packages. At a paltry 0.2 times sales, there’s no denying Safeway shares have room to rise if Jana can implement one of more of these initiatives.

Of the two activist stakes, both Outerwall and Safeway are attractively priced with multiple possibilities present that can generate appreciation. We’ll continue to watch this activist’s filings with the SEC, so stay tuned for updates.

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