Outerwall's (OUTR) Increased Dividend is Credit-Negative Development - Moody's

Moody's Investors Service said that Outerwall Inc.'s (Nasdaq: OUTR) recent announcement to double its quarterly dividends from $0.30 per share to $0.60 per share is a credit negative development but will not impact its Ba3 Corporate Family rating (CFR) and the rating outlook remains negative. The company also announced that it plans to explore strategic and financial alternatives to enhance shareholder value, while continuing to focus on streamlining its operations and using cash flows to execute shareholder payouts and debt retirement. The announcement comes at a time when Outerwall's largest business segment, Redbox, is facing challenging business conditions due to accelerated secular pressure in the physical DVD rental business. Engaged Capital LLC, which owns 14.6% of the company's outstanding shares, has been pressurizing management to take actions to boost shareholder returns, including increasing dividends and / or a possible sale of the company. On February 19, 2016, Moody's downgraded Outerwall's CFR from Ba2 to Ba3 and changed the rating outlook to negative from stable following the company's weak earnings announcement (for Q4-2015) and bleak outlook for its Redbox business.

The dividend increase is effective from the second quarter of 2016 and will amount to approximately $45 million on an annualized basis. We expect dividends to be funded entirely from internally generated cash flows and the company is expected to generate free cash flows of between $100 million - $145 million (after dividends). In Moody's opinion the significant increase in dividends is credit negative as these dividends payments will consume financial resources that could have otherwise been used to reduce debt or invest in the business. However, our concerns surrounding outsized shareholder payouts are somewhat tempered by restrictive covenants in indentures governing Outerwall's bonds. Covenants in the indenture and credit agreement limit the company's ability to make large shareholder payouts as restricted payments are permitted subject to satisfaction of a defined consolidated net leverage ratio of less than 2.5x. If that net leverage ratio exceeds 2.5x, restricted payments would be limited to $25 million over the life of the bonds. This restriction also includes restrictions by the bank credit agreement on repaying senior unsecured notes, but presumably not after full repayment of the bank revolver and term loan. As of 12/31/2015, the company had roughly 24% EBITDA cushion under the 2.5x test. Notably, if operating performance in 2016 tracks to the lower end of management's EBITDA guidance and the company does not reduce debt (beyond the $13 million term loan amortization), it may not be able to meet the 2.5x test and the restricted payments provision would prevent shareholder payouts beyond $25 million over the life of the bonds. We believe that management wishes to avoid this and will endeavor to manage the company's debt leverage closer to the lower side of its 1.75x to 2.25x reported leverage target range, putting aside the potential for a strategic or financial alternative.

Outerwall's decision to assess strategic alternatives raises the possibility of a leveraged buyout by a private equity sponsor, or sale of all of the company or a minority interest to a strategic investor. Moody's notes that in addition to the restricted payments covenants, which would prevent a leveraged recap from occurring, the indentures also consist of a change of control provision, which somewhat protects bondholders from risks associated with a leveraged buyout. The change of control put/make whole is triggered if greater than 50% of the voting power of the company is acquired by any investor. However, an investor could acquire 49% of the company and not trip the change of control provision, yet have significant influence over the board to refinance the bank facility thereby removing the 3.0x leverage maintenance requirement and ultimately allowing the company to lever as the business degrades. But the 2.5x restricted payment test in the notes would remain and may prevent a buyer from using new bank debt to buy out half the shares at leverage beyond 2.5x, and the company would remain very limited from making future distributions to investors or buying back further shares until the debt is repaid.

Moody's will continue to monitor developments and will comment further as management makes progress in its evaluation of strategic alternatives for the company.

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