Description

Nautilus (NLS) is a pandemic beneficiary that is -30% YTD and -60% from its February highs on excessive fears over what normalized earnings might look like post-COVID. It’s also an ugly cousin competitor to Peloton and has suffered as a perceived share-loser who missed out on the rise of at-home class fitness. 

Pre-pandemic, NLS initiated a restructuring effort in 4Q19 that included an entirely new C-suite and strategic plan to (1) streamline its equipment offering, (2) introduce a subscription product, and (3) refresh the brand (remember those infomercials?). 2020 was a banner-year thanks to the pandemic but the underlying changes taking place have been lost amid the fear of a reopening hangover. Short interest of >15% for the last year has been a winning trade.

The thesis here is simple: if you think interest in home fitness has structurally increased due to COVID and the rise of the hybrid workplace model, then Nautilus is ideally positioned to benefit. It is a well capitalized leading fitness brand offering high quality equipment at competitive prices, with strong retail and DTC distribution, and is led by new management who are focused on increasing margins and reducing cyclicality by growing a greenfield subscription product.

At $12/share NLS today is a $380m market cap / $300m EV business that will generate $600m in sales this year while earning a depressed ~5% operating margin due to (1) logistics & input cost inflation and (2) a large brand marketing campaign to launch the new subscription product. Both of these headwinds will decline over time.

Management target $1bn sales and 15% operating margins by 2026. If these targets are achieved the equity today is screamingly cheap (i.e. <2.5x earnings). But even if sales are flat in 4 years and margins only normalize to 10%, NLS will generate $60m of operating profit, implying <5x EV/EBIT, 8x earnings and a 10% FCF yield on today’s price. This appears too cheap for a net cash business that has already shown signs of a successful turnaround, and whose subscription offering is growing >100% p.a. and has been well received by critics. 

Overview

NLS owns three equipment brands: Bowflex, Schwinn and Nautilus. Bowflex is the flagship brand and offers all-in-one home gyms, treadmills, stationary bikes and weights. Cardio equipment is 75% of sales, and sales are split 60/40 retail/direct, with retail sales gaining share as NLS embraces an omnichannel selling approach (notably Amazon).

The company has reduced SKU count by 22% over the last year, simultaneously increasing revenue per product by 3x. They have focused on higher-value connected devices and have introduced a new flagship bike (Velocore) and treadmill (Treadmill 22). 

Most importantly, the digital subscription offering, called JRNY, launched last September and has grown membership 2x from January to June of this year, likely to over 125k users. JRNY is priced at $149/yr and offers on-demand trainer-led workouts, as well as “explore the world” workouts and entertainment connectivity with Netflix, Prime, DIsney+ and Hulu. JRNY is dilutive to the group today but targets above-group 20% EBIT margins. Mgmt. expect 20% of group sales to come from JRNY by 2026 and most recently reiterated the target of 250k subscribers by March 2022. They don’t yet disclose important KPIs like churn and CAC for JRNY but have committed to doing so once 250k subscribers is achieved. The FY26 goal of 2m JRNY subscribers is equivalent to Peloton’s subscriber base earlier this year. 

Notably, and unlike PTON, Bowflex’s connected equipment are open platform, meaning they are compatible with Peloton, Zwift and JRNY, plus entertainment like Netflix, Amazon, Disney+ and Hulu. Their starter bike is $999 vs. $1,900 for Peloton. After suffering 6-month backlogs for popular products last year, most SKUs are now in-stock for immediate delivery. 

Two retailers account for >10% of sales each: Amazon has gone from 11.5% of sales in 2018 to 17.1% in 2020 while Dick’s declined from 13.8% to 10.2%. I’m not worried about the Amazon exposure despite the GM impact and consider it a positive that NLS has successfully grown its marketplace sales, especially internationally.

During the 6/30 quarter (fiscal 1Q22) sales were +62% to $185m despite being the first quarter to lap pandemic comps. FQ2 sales - a seasonally slow quarter - are guided to be ~$150m which is flat yoy. NLS attracted 40k new customers during FQ1 and 380k over the last 15 months vs. a pre-pandemic average of 100k/yr. Sales were 65% via retailers and NLS added 3k retail doors over the last 15 months (Target, Best Buy, Costco, Sams Club). Sales were materially supply constrained last year and NLS has adjusted manufacturing to no longer be factory capacity constrained by YE21. 

During the most recent quarter gross margins declined from 41% to 30% due primarily to chip shortages and logistics headwinds, as well as the mix shift towards retail sales. Historically gross margins have been in the 45%-50% range but will likely trend lower as retail sales increase. Technogym enjoys 65% gross margins with an exclusively DTC model. 

Competition

First on Peloton. I admit to being a PTON skeptic. PTON had a massive first mover advantage in at-home class fitness, turbocharged by the pandemic, but at the end of the day it offers a replicable service at premium pricing. Big and small competitors are catching up. The return-to-gym risk is a red herring. The real risks involve gross margin pressure as its prices inevitably come down, competitor pressure, customer churn once bikes are paid off, and the key-man risk popular trainers hold over the brand.

Even after declining 35% from its peak, PTON’s $34bn market cap trades at 4.8x EV/sales and 41x EV/EBITDA on 2023 estimates that have sales +70% and EBITDA +225% from 6/2021, which was a record year-end that I’d argue represent a reputational and competitive peak for PTON. It’s only going to get harder from here. I’ve seen serious fund managers suggest PTON subscribers will grow 8x over the next 4 years to 16m people, and float the possibility of 100m subscribers globally someday. I find both figures ridiculous. PTON has already captured the wealthiest 2.0m American customers – the next 2.0m will be much tougher. Best-case from here for PTON equity holders might be Apple acquiring the business for a 30% premium. [As an aside, if you haven’t tried the Apple Fitness product I recommend it. The Apple watch integration is better than PTON’s offering and the instructors are less caffeinated].

NLS has a material pricing advantage. PTON’s subscription costs $39/month and the bike costs an additional $49-$76/month depending on the configuration. The premium bike starts at $2,695 and offers 39 month financing via Affirm to ease the pain. PTON has 45% gross margins, low when considering that ~40% of its normalized revenue comes from software subscriptions, and it will only earn a 5% EBITDA margin this year, suggesting a bloated cost structure and/or unsustainable CAC. What happens when Apple starts poaching its star instructors (or minting its own)? What happens when PTON necessarily has to reduce its hardware and software pricing? Also the impressive 92% 18-month retention data is meaningless when you consider these are captive customers still paying off their expensive bikes. Show me retention once the bike is fully paid off, 39 months later. Only then can PTON really call itself a software company.

By comparison, Bowflex’s new flagship bike, the Velocore, costs $1,699 and the optional JRNY subscription costs $149/yr ($12.42/m). Bowflex’s starter-bike costs $999 and is BYOD (bring your own device). Although Bowflex only offers 18-month financing, it still represents a materially cheaper alternative to Peloton, which at >$100/month is out of reach to most consumers.

Other competitors clearly exist. At the high end Technogym offers a $4,200 bike, but Amazon offers plenty of no-name options for <$500 (none with a screen though). Nordictrack makes comparably priced aerobic equipment that by reputation have an inferior build quality but superior subscription platform (iFit, $396/yr for family plan). In the good/better/best framing Bowflex will always appear inferior to Peloton/Technogym, but at half the price it offers a viable alternative. Comparison reviews online are surprisingly favorable to the new Velocore bike vs. Peloton and especially like the fact that the flatscreen interface is not a walled garden, one of Peloton’s biggest criticisms. 

Bowflex bikes are priced to be the stalking horse to Peloton, and anyone seriously considering a bit of home gym equipment will spend time reviewing the Bowflex offering before making a decision. If Peloton proves too expensive -- as it will for many consumers -- Bowflex is the most obvious alternative. And for anyone who wants resistance training or weight equipment, Bowflex is arguably the #1 at-home brand.

Management

The entire C-suite of NLS was overhauled following the former CEO’s resignation in 2019:

CEO Jim Barr joined in July 2019 and CFO Aina Konold in December. Aina spent most of her career at Gap and Jim was most recently the CEO of Richie Bros. but spent most of his career at MSFT running their Commerce & Marketplace properties. He was hired by NLS for his e-commerce experience and he has since installed new leadership in Marketing, Digital and Supply Chain. Overall the revamped group has an impressive set of bios/experiences, coming from senior roles at Dell, Avis, Clorox, Intel, Broan-Nutone, Oreck and other dominant businesses.

Jim is paid $571k base. He has an annual cash bonus of up to 100% of base calculated against net sales (40%) and EBITDA (60%). An LTIP of up to 150% of base offers RSU and PSU grants that vest over 3 years with performance metrics tied to operating income growth and ROIC, which seem like the right metrics. He is sitting on $8m worth of deeply in-the-money grants.

No real insight on the board other than the fact that despite some long standing members they successfully oversaw the mgmt shakeup and strategic revamp.

Granaham owns 10.5%. There has been some call for activism in the past although an activist angle is less obvious today given the operational success of the new mgmt team. At a certain point I suppose a new shareholder could demand the company attempt to sell itself. Both NLS haand Nordictrack have been PE owned in the past.

Valuation

The business is net cash with gross cash of $83m and debt of $13m. Payables and receivables roughly offset one another and there is $111m of inventory (60% of which was in-transit at 6/30). The JRNY product is on track for 250k subscribers by 3/31/22. Subscription MSRP is $149/yr but discounts might make it closer to $100/yr per subscriber on average, implying $25m of subscription revenue this year – i.e. the firm only trades for 12x recurring revenue of a product that is 10 months old and growing >100% p.a. If you normalize in-transit inventory the enterprise valuation is even cheaper.

Take the FY26 targets: $1bn of sales and 15% operating margins. Of this, mgmt target $200m of revenue coming from 2m JRNY subscribers at 20% margins. This implies a 6% CAGR in equipment sales, which is ambitious but hardly impossible, especially given underpenetrated international markets now available via Amazon. Should these FY26 targets be met the stock today is laughably cheap. $200m of operating profit with no interest payments taxed at 22% offers $156m net income or $5 EPS, meaning the stock today trades at <1.5x EV/EBIT and 2.4x fwd earnings.

FY26 is far away and I have limited conviction around mgmt’s targets. When considering the downside I gain a lot of comfort from the following set of assumptions: 

If NLS reverts to pre-pandemic consumer behavior and attracts only 125k customers/year (vs 380k over the last 15 months), each spending $4k on equipment (the historic average, which includes the impact of some bulk corporate orders), that implies $500m of equipment sales annually, a 17% decline from FY21. On JRNY subscribers, I assume they achieve the current-year goal of 250k subscribers and then that 90% of new customers sign up over the next 3 years with 5% annual churn, for a FY24 grand total of 535k subscribers paying $100/yr for $54m of subscription revenue. That’s $554m of group sales. I assume equipment gross margins of 40% and JRNY gross margins of 90% offer $249m gross profit. From this deduct $160m of operating expenses (⅔ of which is marketing) for $89m EBIT, a 16% margin. Taxed at 22% this leaves $70m net income, $2.25 of EPS. Even in this hugely below-guidance scenario today’s equity trades at 5.5x earnings (3.3x EV/EBIT), which seems too low for what would still be a leading home fitness equipment manufacturer with a net cash balance sheet and a subscription service growing >20% p.a.

The above ignores cash flows, which will be materially positive. With only $15m/yr of capex and working capital headwinds only if/as sales/inventory grow, free cash available to equity could be $50m in FY24, a 13% yield on today’s market cap. Net cash should also grow between now and then from $80m to $150m, making the enterprise valuations even cheaper.

Risks

• Input cost inflation - Steel, plastic, memory chips and logistics are all current headwinds to gross margin. The ability to raise prices to offset landed cost inflation isn’t guaranteed and there appears to be a timing mismatch between unhedged input costs and order visibility.

• FX/China - NLS relies on primarily Chinese contract manufacturers, exposing it to RMB/USD fx as well as geopolitics.

• Inferior brand reputation - there is no denying that Bowflex isn’t nearly as cool as Peloton, which offers a superior product at 2x-3x the price. As Peloton reduces price-points and if it ever decides to open its walled-garden ecosystem that could materially hurt NLS sales and particularly JRNY.

Catalyst

• Getting through the next 2-3 quarters to show that sales won’t crater back to pre-pandemic levels thanks to successful restructuring efforts

• Hitting 250k JRNY subscribers by 3/31/22 and disclosing what could be strong KPIs around customer engagement and retention

• Gradual success of the new brand marketing campaign (see example ads here)