Nautilus (NLS) – value destruction could lead to an opportunity
Nautilus is a fitness equipment manufacturer. The company makes consumer fitness products such as cardio and strength equipment, and owns some of the most recognizable fitness brand names in the industry, including Bowflex, Schwinn and Universal.
Nautilus operates in two segments, direct to consumer and retail. Each segment has a separate distribution channel, with direct to consumer utilizing online, TV and catalog ads to reach people in the home, while the retail segment sells product through a network of independent companies to reach both consumers and brick and mortar fitness clubs.
Most should be familiar with the brand(s), as Nautilus equipment is, in some form, inside nearly every gym in the US, while Bowflex is one of the best selling infomercial products of all time, and a staple in-home fitness product. Nautilus spends an incredible amount of resources on marketing, blitzing consumers with intense workout clips, celebrity endorsements, and even social ads. After awareness is built, they then try to roll those products out to commercial customers.
Nautilus takes advantage of the large market for cardio products, with 82% of 2018 revenues deriving from sales of this type of equipment. A tiny bit of revenue (less than 2%) is also earned via licensing. Its interesting to note that Amazon and Dick’s Sporting Goods represented over 23% of sales in 2018.
I’d estimate that Nautilus has around a 3.5-5% market share of US direct to consumer equipment sales, with total industry sales coming in at around $7-11 billion in 2017, and Nautilus capable of about $400mm in revenues for 2019 (my estimate).
*Side note: this makes Peloton’s recent $1.2B valuation on the back of $160mm in sales quite puzzling. However that’s another post for another day.
The direct to consumer fitness equipment business is tough, with heavy upfront (and ongoing) investment in sales and marketing, and a concentration in selling lower quality and less durable equipment to price sensitive consumers. The industry has been susceptible to rapidly changing trends and the ever-fickle consumer, which is why I believe we are seeing both secular decline in the direct to consumer equipment side of things, as well as a growing number of fitness subscription models w/ various products.
Over the years, product innovation has become the heart of what the company does, and when it comes to in-home fitness equipment, its hard to do better than a Nautilus product.
So all of that is great, but following a solid tenure under former CEO Bruce Cazenave from 2012 to March of this year, Nautilus has seen the beginning of what looks to be a large amount of value destruction, with revenues declining 17% from 2016, and EBITDA down 118% into cash flow negative territory. This is despite continued attempts at product innovation – such as the new Bowflex Max Fitness line – heavy marketing spend (consistently around 30% of revenues) and a number of strong fitness brands to leverage in the direct to consumer market.
Shares have responded to the recent business performance, dropping from a high of $16.50 a year ago to $2.50 today.
With that said, NLS has all the markings of a traditional deep value investment, including worsening operating performance, secular decline, market cap below current asset value, 0.5x price/book, a large share buyback program in place, and extreme pessimism surrounding the business. Add in a new CEO and strategic direction, moving through inventory backlogs, and continued share repurchases, it’s possible that the worst has been priced into the stock.
While its difficult to come up with current valuation numbers with TTM EPS and TTM FCF both negative, with an EV of $72mm (excluding operating leases), and 2019 run rate revenues most likely in the range of $340-$360mm, there could be an opportunity for shareholders to see some value creation moving forward. We can note the (most likely trough) TTM EBITDA number of around $10mm, representing a 7x multiple for a business that should see improved operating performance moving forward. Not too demanding.
However, looking a bit closer reveals some troubling data surrounding fitness industry trends and Nautilus operating performance.
So what happened?
As stated above, operating performance took a surprising turn starting in 2017.
The company blamed the poor operating results on higher product costs, and product mix shifts, including phase downs of the Bowflex Max Trainer and TreadClimber (both $1,800 products). In addition, management also cited ‘sub-optimal’ advertising for new Bowflex products, even though NLS has spent over $500mm in sales and marketing in the past four years alone, routinely dropping over $100mm per year to create awareness and buzz for new products.
I think the changes – currently being reflected through Q1 2019 – are the result of a few other things that don’t bode well for Nautilus moving forward, and changes that management hasn’t quite grasped or understands.
I believe that the steep decline in revenues can be attributed a few things:
Changing trends in the fitness landscape
A strategy shift to a new type of product – digital/technology related (that hasn’t been selling as management anticipated)
Competition and the rise of the boutique fitness industry
Nautilus products are really expensive!
I’ll address each point briefly.
Changing trends in the fitness landscape
Group exercise and functional training continue to grow
In 2017, approximately 14 million U.S. health club members maintained a membership in more than one commercial facility. This trend is likely due to exercisers’ desire for variety of training and intensity as well as social engagement, ultimately resulting in fitness facilities shifting their deployment of floor space and modifying their equipment purchasing patterns to match evolving exerciser preferences
This shift in group exercise and boutique training has resulted in the many new exercise classes and fitness routines we see today – Orange Theory, Crossfit, SoulCycle, F45 etc., and all require leaving the house
The need for digital content and tech integration as it relates to excercise
Being able to track performance outside of a workout class, or with a wearable device seems important to most fitness participants
A strategy shift to a new type of product – digital/technology related (that hasn’t been selling as management anticipated)
After reviewing the operating results and reading the conference calls, I’m under the impression that the new Bowflex Max Trainer product may be a flop. In addition, the expensive, odd looking machine is being introduced at a tough time for the direct to consumer fitness equipment industry
From the Q4 press release:
Bruce M. Cazenave, Chief Executive Officer, stated, “While there were pockets of growth and profit improvement, the overall results for the quarter were clearly below our expectations. Our Direct segment’s disappointing results more than offset the strong Retail growth primarily due to much slower than expected sales of our refreshed Max Trainer product line launched in November which now incorporates an innovative digital personalized coaching platform called Max IntelligenceTM. We partially attribute the reduced sales of the Max Trainer product to low consumer awareness and understanding of this added digital capability which delivers a greatly enhanced consumer experience. The negative impact of slow initial traction of the Max Intelligence platform was magnified because the launch coincided with the critical holiday and fitness season, but there were many valuable lessons during these first two months of introduction.
Although this is what management is trying to do, it’s very difficult to blame a 15% decline in sales and 30% decline YoY from Q4 2018 on poorly timed and constructed marketing. In addition, things are going well right now (depending on who you ask) in terms of economic activity. What happens during a downturn? Low operating leverage will really sting this business due to high fixed costs embedded in COGS
We can give it a few more quarters to see how consumers respond to the new Bowflex, but I’m not optimistic, especially at a price point of around $2000
Nautilus products are expensive!
Combing through the Nautilus or Bowflex product pages, you can see prices ranging from $500 (for a low end treadmill/basic Bowflex machine) to over $2000
This is an incredibly high price point, especially for new customers (who don’t already have equipment in the home) and millenials
Compared to your standard gym membership, boutique fitness classes charge members 15-20x more than low-cost operators, competing on brand prestige, elite status (more on that below), marquee urban locations, and a highly-tailored experience
Nautilus charges the same price point upfront for many boutique fitness clubs (let’s call a $120-150/month membership for 12 months equal to one new Bowflex machine or treadmill) but without any of the above perks
The global fitness industry is a vibrant and growing sector within the $4.2 trillion global health and wellness market. The health club market reached record revenue and membership levels in 2017, generating approximately $87.2 billion in revenue with approximately 174 million active participants. The number of active club members has grown steadily, adding 71 million members since 2005, with 23 million members joining in the past two years alone. The health club market has proven to be resilient to economic cycles. Industry revenue has grown at a compound annual growth rate of approximately 4% since 2005 and without much interruption during economic downturns.
As mentioned above, boutique fitness seems to be re-defining the industry, driving much of the membership growth to new places over the past decade. They adapt to the unique preferences of millennials and younger generations who are seeking out more specialized experiences, a sense of community, and flexible participation (read: no pushy sales, or year-long unbreakable contracts). Highlighting their rapid expansion, the definitive trade organization IHRSA notes that boutique memberships expanded 74% from 2012 to 2015, compared to 5% for health clubs. Admittedly, boutiques started from a smaller base, but their share of total revenue—some 35%—proves their presence is significant.
From a more macro standpoint, a fascinating microcosm of broader economic shifts is that the fitness industry illustrates pervasive trends across the economy, trends that are relevant to many consumer-facing businesses: the separation of premium and low-cost options, the un-bundling of experiences from large aggregators to specialized providers, the rise of the experience economy, and the experience itself as self-branding and status symbol.
In an interesting article about ClassPass (a fit tech startup), founder Payal Kadakia, described boutique studios as “magical” and a “way of life.” And it’s a lifestyle that’s only getting more popular. Today, a record 18.2 million Americans now belong to at least one fitness studio, according to the International Health, Racquet, and Sportsclub Association. And we’re paying more than ever for the privilege of working out in intimate quarters—often between $50 and $150 a month. (For some women who pay the now-standard $35 per class, that figure can be more like $150 per week.)
“It’s a realm of conspicuous consumption that our culture still accepts and even celebrates,” says Natalia Mehlman Petrzela, PhD, a fitness historian at The New School. “Boutique fitness is increasingly being seen less as a luxury item and more like a core activity, tied to people’s sense of self,” where positioning yourself as a regular carries with it an implicit humblebrag. “It’s seen as virtuous,” says Petrzela.
On the other hand, I have a hard time imagining someone bragging about their new Bowflex. In addition – and this is the reason why many fad fitness products ultimately flameout, and why I’m a huge skeptic of the valuation and growth runway for Peloton – signing up for a boutique fitness class provides a few things that Bowflex or any in-home product could never replicate
Don’t have to think about working out – show up, listen, do the work, leave
I’d imagine that most people are much more interested in paying for the above than being able to stream a cycling trail on their stationary bike TV.
Quick Look at One Comp
Life Fitness, a former subsidiary of Brunswick Corporation, that nearly went public via spinoff from Brunswick (before being acquired by KPS Partners), and the manufacturer of fitness equipment brands such as Hammer Strength, Cybex and Life Fitness, has also started seeing declines in operating performance as of Q4 2018 (to be fair, they also lost their largest customer, Planet Fitness, who scrapped their exclusivity deal with Life in order to offer a wider range of equipment choices to members).
During the fourth quarter of 2018, Life Fitness’ commercial cardio sales ($158.2 million) and consumer fitness sales ($106.2 million) both decreased by 13 percent and 5 percent, respectively, while commercial strength sales ($106.2 million) increased by 8 percent. Life Fitness’ operating earnings also decreased to a loss of $2.7 million, versus a positive $7.9 million during the same period last year.
While a different type of business – less direct to consumer, more commercial – and much larger than NLS, Life was able to hit normalized EBITDA margins in the 10-12% range, with sales of over $1B. It’s not a perfect comp, but it will be interesting to see if Life can return to equipment sales growth as well.
It seems both easy and difficult to imagine a positive return profile from here (that type of analysis is why you’re reading this blog…). Shares are at an all time low, pessimism is at an all time high, the company has cash, inventory and receivables in excess of its market cap, a small net cash position, is buying back shares, has new management in place, and is one good quarter away from seeing a pop in the share price. However, it’s unclear whether NLS products are to remain a part of the current fitness landscape, unclear whether they will return to growth anytime soon, and unclear if we are witnessing one of the all time great fitness brands slowly fade away. I don’t have the information or expertise to answer that question, and would probably view this as more of a value trap, especially with limited avenues for reinvestment into the core business.
There are attempts to now convert Bowflex buyers (and users) to subscription based customers, but trying to imagining fitness subscriptions deriving a large portion of revenues would be goofy at this stage. Management has provided no measures for subscription usage, growth in subscribers or customer acquisition costs.
Nautilus fell way below their 2018 guidance (50% miss in operating income), and although that was under the former CEO, it remains to be seen whether their internal projections can be trusted. They also predicted retail and commercial channel growth returning in 2018, which they also whiffed on.
There doesn’t seem to be much of an explanation for the poor performance either.
From the Q1 2019 call:
In summary, we have a robust plan in place to work through our temporary setbacks and to position Nautilus for growth and success in the coming years. We will continue to provide regular updates throughout the year on the status of these actions and the expected improving health of the business.”
Without being sure how this will be accomplished, management has made the commitment to get the Direct business back to profitability by Q4 2019.
More from the Q1 call:
Initiatives including a workforce reduction, broad cost containment controls, value engineering initiatives and simplification of processes have been executed or are underway and will support improving our current operating margins and re-scale our operations to be more profitable at current revenue levels and lay the foundation to restore growth to the sales base.
While we are not now in a position to provide full year guidance, any visibility into the traction gained from these various initiatives, we expect to see the changes we are making to the business start to impact results positively in the latter part of 2019.
If we want to try and paint a pie-in-the-sky scenario, let’s say that the direct to consumer market for fitness equipment continues to expand, the new Bowflex Max Trainer product is a huge success, and the company can start to grow revenues again at a mid-single digit rate (4-5%). Let’s say they can convince people to pay up for their high priced equipment, and gross margins improve a few hundred basis points, to 45%. THEN let’s say the heavy lifting for marketing is behind them (not likely) and they are able to scale down the spend to a more normalized level (let’s say $90-100mm/year) while continuing R&D to build new products.
So 4% growth in revenues for the next two years gets us to somewhere around $430mm, with 45% gross profit, which leaves $192mm. Subtract somewhere around $28mm in G&A costs, $100mm marketing spend, and $15mm R&D, and we’re left with $50mm-ish in operating income. Not too bad for a business being valued at $72mm. There’s also a $15mm share buyback program in place through February 2020, of which $1mm has been used. The company could use $2-2.5mm in cash or more to repurchase 3-5% of the business. Tempting!
In reality, there are an incredible amount of assumptions baked into the above that are not likely to materialize. I just don’t see how NLS can go from a 30% decrease in sales to posting positive numbers anytime soon, and I don’t have any visibility into how/when they can again achieve core business growth. Without an aggressive cost-cutting program (which would then go against the notion that sales and marketing need to be beefed up), I don’t see how near-term results get any better.
Finally, Nautilus will be competing heavily against upstarts like Peloton, Tonal and Mirror when it comes to consumers making expensive in-home equipment purchases, and I’m not sure their products can measure up to the cool integration of fitness and tech.
I think this is a good example where primary research could serve as a huge value-add. Attending fitness tradeshows, talking to product people, salesmen and consumers would help paint a much better picture of Nautilus place in the fitness equipment space moving forward.
This is ultimately going to be a pass for me. I’m not a big fan of the fitness equipment space, and it appears that the industry is trending in the general direction of less at-home fitness (necessitated by expensive equipment purchases) toward boutique, community style classes where consumers forego spending in one category and funnel that money into health and wellness.
Things I didn’t cover:
Carl Johnson is the current interim chairman and CEO after taking over for the departed Bruce Cazenave
Insider ownership is low
Didn’t spend a ton of time on this – product reviews aren’t bad, Glassdoor score is decent etc.