Gaiam Shooting for Explosive Organic Growth

As investors in this environment we need to be looking for businesses that will drive revenues with little leverage. We’ve all heard the buzz around solar and who hasn’t yet been invited to a friend’s Pilates class? Think of our friends who are doing this: they are typically well paid, well educated, driven women in secure corporate positions and they’re getting us – the out of shape, looking for a new workout, modern man – to join them. I sought out to find some companies that brought together profit with platform innovation which would be able to direct traffic towards their product platform without spending a lot of capital.

So, as an opportunity hunter in a market that has taken it to retailers, I look for ideas that generate cash, have strong growth potential, mitigated downside risk and operate with little debt. Let’s talk about what we know: retailers who have developed strong customer databases and loyalty do well cross selling new product lines; we want to invest in asset light businesses holding little inventory; and corporate America is turning to wholesome workouts like Pilates and Yoga in massive numbers.

Imagine for a moment that you’re a retailer who brands itself on a lifestyle – the “green” lifestyle that is sweeping America – and creates and distributes media and related products focused on personal development, healthy living and an environmentally friendly lifestyle. Just think, you’d make the perfect Oprah guest. Online communities are growing faster than ever before, providing well positioned retailers to benefit from additional channels to customers. So how do we play this?

A friend recently brought to my attention Gaiam (GAIA) - a growing retailer, with no debt, who generates revenue primarily through the sale of fitness and wellness related products from non-theatrical media products to Yoga essentials and eco friendly bedding. The company, at first glance, has a lot going on: it owns a profitable solar installation business, is growing a subscription club, developing an on-line community, building relationships with the country’s top retailers (like Target (TGT)) to sell their product and corporate accounts. A company that has grown reported earnings by 50% for the past two years and is currently trading at 30x forward p/e.

When you consider that they are selling their solar business for what analysts expect to be between $4 - 7 dollars a share, while it will add to the company's cash hoard – currently $2.63 per share - it’s not an important business for me to focus on going forward. I’m left wondering where the growth is going to come from that justifies their current multiples.

So, to make our analysis more simple, let’s break the company into two main segments – direct to consumer (subscription clubs, online communities etc) and formal business (corporate accounts, in store retailers). The formal business segment has improved operating margins from 5.5% in 2005 to 11.4% in 2007 with revenue growth of 60% and, according to management, continues to win market share. Okay, so I have a steady business and everyone out there must be reading the analyst and company guidance that suggests this business segment will grow earnings by 40% next year. So where do I get my edge? What makes this deserve a higher p/e?

In 2006, the direct to consumer business decided to launch a new subscription club membership: Gaiam Community and Spiritual Cinema Circle. Their competitive edge in developing these new web 2.0 membership clubs is a proprietary 8 million member subscription list from their direct to consumer catalogue. The company has found a way to cross sell against sticky customers. The benefit is in GAIA’s operating leverage for this business segment. I estimate GAIA as 85% gross margins in this business, compared with their roughly 70% in their other direct to consumer lines. Online communities have very little incremental costs as they grow revenue (think Google (GOOG)). Increased membership will translate into explosive bottom line growth.

The key to this bet is to figure out membership growth, as the company estimates 250,000 members gets them to break even (assuming forward ARPU rates of $8.00 for Gaiam community subscribers and $21 dollars for Spiritual Cinema subscribers – a 20% discount to past ARPU rates). Analysts are estimating about 290,000 subscribers by the end of 2008. With management disposing of the solar business, if management focuses more energy on acquiring new members, as it’s the most profitable arm of the business and in turn will lock in 350,000, you will see operating margins for the direct to consumer business beating analyst expectations. In turn, they will drive EPS above $0.54 a share for 2008 or 53% in earnings growth, which should justify a higher than the current 28x f p/e. According to management, they are at better than 50% hit ratio for catalogue subscribers spending the extra $10 a month to join the Gaiam Community, which means this part of the business could produce 4 million new customers over the next couple of years.

I think GAIA is worth a 40x f p/e multiple, given the above rationale on future market potential and their expecting y-o-y earnings growth of 50+%. That would mean the stock trades in the $27-29 range. Adding back between $4-6 dollars in cash for the sale of the solar business, and I see the stock in a $33 – 35 dollar range over the next year. With today’s levels in the $17 dollar range, I see a good entry point.

Management, including the board of directors is excellent. Just do a quick online search of their board chairman - Jirka Rysavy; he’s good at building small media businesses and making share holders money.

Disclosure: none