- Nautilus is a smaller player in the connected fitness industry which is undergoing a business transformation.
- The company seems to be currently undervalued assuming continuity of the business.
- The major risks to the bull thesis are the lack of scale, the potential oversaturation of the market as well as the continued at-home fitness trend after covid.
The current price of Nautilus (NLS) suggests that the company does not have a bright future ahead of itself. I think it seems undervalued based on fundamentals and might have some upside if the management can execute well on the business plan.
Situation and Company Overview
The company was founded in 1986 and is currently listed on the NYSE with a current market cap of ~USD304mm (as of 30th September 2021). The company designs, develops and markets cardio and strength fitness products and related accessories internationally but with a majority of sales (~84%) in the US.
The current CEO James "Jim" Barr IV, joined the company on July 29th, 2019 and started a digital transformation with the code name "North Star". The digital transformation prioritizes a focus on connected Fitness with a more subscription reliant approach through a connected fitness application called "JRNY". The main goal of the transformation is to have the majority of products being able to use the digital experience offering and around 20% of revenues from subscriptions by 2026.
On September 2nd this year, the company also acquired VAY AG for an undisclosed amount. VAY AG's products include gym and fitness solutions with real-time tracking, audio feedback and metrics, and health solutions that track motion to functional movements for physical therapy and rehabilitation. VAY AG is a spin-off of ETH Zurich, which is one of the leading universities in science, technology, engineering, and mathematics.
The Asset Value of the Company
The worst-case scenario of the company would be that next year or in two years the no one would buy their products anymore and they have to file for bankruptcy at some point. In that case, the assets would be liquidated and we need to assess the approximate liquidation value of the assets. Taking the assets at face value and deducting the liabilities leaves the company with an equity value of US$197mm which is around US$6 per share. It's always hard to estimate the exact liquidation value because that would require a professional valuation of all the assets but an approximation should be fine just to get a sense for it. I estimate that the liquidation value of the company's assets is around US$4.5 per share:
(Source: Company Filings, Author calculations)
I think that scenario is highly unlikely given the fact that the company is not in a dying industry and at home fitness should be relevant even after Covid. If the company is not going bust and is operating in a viable industry it is not appropriate to take the asset value based on the liquidation value. In that case, assets should be valued based on the reproduction value, meaning how much would a competitor or new entrant need to invest in order to arrive at the scale of the company. For the reproduction value, I mostly take the assets at face value. Usually, you would adjust PP&E to reflect the fact that those assets have been depreciated and could be acquired for a cheaper price now. When I did this adjustment, I arrived at US$25.1mm PP&E value which is almost the same value as the US$24.7mm of PP&E currently on the books. In addition to the Balance Sheet, we need to consider intangibles such as SG&A and R&D costs which a new entrant would need to spend in order to get the business started. For that, I take 1.5x of FY20 SG&A expenses and 2x of FY20 R&D expenses and add them as a proxy for the intangibles of the company to the equity value. Those adjustments summed together equals a reproduction cost value of the company's assets of US$12.2 per share.
(Source: Company filings, Author calculations)
Based on the approximate reproduction value of the company's assets the company seems to be undervalued. If however, someone thinks that the company does not have a future then the current price of US$9.6 per share seems still too expensive as the liquidation value is around US$4.5 per share.
The Expectations in the Current Share Price
When assessing a company it's always helpful to see what earnings level the market has priced in already. I do this with the help of the earnings power value of a company. This method discounts a sustainable operating income into infinity with an appropriate discount rate. The method can be used for companies in competitive industries which do not have any competitive advantage or significant barriers to entry.
In my view, nautilus does not have any competitive advantage. They don't have superior technology, privileged access to customers nor economies of scale. I would actually say they operate at a slight competitive disadvantage because they are a relatively small player with limited resources available to spend on marketing and new initiatives. Companies like Peloton (PTON) and iFit Health & Fitness (IFIT) are able to outspend Nautilus by a huge amount. For example, Peloton spent around US$730mm in sales and marketing in their FY21 and iFit around US$620mm in their FY21. Nautilus on the other hand spent only around US$78mm in their FY20. There is the argument to be made that Nautilus sales and marketing expenses are slightly more efficient as their margin is lower, however, in a competitive environment the absolute size is relevant. Luckily the very well-known brands and the good reputation help the company to make up for some of those expenses.
Currently, NLS is priced at a sustainable EBIT level of US$26.8mm. The core assumptions are a discount rate of 9% and a cash tax rate of 21%.
(Source: Author calculations, as of 30th September 2021)
The priced in EBIT represents a decline of 73% from current levels. Meaning if the company can sustain an EBIT of US$26.8mm for many years, the stock price is currently fairly valued and will not have future upside. Everything that exceeds that level should in theory be beneficial to the share price.
Reaching for the Stars
To assess the potential upside or the best-case scenario, we can take the management guidance for FY26 as sustainable EBIT and see how much this earnings power value is worth today.
It remains to be seen if management actually can achieve this target. I think it should be rather challenging based on the current industry environment. As already mentioned, the industry is very competitive and Nautilus is up against much larger and frankly better competitors in the connected fitness space. I also think they have a lot of work left with their app and membership which does feel a bit clunky compared to the application of iFit and Peloton.
(Source: Company Investor Presentation, Author Calculations)
The company mentioned an operating margin of 15%. I think that is quite optimistic so I lowered it to 10% just to be a bit more conservative. Again, the revenue target of US$1bn is not an easy task to achieve, and very unsure but I just try to capture the possible upside of the stock if the company can execute its business plan. If we take a sustainable EBIT level of US$100mm deduct a cash tax rate of 21% and discount that by 9%, the company should be valued at around US$877.8mm which would represent an upside of 273.5%.
There are several risks for the company in the current market environment. First, the current at-home fitness trend which really accelerated during covid might be not there to stay. When Covid is over and gyms reopen, many might simply prefer to go to the gym. The company mentioned that around 25% would still prefer at-home fitness over the gym but how accurate that survey number is, is not clear.
Second, the people who do like at-home fitness probably already got their gear during the pandemic and the market might be oversaturated with no new customers to buy at-home fitness gear. This could lead to a huge drop in revenues in the next few years and it would be very challenging to grow back to US$1bn revenues by FY26. It is hard to judge how saturated the market is, and the replacement cycle for such equipment. I think it might be rather long, often several years until a customer replaces or upgrades fitness equipment. The thing that could be beneficial for the company, is that as connected fitness gains more traction, people who still use non-connected fitness devices at home might upgrade their devices which could still lead to additional revenues in the future.
Third, the company operates in a highly competitive market, with large and famous players such as Peloton. Currently, Peloton is still losing money and I am not sure how long they can continue to do that before they need to think about profitability but the sheer size that Peloton has could just be too overwhelming for Nautilus. Peloton could have already established itself as the go-to connected fitness brand as Netflix (NFLX) is for streaming. However, compared to streaming where I do think it's reasonable to have multiple subscriptions from different providers, I have a harder time imagining someone having multiple connected fitness subscriptions or multiple training devices at home. This would make it very hard for Nautilus to continue to grow its JRNY memberships.
Fourth, the management does not own a lot of shares in the company which is usually not a good sign for a passive shareholder as the interests are not aligned. However, if management does not own a lot of shares it makes it easier for an outside party to acquire the company.
Finally, the current supply chain restrictions are for sure a problem for the company and especially for its margins. However, I think most companies are currently affected by this so it's more an industry-wide risk rather than a company-specific risk.
I think at the current valuation the company has good upside potential despite the current risks the company is facing. Even if management falls short of the business plan and falls back to past levels of EBIT the company has assets that support a valuation of around US$12 per share if they don't go bankrupt. This represents a margin of safety of around 26% (as of 30th September 2021). A company in a competitive industry usually should have the earnings power level and reproduction cost of assets on a similar level. That would imply a sustainable EBIT level of around US$36mm, which is in line with the company's past performance. Of course, past performance is not an indication for future success but is still good guidance on what should be possible if management cares enough.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of NLS either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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