Nautilus Stock: Cheaper Connected Fitness Play

Summary

• 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.

Tara Moore/DigitalVision via Getty Images

Investment Thesis

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%.

The risks

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.

Conclusion

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.

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.

Comments

[Add Value]

I think for anyone interested and in NLS (as I am), have a look at my new article on the industry. I bring industry research to the discussion.

[GwailoHK]

@Add Value thank you 🙏

[J2.0]

Thanks for this article!

[GwailoHK]

Strategy is right but boy, current numbers are ugly.

Very unlucky with the supply chain situation.

There could be a positive surprise from holiday season as they’ve massively built up inventory

[PG Research]

@GwailoHK Yeah I saw the inventory build-up, but hope it will actually get sold then... but you are right numbers don't look pretty but they sounded quite confident on the earnings call but I guess everyone does sound confident on the earnings call :)

[Add Value]

@PG Research I will say that I believe that earnings call was not as bad as the market perceived. It appears that their JRNY timeline is moved up one year.

[J2.0]

@Michael Abd El Meseah I agree. I like this little company and its undervalued. The market was to harsh. No its not the next peloton. But thats not necessary. With the TAM and new strategy there is a lot of upside. I do agree with the discribed risk by the author (@PG Research). Still, i keep buying at these levels. And i will follow it closley. I would be awesome it insiders would buy more. Put you money where your mouth is. ;)

[AlexL1]

www.nautilusinc.com/...

[AlexL1]

Hi Folks, I'm courious to know what you think about the recent s-3/a filling from NLS?

[PG Research]

@alexandre Lane Hey, I have seen it but currently no thoughts on it to be honest. They didn't state a clear purpose yet other than corporate expenses. So, everything would be mere speculation, will be interesting to see when they actually make use of it. What do you think?

[ietgods]

Hi Folks,

Just like to say that I really appreciate the article and subsequent intelligent discussions in the comments. I don’t have much to contribute except that I’m deep value investor who just 10x’d my portfolio in the last year (mostly via oil and gas) looking to diversify, and am on the lookout for other (unreasonably) cheap and hated stocks…

I’m an ex lunk-head and haven’t been following the rise of Peleton closely (IMO on a cursory glance - seems like just another “tech bubble” type stock), but back in the day when I was throwing weights around - Nautilus was legendary… Arthur Jones, Mike Mentzer, Casey Viator all legends associated with Nautilus.

I’ve trained to be a personal trainer and have worked in exercise equipment sales and repair. To me if you say “Nautilus” in regards to exercise equipment (commercial equipment admittedly) it’s equivalent to saying “Rolex” when it comes to watches. You say “Peleton” and I think of little kids getting sucked under treadmills. Maybe at 42 I’m too old now…

Disappointed to find out that it appears that the commercial side of Nautilus has nothing to do with the “home fitness” side as I’d believe it would give this company the “street cred” it could use along with synergies… not sure the Nautilus name has a lot of value anymore for anyone younger than myself.

That being said I’ll keep NLS on my “watch list” for now… it’s still not cheap enough to be a no-brainer for me. If they still had the commercial machines I’d buy in as if people leave home for the gym again, you’d be covered as I think people will be looking to get out and socialize over the next few years and not stay at home!

I’d also look for a bit of an uptrend before buying (never a good idea to try to buy right at the bottom, stocks can both go lower or higher than you could ever imagine).

[PG Research]

@ietgods Thanks a lot for your reply, really appreciate it and congrats on your 10x, that's awesome!
What "fair value" would you give Nautilus?

[ietgods]

@PG Research you know, I'm just totally lost when it comes to a valuation for NLS.

I know oil and gas and which are the lower cost plays, pretty easy to run valuations and pick out winners and losers, and read PV10 numbers and look for bargains. It was a no-brainer to pick those up in the energy price crash in 2020 (oil price wasn't going stay negative for long, and I know for a fact it costs actually $40 barrel to produce), just buy the lowest cost producers that you know have a decent enough balance sheet to survive and wait - make 10x (plus) in a year. Helps to work in industry too I guess.

I look at the metrics for Peloton and look a the metrics for NLS and there is no comparison. Since Peloton has no earnings, the PE, EBITDA metrics are out the window... Just comparing EV to sales, Peloton is trading at EV to sales over 6 and NLS is like 0.38... so one could say that makes NLS an easy 10x from here... especially since those NLS sales come with earnings and profits!

This market is so damn crazy... It's like trying to compare GM to TSLA, either one is worth WAY more, or the the other WAY less. Actually, apparently Stellantis is the value play in automotive right now...

Proper play here would really be to short Peloton and go long Nautilus, but that's way too smart for this market. Is there another comparable "home exercise stock" to be running metrics on?

Looking at the numbers I'd think with the good balance sheet, good profitability and all that... Just in isolation, I think NLS should be trading around $25 if I had to give it a target... based on the metrics (and I'm a very cheap deep value investor, I'm not into "growth" at all, PE over 10 and I'll bail in general).

You might have me convinced me to nibble, I just sold more O&G today (not because I don't think there's more upside - but just to re-balance).

[r Negoro]

@ietgods and you made trade of the month. Pton tanked so bad.

[patrick.quest]

Great article thanks. I am long NLS but my major concern is how PTON is so much more polished in their products and their app that I wonder if this isn’t a winner takes all market. What about BODY as a competitor here - they have a connected bike as well?

[PG Research]

@patrick.quest Thanks for the feedback, really appreciate it!
I also checked BODY, and to be honest, I think a combination of the two would make so much sense in my view. BODY only recently got into connected bikes when they merged with another equipment company in the SPAC deal. The revenue from connected fitness equipment is still relatively small only around 3% of total revenue but they are huge in nutrition and have over 2.7m digital subscriptions.

[r Negoro]

@patrick.quest pton is a mess. Dont touch it.

[Microdeity]

Good effort, well articulated reasoning and explanations, especially liked challenging management's 1 billion revenue target. Much appreciated.

A couple of additions regarding some statements in the article that may be helpful to set the record straight and aid in future articles.

1- "Management does not own enough shares". They have 1.06 million stock options and RSUs with a weighted average price of $2.20 according to 10-K. I would say even with the current share price it is a very strong incentive and aligns shareholder and management interest.

2- Marketing and sales comparison is not a very good comparable on its own. Also M&S is not a great predictor of long term success in my opinion, companies with biggest marketing budgets do not always conquer the market. It would be better to split marketing from sales and break down other costs (stock compensation) for more direct comparison. Finally, especially for online and social media advertising the incremental spending hardly justifies the marginal returns in my opinion and experience.

3-Product comparison with competitors. I missed this part the most in the article for a product company. There is a positive buzz from customers about NLS brands like Bowflex leaning exercise bike and products get good reviews. In an expanding market there is room for several competitors to thrive and grow.

4-Business model analysis. NLS is company with a profitable hardware sales business (excepting 2019) for past 10 years trying to add a 2nd revenue stream through JRNY with a recurrent subscription model. But as they are a hardware first business, the connected fitness equipment works also with competitor's applications (e.g Peloton). Opening connected fitness equipment to other brands' apps is not a bad competitive move.

I agree with the seemingly low valuation at the moment (using a more conservative calculation there seems to be around 30% gap in the intrinsic value of company versus current share price of $10).

The threat I see is less from competition and more from sustained global supply chain pressure creating bottlenecks and cost increases which is compressing gross margins by more than 13% YoY, from 43.7% to 30% in latest quarter. Though, It looks to me they're doing a little better in cost management than Peloton Interactive whose gross margin is at 27%.

[PG Research]

@Microdeity Thanks a lot for taking the time to read the article and the great inputs!

I agree with the points you made just think that the general share amount as % of the total share is rather on the low side. There is some alignment but with a strike price of 2.20 which seems to be based on the very worst trading period of Nautilus, it's kinda hard to say how much incentive they still have as they basically just need to keep the company afloat to make a profit out of their options.

I tried to keep it on the shorter end and focus more on number valuation as other articles discussed the business model before, but I agree a thorough analysis would certainly include more details as you mentioned.

What do you think of the fact that they allow users to use Peloton on their machines? On one hand, I like it as it provides more flexibility and might attract more people who might prefer Peloton app but Nautilus bike. On the other hand, isn't it a shot in the knee if they also want to develop their own fitness app and focus on that? I think subscription revenue would be much more predictable whereas if they position as a hardware sales company the rather long replacement cycle might be an issue? To be honest I am kinda split on that part.

[Microdeity]

@PG Research Thanks for the reply. For a challenger with immaterial number of subs at the moment, app agnosticity is the right way to compete with Peleton and others, if it helps them sell extra fitness hardware to fund JRNY. I don't know the costs to judge if recurrent subscription business will be better and more profitable than hardware sales and will lead to higher revenue and profits for NLS. What if it leads to more top line but lowers profits consistently?

I think it is speculative to value JRNY subscriptions at the moment and will wait until there is more clarity, NLS breaking out the development and content costs, nr of quarterly subs, churn, etc figures to assess it as a standalone business. Till then my solution for value investing is to not to pay for the unproven subscription side of the business and apply a higher discount factor to future cash flows.

[PG Research]

@Microdeity
Thanks a lot for the good insights, this is very helpful. It's good to hear that it is beneficial for them to allow other apps on their platform.
With the subscription, I was more talking about the predictability of the revenues as hardware sales might be more volatile but just a guess. For profitability, I am also not sure when looking at the EBIT level, but when looking at Peloton and iFit their Gross Margin for the subscription part is much higher than the hardware sales with 62% and 87% Gross Margin respectively.

But I certainly agree that JRNY subscriptions should not be valued as of yet as it's still not a meaningful part of the business.