Description

Welcome to Bowflex 2.0. If you’re looking for an infomercial you won’t find one. Nautilus is back from the dead. Catching a huge COVID tailwind, and under new management, the Company is about to SMASH Q2 earnings estimates and have a blowout FY20.

Earnings expectations for Q2 and FY20 are light by orders of magnitude. 

Based on 2020E EBITDA alone, NLS is worth $16-19 per share in the near term, representing 50-80% upside from the current price. The home fitness trend will continue beyond 2020, and Nautilus has a viable path to becoming the #2 player in connected fitness behind Peloton, which would represent significant further upside. Additionally, we believe a buyout from a universe of interested buyers in the next 12 months is likely. 

Why this opportunity exists

1. New management downplayed expectations in its Q1 earnings call in May. Despite seeing a huge spike demand in the latter half of march, the CEO withdrew guidance. When pushed on Q2, management was coy and cited temporary supply chain disruptions and historic seasonality (Q2 is weakest). The conservatism is understandable given the company's recent troubles. Last quarter was also the CEO’s second quarter in charge, so I don’t expect chest pounding just yet. 

2. NLS is a small cap that is underfollowed and has limited analyst coverage. The stock traded at <$2/share for much of 2019. Additionally, since earnings in May, research analysts have not increased estimates despite noting continued elevated demand and the stalled reopening. 

3. And to an extent - the sentiment that “the stock has gone up too far too fast". We note that NLS is still trading below where it was 18 months ago, with significantly stronger 1) structural tailwinds 2) management 3) product lineup
While NLS no doubt benefited from COVID, the turnaround under the new management team (joined mid-2019) was already under way, and the company is very well positioned to capitalize on a rapidly expanding and underpenetrated home fitness market.

The Company

Nautilus sells home fitness equipment primarily under the Bowflex brand, but also the Schwinn and Nautilus brands. 

-80% of revenue is from cardio equipment (studio-style bikes, treadmills, ellipticals)

-20% of revenue is from strength equipment (dumbbells, kettlebells, home gym systems)

-Manufacturing is done with long-standing contract manufacturing partners in China
-Selling is done both DTC and retail

More on the company later, but first let’s take a look at upcoming earnings

We expect a significant beat in both Q2 and FY20

For Q2, street expects $74mm in net sales and breakeven EBITDA. Our diligence leads us to believe $100mm+ in net sales and $10mm+ EBITDA is not only possible but likely. 

We expect analysts to increase their FY20E numbers significantly after Q2 earnings and for the stock to rerate. Current FY20E sales of $343mm implies a mere 10% growth y-o-y for the remaining three quarters. Talk to any gym equipment store owner in the country and they will tell you that sales have doubled or more. There is no state of the world in which NLS does not do $400mm+ in sales this year. Production is in overdrive with added capacity and the company has been sold out of almost every SKU since March.

Additionally, NLS has SIGNIFICANT operating leverage. This has been a huge drag the past few years with declining DTC sales, but will now swing violently in the company’s favor. 

Our base case values NLS at ~$500mm TEV off of FY20 EBITDA of $50mm, though we think $70mm+ is probable. Our valuation implies a share price of $16/share. Our 10x multiple is within the historic range (8-12x), though we believe a premium is justifiable given the huge tailwinds. A 12x multiple represents $19/share. 

Below is our rationale on these numbers:

● First off - while NLS almost certainly had a blowout Q2, even if sales were flat y-o-y, they would almost beat on backlog fulfillment alone

- 3/31 backlog was $13.8mm from initial demand after stay-at-home orders; NLS typically has no material backlog

● Now let’s turn to some commentary around demand from the Q1 earnings call:

"The spike in visits on bowflex.com was driven primarily by organic traffic, which was up nearly 300% versus March 2019. In March, bowflex.com revenue grew 140% versus March 2019. And for the second half of March, bowflex.com revenue increased over 250%."

"In the full month of March, our revenue was up 9x compared to March 2019." (This is for Schwinn)

"Call center sales were also strong...The revenue per day for the last half of March was 80% higher than December 2019's holiday volume."

"Bowflex and Schwinn experienced strong year-over-year sales increases through retail partners, e-commerce and curbside pickup platforms...our Bowflex SelectTech 552 was a consistent hot seller on Amazon, including 1 day when we sold 6,000 units or 17 cargo containers in a single day."  (That’s $2mm+ sales in dumbbells in a day)

● Our weekly channel checks suggest demand has remained elevated since March, with almost all items still out of stock; delivery windows have continued to grow for more products 

- Lead times can be shortened to 4 weeks, so same-quarter order fulfillment should be no problem 

- NLS is actively working through backlog and many customers have indicated shorter-than-promised delivery times (4 weeks actual vs. 8 weeks promise)

● Import shipment data from Panjiva confirms our channel checks. Shipment volumes are exceeding peak Q4 holiday volumes

-For reference, sales are historically $100mm+ in Q4, and that is with heavy holiday discounting

-Currently, NLS is not only selling most items at full price, they have increased pricing for some items

● Our base case of $435mm in sales and $50mm in EBITDA is based off the following assumptions. We kept it simple to illustrate the opportunity:

Holiday-level sales of $100mm in Q2, $120mm in Q3, $120mm in Q4. We know the supply chain can handle these volumes and recent shipment data corroborates this. Actual demand is likely much stronger than a typical Q4 and management has stated they have increased capacity.

Essentially flat consolidated gross margins of 37% vs. last year. Actual gross margins are likely to come in MUCH higher, as a portion of distribution cost is fixed. GM has historically been over 45% (2019 was a distressed year). Additionally, the company is experiencing a more favorable mix of Direct Sales (50%+ margin) vs. Retail Channel Sales (~25% margin). Margins should be further boosted by little to no promotional pricing. Every 1% increase here would be an additional $3.5mm in EBITDA.

Keeping S&M (excl. DTC marketing), R&D, G&A all flat. These costs are largely fixed and have remained flat over the past few years, despite sales fluctuations. Operating leverage is key here. 

Cutting DTC marketing by 40% for remainder of the year. Management has indicated they are cutting marketing (no point running ads when customers need to wait 8 weeks). We expect this to continue until the company catches up on demand, which could be 2021. EBITDA contribution here is significant as this is by far the largest variable cost for the company. 

Again, we think $50mm in EBITDA is highly conservative, and believe $70mm+ is easily achievable. Projections available at the end of write-up.

Note that our short term price target is based on short-term NLS earnings potential alone. Going forward, we believe NLS enjoys significant competitive advantages as an incumbent in the rapidly growing home fitness industry. Successful executing on these advantages would represent additional upside. These advantages are also why we believe NLS will be acquired by a strategic.

Recent History

The Company was a pioneer in the home fitness industry with its Bowflex home gyms. Bowflex enjoyed huge success in its early decades of DTC marketing through its famous (infamous) informercials. After the recession, the company rode the wave of health and wellness, with sales peaking in 2015. 

To say Nautilus was slow in its digital uptake would be an understatement. With sales slipping, instead of rethinking market strategy, management doubled down on a bad hand and increased TV ad spend. From 2015 until the previous CEO’s departure in 2019, direct marketing costs ballooned as sales continued to tank. Expanding retail channel sales were not enough to offset the direct channel declines. Rising gym memberships exerted additional pressure. NLS also fell behind on innovation. 

Competition

Throughout much of the 2010s, equipment makers competed for the larger commercial/hospitality market. The consumer home gym market was small and unattractive by comparison. Selling $5,000+ cardio equipment into corporate accounts was more profitable (no marketing), and growth was faster and with predictable refresh cycles. Bowflex, armed with a large marketing budget, faced little direct competition in home gym equipment at its price points ($500-$2,000). Competition mainly came from inexpensive private-label equipment from retailers, and other DTC fitness concepts such as Beach Body and P90X. 

The rise of Peloton’s $2,500 bike attracted interest and investment to the home fitness industry. On its heels followed copycats such as NordicTrack and Echelon ($1,500+) and a whole host of well-funded startups aiming to bring a social, and trainer-led fitness experience to consumers' living rooms. 

The emergence of premium, innovative competition heavily eroded the value proposition of Nautilus’ lineup of $700-$900 bikes**. The shift to eCommerce also made available increasing options of no-name-brand but well-reviewed exercise bikes (<$300) deliverable in 48 hours. NLS’ previously “premium” price points were now in no man’s land. 

**This writeup will focus on bikes, as this is currently the largest and best-understood market thanks to Peloton. Bikes are also the biggest driver of sales for NLS recently. NLS also has a lineup of treadmills and ellipticals, and industry dynamics for those categories are similar (albeit more nascent). 

Turnaround started in 2019 before COVID

New CEO Jim Barr joined in mid-2019 and was tasked to turnaround the company. He had previously built a career out of helping legacy companies catch up on digital. Barr brought in a new CFO and head of marketing. Working with a new ad agency, NLS launched a totally rebranded ad campaign that was well received. Take a look here - it’s 30 seconds. This is not your father’s Bowflex. 

https://www.youtube.com/watch?v=qElAwFnYIX8&list=PLL3tp4lasjfMCOImr7ogU7FO1S4oRelcR&index=10&t=0s

In Q4’19, Barr’s first full quarter, revenue was down 10% y-o-y, a marked improvement from the first 9 months decline of 27% y-o-y. All of this was achieved on a dramatically reduced marketing budget.

The successful fall product launch no doubt also played a big part here. The new lineup of cardio equipment, as well as the industry’s first adjustable kettlebell, earned great reviews across the board. 

Undoubtedly the stars of the launch were the new Bowflex/Schwinn bikes. This is where it gets interesting. The bikes were designed to be compatible with third party apps including Zwift, Rouvy and Peloton Digital. By contrast, competitor equipment is closed - e.g. NordicTrack’s hardware only works with their iFit app. For NLS, an open system made sense as an interim solution to sell bikes while it played catch up its own fitness app called JRNY. 

Nonetheless, the products' new value proposition resonated with customers. The bikes flew off the shelves, selling out in Q4 with demand continuing through Q1. At $900, the bikes' positioning was now well-defined --- the lowest-cost ‘connected' bike on the market.

The timing of all this could not have been better. 

The Strategy / Acquisition Case 

Enter COVID. By a huge stroke of fortune, Nautilus finds itself alone in the mid-priced hardware segment of the market that was previously abandoned by its competitors. 

Regardless of your view on vaccine development, gyms are not recovering any time soon. There were 65 million gym memberships in the US in 2019. By contrast, Peloton has sold less than 750k connected bikes. The rest of the industry has sold fewer connected units combined. The market is severely under penetrated and the shift to home fitness will bring millions of consumers looking for more affordable options.

For NLS, the strategy is to rapidly expand its install base of bikes. In terms of units sold, we believe NLS is already solidly #2, and pulling away from rest of the pack. SaaS monetization can wait for later. The company continues to develop its JRNY app. Content partnerships are another possibility down the road. We believe there will be no shortage of interest given the size of the hardware install base. 

Some quick calcs to illustrate the subscription opportunity for NLS:

- We estimate NLS will have a minimum 500k install base of connected units by Dec '21
- 500k x $20/mo x 12mo = $120mm ARR opportunity

Even capturing a portion of the ARR opportunity should result in significant multiple expansion. Peloton current trades at over 10x revenue, even though over 75% of their revenue is from hardware.

There will no doubt be new competition. But NLS enjoys a few key competitive advantages:

1. Strong brand awareness for its Bowflex (and Schwinn) brands from decades of marketing 

2. Retail distribution in both big box and specialty - no competitor comes close 

3. An existing line of connected products

We believe these advantages are sustainable at least in the short to medium term. No competitor possesses all three, and each one is difficult to replicate. 

For competitors, developing new equipment and accompanying software or app integration will take time. Not to mention establishing manufacturing, distribution and marketing. There is a race against the clock as this wave of consumer adoption is likely to be front-loaded. The risk of a failed product launch is heightened. 

A buyout of NLS presents a more attractive option. For a modest price, a buyer solves the manufacturing, distribution and marketing problems, and can focus on developing the subscription content. The content side is asset-light and far more lucrative. It also more closely aligns to the core competencies of many potential acquirers. 

The universe of potential suitors is large. The $35bn fitness industry has been turned on its head overnight. Gyms, fitness studios, athletic apparel companies (LULU recently acquired Mirror), and commercial equipment makers are all vying to get into the home fitness business.

Whether they go-alone or get acquired, we believe the state-of-play in the home fitness industry sets up very favorably for NLS. 

Conclusion

We believe NLS is severely undervalued. Earnings expectations are far too low given the huge demand the company is seeing. Our diligence and management commentary lead us to believe the company will have a blowout FY20 with momentum continuing into 2021. Our short term price target of $16-$19 per share is valued off of its FY20 earnings potential. Successful execution beyond 2020 or a buyout would represent additional upside. 

Projections

Risks

Supply chain disruptions in Q2 were worse than expected. This would move some Q2 revenue to Q3 and would not change our overall thesis. 

Consumer credit - a portion of direct sales are financed by third party lenders who bear the credit risk. Tightening consumer credit could affect the demand picture. We don’t expect any impact in the near term given overwhelming demand. 

Execution

Catalyst

Q2 Earnings - we expect a strong Q2 and FY20 outlook, and the stock to rerate 

Acquisition