Description

Why buy NLS?:
The market is not giving Nautilus full credit despite significant progress by the new management. The business model has been transformed and Nautilus is now taking market share in retail. We believe NLS stands better positioned to capitalize than they did at any point in the last two years and because of the traction they have gained, the risks have diminished. The market has not yet recognized that what was a turn-around story, is now a growth story…the stock deserves a higher multiple.

We believe NLS deserves at least a 20x forward EPS multiples and a 12x fwd EBITDA multiple; we see 30% upside by year-end.

20x $1.73 = $34 year-end target …30% upside; 12x $75M =$35+ year-end target


Summary Info:
Current Price $25.75
Shares Out 33.29M
Float 30.7M
Mkt Cap $871M
Short Interest 7.27M
Cash $123M less $68M for Pearl iZumi acquisition (just closed)
Debt $0
EV $748M, or $816M after the Pearl iZumi acquisition
Dividend yield 1.4%

Consensus Our Estimate Cons. EPS Gr Cons. P/E
2004 EPS $.90 -13%
2005E EPS $1.20 $1.22 33% 21.8x
2006E EPS $1.64 $1.73 37% 16.0x

2005E FCF $20M or 2.2% yield
2006E FCF $55M or 6% yield
Growth EV/EBITDA
2005E EBITDA $75M 31.5% 9.97x
2006E EBITDA $105M 40% 7.12x

So post the Pearl acquisition which closed this Q, there is cash on the balance sheet of $2. We expect them to generate another $3+ in the next 18months.


Analyst Coverage:
8 sell-side analysts (5 buys, 3 holds), but the largest is probably Wedbush.


Industry:
Fitness equipment is growing 5-7% annually supported by
• aging baby boomers;
• increased awareness of the health benefits of exercise;
• increased obesity;
• rising healthcare costs....are more carrot and stick programs on the way?

Addressable market for NLS is $12B: Exercise equipment is $5B, High-performance apparel is $2B, and Nutrition is $5B.

NLS ’04 sales were $523M, essentially all equipment… so 10% share in equipment.

Competitors:
• Icon has the largest market share at 16%
• LifeFitness (division of Brunswick) <10%
• Precor <8%
• Cybex ~2%


Transformed Business Model:
NLS owns the Nautilus, BowFlex, Schwinn Fitness, and Stairmaster brands of strength and cardio machines and cycles.

In ’02, 65% of NLS sales were from a single product, BowFlex, through a single channel, direct-to-consumer. Revenue was growing 60%+, EBIT margins were 26%+…but the infrastructure and R&D was not in place to continue growth and success was dependent on a single product.

Icon introduced a competing product, the CrossBow, which caused BowFlex sales to plummet 40% in late ’02. Nautilus and Icon are still in court battling over patent infringement.

In 2003, Gregg Hammann came in with a bolder vision for the company and began the transformation of the business model. The new model is multi-product via multi-channels = leveraging the core R&D and brands. In order to support the model, NLS has invested in sourcing infrastructure, brand building, sales and marketing, and R&D.

80% of consumers purchase fitness equipment at retail as opposed to direct.

Porter’s Five Forces – Nautilus is strengthening its competitive position:
1) Barriers to Entry
• R&D intensive, patents, access to distribution;
2) Supplier Power
• Increased Chinese manufacturing capacity creates significant COGs opportunity for NLS;
• More efficient internal buying team;
3) Buyer Power
• Retailers are “dying for a brand”;
4) Threat of Substitutes
• Limited field of sizeable competitors and Icon is financially troubled;
5) Degree of Rivalry
• Industry growth is solid;
• Switching costs can be made more difficult if NLS successfully structures long-term contracts with commercial customers;


Earnings Growth
Topline growth
• 30%+ this year, 20%+ next, and 15% in ’07.
• Retail is the high-growth channel… it is a penetration game right now = new doors and new products in existing doors…the growth is not yet dependent on comp sales...NLS is winning business with mass retailers, sporting goods stores, and specialty stores.
• Multiple new products…30% of sales in ’04 were new products…similar amount expected in ’05.
• Sears win is a major milestone....Sears sells $400M+ in fitness equipment, with Icon holding the dominant share.
• Acquisitions: Pearl Izumi facilitates $200M apparel opportunity for NLS brands. A nutrition foray should be expected.
• GE financing partnership for commercial (very limited recourse to NLS)

Operating Margins
• EBIT is expected to rise 150bps in ’06 and ’07, with an intermediate-term target of 12-15%;
• A move from a corporate holding structure to a divisional structure: consolidation of accounting, finance, & IT;
• More efficient supply chain and consolidation of purchasing…e.g. despite much higher fuel prices, freight expense should be down ;
• Operating leverage on high-teen %+ sales growth;
• Price optimization;
• Expansion will come all while NLS makes significant investments in R&D and invests mktg dollars to build its brands.

ROIC
• asset turns will accelerate as Capex declines and revenue growth continues as significant pace;
• EBIT margin expansion is meaningful.

Free Cash Flow
• will be significant in ’06 = ~6% yield.

Board has already authorized a buyback of $100M
• the company has a level where it has committed internally to stepping up…we believe around $25.


Risks
• Execution…especially in meeting retailers expectations….management is confident in delivering on what has already been promised in terms of initial orders, but if sell through is strong, upside may be limited …at least this year.
• Management gets too ambitious too quickly…Pearl Izumi acquisition came sooner than expected…we’d be concerned if they make another acquisition in the next 6-9 months,
• Icon financial heath – very big variable
• Icon lawsuit – the real prize is putting Icon out of business; any financial reward is a bonus.
• Chinese brands or Chinese private label for the major sports brands

Catalyst

• Analyst day on Sep 15th
• Additional retail business win announcements
• 2H retail (peak season) sell-through
• Proper discounting of ‘06