Description
Simply, this is a company with a very solid balance sheet and is cheap, by any valuation measure. NLS has a market cap of $1 billion, has no debt, with return on equity figures of over 50%, net profit margins in excess of 17% and earnings per share growth well in excess of 40% each of the last 3 years, yet trades at 13.5X ttm earnings and 11X 2002 estimated earnings.
Valuation
Should one find this idea interesting on the face of it, the financial valuation will be discussed first and should anyone care to review the details of the company, it will be found below.
Important data includes the following (in 000’s except per share and %):
2001 2000 1999
Revenues 363,862 223,927 133,079
Earnings 66,583 41,626 20,343
EPS 1.85 1.15 0.58
Net Margin 18% 18% 15%
ROE 55% 57% 57%
Long term debt 0 0 0
CFFO 66,876 52,785 20,806
Earnings per share growth has been very high, exceeding 50% each of the past 3 years. Growth rates of this magnitude are not sustainable for long periods of time and future growth rates of this size are not at all expected from this idea. However, it is possible for this company to grow earnings at a higher than average growth rate for years to come. For reasons discussed below, one can make a reasonable argument to expect growth rates of 20% annually for the next 5 years. This assumption becomes easier to swallow when one realizes that earnings should grow at least 40% in 2002.
First quarter results were very positive and business operations were above expectations. The company has provided guidance for sales to grow 60% in 2002 and for earnings per share to grow 40%. Given the order backlog and first quarter results, these figures seem reasonable at this point. One thing that NLS has done consistently over the past three years is to significantly exceed expectations. In fact, following the 1st quarter results, management guided analysts to increase sales from a previous estimate of 40% to 60% and earnings from 30% to 40%.
This company continues to generate large sums of annual free cash flow. Management has shown an ability to use these cash flows to build shareholder value, through share repurchases and acquisitions of related assets at distressed prices.
One can model their discounted cash flow analysis with a variety of assumptions. Suffice it to say, it has been modeled with income growth rates as low as 15%, discount rates as high as 12% and this idea still makes sense. A thorough look at this company would warrant an earnings growth rate higher than 15%, especially looking at the current year’s expected growth rate of 40%. The current discounted value of this company is a minimum of $40 a share and arguably as high as mid-$50 a share.
The Business
NLS has two primary business segments, which are broken into: 1) products directly marketed to the consumer; and 2) commercial/retail products. The products sold direct to the consumer are Bowflex Home Fitness Equipment and Nautilus Sleep Systems. Products sold to the commercial/retail market are Nautilus, Schwinn and Stairmaster fitness equipment. In 1999, the company had its initial public offering through its prior symbol of DFXI, which earlier this year was changed to NLS as the company was re-named, The Nautilus Group.
Bowflex Home Fitness Equipment
The Bowflex has been sold to consumers since 1986 and through 1Q2002, over 599,000 units have been sold to date, including 59,000 units in the first quarter. Brian Cook, the company founder and current CEO, began marketing the Bowflex in 1986 and has since 1993 has been primarily marketing Bowflex through the use of cable television ads. Marketing of Bowflex is primarily done through 60 second television commercial spots and 30 minute television infomercials, that you have all seen at one time. Four different models of the Bowflex are available, ranging in price from $699 to $2,098. In 1Q2002, the average sales price of a purchased Bowflex was $1400. In late 2001, Bowflex introduced the 4th model, the Bowflex Ultimate, which is priced at the high end of the price range. Sales of the Ultimate have exceeded all expectations and have resulted in higher profit margins for NLS.
NLS has presumably become the preeminent direct marketer of products in the US. Beginning in 1994, NLS has spent significant resources on creating a marketing database which measures the success of various ads and sales methods. The company has utilized over 1,000 different 800 numbers to measure the effectiveness of different advertising. The beauty of this system data is that it is applicable in many ways to the success of future products to be offered directly to consumers. This is valuable information and will be a key to the long term success of NLS.
Nautilus Sleep Systems
Beginning in December 1999, NLS began directly marketing the Nautilus Sleep Systems to consumers through the same manner in which the Bowflex has been offered. The Nautilus Sleep Systems is a line of high quality air support mattresses, with four different product offerings. The prices range from $499 to $1,999 (plus up to an additional $399 for a bed foundation). The majority of the systems allow for the firmness to be adjusted on either side of the bed and the high end systems come complete with high quality pillow top mattresses.
The sleep systems have been growing well, although NLS does not break out unit sales for the sleep systems. One of the interesting sales tactics they employ is offering a 90 day guarantee on their sleep systems. A consumer may return a purchase anytime in the first 90 days for any reason.
A third product is currently offered as an “add-on” to the Bowflex sales. This is a nutritional supplement marketed under Champion Nutrition. Currently the sales of Champion are not significant to this analysis, although NLS does have an option to purchase the entire Champion company for $6 million through October 2002.
It is of note to mention that 41% of the direct sales are financed purchases. NLS has partnered with a consumer finance company to provide the financing for is buyers. NLS sales people have the ability to process loan applications directly over the phone and provide instantaneous credit approval to potential purchasers. The transactions are financed through a third party and NLS has no recourse on this debt. Management has stated that the finance company has been very pleased with the demographic make-up of NLS buyers and although they do not report specific default rates, they are evidently below average default rates according to NLS management.
In 2000, the direct sales represented 88.5% of total sales. Total sales in the direct marketing segment grew 47.7% in 2001 and represented 80.4% of total sales. In 1Q2002, 66% of sales were from direct sales and for the full year, it is expected that direct sales will decrease to 60% of total sales. By 2003, it is anticipated that direct sales may decrease to an amount of roughly 50% of total sales.
NLS has developed very strong websites for both the Nautilus and Bowflex products. As of the end of 2001, over 22% of orders for these products were processed online. This trend continues to positively add to margin expansion.
Commercial/Retail Sales
Pursuant to company strategy, the commercial sales are becoming a greater percentage of total revenue for NLS. In 2000, the commercial market was responsible for 11.5% of total sales which grew to 19.6% of total sales in 2001. Interestingly, company-wide net margins remained stable during this respective sales growth. In 1Q2002, commercial/retail sales were 33% of total sales. Given the two acquisitions discussed below, the commercial/retail segment is expected to make up to 40% of total sales in 2002.
The commercial/retail market consists of sales of Nautilus, Schwinn Fitness, Stairmaster, Quinton and Trimline commercial fitness equipment through a network of 1200 worldwide dealers and an internal sales force. End buyers are typically health clubs and fitness clubs. The vast majority of sales are currently domestic sales, although a primary focus of NLS is to continue its international expansion.
In September 2001, NLS purchased certain assets of Schwinn Fitness through a bankruptcy auction. This was a $69.8 million cash acquisition on the part of NLS.
Essentially NLS purchased the non-bicycle segments of Schwinn, as the bicycle segment of Schwinn was purchased by Pacific Cycle, LLC. In that the purchase was a distressed sale and that the current president of NLS, Kevin Lamar, was a former officer with Schwinn Fitness in the 1990s, the integration of this line of fitness equipment should fit well within NLS.
In February 2002, NLS again made a purchase of assets through a bankruptcy auction. NLS purchased the assets of Stairmaster for $26.1 million in another all cash transaction. Stairmaster offers stair steppers, treadmills, exercise bicycles and other fitness equipment for sale. Again, this appears to be another purchase with great potential of increasing sales and fitting into the current product offerings of NLS.
Combined, these two purchases should add in excess of $125 million in initial annual sales to NLS. The management of NLS is focused on diversifying its product offering into the years to come. It is keenly aware of not being a “one hit wonder” and compared to the likes of Nordic Track in the past. In fact, NLS currently has 50 employees evaluating new products that are constantly provided to the company for manufacture and distribution in the future. Clearly, NLS plans to roll out new direct sales products in the near future and has been working diligently for years in researching these various potential products. The implementation of this is a true key to the financial success of this company.
The gross margins for direct sales were 72% in 1Q2002 and the gross margins for the commercial/retail segment was 26%. The commercial/retail segment should see significant expansion of margins during 2002 as numerous actions have taken place to consolidate the various operations of the commercial/retail area. It is expected that gross margins for the entire company should be in the 55-57% range, with 40% of the sales coming from the commercial/retail side and 60% from direct sales in 2002.
The Future
Clearly, the management of NLS is focused on diversifying the income stream of the company, while attempting to continue to grow company earnings at an above average rate. In the last year, they have completed two cash acquisitions at distressed prices, which will allow NLS to continue to grow profitably. Management has been able to build a very strong balance sheet and seemingly use excess cash flow responsibly. The products from these two acquisitions should fit well into the current structure of NLS and be reasonably integrated in the commercial/retail sales market.
Thus far, the primary market for NLS has been the domestic market. The company does have a minor overseas presence, however now that the company has expanded its commercial/retail product line, it is making an emphasis on growing the international market. This has the ability to provide very strong sales growth for years to come, as demand for fitness equipment will continue to grow in Europe, Asia and South America.
Additionally, NLS has a constant stream of inventors and innovators bringing their products for review and potential implementation into NLS’ powerful direct sales model. Over 50 full-time employees have been working in the design, development, prototype and testing of these products with the intent of bringing future products to market. Management has long since realized that this is not a “bowflex only” company and has been taking steps for the past few years to make this a reality. What NLS has created is a strong marketing model that others have difficulty competing against. The marketing model does have strong potential in future years.
Concerns
A risk that Wall Street has been concerned about since the IPO is the reliance of NLS on sales of the Bowflex product. To date, NLS has been able to exceedingly surpass all estimates of sales and earnings from this product. There has been a healthy amount of skepticism from critics doubting that NLS can continue to realize success with this product. It has proven all the nay-sayers wrong to date, time and time again. Bowflex sales as a percentage of overall sales have been and will continue to fall as management intentionally introduces new products to The Nautilus Group. However, sales of Bowflex are expected to be strong and significantly contribute to overall sales over the next five years.
Profitable sales of Bowflex are contingent upon many factors, one being the availability of reasonably priced television advertising. Should the television advertising market become cost prohibitive, this would have a large impact on the direct to consumer sales of NLS, both of Bowflex and Nautilus Sleep Systems and any future products to come out.
There has been an ample amount of short sellers involved in this stock for the past few years. The business has seen much higher than average sales and earnings growth and with the abovementioned skepticism, short sellers have always been present. Looking at the price fluctuations of NLS over the past 3 years could make a person a bit leery, however it should appeal to the mind of a true investor as the overall result is a large increase in the value of the company over the years. In a slight hesitation to bring this up, the short sellers have increased as of late. A certain “writer” from a media outlet that this author refuses to recognize, has been jumping on the bandwagon of bashing companies. If a reasonable person takes a close look at the criticism invoked by this individual, one has to scratch their head in confusion. Through the use of more than ten negative articles directly attacking NLS, there is not one reasonable business concern included. One can make their own judgment on this matter, however it has seemed to be recently popular to prey on the fears of individuals investing in the market these days. This has clearly been attempted here as the short sellers have increased to a much higher than normal level after the release of these articles over the past month. Recent trends point to shorts beginning to cover and should the company announce expected positive earnings news on July 16, the short selling should dissipate.
Other concerns would include the ability of NLS to profitably integrate the new products from Schwinn and Stairmaster into their current sales and dealer network. The presence of Kevin Lamar should help to mitigate these concerns, as discussed above.
Patent expiration of the Bowflex power rods will take place in 2004. NLS feels that due to proprietary manufacturing methods for these rods as well as the strong brand recognition it has created, will make it more difficult for imitators to recognize significant sales of similar looking products.
NLS has also begun to implement a seemingly good plan of decreasing the reliance on the sales of the Bowflex product. While it is estimated that the Bowflex product will still have good growth prospects ahead, we all realize that huge earnings increases cannot continue indefinitely from one product. NLS has taken steps to mitigate this risk and from all indications will continue to do so in the future.
Catalysts:
1) Quarterly earnings release on July 16
2) Continued execution of company’s business plan
3) Short covering
4) Share repurchases
5) A return to reasonable and logical thinking
Catalyst
1) Quarterly earnings release on July 16
2) Continued execution of company’s business plan
3) Short covering
4) Share repurchases
5) A return to reasonable and logical thinking