Is Nautilus, Inc., the next Blockbuster?

Why I bought NLS shares

Published on:
August 4, 2019
Reading time: 4 Minutes
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

This week I noticed that Nautilus Inc. (NLS on Nyse)traded at a 5-year low. I knew little about the sports equipment company but thought that a 67% discount to book value was enough of reason to read more.

Why Mr. Market is angry with Nautilus

From Barron's, I read that Mr. Market views sports equipment companies such as Nautilus to be a thing of the past, doomed to be a Blockbuster [1]. Today Mr. Market cheers companies such as Planet Fitness (PLNT on Nyse) and Peloton. They are the future, the Netflix of the industry.

Nautilus' management talks to investors about consolidation.  But Planet's management reports to shareholders with Silicon Valley jargon: "network effect," "economies of scale" and "disruption." 

Nautilus' management talks consolidation. But Planet Fitness' management talks network effect.

Mr. Market also worries about a looming recession.  Recession will first hurt companies that rely on our disposable income. So Nautilus is the opposite of a recession-proof company. Its products are expensive, and largely depend on third-party consumer credit. In short, indoor exercise gear is the last thing on our minds when times are tough.

Nautilus revenue and pre-tax income 2018, 2014 and 2009
Nautilus revenue and pre-tax income

The change in Nautilus senior management was worrisome too. Bruce Cazenave, Nautilus' boss since 2011, resigned early this year [2]. Since Cazenave was mostly in charge of the company's growth over the past seven years, Jim Barr, its new boss,  is stepping into big shoes.

I also saw that the stock price lost 87% over the past year. NLS traded in 2018 as low as $10 and as high as $17. In 2017, it traded as low as $12 and as high as $19. It now trades at less than $2.

Cooke & Bieler, a value cap manager I admire, sold the entire position. Their portfolio managers sold 1.9 million shares (about 6% of the outstanding stock), which they bought for about $16 a share.


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Nautilus' exposure to consumer debt

"To facilitate consumer sales," writes management on page 3 of the 10-k report, "We partner with several credit providers. Credit approval rates are an important variable in the number of products we sell in a given period."

In numbers: Over half of Nautilus customers borrowed money to buy the products. In 2018 and 2017, 54% and 51% of customers bought using credit, respectively. 

When over half of the sales are dependent on capital markets, if anything interrupts the credit environment, then sales decline. 

Also, at times of economic duress, common sense is that consumers will not buy the product in the first place. Perhaps management will propose investors that recession time is the time we should exercise even more – but it would be hardly a convincing argument and one that does follow the historical record. 

When over half of the sales are dependent on capital markets, if anything interrupts the credit environment, then sales decline. 

In the Great Recession, Nautilus' revenue declined to $284 million in 2008 from $501 million in 2007. During the last five years, the interest rate climate has been artificially low. That means it was easy for Nautilus's customers to load up on debt and to pay the monthly debt obligation.

Yet as soon as the interest rate environment returns to historical levels, the cost of debt will increase. It will be challenging to justify a personal exercise machine when one could quickly go to the local gym, at half the price. 

NLS balance sheet
Nautilus price to book value

Nautilius 2019 first-quarter results

January is the time we promise ourselves that we will be in better shape than ever in the upcoming year. And this annual resolution affects the earnings of companies such as Nautilus. So the first quarter results for sports equipment or wellness companies often show the highest quarterly revenue.

Yet Nautilus' first-quarter results were dismal. If you annualize the first quarter, you will find $338 million in expected revenue for 2019, remove $144 million for the cost to manufacture and deliver the machines. And after marketing, research and development and general and administrative expenses of $183 million, we estimate an operating loss this year of $39 million or $1.1 loss per share - the first (expected) loss since 2010.

There are also accounting irregularities that I have yet to understand. In 2018, the company reported $38 million in cash and $25 million in marketable securities. But as of the last public filing,  cash was down to $11 million, and marketable securities dropped to $12 million. Management also added a new line-item called "operating and finance lease rights." The classification of the asset, worthwhile to note, is not a short-term asset, such as cash and marketable securities, but long-term.


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But I couldn't resist buying a few shares. I will rationalize the purchase as follows:

(1) The company has not diluted shareholders. Ten years ago, there were 30.66 million shares, roughly the same number of shares are outstanding today.

(2) The company hardly carries debt, which results in an operating income to interest expense ratio greater than ten times, allowing the company to experience "dry spell years."

(3) The current valuation of $43 million in market capitalization is less than the pre-tax earnings in 2015 of $51.4 million.

Finally, when the cost of sales is half of the revenue, management has a lot of room to improve operations. Management can focus on becoming leaner, reducing overhead, or perhaps utilizing better marketing strategies, which I will explore in future essays.


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FOOTNOTES: [1] Blockbuster was a provider of home movie and video game rental services. Competition from Netflix and other video-on-demand services led to its bankruptcy filing in 2010. [2 ] Cazenave landed a gig at the direct-to-consumer retailer, Bluestem Group Inc.
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