Nautilus’ Opportunity is Enormous, as is its Risk – CML

On 9-22-2020 we added Nautilus (NLS) as our number six Spotlight Top Pick for $15.84.

This places Nautilus in the inner most circle of this logic diagram:

The number six Spotlight Top Pick position is one we hold for vastly underappreciated stories that may or not may not turn out well.

We see the upside, but we equally recognize and appreciate the downside.

The company reported earnings on 11-9-2020.

We added NLS to Top Picks on 9-22-2020 for $15.84.

As of this writing the stock is trading at $20.49, up 29% in six weeks.

Since we added this company this year and our auditor performs verification once a year (at year end), this entry has not yet been verified (but it will, of course).

Since this is our first earnings season with the company as a Top Pick, this dossier will read a little longer than future ones.

But we can start with earnings for those already familiar with the thesis and the company.

The reported numbers were an immense blow out of all expectations.

This would be a moment of humility for us rather than a victory lap because while we feel very strongly about the future for Nautilus, in no way did we predict the numbers the company just reported would be this good, this soon.

* The company reported revenue growth of 152% and the number itself was the highest quarterly sales in the last decade.

* The company reported its most profitable quarter ever. (I know, it’s crazy, a profitable company — they do exist!)

* Guidance for Q4 revenue (2020) is to substantially more revenue than Q3, which means it again will be the highest quarterly sales in the last decade.

* The company noted that “even as more gyms re-opened, our business continued to outperform.”

* The company noted increased investment in marketing, JRNY® (its recurring revenue app) and product development to target gym-goers.

* The company established new JRNY® (pronounced ‘Journey’) business unit and hired a Chief Digital Officer to focus on recurring revenue.

* The company saw a 7-fold increase in new customers.

* The company saw a 3-fold increase in traffic to

The stock has moved down slightly off of earnings rather than up and we will discuss the stock move after we wade through the details of the report.

Wall Street has a radically mixed view of this company, which is to say, estimates called for 73% growth in the quarter just reported and actual results were 152%.

Estimates trailed off to 24% for Q4, but the company guided to 63%.

Estimates for all of 2021 and 2022 are remarkably to -2% (negative) for all of 2021 and 1% for all of 2022.

Those numbers work out to estimates of a smaller company in revenue in 2022 than estimated for all of 2020.

* Revenue: $155 million, up 152% year-over-year, versus analyst expectations of $115 million.
This is a big beat.

* Adjusted EPS: $0.87 versus analyst expectations of $0.37.
This is a big beat.

* Next Quarter Revenue Guidance: $187 million versus analyst expectations of $131 million.
This was a big raise.

* Full Year Revenue Guidance: $550 million versus analyst expectations of $448.45 million.
This is a big raise.

Stock Price Move
We rarely talk about immediate stock price moves, but in this case a few words may be appropriate.

The stock move after earnings was driven by two factors.

First, the company announced a $100 million shelf offering, which is a fancy way of saying the company now has the right to raise money for growth.

When a company is growing this fast and is profitable, there is only one reason to raise cash — to go after a new market.

Nautilus doesn’t need extra cash to keep doing what it has been doing — it’s cash flow positive.

The company will raise funds, if it so chooses, to go after the recurring revenue digital world in workouts.

We applaud this news and further, if the company didn’t show some signs of an aggressive move to approach the recurring revenue market, it would not be a Top Pick.

But, the much larger stock reaction is due to other news.

On Monday 11-9-2020, the world was shaken by immensely hopeful news that a COVID vaccine with 90% efficacy was coming.

This news has caused an abrupt sell-off in what the market perceives as “stay at home stocks,” which is code word for all of technology.

Our view of this news is quite different.

We view a vaccine with this level of efficacy, if it were to materialize, as not just good news for Top Picks, but valuation changing good news.

An effective vaccine means healthier people, better business, more profitability, more jobs, more spending by the consumer, and a radical GDP recovery.

I’m afraid to say that we don’t see any of those things as bad news, not even for technology.

We have seen time and again the market consternation surrounding advertising dollars for numbered Spotlight Top Picks Roku, Pinterest, and The Trade Desk.

The consternation focused on reduced ad budgets due to a recession.

Well, if the recession ends, then the advertising dollars will flow too.

However bullish we were on those three names; we are more bullish with even the possibility of this vaccine materializing.

In the software realm, we have seen the beating that Spotlight Top Pick Alteryx (AYX) has taken due to restricted budgets born by the COVID recession.

Well, if the recession ends, then the budget dollars will flow too.

We have seen the beating that numbered Spotlight Top Pick Fastly took when it reported that traffic on its network was slightly lower due to timing of new accounts and industry segments (read: travel, leisure) getting decimated by the virus.

Well, if the recession ends, then the traffic will flow too.

Now we see the market’s reaction to the potential of stay at home activities dropping due to a vaccine, like working out from home.

Well, if the recession ends, then the consumers’ spending power returns and we’re not sure how the logic flows about working out from home.

Are we to believe that the money spent on equipment and the habits formed by the interactive workouts will be thrown away — “onward, back to the gym, who needs this bike!”

Are we to believe that the companies that pressed so hard to get their businesses on line will, now, with a vaccine, take down their websites — “eh, I never liked the web anyway, online orders are dumb. Turn it off!”

Friends, the digital transformation (DX) did not invent trends — it simply accelerated them.

This new cognition for millions of people will not disappear. There is no delete button in the brain.

What we know we can do now digitally has forever changed the trajectory of technology.

We feel the same about work out from home (and work from home, for that matter).

Of course, millions of people will return to their beloved gyms (or offices) — but the movement that was occurring already has forever been thrust forward.

Nautilus will see more sales due to a vaccine, not fewer.

The rub… it’s going to take some time to happen.

We do not invest for 10 seconds — we invest for 10 years.

In the long-term, an effective vaccine is absolutely world changing, and other than ‘inferior goods’, this is good news for all things, all businesses, in all ways.

It just is.

Now let’s talk more in depth about Nautilus.

COVID-19 has had an immense impact on the world, and with respect to business, it has thrust certain technologies forward so far and so fast that it has earned a name; the Digital Transformation (DX).

While we have written extensively about the DX and the incredible opportunities it has afforded us at CML Pro, there are still parts of this DX that are under appreciated, in our view.

One of these parts is the radical change in consumer behavior toward exercising.

While the early days of COVID-19 had unthoughtful investors believe that since gyms were doomed, so too were workout gear manufacturers, but along came a new company called Peloton.

Peloton was revolutionary not in that it sold expensive equipment, but in its introduction to the world of exercising from home in a connected way.

That is, as opposed to the old way of thinking which insisted that a workout from home was tautologically the anti-thesis of a workout at a gym — it was alone, unsocial, and uninstructed — it turned out that it was in fact done in a group, specifically social, and with instruction.

It is now well understood that connected gym equipment meant a connected gym in your house and that means recurring revenue.

And once recurring revenue is introduced to workout OEMs, everything changeswith respect to growth trajectory and valuation.

Even further, once this connection is made in the consumers’ mind, it never goes away.

Once a ‘better way’ is discovered, no matter how it was discovered, the cognition doesn’t go away — it is permanent.

The gym membership / health club world in the United States is massive, with 71.5 million consumers as of 2019 according to the International Health, Racquet & Sportsclub Association (IHRSA).

In 2018, well before COVID19, gym industry revenue rose 8.4% year-over-year to $35 billion.

According to Statista, the number of members in health and fitness clubs in North America rose 19% from 2012 to 2017, and using the 71.5 million number for 2019, saw a 28% growth from 2012 to 2019.

But with the gym came unused memberships and poor visit rates.

For people that stopped going to the gym in 2017, Piper Jaffray’s poll results show that traditional gym users canceled primarily because the gym was:

* Too expensive (13%)
* Not convenient (18%)
* People felt out of place (10%)
* Or people simply weren’t using it (22%)

When we look at the same data but for those that canceled boutique gyms, the numbers are to 24%, 18%, 15%, 10% respectively.

We call these primary reasons out because each of them is alleviated (either wholly or in part) by the advent of a home gym — and in particular a connected home gym.

Home gyms are less expensive for ongoing payments.

Home gyms are very convenient.

Home is the place where we feel the least out of place.

And, finally, for whatever portion of people that want to workout, a home gym should be the lowest hurdle to cross to get usage.

In the old version of the world, let’s call it pre-COVID, Nautilus was a sports equipment maker with strong brands (Nautilus and Bowflex) but a fledgling business through 2019.

The company sells in two distinct categories, namely its direct segment, which offers products directly to consumers through direct advertising, catalogs and the Internet, and its retail segment which sells products through a network of independent retail companies with stores located in the United States and Canada.

For the combined business, revenue dropped precipitously from $409 million for the trailing twelve-month period ending Sep 30, 2018 down to $309 million for the trailing twelve-month period ending Dec 31, 2019. Here is a chart of revenue (TTM).

Yep, the company saw revenue shrink by nearly a quarter in a little over a year.

In the midst of this collapse, the company named Jim Barr as the new CEO on July 8th, 2019 and specifically called out his digital background.

Barr most recently served as group president at Ritchie Bros., a used industrial equipment company with transaction value of $5.3 billion, according to Nautilus. During his time there, he led a digital transformation that expanded the 60-year-old company’s offerings from its core onsite auctions to an array of onsite and online formats.

Prior to Ritchie, he led a successful turnaround at Office Max where he “transformed the company’s online and omnichannel experi­ences.”

He also was an executive for 12 years in Microsoft’s online businesses as general manager, MSN Business Development, where he partnered to bring revenue, content and capabilities to the MSN network before heading the company’s B2C online businesses.

The point is, Nautilus saw the need to digitally transform well before COVID-19.

But then COVID-19 hit, and the stock, presumed to be a disaster as it had been, sunk to a closing low of $1.20.

The market soon came to realize that the DX was going to hit gym equipment makers too, if they had a strong brand and the aptitude from a digital transformation.

Nautilus did indeed fit the bill, and in Q2 of 2020, the company reported 94% growth from Q2 in 2019, then in Q3 of 2020 it reported 152% growth.

Nautilus was well on a path to a digital transformation before COVID-19, but COVID-19 forced the company, and the world, into it faster and bigger.

But Wall Street isn’t focusing on the right story.

While 152% growth is truly incredible, especially when just three quarters prior the company was realizing multi-year lows in revenue, that number is just the headline, which as finance goes, means it’s a nothing.

Analysts have Nautilus shrinking by about 2% for all of 2021 versus 2020 and that was before the new numbers provided for 2020 guidance.

Actually, as of this moment, before estimates are updated, analysts have NLS shrinking by 25% next year since the guidance for 2020 obliterated the standing estimates.

By 2022, analysts have it at the same number as 2021.

This numbers mash is all meant to point at one strongly held conviction by Wall Street — this DX we have faced is ending and it will not lead to extended growth for the company.

We care about revenue getting transformed from a onetime equipment sale into a recurring subscription for service.

This is the focus — the rest is just conversation.

The Real Story
We refer back to our reference of the DX.

While Wall Street certainly noted that the company had returned to substantial growth and the calls for its demise were in error, it has not caught on to the most important part of the DX — recurring revenue through digital subscriptions.

Well back in October of 2019, just three-months after Jim Barr took the helm as CEO, Nautilus pushed out a little noticed press release:

Nautilus, Inc. Raises Bar on Connected Fitness and Personalized Workouts with JRNY Digital Platform; Delivers AI-Driven Coaching Technology to Multiple Products.

JRNY is an AI-powered, adaptive coaching platform that runs on multiple Bowflex® products to create truly personalized home workouts.

It is connected to the JRNY app, which delivers real-time coaching and guided runs that automatically adjust to people’s fitness level.

Each custom workout is adjusted automatically based on how the user is feeling, how much they improve, and their past performance. Users also receive real-time feedback and expert guidance from a virtual trainer, as well as rewards to celebrate their achievements.

JRNY also features an expanded library of trainer-led workouts based on a user’s fitness level, personalized running and walking coaching for treadmill users, and additional rewards to celebrate and motivate users to complete their workouts.

Users have entertainment options with JRNY, including Bowflex radio and access to streaming services such as Netflix, Amazon Prime Video and Hulu.

And then the most important descriptor: “Following the trial period, a premium subscription will cost $19.99 per month or $149 per year.”

Yep, back in October of 2019, well before COVID-19, Nautilus was on the track to transform. COVID-19 has thrust that transformation ahead by years and it is the company’s prior commitment to its own personal DX that led it to a position where it could succeed in the world’s DX.

Nautilus also has its “The Explore the World™ App.” It allows users to “virtually travel the globe from the comfort of home and automatically adjusts in real-time to the speed of your Bluetooth® enabled Nautilus Fitness products.”

“Take control of your journey with dozens of high definition destinations and course lengths to choose from, including 5Ks through the Japanese countryside, 10Ks through the Scottish Highlands, full marathons through the streets of Prague, and many more. Challenge yourself to travel the entire globe, and stay motivated with new destinations added each month.”

“* 3 free courses available. Unlock all courses with an Explore the World™ subscription.”

Now, when COVID-19 ends (it will end), a large part of the outsized demand for home workout equipment will ebb, what we believe will in fact grow is the subscription portion of its business.

In short, we believe working out from home with connected equipment will be a forever change — it will grow on a new, higher, trajectory, and we see Nautilus well positioned to benefit from this trend due its earlier preparation to go down this path.

The CEO noted on the Q2 earnings press release (our emphasis has been added):

“The operational improvements we implemented in the back half of 2019 changed our trajectory in the first quarter of 2020 and were instrumental in record results in Q2.”

This is a case, in our opinion, of preparation intersecting an exogenous event and resulting in a thrust forward.

Financials, Valuation, ‘n Stuff
As of 11-10-2020, Nautilus is trading at a $594 million market cap, or about 1.1 times fiscal 2020 guidance of $550 million.

That valuation is a clear message from Wall Street that the recurring revenue model has been given no value.

We believe this phenomenon is in error.

We could be wrong.

This, fundamentally is the bullish thesis for Nautilus, which for CML Pro is always two-fold; a booming thematic and an underappreciated company growing within that thematic.

Again, we could be wrong about Nautilus. Maybe it is just an equipment maker.

The market will have an unnatural response to this unnatural disturbance and equally unnatural intervention.

It is going to get bumpy and the stock volatility to follow is the only part of this whole thing that is natural.

When the best investors in the world hear consternation about a stock price ‘on that day that time’, they don’t hear it.

It’s not a reluctance to it, it simply means nothing.

A day cannot encapsulate the changes that have already been laid.

This understanding that whatever the market does today has no impact on the view of the future has a name.

It’s called perspective.

The rare (rare) few have it.

It is these rare few that we call the best investors in the world.

It is this group of people that you can join, by making a decision.

You are the best investor in the world with perspective.

Risks are aplenty for Nautilus and this will not be a fast road to success.

* The percentage of revenue that comes from subscriptions is unknown and the real question is not if it is material now, but if the company believes it can be material in the future. If it cannot, then this is an equipment manufacturer, and yes, a 1.0 price to sales ratio is fair — which is to say, each sale is one time and there is no obvious recurring element.

* The impact of COVID-19 on supply is unknown as is the stickiness of Nautilus’ platform. Maybe being back ordered simply means consumers go elsewhere and the sale is lost not just in the moment, but also (therefore) is lost as a recurring stream.

* Market acceptance of the JRNY app is unknown. Everything reads well, but when it’s all said and done, if the app is bad, if the network is bad, if the experience is bad, it will fail and there may not be time for yet another iteration.

* Other fitness apps could supersede the JRNY app, relegating Nautilus to an equipment maker with a little known and little used app. In other words, consumers could purchase the Nautilus (or Bowflex) equipment, but happily switch over to another app to connect with friends and instructors.

* Sales growth is dependent on an uninterrupted supply chain, so expect bumps.

* Operating Expenses will be higher versus adjusted 1st half due to increased marketing to support new product launches.

* Competition is fierce and another large entrant is likely to manifest. If that large entrant is, we would actually view that as a positive as it would thrust cognition higher.

* The economic impact of COVID-19 is also unknown. Nautilus is not yet cash flow positive and doesn’t have a mountain of cash. There is a doomsday scenario where the company needs to raise cash and cannot.

In all, there is a lot of risk.

Here’s the thing though, there’s also a lot of upside if the company can mitigate those risks.

We see Nautilus (NLS) as a turnaround story that started in mid-2019 with a new CEO.

The digitally focused turnaround prior to COVID-19 was the necessary precursor to succeeding in the world of a post-COVID driven DX.

We don’t have great data into the recurring portion of revenue nor do we fully know the extent to which other fitness apps could supersede the JRNY app, relegating Nautilus to an equipment maker with a little known and little used app.

But, a number six Spotlight Top Pick is position we hold for vastly underappreciated stories that may or not may not turn out well.

We see the upside, but we equally recognize and appreciate the downside. After all, this was a $1 stock seven months ago.

The author is long shares of NLS and is long call spreads as well.

The author is long shares of ROKU, FSLY, PINS, TTD, and AYX of the other companies mentioned.

Thanks for reading, friends.

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