Our preliminary due diligence on Nautilus Group (NLS) led us to code the company as a GeoBargain at $3.70 on January 2, 2013.

Astute investors who are on the prowl for undervalued stocks can often find value in companies that capitalize on large secular trends. Although some may feel that the Baby Boomers in many ways posed challenges for future generations, it has also opened those who have positioned themselves appropriately to profit from a vast array of opportunities. We would like to call to your attention to Nautilus, a company whose 2007 restructuring efforts have will allow it to benefit from this aging population and the large cross sections of population in the younger demographics. Through the years NLS has built a portfolio of enviable brand names and refocused its operations away from the low margin commercial fitness market to the higher margin consumer market, setting the stage for future growth and a premium valuation. In fact, NLS expressed its optimism for growth prospects in an investor presentation at the 15th Annual ICR Xchange on January 17, 2013 where it stated it:

“Sees significant EPS growth on an annual and quarterly basis.”

Company Description

Nautilus, Inc. (Nautilus) is a consumer fitness products company. The Company’s principal business activities include designing, developing, sourcing and marketing cardio and strength fitness products and related accessories for consumer use, primarily in the United States, Canada with some sales overseas. With a brand portfolio including Nautilus®, Bowflex®, TreadClimber®, Schwinn®, Schwinn FitnessTM, Universal® and CoreBody Reformerâ„¢, Nautilus markets innovative fitness products through Direct and Retail channels.

We can think of at least 4 reasons why NLS shares should rise from current levels

1. Iconic Brand Names that appeal to the Baby Boomer generation

The Baby Boomer generation is generally defined as individuals who were born from 1963 through 1964. This generation started consuming fitness during an era when Universal, Nautilus and Schwinn were providing consumers with alternatives to traditional fitness free weight exercises. Our youth is introduced to fitness mainly through gym classes or sports programs at school. This is particularly important with respect to NLS. Universal, Nautilus and Schwinn were absolutely the dominant players in the consumer fitness equipment segment during the years when the Baby Boomer generation started consuming fitness. Universal and Nautilus were the originators of the selectorized equipment that is used by many in current day exercise facilities. In addition, the bicycle of choice for this generation was Schwinn. For the post-school years of this era, those who watched television or contemplated a home exercise program would recognize Bowflex as an iconic name with significant brand awareness. As this generation continues to age, the emphasis towards maintaining good health will continue to rise. This puts NLS in the sweet spot to dominate this large market, specifically due to the premiere names that they own. Without a doubt, NLS is a leader in the home fitness market and possesses many of the top fitness names.

2. Margin Expansion

The company’s current goal is to achieve operating margins of 7 to 10%. In 2011, operating margins were 2% and have slightly exceeded this mark through the first nine months of 2012 (see footnote). Thus, significant growth in quarterly EPS should be in the cards well into the future. The company is currently benefiting from past measures that were designed to improve margins. For example, since 2007 the company has reduced its employee head count from 1700 to 330; since 2010 NLS has eliminated its entire 2010 $5.1M debt load. In 2009 Nautilus divested its unprofitable commercial business which it marketed to hotels, rehab centers and gyms. The commercial segment had significant overhead and operated at low margins. This has allowed the company to focus more on retail opportunities like Dicks, Sports Authority, and Amazon. In addition, the company is able to emphasize products directly to the customer. Nautilus previously had one source for production of its products. NLS outsources the manufacturing of its products; in the past, the company relied on just one firm to make its equipment. As part of the restructuring process, NLS now relies on multiple sources of production. This allows NLS to pick the manufacturer that offers the best pricing options, allowing costs to come down and margins to improve. Another catalyst for improving margins is the company’s operating leverage, meaning that income will grow faster than sales.

3. Market Expansion

International Sales

Nautilus (NLS) is seeking to expand its sales efforts internationally. International sales comprise approximately one percent of sales. This opportunity offers tremendous market potential. The United States is the market leader of the fitness industry, with approximately 40% of all facilities, 31% of fitness members and 30% of total international revenues, (IHRSA 2007). Approximately 45 other countries generate the rest of the market. These statistics show that two thirds of the available market is outside of the United States. As Nautilus expands its efforts internationally one can easily see the large potential with a market size two times that of the United States.

New Products (Home Exercise Videos)

Anyone remotely aware of current fitness trends has heard the name P90x and how this video fitness program has exploded with the home fitness video market. This video exercise program has opened the doors for other venues to enter the home fitness market. The sheer sales numbers of P90x are enough to capture anyone’s attention with a whopping 400 million in sales from 2001 through 2011. This market offers exciting potential from an investor’s vantage point due to its very high profit margins. Nautilus has entered this product category.

Housing Market Recovery

Nautilus revenue expansion is also correlated with and improving housing market. The rebounding housing market has been stressed by many market experts in the last several months, which has been substantiated by the flow of increasingly strong data related to this sector. As individuals choose home ownership vs. renting, the extra space needed for home fitness equipment and home gyms also becomes a reality.

4. Unique Competitive Advantage

The extension of credit has improved since the great recession, but has still been a source of angst for many businesses and consumers. With internal financing available for customers of Nautilus products, larger ticket sales can be expedited without the hindrance of third party lenders. This is a significant benefit that cannot be overlooked.

Valuation

The company just pre announced 2012 year end results that beat analyst expectations.

• Nautilus expects to report net sales of approximately $65.0 million for the fourth quarter of 2012, an increase of 8.4% compared to the fourth quarter of 2011. For the full year 2012, net sales are expected to approximate $194.0 million, an increase of 7.5% compared to 2011.
• Fully diluted earnings per share from continuing operations are estimated to be in the range of $0.21 – $0.23 for the fourth quarter of 2012, compared to $0.11 per share for the fourth quarter of 2011. Fully diluted earnings per share from continuing operations on a full year basis are expected to be in the range of $0.32 – $0.34 in 2012, versus $0.08 per share in 2011.

Analysts expect NLS to grow 2013 EPS around 30% to $0.40 on about $210 million in revenues.

NLS is selling at a price to sales multiple of 0.70. We believe this valuation significantly underplays:

• The company’s dominant market position in the consumer fitness industry
• A healthy balance sheet with a return on equity near 15%, and
• Reinvigorated growth prospects

All of these factors are expected to lead to successive quarterly favorable growth comps. We also believe that the market will be forced to quickly assign a price to sales multiple of at least 1.0. Based on 2013 revenue estimate we believe a reasonable near term price target for the stock should be $6.70.

Footnote: On January 16, 2012 the company reported preliminary fourth quarter 2012 results. However, management has not yet disclosed fully year operating margins, which is why we only reference nine month results for this statistic.

Disclosure: Long NLS

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