Corporate Finance of Nautilus - Research Paper Example

? Corporate Finance Nautilus Executive Summary Sales growth is very poor, and the products are not sufficiently balanced or diversified Equity investors cannot be pleased with the company’s performance, which offers very low or negative returns The company is not profitable, as it has been making heavy losses during most of the period under study Assets are not working hard enough, and have been showing steady decline in value Financial leverage has been increasing and is inappropriate, as it is not only high, but is also not accompanied by corresponding growth in assets. Equity has shown negative growth during most of the years, and only a small positive growth in the last year. Both operating and free cash flows have been good, but this has come mainly through liquidation of current assets, and hence is not sustainable. The company seems to be highly risky on almost every count. The appropriate discount rate is 6.04%, which is the weighted average cost of capital. The present value of the firm with this discount factor and the predicted cash flows is $12,885,000. Introduction Nautilus Inc. is a Consumer Fitness Products Company founded in 1986 and headquartered in Vancouver, Washington. The company was incorporated in 1993 in the state of Washington. The company targets individuals and enthusiasts who wish to enjoy the benefits of regular exercise and thereby improve their health. The company sells its products through two channels – direct and retail. The main objective of corporate finance is to maximize the value of shareholders by making proper investment and financing decisions. This paper examines the extent to which Nautilus has been successful in meeting this objective, and whether the stocks of the company represent a safe and worthwhile investment. Observations In order to evaluate the performance and financial status of the company, some of the important financial ratios, trends and market information were collected and analyzed. Some of the important financial figures for a period of five years between 2007 and 2011 are shown in Appendix-1. Relevant ratios have been calculated and are shown in Appendix-2. Sales The growth in sales for the year ended December 31, 2011 was 7.1% over the figures of 2010. However, for the three preceding years the growth has been negative. The trend has been good, and in each year the negative growth has been reduced, and the growth rate has become positive in 2011. The company operates in two segments, namely direct sales and retail sales. The segment wise sales figures for the years 2010 and 2011 are shown in Table-1. It can be seen that direct sales constituted almost 60% of the total sales, while retail sales made up the remaining 40%. A small portion of the total income has come from royalty. A look at the distribution of the sales shows that cardio products accounted for the major portion of the sales accounting for 42% of the direct sales in 2011 and 32% in 2010. Overall, cardio products accounted for 66.35% in 2011. Cardio products have also shown a healthy growth in direct sales but a small decline in retail sales. Strength products accounted for 31.02% in 2011. Percentage of Total Year Ended December 31, 2011 2010 Change % Change 2011 2010 Direct net sales: Cardio products (1) $75,982 $54,409 $21,573 39.60% 42.12% 32.30% Strength products (2) 31,079 42,259 -11,180 -26.50% 17.23% 25.09% Total Direct net sales 107,061 96,668 10,393 10.80% 59.34% 57.39% Retail net sales: Cardio products (1) 43,718 43,628 90 0.20% 24.23% 25.90% Strength products (2) 24,873 24,161 712 2.90% 13.79% 14.34% Total Retail net sales 68,591 67,789 802 1.20% 38.02% 40.24% Royalty income 4,760 3,993 767 19.20% 2.64% 2.37% Total net sales $180,412 $168,450 $11,962 7.10% 100.00% 100.00% Table-1 Distribution and Growth of Sales1 Equity Growth and Profitability Equity investors are concerned primarily with the return on their investment and the growth of their wealth. Various profitability ratios and equity growth are showninTable-2 Profitability 2011 2010 2009 2008 2007 Return on Equity 4.44% -74.16% -101.55% -87.37% -28.31% Gross Margin 43.49% 45.56% 51.00% 47.86% 35.77% Net Margin 1.99% -5.68% -15.43% -20.26% -13.68% Return on Investment 1.71% -29.15% -46.28% -45.86% -14.23% Return on Assets 1.71% -29.15% -46.28% -45.86% -14.23% Equity Growth 3.75% -41.32% -49.38% -47.22% Table-2 Profitability Ratios2 The return on equity has been fluctuating widely over the years and has been negative for four of the five years. The other profitability indices, barring gross margin, have shown a similar trend. While the profitability has become marginally positive in 2011, and the trend shows an improvement over the last three years, the profitability is far from satisfactory. Figure-1 and figure-2 show the profitability and equity growth in graphical form. Figure-1 Profitability Trends Figure-2 Equity Growth3 Efficiency Ratios – Asset Utilization The efficiency ratios are shown in Table-3. Asset turnover has been 2.18 in 2011. Although the figure appears to be low in absolute terms, the trend has been positive. Inventory turnover was 8.79 and receivables turnover was 7.59 in 2011. In both cases the trend has been an improving one. The trends can be readily seen from figure-3. Efficiency 2011 2010 2009 2008 2007 Asset Turnover 2.1785 2.1495 1.6433 1.4364 1.2831 Inventory Turnover 8.7883 8.8629 7.0695 3.3772 5.4678 Receivables Turnover 7.5867 8.5799 6.8082 5.2764 5.6785 Table-3 Efficiency Ratios4 Figure-3 Asset Turnover Ratios5 Asset Growth Assets have registered a negative growth during the first four years, and have shown a small increase in the last year. The trend in the value of the assets can be seen from Table-4 and Figure-4. 2011 2010 2009 2008 2007 Total current assets 58,087 51,595 77,263 126,701 276,720 Total assets 82,813 78,367 115,172 197,519 390,840 Table-4 Growth in Assets6 Figure-4 Chart Showing Asset Growth 7 Financial Leverage The debt-to-equity and the debt-to-asset ratios are shown in Table-5. The debt component has been increasing over the years. In the years 2007 and 2008, the debt component was slightly less than the equity component. However, this has changed in 2009, and the debt component is quite high in 2011. Year 2011 2010 2009 2008 2007 Debt-to-Equity 1.5917 1.5445 1.1945 0.9050 0.9895 Debt Ratio (Debt-to-Assets) 0.6142 0.6070 0.5443 0.4751 0.4974 Table-5 Debt Ratios8 The trend of the debt ratios can be readily seen from figure-5. Figure-5 Trend of Debt Ratios9 Cash Flows The operating and free cash flows for the five years 2007-2011 are shown in Table-6. 2011 2010 2009 2008 2007 Operating Cash Flow 4,598 -10,659 14,782 5,570 8,504 Free Cash Flow 3131 7007 1742 -2364 3649 Table-6 Operating and Free Cash Flows10 Although the years 2007 to 2010 recorded losses of 55,613, 90,588, 53,297, and 22,841 respectively, the operating cash flows have been positive for the first three years, and -10,659, against a loss of 55,613, in 2010. A look at the trade receivables and inventories figures for these years provides an explanation of how this has been achieved. The figures are shown in Table-7 for ready reference. Year Ended December 31 2011 2010 2009 2008 2007 Trade receivables 23,780 19,633 27,799 53,770 88,311 Inventories 11,601 10,347 13,119 43,802 58,910 Change in Receivables + Inventories (5401) 10938 56654 49649 Table-7 Trade Receivables and Inventories11 The substantial decrease in inventories and receivables has contributed to the increase in the cash flows offsetting the effect of the huge losses in these years. Analysis Sales Sales growth has been negative for all the years except the last year. In the last year, the sales growth was 7.1%. From these figures, it can be seen that the overall sales growth has been far from satisfactory. However, the company has managed to break a fairly long period of negative growth and has entered into a positive growth phase in the latest year. If this trend continues, the company can achieve a respectable growth in sales. Sales are not diversified well. There are just two segments and two product categories. Each of the product categories is made up of a very limited number of products. No new product seems to have been introduced in a fairly long period of time. The products are also not balanced, as three is heavy reliance on a single product. Thus the sales growth is very sluggish, and the products are neither diversified nor balanced. Equity Investors Equity investors have no reason to be happy with the company’s performance. The return on equity was negative in four of the five years under study. The latest year has shown a positive return, but considering the risk associated with the investment, this return is too low. The profitability ratios do not show a very bright picture. Moreover the growth in shareholders’ wealth has also been negative for most of the period, and very low in the only year in which there was some growth. Profitability The Company has not been profitable during the first four of the last five years. During this period, it has reported fairly heavy losses. Return on equity, return on assets, return on investment, and net margin were negative for the first four years, and positive but very low in the latest year. Only the gross margin has been good. Thus the company has not been profitable enough. During the first three years, the magnitude of losses has shown an increasing trend. However, the losses have decreased in the fourth year, and the company has made a small profit in the latest year. Although the trend is encouraging, the growth in profit cannot be considered good because of the wide fluctuations and heavy losses during most of this period. Efficiency of Assets The assets turnover has varied between 1.28 and 1.64 in the first three years, indicating that the assets are not generating sufficient income. The asset turnover has increased in the last two years, but the figure continues to be very low in absolute terms. Both inventory and receivables turnover have been good for the last three years, and the trend is also positive. On the whole, asset management can only be described as average. Asset growth has been negative, and both current assets and total assets have steadily declined in value over the years, showing a decline in the wealth of the firm. Effect and Appropriateness of Financial Leverage The company has steadily transited from a position of low leverage to one of high leverage. As of December 2011, the leverage is fairly high. The effect of this is to increase the riskiness of the firm in terms of its solvency. At the same time, this approach has brought down the weighted average cost of capital substantially. The high leverage employed by the company is not appropriate as it has been suffering heavy losses over the past several years. The increase in leverage appears to be due to the failure to generate the required funds internally because of the losses suffered. The capital structure is inappropriate on several counts. Firstly, the company’s profitability has been negative or very low, making debt servicing in the future a major question. This could increase the risk of becoming unable to meet long-term commitments and make the firm less solvent. Secondly, the high leverage will make it difficult for the company to raise more loans in future. Given the poor returns on equity, the company will also find it difficult to raise fresh equity capital. Thus this policy could make it difficult for the company to raise the required capital in future. Thirdly, the increase in leverage is not accompanied by corresponding increases in the asset base of the company. Stockholders’ equity has registered a steep decline because of erosion in retained earnings in the face of continued losses. The increase in the debt-equity ratio against such a background clearly shows that there has been a substantial increase in the amount of loan funds. However, such increased loans are not accompanied by increase in assets. In fact, assets have also declined during the period. This shows that the debt funds have been utilized to offset losses, and hence the high leverage is most inappropriate. Growth of Equity As can be seen from figure-2, equity growth has been negative for most of the period. What is of greater concern is the magnitude of the erosion on a consistent basis. During three of the four years, equity has actually declined by 40-50% each year. The value of the stock in the hands of the equity shareholder has come down steadily and substantially. This is reflected to some extent by the market price of the stock, which has been stagnant for the last three years, but has suffered a sharp decline in the second year of this analysis. Operating and Free Cash Flows The operating and free cash flows are shown in Table-6, which is reproduced below for ease of reference. 2011 2010 2009 2008 2007 Operating Cash Flow 4,598 -10,659 14,782 5,570 8,504 Free Cash Flow 3131 7007 1742 -2364 3649 Table-6.12 Both operating cash flows and free cash flows have been quite good. Operating cash flows were positive for the first three years, although the company has been making substantial losses during this period. Similarly, free cash flow has been positive except in the year 2008. However, the positive operating cash flows are misleading and do not represent a healthy financial performance during these years. The positive cash flows were mainly on account of reductions in receivables and inventories. This is obviously not sustainable in the long run. Already these assets have reached their low levels and the year 2011 shows an increase in these two current assets. The good part is that in spite of increases in both receivables and inventories, the latest year shows positive cash flows. While the earlier cash flows are clearly not sustainable, the firm should be able to sustain the positive cash flows if it continues to generate profits in the future. Predicted Free Cash Flows for the next Five Years The free cash flows are predicted for the next five years assuming that the behavior of the company will not change. Implicit in this assumption are the following assumptions which have been used in making the projections. 1. The Growth rate for the latest year was 7.10%. It is assumed that this growth rate will be maintained for the next five years. 2. Cost of Sales was 0.5651 of Sales. It is assumed that this figure will be maintained over the next five years. 3. Operating expenses, other expenses, and income tax are also assumed to remain at a constant percentage of sales, operating expense, and net income respectively. Table-8 shows the predicted cash flows under these assumptions. Net cash flows from investment and financing activities are assumed to be nil. The free cash flows for the five years 2012-2016 under these assumptions work out to 2,679, 2,869, 3,072, 3,291, and 3,524. 2011 2012 2013 2014 2015 2016 Factor Sales 180,412 193,221 206,940 221,633 237,369 254,222 7.10% Cost of Sales 101,953 109,192 116,944 125,247 134,140 143,664 0.565112 Gross Profit 78,459 84,030 89,996 96,385 103,229 110,558 Operating Expenses 74,860 80,175 85,867 91,964 98,494 105,487 0.414939 Operating Income (Loss) 3,599 3,855 4,128 4,421 4,735 5,071 Other Income (Expenxe) 412 441 473 506 542 581 0.005504 Income (Loss) from Operations 3,187 3,413 3,656 3,915 4,193 4,491 Income Tax 686 735 787 843 903 967 0.215249 Net Income (Loss) 2,501 2,679 2,869 3,072 3,291 3,524 Table-8 Predicted Free Cash Flows How Risky is the Company Risk can be assessed on various grounds. Unpredictability of the performance of the company based on the high volatility in the results indicates higher risk. Both the market price of the stock and the financial performance of the firm show a very high level of volatility. Secondly, the high leverage of the firm, against the background of heavy losses, indicates that the company has been borrowing indiscriminately to make up for the losses. This makes the company risky by placing pressure on its solvency in the long term. Thirdly, the company operates in a highly competitive environment and does not seem to have a differentiating factor that can help it to outperform competition. New products have not been introduced and there seems to be little innovation in either the products or marketing strategy. Price differentiation also appears to be difficult given its track record of losses. Thus on all counts, the company appears to be highly risky. Discount Factor Using the Capital Asset Pricing Model (CAPM), the cost of equity capital for the firm has first been worked out. The assumptions and calculations are shown below. Assumptions 1. The risk free rate has been assumed as 2.16%. This is the current rate on 10-year US Treasury bonds 2. The market return has been assumed as 8% The cost of equity capital under the CAPM is given by Re = Rf + ? * (Rm-Rf), where Re = Expected return (Cost of capital) Rf = Risk free rate Rm = Market rate Substituting, Re = 2.16 + 2.14 * (8-2.16) = 2.16 + 2.14* 5.84 = 14.6576 This rate represents the return expected by the equity investors. The total long term debt was 5,598. The financing costs were 35. The average interest rate works out to 35/5598 = 0.625%. The cost of debt capital = 0.625% Debt-to-Equity Ratio = 1.59 Hence the weighted average cost of capital = (1.59 * 0.625 + 14.66)/2.59 = (0.99375 + 14.66)/ 2.59 = 6.04% This is taken as the discount factor. The weighted average cost of capital represents the minimum return that the business must earn in order to meet the expectations of various classes of investors, and hence it is taken as the discount factor. The present value of the predicted cash flows with a discount factor of 6.04% is 12,885 (all figures are in thousands of dollars). Conclusion Most financial indicators show the company in a very poor light. The profitability of the company is very poor, and the leverage is high and inappropriate for the situation of the company. There has been no growth in equity or assets. Assets are not being utilized well. Cash flow has been good, but only because of liquidation of current assets, and hence this is not sustainable. Given this situation, the stocks of the company do not represent a good investment for equity holders. However, the trend for the latest year has been to reverse most of these shortcomings, and if this trend can be maintained, the company could become somewhat attractive in the next five years. References Nautilus (2012) United States Securities and Exchange Commission: Form 10-K, Nautilus, Inc. Retrieved April 9, 2012 from http://investors.nautilusinc.com/sec.cfm?DocType=Annual Yahoo! Finance (2012) Nautilus, Inc. (NLS). Retrieved April 9, 2012 from http://finance.yahoo.com/q/hp?s=NLS&a=11&b=31&c=2007&d=11&e=31&f=2012&g=m Appendix-1 2011 2010 2009 2008 2007 Net sales 180,412 168,450 189,260 283,712 501,471 Cost of sales 101,953 91,704 92,745 147,930 322,108 Gross profit 78,459 76,746 96,515 135,782 179,363 Operating expenses: Selling and marketing 54,494 64,039 75,827 107,613 181,244 General and administrative 17,143 19,371 24,616 35,353 74,606 Research and development 3,223 2,905 5,222 6,615 10,425 Restructuring/ Litigation Setttlement 14,151 13,938 (18,300) Intangible asset impairments 5,904 —   Goodwill impairment —   29,755 Total operating expenses 74,860 86,315 125,720 193,274 247,975 Operating Income (loss) 3,599 (29,205) (57,492) (68,612) Total Other Income (Expense) (412) 339 (285) (1,023) Income (Loss) from Continuing Ops BT 3,187 (9,230) (29,490) (58,515) Income Tax Expense 686 588 (10,880) (5,918) Income (Loss) from Continuing Ops 2,501 (9,818) (18,610) (52,597) Income (Loss) from Discontinued Ops (1,081) (13,023) (34,687) (37,991) Net Income (Loss) 1,420 (22,841) (53,297) (90,588) (55,613) Net Income (Loss) per share 0.05 (0.74) (1.74) (2.91) (1.76) Weigted Average Shares Outstanding (Diluted) 30,776 30,744 30,664 31,117 31538 Cash and cash equivalents 17,427 14,296 7,289 5,547 7,911 Restricted cash 0 351 54 266 Trade receivables 23,780 19,633 27,799 53,770 88,311 Inventories 11,601 10,347 13,119 43,802 58,910 Prepaids and other current assets 4,433 5,331 5,043 11,362 13,759 Income taxes receivable 454 456 13,178 11,954 11,382 Short-term notes receivable 317 832 2,384 Assets of discontinued operation held-for-sale — 292 10,781 —   75,448 Deferred income tax assets 75 57 18,615 Total current assets 58,087 51,595 77,263 126,701 276,720 Property, plant and equipment, net 4,405 3,795 8,042 32,883 42,291 Goodwill 2,873 2,931 2,794 2,398 32,743 Other intangible assets, net 16,716 18,774 20,838 34,403 39,086 Other assets 732 1,272 1,302 1,134 Total assets 82,813 78,367 115,172 197,519 390,840 LIABILITIES AND STOCKHOLDERS' EQUITY Trade payables 28,563 24,535 37,107 38,198 43,993 Accrued liabilities 7,218 7,045 10,744 15,128 37,318 Short-term Borrowings —   17,944 79,000 Warranty obligations, current portion/Customer Deposits 1,803 3,539 7,129 15,344 2,925 Liabilities of Discontinued Operations 15,867 Deferred income tax liabilities 1,064 1,160 1,220 919 283 Total current liabilities 38,648 36,279 56,200 87,533 179,386 Long-term notes payable 5,598 5,141 Warranty obligations, non-current 214 396 6,919 Income taxes payable, non-current 3,658 3,210 2,866 2,061 2,958 Deferred income tax liabilities, non-current 1,434 1,008 754 1,037 5,123 Other long-term liabilities 1,308 1,534 2,869 3,203 Total liabilities 50,860 47,568 62,689 93,834 194,386 Commitments and contingencies (Note 15) Stockholders' equity: Common stock - no par value, 75,000 shares authorized, 30,747 and 30,744 shares issued and outstanding at December 31, 2011 and 2010, respectively 5,360 5,051 4,414 3,207 4,346 Retained earnings 19,715 18,295 41,136 94,433 185,021 Accumulated other comprehensive income 6,878 7,453 6,933 6,045 7,087 Total stockholders' equity 31,953 30,799 52,483 103,685 196,454 Total liabilities and stockholders' equity 82,813 78,367 115,172 197,519 390,840 Market Price as on 31 Dec 2.41 2.44 2.51 1.39 4.65 Appendix-2 Year 2011 2010 2009 2008 2007 Growth Sales Growth 7.10% -11.00% -33.29% -43.42% Equity Growth 3.75% -41.32% -49.38% -47.22% Cash Flow 2,780 7,304 1,530 -2,098 7,911 Profitability Return on Equity 4.44% -74.16% -101.55% -87.37% -28.31% Gross Margin 43.49% 45.56% 51.00% 47.86% 35.77% Net Margin 1.99% -5.68% -15.43% -20.26% -13.68% Return on Investment 1.71% -29.15% -46.28% -45.86% -14.23% Return on Assets 1.71% -29.15% -46.28% -45.86% -14.23% Efficiency Asset Turnover 2.1785 2.1495 1.6433 1.4364 1.2831 Inventory Turnover 8.7883 8.8629 7.0695 3.3772 5.4678 Receivables Turnover 7.5867 8.5799 6.8082 5.2764 5.6785 Liquidity Current Ratio 1.5030 1.4222 1.3748 1.4475 1.5426 Acid-test Ratio 1.2028 1.1370 1.1414 0.9471 1.2142 Solvency Debt-to-Equity 1.5917 1.5445 1.1945 0.9050 0.9895 Debt Ratio (Debt-to-Assets) 0.6142 0.6070 0.5443 0.4751 0.4974 Market Performance EPS 0.05 (0.74) (1.74) (2.91) (1.76) P/E Ratio 48.2 -3.2973 -1.44253 -0.47766 -2.64205 Read More