If you've ever faced a really tough decision in life, you may have resorted to the good old Pro-Con list. You know the drill -- pros on the left side of the page; cons on the right; whichever list is longer wins. That's what I found myself forced to do in assessing one of the current Foolish 8 stocks, Direct Focus (Nasdaq: DFXI), a fast-growing exercise equipment company that has a confounding mix of positives and negatives.
Before diving into the pros and cons, first a little about the business. Direct Focus markets a variety of branded fitness equipment, some of it through distributors and retailers, but most of it on a direct-to-consumer basis (hence the name Direct Focus). The crown jewel of the company's product line is the Bowflex home exercise machine, which comprised 74% of sales in 2001.
You've almost certainly seen the Bowflex advertised on television, especially if you're a late-night channel surfer. The company uses both spot TV advertising and infomercials to sell Bowflex directly to consumers. Removing wholesalers and retailers from the equation, along with the requisite inventory, allows the company's direct business to earn a gross margin above 70%, a net margin above 20%, and an extraordinary return on average assets of 69% (2001).
The company also markets the StairMaster, Nautilus, and Schwinn lines of fitness equipment. These products are sold through distributors and retailers, which reduces the gross margin to around 30% and the net margin to 5%. Return on average assets last year for this segment was only 5.8%. Direct Focus acquired these lines over the past few years in order to diversify its product line and become a complete provider of products to the health and fitness industry.
Overall and including the acquired businesses, Direct Focus has grown its sales from $21.5 million in 1997 to $363.9 million in 2001 -- an amazing 103% compound annual growth rate. In the just-completed first quarter, sales soared another 82% to $135.9 million. Bowflex sales made up approximately 61% of the mix, a figure which I estimated based on a reported 59,000 units sold at an average selling price of $1,400. Outside the direct channel, commercial and retail sales made up 33% of revenues, up from 10% last year, due to the recent acquisitions of StairMaster and Schwinn Fitness. The higher sales from the less-profitable, non-direct businesses caused a decline in the overall gross margin from 66% to 57% and in net margin from 19.6% to 17.7%. The company stated that it expects the direct/non-direct mix for all of 2002 to be approximately 60/40, compared to 80/20 last year.
The Pros
As you can see, there's a lot to like about the Direct Focus business. The company makes the cut on all eight of our Foolish small-cap criteria, which means it has profitable growth, solid inside ownership (11.2%), and a stock that's growing with the business (up 107% over the past year).
In addition, I like the fact that Direct Focus has made its three acquisitions entirely through cash, leaving not a penny of debt on the balance sheet. The company acquired Nautilus in 1999 for $16.6 million, Schwinn Fitness in 2001 for $69.8 million, and StairMaster in February 2002 for $25.8 million. The company's strong free cash flow funded all three purchases.
Also on the pro side is that, even without these acquisitions, growth has been strong. Through purely organic growth, direct business revenues (comprised 90% of Bowflex) have increased from $113 million in 1999 to $198 million in 2000 to $293 million in 2001 -- 61% compound annual growth. The company's new Ultimate Bowflex, which sells for over $2,000, is on back-order because demand has so substantially exceeded management's expectations.
This strong growth reflects the fitness trend in America, which is working to the company's advantage. Research from the National Sporting Goods Association (NSGA) indicates that Americans are not only exercising more but are also exercising more with fitness equipment. According to the NSGA, the percentage of U.S. consumers above the age of seven who participated in exercise with fitness equipment rose from 35.3% in 1990 to 44.8% in 2000.
One final pro worth noting is the company's expertise in direct marketing. Infomercials may seem cheesy, but Direct Focus has made a science of it. The company typically produces several infomercials at a time, which maximizes production efficiencies, and then management scrupulously tracks the results. Direct Focus uses 1,000 different 1-800 numbers in order to measure exactly which ads customers are responding to.
The Cons
For all of the positive attributes of Direct Focus, I found just as many unsavory qualities that also need to be carefully considered.
First and foremost among the cons is the skimpy information offered to investors about individual product line sales. Management refuses to break out sales for any of the products other than Bowflex, which makes it difficult for investors to identify organic growth versus growth by acquisition. It's almost as if the company doesn't want investors to see the company's true underlying growth rate.
Second and similarly, management was evasive on several occasions in the recent Q1 earnings conference call. For example, during the formal part of the call, management increased its 2002 guidance to 60% sales growth and 40% net income growth, up significantly from previous guidance of 40% and 30%, respectively. The factors behind this increase in guidance didn't become clear until the Q&A session of the call when an analyst finally wrangled out the fact that most of this increase in guidance was due to the acquisition of StairMaster. That's quite a material omission in my opinion. Another example on the call came when an analyst asked about the potential impact on Bowflex sales from a competing product by Gold's Gym called PowerFlex. Management wouldn't say more than, "We haven't seen it or felt it at this time." Also, when asked about the potential for sequential sales to taper off in a year from now as the Bowflex line matures, management again resorted to the lame response, "We haven't seen that."
The third con to note is that fitness equipment is a highly unpredictable business given that it's a high-price, one-time-purchase product. At some point Bowflex sales will peak out and growth could slow dramatically, or even decline. Once demand is satisfied for the new Ultimate Bowflex model, growth will likely begin to slow.
Fourth, Direct Focus has key Bowflex patents that will expire in April 2004. Obviously the company will continue to benefit from its trademarks and trade secrets, but inevitably other bow-resistance products will come on the market and profit margins will be squeezed.
Fifth and finally, one of the company's major costs is television advertising and higher ad rates loom in the future as the economy improves. In 2001, Direct Focus spent $63.6 million on advertising, or 17.5% of sales. An increase in ad pricing, which is highly likely over the next 12-24 months, would likely steal several percentage points of net profit margin.
Conclusion
The last consideration for Direct Focus is its price. The stock closed on Friday at $42.13, giving it a market cap of $1.5 billion. At that price, the stock trades for around 20 times trailing earnings and 16 times estimated 2002 earnings. For a fast-growing company, this price looks pretty reasonable on the surface, but I'm hesitant based on the concerns noted above, especially the potential for business to weaken in the next few years and the subtle signs that management may not be 100% forthright.
While a sufficiently low price can offset even the most treacherous imbalance of cons versus pros, I don't like the risk/reward profile at the current price. Considering that 21.5% of the stock's float is short, other investors apparently agree that not all is rosy in this picture.
Matt Richey is a senior investment analyst for The Motley Fool. He fell for an infomercial once and bought a car wash pack, which he never used. At the time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.
