In this episode of Industry Focus, Motley Fool analysts Asit Sharma and Emily Flippen breakdown iFit's S-1 filing in anticipation of a potential future listing. 

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This video was recorded on Oct. 12, 2021.

Emily Flippen: Welcome to Industry Focus. Today is Tuesday, October 12th, and I'm your Consumer Goods host Emily Flippen. Today, I'm joined by Motley Fool analyst Asit Sharma to talk about iFit. It's the fitness platform that's attempting to disrupt at home workouts. Asit, thanks for joining.

Asit Sharma: Emily, thanks for having me and let me lob the first bad pun of this week to note that I fit this podcast in my busy schedule today.

Emily Flippen: Well, I and everybody listening certainly appreciate it. Although it might be worth noting before we get started that iFit actually, as I found out after preparing for today's show, naturally. They temporarily postponed their IPO. Thanks to volatility that we're seeing in the market today. It's just still be fun to dig into it. I know I have a personal connection with this company, and hopefully, this information becomes useful when they decide to reenter public markets, hopefully once the volatilities come down. But until then, I guess this is a prequel to maybe IPO coming up.

Asit Sharma: Yeah, this is one that we were both looking forward to, Emily, because as you're going to tell us, you've got some very regular connection with this company. Yeah, that consumer goods basket, we're going to have to revisit. We looked at Peloton. I still like Peloton as investment, I know it hasn't had a great year, but maybe going through iFit will also give us some more perspective on the industry at large.

Emily Flippen: It certainly did. I have to say, I was really excited to dig into this because I'm an iFit user myself. I believe late last year, I got myself a NordicTrack bike, which is powered by the iFit platform. I really think I fit, in my opinion, does a great job of providing some of the same experiences that you'd get with Peloton. In fact, if you're familiar with Peloton's business model, you're probably already familiar with what iFit does. They make the equipment like NordicTrack, they're the manufacturer, but they're also a platform for on-demand classes. When I pulled up the iFit S-1 and started just scroll through it, I found myself already excited because right there in one of the front pages was an iFit trainer. I frequently watches classes, sometimes live, Gideon Akande. He was right there in the filing, and I was excited. I was a member of this community, I felt like I was seeing a friend. I think iFit does do a similar job of Peloton in creating those feelings among users. At least, if my experience has anything to say about it.

Asit Sharma: I think it's a powerful business model, myself. To me, what interested me overall about this company is that Peloton punched out the awareness of the connected fitness industry, so it's the first mover. Maybe not the first mover as you're going to relate to us, but it's certainly is one that's captured a lot of fitness enthusiasts imagination. But here we've got a company which also has very well-known brands on the hardware side and a robust offering of content. For those of you who might think, "Well, this is like a second choice to Peloton." maybe not as great equipment or maybe the classes aren't as wide reaching or fun, after reading through the S-1 and just poking around on the web. Now, I don't use the products. I didn't feel that at all, I felt like it's just as good an offering and there's no reason not to weigh buying, say a NordicTrack and subscribing to iFit's services versus buying a Peloton and getting on their platform.

Emily Flippen: I will say, I think both the businesses or I should say platforms have moved in the same direction. I think their level of content that you'll get on both is relatively similar, that the average consumer probably has a hard time pulling it apart. The difference is that eye-drop between what iFit got started with versus Peloton is, Peloton was very focused on the studio experience. In fact, their bikes weren't built originally with the inclined and declined functions. It was studio experience intended to give you the stimulation of being in a live cycling class. Heavy focus on cycling, and they've obviously since expanded out into other avenues. Whereas iFit started with what was the experiential aspect of biking, which is, "We're going to go outdoors, we're going to show you a cool trail, we're going to go up and down a mountain." and then got into the studio and the live class experience. Maybe if your focus is on biking outdoors and nature, you might be inclined to go to iFit before Peloton. If you prefer the studio live class experience, Peloton as opposed to iFit. Although, again, it's worth knowing both of them do both now, so they truly are competitive in this space. But what I found really interesting is that iFit sounds like a new fancy tech start-up. When I got my NordicTrack, I had no idea that the iFit platform and the NordicTrack where both owned by the same company. The parent company which recently only changed its name to iFit is actually a really old business. The company that would eventually evolve into iFit today was actually founded as a company called Weslo back in 1977 by the current CEO and founder Scott Watterson. It's a really old business, a really interesting story.

Asit Sharma: Yeah. In 1977, I was walking around as a kid in bell-bottom jeans and Buster Brown shoes. That's the brand. [laughs] This is way back, Emily. Weslo started in the imported furniture business, importing furniture from Asia, worked its way along to selling grills into exercise equipment. Watterson eventually sold the Weslo business to a company called Weider Health and Fitness in 1989, but he stayed on as CEO. I think this is important because you've got in the CEO, a real veteran of the business, whose seen the complete evolution from those first bikes to what we have today with so much technology embedded exercise equipment. By 1994, Weslo was sold off again, this time to Bain Capital, who we mentioned on an off on this show as investors in various consumer goods companies. They started to market more aggressively and penetrate that health and fitness market. They added the brand, NordicTrack, purchased that, and FreeMotion, and then changed the name of the company to Icon Health & Fitness in 2010. This is where the company really started to transition into the company we know today as iFit. Now, in 2015, Foley started to have some success with Peloton. Watterson purchased the majority stake in iFit back from Bain Capital, which is not rare in this industry. Bain Capital, again, is a private equity firm. They're there to extract as much value as they can from the companies they invest in. A lot of times, that simply means cutting employees and squeezing [laughs] every last bit of juice out of a company's operations, but in some cases they will invest into growing industry as they did in this case. Watterson took a page from Peloton's playbook and you mentioned that the live and prerecorded classes, he added that element.

Emily Flippen: Yeah, that is so interesting. John Foley, the CEO and founder of Peloton, actually reportedly came to Eikon, but it's today iFit, back in 2013. He was asking for information and help on developing a stationary bike. iFit essentially turned them away, They said, "We're not giving you any of this stuff, leave." Then Foley went on to create what is today Peloton and had a ton of success with it. That's actually what kicked off at this point, which probably going to be a decades long legal battle between iFit and Peloton, about who owns the proprietary information behind the idea of a connected fitness bike. While the big losses have been settled, you'll note noting through their S-1 that they're still in a handful of legal battles with Peloton over things like the inclined, decline. Over the automatically adjustable resistance levels. These things that one business says they did before the other. Ultimately, I think an eye for an eye leaves everybody blind, and that's probably what we're going to see here. If I were these businesses, I'd be much more focused on creating a ecosystem that keeps people sticky. We'll talk about the numbers, but I think Peloton has done that better than iFit, at least so far.

Asit Sharma: Yeah, the one thing that iFit has done is to maybe over focus on looking over its shoulder, Emily. They have over 400 issued and pending patents. It's as if all along they knew that they have to patent every last step. That takes a lot of energy on management's part. In the industry like this, it almost sounds excessive to me. Maybe you have a point there of where investment and focus should be, it's more about creating that ecosystem. But what can you tell us about the members? This really stood out to me as something that begins to look persuasive in investment thesis. Although the companies got a few caveats that turned me off a bit, but this is a bright part of the business.

Emily Flippen: Yes. There's over six million members. I should clarify that a member isn't necessarily a paying subscriber. Right now, the parent company, iFit, has over 1 1/2 active subscribers. Within those active subscribers, there are people who are authorized users on a primary subscribers account, who would be considered members. People who are consuming free content from iFit, those people would also be considered members. Lots of members, less paying subscriber. But they've had nearly three billion dollars in gross merchandise value, which would make them the largest provider of fitness equipment in the United States by that GMV. They are very large prominent provider, and you're probably already familiar with a lot of their brands. We mentioned NordicTrack, the sales of NordicTrack machines make up more than 50 percent of their revenue, but they've also acquired ProForm, which is a quarter of revenue. iFit subscriptions themselves, that platform we're consuming the content. Those are only around another 13 percent. Right now, the subscription revenue is a pretty small part of this total revenue pie. That's important to note because when somebody comes in and they purchase, like myself, I have a NordicTrack bike. Buy a NordicTrack bike, you get one-year of that iFit subscription for free. Then after that, they start charging. That subscription, I believe it's $15 a month individually, $39 a month if you want a family of five users. That's where the business is trying to get more and more of its revenue, that's recurring revenue that's really, really high margin revenue. But right now, it's still very much a hardware business.

Asit Sharma: This is so interesting, Emily, that the company has such an investment in experiential content as well to make their subscribers members want to renew. The way I think of this industry is you have Peloton on one side, which is more equipment focus. All the way to spectrum of Lululemon's Mirror, which encompasses things like yoga, meditation, etc. But as you mentioned when we were preparing this episode. They've got pretty much everything that you can think of on their platform, which includes rowers, spinning. The yoga meditation that I was just talking about. This is something that the company exhibits a lot of strength in. They integrate this content seamlessly into touchscreen enabled hardware. If you've got an iFit bike or treadmill, not only do classes automatically adjust, but they learn from your fitness level. There is an element of, I would hesitate to call this like great AI. But I would say there's some element of machine learning in this. As the software is learning your experience level, you can adjust that. It will take you into another experiential fitness expedition, like hiking to ever space camp. You can adjust those settings back downward if it's too much. I found that aspect pretty intriguing. Now, here's a statistic that gave you a little bit of pause. I think let me see exactly what you've made it. This 16 percent of iFit subscribers who have been on the platform for more than three years have purchased multiple pieces of equipment. Emily, you said when we were playing this episode, am I the only one who's not really impressed with this? What did you mean by that?

Emily Flippen: Well, they define an a multiple piece of equipment as owning more than one connected fitness product. Somebody comes in like myself, who buys a connected NordicTrack bike. That has the screen on it, the touch screen that I'm paying for that iFit subscription with, somebody who would own multiple pieces of equipment would then say, oh man, I really wish I could have participated in that Everest base camp hike. That was something that was done on the treadmill equipment, not on the NordicTrack bike. After having a good experience on that bike, the next step would be then, OK, well, I'm going to buy the treadmill. Then I get access to the iFit content of treadmill based workouts. I can have both of those things in my universe. I know Peloton has spent a lot of time talking about how they'd create this flywheel effect with their ecosystem. Or when somebody comes in, they keep that average lifetime value really high because they're more likely to make future purchases. To meet that number was really overwhelming. We've already limited the sample supplies there to people who have been paying for iFit for more than three years. These are people pre-pandemic. These are people who are fitness enthusiasts. They were getting on the NordicTrack and iFit training very early. For those people that are still around paying after three-years, only 16 percent of them have made that decision to own more than one piece of equipment. That number could've been higher and I'd have gotten more excited. I almost feel like adding that in distracted. In my excitement, I appreciate knowing it beforehand, but it certainly didn't add to the story in my opinion.

Asit Sharma: Yes. If anything, it raised more questions. Well, let's move on to financials and just make a few big picture observations. Interactive hardware revenue is the lion's share of this company's topline. It's 87 percent of total revenue, 54 percent is generated from retail partners, think Amazon, Best Buy, Dick's, Costco, etc. They've got a good direct-to-consumer component that's 44 percent of the business. This interactive hardware piece has grown 108 percent year-over-year. Before COVID, it was growing at a rate of 16 percent year-over-year. But it's only got a gross margin of 35 percent, while that's up from 26 percent in 2019. For anyone who's been listening for the past year or so, I have a thumbnail that I will point you to for any kind of manufacturing and then you can smooth it there based on the sector or industry. But start with a 50 percent plus gross margin. If you're manufacturing any kind of widget, you are usually doing, OK when you consider your fixed expenses. That's a bit of a slim margin. Subscription revenue from iFit makes up the remaining 13 percent of revenue. As you might expect, that subscription revenue is growing very quickly and it's highly profitable. The subscription revenue grew 85 percent year-over-year in the most recent year. It was also growing pretty briskly. Vis-a-vis that interactive hardware before COVID grew 65 percent year-over-year at the year before COVID. Gross margin in this business is about 87 percent, which I really liked. Emily, what are your observations about these margins?

Emily Flippen: While you would just think that as more revenue come from subscription revenue, which is higher margin, as well as general improvements in both gross margins on the hardware side and the subscription side, that this business, if not being profitable, would at least have a declining net loss as a percentage of revenue. But in reality, it's actually the opposite. Operating losses, their percentage of revenue grew from 3 percent in 2019 to over 7 percent in 2021. This is just because of how much money they are funneling into sales and marketing expenses. That was up more than 120 percent year-over-year. They're really saying, we're not looking at cash right now. Again, they're not even operating cash flow positive this year because they are spending so much money trying to compete with other, I should say, competitors in the market. Peloton is just one of these competitors. It's probably the most formidable. But since iFit has product lines that range in the price of a few $100 to a few $1,000, not only are they competing with Peloton at the high-end, but they're competing with cheaper brands at the low-end as well. They're all across the spectrum here. I do wish that I had seen these margins getting better with time. Although I guess I can understand the mentality of if you really believe that the value of your customers so high, that it's worth it to spend a ton of cash on marketing to pull them into the ecosystem early, then I can buy on. We'll get to this, but I just don't see that leverage in their numbers as it exists today.

Asit Sharma: A little wary of that potential for leverage going forward. All that marketing spend, yes, it drove a doubling of fitness subscribers last year. Revenue doubled. But management really sees the hardware business as the key toward driving the ecosystem further. This margin model, if anything, might show further slacking, meaning it's going to have even less operating leverage. The company bulked up on inventory over the past four quarters. It increased at eight fold to 403 million. This is partly a reflection of a greater, higher sales level. But it's also a reflection of management going ahead and manufacturing more products. They're manufacturing models, actually an outsourced model. But still what they're doing with their cash is bulking up that balance sheet for future sales to drive that hardware part of their business. I'm a little skeptical of that. I almost wish they would slow down, take the foot off the gas pedal a little bit and let the ecosystem evolve more organically. I think it would have a better near-term impact on margins and it might be a better way to grow the business over the longer-term.

Emily Flippen: I was bumped by that too. As an iFit user myself, my focus has always been when I get on that bike and I try to get on that bike at least once a day. Although I will admit, I'm lazy here and there. Last week, I took the entire week off, for instance. But when I get on the bike, I'm not thinking about the equipment. I'm not to keep up the hardware. I'm thinking, well, what class am I going to do today? What new cool thing do I have on the platform? I look forward to what's next and I expected this to read a lot more focus on man, we're creating just a really sticky ecosystem of subscription level of revenue that's going to keep people engaged. But the focus on hardware makes me a bit concerned, especially as we head into what's probably going to be, and I think we've seen it a bit with Peloton's results. A challenging time for hardware workout equipment manufacturers to sell-through, especially at the rate that they did in 2020. 

That's made all the much more concerning to me when I look at some of the numbers they broke down. I'm bumped because they didn't provide a ton of great information, but they did at least break down their lifetime value per customer to their customer acquisition costs. I was really happy to see that their definitions for both of those terms were virtually exactly the same as Peloton's, which provided a nice one-to-one comparison when we look back at Peloton's IPO and the value of their customers versus iFit's. One of the metrics they broke down in addition to that was actually their net monthly churn by cohort. We talked about this so much for Peloton. Peloton has an impressively low monthly churn. It's always been below 1 percent. Most recently, 0.85 percent. That's for all of their products. They have a pretty high level of retention. NordicTrack's monthly churn, a lot more challenging. They say it's 2.3 percent in the most recent quarter, but they are excluding a lot of product sales as a part of that. If you include all of their product sales, the churn becomes closer to three percent. It's significantly higher than Peloton's.

Asit Sharma: Again, that's a per month number. [laughs] For those of you who are listening and saying, wait a minute, that's a per month numbers. That's very high. Emily, we just have a few minutes left. I want to ask you for any further thoughts on customer acquisition costs. I guess we should move to risks. I've got a couple of things and you've got a couple of things to point out as well. Any final thoughts on that long-term value per subscriber?

Emily Flippen: Just that it's not as impressive as you would hope that it would be their lifetime value per touchscreen products subscriber. Again, not all their customers was around $566. For NordicTrack, that numbers around $3,500, so significantly higher. While both NordicTrack and Peloton do have a customer acquisition cost that is greater than that lifetime value right now. For Peloton, it's closer to five dollars per customer. For iFit, more than $57 per customer. They're losing money on every customer acquired. I think it's an example of the type of person that buys a NordicTrack versus a Peloton or any iFit product. They are coming because they're getting a slightly cheaper product. They're not buying for the ecosystem. When that one-year membership is over, they're more likely to churn because they bought the bike, they didn't buy the platform. If you are a Peloton subscriber, yes, you're buying the bike, but in reality, you're buying the brand, you're buying the platform. You want to stay a member of that, so you're less likely to churn when your membership comes up for renewal.

Asit Sharma: Brand has so much to do with, I think Peloton's ability to retain its customers to keep that churn low. Just a risk here, I wanted to point out, this risks arise at the use of proceeds, which is one of the sections I read first in an S-1. The company is going to be refinancing some debt that's on the books. It expects that net about 465 million bucks. Part of that will be used to pay down around 300 million in existing notes, and they've got some preferred shares they want to redeem, which are $262 million worth. They're going to come away with this, with still net debt on the books. The CEO is going to receive a onetime award of 35 million dollars, which isn't specified as exactly what the prominence of it is it an incentive for taking a company public, etc, we don't know. That's OK. What is a little concerning to me is that the company has about $53.2 million in loans to management on books, and additionally one loan to an unnamed executive for 9.3 million. 

Now, in preparation for this IPO, to comply with the Sarbanes-Oxley Act, the company forgave these $62.5 million worth of loans that management owed the company, so that they could go public and be in compliance with the Securities and Registration Acts and the Sarbanes-Oxley level of compliance that came much later. What concerns me is now the company's pulled its IPO Emily, because of market conditions. What if they decide never to go public, we've seen this happen so many times. In essence, the management team will have received $62.5 million worth of loan forgiveness, i.e. income. It just reminds me that this is a company that has been held for a long time. Run is almost a family business which is a risk we're going to talk about here in a second. Sometimes, it takes a little bit of shifting for management team to act like a public company rather than one that's run by just a closely knit family and group of hands. But this segues into a risks that you want to talk about.

Emily Flippen: Yeah, it's a bit disingenuous isn't it and the risks that I want to talk about was, something that we typically associate as a good thing with the business, which is that this is a founder-led business controlled and operated by CEO/founder. Typically, that's a good thing, and there are some things I do like about the ownership structure. One thing that we haven't mentioned is that, Planet Fitness is actually a minority owner in this business. They have some interesting partnerships with them. But the big risk here is that it's not just the founder/CEO, it's a family business. When I see a ton of family that not to be rude, is otherwise not necessarily qualified for the roles that they are sitting in. It starts to make me a little bit nervous, and so the Chief Experience Officer, the Chief Strategy Officer, the Chief Operating Officer, and the Chief Marketing Officer are all family of Scott Watterson's, and even more concerning is the fact that none of them have professional experience prior to coming onto iFit. So they all went straight out of undergrad into the company. Well, they've been in their roles for a long time. It does make me wonder if this company was genuine about ever wanting to go public. These are people who are otherwise probably wouldn't be qualified to sit in their roles at a public company. Management is getting that $60 million kickback for just have been filed in the first place. It does strike me as a little bit, I guess shady is the word I'm looking for.

Asit Sharma: I mean, we'll see time will tell, but it's not a good look to begin with, so we'll give them the benefit of the doubt for now, Emily. But I share your concerns, especially with this element of having group of family members elevated to basically the C-suite. It's sometimes hard to get the correct amount of push back, and tug between consensus, decision-making and thoughtful exercises, where people aren't afraid to contribute their opinions. In family businesses, sometimes, you see a dominant founder, i.e. dad, can exert over sized influence on the rest of the management team. I'm not sure how that translates into the public sphere.

Emily Flippen: Well lets hope we understand when to keep our eye on regardless. Selfishly, I hope that this business does continue to put a ton of money into the iFit platform because as the user myself, I am a big fan. But as an investor, I have not sweating the fact that I own Peloton shares, not iFit shares, even if they were publicly available. Simply because the metrics that we've been provided here make me think that one has set itself apart from the other.

Asit Sharma: For sure. Well, Emily, this was a lot of fun and I feel much more fit after this exercise for the last half hour. Thanks so much.

Emily Flippen: Thanks for joining me and thank you for the puns as always. Listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out to say, hey. You can shoot us an email at industryfocus@fool.com or tweet us @mfindustryfocus. As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for his work behind the screen today. For Asit Sharma. I'm Emily Flippen. Thanks for listening and Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.