Half Netflix/Half Lulu, Gaiam to Unlock Value Via Streaming Video Spin

The ancient discipline of Yoga is on the rise. According to the USA Today, participation grew over 40% between 2008 and 2013. Internet video is clearly on the ascendancy as well. When combined, there's the foundation for a powerful opportunity. Yoga apparel manufacturer/video producer-distributor Gaiam sits prominently positioned to ride that dual tailwind effect, according to Privet Fund Management’s Ross Heller.

Gaiam is uniquely positioned to ride the waves of yoga and streaming and has begun capturing the yoga interest (and business) of hundreds of thousands of Americans that don’t seek trendy yoga studios or flagship stores, but simply want to enjoy a quality yoga experience in the comfort of their homes. After an upcoming spin-off of Gaiam’s yoga video streaming division and the opportunity to expand into new retail markets, Heller thinks Gaiam has the potential to double the yoga, and double in value.

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SumZero: What about Gaiam initially caught your attention as a value investor?

Ross Heller, Privet Fund Management: We think the current situation is an incredible opportunity from a risk/reward standpoint. Gaiam is a well-established, widely known brand that has just launched a new product line to greatly broaden its appeal and an incredibly high growth, recurring revenue streaming content business all housed under the same roof. Not only are the businesses undervalued by the market, but they will be separated within three months as the high growth subscription business will be spun off to shareholders. We think this will bring meaningful clarity and attention to the situation and should result in a substantial increase in the market price of the company. We have a one year price target of $13 on the stock (eventually the combined prices of both independent companies), which is more than 110% above the current market price.

Gaiam is a business that benefits from massive secular tailwinds in athleisure, yoga, wellness and subscription video on-demand (or “SVOD”) services. It’s pretty unique to find one company that can capitalize on all these trends with brands, products and services that it has already developed. For years, Gaiam has been a leading yoga accessories brand providing authentic yoga mats, towels, blocks, and other products. Gaiam’s sole focus and dedication to providing innovative solutions to the yoga community has created a unique authenticity that has resonated with consumers. Multiple studies have shown that the Gaiam brand has a high level of brand recognition and is often one of the top three companies consumers associate with yoga (behind Lululemon and Nike).

Gaiam only recently began to leverage the power of its brand outside of basic yoga equipment -- first through its entry into the wellness category with its “Gaiam Restore” products. Many of these products were developed to enable large broadline retailers to execute on their publicly announced strategic initiatives to grow in the “better for you” health and wellness category. By leveraging their brand awareness and authenticity in this category, large retailers like Target and Kohl’s have allowed Gaiam to become a very visible, anchor brand in their stores.

What we believe will have the biggest impact over the next one to two years is Gaiam’s next brand extension into apparel. Gaiam recently launched an exclusive partnership with Kohl’s to distribute Gaiam-branded women’s apparel in all 1,176 Kohl’s stores. This nationwide rollout only began in late April 2015 and, so far, the sell-through appears to be tracking ahead of expectations. We view this as a significant opportunity for the Company, as Gaiam only achieved $166 million in sales last year (2014) and we project revenue from the apparel launch to approach $20 million in the first eight months of the initiative. As we approach 2016, we believe the success of the apparel rollout will enable the Company to have significantly more options for distribution once the exclusivity agreement with Kohl’s expires in April 2016. With the market for athleisure growing at a rapid pace (Barclay’s expects the U.S. athletic apparel market to increase by nearly 50% to more than $100 billion at retail by 2020), we are very excited about the opportunity for Gaiam to bring affordable, quality yoga and leisure apparel to broadline retailers.

SumZero: What is the market currently missing?

Ross Heller, Privet Fund Management: While Gaiam’s ability to benefit from all these growing markets provides an incredible opportunity, the stock has lagged behind due to a lack of fulsome investor messaging and financial performance clouded by Gaiam’s consolidated financials. What makes Gaiam’s story even more attractive to investors is that this misunderstanding and chronic undervaluation will finally be clarified through specific catalysts occurring over the balance of 2015 and into 2016. Gaiam is already experiencing organic growth in its core product segments and new yoga apparel appears to be a hit at Kohl’s stores since its launch in April. In October 2015, the Company plans to spin off the Gaiam TV business, creating two independent, publicly traded companies in a tax-free transaction. This should enable investors to better understand the value of both business and the stock to more fully reflect the sum of its individual parts.

SumZero: Tell us more about the business Gaiam is spinning off. What are some of the benefits of the separation?

Ross Heller, Privet Fund Management: In addition to the consumer segment, Gaiam operates a growing SVOD service called Gaiam TV (“GTV”) geared towards yoga and wellness content. Think of a Netflix for people who want the most authentic, up-to-date yoga videos. SVOD services continue to grow rapidly as millions of consumers around the globe subscribe for access to media content available on internet-connected devices. One only has to look at Netflix’s 21% CAGR over the past five years for evidence of this trend.

As of the end of the second quarter, GTV had 125,000 subscribers, each willing to pay around $10 per month for this content. Where it differs from something like Netflix (for the better), is that Gaiam TV owns over 90% of its content. That means it does not have to pay royalties for access to titles, and subscribers to GTV can actually download nearly all of the available titles to any device and then watch the content offline. The offline videos stay on the device as long as the subscription is active and then disappear. This capability is not offered through any other major streaming competitors because most others are forced to license third-party content. Since Gaiam owns and operates its own video production studio, the Company has developed the ability to quickly produce low-cost fitness videos, producing approximately 10 new titles per week. We think that GTV has enormous revenue potential as its brand awareness and authenticity have shown it capable of garnering subscribers at a rapid rate (125k currently, up from 50k 18 months ago). We see the Company putting additional sales and marketing muscle behind the service following the spin-off, but we think this company can be a high growth beneficiary as consumers continue to cut the cord and seek out their own content.

SumZero: Gaiam was founded a decade before popular competitor Lululemon. What has held it back from capitalizing on first mover advantage?

Ross Heller, Privet Fund Management: Gaiam’s business has evolved a few times since its founding in 1996. Outside of yoga accessories, Gaiam has also operated a media distribution business, an eco-travel company and a solar technology company. Some of these tangential projects have disrupted management’s focus and taken valuable company resources away from growing and innovating within the consumer brand. Even recently, the founder and current Chairman of the Company has spent most of his time on Gaiam TV. We believe it is only since the decision was made to build out Gaiam TV as a standalone entity and spin it off to shareholders that the Gaiam consumer brand has been able to operate without other corporate distractions and focus more on innovating and growing.

It is also helpful to note that high-end yoga apparel brands like Lululemon, Lucy and Sweaty Betty sell only through company-owned specialty retail stores. We don’t believe Gaiam had any interest in entering the retail business and moving away from its traditional distribution model. Instead, Gaiam evaluated the yoga apparel market and identified a need for an authentic, lower priced yoga apparel line that could be available to larger segments of the population through broadline retailers. Based on the Company’s past success selling affordable and differentiated products through stores like Target and Sports Authority, we think this strategy can work very well for apparel. So, though it may appear that they are fighting an uphill battle against some of the first movers in the category, we think this strategy of bringing quality specialty apparel to the mass market will be very successful.

SumZero: As far as the video component, what about competition from rapidly growing competitors like the Daily Burn?

Ross Heller, Privet Fund Management: With a rapidly growing SVOD market, we expect GTV to face some competition. That being said, Gaiam has some distinct advantages over comparable services such as the Daily Burn. First, Gaiam owns its own content, enabling subscribers to download and view content offline. This is a huge advantage over most services which require an internet connection in order to view. Next, Gaiam’s reputation and brand association are narrowly focused on yoga, health and wellness, which we see as a differentiator over much broader fitness and training subscription products like the Daily Burn. We think it is less likely that someone interested in yoga would pay $12.95 per month for the Daily Burn, a service that includes everything from cardio to kettlebell workouts to Bollywood dancing and just happens to include some yoga content, when Gaiam TV is $10 per month and is focused exclusively on providing a broad selection of high-quality yoga content. Because it is so narrowly focused within a specific niche, we see GTV as a service that actually complements other non-specialized SVOD services such as Netflix and Hulu, rather than competing with them. Since most SVOD subscriptions start around $10 per month, we see consumers bundling a number of different offerings and still paying less than traditional TV. This seems to be borne out by the fact that 50% of GTV’s subscribers also have a Netflix subscription. We believe that, as consumers cut the cord and begin to effectively assemble a customized “bundle” of multiple subscription services, Gaiam TV will continue to gain additional subscribers at a rapid pace.

SumZero: Conversely, is there any potential for an acquisition of Gaiam TV once it is spun off?

Ross Heller, Privet Fund Management: Of course we think there is strong potential for an acquisition of GTV at some point after the spin. While we believe in GTV’s potential to create value as a standalone business, we also understand the significant synergies that buyers could realize in an acquisition. Companies such as Netflix, Hulu, and even Amazon or Google could be natural buyers for the business. GTV would give these buyers access to the best yoga and wellness video content in the market and expand their subscriber bases. Also, any of those companies could keep Gaiam TV as a separate subscription service and look to sell the yoga content to its embedded customer base through one-click ordering. Even charging only $5 per month as an add-on, selling to Netflix’s 65 million subscribers would be very additive with minimal incremental cost.

While it might be tempting to consider an acquisition in the near-term, we believe GTV has the opportunity to significantly enhance its value over the next three years by executing its growth strategy as an independent company. As a subsidiary of Gaiam, GTV has not put the pedal to the metal on subscriber growth, instead focusing on break-even profitability. On the last earnings call, Gaiam founder Jirka Rysavy even stated that he planned to return to 85%+ growth after the spin-off. If GTV is able to grow at these rates over the next three years, we are talking about an SVOD with closer to one million subscribers with more than $100 million in annual revenue at extremely high margins, so you can see how GTV could potentially be a home run by waiting a few more years. That said, for the right price GTV could also be an attractive target today.

SumZero: Do you foresee any important synergies being lost by the GTV spinoff?

Ross Heller, Privet Fund Management: We don’t see any lost synergies because, for all intents and purposes, Gaiam and GTV already run as independent businesses. For example, each segment has its own operating infrastructure with complete management teams. We actually see significant benefits from the spin-off because the segments can finally focus on making strategic decisions that are best for their respective businesses guided by a board and a shareholder base that fully appreciate the opportunities specific to each business. For Gaiam TV, we are hopeful that without the fear of diluting the profit of the consumer brand as an overhang, the spun-off entity can return its focus to executing an aggressive subscriber growth plan instead of temporarily reigning-in marketing spend to limit cash burn.

SumZero: What makes it so difficult for investors to see GTV performing well as a segment within the greater Gaiam, enough to make Gaiam valued less than the sum of its parts?

Ross Heller, Privet Fund Management: Well, it's no longer that difficult to see GTV’s high-level financial performance since last year the company changed its reporting segments to separate GTV’s revenue and contribution income. However, we still believe that GTV doesn’t get the valuation it deserves as part of the larger legacy entity. Part of the problem is GTV’s inability to execute rapid subscriber expansion while under the Gaiam corporate umbrella.

As mentioned before, instead of the 30% to 35% growth that Gaiam TV has shown the past few quarters while trying to bring the business closer to profitability, we believe GTV is capable of nearly doubling its revenue each year as a standalone company with a mandate to grow as quickly as possible. Attaining this growth requires meaningful investments in sales and marketing that would not provide any near-term benefit to the consumer brand. It is perfectly understandable that the board believes that shareholders in a branded consumer products company have little desire to fund the losses of a high-growth SVOD service, even if that slows the value creation at GTV. This is why we are excited about the prospects of both businesses operating independent of each other. Once investors see how quickly GTV is capable of growing, we believe the Company will be viewed very similarly to other high-margin, recurring revenue businesses that trade on multiples of revenue.

SumZero: What key metrics should investors be paying attention to as your thesis matures?

Ross Heller, Privet Fund Management: We think there are three key metrics to keep an eye on. First, investors should track the growth of Gaiam’s core consumer branded products: accessories, wellness, and their SPRI subsidiary (excluding apparel). We believe that increased penetration (i.e. Target nearly doubling the amount of Gaiam yoga product shelf space by February 2016) will lead to additional growth in existing retail doors, and we see the wellness category as leading the brand into new retailers (Bed, Bath and Beyond, Vitamin Shoppe, etc.). As national retailers continue to emphasize health and wellness as a means to drive growth, we think that there is significant runway for these core branded products to grow at a double digit rate for the foreseeable future.

Second, investors should follow Gaiam’s new yoga apparel launch. The Company is already well on its way to achieving management’s goal of $15 to $20 million of incremental revenue in 2015 while only selling the product for eight months through one retailer (Kohl’s). Next year, we see Gaiam adding an additional one to two retailer partnerships for apparel in addition to being given more selling space at Kohl’s. We believe this will lead to greater than 50% revenue growth in apparel sales alone for 2016.

Finally, investors should pay very close attention to the spin-off of Gaiam TV and how that business scales as a focused, standalone entity. Spin-offs can often be mispriced just after the separation due to a lack of investor understanding or negative sentiment from legacy shareholders. We would not be surprised to see something like that happen here, especially given the small size of the spun-off entity. We believe that as the growth in subscribers accelerates following the separation, more growth-oriented shareholders will find the Company and begin to value it more closely to its content subscription peers.

SumZero: What are the biggest risks associated with the investment in your view?

Ross Heller, Privet Fund Management: We would classify the risks into two main categories: operational and institutional. On the operational side, the yoga apparel and accessories market is very competitive, so Gaiam has to stay on top of its branding and product development in order to maintain product placement and sell-through. We believe that Gaiam’s authenticity resonates with yoga consumers, and the Company continues to innovate in order to stay ahead of new trends in fitness and wellness.

Next, there is the risk that GTV doesn’t achieve our expectations for traction in the SVOD market. However, we think GTV’s proprietary video library and current undervaluation help mitigate this risk. In a downside scenario, GTV could create value by monetizing its video content through an outright sale or licensing agreement with another content distribution network. Also, at the current valuation, we believe Gaiam’s consumer segment is worth more than the entire market valuation of the combined business, so essentially, investors are receiving the GTV business for free.

As for institutional risks, Gaiam’s dual-class share structure is not ideal for shareholders. Through 100% ownership of Gaiam’s Class B shares (ten votes versus one vote for Class A shares), Jirka Rysavy, the founder and current Chairman, controls 75% of the Company. While the share structure can certainly give rise to potential conflicts of interest, we gain comfort from Mr. Rysavy’s strong track record of creating value for shareholders in past companies. Mr. Rysavy has been a visionary in multiple industries and demonstrated the ability to lead businesses to successful outcomes, including Crystal Market (later Wild Oats) and Corporate Express (which sold with $4.5 billion in revenue, and is now Staples). At Corporate Express, Mr. Rysavy was able to grow a local office supplies store into a national powerhouse by leveraging a proprietary inventory software, unique merchandising plan and several acquisitions. Under Mr. Rysavy’s leadership, Corporate Express grew from a single store operation to a Fortune 500 company.

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