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Nautilus Group 10-Q 2006

Documents found in this filing:

  1. 10-Q
  2. Ex-10.2
  3. Ex-31.1
  4. Ex-31.2
  5. Ex-32.1
  6.  
Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission file number: 000-25867

NAUTILUS, INC.

(Exact name of registrant as specified in its charter)

 

Washington   94-3002667

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

16400 S.E. Nautilus Drive

Vancouver, Washington 98683

(Address of principal executive offices, including zip code)

(360) 859-2900

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer   x            Accelerated Filer   ¨            Non-Accelerated Filer   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Number of shares of issuer’s common stock outstanding as of November 2, 2006: 31,472,886

 



Table of Contents

NAUTILUS, INC.

TABLE OF CONTENTS

 

          Page
PART I. FINANCIAL INFORMATION   
Item 1.    Financial Statements (Unaudited)    3
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    16
Item 3.    Quantitative and Qualitative Disclosures About Market Risk    24
Item 4.    Controls and Procedures    25
PART II. OTHER INFORMATION   
Item 1.    Legal Proceedings    26
Item 1A.    Risk Factors    27
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds    27
Item 6.    Exhibits    27
Signatures    28
Exhibit Index    29

 

2


Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

NAUTILUS, INC.

CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands)

 

    

September 30,

2006

  

December 31,

2005

 

ASSETS

     

CURRENT ASSETS:

     

Cash and cash equivalents

   $ 3,404    $ 7,984  

Trade receivables (net of allowance for doubtful accounts of $3,544 and $4,085 at September 30, 2006 and December 31, 2005, respectively)

     120,901      116,908  

Inventories

     69,546      96,084  

Prepaid expenses and other current assets

     8,002      8,369  

Short-term notes receivable

     2,556      2,496  

Assets held for sale

     1,742      6,115  

Deferred tax assets

     5,633      7,235  
               

Total current assets

     211,784      245,191  

PROPERTY, PLANT AND EQUIPMENT (at cost, net of accumulated depreciation of $48,026 and $43,802 at September 30, 2006 and December 31, 2005, respectively)

     54,374      59,320  

GOODWILL

     65,064      64,404  

INTANGIBLE AND OTHER ASSETS, net

     50,353      44,371  
               

TOTAL ASSETS

   $ 381,575    $ 413,286  
               

LIABILITIES AND STOCKHOLDERS’ EQUITY

     

CURRENT LIABILITIES:

     

Trade payables

   $ 49,704    $ 61,132  

Accrued liabilities

     25,388      29,097  

Short-term borrowings

     35,000      40,147  

Income taxes payable

     1,843      3,810  

Customer deposits

     2,084      3,327  

Current portion of long-term debt

     178      707  
               

Total current liabilities

     114,197      138,220  

LONG TERM DEBT

     4,245      5,610  

NONCURRENT DEFERRED TAX LIABILITIES

     16,917      16,990  

COMMITMENTS AND CONTINGENCIES (Note 11)

     

STOCKHOLDERS’ EQUITY:

     

Common stock – no par value, 75,000 shares authorized; 31,473 and 32,780 shares issued and outstanding at September 30, 2006 and December 31, 2005, respectively

     405      3,549  

Unearned stock compensation

     —        (1,947 )

Retained earnings

     241,719      248,123  

Accumulated other comprehensive income

     4,092      2,741  
               

Total stockholders’ equity

     246,216      252,466  
               

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 381,575    $ 413,286  
               

See notes to consolidated financial statements.

 

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Table of Contents

NAUTILUS, INC.

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited, in thousands, except per share amounts)

 

    

Three Months

Ended September 30,

  

Nine Months

Ended September 30,

     2006     2005    2006     2005

NET SALES

   $ 159,583     $ 163,308    $ 482,185     $ 449,277

COST OF SALES

     87,493       91,022      270,192       242,164
                             

Gross profit

     72,090       72,286      211,993       207,113
                             

OPERATING EXPENSES:

         

Selling and marketing

     42,621       44,526      137,887       129,425

General and administrative

     14,507       11,146      40,399       34,567

Research and development

     2,521       2,856      8,321       8,768

Royalties

     1,296       1,297      3,991       3,952
                             

Total operating expenses

     60,945       59,825      190,598       176,712
                             

OPERATING INCOME

     11,145       12,461      21,395       30,401

OTHER INCOME (EXPENSE):

         

Interest income (expense), net

     (537 )     145      (1,152 )     1,460

Other income (expense), net

     (2 )     31      1,220       542
                             

Total other income (expense)

     (539 )     176      68       2,002
                             

INCOME BEFORE INCOME TAXES

     10,606       12,637      21,463       32,403

INCOME TAX EXPENSE

     1,230       4,366      5,215       11,373
                             

NET INCOME

   $ 9,376     $ 8,271    $ 16,248     $ 21,030
                             

EARNINGS PER SHARE:

         

BASIC

   $ 0.29     $ 0.25    $ 0.50     $ 0.63

DILUTED

   $ 0.29     $ 0.24    $ 0.50     $ 0.62

WEIGHTED AVERAGE SHARES OUTSTANDING:

         

BASIC

     32,138       33,549      32,577       33,367

DILUTED

     32,240       34,365      32,732       34,090

See notes to consolidated financial statements.

 

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Table of Contents

NAUTILUS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME

NINE MONTHS ENDED SEPTEMBER 30, 2006 AND YEAR ENDED DECEMBER 31, 2005

(In Thousands, Except Share Data)

 

     Common Stock    

Unearned

Stock

Compensation

   

Retained

Earnings

   

Accumulated

Other

Comprehensive

Income

    Total  
   Shares     Amount          

BALANCES, January 1, 2005

   33,147,758     $ 10,682     $ (1,204 )   $ 238,474     $ 4,084     $ 252,036  

Net income

   —         —         —         23,000       —         23,000  

Foreign currency translation adjustment

   —         —         —         —         (1,343 )     (1,343 )
                  

Comprehensive income

               21,657  

Dividends paid

   —         —         —         (13,351 )     —         (13,351 )

Unearned stock compensation

   —         1,106       (1,106 )     —         —         —    

Amortization of unearned stock compensation

   —         —         363       —         —         363  

Options exercised

   462,553       5,609       —         —         —         5,609  

Stock repurchased

   (830,700 )     (15,636 )     —         —         —         (15,636 )

Tax benefit of exercise of nonqualified options

   —         1,788       —         —         —         1,788  
                                              

BALANCES, DECEMBER 31, 2005

   32,779,611       3,549       (1,947 )     248,123       2,741       252,466  

Net income

   —         —         —         16,248       —         16,248  

Foreign currency translation adjustment

   —         —         —         —         1,351       1,351  
                  

Comprehensive income

               17,599  

Dividends paid

   —         —         —         (9,760 )     —         (9,760 )

Stock repurchased

   (1,344,200 )     (3,761 )     —         (12,892 )     —         (16,653 )

Unearned stock compensation

   —         (1,947 )     1,947       —         —         —    

Stock-based compensation

   —         2,044       —         —         —         2,044  

Options exercised

   37,100       484       —         —         —         484  

Tax benefit of exercise of nonqualified options

   —         36       —         —         —         36  
                                              

BALANCES, SEPTEMBER 30, 2006

   31,472,511     $ 405     $ —       $ 241,719     $ 4,092     $ 246,216  
                                              

See notes to consolidated financial statements.

 

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Table of Contents

NAUTILUS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

 

    

Nine Months Ended

September 30,

 
     2006     2005  

CASH FLOWS FROM OPERATING ACTIVITIES:

    

Net income

   $ 16,248     $ 21,030  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

     12,815       11,066  

Amortization of unearned stock compensation

     —         255  

Stock-based compensation

     2,044       —    

Amortization of discount on long-term debt

     —         12  

Loss on sale of property, plant and equipment

     109       15  

Tax benefit from exercise of nonqualified options

     —         1,942  

Excess tax benefit from exercise of employee stock options

     (36 )     —    

Deferred income taxes

     1,182       2,032  

Foreign currency transaction gain

     (1,115 )     —    

Changes in assets and liabilities:

    

Trade receivables

     (2,338 )     8,935  

Inventories

     27,559       (21,035 )

Prepaid expenses and other current assets

     370       (7,064 )

Trade payables

     (12,678 )     (617 )

Accrued liabilities

     (4,072 )     (2,812 )

Income taxes payable

     (1,907 )     (7,651 )

Customer deposits

     (1,523 )     542  
                

Net cash provided by operating activities

     36,658       6,650  
                

CASH FLOWS FROM INVESTING ACTIVITIES:

    

Purchases of property, plant and equipment

     (8,372 )     (23,210 )

Proceeds from sale of property, plant and equipment, and assets held for sale

     6,064       2,972  

Net increase in intangible and other assets

     (7,501 )     (306 )

Acquisition, net of cash acquired

     —         (73,688 )

Purchases of short-term investments

     —         (49,352 )

Proceeds from maturities of short-term investments

     —         134,671  

Net increase (decrease) in notes receivable

     (60 )     107  
                

Net cash used in investing activities

     (9,869 )     (8,806 )
                

CASH FLOWS FROM FINANCING ACTIVITIES:

    

Cash dividends paid on common stock

     (9,760 )     (10,010 )

Proceeds from exercise of stock options

     484       5,565  

Excess tax benefit from exercise of employee stock options

     36       —    

Stock repurchases

     (16,653 )     (4,580 )

Net reduction in short-term borrowings

     (5,147 )     —    

Principal payments on long-term debt

     (1,900 )     (89 )
                

Net cash used in financing activities

     (32,940 )     (9,114 )
                

Net Effect of Foreign Currency Exchange Rate Changes

     1,571       (566 )
                

Net Decrease in Cash and Cash Equivalents

     (4,580 )     (11,836 )

Cash and Cash Equivalents, beginning of period

     7,984       19,266  
                

Cash and Cash Equivalents, end of period

   $ 3,404     $ 7,430  
                

Supplemental Disclosures:

    

Cash paid for interest

   $ 1,479     $ 55  
                

Cash paid for income taxes

   $ 6,685     $ 14,461  
                

Supplemental Disclosure of Other Non-cash Investing and Financing Activities:

    

Promissory notes issued or assumed in business acquisitions

   $ —       $ 6,854  
                

See notes to consolidated financial statements.

 

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Table of Contents

NAUTILUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1. BASIS OF PRESENTATION

Nautilus, Inc. is referred to as “we,” “us,” “our” or “Company” in this report. The accompanying consolidated financial statements relate to Nautilus, Inc. and its subsidiaries as of September 30, 2006 and for the three and nine month periods ended September 30, 2006 and 2005. The consolidated financial statements of the Company include the accounts of Nautilus, Inc. and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.

The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. These financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

The financial information included herein reflects all adjustments (consisting of normal recurring adjustments), which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods presented. The results of operations for the three and nine months ended September 30, 2006 are not necessarily indicative of the results to be expected for the full year.

Use of Accounting Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Our significant estimates relate to revenue recognition, stock-based compensation, warranty reserves, legal reserves, sales returns and discounts, the allowance for doubtful accounts, inventory valuation, intangible asset valuation, and income taxes.

New Accounting Pronouncements

In September 2006, the staff of the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). In SAB 108, the SEC staff established an approach that requires quantification of financial statement misstatements based on the effects of the misstatements on each of the Company’s financial statements and the related financial statement disclosures. The Company will adopt SAB 108 in December 2006 and is currently evaluating the impact that the adoption will have on the Company’s results of operations, cash flows or financial position.

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 157, Fair Value Measurements (“SFAS 157”). This statement defines fair value, establishes a framework for measuring fair value in U.S. GAAP, and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2006. The Company is currently evaluating the impact that the adoption will have on the Company’s results of operations, cash flows or financial position.

In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 provides a two-step approach for recognizing and measuring tax benefits and requires companies to make disclosures about uncertainties in their income tax position, including a detailed rollforward of tax benefits taken that do not qualify for financial statement recognition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact that the adoption will have on the Company’s results of operations, cash flows or financial position.

 

2. STOCK BASED COMPENSATION

2005 Long Term Incentive Plan

In 2005, the Company’s shareholders approved the Company’s 2005 Long Term Incentive Plan (the “Plan”). The Plan permits flexibility in types of awards, and specific terms of awards, which allow future awards to be based on then-current objectives for aligning compensation with increasing long-term shareholder value. The aggregate number of shares of common stock authorized for issuance as awards under the Plan is 4,000,000, plus any shares of common stock that were previously reserved for issuance under the Company’s Stock Option Plan and were not subject to grant on June 6, 2005 or as to which the option award is forfeited on or after June 6, 2005. The maximum aggregate number of shares of common stock subject to stock options, stock appreciation rights, restricted stock or stock unit awards which may be granted to any one participant in any one year under the Plan is 1,000,000. The aggregate number of shares available for issuance under the Plan is reduced by two shares for each share delivered in settlement of any stock appreciation rights, restricted stock, stock unit or performance unit award, and one share for each share delivered in settlement of a stock option award.

 

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Table of Contents

Adoption of SFAS 123(R)

Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS 123(R)”) for its share-based compensation plan using the modified prospective transition method. The Company previously accounted for the plan under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25” or “Opinion 25”) and related interpretations and disclosure requirements established by SFAS 123, Accounting for Stock-Based Compensation, and SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. In March 2005, the SEC issued SAB No. 107, Share-Based Payment (“SAB 107”), relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).

Under APB 25, no expense was recorded in the income statement for the Company’s stock options granted at fair market value. The pro forma effect on income for stock options was instead disclosed in a footnote to the financial statements. Expense was recorded in the income statement for equity awards granted below fair market value on the date of grant.

Under SFAS 123(R), the Company recognizes compensation expense from share-based payments over the requisite service periods of the individual grants, which generally equal the vesting periods. Consistent with prior years, the fair value of each equity award is estimated at the date of grant using the Black-Scholes-Merton option pricing model which requires extensive use of accounting judgment, including estimates of the expected volatility of the Company’s common stock price over the expected term, the dividend yield, expected term option holders will retain their vested awards before exercising them, and the number of awards that will be forfeited prior to the completion of their vesting requirements. Application of alternative assumptions could produce significantly different estimates of the fair value of equity awards and consequently the related amounts of compensation cost recognized in the Consolidated Statements of Income.

The following table illustrates the effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to its equity awards for the periods prior to adoption of SFAS 123(R):

 

(in thousands, except per share amounts)   

Three Months Ended

September 30, 2005

   

Nine Months Ended

September 30, 2005

 

Net income, as reported

   $ 8,271     $ 21,030  

Add: Stock-based employee compensation expense included in reported net income, net of tax

     55       165  

Deduct: Stock-based employee compensation expense determined under fair value based method, net of tax

     (664 )     (1,837 )
                

Net income, pro forma

   $ 7,662     $ 19,358  
                

Basic earnings per share:

    

As reported

   $ 0.25     $ 0.63  

Pro forma

   $ 0.23     $ 0.58  

Diluted earnings per share:

    

As reported

   $ 0.24     $ 0.62  

Pro forma

   $ 0.22     $ 0.57  

As a result of adopting SFAS 123(R), the Company’s income before income taxes and net income for the three months ended September 30, 2006 are $0.7 million and $0.6 million lower, respectively, than if it had continued to account for share-based compensation under Opinion 25. The Company’s income before income taxes and net income for the nine months ended September 30, 2006 are $2.0 million and $1.5 million lower, respectively, than if it had continued to account for share-based compensation under Opinion 25. The Company’s basic and diluted earnings per share for the three and nine months ended September 30, 2006 are $0.02 and $0.06, respectively, lower than if it had continued to account for share-based compensation under APB 25. The Company did not capitalize any of its share-based compensation costs in any of the periods.

Stock Options

Stock option awards are granted with an exercise price equal to the market price of the Company’s stock on the date prior to the award grant date, generally vest based on four years of continuous service and have a seven year contractual term.

 

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A summary of the Company’s stock option plan activity for the three months ended September 30, 2006 is as follows:

 

(in thousands, except exercise price)   

Total

Shares

    Weighted-Average
Exercise Price
  

Weighted-
Average
Remaining

Contractual Life

(in years)

   Aggregate
Intrinsic
Value

Outstanding at June 30, 2006

   2,702     $ 16.63      

Granted

   4       13.06      

Forfeited or canceled

   (39 )     18.74      

Expired

   (19 )     28.03      

Exercised

   (13 )     10.49       $ 39
                      

Outstanding at September 30, 2006

   2,635     $ 16.54    6.75    $ 2,671
                        

A summary of the Company’s stock option plan activity for the nine months ended September 30, 2006 is as follows:

 

(in thousands, except exercise price)   

Total

Shares

   

Weighted-Average

Exercise Price

  

Weighted-

Average

Remaining

Contractual Life

(in years)

  

Aggregate

Intrinsic

Value

Outstanding at December 31. 2005

   2,277     $ 17.39      

Granted

   645       15.63      

Forfeited or canceled

   (123 )     19.82      

Expired

   (127 )     24.96      

Exercised

   (37 )     13.06       $ 135
                      

Outstanding at September 30, 2006

   2,635     $ 16.54    6.75    $ 2,671
                        

Exercisable at September 30, 2006

   938     $ 16.78    6.27    $ 1,386
                        

The fair value of the Company’s equity awards was estimated utilizing the following assumptions:

 

    

Three months ended

September 30,

2006

   

Nine months ended

September 30,

2006

 

Expected life (years)

   4.75     4.75  

Risk-free interest rate

   4.8 %   4.8 %

Expected dividend yield

   3.1 %   2.6 %

Expected volatility

   44 %   44 %

Expected life represents the period that the Company’s equity awards are expected to be outstanding and was determined based on historical experience of similar awards, giving consideration to the contractual terms of the equity awards and vesting schedules. Risk-free interest rate is based on the implied U.S. Treasury zero coupon yield curve in effect in the month of grant. Expected dividend yield is calculated based on the authorization by the Company’s Board of Directors of the payment of the 2006 quarterly dividends in the amount of $0.10 per share. Expected volatility utilized in the model is calculated using daily historical volatility of the Company’s stock price. When estimating forfeitures, the Company considers terminations as well as anticipated retirements based on an analysis of historical data.

Performance Units

In December 2005, the Company granted performance unit awards to members of its executive team. The performance unit awards vest if the Company meets earnings targets set by the Compensation Committee of the Board of Directors. The fair value of the performance units is based on the closing market price of the Company’s common stock on the date preceding the grant date and is amortized over the estimated requisite service period when it becomes probable that the performance targets are expected to be met. The amount of stock-based compensation expense is based on the number of performance unit awards ultimately expected to vest, and therefore has been reduced for estimated forfeitures.

 

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At September 30, 2006, there was approximately $2.9 million of total unrecognized stock-based compensation costs related to performance units with the intrinsic value of approximately $2.4 million. None of the performance units were vested at September 30, 2006. There were no performance units in the comparable period of fiscal 2005. The Company did not record any compensation expense related to the performance unit awards in the three and nine month periods ended September 30, 2006. A summary of the Company’s performance units activity for the three months ended September 30, 2006 is as follows:

 

(in thousands, except fair value amounts)   

Performance

Units

  

Weighted Average

Grant Date Fair

Value

Outstanding at June 30, 2006

   156    $ 15.15 - $17.70

Granted

   18      12.52

Forfeited or canceled

   —        —  

Expired

   —        —  

Exercised

   —        —  
           

Outstanding at September 30, 2006

   174    $  12.52 -$ 17.70
           

A summary of the Company’s performance units activity for the nine months ended September 30, 2006 is as follows:

 

(in thousands, except fair value amounts)   

Performance

Units

  

Weighted Average

Grant Date Fair

Value

Outstanding at December 31, 2005

   125    $ 17.70

Granted

   49      12.52 -15.15

Forfeited or canceled

   —        —  

Expired

   —        —  

Exercised

   —        —  
           

Outstanding at September 30, 2006

   174    $ 12.52 -$ 17.70
           

 

3. INVENTORIES

Inventories consisted of the following:

 

(in thousands)   

September 30,

2006

  

December 31,

2005

Finished goods

   $ 49,029    $ 69,178

Work-in-process

     1,431      1,368

Parts and components

     19,086      25,538
             

Inventories

   $ 69,546    $ 96,084
             

Inventories are stated at the lower of standard cost or market. The Company evaluates the need for inventory valuation adjustments associated with obsolete, slow-moving and not saleable inventory by reviewing current transactions and forecasted product demand on a quarterly basis.

 

4. INTANGIBLE AND OTHER ASSETS

Intangible assets, exclusive of goodwill, consisted of the following:

 

(in thousands)   

Estimated Useful

Life (in years)

   September 30, 2006     December 31, 2005  

Intangible assets:

       

Indefinite life trademarks

   N/A    $ 37,310     $ 30,465  

Definite life trademarks

   20      —         6,800  

Patents

   1 to 17      7,336       1,597  

Customer base

   8      3,400       3,400  

Developed technology

   4      2,500       2,500  

Non-compete agreements

   3      1,722       1,647  
                   

Total intangible assets

        52,268       46,409  

Accumulated amortization

        (4,746 )     (3,233 )
                   

Intangible assets, net

        47,522       43,176  
                   

Other assets

        2,831       1,195  
                   

Intangible and other assets

      $ 50,353     $ 44,371  
                   

 

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Identifiable intangible assets such as license agreements, patents, and trademarks are recorded at cost, or when acquired as part of a business combination, at estimated fair value and are amortized over a period they provide the Company with economic benefit, or using the straight-line method over their estimated useful life. The amortization expense for the next five full succeeding years is estimated at $2.3 million, $1.9 million, $1.4 million, $1.1 million, and $1.1 million per year.

 

5. ACCRUED LIABILITIES

Accrued liabilities consisted of the following:

 

(in thousands)   

September 30,

2006

  

December 31,

2005

Accrued warranty expense

   $ 8,258    $ 10,210

Payroll

     5,794      8,457

Sales return reserve

     1,555      1,049

Royalty reserve

     1,255      1,685

Other

     8,526      7,696
             

Accrued liabilities*

   $ 25,388    $ 29,097
             

 

* Other accrued liabilities consist primarily of finance fees, commissions, accrued advertising and marketing fees, reserve for product liability, and miscellaneous accruals.

Warranty reserve activity for the nine months ended September 30, 2006 and 2005 was as follows:

 

(in thousands)   

Balance at

Beginning

of Period

  

Charged to

Costs and

Expenses

   Deductions*   

Balance at

End of

Period

2006

   $ 10,210    $ 5,831    $ 7,783    $ 8,258

2005

   $ 7,537    $ 6,442    $ 5,617    $ 8,362

 

* Deductions represent warranty claims paid out in the form of service costs and/or product replacements.

Warranty costs are estimated based on the Company’s historical experience and are charged to cost of sales. Beginning in 2006, the Company has been able to offset its warranty costs by recovering a portion of such costs from its suppliers.

 

6. LINE OF CREDIT AND OTHER DEBT

In November 2005, the Company entered into an unsecured credit agreement with two domestic lending institutions. In August 2006, the Company amended its credit agreement. The agreement, as amended, provides for a revolving credit facility for a maximum commitment of $65 million, includes revolving loans, letters of credit and swing loans, and expires on November 17, 2010. Under this credit facility, borrowings bear interest based at either the Prime Rate, Federal Funds Effective Rate or Eurodollar rates plus the applicable margin for either Base Rate Loans or Eurodollar Loans based upon the Company’s consolidated leverage ratio. The credit facility has a default rate of two percent in excess of the rate otherwise applicable and provides for a facility fee at the annual rate equal to the applicable Facility Fee Rate in effect on the payment date. The facility fee is based on the average daily total commitment amount in effect during the quarter and is payable quarterly. At September 30, 2006, the borrowing limit under the credit facility was $65 million of which $23.5 million was available. The interest rate on the amount of borrowings outstanding at September 30, 2006 ranged between 5.990% and 6.025%. The interest rates ranged between 5.025% and 5.275% on the amount of borrowings outstanding at December 31, 2005. At September 30, 2006, the Company had $6.5 million in standby letters of credit primarily with Asian vendors which reduced the balance available under the credit facility.

Under the terms of the credit facility, the Company may use proceeds for working capital and other general corporate purposes, including acquisitions. The terms of the credit facility also allow the use of funds for the repurchase of shares of the Company’s common stock in an aggregate amount not to exceed $30 million until the fixed charge coverage ratio is equal to or greater than 1.20 to 1.00. The credit facility, as amended, contains certain financial and non-financial covenants with which the Company was in compliance at September 30, 2006.

As part of its plan to expand its borrowing capacity to $125 million, the Company entered into a $25 million unsecured revolving credit agreement (the “Facility”) with a lender in October 2006. The Facility expires on December 30, 2006. The Facility is intended for general corporate purposes, including working capital, stock repurchases, and permitted acquisitions. The Facility provides for either Base Rate or Eurodollar Rate loans. Base Rate loans bear interest at the higher of the Federal Funds Rate plus  1/2 of 1.0% or the Prime Rate; Eurodollar loans bear interest at the Eurodollar Rate plus 1.00%. The Facility includes a commitment fee of 0.25% per annum for the unused portion of the commitment and contains certain financial and non-financial covenants which include but are not limited to a leverage ratio.

 

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In 2005, the Company issued a $1.5 million non-interest bearing promissory note ($1.3 million, net of imputed interest) as part of the purchase price of the Belko Canada acquisition payable in full in May 2008. At June 30, 2006, the Company reached an agreement with the noteholder to settle the entire amount of the note in fiscal 2006. The Company paid off the remaining balance of the note in August of 2006.

As part of the acquisition of Pearl Izumi, the Company became obligated on two non-interest bearing notes of $4.4 million and $0.9 million, net of imputed interest. The $4.4 million note requires payments of $0.3 million in February 2006, and $0.15 million per quarter beginning March 2007 through December 2016. The $0.9 million note requires payments of $0.15 million per quarter beginning September 2005 through December 2006.

 

7. COMPREHENSIVE INCOME

Accounts of the Company’s foreign operations are measured using the local currency as the functional currency. These accounts are then translated into U.S. dollars using the current rate method with translation gains and losses accumulated as the comprehensive income component of stockholders’ equity, except for gains or losses from intercompany transactions which are recorded in the Consolidated Statement of Income.

Comprehensive income was as follows:

 

(in thousands)   

Three Months Ended

September 30,

  

Nine Months Ended

September 30,

 
   2006    2005    2006    2005  

Net income

   $ 9,376    $ 8,271    $ 16,248    $ 21,030  

Foreign currency translation adjustments

     300      226      1,351      (1,041 )
                             

Comprehensive income

   $ 9,676    $ 8,497    $ 17,599    $ 19,989  
                             

 

8. EARNINGS PER SHARE

The calculation of the number of outstanding shares is as follows:

 

    

Three Months Ended

September 30, 2006

  

Three Months Ended

September 30, 2005

 
(in thousands, except per share amounts)    Income    Shares   

Per Share

Amount

   Income    Shares   

Per Share

Amount

 

Basic EPS:

                 

Net income

   $ 9,376    32,138    $ 0.29    $ 8,271    33,549    $ 0.25  

Effect of dilutive securities:

                 

Stock options

     —      102      0.00      —      816      (0.01 )
                                       

Diluted EPS:

                 

Net income

   $ 9,376    32,240    $ 0.29    $ 8,271    34,365    $ 0.24  
                                       

Antidilutive stock options *

      1,864          250   
                     

 

     Nine Months Ended
September 30, 2006
   Nine Months Ended
September 30, 2005
 
(in thousands, except per share amounts)    Income    Shares    Per Share
Amount
   Income    Shares    Per Share
Amount
 

Basic EPS:

                 

Net income

   $ 16,248    32,577    $ 0.50    $ 21,030    33,367    $ 0.63  

Effect of dilutive securities:

                 

Stock options

     —      155      0.00      —      723      (0.01 )
                                       

Diluted EPS:

                 

Net income

   $ 16,248    32,732    $ 0.50    $ 21,030    34,090    $ 0.62  
                                       

Antidilutive stock options *

      1,818          263   
                     

 

* Stock options not included in the calculation of diluted earnings per share for each respective period because they would be antidilutive.

 

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9. STOCK REPURCHASE PROGRAM

In March 2005, the Company’s Board of Directors authorized the repurchase of up to $100 million of the Company’s common stock in open-market transactions at times and in such amounts as management deems appropriate depending on market conditions and other factors. The authorization expires on March 31, 2008 unless extended by the Board of Directors. The repurchase program does not obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time. During the three and nine months ended September 30, 2006, the Company acquired 1,344,200 shares of common stock at an average price of $12.42 per share for a total cost of $16.7 million. During 2005, the Company acquired 830,700 shares of common stock at an average price of $18.82 per share for a total cost of $15.6 million.

 

10. INCOME TAXES

The Company’s effective tax rates for the three and nine months ended September 30, 2006 were 11.6% and 24.3%, respectively. The income tax provision for the three months ended September 30, 2006 includes a discrete $3.0 million net benefit related to the reduction of tax contingency reserves resulting from determination that certain statutory periods for the assessment of additional state income tax are now closed, and a discrete $0.2 million net increase related to adjustments of the 2005 tax provision to the final filed tax returns. The Company’s effective tax rates for the three and nine months ended September 30, 2005 were 34.5% and 35.1%, respectively.

 

11. COMMITMENTS AND CONTINGENCIES

Legal Matters

We are involved in various claims, lawsuits and other proceedings from time to time. Such litigation involves uncertainty as to possible losses we may ultimately realize when one or more future events occur or fail to occur. We accrue and charge to income estimated losses from contingencies when it is probable that a liability had been incurred and the amount of loss can be reasonably estimated. Differences between estimates recorded and actual amounts determined in subsequent periods are treated as changes in accounting estimates. The Company estimates the probability of losses on legal contingencies based on the advice of internal and external counsels, outcomes from similar litigation, the status of the lawsuits (including settlement initiatives), legislative developments, and other factors. Due to numerous variables associated with these judgments and assumptions, both the precision and reliability of the resulting estimates of the related loss contingencies are subject to substantial uncertainties. We regularly monitor our estimated exposure to these contingencies and, as additional information becomes known, may change our estimates significantly. A significant change in our estimates, or a result that materially differs from our estimates, could have a significant impact on our financial position, results of operations and cash flows.

In November 2005, the Company proceeded to trial in Salt Lake City, Utah in a case filed by ICON Health & Fitness, Inc. (“ICON”) claiming false advertising involving the Company’s advertising and promotion going back to 1987 for certain elements of its Bowflex home gyms and claiming trademark infringement for the name placed on a treadmill belt sold in 2002. On November 15, 2005, the jury returned a verdict in favor of ICON in the amount of $7.8 million which the Court subsequently increased to $8.1 million. By an order dated April 21, 2006, the Court refused to modify the amount of the jury verdict. The Company has filed a notice of appeal of this judgment and has posted the necessary bond with the Court for the appeal. The Company, based on discussion with its legal counsel, believes the verdict is inconsistent with the law and the evidence presented at trial. Further, the Company believes that the evidence does not support the damage award and thus the likelihood of loss is neither probable nor is the amount of potential loss estimable. Therefore, no accrual has been recorded by the Company.

In December 2002, the Company filed suit against ICON in the Federal District Court, Western District of Washington (the “District Court”) alleging infringement by ICON of the Company’s Bowflex patents and trademarks. The Company sought injunctive relief, monetary damages and its fees and costs. In October 2003, the District Court dismissed the patent infringement claims. The Company appealed the District Court’s decision to the United States Court of Appeals for the Federal Circuit (the “Appeals Court”) and in November 2003, the Appeals Court overruled the District Court and reinstated the patent infringement claims. In May 2005, the District Court again dismissed the patent infringement case against ICON. The Company appealed this case to the Appeals Court, which issued an order in August 2006 affirming the ruling of the District Court dismissing the patent infringement case.

In July 2003, the District Court ruled in favor of the Company on a motion for preliminary injunction on the issue of trademark infringement and entered an order barring ICON from using the trademark “CrossBow” on any exercise equipment. In its ruling, the District Court concluded that the Company showed “a probability of success on the merits and irreparable injury” on its trademark infringement claim. In August 2003, the Appeals Court granted ICON a temporary stay regarding the motion for a preliminary injunction, which enjoined ICON from using the trademark “CrossBow.” This stay allowed ICON to continue using the trademark “CrossBow” until a decision was issued by the Appeals Court. In June 2004, the Appeals Court issued its decision

 

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upholding the issuance of an injunction and preventing ICON from selling exercise equipment using the trademark “CrossBow” pending trial on the trademark issue. A trial date has been set for February 2007 in the District Court on this claim.

In October 2006, the Company filed a complaint in the Superior Court for Clark County, Washington against Gately’s LLC (the “defendant”) seeking damages in the amount of $5.1 million plus interest, attorney’s fees and costs, for collection of outstanding accounts receivable for product purchased by the defendant. No trial date has been set in this matter.

There have been no other significant subsequent developments relating to the commitments and contingencies reported in the Company’s most recent Annual Report on Form 10-K.

In addition to the matters described above, from time to time the Company is subject to litigation, claims and assessments that arise in the ordinary course of business, including disputes that may arise from intellectual property related matters. Many of our legal matters are covered in whole or in part by insurance. Management believes that any liability resulting from such matters will not have a material adverse effect on the Company’s financial position, results of operations, or cash flows.

Guarantees

From time to time, the Company arranges for commercial leases or other financing sources with third parties to enable certain of its commercial customers to purchase the Company’s commercial products. While most of these financing arrangements are without recourse, in certain cases the Company provides a guarantee or other recourse provisions to the independent finance company of all or a portion of the lease payments in order to facilitate the sale of the commercial products. In such situations, the Company ensures that the transaction between the independent leasing company and the commercial customer represents a sales-type lease. The Company monitors the payment status of the lessee under these arrangements and provides a reserve under SFAS No. 5, Accounting for Contingencies, in situations when collection of the lease payments is not probable. At September 30, 2006 and December 31, 2005, the maximum contingent liability under all recourse and guarantee provisions was approximately $2.2 million and $4.1 million, respectively. At September 30, 2006, lease terms on outstanding commercial customer financing arrangements were between 3 and 5 years. A reserve for estimated losses under recourse provisions of approximately $0.1 million was recorded based on historical loss experience and is included in accrued expenses at both September 30, 2006 and December 31, 2005. In accordance with FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, the Company has also recorded a liability and corresponding reduction of revenue for the estimated fair value of the Company’s guarantees issued during those periods. The fair value of the guarantees was determined based on the estimated risk premium a bank or similar institution would require in order to extend financing to a customer in the absence of a third-party guarantee. This liability is being reduced over the life of each respective guarantee. In most cases if the Company is required to fulfill its obligations under the guarantee, it has the right to repossess the products from the commercial customer. It is not practical to estimate the amount of proceeds that would be generated from the sale of these assets in such situations.

The Company has an agreement with a financing company to provide second tier financing for its consumers. Under normal circumstances, funding for this reserve comes from a percentage of each sale held back by the financing company. In the event that the financing company experiences higher consumer default rates than specified under our contract, the Company will be required to pay an additional amount to the financing company. At September 30, 2006, the Company accrued approximately $0.6 million for this liability.

At September 30, 2006, the Company also had approximately $6.5 million in outstanding commercial letters of credit expiring between December 2006 and January 2007.

 

12. REPORTABLE SEGMENTS

The Company’s operating segments are evidence of the structure of the Company’s internal organization and are organized to allow focus on specific business opportunities in the Company’s worldwide market place. The Company’s three business segments are Fitness Equipment Business, International Equipment Business, and Fitness Apparel Business.

The Fitness Equipment Business is responsible for the design, production, marketing and selling of branded fitness equipment sold under the Nautilus, Bowflex, Schwinn Fitness and Stairmaster brand names and is responsible for servicing customers within the Americas, which includes the United States, Mexico, Canada and South America.

The International Equipment Business is responsible for the marketing and selling of branded fitness equipment sold under the Nautilus, Bowflex, Schwinn Fitness and Stairmaster brand names and is responsible for servicing customers outside of the Americas.

 

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The Fitness Apparel Business is responsible for the design, production, marketing and selling of branded fitness apparel, footwear and accessory products sold primarily under the Pearl Izumi brand in both domestic and international markets.

The three business segments are supported by teams that provide services to support the entire entity including finance and reporting, legal, human resources and other centralized functions. Management does not allocate expenses from the centralized functions to the business segments. As a result, the business segments operating results are reviewed based on revenue and gross profit.

Net sales from external customers for the Company’s consolidated operations were as follows:

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
(in thousands)    2006    2005    2006    2005

Fitness Equipment Business

   $ 128,257    $ 134,013    $ 389,176    $ 395,057

International Equipment Business

     14,584      14,160      43,002      39,085

Fitness Apparel Business

     16,742      15,135      50,007      15,135
                           

Net Sales

   $ 159,583    $ 163,308    $ 482,185    $ 449,277
                           

Gross profit from external customers for the Company’s consolidated operations was as follows:

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
(in thousands)    2006    2005    2006    2005

Fitness Equipment Business

   $ 61,687    $ 61,647    $ 179,621    $ 189,186

International Equipment Business

     2,994      3,615      10,473      10,903

Fitness Apparel Business

     7,409      7,024      21,899      7,024
                           

Gross Profit

   $ 72,090    $ 72,286    $ 211,993    $ 207,113
                           

Assets from the Company’s three operating segments were as follows:

 

(in thousands)    September 30,
2006
   December 31,
2005

Fitness Equipment Business

   $ 262,648    $ 304,033

International Equipment Business

     32,274      31,034

Fitness Apparel Business

     86,653      78,219
             
   $ 381,575    $ 413,286
             

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

FORWARD-LOOKING STATEMENTS

Certain statements contained in this Form 10-Q, including, without limitation, statements containing the words “could,” “may,” “will,” “should,” “plan,” “believes,” “anticipates,” “estimates,” “predicts,” “expects,” “projections,” “potential,” “continue,” and words of similar import, constitute “forward-looking statements.” Investors are cautioned that all forward-looking statements involve risks and uncertainties, and various factors could cause actual results to differ materially from those in the forward-looking statements. From time to time and in this Form 10-Q, we may make forward-looking statements relating to our financial performance, including the following:

 

    Anticipated revenues, expenses and gross margins

 

    Seasonal patterns

 

    Expense as a percentage of revenue

 

    Anticipated earnings

 

    New product introductions, and

 

    Future capital expenditures.

Numerous factors could affect our actual results, including the following:

 

    The availability of media time and fluctuating advertising rates

 

    A decline in consumer spending due to unfavorable economic conditions including high fuel and energy costs, as well as increasing interest rates

 

    Our ability to effectively develop, manufacture, market and sell future products

 

    Our ability to get foreign sourced products through customs in a timely manner

 

    Our ability to effectively identify and negotiate any future strategic acquisitions

 

    Our ability to integrate any acquired businesses into our operations

 

    Our ability to adequately protect our intellectual property

 

    Introduction of lower priced competing products

 

    Unpredictable events and circumstances relating to our international operations, including our use of foreign manufacturers

 

    Unpredictable changes in exchange rates of foreign currencies and the market cost of key commodities such as steel

 

    Government regulatory action, and

 

    Our ability to retain key employees.

We describe certain of these and other key risk factors elsewhere in more detail in this Form 10-Q and in our most recent Annual Report on Form 10-K. Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. Except to the extent required by the federal securities laws, we undertake no obligation to update publicly any forward-looking statements to reflect new information, events, or circumstances after the date of this Form 10-Q or to reflect the occurrence of unanticipated events.

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with our Interim Consolidated Financial Statements and related notes included elsewhere in this report as well as with the MD&A in our most recent Annual Report on Form 10-K. We believe that period-to-period comparisons of our operating results are not necessarily indicative of future performance. You should consider our prospects in light of the risks, expenses and difficulties frequently encountered by companies that operate in evolving markets. We may not be able to successfully address these risks and difficulties and, consequently, we cannot assure you of any future growth or profitability.

OVERVIEW

Nautilus, Inc. (“we,” “us,” “our” or “Company”) is a leading marketer, developer and manufacturer of branded health and fitness products sold under well-known names such as Nautilus, Bowflex, Schwinn Fitness, StairMaster and Pearl Izumi. Our products are distributed through diversified direct, retail and commercial sales channels, both domestically and internationally. We market and sell a variety of branded products that are targeted at specific locations where people shop or exercise. Nautilus, StairMaster and Pearl Izumi brands are most commonly marketed through the commercial and high-end specialty retail markets, while the Bowflex and

 

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Schwinn Fitness branded products are marketed primarily through retail and direct sales channels. Our product marketing includes direct response marketing utilizing a combination of television commercials, infomercials, response mailings, the Internet, catalog, and inbound/outbound call centers to sell our products directly to customers. It also includes a sales force and dealer network marketing to retail organizations, health clubs, government agencies, hotels, corporate fitness centers, colleges, universities and assisted living facilities worldwide.

Summary of the Third Quarter 2006 Results

Net sales for the third quarter of 2006 were $159.6 million, compared to $163.3 million in the same quarter of 2005, a decrease of $3.7 million or 2.3%. The decrease is primarily the result of greater visibility provided by our new information system allowing us to better analyze our sales and margin information by customer, channel, brand and product. As a result, we have restructured some of our relationships with existing customers and discontinued less profitable product offerings to improve profitability. Additionally, seasonal purchase patterns by retailers with more purchases moving into the last quarter of the current year further contributed to a decline in net sales. Gross profit margin increased to 45.2% in the third quarter of 2006 compared to 44.3% in the same quarter of 2005 as a result of continuing improvements in our operational and manufacturing efficiency, our ability to reduce warranty costs by recovering a portion of such costs from our suppliers, and reducing cost of our sourced products. Quarterly operating income declined to $11.1 million or 7.0% of net sales compared to $12.5 million or 7.7% of net sales in the third quarter of 2005. During the third quarter of 2006, the Company recorded a $3.0 million reduction of tax contingency reserves as a result of closing of certain statutory periods and $0.7 million of equity compensation expense; there were no similar items in the corresponding quarter of 2005. Diluted earnings per share for the quarter were 29 cents, compared to 24 cents a year ago.

CRITICAL ACCOUNTING ESTIMATES AND ASSUMPTIONS

The preparation of financial statements in conformity with U.S. GAAP requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements. As described by the Securities and Exchange Commission, critical accounting estimates and assumptions are those that may be material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and that have a material impact on the financial condition or operating performance of the company. There were no changes to our critical accounting estimates and assumptions in the three and nine month periods ended September 30, 2006. Refer to our most recent Annual Report on Form 10-K for a complete description of our critical accounting estimates and assumptions.

 

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RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2005 AND 2006

The following tables present certain consolidated financial data as a percentage of net sales and statement of income data comparing results for the three months ended September 30, 2006 and 2005:

Statement of Income Data

(In thousands)

 

     Three Months Ended September 30,  
     2006    

% of

net sales

    2005   

% of

net sales

    $ change    

%

change

 

Net sales

   $ 159,583     100.0 %   $ 163,308    100.0 %   $ (3,725 )   (2.3 %)

Cost of sales

     87,493     54.8 %     91,022    55.7 %     (3,529 )   (3.9 %)
                             

Gross profit

     72,090     45.2 %     72,286    44.3 %     (196 )   (0.3 %)

Operating expenses:

             

Selling and marketing

     42,621     26.7 %     44,526    27.3 %     (1,905 )   (4.3 %)

General and administrative

     14,507     9.1 %     11,146    6.8 %     3,361     30.2 %

Research and development

     2,521     1.6 %     2,856    1.7 %     (335 )   (11.7 %)

Royalties

     1,296     0.8 %     1,297    0.8 %     (1 )   (0.1 %)
                             

Total operating expenses

     60,945     38.2 %     59,825    36.6 %     1,120     1.9 %
                             

Operating income

     11,145     7.0 %     12,461    7.7 %     (1,316 )   (10.6 %)

Other Income (Expense):

             

Interest income (expense), net

     (537 )   (0.3 %)     145    0.1 %     (682 )   (470.3 %)

Other income (expense), net

     (2 )   0.0 %     31    0.0 %     (33 )   (106.5 %)
                             

Total other income (expense)

     (539 )   (0.3 %)     176    0.1 %     (715 )   (406.3 %)
                             

Income before income taxes

     10,606     6.7 %     12,637    7.8 %     (2,031 )   (16.1 %)

Income tax expense

     1,230     0.8 %     4,366    2.7 %     (3,136 )   (71.8 %)
                             

Net income

   $ 9,376     5.9 %   $ 8,271    5.1 %   $ 1,105     13.4 %
                             

Net Sales

Fitness Equipment Business

Total net sales for the Fitness Equipment Business were $128.3 million in the third quarter of 2006 compared to $134.0 million in the same period of 2005, a decrease of $5.7 million or 4.3%. The decrease is the result of our strategy to improve profitability by refining or eliminating certain of our customer relationships, slower sales during the quarter as a result of seasonal purchase patterns by retailers with more purchases moving into the last quarter of the current year, discontinuation of less profitable product offerings, and decreased advertising.

Net sales from the commercial channel were $17.9 million in the third quarter of 2006 compared to $18.2 million in the same period of 2005. Commercial sales include sales to commercial dealers, health clubs, hotels and living complexes. The decrease in commercial net sales is primarily due to price increases and renegotiation of less profitable volume terms with our dealers to increase profitability.

Net sales from the specialty retail channel were $15.9 million in the third quarter of 2006 compared to $17.8 million in the same period of 2005, a decrease of $1.9 million or 10.7%. Specialty retail sales include sales to fitness retail stores and independent bicycle dealers that typically sell health club-quality equipment to the end consumer for home and small business use. The decrease in specialty net sales is primarily due to slower sales during the quarter as a result of seasonal purchase patterns by retailers with more purchases moving into the last quarter of the current year.

Net sales from the retail channel, which include sales to sporting good stores, warehouse clubs, and department stores, were $27.1 million in the third quarter of 2006 compared to $29.7 in the same period of 2005, a decrease of $2.6 million or 8.8%. The decrease in retail net sales is primarily due to our strategy to discontinue less profitable product offerings and refining or elimination of some customer relationships to improve profitability. The overall decrease in net sales was slightly offset by additional net sales due to launching the Bowflex Blaze product during the quarter.

Net sales from the direct channel were $67.1 million in the third quarter of 2006 compared to $68.3 million in the same period of 2005, a decrease of $1.2 million or 1.8%. The direct channel includes internet sales, catalog sales and sales from direct response advertising. During the current quarter, we increased our media support for our new generation of Bowflex home gyms, the Bowflex Revolution, which was launched in July of 2005, and decreased the amount of advertising spent on our rod based home gyms.

 

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International Equipment Business

Net sales from the International Equipment Business were $14.6 million in the third quarter of 2006 compared to $14.2 million in the same period of 2005, an increase of $0.4 million or 2.8%. The International Equipment Business represents sales outside of the Americas and includes primarily commercial sales, with increasing retail and initial direct marketing sales. The increase in net sales is due to expansion of the commercial and retail channels in Germany and the commercial channel in Italy.

Fitness Apparel Business

Net sales from the Fitness Apparel Business were $16.7 million in the third quarter of 2006 compared to $15.1 million in the same period of 2005, an increase of $1.6 million or 10.6%. The Fitness Apparel Business was created in July 2005 with the Company’s acquisition of Pearl Izumi. The Fitness Apparel Business sells high quality fitness apparel and footwear for cyclists, runners and fitness enthusiasts. The revenue stream of the Fitness Apparel Business is generally seasonal with the first and third quarters having the highest sales and the second and fourth quarters having lower sales. Much of this is related to the timing of when our customers purchase inventory to stock their shelves. The increase in net sales is primarily due to strong sales of the core Pearl Izumi cycling and running products with domestic net sales increasing approximately $0.5 million, and international direct and distributor net sales contributing approximately $0.6 million and $0.3 million, respectively.

Gross Profit

As a result of lower sales, total gross profit was $72.1 million in the third quarter of 2006 compared to $72.3 million in the same period of 2005, a decrease of $0.2 million or 0.3%. As a percentage of net sales, gross profit margins increased to 45.2% in the third quarter of 2006 compared to 44.3% in the comparable period of 2005. The increase is the result of increased visibility provided by our new information system which allows us to better analyze our relationships with existing customers resulting in sales to more profitable customers. Additionally, we have been able to offset our warranty costs by recovering a portion of such costs from our suppliers. Further, we realized cost reductions for our products sourced internationally.

Fitness Equipment Business

Gross profit for the Fitness Equipment Business remained unchanged at $61.7 million in the third quarter of 2006 compared to $61.6 million in the same period of 2005. As a percentage of net sales, gross profit margins increased to 48.1% in the third quarter of 2006 compared to 46.0% in the comparable period of 2005, an increase of 2.1%. The increase in the gross profit margin is attributable to our ability to reduce warranty costs by recovering a portion of such costs from our suppliers. We have also realized cost reductions for our products sourced internationally which were offset by a continuing increase in freight expenses due to high fuel prices.

International Equipment Business

Gross profit for the International Equipment Business was $3.0 million in the third quarter of 2006 compared to $3.6 million in the same period of 2005, a decrease of $0.6 million or 16.7%. As a percentage of net sales, gross profit margin was 20.5% in the third quarter of 2006 compared to 25.4% in the comparable period of 2005. The decrease in gross profit is the result of clearing out older cardio products at discounted prices.

Fitness Apparel Business

Gross profit for the Fitness Apparel Business was $7.4 million in the third quarter of 2006 compared to $7.0 million in the same period of 2005, an increase of $0.4 million or 5.7%. As a percentage of net sales, gross profit margin decreased to 44.3% in the third quarter of 2006 compared to 46.4% in the comparable period of 2005, a decrease of 2.1%. The decrease in the profit margin is due to the mix of products offered by the Fitness Apparel Business and a larger portion of sales coming from the international direct and distributor markets which have lower profit margins.

 

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Operating Expenses

Selling and Marketing

Selling and marketing expenses were $42.6 million in the third quarter of 2006 compared to $44.5 million in the same period of 2005, a decrease of $1.9 million or 4.3%. The decrease is primarily due to a reduction of discretionary amounts spent on marketing costs.

General and Administrative

General and administrative expenses were $14.5 million in the third quarter of 2006 compared to $11.1 million in the same period of 2005, an increase of $3.4 million or 30.2%. As a percentage of net sales, general and administrative expenses were 9.1% in the third quarter of 2006 compared to 6.8% in the same period of 2005. The increase is primarily due to expenses relating to our new ERP system that was implemented in the third quarter of 2005, legal costs, additional depreciation and rent for our new corporate headquarters which we occupied late in the third quarter of 2005, and stock-based compensation expense resulting from the adoption of SFAS 123(R).

Research and Development

Research and development expenses were $2.5 million in the third quarter of 2006 compared to $2.9 million in the same period of 2005, a decrease of $0.3 million or 11.7%. As a percentage of net sales, research and development expenses were 1.6% in the third quarter of 2006 compared to 1.7% in the same period of 2005. The slight decrease is due to a reduced headcount as we aligned our research and development to support our current pace of product innovation.

Royalties

Royalty expenses were $1.3 million in the third quarter of both 2006 and 2005.

Interest income (expense), net

Net interest expense increased to $0.5 million in the third quarter of 2006 compared to interest income of $0.1 million in the same period of 2005. The increase in interest expense is due to short-term borrowings outstanding during the third quarter of 2006. The Company did not have such borrowings in the comparable period of 2005.

Income Tax Expense

Income tax expense was approximately $1.2 million in the third quarter of 2006 compared to $4.4 million in the same period of 2005, a decrease of $3.1 million or 71.8%. Our effective tax rate for the third quarter of 2006 was 11.6% compared to 34.5% in the same period of 2005. The decrease in the effective tax rate is primarily due to a $3.0 million reduction of tax contingency reserves resulting from our determination that certain statutory periods for the assessment of additional state income tax are now closed.

 

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RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005

The following tables present certain consolidated financial data as a percentage of net sales and statement of income data comparing results for the nine months ended 2006 and 2005:

Statement of Income Data

(In thousands)

 

     Nine Months Ended September 30,  
     2006    

% of

net sales

    2005   

% of

net sales

    $ change    

%

change

 

Net sales

   $ 482,185     100.0 %   $ 449,277    100.0 %   $ 32,908     7.3 %

Cost of sales

     270,192     56.0 %     242,164    53.9 %     28,028     11.6 %
                             

Gross profit

     211,993     44.0 %     207,113    46.1 %     4,880     2.4 %

Operating expenses:

             

Selling and marketing

     137,887     28.6 %     129,425    28.8 %     8,462     6.5 %

General and administrative

     40,399     8.4 %     34,567    7.7 %     5,832     16.9 %

Research and development

     8,321     1.7 %     8,768    2.0 %     (447 )   (5.1 %)

Royalties

     3,991     0.8 %     3,952    0.9 %     39     1.0 %
                             

Total operating expenses

     190,598     39.5 %     176,712    39.4 %     13,866     7.9 %
                             

Operating income

     21,395     4.4 %     30,401    6.7 %     (9,006 )   (29.6 %)

Other income (expense):

             

Interest income (expense), net

     (1,152 )   (0.2 %)     1,460    0.3 %     (2,612 )   (178.9 %)

Other income, net

     1,220     0.3 %     542    0.1 %     678     125.1 %
                             

Total other income (expense)

     68     0.1 %     2,002    0.4 %     (1,934 )   (96.6 %)
                             

Income before income taxes

     21,463     4.5 %     32,403    7.1 %     (10,940 )   (33.8 %)

Income tax expense

     5,215     1.1 %     11,373    2.5 %     (6,158 )   (54.1 %)
                             

Net income

   $ 16,248     3.4 %   $ 21,030    4.6 %   $ (4,782 )   (22.7 %)
                             

Net Sales

Net sales were $482.2 million for the first nine months of 2006 compared to $449.3 million in the same period of 2005, an increase of $32.9 million or 7.3%. The increase is attributable to the acquisition of the Fitness Apparel Business in the third quarter of 2005 which contributed approximately $50.0 million of net sales in the first nine month period ended September 30, 2006 compared to $15.1 million in the same period of 2005.

Fitness Equipment Business

Net sales for the Fitness Equipment Business were $389.2 million for the first nine months of 2006 compared to $395.1 million in the same period of 2005, a decrease of $5.9 million or 1.5% primarily due to lower net sales in the direct channel and discontinuation of less profitable product offerings.

Net sales from the commercial channel were $52.1 million for the first nine months of 2006 compared to $53.1 million for the same period of 2005, a decrease of $1.0 million or 1.9%. The decrease in net sales is the result of greater visibility provided by our new information system which allows us to refine our relationships with existing customers and to identify less profitable product offerings which we discontinued to improve profitability.

Net sales from the specialty retail channel were $53.7 million for the first nine months of 2006 compared to $52.8 million for the same period of 2005, an increase of $0.9 million or 1.7%. The increase in net sales is primarily due to gaining additional customers and expanding the number of products offered at existing dealers.

Retail net sales were $72.2 million for the first nine months of 2006 compared to $66.8 million for the same period of 2005, an increase of $5.4 million or 8.1%. The increase is due to gaining additional customers, introduction of new product offerings within our Schwinn Fitness line of cardio equipment, and launching the Bowflex Blaze product in the third quarter of 2006.

Net sales from the direct channel were $211.0 million for the first nine months of 2006 compared to $222.3 million for the same period of 2005, a decrease of $11.3 million or 5.1%. The decrease is due to a combination of reduced advertising in the second quarter of 2006 as a result of increased competition for media space, lower conversion rates as consumer confidence was negatively affected by higher interest rates and fuel prices, and a decrease in sales of our Bowflex rod based technology home gyms as a result of the introduction of a new generation of Bowflex home gyms, the Bowflex Revolution.

 

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International Equipment Business

Net sales from the International Equipment Business were $43.0 million for the first nine months of 2006 compared to $39.1 million for the same period of 2005, an increase of $3.9 million or 10.0%. The increase is due to net sales from the addition of new retail distributors, including expansion of our commercial and retail channels in China, and increased sales in Sweden, Germany, India, Russia and the Benelux countries.

Fitness Apparel Business

Net sales from the Fitness Apparel Business were $50.0 million for the first nine months of 2006 compared to $15.1 million in the same period of 2005, an increase of $34.9 million. The Fitness Apparel Business was created in July 2005 with the Company’s acquisition of Pearl Izumi.

Gross Profit

Gross profit was $212.0 million for the first nine months of 2006 compared to $207.1 million in the same period of 2005, an increase of $4.9 million or 2.4%. The increase is primarily attributable to the full integration of the Fitness Apparel Business acquired in the third quarter of 2005. As a percentage of net sales, gross profit margin decreased to 44.0% in the first nine months of 2006 compared to 46.1% in the comparable period of 2005. The decrease is a result of lower direct channel sales which generally have a higher margin than sales in our other channels, and the addition of the Fitness Apparel Business which had a gross profit margin of 43.8% for the first nine months of 2006.

Fitness Equipment Business

Gross profit for the Fitness Equipment Business was $179.6 million for the first nine months of 2006 compared to $189.2 million for the same period of 2005, a decrease of $9.6 million or 5.1%. As a percentage of net sales, the gross profit margin was 46.1% in the first nine months of 2006 compared to 47.9% in the comparable period of 2005. The decrease in the gross profit margin as a percent of net sales is primarily due to changing channel and product mix and increased freight costs experienced in the first nine months of the current year, offset by reduced warranty costs as a result of recovering a portion of such costs from suppliers and reducing the cost of our sourced products. In addition, the gross profit margin decreased as a result of lower margins realized in the direct channel and the higher margin direct channel representing a smaller percentage of total sales. The direct channel represented approximately 54.2% of net sales during the first nine months of 2006 compared to 56.3% of net sales in the same period of the prior year.

International Equipment Business

Gross profit for the International Equipment Business was $10.5 million for the first nine months of 2006 compared to $10.9 million for the same period of 2005, a decrease of $0.4 million or 3.7%. As a percentage of net sales, the gross profit margin was 24.4% in the first nine months of 2006 compared to 27.9% for the same period of 2005. The decrease in the profit margin is a result of competitive pressures in Europe, increases in freight costs, and clearing out both our older cardio products at discounted prices.

Fitness Apparel Business

Gross profit for the Fitness Apparel Business was $21.9 million for the first nine months of 2006 with a gross profit margin of 43.8% compared to $7.0 million and 46.4%, respectively, during the same period of 2005. The Fitness Apparel Business was acquired in the third quarter of 2005. The decrease in the profit margin is due to the mix of products offered by the Fitness Apparel Business and a larger portion of sales coming from the international direct and distributor markets which have lower profit margins.

Operating Expenses

Selling and Marketing

Selling and marketing expenses were $137.9 million for the first nine months of 2006 compared to $129.4 million for the same period of 2005, an increase of $8.5 million or 6.5%. The increase is primarily due to including operating results of two acquisitions made in 2005.

General and Administrative

General and administrative expenses were $40.4 million for the first nine months of 2006 compared to $34.6 million for the same period of 2005, an increase of $5.8 million or 16.9%. As a percentage of net sales, general and administrative expenses were 8.4% in the first nine months of 2006 compared to 7.7% in the same period of 2005. The increase is due to inclusion of expenses of our

 

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acquired businesses in 2005, expenses relating to our new ERP system that was implemented in the third quarter of 2005, legal costs, additional depreciation and rent for our new corporate headquarters which we occupied late in the third quarter of 2005, and stock-based compensation expense resulting from the adoption of SFAS 123(R).

Research and Development

Research and development expenses were approximately $8.3 million for the first nine months of 2006 compared to approximately $8.8 million for the same period of 2005, a decrease of approximately $0.4 million or 5.1%. The slight decrease is due to a reduced headcount as we aligned our research and development to support our current pace of product innovation.

Royalties

Royalty expenses remained unchanged for the first nine months of 2006 and 2005 at $4.0 million in each of the periods.

Interest and other income (expense), net

Net interest expense increased to $1.2 million in the first nine months of 2006 compared to net interest income of $1.5 million in the same period of 2005. The increase in expense is due to an average balance of short-term borrowings outstanding during 2006; the Company was in a cash investment position during the same period of 2005.

Net other income increased to $1.2 million in the first nine months of 2006 from $0.5 million in the comparable period of 2005. The increase is due to additional foreign currency gains realized by the Company in the second quarter of 2006.

Income Tax Expense

Income tax expense was approximately $5.2 million for the first nine months of 2006 compared to $11.4 million in the same period of 2005, a decrease of $6.2 million or 54.1%. Our effective tax rate for the first nine months of 2006 was 24.3% compared to 35.1% in 2005. The decrease in the effective tax rate is primarily due to a $3.0 million reduction of tax contingency reserves resulting from our determination that certain statutory periods for the assessment of additional state income tax are now closed. Including this and an additional expected tax reserve reversal of $0.8 million in the fourth quarter, we expect our 2006 effective tax rate be 28.5%, returning to 37% in fiscal 2007.

LIQUIDITY AND CAPITAL RESOURCES

During the first nine months of 2006, our operating activities generated $36.7 million in net cash compared to $6.7 million in the same period of the prior year. The improvement from the prior year was primarily the result of a decrease in inventories as the Company focused on improving its forecasting and distribution processes.

Net cash used in investing activities was approximately $9.9 million in the first nine months of 2006 compared to $8.8 million in the same period of 2005. Capital expenditures were approximately $8.4 million in the first nine months of 2006 compared to $23.2 million in the same period of 2005. Capital expenditures during the first nine months of 2006 consisted of manufacturing equipment, website development costs to support our innovative product offerings, and computer equipment to maintain and expand current information systems for future growth. We have also purchased an intellectual property package for $5.8 million. Further, the Company collected $6.1 million from the sale of our former headquarters building located in Vancouver, Washington.

Net cash used in financing activities was $32.9 million in the first nine months of 2006 compared to $9.1 million in the same period of the prior year. The increase was primarily due to the Company’s stock repurchases of $16.7 million and paying down its short and long-term borrowings by $7.0 million.

We believe our existing cash and cash equivalents, cash generated from operations and borrowings available under our credit facilities will be sufficient to meet our capital requirements in the foreseeable future.

OFF-BALANCE SHEET ARRANGEMENTS

From time to time, we arrange for leases or other financing sources with third parties to enable certain of our commercial customers to purchase our commercial products. While most of these financings are without recourse, in certain cases we may offer a guarantee or other recourse provisions. The purpose of these guarantees is to increase our selling opportunities to commercial customers that would not otherwise be able to obtain affordable financing to purchase our commercial products. At September 30, 2006 and December 31, 2005, the maximum contingent liability under all recourse provisions was approximately $2.2 million and $4.1 million, respectively.

 

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In addition, the Company has an agreement with a financing company to provide second tier financing for consumers. Refer to Note 11 of the Notes to Consolidated Financial Statements for further discussion of the accounting treatment for these arrangements.

INFLATION AND PRICE CHANGES

Although we cannot accurately anticipate the effect of inflation on our operations, we do not believe that inflation has had, or is likely in the foreseeable future to have, a material adverse effect on our financial position, results of operations or cash flows. However, increases in inflation over historical levels or uncertainty in the general economy could decrease discretionary consumer spending for products like ours.

During both 2006 and 2005, we experienced increases in transportation costs as a result of increases in the price for fuel. To the extent these costs continue to increase, our gross margins in 2006 may continue to be negatively impacted. Additionally, during 2006 and 2005, the Company implemented transportation surcharges passing some of these cost increases to the end consumer.

SEASONALITY

In general, based on historic trends, we expect our sales from fitness equipment products both domestic and international to vary seasonally with net sales typically strongest in the fourth quarter, followed by the third and first quarters, and weakest in the second quarter. Our analysis shows such factors as the broadcast of national network season finales and seasonal weather patterns influence television viewership and cause our television commercials on national cable television to be less effective in the second quarter than in other periods of the year. In addition, during the spring and summer consumers tend to do more activities outside including exercise, which impacts sales of fitness equipment that is used indoors. Sales from our fitness apparel products are strongest in the first and third quarters and weakest during the fourth quarter. We expect the fluctuation in our net sales between our highest and lowest quarters to be between 40% and 70%.

NEW ACCOUNTING PRONOUNCEMENTS

For a description of the new accounting standards that affect us, refer to Note 1 to our Consolidated Financial Statements included under Part I, Item 1 of this Form 10-Q.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

There have been no material changes in our reported market risks since the filing of our 2005 Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission on March 16, 2006.

We hold our cash and cash equivalents primarily in bank deposits and in liquid debt instruments with maturity dates of less than one year. We are subject to concentration of credit risk as bank deposits may exceed federally insured limits. Additionally, there is risk of loss of the entire principal with any debt instrument we invest in. To reduce risk of loss, we limit our exposure to any individual debt issuer and require certain minimum ratings for debt instruments that we purchase.

FOREIGN EXCHANGE RISK

We are exposed to foreign exchange risk from currency fluctuations, mainly in Canada and Europe, due to sourcing of products in U.S. Dollars and selling of products primarily in Canadian Dollars, Swiss Franks and Euros, respectively. Given the relative size of our current foreign operations, we have chosen not to enter into foreign currency hedges.

INTEREST RATE RISK

We are exposed to market risk for changes in interest rates related to our credit agreements. The credit agreements are at variable interest rates and, at September 30, 2006, we had outstanding borrowings under the credit facility of $35 million. Due to the short-term nature of these borrowings, management believes that any reasonably possible near-term changes in related interest rates would not have a material impact on the Company’s financial position, results of operations, or cash flows.

 

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Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management has evaluated, under the supervision and with the participation of our Chairman, Chief Executive Officer and President, and Chief Financial Officer, Treasurer and Secretary, the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), as amended) as of the end of the period covered by this quarterly report on Form 10-Q pursuant to Rule 13a-15(b) and 15d-15(b) under the Exchange Act. Based on this evaluation, our Chairman, Chief Executive Officer and President, and Chief Financial Officer, Treasurer and Secretary, concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective at the reasonable assurance level that information required to be disclosed in our Exchange Act reports is: (1) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) accumulated and communicated to our management, including our Chairman, Chief Executive Officer and President, and Chief Financial Officer, Treasurer and Secretary, as appropriate to allow timely decisions regarding required disclosure. Management does not expect that our disclosure controls and procedures will prevent or detect all errors and fraud. Any control system, no matter how well designed and operated, is based on certain assumptions and can provide only reasonable, not absolute assurance, that its objectives will be met. Further, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected.

Changes in Internal Controls

As reported in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, management identified a material weakness in the Company’s controls for testing of and training for the enterprise resource planning (“ERP”) system. In addition, management also determined that efforts to mitigate the impact from the lack of testing and training for the implementation of the ERP system resulted in an additional material weakness from insufficient resources being devoted to controls over analyzing and recording contingencies. During the first nine months of 2006, the Company took action to correct the material weaknesses in internal control over financial reporting by:

 

    Identifying and correcting data migration issues;

 

    Providing additional training on the effective and efficient use of the ERP system to ensure data accuracy;

 

    Enhancing system reporting from the ERP system;

 

    Providing additional training to staff responsible for determining the financial impact of each contingency;

 

    Enhancing the review process and responsibility for review of accounting estimates and contingencies; and

 

    Implementing an additional level of review for all significant accounting estimates by the Vice President of Finance, Fitness Equipment Business.

Management believes it has made considerable progress in its efforts to remediate the material weaknesses since December 31, 2005. As on-going remediation continues, the Company is focusing its training and education efforts so that operating effectiveness can be demonstrated over a period of time that is sufficient to conclude that the material weaknesses have been remediated.

Except for the items identified above, there have been no other changes in the Company’s internal control over financial reporting during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

We are involved in various claims, lawsuits and other proceedings from time to time. Such litigation involves uncertainty as to possible losses we may ultimately realize when one or more future events occur or fail to occur. We accrue and charge to income estimated losses from contingencies when it is probable that a liability had been incurred and the amount of loss can be reasonably estimated. Differences between estimates recorded and actual amounts determined in subsequent periods are treated as changes in accounting estimates. The Company estimates the probability of losses on legal contingencies based on the advice of internal and external counsels, outcomes from similar litigation, the status of the lawsuits (including settlement initiatives), legislative developments, and other factors. Due to numerous variables associated with these judgments and assumptions, both the precision and reliability of the resulting estimates of the related loss contingencies are subject to substantial uncertainties. We regularly monitor our estimated exposure to these contingencies and, as additional information becomes known, may change our estimates significantly. A significant change in our estimates, or a result that materially differs from our estimates, could have a significant impact on our financial position, results of operations and cash flows.

In November 2005, the Company proceeded to trial in Salt Lake City, Utah in a case filed by ICON Health & Fitness, Inc. (“ICON”) claiming false advertising involving the Company’s advertising and promotion going back to 1987 for certain elements of its Bowflex home gyms and claiming trademark infringement for the name placed on a treadmill belt sold in 2002. On November 15, 2005, the jury returned a verdict in favor of ICON in the amount of $7.8 million which the Court subsequently increased to $8.1 million. By an order dated April 21, 2006, the Court refused to modify the amount of the jury verdict. The Company has filed a notice of appeal of this judgment and has posted the necessary bond with the Court for the appeal. The Company, based on discussion with its legal counsel, believes the verdict is inconsistent with the law and the evidence presented at trial. Further, the Company believes that the evidence does not support the damage award and thus the likelihood of loss is neither probable nor is the amount of potential loss estimable. Therefore, no accrual has been recorded by the Company.

In December 2002, the Company filed suit against ICON in the Federal District Court, Western District of Washington (the “District Court”) alleging infringement by ICON of the Company’s Bowflex patents and trademarks. The Company sought injunctive relief, monetary damages and its fees and costs. In October 2003, the District Court dismissed the patent infringement claims. The Company appealed the District Court’s decision to the United States Court of Appeals for the Federal Circuit (the “Appeals Court”) and in November 2003, the Appeals Court overruled the District Court and reinstated the patent infringement claims. In May 2005, the District Court again dismissed the patent infringement case against ICON. The Company appealed this case to the Appeals Court, which issued an order in August 2006 affirming the ruling of the District Court dismissing the patent infringement case.

In July 2003, the District Court ruled in favor of the Company on a motion for preliminary injunction on the issue of trademark infringement and entered an order barring ICON from using the trademark “CrossBow” on any exercise equipment. In its ruling, the District Court concluded that the Company showed “a probability of success on the merits and irreparable injury” on its trademark infringement claim. In August 2003, the Appeals Court granted ICON a temporary stay regarding the motion for a preliminary injunction, which enjoined ICON from using the trademark “CrossBow.” This stay allowed ICON to continue using the trademark “CrossBow” until a decision was issued by the Appeals Court. In June 2004, the Appeals Court issued its decision upholding the issuance of an injunction and preventing ICON from selling exercise equipment using the trademark “CrossBow” pending trial on the trademark issue. A trial date has been set for February 2007 in the District Court on this claim.

In October 2006, the Company filed a complaint in the Superior Court for Clark County, Washington against Gately’s LLC (the “defendant”) seeking damages in the amount of $5.1 million plus interest, attorney’s fees and costs, for collection of outstanding accounts receivable for product purchased by the defendant. No trial date has been set in this matter.

There have been no other significant subsequent developments relating to the commitments and contingencies reported in the Company’s most recent Annual Report on Form 10-K.

In addition to the matters described above, from time to time the Company is subject to litigation, claims and assessments that arise in the ordinary course of business, including disputes that may arise from intellectual property related matters. Many of our legal matters are covered in whole or in part by insurance. Management believes that any liability resulting from such matters will not have a material adverse effect on the Company’s financial position, results of operations, or cash flows.

 

26


Table of Contents
Item 1A. Risk Factors

There have been no material changes to the risk factors identified in our annual report on Form 10-K for the year-ended December 31, 2005.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Registrant’s Purchases of Equity Securities:

 

Period

  

Total Number of

Shares Purchased

  

Average Price

Paid per Share

  

Total Number of

Shares Purchased

as Part of

Publically

Announced Plans

or Programs (1)

  

Approximate Dollar

Value of Shares that

May Yet Be

Purchased Under

the Plans or

Programs

July 1, 2006 to July 31, 2006

   —      $ —      —      $ 84,364,000

August 1, 2006 to August 31, 2006

   1,300,700      12.43    1,300,700      68,241,000

September 1, 2006 to September 30, 2006

   43,500      12.20    43,500      67,710,000
                       

Total

   1,344,200    $ 12.42    1,344,200    $ 67,710,000
                       

 

(1) In March 2005, the Company’s Board of Directors authorized the repurchase of up to $100 million of the Company’s common stock in open-market transactions, at times and in such amounts as management deems appropriate, depending on market conditions and other factors. The authorization expires on March 31, 2008, unless extended by the Board of Directors. The repurchase program does not obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time.

 

Item 6. Exhibits

The following exhibits are filed herewith.

 

Exhibit No.   

Description

10.1    Summary of Performance Unit Award - Incorporated by reference to the Company’s Current Report on Form 8-K, as filed with the Commission on August 3, 2006.
10.2    First Amendment to Nautilus, Inc. 2005 Long Term Incentive Plan
31.1    Certification of Principal Executive Officer pursuant to Rule 13a-14 (a) of the Securities Exchange Act of 1934, as amended
31.2    Certification of Principal Financial Officer pursuant to Rule 13a-14 (a) of the Securities Exchange Act of 1934, as amended
32.1    Certification of Principal Executive Officer and Principal Financial Officer pursuant to Rule 13a-14(b) of the Securities and Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

27


Table of Contents

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

    NAUTILUS, INC.
November 8, 2006    

By:

  /s/ Greggory C. Hammann
Date       Greggory C. Hammann, Chairman, Chief Executive
      Officer and President (Principal Executive Officer)

 

November 8, 2006    

By:

  /s/ William D. Meadowcroft
Date       William D. Meadowcroft, Chief Financial Officer,
      Treasurer and Secretary (Principal Financial Officer)

 

28


Table of Contents

EXHIBIT INDEX

 

Exhibit No.   

Description

10.1    Summary of Performance Unit Award - Incorporated by reference to the Company’s Current Report on Form 8-K, as filed with the Commission on August 3, 2006.
10.2    First Amendment to Nautilus, Inc. 2005 Long Term Incentive Plan
31.1    Certification of Principal Executive Officer pursuant to Rule 13a-14 (a) of the Securities Exchange Act of 1934, as amended
31.2    Certification of Principal Financial Officer pursuant to Rule 13a-14 (a) of the Securities Exchange Act of 1934, as amended
32.1    Certification of Principal Executive Officer and Principal Financial Officer pursuant to Rule 13a-14(b) of the Securities and Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

29

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