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Nautilus Group 10-Q 2017
Document
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
 
 
(Mark One)
[x]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2017
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: 001-31321
 
 
 
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.)

17750 S.E. 6th Way
Vancouver, Washington 98683
(Address of principal executive offices, including zip code)

(360) 859-2900
(Registrant's telephone number, including area code)

N/A
(Former name, former address and former fiscal year, if changed since last report) 
 
 
 
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  [x]    No  [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer [ ]
 
Accelerated filer [x]
 
Non-accelerated filer [ ]
 
Smaller reporting company [ ]
 
Emerging growth company [ ]
 
 
 
 
(Do not check if a smaller reporting company)
 
 
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [ ]
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  [ ]    No  [x]
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:
The number of shares outstanding of the registrant's common stock as of April 30, 2017 was 30,711,598 shares.
 



NAUTILUS, INC.
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2017





PART I.    FINANCIAL INFORMATION
    
Item 1.     Financial Statements

NAUTILUS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited and in thousands)
 
As of
 
March 31, 2017
  
December 31, 2016
Assets
 
  
 
Cash and cash equivalents
$
27,760

  
$
47,874

Available-for-sale securities
61,053

 
31,743

Trade receivables, net of allowances of $136 and $170
24,870

  
45,458

Inventories
34,295

  
47,030

Prepaids and other current assets
6,986

  
8,020

Income taxes receivable
1,707

  
3,231

Total current assets
156,671

 
183,356

Property, plant and equipment, net
16,718

  
17,468

Goodwill
61,905

  
61,888

Other intangible assets, net
68,983

  
69,800

Deferred income tax assets, non-current

 
11

Other assets
513

  
543

Total assets
$
304,790

 
$
333,066

Liabilities and Shareholders' Equity
 
  
 
Trade payables
$
39,408

  
$
66,020

Accrued liabilities
12,162

  
12,892

Warranty obligations, current portion
3,040

  
3,500

Note payable, current portion, net of unamortized debt issuance costs
 of $7 and $7
15,993

 
15,993

Total current liabilities
70,603

 
98,405

Warranty obligations, non-current
3,952


3,950

Income taxes payable, non-current
2,520

  
2,403

Deferred income tax liabilities, non-current
16,613

 
16,991

Other long-term liabilities
2,419

  
2,481

Note payable, non-current, net of unamortized debt issuance costs
 of $19 and $21
43,984

 
47,979

Total liabilities
140,091

 
172,209

Commitments and contingencies (Note 14)


 


Shareholders' equity:
 
  
 
Common stock - no par value, 75,000 shares authorized, 30,712 and
30,825 shares issued and outstanding
506

  
578

Retained earnings
165,239

  
161,496

Accumulated other comprehensive loss
(1,046
)
  
(1,217
)
Total shareholders' equity
164,699

  
160,857

Total liabilities and shareholders' equity
$
304,790

  
$
333,066



See accompanying Notes to Condensed Consolidated Financial Statements.

1


NAUTILUS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited and in thousands, except per share amounts)
 
 
 
Three Months Ended March 31,
 
 
2017
 
2016
Net sales
 
$
113,252

 
$
120,928

Cost of sales
 
51,507

 
54,584

Gross profit
 
61,745

 
66,344

Operating expenses:
 
 
 
 
Selling and marketing
 
37,665

 
35,179

General and administrative
 
7,486

 
8,231

Research and development
 
3,911

 
3,634

Total operating expenses
 
49,062

 
47,044

Operating income
 
12,683

 
19,300

Other income (expense):
 
 
 
 
Interest income
 
131

 
54

Interest expense
 
(444
)
 
(466
)
Other, net
 
(47
)
 
(124
)
Total other income (expense), net
 
(360
)
 
(536
)
Income from continuing operations before income taxes
 
12,323

 
18,764

Income tax expense
 
4,138

 
7,178

Income from continuing operations
 
8,185

 
11,586

Discontinued operations:
 
 
 
 
Loss from discontinued operations before income taxes
 
(1,626
)
 
(124
)
Income tax expense (benefit) of discontinued operations
 
(534
)
 
18

   Loss from discontinued operations
 
(1,092
)
 
(142
)
Net income
 
$
7,093

 
$
11,444

 
 
 
 
 
Basic income per share from continuing operations
 
$
0.27

 
$
0.37

Basic loss per share from discontinued operations
 
(0.04
)
 

Basic net income per share
 
$
0.23

 
$
0.37

 
 
 
 
 
Diluted income per share from continuing operations
 
$
0.26

 
$
0.37

Diluted loss per share from discontinued operations
 
(0.04
)
 

Diluted net income per share(1)
 
$
0.23

 
$
0.37

Shares used in per share calculations:
 
 
 
 
Basic
 
30,713

 
31,016

Diluted
 
31,127

 
31,295

 
 
 
 
 
(1) May not add due to rounding.
 
 
 
 


See accompanying Notes to Condensed Consolidated Financial Statements.

2


NAUTILUS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited and in thousands)
 
 
 
Three Months Ended March 31,
 
 
2017
 
2016
Net income
 
$
7,093

 
$
11,444

Other comprehensive income (loss):
 
 
 
 
Unrealized gain (loss) on available-for-sale securities, net of income tax expense (benefit) of $(12) and $12
 
(19
)
 
18

Gain (loss) on derivative securities, effective portion, net of income tax expense (benefit) of $72 and $(413)
 
119

 
(682
)
Foreign currency translation, net of income tax benefit of $0 and $(7)
 
71

 
552

        Other comprehensive income (loss)
 
171

 
(112
)
Comprehensive income
 
$
7,264

 
$
11,332



See accompanying Notes to Condensed Consolidated Financial Statements.


3


NAUTILUS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited and in thousands)  
 
Three Months Ended March 31,
 
2017
 
2016
Cash flows from operating activities:
 
 
 
Income from continuing operations
$
8,185

 
$
11,586

Loss from discontinued operations
(1,092
)
 
(142
)
Net income
7,093

 
11,444

Adjustments to reconcile net income to cash provided by operating activities:
 
 
 
Depreciation and amortization
2,244

 
1,935

Provision for allowance for doubtful accounts
83

 
97

Inventory lower-of-cost-and-net-realizable-value adjustments
95

 

Stock-based compensation expense
625

 
701

Loss on asset dispositions

 
10

Deferred income taxes, net of valuation allowance
(435
)
 
5,342

Excess tax benefit related to stock-based awards

 
(1,514
)
Other
5

 

Changes in operating assets and liabilities:
 
 
 
Trade receivables
20,471

 
20,540

Inventories
12,564

 
7,366

Prepaids and other current assets
1,060

 
(1,028
)
Income taxes receivable
1,524

 
(3,406
)
Trade payables
(27,232
)
 
(20,949
)
Accrued liabilities, including warranty obligations
(1,077
)
 
(1,854
)
Net cash provided by operating activities
17,020

 
18,684

Cash flows from investing activities:
 
 
 
Purchases of available-for-sale securities
(36,665
)
 
(9,112
)
Proceeds from maturities of available-for-sale securities
7,355

 
10,323

Acquisition of business, net of cash acquired

 
(3,469
)
Purchases of property, plant and equipment and intangible assets
(45
)
 
(787
)
Net cash used in investing activities
(29,355
)
 
(3,045
)
Cash flows from financing activities:
 
 
 
Payments on long-term debt
(4,000
)
 
(4,000
)
Payments for stock repurchases
(3,427
)
 

Proceeds from exercise of stock options
120

 
35

Tax payments related to stock award issuances
(741
)
 
(221
)
Excess tax benefit related to stock-based awards

 
1,514

Net cash used in financing activities
(8,048
)
 
(2,672
)
Effect of exchange rate changes on cash and cash equivalents
269

 
282

Increase (decrease) in cash and cash equivalents
(20,114
)
 
13,249

Cash and cash equivalents:
 
 
 
Beginning of period
47,874

 
30,778

End of period
$
27,760

 
$
44,027

Supplemental disclosure of cash flow information:
 
 
 
Cash paid for interest
$
446

 
$
466

Cash paid for income taxes, net
2,332

 
4,705

Supplemental disclosure of non-cash investing activities:
 
 
 
Capital expenditures incurred but not yet paid
$
590

 
$
281


See accompanying Notes to Condensed Consolidated Financial Statements.

4


NAUTILUS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(1) GENERAL INFORMATION
 
Basis of Consolidation and Presentation
 
The accompanying condensed consolidated financial statements present the financial position, results of operations and cash flows of Nautilus, Inc. and its subsidiaries, all of which are wholly owned. Intercompany transactions and balances have been eliminated in consolidation.
 
The accompanying condensed consolidated financial statements have not been audited. We have condensed or omitted certain information and footnote disclosures normally included in financial statements presented in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). Management believes the disclosures contained herein are adequate to make the information presented not misleading. However, these condensed consolidated financial statements should be read in conjunction with our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2016 (the “2016 Form 10-K”).
 
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 as of the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Further information regarding significant estimates can be found in our 2016 Form 10-K.
 
In the opinion of management, the accompanying condensed consolidated financial statements reflect all adjustments necessary to present fairly our financial position as of March 31, 2017 and December 31, 2016, and our results of operations and comprehensive income for the three months ended March 31, 2017 and 2016, and cash flows for the three months ended March 31, 2017 and 2016. Interim results are not necessarily indicative of results for a full year. Our revenues typically vary seasonally and this seasonality can have a significant effect on operating results, inventory levels and working capital needs.
 
Unless indicated otherwise, all information regarding our operating results pertain to our continuing operations.
 
New Accounting Pronouncements

ASU 2017-04
In January 2017, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2017-04, "Intangibles - Goodwill and Other (Topic 350) - Simplifying the Test for Goodwill Impairment". ASU 2017-04 simplifies the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test. An entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount, and recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit's fair value, if applicable. The loss recognized should not exceed the total amount of goodwill allocated to the reporting unit. The same impairment test also applies to any reporting unit with a zero or negative carrying amount. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary.ASU 2017-04 is effective for public companies' fiscal years, including interim periods within those fiscal years, beginning after December 15, 2019, on a prospective basis. Early adoption is permitted for interim or annual goodwill impairment tests performed after January 1, 2017. We do not expect the adoption of ASU 2017-04 to have a material effect on our financial position, results of operations or cash flows.

ASU 2016-15
In August 2016, the FASB issued ASU 2016-15, "Statement of Cash Flows (Topic 230) - Classification of Certain Cash Receipts and Cash Payments." The amendments in ASU 2016-15 are intended to add or clarify guidance on the classification of certain cash receipts and payments in the statement of cash flows, with the intent of reducing diversity in practice for the eight (8) types of cash flows identified. ASU 2016-15 is effective for public companies' fiscal years, including interim periods within those fiscal years, beginning after December 15, 2017. Early adoption is permitted. Entities must apply the guidance retrospectively to all periods presented, but may apply it prospectively if retrospective application would be impracticable. We do not expect the adoption of ASU 2016-15 to have a material effect on our financial position, results of operations or cash flows.


5


ASU 2016-13
In June 2016, the FASB issued ASU 2016-13, "Financial Instruments - Credit Losses (Topic 326) - Measurement of Credit Losses on Financial Instruments." The amendments in ASU 2016-13 replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. ASU 2016-13 is effective for public companies' annual periods, including interim periods within those fiscal years, beginning after December 15, 2019, using a modified-retrospective approach, with certain exceptions. Early adoption is permitted. While we do not expect the adoption of ASU 2016-13 to have a material effect on our business, we are evaluating any potential impact that adoption of ASU 2016-13 may have on our financial position, results of operations or cash flows.

ASU 2016-12
In May 2016, the FASB issued ASU 2016-12, "Revenue from Contracts with Customers (Topic 606) - Narrow-Scope Improvements and Practical Expedients." ASU 2016-12 clarifies aspects of Topic 606 related to assessing collectibility, presentation of sales taxes, non-cash consideration, and completed contracts and contract modifications at transition, while retaining the related core principles for those areas. The effective date and transition requirements for ASU 2016-12 are the same as the effective date and transition requirements for Topic 606 (ASU 2014-09). While we do not expect the adoption of ASU 2016-12 to have a material effect on our business, we are evaluating any potential impact that adoption of ASU 2016-12 may have on our financial position, results of operations or cash flows.
 
ASU 2016-10
In April 2016, the FASB issued ASU 2016-10, "Revenue from Contracts with Customers (Topic 606) - Identifying Performance Obligations and Licensing." ASU 2016-10 clarifies aspects of Topic 606 related to identifying performance obligations and the licensing implementation guidance, while retaining the related core principles for those areas. The effective date and transition requirements for ASU 2016-10 are the same as the effective date and transition requirements for Topic 606 (ASU 2014-09). While we do not expect the adoption of ASU 2016-10 to have a material effect on our business, we are evaluating any potential impact that adoption of ASU 2016-10 may have on our financial position, results of operations or cash flows.
    
ASU 2016-09
In March 2016, the FASB issued ASU 2016-09, "Compensation - Stock Compensation (Topic 718) - Improvements to Employee Share-Based Payment Accounting." ASU 2016-09 simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. ASU 2016-09 is effective for public companies' annual periods, including interim periods within those fiscal years, beginning after December 15, 2016. Early adoption is permitted subject to certain requirements, and the method of application (i.e., retrospective, modified retrospective or prospective) depends on the transaction area that is being amended. Related to forfeitures, we changed our accounting treatment of forfeiture expense reversals from "at vest date" to "at forfeiture date". We applied the guidance on a modified retrospective basis, which resulted in a cumulative effective adjustment (in thousands) of $28 reduction to beginning retained earnings. In addition, related to excess tax benefits, we recognized all current period expense through the statement of operations and presented excess tax benefits as an operating cash flow, applied prospectively, with no adjustment to prior periods. The adoption of ASU 2016-09 in January 2017 did not have a material impact on our financial position, results of operations or cash flows.

ASU 2016-02
In February 2016, the FASB issued ASU 2016-02, "Leases (Topic 842)." ASU 2016-02 replaces the existing guidance in Accounting Standards Codification ("ASC") 840, Leases. The new standard would require companies and other organizations to include lease obligations on their balance sheets, including a dual approach for lessee accounting under which a lessee would account for leases as finance leases or operating leases.  Both finance leases and operating leases will result in the lessee recognizing a right-of-use ("ROU") asset and a corresponding lease liability.  For finance leases the lessee would recognize interest expense and amortization of the ROU asset, and for operating leases the lessee would recognize a straight-line total lease expense. Lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. ASU 2016-02 is effective for public companies' annual periods, and interim periods within those fiscal years, beginning after December 15, 2018. We are currently evaluating any potential impact that adoption of ASU 2016-02 may have on our financial position, results of operations and cash flows.

ASU 2015-11
In July 2015, the FASB issued ASU 2015-11, “Simplifying the Measurement of Inventory (Topic 330).” ASU 2015-11 simplifies the accounting for the valuation of all inventory not accounted for using the last-in, first-out (“LIFO”) method by prescribing inventory be valued at the lower of cost and net realizable value. ASU 2015-11 is effective for public companies' annual periods, including interim periods within those fiscal years, beginning after December 15, 2016 on a prospective basis. Early adoption is

6


permitted. Our adoption of ASU 2015-11 in January 2017 did not have a material effect on our financial position, results of operations or cash flows.

ASU 2014-09
In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers." ASU 2014-09 replaces most existing revenue recognition guidance, and requires companies to recognize revenue based upon the transfer of promised goods and/or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and/or services. In addition, the new guidance requires enhanced disclosures, including revenue recognition policies to identify performance obligations to customers and significant judgments in measurement and recognition. ASU 2014-09 is effective, as amended, for annual and interim periods beginning on or after December 15, 2017, applied retrospectively to each prior period presented or retrospectively with a cumulative effect adjustment recognized as of the adoption date. We expect to adopt the new standard on January 1, 2018, and have not yet selected a transition method. We are currently evaluating the overall impact this guidance will have on our consolidated financial statements. Based on our preliminary assessment, we do not expect the adoption of ASU 2014-09 to materially change the timing of revenue recognition and classification of transactions within our consolidated financial statements. We are, however, continuing our assessment, which may identify potential impacts.

(2) DISCONTINUED OPERATIONS

There was no revenue related to discontinued operations for the three months ended March 31, 2017 or the year ended December 31, 2016. However, we continue to have legal and accounting expenses as we work with authorities on final deregistration of certain foreign entities and product liability expenses associated with product previously sold into the Commercial channel.

During the first quarter of 2017, our litigation with Biosig Instruments, Inc. ("Biosig") was settled. The litigation began in 2004 and alleged patent infringement in connection with our incorporation of heart rate monitors into certain cardio products of our former Commercial business. We paid Biosig $1.2 million under the settlement, and the matter was dismissed with prejudice.

(3) FAIR VALUE MEASUREMENTS

Factors used in determining the fair value of financial assets and liabilities are summarized into three broad categories:

Level 1 - observable inputs such as quoted prices (unadjusted) in active liquid markets for identical securities as of the reporting date;
Level 2 - other significant directly or indirectly observable inputs, including quoted prices for similar securities, interest rates, prepayment speeds and credit risk; or observable market prices in markets with insufficient volume and/or infrequent transactions; and
Level 3 - significant inputs that are generally unobservable inputs for which there is little or no market data available, including our own assumptions in determining fair value.
 

7


Assets and liabilities measured at fair value on a recurring basis as of March 31, 2017 and December 31, 2016 were as follows (in thousands):
 
 
March 31, 2017
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
 
Cash Equivalents
 
 
 
 
 
 
 
 
Money market funds
 
$
5,229

 
$

 
$

 
$
5,229

Commercial paper
 

 
2,996

 

 
2,996

Total cash equivalents
 
5,229

 
2,996

 

 
8,225

Available-for-Sale Securities
 
 
 
 
 
 
 
 
Certificates of deposit(1)
 

 
21,097

 

 
21,097

Commercial paper
 

 
15,931

 

 
15,931

Corporate bonds
 

 
15,019

 

 
15,019

U.S. government bonds
 

 
9,006

 

 
9,006

Total available-for-sale securities
 

 
61,053

 

 
61,053

Derivatives
 
 
 
 
 
 
 
 
Interest rate swap contract
 

 
152

 

 
152

 
 
 
 
 
 
 
 
 
Total assets measured at fair value
 
$
5,229

 
$
64,201

 
$

 
$
69,430


 
 
December 31, 2016
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
 
Cash Equivalents
 
 
 
 
 
 
 
 
Money market funds
 
$
9,635

 
$

 
$

 
$
9,635

Commercial paper
 

 
3,999

 

 
3,999

Total cash equivalents
 
9,635

 
3,999

 

 
13,634

 
 
 
 
 
 
 
 
 
Available-for-Sale Securities
 
 
 
 
 
 
 
 
Certificates of deposit(1)
 

 
22,820

 

 
22,820

Corporate bonds
 

 
6,922

 

 
6,922

U.S. government bonds
 

 
2,001

 

 
2,001

  Total available-for-sale securities
 

 
31,743

 

 
31,743

 
 
 
 
 
 
 
 
 
Total assets measured at fair value
 
$
9,635

 
$
35,742

 
$

 
$
45,377

 
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
Derivatives
 
 
 
 
 
 
 
 
Interest rate swap contract
 
$

 
$
(38
)
 
$

 
$
(38
)
 
 
 
 
 
 
 
 
 
Total liabilities measured at fair value
 
$

 
$
(38
)
 
$

 
$
(38
)

(1) All certificates of deposit are within current FDIC insurance limits.

For our assets measured at fair value on a recurring basis, we recognize transfers between levels at the actual date of the event or change in circumstance that caused the transfer. There were no transfers between levels during the three months ended March 31, 2017, nor for the year ended December 31, 2016.

8



We did not have any changes to our valuation techniques during the three months ended March 31, 2017, nor for the year ended December 31, 2016.

We classify our marketable securities as available-for-sale and, accordingly, record them at fair value. Level 1 investment valuations are obtained from real-time quotes for transactions in active exchange markets involving identical assets. Level 2 investment valuations are obtained from inputs, other than quoted market prices in active markets for identical assets, that are directly or indirectly observable in the marketplace and quoted prices in markets with limited volume or infrequent transactions. The factors or methodology used for valuing securities are not necessarily an indication of the risk associated with investing in those securities. Unrealized holding gains and losses are excluded from earnings and are reported net of tax in comprehensive income until realized.

The fair value of our interest rate swap contract is calculated as the present value of estimated future cash flows using discount factors derived from relevant Level 2 market inputs, including forward curves and volatility levels.
 
We recognize or disclose the fair value of certain assets, such as non-financial assets, primarily property, plant and equipment, goodwill, other intangible assets and certain other long-lived assets in connection with impairment evaluations. All of our nonrecurring valuations use significant unobservable inputs and therefore fall under Level 3 of the fair value hierarchy. We did not perform any valuations on assets or liabilities that are valued at fair value on a nonrecurring basis during the first three months of 2017. During the fourth quarter of 2016, we performed our annual goodwill and indefinite-lived trade names impairment analyses effective as of October 1, 2016. During the three months ended March 31, 2017 and the year ended December 31, 2016, we did not record any other-than-temporary impairments on our financial assets required to be measured at fair value on a nonrecurring basis.

The carrying values of cash and cash equivalents, trade receivables, prepaids and other current assets, trade payables and accrued liabilities approximate fair value due to their short maturities. The carrying value of our term loan approximates its fair value and falls under Level 2 of the fair value hierarchy, as the interest rate is variable and based on current market rates.

(4) DERIVATIVES

From time to time, we enter into interest rate swaps to fix a portion of our interest expense. We do not enter into derivative instruments for any purpose other than to manage interest rate exposure to fluctuations in the one-month LIBOR benchmark. That is, we do not engage in interest rate speculation using derivative instruments.

As of March 31, 2017, we had a $60.0 million interest rate swap outstanding with JPMorgan Chase Bank, N.A. This interest rate swap matures on December 31, 2020 and has a fixed rate of 1.42% per annum. The variable rate on the interest rate swap is the one-month LIBOR benchmark. At March 31, 2017, the one-month LIBOR rate was 0.78%.

We typically designate all interest rate swaps as cash flow hedges and, accordingly, record the change in fair value for the effective portion of these interest rate swaps in accumulated other comprehensive income rather than current period earnings until the underlying hedged transaction affects earnings. Gains and losses on the derivative representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings. For the three months ended March 31, 2017, there was no ineffectiveness. As of March 31, 2017, we expect to reclassify a gain of $0.2 million from accumulated other comprehensive income to earnings within the next twelve months.

The fair value of our derivative instruments was included in our condensed consolidated balance sheets as follows (in thousands):
 
 
Balance Sheet Classification
 
As of
 
 
 
March 31, 2017
 
December 31, 2016
Derivatives instruments designated as cash flow hedges:
 
 
 
 
 
 
Interest rate swap contract
 
Prepaids and other current assets
 
$
152

 
$

 
 
Accrued liabilities
 

 
38

 
 
 
 
$
152

 
$
38



9


The effect of derivative instruments on our condensed consolidated statements of operations was as follows (in thousands):
 
 
Statement of Operations Classification
 
Three Months Ended March 31,
 
 
 
2017
 
2016
Derivatives instruments designated as cash flow hedges:
 
 
 
 
 
 
Gain (loss) recognized in other comprehensive income before reclassifications
 
---
 
$
51

 
$
(761
)
Loss reclassified from accumulated other comprehensive income to earnings for the effective portion
 
Interest expense
 
$
(102
)
 
$
(128
)
Income tax benefit
 
Income tax expense
 
$
34

 
$
49


For additional information related to our derivatives, see Notes 3 and 10.

(5) INVENTORIES

Inventories are stated at the lower of cost and net realizable value, with cost determined based on the first-in, first-out method. Our inventories consisted of the following (in thousands):
 
As of
 
March 31, 2017
 
December 31, 2016
Finished goods
$
30,314

  
$
43,130

Parts and components
3,981

  
3,900

Total inventories
$
34,295

  
$
47,030


(6) PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment consisted of the following (in thousands):
 
Estimated
Useful Life
(in years)
 
As of
 
 
March 31, 2017
 
December 31, 2016
Automobiles
5
to
6
 
$
139

 
$
139

Leasehold improvements
4
to
20
 
3,426

 
3,388

Computer software and equipment
3
to
7
 
25,920

 
25,899

Machinery and equipment
3
to
5
 
13,769

 
13,085

Furniture and fixtures
5
to
20
 
2,238

 
2,238

Work in progress(1)
N/A
 
505

 
768

Total cost
 
 
 
 
45,997

 
45,517

Accumulated depreciation
 
 
 
 
(29,279
)
 
(28,049
)
Total property, plant and equipment, net
 
 
 
 
$
16,718

 
$
17,468

(1) Work in progress includes production tooling and computer software.

(7) GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill
The rollforward of goodwill was as follows (in thousands):
 
Direct
 
Retail
 
Total
Balance, January 1, 2016
$
2,113

 
$
58,357

 
$
60,470

Currency exchange rate adjustment
67

 
3

 
70

Business acquisition - measurement period adjustments

 
1,348

 
1,348

Balance, December 31, 2016
2,180

 
59,708

 
61,888

Currency exchange rate adjustment
18

 
(1
)
 
17

Balance, March 31, 2017
$
2,198

 
$
59,707

 
$
61,905


10


Other Intangible Assets
Other intangible assets consisted of the following (in thousands):
 
Estimated
Useful Life
(in years)
 
As of
 
 
March 31, 2017
 
December 31, 2016
Indefinite-lived trademarks
N/A
 
$
32,052

 
$
32,052

Definite-lived trademarks
10
to
15
 
2,600

 
2,600

Patents
8
to
24
 
31,487

 
31,487

Customer relationships
10
to
15
 
24,700

 
24,700

 
 
 
 
 
90,839

 
90,839

Accumulated amortization - definite-lived intangible assets
 
 
 
 
(21,856
)
 
(21,039
)
Other intangible assets, net
 
 
 
 
$
68,983

 
$
69,800


Amortization expense was as follows (in thousands):
 
Three Months Ended March 31,
 
2017
 
2016
Amortization expense
$
817

 
$
960


Future amortization of definite-lived intangible assets is as follows (in thousands):
Remainder of 2017
$
2,439

2018
3,164

2019
3,134

2020
3,108

2021
3,078

Thereafter
22,008

 
$
36,931


(8) ACCRUED LIABILITIES

Accrued liabilities consisted of the following (in thousands):
 
As of
 
March 31, 2017
 
December 31, 2016
Payroll and related liabilities
$
3,105

 
$
4,579

Royalties
3,615

 
3,172

Other
5,442

 
5,141

  Total accrued liabilities
$
12,162

 
$
12,892


(9) PRODUCT WARRANTIES

Our products carry defined warranties for defects in materials or workmanship which, according to their terms, generally obligate us to pay the costs of supplying and shipping replacement parts to customers and, in certain instances, pay for labor and other costs to service products. Outstanding product warranty periods range from thirty days to, in limited circumstances, the lifetime of certain product components. We record a liability at the time of sale for the estimated costs of fulfilling future warranty claims. If necessary, we adjust the liability for specific warranty-related matters when they become known and are reasonably estimable. Estimated warranty expense is included in cost of sales, based on historical warranty claim experience and available product quality data. Warranty expense is affected by the performance of new products, significant manufacturing or design defects not discovered until after the product is delivered to the customer, product failure rates, and higher or lower than expected repair costs. If warranty expense differs from previous estimates, or if circumstances change such that the assumptions inherent in previous estimates are no longer valid, the amount of product warranty obligations is adjusted accordingly.


11


Changes in our product warranty obligations were as follows (in thousands):
 
 
Three Months Ended March 31,
 
 
2017
 
2016
Balance, beginning of period
 
$
7,450

 
$
8,545

Accruals
 
803

 
1,530

Payments
 
(1,261
)
 
(1,363
)
Balance, end of period
 
$
6,992

 
$
8,712


(10) ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following tables set forth the changes in accumulated other comprehensive income (loss), net of tax (in thousands) for the periods presented:
 
 
 
 
 
 
 
 
 
Unrealized Loss on Available-for-Sale Securities
 
Gain (Loss) on Derivative Securities (Effective Portion)
 
Foreign Currency Translation Adjustments
 
Accumulated Other Comprehensive Income (Loss)
Balance, January 1, 2017
$
(8
)
 
$
(24
)
 
$
(1,185
)
 
$
(1,217
)
Current period other comprehensive income (loss) before reclassifications
(19
)
 
51

 
71

 
103

Reclassification of amounts to earnings

 
68

 

 
68

Net other comprehensive income (loss) during period
(19
)
 
119

 
71

 
171

Balance, March 31, 2017
$
(27
)
 
$
95

 
$
(1,114
)
 
$
(1,046
)
 
 
 
 
 
 
 
 
 
Unrealized Gain (Loss) on Available-for-Sale Securities
 
Loss on Derivative Securities (Effective Portion)
 
Foreign Currency Translation Adjustments
 
Accumulated Other Comprehensive Loss
Balance, January 1, 2016
$
(16
)
 
$

 
$
(1,311
)
 
$
(1,327
)
Current period other comprehensive income (loss) before reclassifications
18

 
(761
)
 
552

 
(191
)
Reclassification of amounts to earnings

 
79

 

 
79

Net other comprehensive income (loss) during period
18

 
(682
)
 
552

 
(112
)
Balance, March 31, 2016
$
2

 
$
(682
)
 
$
(759
)
 
$
(1,439
)

(11) STOCK REPURCHASE PROGRAM

On May 4, 2016, our Board of Directors authorized the repurchase of up to $10.0 million of our outstanding common stock from time to time during the period of 24 months following such approval. Repurchases may be made in open market transactions at prevailing prices, in privately negotiated transactions, or by other means in accordance with federal securities laws. Share repurchases are funded from existing cash balances, and the repurchased shares are retired and returned to unissued authorized shares.

The repurchase program expires on May 4, 2018. As of March 31, 2017, there was $4.6 million remaining available for repurchases under the $10.0 million share repurchase program.

Cumulative repurchases pursuant to the program are as follows:
Quarter Ended
 
Number of Shares
 
Repurchased Amount
 
Average Price Per Share
December 31, 2016
 
120,996
 
$1,957,882
 
$16.18
March 31, 2017
 
218,515
 
3,426,959
 
15.68
Totals-to-Date
 
339,511
 
$5,384,841
 
$15.86
 

12


(12) INCOME PER SHARE

Basic per share amounts were computed using the weighted average number of common shares outstanding. Diluted per share amounts were calculated using the number of basic weighted average shares outstanding increased by dilutive potential common shares related to stock-based awards, as determined by the treasury stock method. The weighted average numbers of shares outstanding used to compute income per share were as follows (in thousands):
 
 
Three Months Ended March 31,
 
 
2017
 
2016
Shares used to calculate basic income per share
 
30,713

 
31,016

Dilutive effect of outstanding stock options, performance stock units and restricted stock units
 
414

 
279

Shares used to calculate diluted income per share
 
31,127

 
31,295


The weighted average numbers of shares outstanding listed in the table below were anti-dilutive and excluded from the computation of diluted income per share. In the case of stock options, this is because the average market price did not exceed the exercise price. In the case of restricted stock units, this is because unrecognized compensation expense exceeds the current value of the awards (i.e., grant date market value was higher than current average market price). These shares may be dilutive potential common shares in the future (in thousands):
 
 
Three Months Ended March 31,
 
 
2017
 
2016
Stock options
 
14

 
11

Restricted stock units
 
15

 


(13) SEGMENT AND ENTERPRISE-WIDE INFORMATION

In accordance with FASB ASC 280, Segment Reporting, we determined that we have two operating segments as of December 31, 2016 - Direct and Retail. There have been no changes in our operating segments during the three months ended March 31, 2017.

We evaluate performance using several factors, of which the primary financial measures are net sales and reportable segment contribution. Contribution is the measure of profit or loss, defined as net sales less product costs and directly attributable expenses. Directly attributable expenses include selling and marketing expenses, general and administrative expenses, and research and development expenses that are directly related to segment operations. Segment assets are those directly assigned to an operating segment's operations, primarily accounts receivable, inventories, goodwill and other intangible assets. Unallocated assets primarily include cash and cash equivalents, available-for-sale securities, derivative securities, shared information technology infrastructure, distribution centers, corporate headquarters, prepaids and other current assets, deferred income tax assets and other assets. Capital expenditures directly attributable to the Direct and Retail segments were not significant in any period.




13


Following is summary information by reportable segment (in thousands):
 
Three Months Ended March 31,
 
2017
 
2016
Net sales:
 
 
 
Direct
$
74,703

 
$
81,234

Retail
37,805

 
38,805

Royalty
744

 
889

Consolidated net sales
$
113,252

 
$
120,928

Contribution:
 
 
 
Direct
$
15,333

 
$
21,144

Retail
2,212

 
3,944

Royalty
733

 
870

Consolidated contribution
$
18,278

 
$
25,958

 
 
 
 
Reconciliation of consolidated contribution to income from continuing operations:
 
 
 
Consolidated contribution
$
18,278

 
$
25,958

Amounts not directly related to segments:
 
 
 
Operating expenses
(5,595
)
 
(6,658
)
Other income (expense), net
(360
)
 
(536
)
Income tax expense
(4,138
)
 
(7,178
)
Income from continuing operations
$
8,185

 
$
11,586


There was no material change in the allocation of assets by segment during the first three months of 2017 and, accordingly, assets by segment are not presented.

For the three months ended March 31, 2017 and 2016, no customer represented 10.0% or more of total net sales.

(14) COMMITMENTS AND CONTINGENCIES

Guarantees, Commitments and Off-Balance Sheet Arrangements
As of March 31, 2017, we had no standby letters of credit.

We have long lead times for inventory purchases and, therefore, must secure factory capacity from our vendors in advance. As of March 31, 2017, we had approximately $26.6 million in noncancelable market-based purchase obligations, primarily for inventory purchases expected to be received within the next twelve months. Purchase obligations can vary from quarter-to-quarter and versus the same period in prior years due to a number of factors, including the amount of products that are shipped directly to Retail customer warehouses versus through Nautilus warehouses.

In the ordinary course of business, we enter into agreements that require us to indemnify counterparties against third-party claims. These may include: agreements with vendors and suppliers, under which we may indemnify them against claims arising from use of their products or services; agreements with customers, under which we may indemnify them against claims arising from their use or sale of our products; real estate and equipment leases, under which we may indemnify lessors against third-party claims relating to the use of their property; agreements with licensees or licensors, under which we may indemnify the licensee or licensor against claims arising from their use of our intellectual property or our use of their intellectual property; and agreements with parties to debt arrangements, under which we may indemnify them against claims relating to their participation in the transactions.

The nature and terms of these indemnification obligations vary from contract to contract, and generally a maximum obligation is not stated within the agreements. We hold insurance policies that mitigate potential losses arising from certain types of indemnification obligations. Management does not deem these obligations to be significant to our financial position, results of operations or cash flows, and therefore, no related liabilities were recorded as of March 31, 2017.


14


Legal Matters
In 2004, we were sued in the Southern District of New York by Biosig Instruments, Inc. for alleged patent infringement in connection with our incorporation of heart rate monitors into certain cardio products. No significant activity in the litigation occurred until 2008. In 2012, the U.S. District Court granted summary judgment to us on grounds that Biosig’s patents were invalid as a matter of law. Biosig appealed the grant of summary judgment and, in April 2013, the U.S. Court of Appeals for the Federal Circuit reversed the District Court’s decision on summary judgment and remanded the case to the District Court for further proceedings. On January 10, 2014, the U. S. Supreme Court granted our petition for a writ of certiorari to address the legal standard applied by the Federal Circuit in determining whether the patents may be valid under applicable law. The case was argued before the Supreme Court on April 28, 2014. By decision dated June 2, 2014, the Supreme Court unanimously reversed the Federal Circuit, holding that its standard of when a patent may be “indefinite” was incorrect and remanding to the Federal Circuit for reconsideration under the correct standard. The remand hearing in the Federal Circuit was held on October 29, 2014. By decision dated April 27, 2015, the same panel of the Federal Circuit affirmed its earlier reversal of the District Court’s decision on summary judgment. On May 27, 2015, we filed a petition for a rehearing en banc in the Federal Circuit, which was denied on August 4, 2015 and a Petition for Review by the U. S. Supreme Court which was also denied. The case was then returned to the District Court.
 
Pursuant to agreement of the parties, the litigation involving Biosig was settled effective as of March 28, 2017. We paid $1.2 million under the settlement, and the District Court dismissed the matter with prejudice. The settlement was recorded in discontinued operations.

In addition to the matter described above, from time to time, we may be involved in various claims, lawsuits and other proceedings. These legal and tax proceedings involve uncertainty as to the eventual outcomes and losses which may be realized when one or more future events occur or fail to occur.

Litigation and jury verdicts are, to some degree, inherently unpredictable, and although we have determined that a loss is not probable in connection with any current legal proceeding, it is reasonably possible that a loss may be incurred in connection with proceedings to which we are a party. Assessment of whether incurrence of a loss is probable, or a reasonable possibility, in connection with a particular proceeding, and estimation of the loss, or a range of loss, involves complex judgments and numerous uncertainties. Management is unable to estimate a range of reasonably possible losses related to litigation in which the damages sought are indeterminate, or the legal and factual basis for the relevant claims have not been developed with specificity. As such, zero liability is recorded as of March 31, 2017.

We regularly monitor our estimated exposure to these contingencies and, as additional information becomes known, may change our estimates accordingly. We evaluate, on a quarterly basis, developments in legal proceedings, investigations or claims that could affect the amount of any accrual, as well as any developments that would make a loss probable or reasonably possible, and whether the amount of a probable or reasonably possible loss is estimable. Among other factors, we evaluate the advice of internal and external counsel, the outcomes from similar litigation, current status of the lawsuits (including settlement initiatives), legislative developments and other factors. Due to the 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.

(15) SUBSEQUENT EVENTS

On April 25, 2017, our Board of Directors authorized an additional $15.0 million share repurchase program, bringing the total authorization under existing programs to $25.0 million. Under the new program, shares of our common stock may be repurchased from time to time through April 25, 2019. Repurchases may be made in open market transactions at prevailing prices, in privately negotiated transactions, or by other means in accordance with federal securities laws. Share repurchases will be funded from existing cash balances, and repurchased shares will be retired and returned to unissued authorized shares. To date, we have not repurchased any shares under the new $15.0 million program.
 

15


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

The following discussion and analysis is based upon our financial statements as of the dates and for the periods presented in this section. You should read this discussion and analysis in conjunction with the financial statements and notes thereto found in Part I, Item 1 of this Form 10-Q and our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2016 (the “2016 Form 10-K”). All references to the first quarter and first three months of 2017 and 2016 mean the three-month periods ended March 31, 2017 and 2016, respectively. Unless the context otherwise requires, “Nautilus,” “we,” “us” and “our” refer to Nautilus, Inc. and its subsidiaries. Unless indicated otherwise, all information regarding our operating results pertains to our continuing operations.

Our results of operations may vary significantly from period-to-period. Our revenues typically fluctuate due to the seasonality of our industry, customer buying patterns, product innovation, the nature and level of competition for health and fitness products, our ability to procure products to meet customer demand, the level of spending on, and effectiveness of, our media and advertising programs and our ability to attract new customers and maintain existing sales relationships. In addition, our revenues are highly susceptible to economic factors, including, among other things, the overall condition of the economy and the availability of consumer credit in both the U.S. and Canada. Our profit margins may vary in response to the aforementioned factors and our ability to manage product costs. Profit margins may also be affected by fluctuations in the costs or availability of materials used to manufacture our products, costs associated with acquisition or license of products and technologies, product warranty costs, the cost of fuel, and changes in costs of other distribution or manufacturing-related services. Our operating profits or losses may also be affected by the efficiency and effectiveness of our organization. Historically, our operating expenses have been influenced by media costs to produce and distribute advertisements of our products on television, the Internet and other media, facility costs, operating costs of our information and communications systems, product supply chain management, customer support and new product development activities. In addition, our operating expenses have been affected from time-to-time by asset impairment charges, restructuring charges and other significant unusual or infrequent expenses.

As a result of the above and other factors, our period-to-period operating results may not be indicative of future performance. You should not place undue reliance on our operating results and should consider our prospects in light of the risks, expenses and difficulties typically encountered by us and other companies, both within and outside our industry. We may not be able to successfully address these risks and difficulties and, consequently, we cannot assure you of any future growth or profitability. For more information, see our discussion of risk factors located at Part I, Item 1A of our 2016 Form 10-K.

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as "plan," "expect," "aim," "believe," "project," "intend," "estimate," "will," "should," "could," and other terms of similar meaning typically identify forward-looking statements. Forward-looking statements include any statements related to our future business and financial performance; anticipated fluctuations in net sales due to seasonality; plans and expectations regarding gross and operating margins; plans and expectations regarding research and development expenses and capital expenditures; anticipated losses from discontinued operations; results of media investment in the Direct segment; plans for new product introductions and anticipated demand for our new and existing products; and statements regarding our inventory and working capital requirements and the sufficiency of our financial resources. These forward-looking statements, and others we make from time-to-time, are subject to a number of risks and uncertainties. Many factors could cause actual results to differ materially from those projected in forward-looking statements, including our ability to timely acquire inventory that meets our quality control standards from sole source foreign manufacturers at acceptable costs, the effectiveness, availability and price of media time consistent with our cost and audience profile parameters, greater than anticipated costs associated with launch of new products, our ability to successfully integrate acquired businesses, a decline in consumer spending due to unfavorable economic conditions, softness in the retail marketplace, an adverse change in the availability of credit for our customers who finance their purchases, our ability to pass along vendor raw material price increases and increased shipping costs, our ability to effectively develop, market and sell future products, our ability to protect our intellectual property, the introduction of competing products, and our ability to get foreign-sourced product through customs in a timely manner. Additional assumptions, risks and uncertainties are described in Part I, Item 1A, "Risk Factors," in our 2016 Form 10-K as supplemented or modified in our quarterly reports on Form 10-Q. We do not undertake any duty to update forward-looking statements after the date they are made or conform them to actual results or to changes in circumstances or expectations.


16


Overview
 
We are committed to providing innovative, quality solutions to help people achieve a fit and healthy lifestyle. Our principal business activities include designing, developing, sourcing and marketing high-quality cardio and strength fitness products and related accessories for consumer use, primarily in the U.S., Canada and Europe. Our products are sold under some of the most-recognized brand names in the fitness industry: Nautilus®, Bowflex®, Octane Fitness®, Schwinn® and Universal®.

We market our products through two distinct distribution channels, Direct and Retail, which we consider to be separate business segments. Our Direct business offers products directly to consumers through television advertising, catalogs and the Internet. Our Retail business offers our products through a network of independent retail companies and specialty retailers with stores and websites located in the U.S. and internationally. We also derive a portion of our revenue from the licensing of our brands and intellectual property.

Net sales for the first three months of 2017 were $113.3 million, a decrease of $7.7 million, or 6.3%, as compared to net sales of $120.9 million for the first three months of 2016. Net sales of our Direct segment decreased $6.5 million, or 8.0%, in the first three months of 2017, compared to the first three months of 2016, primarily due to a decline in TreadClimber® sales. Net sales of our Retail segment decreased by $1.0 million, or 2.6%, in the first three months of 2017, compared to the first three months of 2016, primarily due to overall weakness in the retail market and the impact of certain customers rebalancing their inventory levels.

Gross profit for the first three months of 2017 was $61.7 million, or 54.5% of net sales, a decrease of $4.6 million, or 6.9%, as compared to gross profit of $66.3 million, or 54.9% of net sales, for the first three months of 2016. The decrease in gross profit dollars was primarily due to the decrease in net sales. Gross margin decreased 0.4%, due to a decline in the Direct channel margin, resulting from higher discounting on certain cardio products, coupled with an unfavorable segment mix, reflecting an increased percentage of Retail sales.

Operating expenses for the first three months of 2017 were $49.1 million, an increase of $2.0 million, or 4.3%, as compared to operating expenses of $47.0 million for the first three months of 2016. The growth in operating expenses was primarily related to increased sales and marketing spending, which included a $1.2 million charge related to a royalty dispute.

Operating income for the first three months of 2017 was $12.7 million, a decrease of $6.6 million, or 34.3%, as compared to operating income of $19.3 million for the first three months of 2016. The decrease in operating income for the first three months of 2017 compared to the first three months of 2016 was driven primarily by the lower net sales and increased sales and marketing spending.

Income from continuing operations was $8.2 million for the first three months of 2017, or $0.26 per diluted share, compared to income from continuing operations of $11.6 million, or $0.37 per diluted share, for the first three months of 2016. The effective tax rates for the first three months of 2017 and 2016 were 33.6% and 38.3%, respectively. The 4.7% year-over-year rate decrease was primarily due to excess tax benefits related to stock-based compensation.

Net income for the first three months of 2017 was $7.1 million, compared to net income of $11.4 million for the first three months of 2016. Net income per diluted share was $0.23 for the first three months of 2017, compared to $0.37 for the first three months of 2016. In the first quarter of 2017, we recognized an expense of $1.2 million related to a legal settlement with Biosig Instruments, Inc. See discussion in "Discontinued Operations" below for additional information.

Discontinued Operations

Results from discontinued operations relate to the disposal of our former Commercial business, which was completed in April 2011. We reached substantial completion of asset liquidation at December 31, 2012. Although there was no revenue related to the Commercial business in either the 2017 or 2016 periods, we continue to have legal and accounting expenses as we work with authorities on final deregistration of each entity, and product liability and other legal expenses associated with product previously sold into the Commercial channel.

During the first quarter of 2017, our litigation with Biosig Instruments, Inc. was settled. The litigation began in 2004 and alleged patent infringement in connection with our incorporation of heart rate monitors into certain cardio products of our former Commercial business. We paid Biosig $1.2 million under the settlement, and the matter was dismissed with prejudice. For additional information, see Note 14 to our condensed consolidated financial statements, and Part II, Item 1 to this Form 10-Q.


17


RESULTS OF OPERATIONS

Results of operations information was as follows (dollars in thousands):
 
 
 
 
 
 
 
 
 
Three Months Ended March 31,
 
Change
 
2017
 
2016
 
$
 
%
Net sales
$
113,252

 
$
120,928

 
$
(7,676
)
 
(6.3
)%
Cost of sales
51,507

 
54,584

 
(3,077
)
 
(5.6
)%
Gross profit
61,745

 
66,344

 
(4,599
)
 
(6.9
)%
Operating expenses:
 
 
 
 
 
 
 
Selling and marketing
37,665

 
35,179

 
2,486

 
7.1
 %
General and administrative
7,486

 
8,231

 
(745
)
 
(9.1
)%
Research and development
3,911

 
3,634

 
277

 
7.6
 %
Total operating expenses
49,062

 
47,044

 
2,018

 
4.3
 %
Operating income
12,683

 
19,300

 
(6,617
)
 
(34.3
)%
Other income (expense):
 
 
 
 
 
 
 
Interest income
131

 
54

 
77

 
 
Interest expense
(444
)
 
(466
)
 
22

 
 
Other, net
(47
)
 
(124
)
 
77

 
 
Total other expense, net
(360
)
 
(536
)
 
176

 
 
Income from continuing operations before income taxes
12,323

 
18,764

 
(6,441
)
 
 
Income tax expense
4,138

 
7,178

 
(3,040
)
 
 
Income from continuing operations
8,185

 
11,586

 
(3,401
)
 
 
Loss from discontinued operations, net of taxes
(1,092
)
 
(142
)
 
(950
)
 
 
Net income
$
7,093

 
$
11,444

 
$
(4,351
)
 
 

Results of operations information by segment was as follows (dollars in thousands):
 
 
 
 
 
 
 
 
 
Three Months Ended March 31,
 
Change
 
2017
 
2016
 
$
 
%
Net sales:
 
 
 
 
 
 
 
Direct
$
74,703

 
$
81,234

 
$
(6,531
)
 
(8.0
)%
Retail
37,805

 
38,805

 
(1,000
)
 
(2.6
)%
Royalty
744

 
889

 
(145
)
 
(16.3
)%
 
$
113,252

 
$
120,928

 
$
(7,676
)
 
(6.3
)%
Cost of sales:
 
 
 
 
 
 
 
Direct
$
25,779

 
$
27,372

 
$
(1,593
)
 
(5.8
)%
Retail
25,717

 
27,193

 
(1,476
)
 
(5.4
)%
Royalty
11

 
19

 
(8
)
 
(42.1
)%
 
$
51,507

 
$
54,584

 
$
(3,077
)
 
(5.6
)%
Gross profit:
 
 
 
 
 
 
 
Direct
$
48,924

 
$
53,862

 
$
(4,938
)
 
(9.2
)%
Retail
12,088

 
11,612

 
476

 
4.1
 %
Royalty
733

 
870

 
(137
)
 
(15.7
)%
 
$
61,745

 
$
66,344

 
$
(4,599
)
 
(6.9
)%
Gross margin:
 
 
 
 
 
 
 
Direct
65.5
%
 
66.3
%
 
(80
)
basis points
Retail
32.0
%
 
29.9
%
 
210

basis points

18


The following table compares the net sales of our major product lines within each business segment (dollars in thousands):
 
 
 
 
 
 
 
 
 
Three Months Ended March 31,
 
Change
 
2017
 
2016
 
$
 
%
Direct net sales:
 
 
 
 
 
 
 
Cardio products(1)
$
68,703

 
$
77,092

 
$
(8,389
)
 
(10.9
)%
Strength products(2)
6,000

 
4,142

 
1,858

 
44.9
 %
 
74,703

 
81,234

 
(6,531
)
 
(8.0
)%
Retail net sales:
 
 
 
 
 
 
 
Cardio products(1)
29,039

 
29,953

 
(914
)
 
(3.1
)%
Strength products(2)
8,766

 
8,852

 
(86
)
 
(1.0
)%
 
37,805

 
38,805

 
(1,000
)
 
(2.6
)%
 
 
 
 
 
 
 
 
Royalty
744

 
889

 
(145
)
 
(16.3
)%
 
$
113,252

 
$
120,928

 
$
(7,676
)
 
(6.3
)%
 
 
 
 
 
 
 
 
(1)   Cardio products include: Max Trainer®, TreadClimber®, Zero Runner®, treadmills, exercise bikes and ellipticals.
(2)   Strength products include: home gyms, selectorized dumbbells, kettlebell weights and accessories.

Direct     

Direct net sales decreased 8.0% for the three month period ended March 31, 2017 compared to the same period of 2016. The decrease in net sales in the first quarter of 2017 was primarily related to a 10.9% decline in cardio sales, which was driven by the TreadClimber® product line. The decrease in cardio sales was partially offset by a 44.9% increase in strength products that resulted from higher sales of gyms and dumbbell products, including the recently launched SelectTech® 560 line.

Combined consumer credit approvals by our primary and secondary U.S. third-party financing providers for the first quarter of 2017 was 52.6%, compared to 49.9% in the same period of 2016. We continue to experience improved credit approval rates due to our media strategy, which focuses on generation of qualified responders. Additionally, our Tier 1 credit provider has noted strong performance from our account portfolio, and due to that history, has progressively loosened approval standards. We remain focused on maintaining a healthy payment balance between credit card and financed purchases.

The $1.6 million decrease in cost of sales of our Direct business in the first quarter of 2017 compared to the same period of 2016 was due to lower net sales.

For the three month period ended March 31, 2017, Direct gross margin decreased 80 basis points as compared to the same period of 2016 primarily due to higher discounting of the TreadClimber® product line.
 
Retail

Retail net sales decreased 2.6% for the three month period ended March 31, 2017 compared to the same period of 2016. The decrease was primarily driven by the impact of certain customers rebalancing their inventory levels, coupled with some softness in the retail market.

The decrease in cost of sales of our Retail business for the three month period ended March 31, 2017 compared to the same period of 2016 was primarily related to the decrease in Retail net sales as discussed above.

For the three month period ended March 31, 2017, Retail gross margin increased 210 basis points compared to the same period of 2016 due improvement in product mix.


19


Selling and Marketing
 
 
 
 
 
 
 
 
Dollars in thousands
Three Months Ended March 31,
 
Change
 
2017
 
2016
 
$
 
%
Selling and marketing
$37,665
 
$35,179
 
$2,486
 
7.1%
As % of net sales
33.3%
 
29.1%
 
 
 
 

The $2.5 million increase in selling and marketing expense in the three month period ended March 31, 2017 compared to the same period of 2016 was related to higher media advertising of $2.5 million and a $1.2 million reserve related to a royalty dispute, offset by lower variable selling expenses of $1.4 million.

Media advertising expense of our Direct business is the largest component of selling and marketing and was as follows:
 
 
 
 
 
 
 
 
Dollars in thousands
Three Months Ended March 31,
 
Change
 
2017
 
2016
 
$
 
%
Media advertising
$20,003
 
$17,509
 
$2,494
 
14.2%

The increase in media advertising in the three month period ended March 31, 2017 compared to the same period of 2016 was primarily related to significantly favorable media response rates achieved in the first quarter of 2016 associated with the Max Trainer® M7 launch.

General and Administrative
 
 
 
 
 
 
 
 
Dollars in thousands
Three Months Ended March 31,
 
Change
 
2017
 
2016
 
$
 
%
General and administrative
$7,486
 
$8,231
 
$(745)
 
(9.1)%
As % of net sales
6.6%
 
6.8%
 
 
 
 

The decrease in general and administrative in the three month period ended March 31, 2017 compared to the same period of 2016 was primarily due to lower employee compensation of $0.7 million and $0.3 million of corporate administration expenses related to acquisition and integration costs of Octane. These costs were partially offset by higher litigation expenses of $0.4 million in the same comparative period.

Research and Development
 
 
 
 
 
 
 
 
Dollars in thousands
Three Months Ended March 31,
 
Change
 
2017
 
2016
 
$
 
%
Research and development
$3,911
 
$3,634
 
$277
 
7.6%
As % of net sales
3.5%
 
3.0%
 
 
 
 

The increase in research and development in the three month period ended March 31, 2017 compared to the same period of 2016 was primarily due to our investment in additional engineering and product development headcount as we continue to supplement our new product development resources required to innovate and broaden our product portfolio.

Interest Expense
Interest expense of $0.4 million decreased less than $0.1 million for the three month period ended March 31, 2017 compared to the same period of 2016.

Other, Net
Other, net relates to the effect of exchange rate fluctuations between the U.S. and our foreign subsidiaries, primarily Canada, China and Europe.

20


Income Tax Expense
 
 
 
 
 
 
 
 
Dollars in thousands
Three Months Ended March 31,
 
Change
 
2017
 
2016
 
$
 
%
Income tax expense
$4,138
 
$7,178
 
$(3,040)
 
(42.4)%
Effective tax rate
33.6%
 
38.3%
 
 
 
 

The decrease in the effective tax rate from continuing operations for the three month period ended March 31, 2017 compared to the same period of 2016 was primarily due to $0.4 million of excess tax benefits related to stock-based compensation recognized as a current period benefit through the statement of operations, resulting from adoption of ASU 2016-09 in January 2017.

LIQUIDITY AND CAPITAL RESOURCES
 
As of March 31, 2017, we had $88.8 million of cash and investments compared to $79.6 million as of December 31, 2016. Cash provided by operating activities was $17.0 million for the three months ended March 31, 2017, compared to $18.7 million for the three months ended March 31, 2016. We expect our cash, cash equivalents and available-for-sale securities at March 31, 2017, along with cash expected to be generated from operations, to be sufficient to fund our operating and capital requirements for at least twelve months from March 31, 2017.

The decrease in cash flows from operating activities for the three months ended March 31, 2017 as compared to the same period of 2016 was primarily due to the decline in operating performance, partially offset by changes in our operating assets and liabilities as discussed below.