Nautilus Inc (NLS) 2003 Q4 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to The Nautilus Group Q4 earnings conference call.

At this time all participants are in a listen-only mode. Following today's presentation instructions will be given for the question-and-answer session.

If anyone needs assistance at any time during the conference, please press the star followed by the zero. As a reminder, this conference is being recorded Wednesday, January 28, 2004.

I would now like to turn the conference over to President and CEO of Nautilus Group, Gregg Hammann. Please, go ahead, sir.

Thanks.

Good afternoon, and thanks for joining us for our review of the fourth quarter and year ended December 31, 2003. With us today is Rod Rice, our Chief Financial Officer.

Now on the call today we're going to update everyone on the progress of our strategic turnaround, and how we believe we are better positioning The Nautilus Group for long-term growth opportunities that we see ahead of us.

Rod's then going to take us through our operating and financial results for the fourth quarter, with our year ended December 31, 2003, and will provide guidance. I'll then conclude this section of the call with a review of our business and a summary of our current trends and overall business. We're then going to open up the call to questions.

So before I get started, here's the Safe Harbor statement, and I'd like to remind everyone that our prepared remarks contain forward-looking statements. We may make additional forward-looking statements in response to your questions.

These statements do not guarantee future performance, and therefore undue reliance should not be placed on them. We refer to all of you to our most recent periodic reports on Form 10-K and 10-Q as filed with the Securities and Exchange Commission for more detailed discussions of the factors that could cause actual results to differ materially from those projected in our forward-looking statements.

Okay. With that out of the way, 2003 was a challenging year for The Nautilus Group. We realize that despite the fact we have the most recognized and respected portfolio of brands in the health and fitness industry, we were not developing and positioning our products to reach their full potential. So after a thorough due diligence process in which we interviewed our internal team, talked with industry consultants, and conducted the most comprehensive marketing research study in our history, we came to understand the Nautilus brand strengths and weaknesses.

So on the positive side we have the strongest, most recognized brands in the fitness industry, the most diversified sales channels to distribute our products, and the strongest balance sheet to invest in our future. But we also had to acknowledge that we were not correctly positioning our products in the marketplace. We were not providing consumers the products they want in the locations they shop, said quite simply, and we were not capitalizing on the many opportunities available to us in the $11.4 billion exercise, rest, and nutrition markets that we were not pursuing at this time

So as we discussed in our last conference call, in the latter part of 2003 we began to implement our three-phase, approximately 18-month turnaround plan to reposition our brands and improve our sales channels in order to begin to grow revenue and earnings again.

Now the core of this plan is an internal initiative that we call FIT 1. I've discussed this previously, but want to just go through it quickly to reiterate it, because it's the foundation of our plan to create long-term shareholder value.

So FIT 1 stands for financial rigor, innovation, trust, and the drive to be Number 1 in the categories we compete. These are the core strategic elements around which we will structure our activities, enabling our company to refocus our efforts and begin to grow again.

Okay. So financial rigor means that we will maintain a tight control on expenditures. Innovation means providing our consumers with the most differentiated products, at a faster pace than we have ever done in the past. And the third part of FIT 1 is trust. We must reestablish our credibility with the financial community and our shareholders by delivering what we promise.

It also means we must ensure we are taking care of our customers and doing everything we possibly can to serve them. Finally, the Number 1 component. We must always strive to be Number 1 in each segment that we compete.

So, I am pleased to report that while we are currently in Phase 1, beginning control phase of our turnaround, we have begun to put all of the FIT 1 elements to work. Now during this first phrase our focus has been to improve operating efficiencies and increase cash flow. By leveraging each of these sales opportunities from our performing brands we managed to post an over 30% sequential increase in revenue and a 100 basis point improvement in operating margins from the third quarter of 2003, and we grew our cash position to $73 million from $64 million at the end of the third quarter of 2003.

Now at the same time we've been undergoing a sales channel and brand shift from primarily the direct channel to a more diversified and balanced penetration in retail, commercial, and direct as a combination, while simultaneously creating a better balance between our cardiovascular and strength training products. We have been primarily focused on selling strength products through our direct channel, but our research showed that 80% of our consumer target market buys fitness products through the retail channel, and 60% of those dollars spent are on cardiovascular products.

So in order to diversify our product offering and to capture a greater portion of the $5 billion fitness equipment market, we introduced several new fitness products to the consumer market. And included in this list is the revolutionary TreadClimber cardio product, which Consumer Reports rated as a best TV consumer cardio product, and they rated our consumer treadmills as a best buy and a very good buy. So we've come a long way here in the last six months in driving innovation.

As we move from Phase 1, gain control, to phase 2, stabilize, we will increase our focus on the development and repositioning of our brands and leverage of those brands in each one of our sales channels. Now our goal is to have healthy brands with a differentiated consumer focus products being sold through our sales channel, that will contribute to our growth and improve our performance.

Now the final phase of our turnaround is when we begin to experience meaningful growth. And as we've previously stated, we believe this will not begin until the fourth quarter of 2004.

This final phase is when we have repositioned our brands, we've improved our sales channels, and we're able to offer the consumer products where they shop. We must be able to leverage all aspects of our organizations competency so we are working as one powerful company. Our goal is to be firing on all cylinders, so to speak, by the end of 2004.

Now before I get into more detail about our strategic initiatives for 2004, I'd like to turn the call over to Rod who's going to take you through a thorough review of our operating and financial results for the fourth quarter and year ended December 31. Rod is also going to provide you with guidance.

Mr. Rice.

Thanks Gregg.

As we look at our results for the latter half of 2003, I am encouraged that we're seeing the initial results of the turnaround plan. We are gaining control our business and maximizing the revenue of our performing brands.

We certainly have a lot of work ahead of us, but I'd like to point out a number trend that we saw during the latter half of 2003 that we hope to build upon.

First, fourth quarter earnings for the promotional retail segment increased by over 150% compared to the same period in 2003. We were able to leverage the hundreds of millions of dollars spent on television advertising of the Bowflex product to create consumer demand at retail where the consumers want to buy premium fitness products.

Also, we continued to diversify our earnings and revenue streams with new products such as the TreadClimber, which did not begin shipping until the end of the first quarter. This product in the fourth quarter continued to exceed our expectations and contributed a total of $18.9 million in revenue for 2003.

These sales were achieved even though we implemented a plan of restrained demand. We wanted to ensure that when we rolled out the TreadClimber, our manufacturing, marketing, and operations are all performing in unison before we expand our marketing efforts.

We are excited about the potential this newly created brand will offer for years to come. In fact, in 2004 we believe this product will generate approximately $50 to $60 million in revenue. And we have a patent that lasts for over ten years on this product.

Also in the fourth quarter, our Bowflex brand sold 32,000 units through the direct channel, compared to 29,000 for the third quarter of 2003. And through our direct and retail channels combined, we sold 53,000 units compared to 49,000 units in the third quarter. One of the reasons we were able to achieve this growth in Bowflex units is because of our synergy between the direct and retail channels.

Our diversified sales channels approach is offering consumers the products they want, where they want to shop. Also, our average selling price through the direct channel has continued to stay about $1500 per unit.

We are encouraged about this turnaround and sales trends for this brand, and we are looking forward to a bright future for Bowflex. You know, we have innovated this product more in the last five months than I have the previous five years.

As we mentioned on our third quarter call, we are repositioning the Nautilus Sleep System by improving the features of this brand, exploring unique specialized channels of distribution. Our repositioning effort will not be complete on this product until the latter half of 2004, and at that time we expect to relaunch the Sleep System.

Turning to the financials, revenues and earnings for the fourth quarter and year-end were in line with guidance we gave during second quarter conference call and reiterated on the third quarter conference call.

Net sales for the fourth quarter were $152.8 million, compared to $155.5 million for the corresponding period last year. Net income during the period was $9.4 million, and earnings per share for the fourth quarter were 28 cents per diluted share, compared to $23 million, or 59 cents per diluted share for the corresponding period in the previous year.

Net sales for year-end 2003 were $498.8 million, compared to $584.7 million for last year. Net income for the year 2003 was $34.4 million, or $1.04 per diluted share, compared to $97.9 million, or $2.97 per diluted share for the prior year.

Gross profit margin for the fourth quarter was 44.7%, compared to 53.4% for the fourth quarter of 2002. For the year ended 2003 gross profit margin was 49.3%, compared to 56.9% for the previous year. The reduction in gross profit margin was mainly due to a more diversified sales channel mix, with higher sales in the retail channel, which have lower margins than our direct channel.

The fourth quarter has historically been the strongest quarter for the retail fitness channel. In addition, declining sales in the direct segment have resulted in higher fixed costs per sale.

A change in sales mix from a higher margin Bowflex to TreadClimber further reduced gross margin. As we continue to sell more units of the TreadClimber, we believe our margins will increase due to leveraging our fixed overhead.

Selling and marketing expense for the fourth quarter was $39.6 million, or 25.9% of net sales, compared to $38.9 million, or 25% of net sales for the fourth quarter of 2002. For the year, selling and marketing expense was $149.2 million, compared to $145.3 million last year. The increase in selling and marketing is mainly due to reduced effectiveness of our direct advertising results, but this was offset by leveraging the direct channel advertising investment in the retail channel, where we 80% of the consumers prefer to buy fitness equipment.

General and administrative expenses for the fourth quarter were $12.2 million, up from $6.7 million for the same period in 2002. For the year ended December 31, 2003, G&A expenses were $37.1million, compared to $26 million for the same period last year. The increase in G&A expenses are primarily due to legal costs, and secondarily, to our new computer system.

Consolidated operating income for the fourth quarter was $14.3 million, equating to a 9.4% operating income margin, compared to $35.2 million and a 22.6% operating margin for the fourth quarter of 2002. For the year, operating income was $51.8 million compared to $151.2 million for the same period last year.

The reduction in operating margin was primarily due to higher percentage of commercial and retail products, combined with higher direct marketing expenses due to advertising effectiveness. Looking at the fourth quarter compared to third quarter, our operating margin improved by over 100 basis points.

Now I would like to discuss revenue and earnings by segment. For the fourth quarter 2003, net sales from our direct segment were $59.1million, compared to $91.4 for the fourth quarter last year. Direct segment earnings per share for the fourth quarter were 9 cents per share, compared to 59 cents per diluted share for the same period last year.

For the year of 2003, direct segment net sales were $246.9 million, and earning were 58 cents per diluted share, compared to net sales of $392.6 million, and $2.72 per diluted share for last year.

We believe the decrease in net sales was primarily due to competition, which adversely impacted Bowflex sales through our direct segment. However, we are seeing signs that the decrease in Bowflex units sold through our direct segment is slowing. We sold 32,000 Bowflex units direct during fourth quarter, compared to 29,000 in third quarter. And overall Bowflex units sold through the direct and retail channels increased from 49,000 units in third quarter, to 53,000 units during the fourth quarter of this year.

Our commercial and retail segment net sales were $93.7 million for the fourth quarter, compared to $64.1 million for the same quarter last year, a 46% increase. Commercial and retail segment earnings per diluted share for the fourth quarter were 29 cents, compared to 11cents for the same period last year.

For the year, commercial and retail net sales were $251.9 million, and earnings per share were 66 cents, compared to sales of $192 million, and earnings per share of 14 cents last year. Please note, we acquired StairMaster during the first quarter of 2002. Also Bowflex retail sales equated to $49.2 million, or 20% of overall commercial retail sales in 2003.

You know, I believe that it's important to point out that our commercial and retail revenue accounted for approximately 50% of our overall revenue in 2003, up from approximately 33% in 2002. And non-Bowflex revenue now accounts for 48% in 2003, compared to 39% in 2002.

The operating expenses for our holding company in the fourth quarter were $5.2 million, compared to $1.4 million in fourth quarter of 2002. This increase is primarily due to legal costs. For the year, operating expenses for our holding company were $11.2 million, compared to $6 million for the same period in 2002.

Our cash and short-term investment positions improved to $72.6 million at the end of 2003, compared to $49.3 million at year-end of 2002. This 47% increase was achieved even after paying $13 million in dividends and spending approximately $7 million on capital expenditures during 2003. We believe our capital expenditures for 2004 will be in line with 2004 D&A expense of approximately $13 million.

Our accounts receivable at the end of 2003 was $75.5 million, compared to $50.1 million at year-end 2002. This increase is due to higher volume of sales through our commercial retail division in Q4 of 2003, compared with Q4 of 2002.

Our DSOs on the direct side, they average about three days, On the commercial retail side, DSOs were 71 days in the fourth quarter of this year, compared to 68 days for the fourth quarter the prior year.

Inventories decreased to $53.1 million at the end of 2003 from $63.8 million at year-end 2002.

Our cash flow from operations was $12.6 million for the fourth quarter 2003, compared to $22.8 million for the same period last year.

Operating cash flow for the year was $43.1million, compared to $100.6 million for the previous year. We continued to generate positive cash flow to pay our dividends to shareholders, invest in our future, and at the same time increase our cash position.

Moving to guidance. I would like to elaborate on a few factors that we consider when determining our guidance.

First, in light of the current turnaround position, we remain cautious about guidance and believe it is prudent at this time to provide only detailed guidance for the first quarter.

Second, as we move to a more diversified revenue stream, we expect to experience seasonality similar to the retail and commercial sales channels. We believe our revenue and earnings will be lower in the first half of 2004 compared to the latter half of the year, with the second quarter experiencing the most softness. Last year our commercial retail sales channel generated approximately 37% of its full year revenue in the first six months of the year and only 22% of its full year net income in the first half of the year.

Third, we'll be increasing our investment in R&D in 2004. We believe we need to renew and enhance products to market quicker, to drive diversified revenue and profits.

And fourth, as Gregg has discussed, our company is in the beginning stages of a turnaround process. And while we're encouraged by our progress to date, we do not believe that we'll begin to experience meaningful growth until the fourth quarter of 2004. As such, we are cautiously optimistic about our performance, and we'll only be giving guidance for the first quarter of 2004 at this time.

Now, our first quarter revenue is expected to be in the range of $120 to $130 million, with earnings per share in the range of 18 cents to 20 cents. We are projecting our gross profit margin to be in the range of 46% to 49%, with operating cash flow in the range of $9 to $10 million. We will provide additional guidance, as well as update on progress of our turnaround during our first quarter conference call.

Our net dividend payment of 10 cents per share will be payable on March 10, 2004 to shareholders of record at the end of close of business on February 19, 2004.

Now, I'd like to turn the call back over to Gregg to discuss the trends of our business.

Gregg.

Thanks Rod.

During the fourth quarter, we continued to see sales momentum for the Bowflex brand, and in the consumer strength and fitness industry, this product is widely regarded as one of the most highly sought after and innovative products. And as Rod stated earlier, we have developed more innovation in Bowflex in the past five months than we have in the previous five years.

We'll have Bowflex product differentiation in multiple sales channels that will be differentiated to fit the needs of consumers shopping in those channels. For example, we're not going to be selling the same exact Bowflex product in Costco that we are selling in specialty retail and in the direct sales channel. This strategy will allow our company and our retail partners to have differentiated products under the same brand so we can all make more money and deliver the products to the consumers that they want, in the sales channel that they choose to shop.

Now our innovation of other products is also starting to get notice. Our new innovation in free weights, the SelectTech adjustable dumbbells, received national recognition for one of the best new, innovative fitness products of the year by several national magazines.

And Consumer Reports just ranked one of our Schwinn consumer treadmills as a best buy, and one of our Nautilus treadmills as a very good buy. Consumer Reports also ranked our new TreadClimber as the best TV consumer cardio product, and they named Bowflex best TV consumer strength product. Based on our current R&D product release schedule, we'll be positioned very well for the 2004 consumer fitness season that the retailers will start taking delivery on for the first half of this year.

Now, in our commercial business, we launched the new commercial treadmill in the latter half of 2003. We also introduced a number of new products at the October Club Industry Commercial Fitness Equipment Show in Chicago -- that's a mouthful. One of the products was our new commercial elliptical machine. We began production in the fourth quarter and shipped the new elliptical machine during the quarter.

We also introduced the new Nautilus NITRO Plus commercial strength equipment line. We began production on this new strength line at the end of the fourth quarter, and we'll begin selling this product during the latter part of the first quarter. Later in the year we plan to launch the first variable stride elliptical commercial cardio machine, and by the end of this year, we plan on launching a commercial version of the popular TreadClimber cardio product.

Looking forward in the commercial sales channel, we continue to become more competitive in our commercial business because of our ability to offer a complete line of cardiovascular equipment, which represents about 60% of the dollars spent in the commercial industry.

In the past this has been an under-represented area of our product offering. However, with the addition of our new commercial elliptical and commercial treadmills, we are now beginning to address this underserved market opportunity. We now have the opportunity to sell a complete package of cardiovascular and strength products together.

In summary, Nautilus has had a difficult year in 2003 and will also present a number of challenges to us in 2004. But I'm encouraged about the progress to date on our turnaround plan and our long-term potential.

We believe that we can deliver more results like the ones you've just heard about in the fourth quarter, and we expect to continue to generate positive cash flow in 2004. The plan we embarked upon over six months ago is a rigorous undertaking, but I have confidence that the brand and channel segmentation work we initiated will create the leading health and fitness company and deliver long-term value for our shareholders and employees in 2004 and beyond.

So, here's what we're going to do. One, we plan to continue to diversify our product line with innovative products that consumers demand.

Two, we are going to establish a stronger foothold in the cardio market and capture a significantly greater share of this large and growing market.

Three, we plan to leverage our sales channels and sell more products through our retail channels to diversify our portfolio and sell products where consumers shop. In addition, we will continue to pursue new sales channels, such as the strategic relationship we began with Amazon.com in the latter half of 2003.

And fourth, we plan to continue to control costs and maximize our operating efficiencies.

So we're excited about Nautilus' prospects as we continue to build on our solid foundation with a blueprint based on financial rigor, innovation, trust, and driving to be Number 1 in the categories we compete.

Through careful planning and consistent execution, we expect to deliver both sales and earnings growth over the long-term, and we have the infrastructure, balance sheet, and management team to support this growth. Over the next 9 to 12 months we intend to continue to lay the foundation for clear and sustainable progress, and we look forward to showing measurable results from these efforts in the latter part of 2004 and beyond.

Now I'd like to open up the call for questions.

Thank you, sir. [OPERATOR INSTRUCTIONS]

Our first question comes from Eric Wold with Merriman Curhan Ford & Company. Please go ahead with your question.

Hi. Good afternoon, guys.

Hey, Eric.

Just a couple of questions on the TreadClimber real quick. Can you maybe talk a little bit about, you know, how the marketing effort will change for that product this year versus last year to get a nice tripling of the sales? And then on that same thing, when you expect the commercial version of that to ship, and if that actually will be hitting locations by the fourth quarter of this year?

And then secondly on the TreadClimber, where, kind of in general terms, where are margins now, where do you think they can go, and just kind of like how that's being manufactured and how that'll change?

Okay. Why don't I start with this one Rod, and then if you want to jump in, you can.

Okay. Sounds good.

So, on the marketing effort, as Rod mentioned in the call here, we've been operating on restrained demand on this product. And the main reason we did that was we wanted to make sure that we had the manufacturing process in a way that was creating quality product coming off the line.

And as many of you know, the initial runs we were doing had up in the double digit range of errors on the product that were having -- we had consumers calling back and asking us for repairs. We've now got that number down under 3%, and it's getting better every day. So we're starting to increase demand on it.

We have the ability to turn up the advertising on this product line, and that is what we intend to do now that we've got the operational efficiencies and the quality where we need to have that brand. As most of you know, when you start dealing with cardio equipment, anything that's better than a 5% error rate is considered extremely high quality in this industry.

So we've got it now down under 3, and we feel good about it. We think we can get it down in the 1.5% to 2% range in 2004. So, that's the main driver from the marketing side that will allow us to start to turn up the volume on this thing

From a commercial standpoint, Eric, we're in the development phases of this thing. I think that you'll probably see products start to show up in the commercial side of the business toward the end of 2004. So it will definitely be fourth quarter, and I think we'll just start to get a revenue stream off of that in the fourth quarter, but I would not project it to be at a full-blown rate until the first part of 2005.

On the margins from manufacturing, I'll just touch on this briefly, and then I'll turn it over to Rod.

We've got a target internally that we've set that's pretty aggressive, but that will help to improve margins as we gain the capacity in our plants and facilities. And the main plant that's developing this product for us is in Tyler, Texas, and we have the operational capacity there. As we start to crank this up, it'll obviously reduce the overall cost of goods sold on the product. So that's kind of the starting point for it. Rod, you want to add anything to that?

Sure, you know, right now our margins are running low 60s, which, in my mind, is very good for what this product is. And I just wanted to say, you know, those guys in Tyler, Texas manufacturing this, this is a complicated product and have done a great job. The manufacturing quality coming out of that plant is excellent at this time, and we're going to go from one line to two lines this year in that.

And, you know, one of the big opportunities about being a direct company where you ship directly to your consumers is, volume helps drive higher margins. And what I mean by that is, we have a system in place here, given our size of our company, that we're able to do a lot of neat things like zone skipping and we'll finally get to the size this year with the TreadClimber where we can start implementing some of that.

So not only are you going to see improvements as a volume, and fix overhead in manufacturing, you're going to see efficiencies in labor, and we're looking at the materials of that that you can see the logistics side of that, too. So we've got a lot of factors working in our favor, and like Gregg said, we're going be aggressively looking at this, and we expect by the end of this year to be in the high 60s. And, you know, if we achieve that, that is the perfect margin for our direct product at this point.

You know, one thing I would like to add, when we talked about launching this product we were hoping for the first 12 months we would do $10 million in revenue in this product. And essentially in nine months we've done almost $19 million. I think there's a lot of potential with that product.

Perfect. Thanks a lot.

Thanks, Eric.

Our next question comes from Carol Buyers with RBC Capital. Please go ahead with your question.

Hi. Good afternoon.

Hi, Carol.

I have a couple of questions. First, I was wondering if you could break out the sales of Bowflex in retail and commercial or an average selling price?

And then second, I was hoping that you could discuss, maybe give us a list of where you're distributed today. Where those 53,000 units were sold at retail?

And then finally, I'm just trying to get a better understanding of leverage, and why we didn't see higher leverage on the $30 million higher sales.

I know -- I notice on your corporate allocation line you have about 10 cents of a reduction in your segment line versus your average of about 3. Can you discuss what's non-recurring and recurring in nature going forward on that line? Thanks.

Okay. Rod, you want to handle this one.

Sure. I could -- I could handle this. In Q4, Carol, roughly our Bowflex retail sales were $20 million.

Okay.

And if you want to look at the units like -- what we said is we did 32,000 units on the direct with ASP of about $1500. On the retail side, 21,000 units and a little bit over $950 was our ASP on that.

And the second part of the question, I quite didn't --

The distribution. She was asking about -- I'll handle this one, and then --

No, No. We know you're at Costco and Amazon but I was wondering if you can kind of give us a laundry list of where you are today.

Yeah, Sports Authority, Garts. We've got product in Dick's Sporting Goods now on the line. We've got some -- additionally, some specialty retailers, Chicago Home Fitness is a great example. They're doing a terrific job on our Bowflex product. And we've got several others on the specialty retail side that have really done a tremendous job with the brand in the fourth quarter, so --

How has Costco been doing?

Costco, you know, we continue to do well there. The thing I'd tell you is, you know, and I think I mentioned this in the last call.

We're a little bit out of position from where we want to be over the long-term, and what we talked about is, we want to have differentiated product by channel, and the unfortunate thing is, is where we are in the place in our turnaround here, we haven't launched some of the new innovation that we've got on the Bowflex brand yet. And so, what you're going to see is similar product in Costco that you're seeing in specialty retail and some of our sporting goods customers.

We'll have that differentiated and in the marketplace in a different way by the second and third quarter, and I think that will really help those retailers to be more competitive with each other and have a chance to attract the consumer that's shopping in their stores in a more unique way.

So, you know, [INAUDIBLE] we're doing great in there, I feel really confident about it. The folks at Costco have been great partners with us. But at the same time, we want to make sure we're doing a better job for them and for our other customers at differentiating going forward.

And I could address your last question as regarding the corporate holding company, the charges in the fourth quarter of roughly 10 cents.

Mm-hmm.

And what I would say is --

And am I right to assume that that's in the SG&A line, as well?

Yes, yes it is. Most all of corporate holding is in S&G -- SG&A line.

And really -- really what that is for is some legal costs. And I could tell you the first half of the year those are going to be gearing up a little bit, too, as we move forward with our ICON case. We'll hopefully -- we'll get that past us in 2004, and that's what most of that is.

And then you mentioned a new computer system?

Yeah, and what that is in the -- you know, one of the nice [INAUDIBLE] assets we have in our company is on the direct side of our business, we launched a new computer system the middle of 2003, and those costs are costs to support the system, but also increase in depreciation. If you look at our depreciation from 2003, it's almost doubled from 2002 and it's an allocation of that.

Thank you.

Thanks, Carol.

Our next question comes from Laura Richardson with Adams, Harkness & Hill. Please go ahead with your question.

Okay, thanks. I have sort of one broader question and then a lot of little more detailed ones. And I'm trying to think of the best way to phrase the broader question.

But it, you know, I kind of -- I heard you say you really only wanted to give first quarter guidance, and you're giving a little sense of the seasonality affecting the second quarter, but you sound confident about things improving by the end of the year, and what do you think that's going to translate into in terms of like when earnings start to increase year-over-year?

All right. And did you want me to answer that one first?

Yeah, please.

Okay. So, as we've said in the turnaround, there's really the three stages, and the fourth stage, or the fourth quarter, third stage, is where we expect to start seeing growth in our business again. And so, if you had to pick a point in the future, I think that's a reasonable spot. And as we move through the year, we will keep you posted on whether we're on that track and proceeding as planned, or if we're ahead or behind. Right now we'd tell you we're right dead center on track.

Okay. And that -- I mean, is there a reason you didn't want to go a little farther out in detail in terms of saying year -- the year overall is going to be up from last year or down from last year or equal to or -- ?

Yeah, I tell you, that was a big debate, Laura. And both with our -- some of the folks that we used to bounce ideas off of, including our Board of Directors. And I'll tell you what the final decision was on this and the rationale for it. We're really in the first phase here, of the turnaround, which is the gain control phase. We said we'd be in that through the first quarter.

Right.

And so we want to just be a little cautious. Because as we talk about FIT 1 and the trust factor, the last thing we want to do is have two in a row and then come out and blow a third, right?

So we want to deliver this third one, make sure that we're finalizing some of the components of this gain control phase, and then I think you'll start to see us as we move into the second and third quarter be able to loosen this thing up a little bit and share with you more of where we're at and where we're going. And I'm -- you know, we're not trying to be secretive by any means. We're just trying to tell you that there's a lot of volatility yet, frankly, in a gain control phase, and we're slowly dealing with it.

I think in the last call I'd mentioned, we call it the gremlins in the closet, and we've still got a few of those. But we're dealing with them one by one. You know, we had this CPSC thing that we dealt with this year, or this quarter. We dealt with it very effectively, and Rod, certainly, and the financial team, very proactive and managed it really well. But that's an example of some of the things that we're still dealing with that, you know -- I think we're doing a pretty good job on it, but I don't want to get overconfident so we're just going to be a little bit cautious here.

Okay. That's fair. Then in terms of other questions, I mean I heard what you said to Carol about the legal expenses. And can you refresh our memory, the Bowflex patents, aren't a lot of them expiring this year? And what does that means for the royalty expense? And if those are expiring, why still battle ICON on those issues?

Okay. So there's two components to the ICON. The first one, to answer a couple other questions you had in there, which is, April is the date that the patents expire.

Okay.

So the royalty payments go away at that point. We are anticipating, and have through our intelligence sources, information that there are some other people that are going to introduce product lines. We think we are in a position per the conversation earlier about some things we are doing to innovate this line, to be, not only in a place to defend our position, but, in fact, to grow it. And so, we're taking steps in that regard, and you'll start to see that in the marketplace very soon. So, we're pretty confident on that factor.

Now, regarding the ICON suit. There's two components to that suit. And the first one is about infringing on our patent, and that one is currently with the Circuit Court of Appeals waiting to come back. And that is the part where the patent expires in April. However, we can receive damages for that.

Okay.

And so we were going to -- we are going to continue to pursue that.

Secondarily, there's the trademark issue. Which, you know, Crossbow --

Right.

We get calls every day in our call center with people saying, "Hey, I'm trying to assemble your product, and I can't figure out how to do it, and can you explain it to me." --

Uh-huh.

-- And we find out its a Crossbow, right?

Consumers are confused. I can tell you before I joined the company, I was confused. I was watching an infommercial and I thought it was one of our products. So we're going to continue to go after that one aggressively, as well. So there's really two components to the ICON suit.

Okay.

But it is expensive, you know. Legal fees aren't cheap.

Yeah. Okay. And Rod did say that they'll probably be -- legal expenses will be higher in '04 than '03?

I would say that's a good prediction.

Okay.

And he'll tell you, as we look at, you know, the -- going forward here -- and Rod did a nice job of touching on this.

But I'd say that the other pieces is, and we'd talked about this, is innovation, with the kind of brands that we have in our portfolio, are critical. And so we are doubling our investment in R&D in 2004. And obviously that has an impact on the earnings, short-term, but certainly positions our company for the long run to be very strong, and we're going after the innovation component very, very aggressively.

Okay. Just a couple follow-ups to what you just said, and then I'm going to ask one more thing. Is -- are there still royalties on other products like -- has the bed had a royalty? And I don't know about the TreadClimber.

I don't believe there's any royalty on the bed, is there?

No, there's not.

I thought -- wasn't there other products, Rod, that had royalties besides Bowflex?

Yeah, yeah. We've got quite a few products. The TreadClimber has a royalty on it similar to the Bowflex. We have some elliptical products with a royalty. And even [INAUDIBLE] and SelectTech dumbbells, the concept was by an outside vendor.

Okay. So that line's not going to totally go away after the first quarter?

No. And what we did to try to make it easier for everybody, if you look on the income statement, is we broke out two categories of royalty now.

Oh, okay.

We broke it out in a related and unrelated.

Okay. That will help.

Okay. And then the last thing I just didn't understand in your commentary was how are you measuring -- you said something about the retail sales benefiting from your direct advertising, which I can see. But you made it sound like you were actually allocating some of the ad costs to the commercial retail division from a, you know, a financial accounting perspective?

No, we're not. It was -- what we're seeing is, and like you said, Laura, there is a halo effect, as we would call it. When we do our Bowflex advertising on TV, even though it's for a direct product, you do see some impact from a traffic standpoint and a purchase intent at the retail level.

So, we don't -- we aren't doing any funny stuff from an accounting stand point. That makes it too complicated. What we're trying to do is, what Rod was referring to is just the halo effect, I guess you would call, from a marketing perspective.

Okay. And what did you say again about the bed? That's going to be relaunched in the end of this year?

I knew you'd ask me that question, Laura.

Well, because I research beds, so I --

I was waiting for that one. Actually, yeah, you're right. So, what we said is we'd get back to you in the first quarter and tell you what our plans are. And we are going to relaunch that bed in the third quarter.

We've got most of the product design work done, but the sourcing of the materials of it just is going to take us some time. And so the -- for us to give meaningful quantities from an inventory perspective, we're probably looking, you know, toward the middle of the third quarter for that relaunch.

So that means we shouldn't expect to see any ads or expect to model any sales for the bed until then?

Well, we've got -- you know, we're going to continue to sell the bed we have.

Okay.

And that bed is, it's a great product. But what I can tell you is, the new one we're coming out with had some pretty dramatic improvements in it. You're going to see a different positioning from us than we had in the past.

Interesting.

In light of not giving away too much competitive info here, I think I'll shut up now.

Yeah, that sounds like a good idea, from a competitive standpoint. Okay. Thanks, guys.

Okay. Thanks, Laura.

Our next question comes from James Bellessa with D.A. Davidson Company. Please go ahead with your question.

Good afternoon.

Hey, James.

In this call three months ago you were guiding to sales of $450 million to $470 million. So what came forth to bring the sales significantly above that level?

Jim, when we looked at it, actually our retail business, December was a very good month for our company in the retail business. We've seen that business starting to pick up.

You know, quite frankly, I think Bowflex retail surprised us a little bit, about the demand that we would see from that. And we had a little, you know, we weren't sure from loading into certain channels, that we did a little bit in the third quarter, what would be the factor, and would we get the sell through, and we did. We got some sell through in that.

And that's the main difference, and luckily we did, because we had more legal costs than we expected, and that was driving our EPS number down.

The number of retail Bowflex units sold at retail, 21,000 is that right? That's slightly up from the third quarter level?

Yeah, just barely up. We did 20,000 in Q3.

And can you characterize the sell through or the channel building and those kind of things?

Sure. I think it went extremely well. Because in these -- typically what happens, you know, when you look at the retail fitness season, what the retailers are going to do is they're going to bring their new products in in the third quarter. And typically they're going to bring them in about September. So they're going to load their channels ahead with the inventory, and that's what created a little bit of uncertainty. We had some inventory loaded in there. We had good sell through, and, in fact, they were able to take more units than their first initial load of it.

Holding company expenses in the most recent quarter? I think I heard $5.2 million versus what was it a year ago?

A year ago it was $1.3 -- $1.4 million.

What explains that significant increase?

A lot of it has to do with legal costs that we're experiencing, and with the ICON case at this point.

When do you expect those expenses to subside?

I believe in the second half. You know, hopefully the third quarter. But you know, this case has lasted longer than I ever expected, but we're going to keep pursuing it. I mean, my guess right now is around Q3 of this year.

Would you like to characterize what you think Bowflex unit sales, both direct and retail, might look like during this year?

I think we're taking it one quarter at a time at this point. I think what you're going to see is a diversified balance approach, like you've seen in the fourth quarter here going forward.

And if you take one quarter at a time, what is your guesstimate for the first quarter then?

You know, we haven't -- we're just giving out the top line of the 120, 130. and the EPS number. Matter of fact, Jim, I don't have those numbers in front of me. So at this point we'll just give you the top and bottom line. If I had them in front of me I would give them to you.

Would you like to discuss the average selling price of TreadClimber? $18.9 million in sales? How many units, or what's the average selling price?

You know, one thing for competitive reasons, because we have a big competitor out there, we don't want to -- we debated for a long time, should we give units and ASP, and all that? But I think we came to a good solution giving you exact revenue. But the ASP is over $2,000. It's the highest product that we have right now.

Don't tell anybody, Jim.

Thanks for your help.

Our final question comes from [Jeff Lick] with Power Capital. Please go ahead with your question.

Hey, guys. How you doing?

Hey, Jeff.

Just quick financial detail, Rod. Could you break out the gross margin and selling and marketing by direct and commercial retail?

Sure. On the direct side, and I'm just going to give percentages.

Okay.

Gross profit margin was right around 68%, and I am doing a little bit of rounding here, not a lot. Selling and marketing was about 52%. And I'm giving you the three months here, too.

Yep. That's what I wanted.

DNA was about 6%. Royalties, you know, combined comes out to about a little over 2% on that. Operating margins about 8%. And then we -- then really just have income taxes, so it comes down to net income about 5%.

So when you look at commercial retail, gross profit margin is about 30%. Selling and marketing is 9%. G&A runs about 4%. Royalties is about 1%. It gets you to roughly operating margin of about 16%, and a net income -- I might be going too fast there, but --

That's okay. You said selling and marketing was 9% for commercial and retail?

Yes.

So the 68% gross margin for direct was a sequential improvement over Q3. Anything driving that? Pretty significant, actually, 450 basis points.

It's, you know what it is it's -- we're helping with the volume of the TreadClimber. You know, one -- somebody asked, well how do you get to your $50 or $60 million increase? You know, we're on a pretty good run rate. I mean, we did over $9 million of TreadClimber in the fourth quarter, so we're on a pretty good run rate, so we're seeing margin improvement. And that's really where you get in at this point.

We've also done -- I mean, you've seen a little bit of innovation with the Bowflex with the extreme product.

Mm-hmm.

And having products like that is also helping on our overall margin on the direct side of the business. I'd -- that's one area, you know, we really have done a lot of innovation, and you're going to it starting here in the second and third quarter. Different Bowflex products differentiated by channels we sell.

How far as the bed product fallen off now in terms of revenue? Is is almost down to below $5 million?

It's -- yeah, it's below $5 million.

Okay. $5 million for the quarter. I mean, it's -- at this rate until we relaunch, it'll be a couple million a quarter. Okay. Great. Well, keep it going guys. Good luck.

Okay. Thanks Jeff.

And that's all the time we have for questions today, Mr. Hammann. Do you have any closing comments?

No. As I said on the last conference call, one in a row. We now have two in a row, and we're going to go back to work right now on getting three in a row.

So thank for all for the questions and tuning in today. I appreciate it.

Alright, ladies and gentlemen. This does conclude The Nautilus Group Q4 earnings conference call. If you'd like to listen to a replay of today's conference call, please dial 800-405-2236 or 303-590-3000. Again that's 800-405-2236 and enter the passcode of 568251.

This does conclude our conference call. You may now disconnect. Thank you.