Nautilus Inc (NLS) 2004 Q4 法說會逐字稿

Welcome to The Nautilus Group fourth quarter earnings conference call. (OPERATOR INSTRUCTIONS). And as a reminder, this conference is being recorded today, Wednesday, February 2, 2005.

Before the call begins, listeners should be advised of the Safe Harbor statement that applies to today's call. Prepared remarks during this call contain forward-looking statements. Additional forward-looking statements may be made in response to questions. These statements, including information about markets, products, brands and channels, do not guarantee future performance. Undue reliance should not be placed upon them.

Listeners should review the Company's most recent periodic reports on Form 10-K and Form 10-Q filed with the Securities and Exchange Commission for more details (technical difficulty) on factors that could cause actual results to differ materially from those projected in forward-looking statements. And now I would like to turn the conference over to Mr. Gregg Hammann, Chairman and CEO of The Nautilus Group. Please go ahead, sir.

And thank you for joining us, for all listeners out there. I have been anxiously awaiting this conference call and the opportunity to share with you the results that we have achieved both in the fourth quarter and to forecast the future for the Company. So today we're going to discuss 4 key areas to give you better insight to the potential of our Company.

First, we going to cover the fourth quarter and year-end results. Second, we will provide you with some highlights of our new three-year gross plan as we move beyond our turnaround into what we believe is sustainable long-term growth. Third, we are to outline the category leadership opportunity we're pursuing, and we believe are uniquely positioned to achieve, creating a true industry leader. Fourth, we're going to give you some guidance for the year and for the quarter.

So about an hour ago we posted our quarterly and year-end financial statements which showed we delivered the quarter as expected. We grew earnings by 51 percent in the fourth quarter on an 11 percent revenue increase. We experienced a very strong direct business and excellent sell-through in our retail business, which outpaced our short-term availability of product supply. For the year, we grew revenues by 5 percent, achieving net sales of nearly 524 million and earnings per share of 90 cents.

With the conclusion of 2004 we wrapped up an 18 month turnaround on schedule, while continuing to increase our cash position. We believe we will continue to generate double-digit revenue and earnings growth for the next 3 years as we progress forward to become the global leader in fitness.

Business results we are achieving are a direct outcome of our commitment to our Fit One operating principles. They are financial rigor, innovation, trust, and putting ourselves on a path to become the leader in every category where we compete. We view 2004 as the year of the turnaround. Not just to get our Company back on a growth track, but to position our organization to become the global leader in health and fitness over the long term.

This required a sequenced multifaceted business plan. It included new leadership, new strategies, integrating past acquisitions, renewing our commitment to quality, entering new categories, forging customer relationships, and investing in innovation. All of these steps has positioned us for 2005, the first year of our new three-year growth plan where we expect to drive growth and invest in the future.

Now before we get into that, let me introduce Rod Rice, to provide a more detailed look at our financials for the fourth quarter and 2004.

As those of you who follow the category know, the fourth quarter is our best quarter of the year due to seasonality. 2004 was no exception. The fourth quarter of 2004 marks the 6th straight quarter our revenue and earnings met or exceeded guidance we gave at the beginning of the quarter. Net sales for the fourth quarter were 169.6 million compared to 152.8 million for the corresponding period last year. That is an 11 percent increase. Gross profit margins were 47.2 percent compared to 45.6 percent a year ago. Operating income for the fourth quarter was 12.2 percent compared to 9.4 percent in the fourth quarter of 2003.

Diluted earnings per share for the fourth quarter were 42 cents. And this does include a 1 cent gain from reducing the taxes after the completion of a normal federal audit. This compares to 28 cents in the fourth quarter of 2003. This is a 50 percent increase year-over-year for that quarter.

Overall, it was a very strong quarter for our direct business. We experienced considerable growth in direct sales with an increase of 24.9 million from the prior year. Due to strong sales of multiple models of the Bowflex home gyms, our Bowflex TreadClimber Cardio products, and a good Bowflex SelectTech dumbbell introduction. To better focus on these growth opportunities in the future, we have decided to exit the Sleep Systems business which had sales of about $200,000 in the fourth quarter.

Commercial and retail sales met our expectations for the quarter, being down 8.1 million from the prior year. The reasons for the decline include manufacturing and supply chain constraints in the fourth quarter of 2004, and a large sell-in of Bowflex products to a major retailer in the fourth quarter of 2003.

For the retail products we did deliver in the fourth quarter of 2004, our retail customers experienced very strong sell-through. We are also experiencing manufacturing capacity constraints because of our strong demand for our Nautilus Nitro Plus commercial (indiscernible) products. We expect to be in a better position in the first half of 2005 to meet commercial demand as a new second shift becomes fully staffed and starts to achieve operational efficiency.

Gross profit margin was consistent for our direct business at 69.4 percent in the fourth quarter of 2004 compared to 68.7 percent in the fourth quarter of 2003. Our commercial and retail margins for the fourth quarter of 2004 were 25.3 percent, down from 31 percent in the fourth quarter of 2003. The primary reasons for the decline were manufacturing variances, startup costs associated with the second shift, and higher logistics costs to expedite products to the retailers. We expect to see margin improvements in 2005 due to our efforts to improve manufacturing and supply chain operations.

Direct selling and marketing costs improved to 45.5 percent of sales. This was the lowest percentage of net sales in 1.5 years. It reflects strong consumer response to innovation and refinements in our marketing and advertising approach. The favorable consumer response helped to drive down our advertising expense for our direct business to 26.2 percent of net sales in the fourth quarter of 2004. This is compared to 29.3 percent in the fourth quarter of 2003, a 10 percent improvement.

Selling and marketing expenses were 9.4 percent of net sales for our commercial and retail business in the fourth quarter of 2004 compared to 9.3 percent in the fourth quarter of 2003. General and administrative expenses declined to 9.9 million in the fourth quarter of 2004 from 12.2 million in the fourth quarter of 2003. The primary reason was the decline of legal costs that we incurred in the prior year of 2003.

Our direct operating margin was 19.6 percent, up from 8.5 percent in the same quarter last year. This is the result of new effective selling and marketing, which drove strong direct sales. Our commercial and retail operating margin was 9.6 percent in the fourth quarter of 2004 compared with 16.7 percent in the same quarter last year. This decline is primarily due to lower gross profit margins and larger investments in research and development to drive our business.

Turning to our strong balance sheet. We finished the year with a cash position of 100.6 million compared to 72.6 million for 2003. Our DSOs increased to 51 days at year end, compared to 44 days at the prior year. This is the result of delivering more products to customers later in the quarter compared to last year. Inventory turns were consistent with the prior year at about 7 times.

One area we did make great improvements in is DPO. They moved up to 37 days at year end compared to 24 days a year ago. As our business continues to generate cash, we envision continuing to pay dividends, increase investments in innovation, make acquisitions of the right opportunity services, or buy back our stock.

Starting with the first quarter of 2005 conference call, we will be giving more information based upon where our customers shop. We believe this'll help investors and analysts gain more insight into our business. We will share our net sales, retail presence and SKU penetration for each of our primary channels on a quarterly basis.

The Company announced today that our Board of Directors has declared a regular quarterly dividend of 10 cents per common share, payable March 10, 2005 to shareholders of record February 20, 2005.

Now for a more complete overview of our sales and marketing plans, I would like to introduce Tim Hawkins, our Chief Customer Officer and Chief Marketing Officer.

The market opportunity for fitness equipment is substantial. Based upon industry reports and estimates the domestic fitness equipment market is $5.4 billion. And the international market is at least another 1 billion. When you look at Nautilus today you see a Company that has about an 8 percent marketshare in the global fitness equipment category. If we were a mature category leader, such as Gatorade is to sports drinks or Nike is to athletic apparel, our marketshare would be around 40 percent. Applied to our industry the market opportunity for our fitness category leader would be $2.5 billion. We are about one-fifth of the way to our goal of being that global leader.

That is before you factor in category growth, which is estimated to be growing at approximately 4 percent annually, and we believe we will accelerate as exercise and good health become part of the fabric of people's everyday lives. It also doesn't consider natural synergies with the sports nutrition market, such as protein supplements, nutrition bars and beverages, which are a $5 billion market and growing.

We made substantial progress positioning our Company for growth. We have the 4 strongest brands in fitness today, with Nautilus, and Bowflex leading the way, followed by Schwinn Fitness and StairMaster. We have momentum through new product innovation which accounted for approximately 30 percent of our revenues in 2004, compared to about 13 percent in 2003. We're the only Company positioned across all channels of distribution, providing us an opportunity to leverage innovations and brands with consumers wherever they shop.

Just a quick overview of the estimated wholesale business for each channel at the beginning of 2005. As a category leader, we believe it is possible to pursue 40 percent marketshare in the categories where we compete. The domestic commercial market such as clubs, hotels, and living complexes is about $800 million. Today we have an 8 share and the number 4 position.

A year ago at this time we introduced a very popular line of Nautilus Nitro Plus strength equipment building on our heritage of strength. We also introduced our first Nautilus Ellipticals. This year we will have a complete assortment of cardio products, which is about 70 percent of the category. This includes new treadmills, variable stride ellipticals, and a commercial version of our very popular TreadClimber Cardio machine. In addition to products, we have just started our leasing program with GE Commercial Finance. Early signs suggest that this will be an important tool for customer value creation.

The specialty retail market where people by club quality equipment for the home is about $800 million. Today we have a 10 share and the number 1 position. We are in about 38 percent of the estimated 420 doors in this category. We envision growing revenues by broadening the product line we offer, expanding both the Nautilus and the high-end Bowflex product assortments. We will also generate revenues through a first-ever Nautilus branded advertising program that began in the fourth quarter, and will intensify as we move into the back half of 2005. Fitness enthusiasts will see our Nautilus branded fitness equipment prominently advertised, creating foot traffic to specialty retailers who showcase our products.

The retail market, such as sporting goods, warehouse clubs and department stores, is about $2.7 billion. Today we have a 2 share and the number 2 position, which reflects our largest near-term revenue opportunity. As we look across this market segment, we estimate there are approximately 8,500 doors domestically. And today we are in about 2,100 of them, or about 25 percent door penetration, compared to less than 10 percent in the previous year. Our primary SKUs by store average between 1 and 2, with certain large format stores leading the way, expanding to 8 to 10 SKUs per door.

We're driving growth in this retail category by introducing a complete range of Bowflex branded fitness equipment, including home gyms, free weights, benches, cages, accessories, treadmills, and TreadClimber, along with our popular Schwinn exercise bikes and best buy rated ellipticals.

Sports Scan data indicates Schwinn exercise bikes have gone from a 1 to 2 share to nearly 30 percent share in their category in just over 1 year. Because we the only Company positions across all channels we have new marketing opportunities. For example, if you were to order certain Bowflex products from us direct, you would receive $100 gift card redeemable at a major retailer in lieu of abnormally discounted dollars. We believe this will drive foot traffic to retailers who support our products and create additional sell-through of our products at retail.

The direct marketshare for the home is about 1.1 billion. Today we have a 24 share and the number 1 position. About a year ago the only direct products we featured were a few Bowflex branded home gyms. Today our direct business includes multiple models of Bowflex home gyms, along with our Bowflex TreadClimber Cardio product, and our Bowflex SelectTech dumbbells. Moving forward we will continue to bring new innovations to the direct market including the upcoming introductions of our new Bowflex Ultimate II home gym, and a new Bowflex home gym that includes a patented revolutionary form of resistance.

In addition, we have employed a new advertising agency to further refine our marketing mix, our messages, and placement. We have also launched our first official home health and fitness catalog. And are moving to have all of our products available for order through our online Website.

Finally, the international market, which is mostly commercial clubs, is larger than $1 billion. Today we have about a 6 share and the number 4 position. We will growth in 2005 as we expand our commercial and retail presence in the UK, Germany, and Australia, and as we expand into China and Eastern Europe. This will bring our international presence to more than 50 countries. In addition, we will be testing a direct approach to selling in the UK, Germany, and Japan to determine the appetite for direct to consumer fitness equipment sales.

The net of all of this, I'm very excited about the significant growth opportunities in all of our channels of trade for 2005 and beyond, as we execute our plans for sales and for marketing.

I will turn the call back over to Gregg for more details about our three-year plan and for guidance.

So we're very pleased with the quarter, although we recognize there is more work ahead with our supply chain management. Our new head of manufacturing operations, Holly Valkama, is addressing this by optimizing capacity at our domestic facilities. We're also establishing a logistics and quality office in Shanghai, and forging strategic relationships with our suppliers. As you heard from Tim, there's substantial opportunity for a category leader, and no Company is better positioned to take that leadership position for the category than Nautilus.

We're embarking on a three-year growth plan, with 2005 serving as the first year of a plan that will move us to global category leadership. If you think of our Company going forward, each year will contain an overall headline or theme to provide clarity and focus for our business. You will recall that last year's theme was about executing the turnaround. This year's theme is about driving growth while investing in our future. 2006 will be about achieving operating excellence. And 2007 will be about global category leadership where our goal is to be either number 1 or 2 in every category we compete.

So here is what we need to invest to make that happen. First, we need to invest more deeply in research and development. Innovation is a catalyst for growth. We have made available more resources to invest in both revolutionary and evolutionary innovations. You have just begun to see the impact of that work. Like Bowflex Extreme II, TreadClimber Cardio machines, SelectTech dumbbells, Schwinn bikes, strength cages, just to name a few.

As a result planned introductions in the first quarter of 2005 include the Nautilus Variable Stride ellipticals and Nautilus treadmills, Bowflex Ultimate II and the introduction of a patented revolutionary new Bowflex home gym. In the second quarter we anticipate the launch of our Nautilus commercial TreadClimber, along with a line extension of our SelectTech dumbbells. We see this fast-paced innovation continuing in the second half of the year.

Second, we need to finish the consolidation of our management information systems into a single platform with state-of-the-art electronic data interchange to support our sophisticated retail customers. Hardware and software in place, portions of the direct business have already been converted. And we will enhance our electronic data interchange with large retailers in the third quarter.

Third, we need to invest in our manufacturing operations. We need a supply chain that can efficiently move us toward higher volumes, better quality, better procurement leverage and more precise product delivery. We're investing in the teams and the systems to make this happen. As one example. We just opened a quality and logistics office in China to help facilitate our plans in Southeast Asia, where we manufacture about 60 percent of our products.

Finally, we will aggressively defend our intellectual property. In 2005 there is 2 prominent cases. Our patent infringement trial against Icon Health and Fitness is expected this April in Seattle. In addition, a trademark infringement case against Icon, where we sought and received injunctive relief, is expected in the back half of 2005. We will vigorously protect our intellectual property to ensure we return maximum value to our Company and shareholders.

In addition to these investments, what else will it take to achieve our objectives for 2005 and put us on the path for long-term growth? First, it is innovation across all functions. The obvious area is product development, but innovation must span our entire Company. We like to challenge ourselves to never been done before thinking. It gets us out of the routine and into a mindset of making our Company better.

Second, it requires a consumer and customer focus. It does beyond customer service and a department. It does beyond mastering the basics of delivering what we promise. It really centers on innovative thinking to address customer challenges. Retail partners need merchandising support. So we're launching a branded display called Make Room for Fitness. Based upon our market insights two-thirds of consumers research fitness products on the Internet. So we created online education and purchasing opportunities.

Now third, it requires systems and processes that are built to last. Here at our Company we call it the power of one. If you think back to just 2 years ago we were essentially a holding Company of 4 independent organizations. Today we are rapidly moving to one fully capable Company, taking advantage of the synergies and efficiencies you would expect. This will streamline our operations, streamline our inventory, and better assure on-time deliveries.

Fourth, it requires operational excellence. We operate from a premise that would ever gets measured, gets managed. We're putting measures in place for virtually every component of the business, assigning executive level accountability, and monitoring that progress weekly or monthly. Some of the information shows we've got a long way to go. Some shows we're making great progress, such as the rising DPO number that Rod mentioned. So we have visibility, we can address the gaps. Our leadership team believes these focus areas will help us drive growth and invest in our future, positioning us well for 2006 to achieve operating excellence. And 2007 for global category leadership in fitness equipment.

So I would like to wrap up our prepared remarks with a summary, and then provide some guidance. We have delivered to our shareholders an 18 month turnaround as planned, while continuing to generate cash. Although we've got plenty of room for improvement, we're now a growing, diversified multi-channel Company. We're positioned for long-term growth, both financially and operationally. And we're driving growth through innovation, channel diversification, brand leveraging, and smart business management. We're now functioning as a united team with the power of 1, rather than a holding company or group. As a result of this, we're changing our name from The Nautilus Group to Nautilus, Inc.

Okay. So let's move on to guidance. First, the first quarter. We anticipate sales of about 145 to 150 million, and fully diluted earnings per share in the 24 to 26 cent range, which is more than a 25 percent earnings growth. For the full year 2005, we anticipate net sales growing around 15 percent, and earnings growing by 25 to 30 percent. This does not include expensing of stock options in the second half of the year. Keep in mind that our business is very seasonal because of the seasonal nature of fitness equipment sales. And we expect more than two-thirds of our earnings to occur in the back half of the year.

We will update guidance each quarter throughout the year. We look forward to a great year of driving growth and investing in our future. The health and fitness of millions are counting on us, and so are you, our investors. Without with that, operator, I believe we're ready for questions.

(OPERATOR INSTRUCTIONS). Ed Aaron with RBC Capital Markets.

A couple of questions for you. First on the direct channel, those numbers came in quite a bit higher than we were looking. And I am just trying to understand where that variance came from most. Could you maybe give us where the TreadClimber sales shook out for the quarter?

One of the things we will talk about here real quick. And then I'm going to turn this over to Tim and let him kind of walk you through it. But as we look at the direct channel, the great thing about our business right now is with the channel diversification that we have in place, we've got the ability to turn up things as we need to. And as we saw some of the delays in shipments coming across the seas for our retail side of our business we were able to crank up the direct business and get that into place to make sure we delivered the expectations here. So I think it shows from our standpoint the diversification process that we have really gone through as a Company and our ability there.

Now, as far as TreadClimber is concerned, we had a very solid fourth quarter with TreadClimber and it continues to grow. One of the things we are going to try to be a little more careful of in these calls as we're providing you with the additional information we just did is not giving specifics on products going forward since the Company's at this point is so diversified that we start to give our competition a leg up on things. So we're going to refrain from giving those numbers out here as we go forward. But I will tell you this, the fourth quarter for the TreadClimber was at or above folk's expectations out there.

And then on the commercial and retail side of the business, the supply constraints, to what -- you mentioned that those results are actually in line with your expectations. So I'm just trying to understand how much of those supply constraints you saw coming say a quarter go versus how much you were maybe somewhat surprised by?

We had a couple of surprises in there actually. You know we expected product delivery from a couple of our suppliers to be in the first week of October and it ended up being in the first week of November, and we lost about 4 weeks of sales obviously in a pretty key selling cycle. So there were a couple of surprises there. And we're in the process right now of -- with those suppliers, Holly and her team have been spending time talking about how we make sure that doesn't happen again. So I think the part that I feel good about that a year ago our Company couldn't have responded to was the ability to again take the diversification of our business and be able to move into other areas that we could crank up that we had inventory on.

So I think we feel pretty confident that we have worked through those issues. And we will have in place for the back half of next year a plan so those kind of things don't happen to us twice, right. Once a fool, twice an idiot, as they say.

There is one other plan I want to point out. Last year in the fourth quarter was kind of a tough comp. We had a large sale-in at Bowflex Rodger's Business (ph) products to a major retailer. And in fact we ended up with too much inventory with that retailer for awhile, about the middle of 2004. So we're in a much different position. And I think when you're going to look at the comps going forward it is going to be a favorable trend.

And I think maybe, Tim, you want to talk about the forecasting process?

Yes, just to close that off, in general, I think we feel ourself right now in a much better place in inventory at retail for looking this year versus last year. We have learned a lot from that and the 2003 shift. And we got a little momentum at retail right now. Two different pieces of our products are selling through at really high rates. You heard me quote the number on Schwinn bikes specifically. You don't go from a 1 to 2 share to a 30 share without selling through. So we're really pleased about that.

In terms of a forecasting process I think we're now feeling comfortable with a sales and operating process that allows us to first plan with the customers. That's the biggest piece. I think we need to be completely aligned as we move further and further into retail. Having the customers' forecast and plans as part of our forecasting process is absolutely critical. Obviously there is a historical element that we add to that mix. But starting with the customer, then doing the supply chain planning with Holly and her team, planning out flow, planning out relationships with vendors, as well as our own manufacturing to make sure we're smoothing out that process. We can't afford the early quarter, late quarter swings. And I think we've got -- we've backed up enough in the process now to say I think we feel comfortable in going into 2005 having that kind of rigor.

So the great thing about all that is that I think it puts us in a position coming out of the gate here for 2005, and we feel very confident about our plans.

(OPERATOR INSTRUCTIONS). Eric Wold with Merriman Curhan Ford.

First question, obviously it is very understandable that your receivables were up in the quarter, given this Q4 was the big sell-in into the retail. Maybe with as much detail as you can talk about what you're seeing out there in terms of inventory channels between various segments of the retail channel in terms of what has been left out there?

Tim, do you want to take that one?

Yes. Again, Eric, like we just talked about, because we delivered late in a lot of cases we were able to adjust flow on a number of these. I would say we are in -- I think a very clean position in retail. I think in specialty fitness, we're even cleaner there. I think we're still living a little light, especially fitness. If you are doing any store checks you would see opportunity there right now. If you guys are out hitting stores, you're going to see places where we're not standing long in anything, especially power ride (ph) technology, and in any of our new cardio products. We're landing some of those things even right now. As they work -- as you guys know, we have got to work through their distribution centers. So as we put product in there DCs they've got to flow it through there. So we are landing goods now. So retail very strong, especially fitness, even leaner so. So again there is a huge differentiation between those two channels, but I think opportunity now to go forward as we do a better job of planning with the customer been planning that product flow.

And secondarily, looking at the guidance for '05 on the top line gets you somewhere a little bit north -- 15 percent gets you a little bit north of $6 million, which is about 25 million above where the consensus is out there. But the EPS guidance is maybe a couple of points below where the consensus is. Where do you think the biggest differential is, and where you spending more that other people out there aren't really taking into (indiscernible).

I think there is a few different places. One is our ERP system. As we roll that out and launch it, we're investing in that this year. So there are some expense associated with that. Too, we're going to spend even more on R&D this year. We had, as you saw, great success in the back half of 2004 with some of the new product introductions. And an old coach of mine said, if the play is working stick with it, right? So we're going to put more money against the R&D side and keep pumping out these new products. And we've got a huge pipeline of new product coming out next year. So we feel really good about that. And it has been based in consumer insights and getting the consumer's feedback as we have gone through the process. So we've think these things are going to be huge.

But does the 2 big areas. And then we've also got some legal expenses associated with Icon, and really focusing on the brand development of our product as well. So from a marketing standpoint, you'll see us start to invest more and more in our brands as we move forward. So those are the big 4.

From a marketing standpoint, we're going to wake the sleeping giant here with advertising Nautilus for the first time in 15 years. Obviously that takes some investment. We have not expensed any marketing -- really significant marketing dollars again that brand. And we are going to go bigger or go home. So we're going to get involved and that is going to take some expense. We believe to continue to invest in both Bowflex and Nautilus brands in a significant way requires some of our investment dollars.

And we believe this is going to help us in retail. It is going to help drive foot traffic into retail and help our sell-through. And what we are trying to do in 2005, like Gregg mentioned, is really position ourselves for growth, even more growth in 2006. Get the foundational elements done.

(OPERATOR INSTRUCTIONS). Mark Rupe with Adams, Harkness.

A quick question here. On the guidance for next year on the top line, is there any chance you can give us a little more clarity on the channel, which channels are expected to drive that 15 percent, or the breakdown of which?

This is Tim. We are growing all of those channels -- obviously all 4 of our major channels are in growth. We see the strongest -- actually I would say all 4 channels are in double-digit growth. The strongest play is for us is going to be the retail segment, obviously. It is our biggest opportunity. But we see the ability to invest in all 4 of those channels. We have been talking about retail for what 18 months now, 12 really in a significant way. We are lining those customers up in 2005. And we see significant growth there. Especially fitness will grow in double-digits. We say our commercial segment also growing in double-digits as we bring on all those new innovations.

We've got health clubs already lining up now to get engaged in what that innovation can offer. And as you heard me say on direct, it is really about opening up the whole breadth of opportunity, our whole product line to that channel. So we see all that movement as well.

And of course you heard me mention in the fit channel, which is international too. And I think there you guys all recognize we're hardly even engaged. We've got -- we just started to get involved in that whole marketplace. And there is significant growth there. We're still the number 4 share there. Nowhere to go but up.

In the international market, I mean in the last few quarters I know you have had very strong growth. You mentioned something about maybe opening up direct businesses in the UK and Germany. Is that an '05 target or is that beyond?

I will answer that one, Mark. We've got some tests in plays. Darryl Thomas and his team that run our international business has been working on that. And I think we'll probably -- it will be a slow ramp up there. And we are awful early right now in the test stage. So not much to tell you yet, but as soon as we have got some info, we will be sharing that with you.

(OPERATOR INSTRUCTIONS) John Rock with Ryan Beck.

Just real quick. I am wondering if you give -- kind of following up on some of those questions there, if you could give an update on what is going on at TSA? I know that you guys were in there, I guess, a little slower than you would've liked. But if you had any update there?

Tim, do you want to do it?

Sure. Sports Authority update is, we have obviously if you're watching the TV right now you're saying some of our partnership activity play out. We have had some great dialogue with them over the last 12 to 18 months. If you look at our assortment at Sports Authority we probably have the broadest assortment of our products available at Sports Authority. They are obviously carrying our home gym products through Bowflex. They have also been engaged in our treadmill business. We're landing strength there right now -- free weights. We've got TreadClimber in a number of places.

They have been very supportive of our bike business. As a matter of fact, our bike sell out there has been remarkable to say the least. We're also -- we also have a number of their stores where we're testing the Make Room for Fitness on Floor campaign. You heard heard Gregg make reference to that. It basically is a way to make that on floor selling space look like a branded selling platform versus what could be a graveyard of fitness equipment if we're not careful. So there are also the retail that we're partnering with on the $100 gift card. So that relationship remains very strong, and we see that continuing into 2005.

And then just to kind of follow up also in the retail channel. I know that you guys had tested with Sears. Is there any update on that or is that really more of a later '05 thing for you?

We did test in 2004 with the bikes. It really is a later 2005 opportunity. We're in the process of reviewing those test results with them right now. As you know, their go to market process has buys being made in spring. And so we're engaging in those conversations with them. More to come on that, I promise.

Eric Wold with Merriman and Curhan.

I have 2 follow-up questions. First one real quick on that (indiscernible) at Sears market opportunity question. It is a winter '05 opportunity. And if anything does come of that in terms of large order, what are your thoughts on being able to supply the product to those stores in addition to what you have currently got in place for '05? And is any Sears in your numbers for '05?

Let me hit that one real quick. How did you get back in the queue, by the way? He is not going to answer that one. Fast fingers.

On the Sears thing, here is how we're managing the business right now. We've got 3 or 4 big customers that could come on. And as we are talking with each one of them, we're managing this with the supply chain folks pretty closely. So Tim has been working with Holly and the rest of the operations folks very close. And I think what is going to end up happening here is depending on which customers we get commitment from early, will determine how much we can really roll out.

So we've got a pretty conservative number of there in the plan that we think is operationally achievable. And we didn't build a revenue line there. As you know, those were staying around 15 percent growth. We haven't been real aggressive on that component of it just because of that. We want to make sure that we can ramp from an operational standpoint. So we're comfortable operationally we can handle that percentage of growth. And then depending on which one of these rather large customers that we're working with comes online first, we may have to pay some of the other ones to go a little bit later as we can absorb them.

And then just a follow up. Just to make sure I didn't (indiscernible) confusion out there that the 25 to 30 percent earnings growth for '05, should we -- we're basing that off the 90 cent number, which will get you to $1.15, $1.17, is that correct?

That's right.

John Stowe with Putnam Investments.

I'm still a little bit concerned about quality of earnings and was wondering if you could address it? As I recall in the third quarter we had a real estate gain. And then I look at this quarter, and congratulations it is a great quarter. But I'm a little bit uneasy because of the DSOs on the retail side are up so much.

And then in the first quarter we're guiding down from what Wall Street expectations were a little bit. If two-thirds come in the back half, it looks like the second quarter as well might be a little bit below expectations. So we're kind of start waiting for the back half of next year. And I just wondered if you could address the quality of earnings and where you are in the turnaround? You make it sound with your enthusiasm that we're there, but the numbers dictate a little something else.

Let me address the first part and then I will turn over to ROD. I disagree with you on what they dictate. They aren't dictating anything. But what I would say to you is this. We have in the fourth quarter number, it is 42 cents versus the Street estimate of 40. And as you have talked about on the call --.

But the DSOs are up 30 base.

Yes, which we can talk about. The second thing I would tell you it is a pretty standard in the fitness industry for the seasonality effect for the back half of the year. And our business isn't an exception to that. We follow the fitness industry. We don't lead it from a standpoint of trying to tell people when they're going to buy it. So from that standpoint we've got what we've got. And I will let Rod address a couple of the DSO issues with you directly here.

Yes, one of the -- if you look at -- this is for the onetime non-recurring event, if you look at -- one thing I want to make a comment that both of those are positive. We have -- you haven't seen out this Company negative non-recurring events. The DSOs are up. And you know what, I'm looking forward to first quarter, because they're going to be down, and capsule is going to be up a lot. And we did have good cash flow in the Q4. Our DSOs are up. They're 51 days. If you look at compared to last year they're still up a little bit. They were right around, I think, it was 45 days last year. At the end of the third quarter there were 44 days. So I think delivering products a little bit later in the quarter put us in that position.

Another one I would point your attention to is inventory levels. Usually as companies aren't meeting numbers their inventory levels tend to creep up too. And what you're seeing from our Company actually inventories is down year-over-year. We ended with $49 million in inventory versus last year of 53. I think we're pretty excited. Grew the business 50 percent.

And when you really look at the business seasonality we're changing how this business is run. When you think about the fitness season, the New Year's resolutions, retailers are going to be buying -- they're going to do the sell-in in late Q3, early Q4 and make sure that product is there for the customers that are going to come in December and January and buy it. So I think this is a business trend you're seeing. And you have really seen this trend -- it is not a 1 year trend. If you really follow our Company you have seen this trend develop over the last 3 years. But I guarantee you we will do a much better job with DSOs in first quarter of this year.

Andy Graves with Pacific Growth.

Nice quarter, gentlemen. Congratulations. I wonder if you could detail for us for the fiscal year, and if even more exactly by quarter what your legal spend looks like?

That number, I have the G&A number. I don't have with me here the exact legal spend. It is running -- it is running about $1.5 million a quarter at this time. In the fourth quarter last year it was really heavy at that time.

And fourth quarter, meaning fourth quarter of '04?

Yes, we're getting prepared for trial. And when you look at the first quarter of this year too you're going to see it run in that range or a little bit hotter. It is a number that we try to predict, but sometimes this litigation is hard to predict. But the only thing we can tell you is we're going to defend our patent rights.

Was the number in the fourth quarter that just finished like over $2 million, or was it more like that 1.5 million?

It was around like 1.6 million in the fourth quarter of 2004. And it was higher in the previous year.

As these too trials commence, and I believe they commence in the second quarter, would you expect that spend to go up to like 2 or $2.5 million?

It is going to be interesting to see, because a lot of the pretrial work is being done, expert witnesses and all that. So I would say you can get a range of probably about 1.2 million to about 1.8. But I can't -- that about as precise as I could get at this time. It is already built into our number for the guidance.

Raymond Smith with Touchstone Investment.

I was wondering if you could give some color on the Bowflex -- I mean I'm the TreadClimber sales, units and revs?

As I mentioned in -- someone asked us that on the first question. We get asked that question, and because of competitor reasons we're not going to be giving that out anymore. But what I did mention to Ed is that we did have a very solid fourth quarter with that product. And based on what the Street had out there for a number we met or exceeded that number.

Well than the Bowflex units or revs?

Same thing. It is a product, so when you're talking about a home gym it a product. What we're talking about now going forward is we are giving you brand and channel specifics. So it gives a little more insight there in the way that we track our business versus tracking it by individual product.

Alright. Well, since I can't get those answered, can I ask you this then? As far as your positioning, you talked a little bit about this, but can you just explain the DSOs are up quite a bit. And you said that inventory went into the channel later than you had anticipated because of some capacity constraints. And the revenues were higher than you guys thought. And I'm just trying to figure out why that based on those factors you feel like your channel inventory is in a better position than it was at the end of last year?

That's an easy one. The -- in 2003 in the fourth quarter we had a large retailer that we --.

Costco, right?

thought the run rate was, and so we loaded volume based on their forecast. And we ended up with way over the forecast. We ended up with about 8 months of inventory sitting in there that shipped in October, November, December, and carried through until June of the following year. So we had to bleed that inventory down. It was a pretty significant inventory position. So as you look at the fourth quarter 2004 on a comparative level, you're going to see a lot less inventory.

The second thing we did, and this is a mistake frankly, but we over reacted and we're very cautious so we pulled the pendulum in the opposite direction and said let's be really careful about the inventory load this time. So we forecasted pretty conservatively. And when we had strong sell-throughs at retail, we were a little slow on replenishment there. So that is what really drove that retail number that we were talking about earlier.

And I think the good and the bad of that is from a bad standpoint, boy, we left some volume on the table there in the fourth quarter for sure. The good side of that though is that we came out of the fourth quarter and into the first quarter this year in a relatively strong position at retail, because we have got pretty late inventories there. So we feel really good about our retail inventory position, as well as the sell-throughs that we're getting. So getting on a better replacement scale now right out of the gate with these folks.

Ed Aaron with RBC Capital Markets.

These are just a couple of follow-ups. First with respect to the tax rate, you had mentioned there was about a penny benefit from the reduced tax reserve. But if I plug in the 36 percent tax rate that you were using before, I come out actually a couple of pennies lower. So I'm trying to figure out I am doing wrong here?

Sure. When you look at the tax rate, it is going to vary. The actual specific dollar amount is right around $400,000 that we reduced the reserve by. The other thing that is happening in our business as we increase our R&D, you have R&D federal tax credits. So you're getting benefit from that. And the other large benefit we're starting to get from our new investment strategy, we are in a short-term basis doing a lot of newly (ph) investing, which are tax frees (ph). So when you look at your rate, if you look at the rate not including this, it would be right around 34.3 percent. And the rate that you are calculating is 32.3 percent.

Going forward I think you're going to see our rate being 35 to 36 percent in '05. And that is based on the R&D tax credits. And the cash investment strategy is just going to be dependent on how we can optimize our interest income.

And then a couple of questions just on some -- on the cost side. My impression is that from a mix perspective cardio products are usually higher margin than strength products. And it seems like your mix is moving more towards cardio. Is that benefiting your product margins? Is that a fair statement?

When you look at it on a retail side, Bowflex has strong margins. And we're not -- we weren't quite in the position we needed to be. We delivered some product late. And we wanted to make sure we met our obligations to our customers, so we expedited some shipments and that starts getting costly. And that did have an impact when you start looking at our gross profit margin. I would expect in the first quarter you're going to see that start trending the other way, and we will actually go up.

But is it a fair statement that cardio products tend to have higher margins than strength products?

It just really varies. Treadmill margins, for example, have lower and some other products have higher. So it kind of varies.

And then also if you could just maybe just comment on commodity inflation and how much of an impact that is having?

That is -- we've seen a little bit of an impact in 2005 -- or excuse me, 2004 -- on that. We did -- well, actually haven't had a price increase on the direct side in 2004. So that could create some opportunity there. And we did have 1 on retail. I think we're managing that pretty well at this point. We're just like everybody else. We're seeing increases in steel, and you're seeing a little bit in resin prices. But our guidance for 2005 includes those increasing a little bit, but not a lot at this time.

Ladies and gentlemen, that does conclude today's question-and-answer session. I would like to turn the conference back to management for any concluding comments. Please go ahead.

As we talked about, we're pretty excited about 2005. I think you had a chance to hear from a couple of our folks here today anyway about the enthusiasm that we all share. And I think as you look at the rest of our organization they are equally, if not more enthusiastic. So we are excited to get going at it. And we're going to start doing it right now as a matter of fact. So thanks very much for listening in.

Ladies and gentlemen, that does conclude The Nautilus Group Q4 earnings conference call. If you'd like to listen to a replay of today's conference you may dial 1-800-405-2236 or 303-590-3000, using pass code 11022318 pound.

Thank you again for your participation in today's conference. And you may now disconnect.