Nautilus Inc (NLS) 2005 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Nautilus Q2 2005 results conference call. [OPERATOR INSTRUCTIONS] As a reminder, this conference is being recorded on Wednesday, July 27th, 2005. I would now like to turn the conference over to Mr. John Mills. Please go ahead, sir.

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 third and fourth quarter forecasts and expected new product introductions, do not guarantee future performance. Nautilus undertakes no obligation to update publicly any forward-looking statements to reflect new information, events or circumstances after the date they were made or to reflect the occurrence of unanticipated events.

Therefore, undue reliance should not be placed upon them. Listeners should review the earnings call to which this conference call relates and the company's most recent periodic reports on Form 10-K and 10-Q 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 forward-looking statements.

And now, I'd like to turn the call over to Greg Hammann, Chairman and CEO of Nautilus.

Thanks, John. Good afternoon and thanks for joining us. With me today are Bill Meadowcroft, who's our CFO; Tim Hawkins, our Chief Customer and Chief Marketing Officer; and Pat Warner, our SVP of Product Development.

Today we're going to provide insights into the second quarter of our 2005 annual operating plan. Our company's business theme this year is to drive growth and invest in the future as we build a solid foundation to grow our business profitably for years to come.

Now on this call, we will cover second quarter results, provide net sales from the 5 sales channels plus our new Nautilus Apparel Division and give you an update on our fast-pace of product innovation. We'll then conclude with some comments and guidance for the balance of 2005.

So about an hour ago, we posted our second quarter 2005 financial results, which showed we delivered the quarter as expected. Net sales were about $125-- $129 million, which was an improvement of 29% over the year-ago quarter. We experienced at least 8% growth in every one of our sales channels and we delivered earnings of $0.10 a diluted share, a 70% improvement.

This is now our 8th straight quarter of meeting or exceeding guidance. We are taking advantage of the seasonally slowest part of the year to move a number of product innovations through the development introduction process. This gives us time to better optimize manufacturing and shipping in advance of the high-volume season that is rapidly approaching. Now you'll see this reflected in the margins for the quarter.

During the quarter, we took several steps toward further accelerating our pursuit of global category leadership. We acquired our Canadian distributor, Belko Canada, now called Nautilus Fitness Canada. This acquisition positions us for multi-channel sales growth in Canada.

We also acquired the high-performance fitness apparel brand, PEARL iZUMi. This will help us leverage our brands, distribution and marketing into the fast-growing fitness apparel market. We'll provide some more perspective on all of this in a few minutes.

For more detail on the second quarter, I'll turn the call over to our CFO, Bill Meadowcroft. Bill?

Thanks, Greg. As you just heard, the second quarter marks the 8th straight quarter that our revenue and earnings met or exceeded our guidance. Net sales for the quarter were $129 million compared to $100.2 million the preceding year, an increase of 29%.

Gross profit margins were 44.8% compared to 49.2% for the year-ago quarter. Gross margins were pressured by the intensified pace of product introductions, giving us time to better optimize manufacturing and shipping ahead of our busiest season. Compared to gross margins for the year-ago quarter, product introductions and additional inventory carrying costs reduced margins by about 290 basis points, while higher transportation costs reduced margins about 150 basis points. We are taking steps to mitigate these costs in the back half of the year.

Operating income in the second quarter was $3.3 million or 2.9% compared to $1.9 million or 2.7% for the year-ago quarter, an improvement of 20 basis points. The reduction in gross margin was offset by lower sales and marketing expenditures during the quarter.

Diluted earnings per share for the quarter were $0.10 compared to $0.06 a year ago, a 70% improvement.

Regarding operating expenses, selling and marketing was 30.9% of sales, down from 36.5% for the year-ago quarter. This reflects our ability to drive efficiencies as we generate greater revenue.

General and administrative expense was 7.7% of sales, up from 7.3% in the year-ago quarter. This includes facilitating growth by making necessary improvements in our business and information systems and continuing to protect our intellectual property.

Research and development was 2.4% of sales compared to 1.3% for the year-ago quarter, an increase of $1.8 million, reflecting our commitment to a fast pace of innovation, introduction 8 new products versus only 3 line extensions in the year-ago quarter.

Turning to our balance sheet, we finished the quarter with cash and short-term investments of $100.3 million compared to $123.3 million for the previous quarter. The change is explained by an increase in product inventory and our acquisition of Belko Canada as we gear up for a successful fall season and deliver upon our commitment to customers. We closed the PEARL iZUMi acquisition on July 7th, so the impact of that transaction will be reflected in the third quarter.

DSOs were 41 days compared to 40 days the previous quarter and 43 days for the year-ago quarter. Annualized inventory turned 4 times in the quarter, equal to the year-ago quarter. Inventories were $70 million at the quarter's end compared to $49 million a year ago, putting us in excellent position for the fall sell-in compared to last year when we experienced tight product supply positions.

Our direct business is a strong and steady component of our business and we expect moderate growth in the future. About 99% of our direct consumers use some form of credit, all of which is non-recourse to Nautilus.

For 8 years we've offered a private Nautilus card that opens up a larger addressable market through special financing programs offered by our third-party finance partners. The share of transactions involving the Nautilus card was about 67% of direct sales for the quarter, which is consistent with 64% for 2004.

Finally, our board of directors has approved a regular quarterly dividend of $0.10 per common share, payable September 9th, 2005, to shareholders of record as of August 19th, 2005.

For a more complete overview of our business by each of our 5 sales channels and an update on our apparel division, I'd like to introduce Tim Hawkins, our Chief Customer Officer and Chief Marketing Officer.

Thanks, Bill. Our addressable market is now $11.9 billion. This includes $5.4 billion in fitness in the Americas, $4.5 billion of fitness outside the Americas and $2 billion in high performance apparel. We raised the international market estimate to $4.5 billion from our very conservative estimate of $1 billion after completing a recent study on the global fitness market place. That study revealed greater opportunities for home fitness globally than we previously expected.

Against 2004 sales, we would have been a 4 to 5 share in a category that is growing at 5% or better. With 5 of the top fitness brands, we have a goal of growing our business over time to a leadership share of 30% to 40% by presenting our brands wherever people exercise and shop for innovative fitness products.

So here are some additional insights into the business segments where we compete.

First, let's start with commercial. Commercial is clubs, hotels, living complexes. It's an $800 million market. Our second quarter net sales were $17.7 million, up 8% from the year-ago quarter.

During the quarter, we completed delivery of our first 500 Nautilus commercial series TreadClimber models for 100 24-Hour Fitness locations. As part of what we have discussed with you on previous calls about changing the game of fitness, this launch is the new model of how we'll introduce products in partnership with customers. This new launch included an exclusive partnership involving double page advertising in leading consumer magazines, offers for free limited-time memberships at 24 Hour Fitness and professional trainers providing education around a new fitness exercise.

For the back half of 2005, we expect to benefit from having a complete line of new cardio products to complement our legendary strength equipment lines. We also expect to benefit from additional commercial partnerships like 24 Hour Fitness later this year.

Our next channel is specialty fitness retail, where people buy club-quality equipment for the home, also an $800 million market. As promised in our last call, second quarter net sales were $15 million, up 15% from the year-ago quarter, reversing the year-over-year slippage last quarter due to supply constraints.

We are benefiting from new product introductions and from solid demand for light commercial and high-end home fitness equipment. We have secured a new distribution relationship, giving our branded products prominent position in 50 doors of the largest specialty fitness chain, Busy Body and OMNI Fitness.

By working with this large specialty retailer, we will have more presence in important markets such as New York metropolitan area, San Francisco and Southern California. This fall we'll have products in about half of the 420 U.S. specialty fitness stores.

A small but growing portion of the specialty fitness segment is the independent bike dealers. In the last few years, these retailers have increased the volume of fitness equipment they sell and, as a result, we have increased our presence to 860 doors, up from 800 last year, and recently added dedicated sales staff to focus on this business opportunity.

Now we believe the PEARL iZUMi acquisition will create some excellent new opportunities for cross marketing, promotions-- and promotions in this category. PEARL iZUMi products are sold in 1800 of the 4500 independent bike dealer locations in the U.S. and Europe, more than double our current fitness equipment penetration.

Our next channel is retail, including sporting goods, warehouse clubs and department stores. We see it at about a $2.7 billion market. Second quarter net sales were $15.9 million, up 206% from the year-ago quarter. About a 2% market share is where we net out.

We are, obviously, still very early in our retail expansion phase. We continue to benefit from annualizing doors and products we've introduced over the previous year and are continuing to add new relationships this year.

In the second quarter we added the 111 doors of the Michigan-based sporting goods retailer Dunham's and 16 locations of the Great Indoors, a division of Sears, with a 13 SKU assortment.

So regarding Sears, we are very excited to report that we will have a 5-SKU assortment in as many as 450 tier-1 stores for Sears, which are the larger-format stores supported by advertising. The assortment, which floors in September, will include an upright and recumbent bike, a home gym, SelectTech dumbbells and a stand under the Schwinn Fitness and Bowflex brands.

In addition, we'll have a presence in the Sears fitness catalog and have products available throughout the Sears website.

As we move into the fall selling season, we will have product on floor in about 2800 doors of about 15 major retail partners. We continue to differentiate our products and programs in partnership with each of our retailers to align with their retail strategy.

In addition to new doors, we are working with our current retail partners to expand SKU assortments and optimize sell-through. One of our key partners, The Sports Authority, is the first retailer to floor our new Bowflex SelectTech 220 dumbbells. In total, The Sports Authority plans to floor as many as 13 to 14 SKUs from Nautilus in their larger format stores this fall and will have merchandising displays in more than 200 locations. That compares with 8 SKUs in late 2004 and 2 SKUs in 2003.

The next channel is our direct channel, which involves Internet, catalog and direct response advertising, which is about a market-- the market size is about $1.1 billion. Our second quarter net sales rose to $69.1 million, up 27% over the year-ago quarter.

We continue to experience strong trends in direct due to multiple product offerings, product innovation and improvements in our advertising placement, format and style. We had healthy growth in Bowflex home gyms, TreadClimber products and SelectTech dumbbells. Specifically, sales have been strong for our new Bowflex Ultimate 2 home gym in its initial product launch. As in all our product launches, we will gain the operating efficiency and improve margins as sales ramp up for the Ultimate 2.

Our catalog and Internet sales have performed very well, along with database marketing techniques that we're testing.

The direct channel is our most developed sales channel. We expect growth to return to a more moderate rate by the fourth quarter as we annualize improvements made in the business a year ago, such as new advertising, multiple product categories, new product innovations and better advertising placement.

We'll also be introducing our second catalog of the year in October after our test catalog in January produced excellent results.

Next is our international channel, which includes sales outside the Americas, which traditionally was mostly commercial but is expanding into other channels. We now estimate this market at $4.5 billion and for the second quarter we had net sales of $11.9 million, up about 9% from the same quarter last year.

Our core business internationally is commercial sales where our products are marketed through our staff and representatives in 49 countries. We gained some share in Italy and we benefited from replenishment in certain clubs in the UK.

We are now forming new retail relationships in Australia and New Zealand, Italy and the United Kingdom that will make our products available to millions of global customers who shop at retail. In addition, we're completing initial research this quarter on direct sales in 5 countries in Western Europe and Southeast Asia.

Finally, our acquisition of PEARL iZUMi is complete as of July 7th, as Bill said, and is now considered our Nautilus Apparel Division. PEARL iZUMi has booked $300 million in net sales for the first half and we expect another $52 million for the second half-- Excuse me, they have booked $30 million in net sales for the first half and we expect another $25 for the second half. I like those numbers better.

The enthusiast performance apparel market for cycling and running in the U.S. and Europe is about $2 billion, giving us an estimated 3% share. We expect our apparel business to grow at least 15% annually as we pursue global leadership in performance fitness apparel.

So going forward we'll provide segment information and commentary on our apparel business each quarter. We already are integrating the administrative functions such as legal, HR, finance, planning and communications. The sales and marketing and operations teams are collaborating to-- collaborating to prioritize growth synergies as part of our 2006 annual operating plan.

In summary, we are, indeed, driving growth, even as we invest in our future. Our core fitness equipment division is poised to grow more than 30% for each of the last 2 quarters versus a year ago. With PEARL iZUMi included for the back half of the year, our annual sales are expected to approach $700 million.

So with that, I'll turn the call over to one of the hardest working and busiest guys in fitness, our SVP of Product Development, Pat Warner.

Thanks, Tim. We are in the midst of our strongest time of innovation in our company, causing some to question whether April through August could still be considered our slow time.

2 years ago we made a substantial commitment to a fast pace of innovation, including a coordinated go-to-market process involving every component of the company. We call it 4P marketing. We certainly need the right products, but they also need to be in the right place at the right price and supported with the right promotion.

That's why we have committed the entire organization to a stage gate process that requires input throughout the development cycle. This includes economic value assessment, market research, computer-aided design, sourcing and rigorous testing through our Nautilus standard for quality. The result is more innovative products, better overall quality and a greater ROI for each dollar invested in product development.

Here are some of the highlights of the process in the last quarter. We began the optimization process for our new Nautilus Pro Series Treadmills and MyStride Elliptical and for the Bowflex Ultimate 2 home gym with power rods. The first 500 Nautilus commercial series TreadClimber cardio units were rolled out through our partnership with 24 Hour Fitness.

We finalized new Nautilus treadmills and Nautilus MyStride Ellipticals for the commercial market. The Nautilus MyStride Elliptical was honored as the best new product at the FIBO Show in Germany, the world's largest fitness equipment show.

We are now taking pre-orders for our Bowflex Revolution home gym with SpiraFlex technology at bowflexrevolution.com. We'll be in full manufacturing mode by the fourth quarter. The Revolution employs a patented resistance technology that is used on the International Space Station and offers people on Earth a versatile home gym-quality workout.

We introduced our Bowflex SelectTech 220 dumbbells, a smaller version of the pair we introduced last year. And finally we added a couple of new models to our Nitro Plus commercial strength line.

The net is, we launched more than twice as many products as we did in the same period a year ago and we have twice as many nearing completion. By doing more of this work in the second and third quarters, we are in a better position for the winter fitness season.

Here are some additional highlights for things yet to come. We will be introducing Nautilus Sport Series Treadmills through specialty retail. This is a brand new concept that will revolutionize the way people think about buying treadmills.

We'll introduce a couple of new Bowflex TreadClimber models and another one next year. We'll introduce high-end Nautilus gym for specialty fitness and vertical markets utilizing our Nitro technology.

We'll refresh and customize Bowflex home gyms and treadmills and the Schwinn elliptical for certain markets. Finally, we'll be introducing additional commercial products that we'll talk about in the near future.

We have product development plans mapped out into 2007, including what we believe will be breakthroughs in both cardio and strength for the commercial and home markets. We expect to invest about one fourth of our research and development funds on revolutionary products and the remainder on evolutionary improvements and upgrades.

Some revolutionary product ideas are researched and designed by our engineering and product development team and other ideas come to us from a third-party inventor. We have a goal of about 30% to 35% of our revenues to come from new products each year.

Innovation is what created every one of our brands. It's also what will keep our brands in a leadership position in health and fitness.

I'll turn the call back over to Greg.

Thanks, Pat, and nice work. We're pleased with the quarter and our overall progress as we drive growth and invest in our future. Our team's focused on moving Nautilus into global category leadership.

We've passed some interesting milestones, including diversifying our brands, products, channels and introducing innovations throughout our business. Now we've made another bold move into high performance fitness apparel, the kind of apparel that fitness enthusiasts need during their intensive workouts. We've found a gem in the Pearl iZUMi team and we look forward to further leveraging the brand, the portfolio of innovative product technology and their expertise as we drive growth in fitness apparel.

We continue to study the needs and preferences of consumers, understanding how we can achieve our goal of global category leadership and an eventual 30 to 40 share in health and fitness. We continue to focus on growing our base business as we look at supplementing our growth through opportunistic acquisitions.

We'll also continue to weigh options of buying back stock when appropriate.

So here's a quick update on our strategic initiatives. First, we're working diligently to make improvements in our supply chain. And there's several factors to that. The first is, we've partnered with our major retail customers and mapped out an entire fitness season based on sell-in and sell-through forecasts. The second component of this is that we've boosted inventories in preparation for a very busy back half of the year, and third, we're making improvements with our contract manufacturers and our 3 manufacturing facilities to accommodate this growth.

The second strategic initiative is our information system initiative and it continues to proceed smoothly as we consolidate 6 information systems into 1. Our next self-imposed milestone is to have all retailers plugged into our state-of-the-art enterprise resource planning platform that provides electronic data interchange by October. We're on track to complete the entire project by mid-2006.

The third strategic initiative is continuing our fast pace of innovation and we're really focused on product development and the marketing components of this and, as you heard from Pat, our formal go-to-market process is already proving successful in helping us maintain a fast pace of innovation with a road map outlined through mid-2007.

We're also initiating a program to manage product life cycles, which will help us streamline-- streamline parts inventory and simplify our customer service business.

So here's a quick update regarding protecting our intellectual property. We've asked the federal court to hear a trademark case we are prosecuting against Icon Health and Fitness sometime between October and January. In addition, we are appealing a patent case against Icon Health and Fitness to the circuit court where we won on appeal twice already in this case. Again, we will continue to aggressively defend our brands, patents and intellectual property.

Finally, we're completing our 2006 annual operating plan and we will update you on the next quarterly call. In keeping with our 3-year plan, we will seek net sales growth of at least 15% from organic business and will seek operating margin leverage in 2006.

All right. So let's move on to guidance. We expect full year sales to be around $690 to $700 million, including about $25 million from PEARL iZUMi in the back half of the year. We remain comfortable with our full year guidance of $1.17 to $1.19 and we are expecting third quarter earnings to be about $0.23 to $0.24 on sales of around $175 to $180 million.

Now I'll conclude by saying that we're excited about our business going forward as we drive growth and invest in the future.

With that, operator, I believe we're ready for questions.

[OPERATOR INSTRUCTIONS] Ed Aaron, RBC Capital Markets.

I wanted to start by congratulating you on the Sears win. Actually, that's kind of what I want to focus on. The 450 doors -- I mean, can you give us a ballpark estimate of what that would equate to, maybe on a-- in terms of the revenue that you might draw from this business? And then-- and then also, is there an opportunity to further expand the door count from that-- from that piece of business?

So, Ed, this is Greg. First, thanks for the congratulations. We've been working on this one for a while and we're really excited about it. I think it's a great next step for us as we expand our retail distribution. I think Tim's really been the leader behind this whole thing, so I'm going to let him answer those questions for you and kind of walk you through what he sees as the opportunity.

Hey, Ed, it's Tim. The history or the way Sears works these processes -- obviously, I've got to take you back to last year. We tested, remember, Schwinn bikes in so many doors. I think we were about, what, 20 doors? I think we had 28 doors.

So the next step of that, the test was successful. We roll into what they call tier-1. That's their terminology. It's the large format stores that actually receive advertising. So that's our first-- our first step.

In terms of is there opportunity to grow further? Absolutely. Like we've done this far, we've gone from 28. We're going to go to 450 and certainly it's our desire to be in all stores, where appropriate. Certainly we expect to gain a lot of leverage with them through their Internet site, as well as their fitness catalog, which will be in stores that have smaller formats. So would we expect to have a humongous assortment in all doors? I think that's probably unrealistic. I think that's where we leverage some of their other-- some of their formats-- selling formats.

In terms of the volume for us this year, we're still working through exactly what that means. We'll probably have more clarity for you on that. But we expect to see them, I would say, in total somewhere around-- in our top 2 to 3 retailers overall as a result of this assortment.

For this year?

Yes, sir.

And then, Greg, on the investment spending that you did in the second quarter, how much of that would you kind of specifically tie to the Sears business?

Well, it's hard to say that any of it's tied to one particular channel or one particular customer, but as we look at the R&D investments that we made, we've made over a $3 million investment this-- this quarter alone, so if you look at that component of it. And we talked a little bit about the 8 SKUs that we launched here in the second quarter, where that investment went. And so I think some of those SKUs are going into Sears, but other of the SKUs are going into our commercial club market. They're going into our specialty retail business and into other channels, including international.

So it's hard to pinpoint one particular place from a customer or from a channel.

OK, great. And then on the-- the Q3 guidance, it's a little bit below where the Street's been modeling for it. Did we just mis-model that to begin with or is there something that changed, maybe some last quarter, that would cause some earnings shift from Q3 to Q4?

No, I think it's been part of our plan for the whole year, so I think it's just as people model things they're doing their best to make estimates on it. But it's certainly where we've been planning the business and no real substantive changes there.

OK. And then also I just wanted to ask about '06. You mentioned expectations for margin improvement. Could you maybe give us some sense of order of magnitude?

Well, I think it's probably a little early for us to do that, but I will tell you this. I mean, the investments we're making this year and the things that we're doing around the IT systems and our manufacturing and operations components are designed specifically to give us that operating leverage. As we get into the fourth quarter conference call, we'll certainly come back and share some specifics with that for you.

[OPERATOR INSTRUCTIONS] Mark Rupe.

Congratulations, as well, on the Sears. It's been much-talked-about. I'm curious how has that relationship evolved? I know, obviously, you had the test last June, I believe. They've went through a lot of changes themselves, I mean, is it-- was there a lot of different relationships you've had there? Or has it been kind of a constant thing you've been just chipping away at for the past year?

Mark, it's Tim. Thanks for the congratulations. Boy, they-- Sears has gone through some changes. Obviously, the biggest one is the K-Mart/Sears new relationship and that creates, I think, for them ongoing change, which we continue to do what we can to assist them by being a Steady Eddie customer through this process.

We have had some changes in relationships. While I will say some have changed, others have been incredibly consistent. We continue to have very close relationships with their VP levels and those have not changed dramatically, but even some of the old changes-- folks that are no longer in position, maybe in new positions yet, continue to be involved. So it's-- I would say it's about half and half in terms of folks now versus folks then and even folks that were-- to go back two years ago, we began the conversation. It's changed significantly and with the K-Mart piece, it's going to continue to evolve.

And I would say this, Mark. I think the one thing that's impressed both Tim and I is they've gone through all these changes. I think that their management team has done a great job in managing the hand-offs. As Tim said, even though some of the folks have gone on to do other jobs and take other responsibilities within the organization, they've continued to help support the new people that came in to make sure they got them up to speed quickly.

So-- so it might have taken us a little longer had Sears not been going through all those changes, but I think certainly hat's off to their people for the work they've put into it.

That's great. Any anecdotes? I know it's early on the 24 Hour Fitness, but any anecdotes on how it's being received from the club members?

Yes, we hear-- I got to tell you, Mark, it's two thumbs up so far. Just anecdotally we are hearing back from both 24 Hour and, most importantly, their consumers, is that comments like members standing in line for the first time that they can remember since StairMaster came out, if you remember that whole craze when you had folks waiting an hour, half-hour to get on a product. We're experiencing lines and in the fitness business that's a big win for the manufacturer, obviously.

Secondly, is we're hearing result comments already. “Boy, I--” People saying like, “Boy, I had no idea that I could walk and get this kind of output.” People are walking off that thing sweating and dripping. Meanwhile, physically their body is walking.

And then lastly, I'll say this. In terms of usage, one of the things we measure, obviously, is how much a product gets used. We are seeing as we go back and read the results from our own product, we're seeing numbers in terms of hours of usage per day that blow away other cardio products. So we-- we're very excited about this and just anecdotally with 24, I think they're experiencing some of them.

And-- That's great. And you mentioned that-- I believe you mentioned that there's potential for future business with them in the back half. Is that correct?

Yes, I think as they're first to market with this, we continue to remain close to them around how much more business they would want to do with this. We're also, as you can imagine, we're getting a lot of-- as this-- the excitement rolls on this, we're getting a lot of push and pull from our other customers. So we're weighing those conversations. But certainly 24 Hour Fitness helped us get into this business. We see us remaining true to that partnership.

Randall Reese (ph), Waddell & Reed.

I am curious if you could describe to me in more detail what the rodless Bowflex means to you in the future? Is this-- is this a big opportunity? Is it a kind of a high-end sweetener? I'd like a little more color on what it really means to the future.

Yes, let me touch on that one, Randy (ph), and just try to see if I can give a little color to it. We're just launching the product and I'll tell you this, the feedback we've gotten from the test groups that have had this product is remarkable. I think the-- what it does is for the first time you've really got a product in the market place that, without a free weight, gives you the feel of a free weight or a weight stack.

And so the strength curve on it is very different than a Bowflex and for those people that wanted the free weight feel of a workout but didn't want the weight and wanted the ability to move the machine around easily, this product certainly hits that niche.

So I think what we do is we really open up an opportunity for a different type of consumer that in the past has passed on our Bowflex product line because of the power rods. Now we've given them something with a strength curve that can really deliver the kind of expectation they have if they were a free weight user. So I think you're starting to get into kind of an upgrade, if you want to call it that, of the Bowflex consumer base where we're actually starting to get into some of-- more of the enthusiast-type consumers now that are-- the 4, 5, 6 time a week exercise folks.

So we see this as a big opportunity. How big it's going to be, I think, is yet to be determined, but we think, certainly, it could become a major part of our Bowflex home gym line going forward.

I'm also curious in the elliptical area. As I've discussed with you before, the existing elliptical products really, I think, fall short in a number of areas in meeting the needs of consumers and I'd like to hear what you're doing there and when your products are coming to market.

You know what? The great thing about that question is we've got our expert here. So I'm going to let Pat address that one. Pat, you want to tell them about MyStride?

Sure. Well, you're right, they do fall short in certain areas and one of the biggest areas they fall short is they are made to one stride length or they made to an adjustable stride length that you have to mechanically adjust and it's cumbersome, to say the least, at times.

But we just introduced 2 new products in the last 2 quarters with what we call MyStride technology on it. And it literally dynamically adjusts to the user's stride. So if you want to stride at 18 inches and your feet are comfortable moving there and that's kind of a walking pace and you want to run, all you have to do is stride longer. So the machine actually follows the body in what it wants to do when you're working out harder.

So it varies the workout, allows multiple size users. If you have a-- one in a home and you have a short user and a tall user, it works really well. There's no adjustments and you get on it and go and you can vary your workout.

Yes, and, Mr. Reese (ph), in terms of our assortment we have been, probably, slow to fill up the gaps on these, but I can tell you, what we've just launched, really, this quarter were 2 new models for specialty fitness, 4 new models for our commercial business and don't be surprised if we start looking at some other channels to catch up in this area. Because we agree with you, this is an area of great opportunity.

Yes and one other thing to think about is some ellipticals you have to try really hard to get a workout on them, a good workout. So the enthusiast, a lot of times, will surpass the workout that an elliptical offers. With the new variable stride, we've taken it to the next level where people that are enthusiasts can still get a great workout on an elliptical machine when they can't do that on all products.

You didn't say anything about the electronics. That is one of the major problems that I see in the commercial ellipticals is the electronics are deceptive in what they say that your work effort level is and what you're accomplishing.

Well, on our commercial elliptical we give multiple data points for your work. We give watts. We give METs. We give calories, calories per hour and we correlate that to a speed, as well, for the walkers and the runners.

Yes, we also strive to be incredibly honest with those algorithms and logistics. We-- I totally agree with you, Randall (ph), there are definitely some potential gaps in competitive product out there. We work to be incredibly fact-based about what's actually happening in our products, for our commercial, especially.

Terrific. Thank you very much.

And I'll just add on to that, one of the things we're doing to make sure that we verify our statistics is a lot of work with our Nautilus Institute and our work with UC-Davis in California where they're-- where Eric Heiden and his team are working to verify all of our facts as it relates to output and input to your workout. We find that as a potentially differentiating factor for our assortment.

Marc Bettinger, Stanford Group Company.

Congratulations on the quarter. A couple things. Bill, I want to know if you could explain a little more in detail about the 290 basis points relative to last year, what comprised that?

Right. Yes, any time you're coming out with that many products, there's certainly costs of just getting them going and getting them to the point that we would want them to be at. So examples -- the initial costs of the product from the vendor. There's often opportunity to get cost take-outs down the road and we are certainly working to that as these products are in our lineup for a longer period of time. Also, just firming up pricing, making sure that we find the price points that really work for the consumer, that will continue-- that whole elasticity, price elasticity model.

We've also got the issues of getting them into our inventory to be able to sell them. We've got, as you see, the additional inventory dollars. That requires additional warehousing, additional people as we will ramp up this business and look at the growth of 30% this year, 15%-plus next year. It certainly takes more capacity from both the warehousing, as well as a people standpoint.

So those would be costs that would go in there, but we're certainly looking into Q3 to attempt, as much as possible, to mitigate that, although we will continue a fast pace of innovation this next quarter. But we are looking at margins in Q3 to strengthen and be more in the 45.5% to 46.5% range.

Yes, I'll just add to that, real quick, Marc. I think the one piece that you look at here that makes me feel very good about the way we performed this quarter is the way our management team has been able to launch that number of new products and manage from 8 new products this year versus 3 last year. And arguably, the 3 last year were sort of just product upgrades, frankly. So these are 8 new products that we're putting in the market place and being able to do that in the slowest period of the year where you've got the least room to move from an earnings standpoint and still deliver the quarter and get ourselves in a position to really kick some tail here in the back half, I think, feels pretty good.

So I'm really proud of the work this group did. I think they did one hell of a job of coming together on this one.

No question. As I said, congratulations on the quarter. You did a great job.

Bill, can you give me a sense of where you think you're going to shake out for the year on the gross margin and the operating margin?

Yes, we should be in-- again, in the range of about 45.5% to 46.5%, 45% to 47% on margins. Operating margins will be in the 9%-ish, around 9%, 8.5% to 9.5%.

OK. Also, for the quarter, the $40 million in selling and marketing, that was the plan number or was that taken down?

The-- we spent pretty much to plan. We were able to find a little bit of efficiency beyond what we were expecting as we continue to find the sweet spot and test various possible markets for our media. We've really done a shift from long form-- a real mix of short form to long form. We're testing more of the short form and we're testing other alternatives, as well.

Yes, I'd say this, just to add to that a little bit. One of the big differences, I think, as we've gone through and continued to grow the businesses, Tim and his team are finding much more efficient ways to place our media. And so they-- they make adjustments within quarter based on the pieces that are working for us. And the print campaign for us really took off this quarter, which did give us a little bit, not a lot, but a little bit of efficiency here that we weren't anticipating.

So I think you'll see us stay pretty much on plan to the marketing budget going through the back half of the year here and as Tim continues to find more efficient ways to do it, working with his team, I think that's all upside potential for us. So we're pretty excited about it.

OK, Greg. In the second half of the year the selling and marketing would be what? About $100 million combined?

What have we got for the back half here, guys? I don't have that number in front of me.

It would approximate that, Marc. Yes, it'd be in that range.

Well, also, Bill, what happened-- what was the other income? You had about $1.3 million, I guess. What was in that number?

Right. The interest was about $800,000 of that and then the rest is a-- we've got a license agreement and also there's currency amounts in there, as well. But most of it is interest income.

OK. And your tax was lower?

Yes, we actually had a settlement of an IRS-- a federal audit and so we're able to relieve some of the reserves related to that. We came in around a 34% versus-- 35.4% is what we would expect for the rest of this year.

For the second half of the year?

What's that now?

In other words, for the second half of the year you would expect about 35.4%?

For the-- yes, for the full year we should end up at 35.4% is what we're anticipating based on current operations.

OK. And last question. I'm sorry, can you just briefly go through the terms, again, of Sears. You said you had 450 doors with how many SKUs?

5. As many as 5.

Up to 5 SKUs?

Correct.

OK and that-- and this is actually going to begin rolling into Sears when?

We'll be shipping in August, in their stores in September.

Rommel Dionisio, Wedbush Morgan.

On the Sears -- not to harp on this too much -- but it sounds like it's a bit late in the year to be signing on such a major contract. Greg, I wonder if you could just go through logistically what this is going to present as a challenge for you, signing on such a major customer? And, as you said, you're going to start shopping in August here.

Yes, Rommel, I'll tell you. It's actually about the perfect timing for us. We're heading into the busy season of fitness. We've been working with this customer for quite a period of time now to develop the forecasting and we certainly didn't mean to be hiding anything here from you in the last conference call, but any means, but until a customer actually says I want-- sends you a PO that says they're going to ship it, we were just trying to be cautious. But we've been working with them on this assortment and what it should be for almost 6 months now.

What you see in our inventory build is prepared in preparation to Sears here as we start and get into the third and fourth quarters. So I think we're actually in a very, very good position and it's perfect timing for us.

We're-- one, we're prepared. Two, we've got the back of the house systems in place now to be able to deliver against the customer and, three, we've got alignment with that customer on where the product's going to go and how it's going to be placed and how we're going to merchandise it, what kind of marketing effort we're going to put behind it, so the whole package has been put together and we're ready to rock and roll.

Great and congratulations again. Your efforts are really coming to fruition here. Thanks.

Thank you.

Eric Wold, Merriman Curhan Ford.

A couple followup questions on the Sears announcement. Could you give a little more details on your assortment into there? Is that going to be replacing comparable products that are already on the floor or are these incremental to what they have there?

And then secondly, in terms of the up-to-5 SKUs going into the stores, do you have any sense on what level of backup inventory Sears will be taking in each of those stores?

Well, let me try to answer it real quick and then, Tim, if I don't cover all the details, you can jump in. But I'd say this, one, from an incremental standpoint, you probably should ask Sears that question. We aren't really sure what they took out or what's being replaced on the floor. So that's probably more appropriate to ask them.

I do know this. I don't think they've really expanded their floor base much. So-- but that's a question I'd ask you to check with them on.

The second piece, as we look at what kind of inventory they're going to carry, they're actually going through an adjustment in that right now with-- with the merger between K-Mart and Sears, so they're deciding what kind of backup inventory they're going to carry and we haven't gotten confirmation from them on that yet, but we're working together with them.

So anything, Tim, that you can add to that?

That's perfect.

Do you have any idea of what they've held in the past with other SKUs? Maybe not specifically yours, but what they've held with other product carriers?

Yes, I don't-- I don't think we know, officially, the answer to that. I don't want to give you any bad information. Again, that's a great question to ask Sears. Greg's point's valid that the K-Mart influence on Sears is creating kind of a new model for them to look at in terms of how they bring in stores and the only thing I can tell you, is we're working very closely with them to make sure that we not only have the pipeline order ready to go, but the backfill, as well. So that's all about collaborative customer planning. So-- but those are probably better questions to ask Sears.

Mr. Hammann, there are no further questions at this time. I will turn the conference call back to you. Please continue with your presentation or closing remarks.

Thanks, George (ph). All I want to say is I am very proud of what this team has done to this point. I think we've got a group of folks here that are very focused and aligned on what we need to accomplish in delivering shareholder value. I think we're right on track with our plan and getting ourselves into a good position to not only have a great back half of the year here, but set us up successfully for '06 and beyond.

So thanks to the Nautilus team for everything they're doing and I appreciate you all listening in today. Thank you.

Ladies and gentlemen, this does conclude the presentation for today. We thank you for your participation and ask that you please disconnect your lines. Have a great evening.