Nautilus Inc (NLS) 2005 Q3 法說會逐字稿

Welcome to the Nautilus, Incorporated third quarter 2005 earnings conference call. [OPERATOR INSTRUCTIONS.]

As a reminder, this call is being recorded on Wednesday, November 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 the fourth quarter and 2006 estimates, along with new products and channels, 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 release to which this conference call relates and the Company's most recent periodic reports on Forms 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 I would now like to turn the conference over to Mr. Gregg Hammann, Chairman and Chief Executive Officer of Nautilus, Incorporated. Please go ahead, sir.

Thanks, Alistair. Good afternoon, and thanks for joining us. With me today are Bill Meadowcroft, our Chief Financial Officer, and Tim Hawkins, our Chief Customer and Chief Marketing Officer.

Today we’ll provide highlights from the third quarter of our 2005 operating plan and our continuing efforts to drive growth and invest in the future. Specifically, we’re going to cover the third quarter results, including net sales from five sales channels, plus our apparel division. We’ll also update guidance for the fourth quarter and provide an update on our strategic business plan.

Now, about an hour ago, we posted our third quarter 2005 financial statements, which showed we delivered net income for the quarter as expected. Net sales of about $163 million was an improvement of 33% over the year-ago quarter. We experienced growth in all but one of our business channels, with the retail channel growing at 80%. Earnings per diluted share were at the high end of our guidance at $0.24, with net incoming improving 32% when excluding a property sale gain in the year-ago quarter.

We also experienced some obstacles during the third quarter. Some of them were uncontrollable -- weather, fuel surcharges, and consumer confidence -- but some of them were also controllable, namely, in the new product development process. Although we introduced six out of seven products with quality, we simply fell short of the world-class expectations we have for our company.

Now, for more detail on the third quarter, I’m going to turn the call over to our Chief Financial Officer, Bill Meadowcroft.

Thanks, Gregg.

Net sales for the quarter were $163.3 million, compared to $123.2 million the preceding year, an increase of 33%. Gross profit margins were 44.3%, compared to 47.6% for the year-ago quarter.

Our business model indicates that gross margins will decline as we diversify in the business channels, other than direct, which has substantially higher gross margins. Compared to a year ago, mixed shift explained about 160 basis points of the difference. Another 160 basis points can be attributed to operational costs related to our fast pace of innovation and to higher fuel and transportation-related costs, which we began to remedy in late July.

Operating income in the third quarter was $12.5 million, or 7.6%, compared to $11.3 million, or 9.2% for the year-ago quarter. The reduction in margin is primarily a reflection of a land sale in the year-ago quarter.

Diluted earnings per share for the quarter were $0.24, compared to $0.19 a year ago, an improvement in net income of 32%, excluding the land sale, or 11%, including the year-ago land sale.

Regarding operating expenses, selling and marketing was 27.3% of sales, down from 30.9% for the year-ago quarter. This reflects our ability to achieve selling and marketing efficiencies as we generate greater revenue from non-direct channels.

General and administrative expense was 6.8% of sales, up from 5.3% in the year-ago quarter, which was lower due to that land sale.

Research and development was 1.7% of sales, compared to 1.4% for the year-ago quarter, an increase of $1.2 million, reflecting our commitment to a fast pace of innovation.

Turning to our balance sheet, we finished the quarter with cash and short-term investments of $7.4 million. This reflects the closing of the Pearl iZUMi acquisition on July 7, expected increases in accounts receivable because of our growth in retail sales, improving our inventory position in advance of the winter fitness season, and buying back 193,000 shares of Nautilus stock, our first buyback since 2002, at an average price of $23.75 per share. We purchased shares up until our insider quiet period began. We have $100 million three-year authorization from earlier this year and have about 95% of that authorization remaining.

During the quarter, we expanded on our line of credit from $10 million to $40 million. We expect pre-cap to slow in the fourth quarter of about $15 million. Combined, we have about $60 million available for working capital acquisitions or stock buybacks.

Compared to a year ago, we are entering the fitness season with a vastly improved inventory position compared to last season when we ran short on a number of key products in December and January. Inventories were $84 million at the quarter’s end, which includes $9 million of apparel inventory.

Finally, our Board of Directors has approved the regular quarterly dividend of $0.10 per share, payable December 9, 2005 to shareholders of record as of November 20, 2005.

For a more complete overview of our business by each of our five 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.

We’re approaching the fall and winter fitness seasons in a very strong position. The fitness equipment and apparel categories where we compete are an addressable market of approximately $12 billion, and our share is around 5%. With five of the top fitness brands, we have a goal of growing our business over time to a leadership share of 30% or more by presenting our brands wherever people exercise and shop for innovative fitness products.

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

First, let’s start with retail, which includes sporting goods, warehouse clubs, department stores, a $2.7 billion market. Third quarter net sales were $29.7 million, up 80% from the year-ago quarter. As we reported last quarter, we entered the fall having product on the floor in about 2,800 doors of about 15 major retail partners and averaging about four products per door. This is more than twice the door and SKU count compared to just one year ago but reflects just a fraction of our business opportunity in this channel. To differentiate assortments, merchandising approach varies by each retail partner depending upon their goals and their consumer profile.

Our new relationship with Sears is off to a great start with up to five product SKUs and more than 600 doors out of Sears' 870 U.S. stores. We have one home gym in more than 600 doors, two exercise bikes in about 500 doors, and our popular SelectTech dumbbells and stand in about 100 doors. We’ll also be in this year’s fitness catalog, have products available at Sears.com, and we’ll be featured in some Sears advertising later this fall.

We reported earlier that our assortment at the sporting goods -- excuse me, at the Sports Authority offers 13 to 14 products in all of the large format doors, a smaller assortment in others, and a merchandising display in 215 locations. Now, Dick's Sporting Goods will carry four to five products in their 235 locations, up from one to two last year, and will test the large merchandising display featuring 11 products in about 25 stores with the theme Fitness That Fits.

The winter retail season is just getting underway, and we are well positioned for growth at retail. However, we remain somewhat cautious about consumer confidence and its effects upon fitness buying patterns.

Next channel, specialty retail, where people buy club-quality equipment for the home; it’s an $800 million market. Third quarter net sales were up $17.8 million -- excuse me, were $17.8 million, up 37% from the year-ago quarter. We are benefiting from new product introductions and from solid demand from light commercial and high-end home fitness equipment. We now have products in about half of the 420 specialty fitness stores in the United States.

In the quarter, we hosted a conference that attracted more than 300 specialty and commercial fitness decision makers. At the conference we presented educational support, point-of-sale materials to improve the shopping experience, and our winter product line-up. Among the products we showcased were our new Nautilus Pro-Series ellipticals with MyStride technology, new Bowflex home gyms, and our new Nautilus Sport Series treadmills that for the first time let consumers choose a platform, the console, and the electronics package that suits them best.

In addition to specialty fitness retailers, we've started to cross-sell our equipment and apparel through independent bike dealers, which was kicked off with a tandem exhibit at the recent Interbike show. Our intention is to expand both our equipment and our apparel presence at independent bike dealers. Combined, we have a presence in about 2,000 of the 4,500 independent bike dealers in the U.S. and Europe.

Let’s the move on to the commercial channel such as clubs, hotels, living complexes, also an $80 million market -- excuse me, an $800 million market. Our third quarter net sales were $18.2 million, down 2% from the year-ago quarter. Business remained strong for our Nautilus strength lines, along with Schwinn Fitness indoor cycling products and certain cardio products.

We’ve been building out a complete line of cardio products to match our long-time leadership in our strength equipment. This includes new Nautilus treadmills, Nautilus ellipticals with MyStride technology, and the Nautilus commercial series TreadClimber cardio machine. The introduction and optimization of these complex innovations has taken some time and resources, more time and resources than expected, which is the reason for some sales softness in the quarter. However, we do expect a very strong fourth quarter to finish the year with a low teen growth rate and to be well positioned for growth in 2006.

We are fine-tuning our Nautilus commercial series TreadClimber. Despite experiencing some inconsistencies in the mechanisms provided by sub-suppliers for these units, we did witness the extreme popularity of this product at 24 Hour Fitness, with them reporting waiting lines and many hours of usage each day. We expect to this product to contribute significantly to our 2006 commercial revenues.

Our next channel is the direct channel, which involves Internet, catalog, and direct response advertising, a market of about 1.1 billion last year. Our third quarter net sales were $68.4 million, up 9% from the year-ago quarter. We continue to benefit from the series of improvements made about a year ago to the direct business, including new advertising, diversified product mix, and improvements to advertising placemat -- placement, format, and style. Sales were led by the Bowflex Ultimate 2 and Extreme 2 home gyms, along with the SelectTech 5 to 52 dumbbells, and the Bowflex TreadClimber machine.

We experienced an unusually large amount of volatility from day to day in the direct business during this quarter, presumably from hurricanes, interest rates, and other non-controllable factors. As a result, direct sales were a little slower than expected.

For the fourth quarter, we’ve started shipping orders for our new Bowflex Revolution home gym and have issued our second fitness catalog of the year, featuring more than 200 products. This month, we’ll introduce our fourth model of the Bowflex TreadClimber cardio machine for in-home use -- it’s called the 5300 -- that offers longer treadmills and enhanced electronics. Finally, we’ve introduced new advertising, including our first-ever segment that showcases both strength and cardio products in a single platform.

Direct is a strong foundation of our business and will account for about 45% of our total sales in the year. However, we do expect our fourth quarter to perform below the year-ago quarter, where we saw an unprecedented sales jump of $27 million from the fourth quarter in 2003. It was a 44% increase. For 2005, we’re expecting direct sales growth in the low- to mid-teens and continued single-digit growth into 2006.

Our international channel includes commercial, along with retail and direct sales, outside the Americas, a $4.5 billion market. For the third quarter, we had net sales of $14.2 million, up about 15% from the same quarter last year.

Our sales growth internationally is reflecting our initial work into channel diversification. For example, in Australia, we’re partnering with Rebel Sport to floor 12 products in 55 doors. In Germany, were partnering with Sport [Teicha][ph] to have 10 product SKUs in the seven markets they serve. And in the UK, we’re partnering with the popular catalog-based retailer Argos to have 21 products appear in their catalog and another 12 products on their web site. And in New Zealand, we’ve initiated a direct and retail business in a partnership with Elite Fitness. Overall, we expect to finish the year in international with percentage growth in the mid-teens while setting up growth opportunities into 2006 and behind.

Finally, our new Nautilus apparel division represents our introduction into the $2 billion fitness apparel market. That division delivered $15.1 million in net sales for the third quarter, which was right on plan. The apparel division continues to set the pace for technology innovations in fitness apparel.

In conjunction with its 300-item winter consumer catalog, our team is introducing Gel Vent cycling gloves, which allow airflow through the highly popular gloves, and Octane cycling shoes with the first-ever titanium sole, the strongest and lightest sole ever introduced.

The fourth quarter is seasonally the slowest for fitness apparel. We expect net sales to approach $10 million for the quarter, and we also expect mid-teen growth rates for fitness apparel.

So, in summary, with the exception of the commercial channel, we ended up with solid sales performance in the quarter and are on a fast-paced growth entering the primary winter fitness season.

I’ll turn it back over to Gregg.

Thanks, Bill and Tim.

So we’re pleased with the quarter and our overall progress as we drive growth and invest in the future. Now, earlier, I mentioned we hit on six of seven of our new product intros. Let me share with you a couple of the issues we had in Q3 and what we’re doing about it.

First, we introduced the first 500 units of a new commercial TreadClimber model in partnership with 24 Hour Fitness in June. The products didn’t meet our quality expectations in the field. We committed to 24 Hour Fitness leaders that we would make the necessary upgrades and finalize testing on those upgrades in the fourth quarter to ensure we have the finest quality products in our customers’ outlets. This change has caused us to go through an extra round of development and testing and has slowed down the manufacturing of other commercial cardio products. However, I am happy to report that we have the issue solved, and we are now moving forward.

Second, we ineffectively managed the flow of inventory going into the busy season. As a result, we created a bottleneck at our distribution centers, resulting in increased handling and storage costs. With a little better planning, we could have flowed the product directly to customers and in and out of our distribution centers to more effectively manage our sales growth. This is a key learning for us and something that we’re taking forward as we move into the future.

So we’ve made some needed adjustments to improve upon the controllables, including appointing a new plant manager in Tulsa, where we make our commercial cardio products, and my taking the interim leadership for manufacturing and operations.

We’re also developing contingency plans for the uncontrollables. Adversity, when managed, makes us a stronger company. We got stronger this quarter, and I’m confident we’re even better positioned to grow our business over the long term.

So while I’ve been critical of our go-to-market process on new product launches, we’re fully committed to a fast pace of innovation. Here are a few of the new product introductions that demonstrate our capacity and capability to do it right -- first, the Bowflex Revolution home gym, where initial orders are now being shipped; second, Schwinn Fitness 438 ellipticals, a popular upgrade of our award-winning home elliptical model; third, Nautilus commercial series treadmills with improved construction electronic features; fourth, Nautilus commercial series ellipticals with MyStride technology; fifth, the Bowflex Conquest home gym; sixth, Nautilus Sports Series treadmills, a first-ever fully customizable treadmill; and finally, the Bowflex 5300 TreadClimber for home use, with longer treadles and more electronic features.

So with that, we’ve accomplished a lot this year. We returned our business to growth. We expect all of our sales channels to post double-digit gains this year. We acquired two fitness companies; Belko Canada, which is now Nautilus Fitness Canada, and Pearl iZUMi USA, which is now the Nautilus Apparel Division. We expanded our channels of distribution, including accelerating our domestic retail expansion and moving into retail and direct in the international marketplace. We further differentiated our portfolio with a blend of more than 20 revolutionary and evolutionary product innovations across all channels.

Through our Power of One initiative, we’re transforming five business operating systems into a single enterprise resource-planning platform. We’re making the necessary supply chain adjustments to accommodate a fast pace of innovation, and this includes our Shanghai operation to oversee contract manufacturing in China and Taiwan. It also includes strengthening our leadership and quality procedures at domestic plants.

Finally, we’re navigating a turbulent economy, remaining focused on building a solid infrastructure and new platforms that will produce growth for years to come.

So I’m proud of what we’ve accomplished, and I’m confident in our long-term growth prospects as a pure fitness company; however, and I want to make this clear, we’re not satisfied. We’re hungry. We’re motivated to perform even better as we achieve global category leadership by providing the tools and education necessary to help more people achieve a fit and healthy life.

We recently launched our 2006 business theme. It is -- Achieving leverage through operational excellence through an intense focus on quality, customer service, and driving out costs. We call it QC squared, and it involves every single person in the Company, along with many of our suppliers and business partners. This initiative is already revealing savings through reverse auctions on goods and services, beginning a consolidation and optimization of our distribution capacity, and committing our plants to a higher quality standard to minimize field service calls and boost customer satisfaction.

With that said, we want to be realistic about the short-term performance. So here’s what we expect. For the fourth quarter, we expect net sales to grow about 25% to around $210 million. We expect fourth quarter earnings to be in the $0.44 to $0.48 range, a 5 to 15% increase. Now this is on top of a 50% increase in earnings during the year-ago quarter that resulted in $0.42, but it is about $0.10 less than we expected after the second quarter.

So here’s how we get to these numbers. As we size up earnings for the fourth quarter, we expect some of the temporary operational issues to cost us about $0.05 to $0.06. We also estimate that a slow-down in consumer spending may have another 5 to 6 impact as well. So if things stack up against us, we can see $0.44 for the fourth quarter. And if some things break in our favor, we could be looking at closer to $0.48.

As we look forward, we continue to be very excited about our growth opportunities. Here are five reasons -- first, fitness is becoming a necessity around the world as global society comes to grips with the health and consequences of inactivity; second, we have five leading fitness brands in the fitness category; third, we have the strongest marketing in fitness; fourth, we have the fastest pace of new product innovation, and fifth, we have the industry’s strongest position across diverse sales channels.

So despite all of our progress, we’re just beginning to penetrate the $17 billion global fitness market. That’s why we continue to believe that our strategic business plan will deliver top-line growth of 15 to 20% and bottom-line growth of 20 to 30% for the foreseeable future. We are pure fitness, and we are on our way to global category leadership.

With that, Alistair, I believe we’re ready for questions.

Thank you. [OPERATOR INSTRUCTIONS.]

Our first question comes on the line of Mark Rupe. Please go ahead.

Hey guys. Just a couple of quick questions here. Just stepping back, a lot of your competitors have recently reported, and there’s not been a lot of growth out of a lot of them [inaudible] for most of them. With your growth mixture expectations of 15 to 20%, obviously you don’t have much penetration at retail, but what gives you the confidence in being able to hit that?

Yes, Mark, that’s a great question. So here are a couple things.

First, as some of these big customers have come online in the back half of the year, as you annualize that volume versus just getting a half-year to a one-quarter convention, you pick up some growth there.

The second piece is we’re starting to expand our distribution in some of these customers, as Tim talked about, and I think that’s going to help us pretty significantly as well.

The third piece is, and we've said, we continue to expect the direct business to grow in those low single digits. So, we’re right in place to grow the business at that 15 to 20% target.

Okay, perfect. And then on the supply chain, obviously the bottom line, you’re still looking for 20 to 30%. Any idea, and maybe Bill can help on this as well, how much will break-up between gross margin or leverage in the sales and marketing or G&A? Where do we see a lot of that coming from?

Well, I’ll take the first part, and then I’ll turn it to Bill. Here’s where I see some of this. I think on the manufacturing and operations side, we’ve got some pretty significant leverage opportunities there, and as the new head of manufacturing operations, I can tell you I’m all over that one. I think there's between probably 6 and 12 million bucks that are go-gets there that we can go after.

In addition to that, I think as Tim has been working on some of the marketing opportunities that he’s got, he’s going to continue to leverage that capability we have in getting the economies of scale around our marketing plan. So there’s some opportunity there. And around G&A expense, we made some big investments in our business this last year around ERP platform and some people investments that we’ve made, and we expect to start getting some leverage from that. Anything else, Bill, that I should --?

No, I think that fills it in pretty well.

Okay, on G&A, are there any major legal expenses in the quarter?

Nothing planned for the fourth quarter, if that’s what you’re asking about --

Perfect.

-- as we go.

Okay. Thank you.

Thanks, Mark.

Our next question comes from the line of Scott Mushkin. Please go ahead.

Hey, guys, thanks. I just wanted to get into the 24 Hour Fitness relationship because I think it’s somewhat important in your strategy overall, the kind of cascading down of these products. I know the TreadClimber has been really a popular item for the home, but I’ve also done some research that it’s been very popular in the 24 Hour, but with the ones not working, how have you guys managed that relationship so you’re making sure it’s okay, and what kind of costs do you think are going to come through in the fourth quarter from doing what you have to do to make that right?

Yes, this is Tim. Good question. You clearly get our strategy. We are all about innovating at the top and having it cascade down. Clearly, when you have a quality hiccup with a customer, there are certainly better things to have done in a relationship than that, but I will give credit where credit is due here. Our friends at 24 Hour Fitness have been phenomenal partners through this, and I think a couple reasons why. One is they understand and respect, I think, the innovation that’s behind the technology. They had -- Scott, they had people standing in line to get on this TreadClimber, and their president played back to me they have not seen a phenomena like that in the commercial market since StairMaster introduced the stairclimber. In today’s compressed society where people don’t have time, people had time to stand in line and wait to get on this piece of equipment. That’s how excited they were about it.

Two is we do have a relationship with 24 Hour Fitness that goes beyond pieces of equipment. I think we have a marketing relationship; we have a partnership with these guys. If you look at the work we put into the TreadClimber with them, it wasn’t just dropping equipment off at the back door; we work with them to drive membership, to drive consumers to this -- to their clubs. And I think they value that, and we’ve certainly valued them through this process. They’ve been great partners. Has it been a difficult piece to manage through? Absolutely. Do I think we come out with a better relationship in the end with this with them? I think we do because we’re working through it with them together. It’s not -- we’re going to come out much stronger in the end.

In terms of costs, Bill, you got that one?

Yes. Certainly during the third quarter we attempted to get as much accrued as we were anticipating. There may be some additional costs, but we went at it and tried to get costs accrued that we were anticipating from the fix.

Okay. That’s real -- that's great. Now, they were on an exclusive six-month contract right, with you guys? And is that extended, and how does that delay you going into other places, or are you even ready to go into other places with the TreadClimber?

Yes, they were -- Scott, they were exclusive, and right now they’re still in that exclusivity period, and we’re working with them right now around what that looks like going forward. Obviously, we’re going to be anxious to move that into the marketplace, but we also want to make sure that we’re fair to our partnership with them, so we’re working through that right now.

Okay. I just have one final one. This is probably more for Gregg since he’s taking over the manufacturing. I know someone -- you were talking about a cost savings, Gregg, but when you look at it, sometimes it seems like the marketing side of the business and the innovation side of the business are really just hitting on all cylinders, yet the manufacturing and logistics maybe haven’t been able to keep up. Do you think not only there are some savings but also some investments you need to make, and have you identified what they are?

There are a couple, but they’re capital items, for the most part, and it’s nothing extensive. I mean we’re looking at some laser cutting tools and a couple of things like that for the factories, but other than that, I think we’re in pretty reasonable shape. We’ve got a new distribution center that we’re putting in place. We’ve got some racking that’s going in there, but that’s, again, a minor detail.

So I think the bigger opportunities, Scott, are around some of our distribution efficiencies. I think there’s some opportunities for us through better forecasting, working with the sales and marketing team to make sure that we get the flow of goods planned much better, and I think as we go forward, we’re starting to get those things in place, and that should certainly help us as we move forward. We, again, think there’s 6 to 12 million bucks of operating efficiencies we can get out of just two or three major initiatives here.

And the new guy down in Oklahoma, has he streamlined that plant? Are you happy with what’s going on down there and the quality of the equipment coming out now?

Well, he’s -- he came to us from Visteon Ford, where they made chassis for many of the higher-end products at Ford, and so [they've] got zero tolerance on a steering wheel, right? So this guy certainly comes from a background of making sure that things come out through a quality fashion, and he’s already starting to put some things in place, and frankly, we've got a pretty good team in Tulsa. I mean those folks work really hard, and I think they’re trying to do the best they can, but with his leadership, I think they’re going to get a heck of a lot better. So, I’m really excited about what he’s doing down there and the work that’s taking place.

Scott Mushkin. All right, listen, thanks for your time.

Thanks a lot, Scott.

Our next question comes from the line of Eric Wold with Merriman Curhan Ford. Please go ahead.

Hey, good afternoon. Following up on an earlier question on the 15 to 20% revenue guidance for next year, can you get a sense of how much of that revenue growth will come from the sell end into, I guess, kind of the three major partners of Sears, TSA, and Dick's?

Yes, Eric, let me take a shot at this one because Tim and I have been working on this one together. And then I can walk you through -- or Tim can walk you through some of the other customers that we see some growth in.

But as you look at the breakdown of that 15 to 20%, we’re also, just so you know, we’re talking three years, the three to five-year cycle here. So we’re talking about an SVP of 15 to 20% growth over time. But if you want to get specific as far as the ’06 piece, what I'd tell you is take a look at what third and fourth quarter looks like for us with these new customers coming on and the expansion, and then you can look at the seasonality and annualize that business. So call that roughly a 3 to 5, maybe 6, 7% tops that’ll be part of that baseline going in to next year from a growth perspective, and then I think the rest of the growth, we still -- with a lot of our customers we’re growing pretty aggressively. So, we’re getting good turns.

There’ve been a couple of questions out there about inventory, so let me address that real quick. The retail inventory is in great position. What we’ve seen happen is a lot of our customers -- TSA, I think, has been one of the leaders in this, but Dick's Sporting Goods, as well, has started to get much more efficient with their inventory management procedures, which is making them a much better company as well. In the process of doing that, though, as you go through it, it -- they’ve basically cut their inventory positions in half that they carry on the floor, which means you don’t have a lot of the clogging up that you used to have, right? Now, what’s that meant for us is we’ve got to carry the inventory on the back side to make sure that we’re getting those turns as quickly as possible, and so as we'd machinate and adjust to that, there’s a little bit of a growth cycle there. But I think we’re going to get that -- we’ll get that learning under our belt here pretty quickly working with them, and we feel pretty good about the way that the process is moving.

So inventories are in good position with these new customers in particular and with the expansion we’ve done with our existing customers, and I think as we look at ’06 you can count on about a third of that growth rate to come from those -- expanded distribution and new customer base.

Okay. And then thinking about them a little further, obviously, you did build up inventory receivables for the right reason, to get those in place and -- for the fill-in into retail in Q4. You mentioned a free cash flow of about $15 million in Q4. Do you have a sense of what it might be in Q1?

Yes, we haven’t gotten the specific guidance for ’06 yet, and we’re still working through our business plans, but can you give him a roundabout --?

Yes, certainly, Eric. Obviously, as we go through the first quarter and finish the heaviest season, our receivables will come down, and that will energize our cash quite considerably. We are, as we’ve talked a bit about, looking at nutrition acquisition, which that could happen in this quarter or in the first quarter, and then inventory. As we head into the second quarter, inventory will go down a bit more as well. So cash in the first quarter should actually and will consistently be our best quarter from a cash standpoint.

Well, then on that, if you end the year within somewhere around, call it 20, $25 million in cash, if we added Q3 plus the 15 in Q4, and then whether or not you buy something or not, how willing are you to delve into that $40 million credit line to buy stock down here?

I’ll tell you what, pretty willing. Still, having said that, it -- you know, today’s prices. So, yes, so we bought stock back at $23.75, I think, or somewhere in that range as you look at it. So certainly at the current numbers, it would be an even greater value, in our opinion. So, we’re going to be after this one; just help us get through Friday, right?

Yes, we can buy on Monday.

Got it. Last question is final CapEx estimates for this year, and any kind of initial estimate for next year?

Yes, we’ll be in the high 20s this year, and next year we should be back down into a 14 to $16 million range.

Okay. Thanks, guys.

Okay. Thanks, Eric.

Our next question comes from the line of Kathryn Thompson with BB&T Capital Markets. Please go ahead.

Hi, thanks. In giving your guidance for Q4 -- and I know you broke out the kind of half and half, where part of it’s kind of operational, part of it's an anticipated softer consumer -- but in that extra $0.05, did you take into account kind of a late Christmas effect? You saw this last year, where basically the consumer didn’t come directly after Thanksgiving, and really sales were weighted more towards the back half of December and even early January? Was this accounted for in your guidance?

Yes, it is, Kathryn--.

[Inaudible].

Yes, and it’s a great point. We’ve seen things from our perspective, at least on a high-level standpoint, things are starting to move closer and closer to that sort of Christmas selling season. We used to pick up volume on the Friday right after Thanksgiving, and then it just ramped up from there until the end of December. We’re starting to see consumers come on later and later now. The problem with that is you get a little bit of a slingshot effect, and especially now, having some focus on this manufacturing operations piece, I can tell you that puts a lot of stress on the system here. So we've factored that into that conservative guidance that we provided you earlier.

Yes, Kathryn, every one of our retailers are -- we're having that planning with the customer experience now, especially now in planning for Q1. Every one of our customers is expecting that to happen. So we’re doing what we can to plan for that, knowing that it will also help us in Q1 as well.

Okay. So it combines not only just a softer consumer, but a consumer that is -- could possibly be buying more like into your first quarter than your traditional Q4?

Correct. And Q1 for us, I mean, because we’re in the fitness business, we do get a January 1 New Year’s resolution benefit.

Yes.

There’s no question. We sell -- when the rest of the world’s in clearance in Q1, we’re actually on full on -- that’s our high season, so.

Absolutely. Now, you just referenced some choppiness in direct sales, which, I think, comes as no surprise. How is the direct sell-through right now? Are you seeing some smoothness into those? And it's also a nice snapshot, in general, just a general consumer sentiment. If you could talk about how sales have been in the past three to four weeks, that would be great.

Q3 was crazy. I mean, literally, there was -- you could watch -- whatever was on CNN was what was affecting our direct sales. It was amazing to watch it day to day.

Now, the good news is Q4, things are smoothing out. Are they coming on super fast? No. It’s coming on slower than we wish it was. We think we’ve got the right plan in place. We think we’re being smart about the impact it has on earnings, and obviously, we’re holding our breath a bit on is there something else that’s going to be an impact, and certainly, we think that the shopping season’s going to be the best piece of news. We could use a little help from the government, we could use a little help from gas prices, but we’re doing everything we -- I'll tell you this. We’re doing everything we sure can to affect the controllables. What we can’t do is bet on the non-controllables. So we’re just kind of keeping our heads down and making sure that we’re executing our plan. We’re running the media we want to run. We’re running the promotions we want to run. We’re not getting silly with giving stuff away. We’re going to continue to hold our plan. But it’s not as -- I’ll say this. It’s not as volatile in Q4 now, in the last three weeks, as it was in Q3. Q3 was nuts. And we do see it coming back slowly, not as fast as we wish it was.

Okay. I guess -- and, finally, just on the commercial cardio, the TreadClimber product, in particular, at 24 Hour Fitness, my understanding is that you actually had to take some product out of certain centers. If you could -- if you could walk through it just in a little bit more detail about that process, what it took to rectify it, and really what will be the real cost into the fourth quarter, in particular, and what most of those -- I mean I know you tried to accrue as much as possible in Q3, but what is it going to take to solve this problem other than kind of what you talked about earlier in the call?

Yes, Kathryn, there are two issues and -- that we’re having to rectify -- one is a hydraulic issue; two is a belt problem. And some of the work that has to be done is a lot easier being done in a central location and off -- certainly 24 Hour Fitness doesn’t want us doing these repairs on their floor. That last thing we need is a big, burly field service guy lying on the floor fixing these pieces. And they are extensive. It does require some work to be done. So we are removing some of them in some locations, getting them off the floor, getting them to a central spot, where we can efficiently and effectively make these changes and very quickly get them back out to the market. Greg, do you want to --?

Yes. So, one of the things we’re trying to do is to kind of rotate the product through so we don’t leave them sitting there without product on the floor, and so part of the process has been with the -- what we call the second series of these. As we produce them, we’re sort of rotating product in and out and then fixing the old product as we go. So in trying to work in partnership with 24 Hour Fitness on that, we’re trying to do the best we can to make sure we’re taking care of their customers that are trying to work out, right? So, that’s the process or general approach we’re trying to take.

The component parts -- and just to be very, very clear here on what we’re dealing with -- we had a bit of a problem with the cylinder. And so what happened, the cylinder -- and the folks that make these things make them for Caterpillar and other large, very expensive sportscar companies and some other things, so it’s not like these folks don’t know what they’re doing -- but the tolerances that were required on that cylinder because of the amount of stress load that was being put on it was causing some failures. And so, we went back working with them in partnership to get some of the design changed on it. We’ve got a new design in place. We've tested it. We feel it’s in pretty good shape. We’ve got it out in the marketplace right now. We’re testing it, and so far, so good. So we feel pretty good about that.

On the treadles, it was with the belts. That was a combination of that cylinder, as it would misfire, and also, a slight spec change that took place from the design process to the actual implementation of the belt. We’ve gone back to the initial design of that and -- that we have in the initial spec, and it seems to be working really for us.

So I think we’ve got that issue reconciled at this point. I’m pretty excited about it. You know, this TreadClimber that we’ve got in the commercial business is the most complicated piece of exercise equipment ever built. And the fact that we got this thing out there with only these two minor problems -- although they were problems, and I don’t want to minimize them -- the fact that we’ve been able to fix them as quickly as we have and get a change out there and then be able to move forward just shows the kind of diligence that this team put behind it. So I’m pretty excited about what the future of that product looks like.

You can tell our new ops guy is all over it.

Hey, yes, there you go. No, I just -- I guess I had some concern about that it worked fine for, say, an hour, but for as much use as you get in a commercial side, that it was not upholding as much, but if you believe you fixed the problem, that again fixes that. We can go with that.

Yes, to be very clear on that, Kathryn, it wasn’t just an hour and then giving it a breather. These things were, when we started to see failures, you know, as Tim described the line-up, those things were going for 16 hours straight without having a breather. And so the problem you’ve got is you’ve got some heat, you got a little dust in there, and then you get some seal breakage on that cylinder, and that’s what the biggest problem was. We think we’ve got that reconciled now through a filter system that we put in on the cylinder head and some other things that we’re doing. So I’m pretty pleased with the way that we’ve made this revision. It’s not like the home version of it where somebody gets on it for 30 to 60 minutes and then hops off and the things got plenty of time to cool off. These things are getting seven days a week, 16, 20 hours a day sometimes. So, ala the name 24 Hour Fitness, right?

Ladies and gentlemen, as a reminder, please limit yourself to a total of three questions. Our next question comes from the line of Ed Aaron with RBC Capital Markets. Please go ahead.

Thanks. Good afternoon, everybody.

Hey, Ed.

Hey. Just a few questions for you. First, on the retail side, can -- your business there is growing at such a high rate that it’s hard to tell what the right number is in terms of relative to expectations. The sales number in that channel this quarter, was that where you thought it would be?

Yes, that was pretty much on plan.

Yes.

Okay. And can give you some indications as to what the sell-through has been like? And I guess we’re kind of coming in to the part of the season where we start to see more and more reorder activity. Can you talk about how those things are kind of trending relative to expectations?

Yes. Ed, we’re just getting at it, as you can imagine. So, for right now, the early read is our takeaway is okay. I’ll tell you this. I know we’re outpacing our competitors, so we’re leading the categories. Specifically, I could talk to you about Sears. I think we’re exceeding -- in their words, we’re exceeding their expectations in terms of consumer takeaway. That’s a great start. I think -- and you’re starting to see the reports from our retailers. They’re starting to come out with some concern, and we’re all talking those concerns together. But right now, takeaway is okay. Are we blowing the doors off? No. But I think we’re exceeding our customers' expectations and/or leading the category.

Great. The Dick's deal was a nice win from the account side, and I was just -- with the business coming on there, I was just kind of wondering how do you go about managing your retailers' needs for exclusivity as you increase the number of accounts that you service?

Yes. I think Gregg summarized it well when he talked about what’s our growth strategy. It’s about brands, it’s about channels, and it’s about innovation. And every single one of those three pieces has opportunity for differentiation. So we can differentiate our product offering and our customers by brand, we can differentiate it by channel, we can differentiate it by merchandise offering, and by marketing. I think that’s the other piece. We’re a marketing company, and that’s one of our strengths, and if you look at what we’re doing at Dick's, totally different than what we’re doing at Sport Authority, completely different than what we’re doing at Sears.

So, we see that as one of the really -- real lever gable assets of our Company is the fact that we’ve got three, four major buckets of our 4P offering that can be modified to fit each customer. Dick's has a very different consumer than some of our other channels. Dick's has a different consumer than some of our other customers even in sporting goods, and we can modify our assortment, our brand, our marketing, as well as our offering the actual assortment to them different from other customers.

Great. And then a couple on the direct side. Can you talk about anything that you’re seeing in terms of credit quality there? And then -- and also, as you look out to next year, you’ve kind of talked about a mid-single-digit growth expectation. How do go about forecasting that business?

All right. I can talk to the credit quality. We have seen a small decline, but nothing of any real substance from a credit standpoint with both household and what we’re seeing with [healthcard][ph].

And in terms of how we forecast the direct business, it's certainly different than retail; I’ll guarantee you that. We start with the consumer. That’s the part where I think it’s the same is we start with the consumer. We look at what potential open to buy and/or consumer trends are in the fitness category are. We look at what our innovation offering is and what can we offer. For example, two years ago we sold one item. At the end of this year, I think if you call our direct number, you got an opportunity probably to buy 12 to 15 products. If you call one of catalog lines, you can buy 200 products. So we look at what is the right product assortment for next year. That drives sales. We look at what is our ad-to-spend ratio. Do we want to -- as you know, it is a direct derivative of what you spend in some cases. So, how much would we want to invest next year in that channel is a variable. And then [what] we also have to balance is how we grow in other channels. We’ve got to look at that in relationship to what's happening in other channels. If you’re going to grow retail at 80%, you better understand what are the implications.

So it’s really kind of been four or five different buckets that are a bit unique than just playing with your customer in terms of how many SKUs are on the floor.

Great. And a final question just for you, Bill. Can you comment on the increase in prepaid expenses on the balance sheet this quarter?

Yes. Most of that is related to some of the new media that we put out early in the fourth quarter and some of the point-of-sale material, that as soon you use it, you need to expense it, and so we had been capitalizing it through the year, and then we went live with it. That’s the increase there.

Thank you.

Thanks, Ed.

Our next question comes from the line of James Bellessa with Davidson and Company. Please go ahead.

Good afternoon, and congratulations on very good cost controls just so that you were able to hit your EPS guidance for the quarter.

Thanks, Jim.

First, I’d like to ask about the strategic business plan that calls for, overall, 15 to 20% sales growth and bottom-line growth of 20 to 30%. That’s kind of an overall picture. I don’t think that you’re -- I want to pin you down to that exactingly, but I’d like to ask about it a little.

Okay.

The net -- if I were to take that literally on your $660 million sales base of this year, do you get the benefit of the Pearl iZUMi acquisition? Already, you have that automatically giving your 4 or 5 percentage points of growth for next year. So, does the 15 to 20% already include the 4 to 5% that you automatically get, or do you get -- will you add that on top of that overall growth target that you have?

No, that is part of it, and as we’ve talked about all along in our strategic plan, that it would be both organic growth and through acquisition, and this is just a part of that plan. So, yes, there’s 4 to 5 there. There’s -- as we talked about earlier, about 5 points to 7 points in that new distribution opportunity that we have. So that gets you to about the, call it, 10, 12 range, and then you’ve got organic growth within the businesses that we currently operate, including the mid-single digit numbers or low-single digit numbers on the direct side.

So that’s how you add it up, and I think when you think about it from that standpoint, you say, boy, there’s a pretty low-risk plan, when these guys lay this thing out. So in the spirit of the way we’ve continued to talk, under promise, over deliver here, and I think we have built a conservative plan, but I think it’s very realistic and achievable and something that we’ve got our hands wrapped around.

Your guidance range for this year has a midpoint of $1.08. I would imagine there’s $0.02 a quarter or $0.08 for the year for what would be called share-based payments that aren’t going to be accounted for this year but starting next year they will be. So, if I take $1.08 less $0.08 -- that's $1.00 face earnings -- and apply the 20 to 30% growth on top of that, is that a reasonable goal for next year?

Yes, that would be about where we’re driving, Jim. And you’re right that our stock-based compensation will be about $0.02 a quarter, or about $0.08 both this year and next year.

How many shares outstanding do you have?

We have 33 point -- about 33.4 million, I believe. I don’t have the exact number in front of me.

And finally, you talked about a nutritional acquisition that you’re considering. Can you give any color to that?

Well, we can’t talk anything in specifics from a company standpoint or anything like that, but there’s actually a couple of companies that we’re considering that we think, one, have a match with us from a cultural standpoint and also from a strategic standpoint of where we’d like to take the business. So they’ve got a management team in place much like we did the Pearl iZUMi acquisition, so that we can get out of the gate fairly quickly without a lot of expense and up side required in order to go out and hire people and do those things. So, the key thing there is we’re looking for companies that can allow us to ramp quickly without having to make a huge investment in the business to get it up and going.

And that marketplace is $5 billion in total global sales?

Yes, it is.

Thank you.

Thanks, Jim.

Our next question comes from the line of Rommel Dionisio from Wedbush Morgan. Please go ahead.

Good afternoon. Two questions. First, on the gross margin line, you cited mix issues as well as some operational issues but not raw materials, so I just wondered what impact that had in the quarter?

Well, that’s a good catch, Rommel. We didn’t go into all the great detail on it, but there certainly was some raw material negativism in that number. We also had the fuel surcharge piece that went into that, so there were several things that impacted us there on the gross margin side. Now, we’re doing a better job, I think, now as we move forward. As an example, one of the things that we’re starting to do with our purchasing team is go back and work with our suppliers on helping them purchase raw materials so that we can help lower their finished cost as well, so reaching deeper into the supply chain here in order for us to get better pricing and then share that with our supplier partners. So, I think that will help us on a go-forward basis but certainly did hurt us in Q3, and until we shake through all of this, will hurt us a little bit in Q4.

Okay. And just a follow-up as well, Gregg. Now that you’re intimately involved in the operational front, you’ve gone through a lot of changes -- new ERP system, new headquarters, new personnel. Can you tell me about what all these changes, the sort of results? What that part of the disruption that you had on the DCs, the bottlenecks that you had there on the quarter?

Yes. The new headquarters, actually, we transitioned that over about a 6-month period because we had -- we were just down the road about a mile. So we slowly moved people over. We actually had zero downtime, believe it or not, in our call centers as we transitioned those. And I think, actually, as you look at it from a headquarters standpoint, the team is really revitalized. They’re excited. People love the new space that they’re in, and it’s much more effective for us than the three or four buildings that we were kind of separated into and not trying to operate out of. So the communication has gotten a lot better.

The real problem on the distribution center side was just that we had a couple of factors going on here.

One, as we brought in inventory for these new customers in anticipation of shipping that product, some of them came back with their new inventory positioning, which is great. It’s a smart move for them, it’s the right thing to do in reducing retail inventories and keeping them so they can get faster turns out of the product lines. So certainly, a smart move and good strategic move for their business. Unfortunately, we’d already shipped the product, and so we’re eventually going to move through that, but it creates a little bit of a bottleneck for us.

The second thing we didn’t do a very good job of, though, that was totally controllable on our part, was as we started shipping this product, we didn’t take into consideration the flow-through. And so we brought a lot of product in at one particular time, which caused us to get those DCs pretty well jammed up, and so that makes it -- as you can imagine, you’ve got a cluttered room; it's tough to move around in it. And that’s exactly what we’re dealing with right now. So, we’re slowly shaking through that, and I think that’ll help us.

This ERP system, as its come online, a lot of new learning. And I will say this; it slowed us down a little bit in the third quarter but not a lot. I think the management team, and certainly the folks in the distribution centers and in our business, have been working really hard to get this thing ramped up quickly, and it’s certainly going to help us from a visibility standpoint on a go-forward basis and help us manage our inventory much better as we move forward. So it is a bit of short-term problem, and we’re certainly dealing with that. Any time you go through change, you do. But it is going to be a much better place in the end for us and help us manage the business much better. So from that standpoint, I’m pretty excited about getting this thing behind us and moving on.

Okay. Thanks, Gregg, good luck with that.

Thank you, Rommel.

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Our next question comes from the line of Marc Bettinger with Stanford Group. Please go ahead.

Hi guys. Gregg, just as a quick follow-up, the $0.05 to $0.06 of the operational issues in Q4, is that confined to Q4, or is that going to repeat in early next year?

Yes, Marc, here’s what I’d tell you. I don’t think that these are long-term issues. Whether a few of them hang on until January, it is possible. They’re working on this for a few weeks now, but I would tell you is they are short-term issues. They are things that we can get under control fairly quickly, and we addressing them as fast as we can. So if it’s a 5 to 6 issue, call it, in the fourth quarter here, then you might be talking a penny or two in the first quarter next year at worst. I think we may be able to get it under control before the end of the year. So, I don’t anticipate this being an ongoing issue.

All right. No problem. And, just to beat a dead horse here, the 15 to 20 and the 20 to 30, is that meant to be something of a [cycular][ph] number, or is that meant to be specific for ’06?

No, that’s a three-year plan. So, as we look at ongoing growth, we think that’s where we’re going to be. Now, what I’ll tell you, as we look at ’06, it’ll be right in that range as well. We’ll come back in January and get more specific around that, but we’re pretty comfortable that there is so much opportunity in this business, and we have got a great team in place, and they're driving against it. And as I look at the business plan and as we look at the up side potential, it is huge. And so how fast we can move, we’re going to take conservative approach to make sure that we’ve got this business in place, and we’re not going to over promise. We’re going to under promise, and then we’re going to over deliver. So, I think as you look at those numbers, those are reasonable places for you to kind of think about ’06, and we’ll come back with very specific on that -- elements of that in our January call. So --.

Okay. So the haircut that you’re taking for consumer spending in the fourth quarter, would that be part of your 20 to 30%? Because it looks like that $0.05 to $0.06 is shaving about 10% of growth off where you're going. That’s not going to be a one-quarter issue. That’s not Q4; that’s going to be all of ’06.

I think that’s a potential, Marc, so if we’re dealing with that in all of ’06, and gosh I hope not, for the entire economy, not just our company, but if it is -- yes, but if it is something that sticks around all ’06, it’ll be the low end of that guidance. And if it’s something that we can get through and the consumer responds and comes out of their shell, then that upper end is certainly achievable. So I think that’s where we’re at, and what happens is for us to [inaudible] as we move through it.

Right. I’m just trying to get a sense of what’s macro and what’s company specific.

Yes.

So is it reasonable to assume that if the economy were to stay this way, at the $0.05, $0.06, that we could be looking more at a 10 to 20% EPS growth rate?

No, we’re in the -- no, no, no, no, no. No. Yes, I don’t want to give you that impression. So if the economy stays like it is, that’s your 20.

Okay.

If the economy improves and the consumer comes back, there’s your 30. And what we’re trying to just make sure of here, and again, we’re trying to share with you the good, bad, and the ugly, right, and be as forthright as we can, and I just want to make sure that we aren’t committing to you guys something that in a non-controllable fashion we don’t have the right to commit to. So, low end is if the economy stays like it is and the consumer’s sitting at home and not watching infomercials and buying direct product, they’re sitting at home period. And the up side is they come out of their shell and start opening up their wallet again.

Marc Bettinger. Okay. So then it seems reasonable that a reasonable worst-case scenario is 15 top line, including Pearl iZUMi, and 20% EPS?

Yes.

Sound right? Okay. And would that be with a gross margin of, what, about 44%?

Yes, we’re still shaking through some of that, and we’ll get back to specifics on that in our next conference call, but reasonable.

Okay. And last question is in terms of new retail relationships, anything that you can comment on in terms of just seeing in the pipeline, I guess, going into early next year? Is it more expansion of existing -- is it more of an expansion of existing relationships or actual new relationships you can see coming on board?

So here are two things on that one. Yes, we’ll think that we’ll add some new distribution in ’06 certainly, but a lot of this is filling out and making sure we’re delivering upon the customer commitments that we have today. And if I were to say anything specific about some of the things we’re working on right now, Mr. Hawkins would kill me and leave me lying bloody on the floor here, so I’m not going to say anything.

No problem. Good luck, guys. Congratulations.

All right, Marc. Thanks a lot.

Sure.

All right, so, that was our last question. I really appreciate your time today and hope to see some of you at the Wedbush Morgan conference in Los Angeles this December. We’re planning on being there and would love to see you. So thanks a lot for listening in on the call, and we look forward to a really, really solid business plan here. I think that things look good for the business going forward, and we’re excited about it. So thanks for listening in today.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line.