Nautilus Inc (NLS) 2006 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Nautilus Inc. fourth quarter 2006 earnings conference call. [OPERATOR INSTRUCTIONS] As a reminder, this conference is being recorded on Wednesday, February 7, 2007. Before this 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 company's 2007 sales and possible acquisitions, 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 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 conference over to Mr. Gregg Hammann, Chairman and Chief Executive Officer of Nautilus, Incorporated. Please go ahead, sir.

Thanks, Dave. Good afternoon, and thanks for joining us. With me today are Bill Meadowcroft, our Chief Financial Officer; Tim Hawkins, President of our Fitness Equipment Business; Juergen Eckmann, President of our Apparel Business; and Mark Meussner, our Senior Vice President of Global Manufacturing, Quality and Engineering. During today's call we'll discuss our fourth quarter and year-end results, 2007 outlook and what to expect in the first quarter. We posted our fourth quarter and year-end financials about an hour ago. Our fourth quarter revenues were about $200 million and 2006 revenues were $682 million. Both are records for our company. And we delivered earnings of $0.41, in line with our guidance of $0.39 to $0.45.

Now before we get into the numbers, I'd like to step back for a moment. For the past three years, our team has focused on rebuilding Nautilus for long-term growth by following our FitOne business principles. FitOne is our commitment to financial rigor, innovation, trust, and striving to be the number one in every category where we compete. These guiding principles have led to building a strong foundation for achieving a sustainable rhythm of revenue and earnings growth. It dramatically reduces a reliance on one brand, one channel, or one manufacturing supplier -- an impressive transformation from four years ago.

So let's recap. Through our commitment to financial rigor, we achieved 2006 expectation of improving supply side efficiencies by approximately $14 million. More than $10 million came from improvements to global sourcing, another $4 million came from improving efficiency and capacity at our two domestic manufacturing facilities, and nearly $0.5 million came from improvements to our distribution and infrastructure by reducing our facilities from 24 to 10 and improving flow. We also invested in initiatives to deliver operational leverage in 2007 through 2009. As one example, we will save $3 to $4 million dollars this year as a result of closing the plant in Tyler, Texas. We also expect substantial improvement from further streamlining our distribution structure, generating additional purchasing leverage and pursuing sustainable engineering initiatives.

Through our commitment to innovation we have entered into new channels, categories and markets where we never competed before expanding our growth potential. We've established a presence across all categories in cardio and strength in the channels where we compete. We've reinvented our product line literally with more than 95% of revenues now coming from products that didn't exist prior to this leadership. We've maintained a pace of revenues from innovations at about 30% per year, and we've now completed the first full lap of our go to market process, reducing our launch time from 16 months to 10, and in 2006, we launched 17 new products on time and with quality. We promised you 14.

Now, through our commitment to trust, we have provided a sustained effort on producing the best quality products in the world, building trust and confidence in our brands. We've improved customer satisfaction scores from an unacceptable 65% in the fall of 2005, to near world-class at 82% by late 2006. And with shareholders, we've now delivered 13 of our past 14 quarters within our earnings guidance.

Finally, with our sights set on being number one in the categories where we compete, we have moved from the number three position to within striking distance of number one. We have the six leading brands with the acquisition of the Universal brand. We have diversified across channels, allowing us to flex our emphasis based on channel performance, and we now have a complete line of strength and cardio products that are routinely receiving best-buy accolades from consumer magazines and global research authorities. We acquired a leading performance apparel company, strengthened our position in Canada, and acquired additional intellectual property. And, we are beginning to hit our stride internationally with our multi channel approach. This includes testing our direct marketing model in other parts of the world.

We move fast with transformational changes and we had to. When our current leadership took over, the company was mostly a single product, single-channel company. We needed to invest in infrastructure, to integrate three previous acquisitions, and to take control of our supply chain. Today we have six leading brands segmented across multiple channels of distribution, with a diversified and well balanced supply chain -- a company that is growing and gaining operational leverage. Today we are uniquely positioned to achieve long-term revenue and earnings growth. However, we're far from complete in making the improvements to our business to drive revenue and profit. As we announced recently, we have a purchase option for Land America, our largest contract manufacturer with operations in Xiamen, China. Our arrangement extends procurement savings for 2007 as well as the opportunity to achieve substantial improvement in gross margins in 2008. For brief update on our plans, I'd like to call on Mark Meussner, our newly appointed and promoted Senior Vice President of Global Manufacturing, Engineering and Quality. By way of introduction, Mark had a 30-year career with Ford and its components company Visteon, where he managed plants in the U.S., Mexico and importantly, China. Mark, and another member of our team -- Dustin Grosz -- have helped lead the transformation you have seen in our manufacturing supply chain in the past 12 months. Mark is calling in from our Independence, Virginia plant today. Mark, go ahead.

Thanks, Gregg. At Nautilus we currently source about 75% of our goods through a dozen contract manufacturers in Asia. With all manufacturers, there is room for further optimization of margins. As we form strategic partnerships with these suppliers, we are working with every one of them to find margin opportunities through improved engineering and manufacturing processes. Much like we have done in our own facilities. One significant opportunity has presented itself with Land America. The company manufactures about one-third of our source goods. So we've been studying a number of ways to further improve our margins through stronger partnerships with this organization. The result is an agreement to extend procurement cost reductions through 2007 and a purchase option allowing us to complete the diligence by June 30th to acquire the company by December 31st, 2007. The company has about 700,000 square feet of modern manufacturing space that is not fully utilized, giving us plenty of room to grow.

We have a great deal of confidence in the Land America leadership team after working with them for the past eight years. And more recently, after shifting three Treadclimber SKUs to Land America late last year, we're already seeing substantial cost improvements on that line and believe there are additional opportunities that will become apparent in the first half of 2007. Our evaluation process already is well under way. We will be validating and refining our business assumptions in the next several months of due diligence. We will also be finishing a transition plan with the plant's existing owner to retain their excellent employees. It is important to emphasize that we fully expect to continue working with our excellent contract manufacturing partners in Asia, as well as our two domestic manufacturing plants. A diversified manufacturing and supply base is critical to maximizing our margin potential and to mitigate supply risks as we grow our business. Back to you, Gregg.

Okay, thanks, Mark. With the diverse set of brands and channels, diversification in our supply chain was the next logical step in preparing us for sustainable and profitable growth. We've been working on this potential acquisition for more than a year now to solidify the third leg of the stool. One, diversified leading brands; two, diversified channels. And, now, three, diversified supply chain. We have the option of financing the acquisition with cash or with $30 million in stock and a balance in cash. Importantly, the timing at the close at the end of this year -- with that close, we can keep our balance sheet at low leverage with $40 to $50 million in short-term debt by the end of 2007. As a reference point to this, we expect to generate around $65 million in cash flow in 2007. This further strengthens our 2007 earnings plan and gives us a healthy running start on achieving our earnings expectations for 2008 and 2009. Let me introduce Bill Meadowcroft for the fourth quarter and year end financials. Bill?

Thanks, Gregg. Net sales for the fourth quarter were $199.3 million, up about 10% from the year-ago quarter. Gross profit margin was 44%, a 460 basis point improvement from the year-ago quarter, as we improved our supply chain to match our pace of innovation and growth. Operating income in the fourth quarter was $19.7 million or 9.9% of net sales compared to $3.4 million or 1.9% of sales for the year-ago quarter, an improvement of 800 basis points. Our SG&A, in actual dollars was down $0.9 million from a year ago. Diluted earnings per share for the quarter were $0.41 on a share count of 31.6 million shares. That compares to $0.06 a year ago, a significant improvement. As we stated on the third quarter call, our fourth quarter earnings include $900,000 in tax reserve reversals as we continue to manage the balance sheet conservatively. Unlike the $3 million reversal in the third quarter, which included reversals from multiple years, it is reasonably possible that the fourth quarter reversal will recur in 2007. For that reason, we consider our base to be $0.81 in earnings for 2006, upon which we expect 20 to 30% improvement in 2007. That places our target range at $0.97 to $1.05 for 2007.

Turning to our balance sheet. Inventories at the end of 2006 were $75.7 million, $20 million less than we were finished -- where we finished a year ago. Receivables were up $22 million for the year reflecting the growth of our business in channels that require longer terms. Our DSO calculation dropped from quarter to quarter from 68 days last year to 63 in the fourth quarter. Higher DSOs over the long-term are a reflection of our business model. We expect to see DSOs in the 50 to 60 range going forward with some seasonality. Regarding doubtful accounts, we experienced an actual charge over the year of about $1.5 million compared to $1.9 million in 2005. We have a $3.9 million for doubtful accounts. The reason our reserve is larger than our recent experience is because we're reserving for some old balances that are in bankruptcy related litigation. As we disclosed last quarter, we took the extraordinary step of suing a former customer to receive payment for goods shipped in the first half of 2006. We did not reserve for this because the company is a going concern -- solid going concern.

In prepaid expenses and other current assets, we show about $15 million more than a year ago. This includes $5 million in prepaid inventory, $2 million in warranty amounts due from vendors, $3 million in purchase discounts, and almost $2.5 million for acquisition related deposits and costs. Short term borrowings net of cash equivalents were $43.2, million as we're in the prime selling season for fitness. Borrowings are expected to drop the next two quarters, approaching zero in the second quarter, and then rise with the fitness season requirements for working capital. On the litigation front with Icon Health & Fitness, we have been in settlement discussions involving a possible resolution of all cases. The federal court in Seattle has agreed to delay the February 26 start of a trademark case pending the result of those discussions. Should those discussions not result in an agreement, we will approach the court in Seattle to request a new trial date at the earliest time available on the court's calendar and proceed to trial. Finally, our board of directors has declared a regular quarterly dividend of $0.10 per common share payable March 9th to shareholders of record as of March 20th, 2007. I'll turn the call over to Tim Hawkins, President of the Fitness Equipment Business, for an overview of our business by channel.

Thanks, Bill. Looking back at 2006, our revenues grew about 8%, while we made substantial improvements to the overall foundation of our business. For the fourth quarter, net sales rose 10%. Here's a quick overview. The direct channel grew 1% to $72.5 million with excellent sales of the Bowflex Revolution and Treadclimber products at dramatically improved margins from just a year ago. The commercial channel was up 6% to $21 million, with new cardio products at our new non-recourse leasing programs opening up new avenues.

For competitive reasons we will now be reporting retail and specialty retail combined going forward. The combined retail channel was up 5% to $71.1 million as we operate with more doors and broader assortments. The international equipment business grew 49%, to $20.9 million. Treadclimber, commercial bikes, large club deals, and retail sales were strong in the quarter. We picked up about $0.8 million in royalty income in the quarter from the acquisition of patents that we announced in the third quarter of 2006. Our 10% target growth for 2007 includes single-digit growth for direct and retail, 10 to 20% growth in commercial, and 15 to 30% growth in the international market. In addition to topline growth, we continue to pursue a range of initiatives to improve gross margins as Gregg discussed earlier. For an update on our apparel business, I'd like to turn the call over to Juergen Eckmann, President of our Apparel Division.

Thanks, Tim. For the fourth quarter our apparel and footwear business was up 46% to $13 million in net sales, compared to the year-ago quarter. We are benefiting from strong momentum for the Pearl iZUMi line, along with diversification and extension of our brands, styles, and distribution. Our business is centered on providing performance, apparel, and footwear that enhances the performance of athletes and fitness enthusiasts. Our products are largely marketed through specialty retailers, independent bike dealers, and international distributors. We also have 11 of our own retail stores, which helps us manage off-season inventory. Our Pearl iZUMi brand continues to set the pace in cycling apparel and footwear. We're gaining ground in the much-larger enthusiast run segment, where we have competed for three years and received prestigious best product recognition from Runner's World. In Q3, 2006, we also launched our first line of Nautilus apparel targeted at the indoor fitness consumer who, until now, has had limited choices targeted to their needs.

Our gross is driven by several factors. First, high levels of service to specialty accounts. This is helping us [accrue rebookings] which are up substantially for fall 2007. Second, by technology. We update our lines twice a year with the latest in function and fashion. One recent example is the next generation Syncro service footwear we have launched for spring 2007. Third, by diversifying our distribution, we are expanding availability of our products. This includes a limited test with Sports Authority on our Nautilus apparel line. Further expansion of specialty accounts and the addition of two more outlet stores later this year. Finally, we are now embarking on cross promotion with our equipment business, expanding our brand presence, and sell-through. Our growth expectation for 2007 is 10 to 20%, our seventh straight year of growth in this range. Back to Gregg.

Thanks, Bill, Tim, Mark and Juergen. So quick summary. We achieved record net sales during the fourth quarter and are well positioned for solid top and bottom line growth in 2007 with an exciting pipeline of innovative products and education across all brands and channels. Now, over the last three years we've delivered upon short-term guidance, but importantly prepared our company for a prosperous future. Here's a few things we've done. We've repurchased $32 million of stock, paid $39 million in dividends, acquired a great apparel company, acquired our Canadian distributor, acquired the Universal brand, acquired a portfolio of patents, invested in information systems to drive better decisions, and made significant investments in our domestic factories. In spite of this, our balance sheet has minimal debt and we anticipate that our strong operating cash flow of $33 million in 2006 should almost double in 2007.

We are transforming our company's foundation with leading yet diverse brands, diversity in our channels of distribution, and diversity of our supply chain to prepare us for sustainable long-term growth. The brands have capacity to grow, we can adapt to sales channels as they grow, and we have a diversified supply chain to support that growth. All of this heavy lifting has positioned us with a solid foundation for sustainable rhythm of sales and earnings growth.

So let's get to guidance. For 2007, we continue to feel comfortable with sales growth of around 10% and earnings growth of 20 to 30%, off the pro forma base of $0.81. For the first quarter, we expect earnings of $0.18 to $0.21, on net sales of $185 to $195 million. Then, we enter the second quarter, which we consider the pregame warmup, where we put in motion additional revenue driving and cost saving initiatives that gain traction as the seasonal cycle begins in September. We're well positioned for an exciting future as we achieve a rhythm of sustainable and profitable growth by changing the game in health and fitness.

As we close the formal presentation and open up for questions, I want to make you aware that we'll take more time on Q&A today, and as always we'll be available after the call for additional questions you may have. I want to thank the analysts on this call who continue to do their homework on our company in a fact-based manner. I know this transformation and pace of change has been challenging sometimes and a lot of work.

Moving into the new year, I want to take a moment and ask you to think about the society we live in. Everything is being automated to take less time. So more can get done. That's great, but there's one intended consequence of that. While our brains long harder and longer our bodies work less. We're heading for a train wreck in our society if we don't reverse the obesity trend and get people moving. And when you think about investment alternatives, there are tons of questions to ask. As a starting point, think of these two important questions: What is one of the biggest issues facing society today? Just talked about that. Obesity -- due to the lack of exercise, questionable eating habits, and not taking care of the only body you have. Two, what company is best positioned to address this issue? Answer, a company that is uniquely positioned in pure fitness. The company that provides the innovative equipment, apparel, and education to help people succeed. The company that can answer these two questions will not only serve a great purpose in our society, but will also reward shareholders. That company is Nautilus. And with that, Operator, I think we're ready for questions.

[OPERATOR INSTRUCTIONS] Our first question comes from the line of Scott Krasik of CL King. Please proceed.

Hi, good afternoon, guys. Great quarter.

Thanks, Scott.

First question relates to demand in the fourth quarter. Do you think your sales were impacted at all by people buying home electronics? And if so, was that at the low end or the high end? Where did you see that?

Well, that's a great question, and the answer is I'm not sure. You know, we had a pretty solid fourth quarter here and business was right about where we expected it to be. You know, there is a little softness I would say in October time frame and then it sort of ramped up as we got into fourth quarter. So that's a tough one to call, Scott.

Okay. And then question on the apparel test that you had with Sports Authority. Can you give more details on how many stores, how many SKUs, when the timing of the rollout is?

It is a limited test right now and we are going to monitor that with Sports Authority as we go through it. Call it 5 to 10 store test right now for a range and we're looking at that. We're monitoring the weekly sales coming out of there.

So it is actually until some stores now?

Yes.

Okay. And then on the Land America, can you talk about what the procurement cost reductions that will continue into 2007, what that means, if you could quantify what those are? And then maybe give an idea of opportunities either -- A, to continue to move additional SKUs into that factory or the leverage that you would get from dealing with the other ones because you have your own captive plan?

Yes, great. So, one, you know, they're operating somewhere in that 65 to 70% capacity range with some upside potential for us as we move forward. So there is room to grow in that factory. Two, as we look at what products we're going to put through there, we recently moved our Treadclimber line in there and it is coming out with very high quality at reduced cost. There is an indicator -- if people can build a TreadClimber in that factory, they can build just about anything. It is a pretty complicated piece of equipment. We feel pretty good about their both competency and capacity. As far as what products we might move in there in the future, the one real advantage to us, getting that factory in place was the intellectual property protection. So things we really want to hold close to the vest and make sure that are not exposed to the broader market, this is a great way for us to be able to produce those in a factory that is owned and operated by us.

Sure. Can you quantify what the incremental cost reductions mean to you in '07, versus '06, coming out of the plant?

Wow, we're still early in the year. We got some targets put in place that match up with the 20 to 30% earnings we talked about, so that's part of the plan. What I can tell you, as we move through the year, we'll keep you posted on that.

Okay. Thanks, guys.

Thanks, Scott.

Thank you. Our next question comes from the line of Kathryn Thompson of Avondale. Please proceed, ma'am.

Thank you. First a clarification -- the $0.41 reported number includes the $0.03 tax reserve reversal?

Yes.

Okay. So that would put it at $0.38. Okay. Also, could you give a little bit more clarity or comments on specialty retail and apparel? I know that you're combining those, but could you give any clarity on the breakout of those sales from the quarter and what type of sales we could expect going forward?

So, one, I want to step back for a second, Kathryn, because just to be clear, if you take the $0.03 out from the $0.41, it is $0.38. But because it is recurring in 2007 and we believe into the future years, the auditors have asked us to actually include it as part of our base. So it's really $0.41, right? On a go-forward basis, at least for you guys planning 2007. I just want to make sure that everybody on the call here understands that. So you were correct in your answer of $0.38 without the one-time charge, but it is not a one-time charge going forward, it is a recurring charge, which is why we had to book the $0.41.

Okay.

Are we clear on that one? I just don't want anyone to get confused. Because all this tax stuff -- it gets me messed up, too.

No, that makes sense. I just was trying to parse out what was recurring versus one-time.

Yes, and then regarding your question on the different divisions, I think Juergen and Tim kind of walked you through the channels of distribution and what we think for the growth rate. The reason that we've combined the retail piece is just that we've had too many instances where, frankly, about half the people on this call are competitors, anymore. And they're listening in to try to get some insights here, and let them figure it out for themselves in the marketplace. No sense in teaching them how on the call.

Okay. So and really what I'm driving at is I've been hearing some softness in specialty retail, and in modeling forward, we've taken that into account in the first quarter. Is it something that you're seeing in the market? It is really just a confirmation of that.

Oh, yes, the specialty market's been a little bit soft. But those trends come and go. So we'll see what happens here in Q1, but I think you're accurate and I know you've done a lot of store checks, because we saw your report that came out. So, I think you're accurate there.

Okay. And just additional question with that. How much of that would you -- that weakness is attributed to cannibalization versus just a little bit softer consumer?

You know, it is a very different consumer, so I don't think you could contribute much of that to cannibalization, frankly. I think it is just a general softness in that channel. A lot of those specialty retailers frankly rely on traffic that's generated from those surrounding them from the strip centers or in the malls, and as you know, some of the strip center traffic has been down of late and I think that has hurt them, too. I wouldn't just say it is industry-specific or it is a channel specific to the industry. To get it that narrowed down I think you have probably a more generalized issue there.

Excellent. That is helpful. And, also, as far as your guidance goes for Q1, and I know that you've been asked this before in previous calls, but how much of your Q1 guidance takes into account a conservative consumer?

Well, what I would say is we think the consumer has been conservative, frankly, for the last two to three quarters as we've looked at it, so we're kind of continuing on that same assumption. And so if a consumer release is here, we can do a little better on the revenue line. But I think we're going with the assumption that it's going to be very consistent with what we've seen over the past couple of quarters.

All right. I'll just hop back into the queue. Thank you very much.

All right. Thanks.

Our next question comes from the line of Scott Mushkin of Banc of America Securities. Please proceed, sir.

Thank you. I was just wondering -- going back to the purchase of your supplier -- lot of people sourced in Asia and it is fairly unusual for them to backward integrate. Maybe you can kind of strategically go over in little more detail what you think you get, why other people you don't think do it? And how complicated is it going to be to manage this, from 6, 7,000 miles away.

Okay. So lot of questions in there, Scott. Let me try to get at that. The reason we think this makes a lot of sense is, one, we are not having to back into it and we aren't having to go over there to find green space, develop a manufacturing facility, try to hire people, get them up to speed, teach them how to use the product and all that and how to manufacture it. All we're having to do is taking somebody who has been doing a hell of a job for us for eight years and have their owner, frankly, the owner of the company, retire, and all of the people that currently run the plant stay with us. So we've got basically we've had year of discussions with them. We've had a chance to talk to their management team about their willingness to stay on and keep going, and we got a good handle on that. And, two, we've got another whole year in 2007 to get through the transition. So this isn't sort of a typical how do you go do this.

Now the upside to us is that we have now, I think, to my point earlier in the discussion here, we now have ourselves in a position where we've got a very, very diversified supply chain that puts minimal risk on that becoming anything that would hinder us from an earnings or revenue growth. You know, we've had situations in the past where one supplier or another -- if something happened to them, we could find ourselves in a deep ditch. And I think we've got ourselves now in a position where there isn't one individual supplier that can hurt us. With this acquisition, it gives us the capability to be able to maneuver in a much more flexible way. So that is the reason we did it. And you're right, we are unique, but we are not totally unique. If you look around at other industries and you look at even within our industry, there is other people that do similar things to what we're doing here.

Okay. Do I have time for one or two more here, or was that too many at once?

No, that's okay, Scott, I'll count that as one.

I don't want to dominate the call though, either. If we looked at your -- you guys used to talk about and I just wanted to get some color here, now that we seem to have gotten out of the worst difficulties for the company and now we're looking forward once again -- long-term margins. I know it's something we talked about way back about a year ago. What do you think you guys think about long-term margin potential? I'm not trying to say percent exactly, but where do you think they can go over time and where does it come from?

So we believe 11 to 14% over the long-term, and my target is 2010, I can tell you that right now, we need to be in that range by that time frame. And we have laid out a plan and, in fact, have a five-year plan that we laid out about a year ago and updated us since then that gets us into that position. So we believe that 11 to 14% operating margins are a very attainable goal. This Land America acquisition adds about 150 to 200 basis points in our target to get there, and so right there is a fairly big step for us. We also believe that through the supply chain efficiencies that we continue to work on, that we're going to continue to gain operating leverage there, and as we continue to grow this business, you obviously get -- real positive variances as you can imagine in the supply chain that you currently have. So there is several elements just in the supply chain element that we believe can help us, and then in addition to that, with all the work we're putting behind innovation -- that innovation, we believe, can help us capture a higher price point and not have to discount as much which gives us the opportunity for higher margins, right? And all that flows right through to the operating level. So some of it is scale, some of it is supply chain efficiency and some of it is the innovation that we're putting behind our business.

And does the guidance for '07 assume any benefit from the purchase, or is that going to be incremental and [inaudible] going to show up in '07?

Well, we've continued as part of our overall supply chain initiative, we've been working with our suppliers to try to take costs out of the system, so certainly there is some of that in '07, but the big opportunity comes for us really in '08, once we close the deal and move on.

All right. That's good enough for me. I'll get back in the queue if I have any others. Thanks very much.

Thanks, Scott.

Thank you. Our next question comes from the line of Laura Richardson of BBT. Please proceed, ma'am.

Thanks, hi, everybody.

Hi, Laura.

I got a couple of modeling questions to actually follow pretty much along the discussion we were just having. The simplest one is probably this for Bill: What should the tax rate be in '07?

We're looking at about a 37.5% rate for '07.

Okay. And it's pretty much even every quarter?

A little bit favorable in the fourth quarter. But not a whole lot. Maybe higher 37s and then low 37 in the fourth quarter.

Okay. And this probably will involve you, too, Bill, but Gregg might want to chime in there. What amount of margin expansion are you expecting next year? If we could talk about the gross margin, also the G&A, also the sales and marketing.

Right. We would expect about 70 to 90 points in gross margins.

Okay. Is that more in the first half, because obviously now your comparison is a little tougher in the second half with what you just did in this fourth quarter?

Right. Certainly there is that benefit. So the first half should look a little bit stronger.

Okay.

But we should see it throughout the year.

Okay. What is happening with G&A?

G&A, as far as a percentage of sales, will be comparable, a little bit down. We will get a little bit of leverage there from the volume increases.

Okay. In terms of people and infrastructure, you feel like you've got the systems and the people you need, so you don't need to build out G&A?

That would assume some increases, because I'm saying consistent as a percentage of sales.

Yes, you're right.

That gives us some opportunity to invest in the people and infrastructure.

Okay. And sales and marketing, what is the thinking there, and what assumptions do you have in there in terms of media costs, and call centers, and sales force, and all that good stuff?

Right. As we've been mentioning, we really expect the best leverage to be coming up in the gross margin this year. We expect in selling and marketing to make some of those important investments in some of the creative and media and some of our new methods we're looking at, continuing to vitalize that direct channel which is where the significant portion of the spend is. So selling and marketing may come down a few 10 or 20 basis points but we're looking to make some important investments in that area this year. We seen some new creative that we put out there early in January.

To be clear here, Laura, we are going to continue to invest on the sales and marketing side of our business. We think it is pretty important to build brand equity.

If you talk about investing in product development you want to make sure the consumer knows about that.

Exactly.

Exactly.

And while we're on product development -- R&D spending, should that be kind of -- what should that do as a percent of sales?

That will be pretty consistent as a percent of sales. We may make a little bit more of an investment, maybe 10 basis points as a percentage so that it gets us to an operating margin that should be up 80 to 100 basis points versus this year.

Okay. That helps. And with the acquisition plan, does that reduce your flexibility for things like buy-backs in '07?

No, not really. Let me take that one, Bill. We're going to continue to monitor the market, and we believe, and I've said this before, and I still believe it because the stock has not moved that much, right? We think our stock is undervalued. We'll keep our eye on it. As there's opportunities, we'll be in the market. We continue to evaluate whether the right thing to do is buy back stock or to look at acquisitions. So we've got the one we just talked about planned for, and we're going to watch that. And if there is opportunities in our stock, we'll take advantage of that.

Thank you. Our next question comes from the line of Ed Aaron of RBC Capital Markets. Please proceed, sir.

Thanks. Hi, everybody.

Hey, Ed.

Couple questions for you. I'm trying to get a little bit more comfortable with your ability to continue to grow the retail part of the business in 2007. In general you kind of had the door growth and you got most of the major retailers that you were shooting for -- you got them as customers now. So it seems that distribution opportunity from here is really with product expansion within those stores. I just want to get a better sense of what existing or new products you think you are going to be able to add into those retailers in 2007.

Ed, we don't see a whole lot of new customer growth. We certainly have opportunity within the current doors that we're in to expand assortments, as well as additional doors. We're not all stores in every chain.

Okay. Can you maybe comment on some of the products that you think when you look at the 2007 fitness selling season could be logical additions into the big-box channel that maybe aren't there today?

Yes, we'll report as those products come to market, as we talked earlier in the script, we do plan more SKUs this year than we did last year, and so as those come to market we'll bring those to light for you guys.

To tailgate off Tim. The only reason we're not telling you that is --again, half of the people are on the call are competitors and we'd just rather not tell them what we're doing.

Can you give me an estimate how many pieces of fitness equipment you're selling in a year at this point?

We don't report it that way, so we just do it by dollars. In terms of revenue number. I think especially with apparel and everything else it gets messy. Lots. How is that for a quantitative answer?

Okay. And I also wanted to circle back on the comment that you made about your expected cash flow generation in 2007, if I just kind of do the math on it, it seems that a good chunk of that would be coming from working capital improvement. I'm hoping you could elaborate on your expectations for working capital, particularly on the DSO side. And kind of just piggybacking on top of that, you had mentioned that DSOs would likely be in the upper 50's in the fourth quarter, and when you reported Q3 and it came in a bit higher than that if you could just clarify that as well.

That is a great question, Ed. Do you want to start that one, Bill and I'll jump in.

Ed, as you said, the income that we're looking at -- we've talked about the $0.97 to $1.05 depreciation and amortization are pretty consistent. So the real opportunity is in continuing to manage working capital and the balance sheet as tightly as possible. We would expect to see ongoing improvement in receivables. We did go from 68 days last quarter down to 63 days this quarter, and continue to work there -- not only from a collections standpoint -- and actually our days past due are not bad, so also working with our customers to make sure that our terms are competitive and make the most sense for driving both the topline as well as the bottom line in managing our cash. Our inventory is at a space where I think we feel pretty comfortable with it, in the $75 to $80 million range, and would look to be able to continue to manage it in that area. Though as the business grows considerably, obviously there will be some upward pressure in that area. Prepaid -- certainly this year there is some stuff in there that, as we collect that in Q1, that number will come down, as well. And so there's a good opportunity from that category, as well. Those would be the major ones that will see some transition this year.

Okay. Thank you.

Thanks, Ed.

Our next question comes from the line of Rick Nelson of Stephens, Incorporated. Please proceed, sir.

Thank you and good afternoon.

Hi, Rick.

Margin improvement that you're targeting, 70 to 90 basis points, I'm wondering what you see as the big drivers there, and how will mix play into that?

Yes, some of the innovations we put in the market, we're getting better margin out of. We've also made some adjustments in customers that we didn't have as profitable product and we got rid of some of the SKUs we talked about in the last quarterly call that were dated and not as profitable for us. So we rode down the product life cycle, got pretty far down the path there, we got those out of there. And just the efficiency we talked about throughout the call, on the supply chain side, and all of the efforts we're putting behind our QC squared initiative that we talked about.

And any comments on the Bow product -- how that performed in the fourth quarter and also the Revolution would be helpful. Thanks.

Bowflex as a brand is continuing to grow and I think the thing we all have to keep reminding ourselves is that Bowflex is a rod-based home gym. It is the new SpiraFlex version of the home gym. It is free weights, it's treadmills, it is SelectTech dumbbells -- the list goes on and on. I can go on with TreadClimber and everything. And so Bowflex is now a big brand for us and it's doing very well. Both the PowerRod and SpiraFlex -- or Revolution component of our business did well for us.

Was the rod product up year-over-year?

It continues to perform very well for us, and again for competitive reasons we're not going to go into specific detail on that.

The retail channel, I know you're expecting an accelerated growth rate in 2007, with no new customers. I guess what is the driver there to that expectation?

Tim, you want to take that one?

Yes, Rick, the drivers are new products as we discussed. As well as -- I want to be crystal clear -- we are not fully assorted at any customer that we sell today that I would say we are where we need to be. We have door growth and we have SKU growth at every single retail customer.

Thank you.

Thank you. Our next question comes from the line of Rommel Dionisio of Wedbush Morgan. Please proceed, sir.

Yes, good afternoon. I wonder if we could draw down just a little bit on the international growth. You have said with great performance in the fourth quarter, with the expectation of 15 to 30% growth, I think you said. Could you talk about what particular markets and products are driving that there?

Actually our European marketplace is doing well. We've done pretty well with some of the new commercial product we launched in Europe and that's gone well for us. Also China has been a great market for us and in fact this acquisition we're making actually I think will help accelerate our opportunities in China. We already have our Huafei arrangement put in place which makes this acquisition a lot easier for us. China has also been a big market for us, Rommel. Both the retail and the commercial side of our business there.

And just as a follow-up, as we're midway through the first quarter, can you give us a feel for how the retail environment is overall for the category and where retail inventories are?

Well, we feel -- the reason we gave the range that we just gave you, 10% topline and the 20 to 30% bottom line and specific estimates that we gave for Q1 -- and we feel pretty comfortable with those. And what I'd tell you is our retail position's about where we want it, and then the other channels of distribution we have are about where we want them to be, so we feel -- I hate to say all systems go, because then I get myself in trouble, right, guys? So what I will tell you though, right now there is no red or yellow lights we're having to deal with.

Thanks, Gregg. Congrats on the quarter.

Thanks, Rommel.

Thank you. Our last question comes from the line of James Bellessa of D.A. Davidson Company. Please proceed, sir.

Good afternoon.

Hey, Jim.

In the Land America transaction, there is something said about rebates, and I don't understand that, so I'd like to have you tell us how that impacts '07 revenues and '07 earnings.

Yes, great question. So, Jim, the net on the Land America rebate is every supplier that we work with, we have different -- based on what works for them, we do different arrangements. And with some it is off invoice discounts and with others they want to do it with rebates and others we do one-time adjustments as they ship products and we get a percentage of free goods or whatever. Each one of our suppliers we work with, the particular arrangement we have with our friends at Land America, is in a rebate format and that is part of our ongoing supply chain initiative. It's baked into the numbers that we have in the 2007 plan.

So you should be -- at some moment in time you get these rebates for all of '06 and you post them to revenues?

Are you talking about '07?

Yes.

Yes, they would be posted up in the revenue line as a reduction in COGS.

Actually, that's not a revenue. It will hit our gross margin, but it is actually a reduction to cost of sales, Jim, based on the volumes that we're buying.

To be clear, Jim, it's up in that gross margin area that is under COGS, is where the rebate shows on the P&L.

Okay. And when I listened to the last call, I thought you were getting some traction in the direct model, but 1% increase doesn't sound like you got much traction. What happened?

Well, actually nothing in a really bad sense other than we had an ice storm up here that shut us down for a couple days, and the fourth quarter that hurts a little bit. So you can attribute a couple million bucks to that, and then we had a little bit of a slow start in October. So the net is the direct business is pretty solid for us, we feel pretty good about it, and as we went through the fourth quarter, the business continued to perform well. So that's part of the diversification strategy that we have. Every once in a while we're going to have things like that, and the key is how do we manage them? And I think the big difference in our company today, versus three years ago, is we can manage ups and downs in any channel, and some of the non-controllables like ice storms in the northwest, and still deliver the number that you're asking us to.

What was the share count at the end of the quarter?

31.5 million shares, Jim.

And then in an earlier question about the baseline of calculating the 20 to 30%, and when I look at the chart, the pro forma chart that you have in the back of your press release, it strips out the state income tax reserve, so the tax benefit is stripped out of the $0.81. Did I understand that correctly or did I mishear it on the call?

That is actually the piece we recognized in the third quarter which pertained to multiple years of reserves that we were able to reverse and we said that would not be part of the base but that the $0.03 we got in Q4 is part of the base, is part of the $0.81, and we expect to be able to lap that going forward.

Oh, that clarifies that for me. Thank you very much.

Thanks, Jim.

Thank you.

Any other questions.

Yes, sir. Question from the line of Eric Wold, of Merriman Curhan Ford.

Hey, Eric.

Afternoon, guys. I want to ask a quick followup question to what Jim brought up on the Land America. Could you get a sense, is the rebate discussed in the 8-K that was filed today or yesterday, is that -- does that rebate come about just with the purchase option, or is that something in place before the purchase option was signed?

Yes, it is separate too. It is part of our ongoing -- as I said, kind of overall supply chain initiative that we had in place, and so that's something that's been there. We put it into the agreement only from the standpoint of trying to give you guys as much visibility as we possibly could.

So the rebate that will come, that is discussed here -- that is for the 18-month period from Jan 1 '06 to June 3 '07 -- is that all being rebated in '07 and why wouldn't some of that have been rebated last year to coincide with '06?

We've been recognizing that since the first half of '06. We've had it in place with them since then.

What amount was expected to come in this year and what came in last year?

It is roughly--yes, you're asking about this for modeling purposes here?

Right.

I tell you, as you look at the back half of the year -- model about the same because the rebate percentage as long as we continue with the volume that we think we will do. As long as the business plan is on track, the rebates continue at the same rate.

What is the rough dollar amount?

Yes, how do you want to answer that, Bill, just so we don't give too much competitive data out here?

Through this year we should see about $0.05 of benefit in '07, versus '06.

Okay.

That's a good way to answer it.

And, lastly, I don't think -- going in the past you talked about kind of longer term growth, of 10 or 15% topline growth and 20 to 30% bottom line growth. Assuming those hold true into '08, is the 1.5 to 2% margin benefit from acquiring Land America -- will that be incremental to that 20, 30% gross rate in '08 or that be included in that growth rate.

Good question, Eric, that is actually part of the plan, so it is included in that number.

Okay. Perfect. I guess lastly, kind of -- a conceptual question. As you look at the opportunity with both the direct channel and the retail channel and your growth rates for the two this year are -- your [inaudible] are fairly comparable in the single digits -- where does it get more economical to start focusing on your growth opportunity? Is it more economical to focus on launching brand new products into the direct channel only which are not sold into the retail channel, and trying to advertise that and focus on that model, or kind of the old direct focus? Or is it to try to grow SKU count door and whatnot into what might be a crowded retail channel.

Yes, let me take a shot at that, and then I'll let Tim jump with some color commentary here. That's a great question. The answer to that is, as we think about the direct channel and the retail channel, we think about the consumers who shop in those channels and we try to create unique products for both. Now there are some products that will cross over and be appropriate for both channels but we try to keep some uniqueness in each of those channels because of the consumer that is shopping there. That is part one. Part two, is as we develop products in the direct channel and advertise heavily against that and create awareness for that product and as it starts to reach a saturation stage, where we can then take it to a broader audience -- we call it a cascading of our brands, and products -- we can cascade that product into a broader channel like the retail channel as an example that we did with Bowflex a couple of years back. But as we did that, Revolution and TreadClimber replaced the Bowflex PowerRods in the direct channel, and that cycle will continue in a similar fashion. So you'll see us continue -- the headlines are, continue to create unique for each channel, and continue to cascade as we have the opportunity to share those across a broader channel. And, Tim?

That's it.

Okay. Thanks, Eric.

Thanks, guys.

Thank you. Our next question comes from the line of Jim Chartier of Monness, Crespi & Hardt. Please proceed, sir.

Thanks, good afternoon.

Hey, Jim.

First question, it looks like the midpoint of your first quarter sales guidance implies about a 2 to 3% increase, and I'm just curious in light of your 10% growth estimate for the full year, what's going on first quarter?

That is a great question. What we try to do is give people, here's the annual number, right? And we believe both the back half of the year is going to be pretty solid for us and we also -- as we go through the first quarter of this year, and look at the numbers we had from last year to annualize. We had some new customers that we brought on in the first quarter of last year, that, as you know, when you first ship that, you get kind of what we call a pipeline fill, which is you have to get product out to all the retail stores and on the floor. So as we did that, we've got a pretty high base from Q1 of last year to build off of. So that is what is showing down that number a little bit. But on a go forward basis and as an annual basis, we believe 10% is a pretty solid number for us.

I notice you took up the price of the Revolution a week or so ago. Can you tell me what the thinking behind that was?

Great question. Actually it's a basic price elasticity analysis and we were selling more than we needed to so we took the price up so we could make more money on it.

And then can you talk little bit more about the commercial leasing program that you put in place, how that has been performing for you and are these exclusive deals that you've announced over the last couple of months a part of that program?

Yes, Tim, you want to start that one, and Bill, do you want to help him?

I'll answer the second half, Jim, and Bill can walk you through the details of the program. New concept for us with some dedicated leasing partners here. And as you know that channel, high capital purchases, and big opportunity for us to have a flexible payment schedule for our customers to get involved in and new customers to take advantage of having our product. So it has been very successful for us.

We're working it hard. The finance team along with the sales team collaborating well and we're getting some good deals in that we haven't historically been able to compete on. But now we've got ways to get into those customers.

What percentage of your commercial sales are through the lease program, and then what is the industry standard there?

Yes, that's another one of those, Jim, for competitive reasons, we're just not going to share that, but I appreciate you asking it. I don't mean it in the wrong way. I just don't want to tell these guys what's going on.

My last question -- part of the think on the Pearl iZUmi, one of the synergies was possibly selling fitness equipment through the independent bike dealers and I was curious how that is progressing?

That is the strength of the Pearl IZUMi brand. Juergen, you want to touch on that one a little bit?

Our distribution is the independent bike dealer [Singiers] that is where we built, and opportunity we have is clearly expanding the distribution now with the running line into the run specialty dealers. So there is a great opportunity expanding distribution next to the innovation we launch.

And have you been successful selling fitness equipment through those bike dealers as well using your Pearl IZUMi sales force?

Let me touch on that one for a second, Jim. We have traditionally sold through the independent bike dealers, that is one of the strengths and that used to be what we called specialty fitness. That was -- independent bike dealers were part of that. So before we even did the acquisition with Pearl iZUMi, we were selling to those folks. We have collaborated and we are working together on some synergistic promotional opportunities in that segment now, where not only can we promote our fitness product but we can work on the apparel side of our business as well. So we're more meaningful to those customers and we can do programs that allow them to better tie in and drive traffic into their location. There is some synergy there but we've always -- both on the apparel side before the Pearl iZUMi acquisition, they sold to the IBD guys and so did our equipment division.

Thanks a lot.

Thank you, Jim.

Thank you. Ladies and gentlemen, that does conclude the question and answer session for today. Mr. Hammann, I will turn the call back to you. Please continue with your presentation or closing remarks.

Thanks, Dave. I just want to say to everybody on here, thanks for your ongoing support. I'm excited about the solid foundation we've built with our brands, channels and now the supply chain we've put into place. We are uniquely positioned, I think, to change the game in health and fitness. And for those who will be at the Banc of America conference in March, we'll see you in New York in March. Thank you very much.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation, and ask that you please disconnect your lines. Thank you, and have a great day.