Nautilus Inc (NLS) 2007 Q2 法說會逐字稿

Welcome to the Nautilus Incorporated second quarter 2007 results conference call. At this time, all participants are in a listen only mode. Following today's presentation, we will have a question and answer session. We will ask callers to limit their questions to two to three. (OPERATOR INSTRUCTIONS). As a reminder this conference is being recorded on Monday, July 16, 2007.

Before the call begins, listeners should be advised of the Safe Harbor statement that applies to this call. Prepared remarks during this call contain forward-looking statements. Additional forward-looking statements may be made in response to questions. These statements, including sales and earnings expectations 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 would like to turn the conference over to Mr. Gregg Hammann, Chairman and Chief Executive Officer of Nautilus Incorporated. Please go ahead, sir.

Thanks, Alex. Good afternoon. With me today is Bill Meadowcroft, our Chief Financial Officer, and thanks for joining us on such short notice. We want to provide you with second quarter results as soon as we could close the books, so we posted results about an hour ago.

What you'll hear during our remarks today are three key points. First, the North American market for home fitness is under pressure due to discretionary spending pullback. Second, our plan to deal with this pullback is to intensify our product and channel diversification. Third, we are continuing to position our Company vertically and through cost takeout to assure leadership in fitness over the long term.

Second quarter net sales of $117 million were off about 15% from last year. Core earnings show a loss of $0.30, although a $0.34 gain from the Icon settlement gives us earnings per share of $0.04 when following GAAP accounting standard rules. The top line shortfall can be attributed to a soft North American home market for fitness equipment especially in home exercise strength products, where we had a large market share. Our retail partners continue to report lighter than expected traffic and sell-through in fitness. As a result, our retailers were sufficiently positioned on most products, and many of our expected Q2 turn orders did not materialize.

Meanwhile, the Home Strength Gym portion of our direct business has experienced softer than expected lead to sale conversion rates, suggesting spending restraint among consumers. This mass progress in three other channels of our business, each which performed in line with their growth plan, this includes commercial, international, and apparel. It also masks the success we're having with Treadclimber in direct and Schwinn bikes and ellipticals at retail. In sizing-up the North American home market for fitness we look to both controllables and non-controllables. The non-controllables include slower housing starts, slower home sales, flattening consumer credit, higher fuel prices, weaker consumer confidence, and intense competition for discretionary spending. We are addressing non-controllables by intensifying our product and channel diversification.

We also believe there are controllables where we must perform better, some highlights? We can improve our assortment at retail. Some retailers have as many as four home gym models on the floor and we can do a better job with model transitions. We need to address consumer confusion on the internet due to the availability of too many models at too many price points being sold there. We've relied too much on tired Bowflex Power Rod creative. We need to improve our on floor point-of-sale presentation, which serves to educate consumers, differentiate our brands, and improve sell-through.

We are taking aggressive steps to fix these and other controllables. We are keeping focused on strengthening the foundation necessary to support and position our organization for long term success. This includes the upcoming close on Land America, our largest supplier in Asia, as well as additional cost takeout in our supply chain. Taking into account trends and discretionary spending, and softness in the North American home fitness market, for the back half of 2007, we expect net sales of $350 million to $380 million and earnings of $0.20 to $0.30 per share.

I'll provide a more complete overview of our plans by channel but first, let's have Bill provide details on the numbers.

Thanks, Gregg. Net sales for the second quarter were $117 million, a decrease of $20 million or 15% below the year ago quarter. Three channels delivered year-over-year growth for the second quarter and were in line with our plans. The international business recorded $18 million in net sales, or 21% growth. The apparel business recorded $14.5 million net sales or 5% growth. The commercial business had $18 million in net sales or 11% growth.

Meanwhile, two channels accounted for the revenue shortfall to plan. The retail business was $12.2 million in net sales, down 62% from a year ago, and accounted for about $13 million of the shortfall. Direct sales were $53.7 million, down 11% from a year ago, and were about $7 million of our shortfall. We also picked up $600,000 from licensing revenue paid to us. For the year, we expect another solid year of international business growth of 15 to 30%, and apparel and commercial business to overperform with growth of 11 to 20%. For the year, we see direct sales off around 10% and retail sales off around 20%.

Looking to the income statement: gross profit margin was 38.9%, 510 basis points lower than the year ago quarter. The difference, as Gregg mentioned, is primarily isolated to home gyms. While we've made good progress in gross margins with certain lines, we are limited on certain lines until we complete our vertical integration with Land America in January. Operating expenses were 37%, down 590 basis points from the year ago quarter. This is inclusive of the $18.3 million valuation of the access we've received to certain intellectual properties through a settlement with Icon Health and Fitness. On a dollar basis operating expenses were consistent with the prior year. Operating income in the second quarter, seasonally our slowest of the year was a loss of $16 million compared to a gain of $1.6 million for the year ago quarter.

Turning to our balance sheet. Inventories were at $92.5 million, up $2.6 million from the previous quarter, the quality of inventory remains high with around 80% of the value accounted for in our higher selling SKUs. We're soon to enter the higher volume fitness season and want to ensure that when the market begins to recover we're well positioned to take advantage of it. DSOs were 60 days compared to 65 in the year ago quarter. Short-term borrowings net of cash was $42.2 million.

Earnings per share for the second quarter 2007 were $1.1 million or $0.04 per share on a GAAP basis compared to year ago results for the same period of $1.7 million or $0.05 per share. The GAAP earnings are inclusive of the $18.3 million or $0.34 per share gain from valuation of the access to intellectual property we received through our legal settlement with Icon Health and Fitness. Without the litigation settlement, second quarter 2007 net earnings would be a loss of $9.5 million or $0.30 per share. About $0.18 in earnings can be attributed to the sales shortfall, $0.11 to channel and product mix, and $0.06 to other operating costs, including higher interest and lower foreign currency gains.

As we reported June 29, we've exercised an option to purchase our contract supplier Land America for $72 million, with a close date of January 2, 2008. We expect this transaction to contribute 150 to 200 basis points of gross margin to our business, plus provide additional leverage by increasing the volume and efficiency of the plan. This transaction is our top priority regarding uses of cash or our short-term credit revolver. We did not repurchase stock in the second quarter. We have $68 million remaining on our authorization.

Finally, our Board of Directors will meet in late July, and we expect approval of a regular quarterly dividend of $0.10 per share payable September 10, 2007 for shareholders of record as of August 20, 2007. Gregg?

Thanks, Bill. We've taken a hard look at our business model to understand what we need to do better or differently to strengthen our position in the face of stiff headwinds. We really have two choices. We can close the hatches and hope the storm blows over or we can continue to strengthen the foundation of the Company to compete for the long term. We chose the latter.

Let's discuss each channel and division and the actions we're taking, starting with Direct. Direct is a good business, but it's hardly the cash cow it was five to eight years ago. Gone are the days when you can scoop up cable advertising inexpensively and use a single advertisement for years. Costs per lead have been escalating, forcing us to diversify into a variety of different Direct products, tools, and forms. Furthermore, conversion rates have softened, suggesting that qualified consumers are more reluctant to buy.

What drives this category? Products that are different, better, and special. So here is how we're approaching it: First, we have introduced three new products, and will soon have a fourth. This includes a Bowflex Treadclimber 6000, SelectTech 10 to 90 dumbbells and the new Bowflex Revolution XP home gym, which moves our new strength technology into an upright style. The fourth is a new category in cardio that combines the ease in elliptical with the work out of a free climber stepper. It has been validated scientifically, has been well received by test subjects and is going through final preproduction testing.

Second, we're taking some new approaches to our Direct advertising. One involves NFL Hall of Fame legend Dick Butkus presenting our Treadclimber products to baby boomers. Few products are as effective while being so gentle on aging bodies. Another showcases our new Revolution XP model home gym, which is well suited for practically any home in America, even lofts, apartments and condominiums. A third ad is designed to shatter the myth that people can diet their way to health. The truth is, diet failure rates are in the high 90th percentile.

Third, we're cracking down on retailers who undercut our Direct business on the internet. They're getting a free ride from our brand marketing, diverting sales and confusing customers. It needs to stop. We're beginning to plug the holes in our distribution model by investigating suspicious websites, but it's going to take some time to clear the internet channels and stop doing business with retailers who don't support our brand strategies.

Fourth, we are launching a new school rewards program to help in the fight against obesity among our youth. Authorities now believe our youth today will live shorter lives than their parents, due exclusively to the preventable cause of inactivity and obesity. We aim to address this by providing a small percentage of revenues as a credit to schools for any home fitness products purchased directly from us. We already have 2000 schools, serving 1 million students, signed up and ready to help. Finally, we are stepping up our effort for our Direct affiliate program. This provides us with new sources of Direct customers, a new generation of brand supporters, and a new way to align actual sales with their originator. We have more than 1,200 affiliates after just two full quarters of operation.

Now let's take a look at Retail. It's a $3.5 billion market opportunity and we have just a five or six share. While we recognize consumers have been cautious with discretionary spending this year, I believe we have significant opportunities to expand our share in the North American consumer fitness business in the years ahead. In addition to focusing on Home Strength gyms and exercise bikes, which represent less than 15% of the retail business, we also need to reach other segments. There are many categories and segments where we either have not had competitive offerings or don't even have an offering today. We've continued to innovate in those categories, but have been slow to gain penetration across the entire category. As a young company, we have a lot of room for improvement in our brand marketing and sales planning efforts. Effective on-floor presentations help consumers make more informed decisions about the high quality equipment we offer.

Frankly, no one in this category does a great job of merchandising. People who shop for fitness often leave more confused rather than better informed. We have to lead the way in changing that. Here is what we're doing: first, we'll be relaunching the Universal brand this Fall. For the first time, the brand will contain six product SKUs on a pad that is properly merchandised. The installation begins in September and continues through December. Second, we're implementing initiatives with all of our retail partners to make on-floor execution impactful for consumers, with a goal of improving sell-through, not just sell-in. Third, we are cleaning up our assortment by channel so that we offer unique products in each channel we serve and properly transition to new models. Finally, we are working to introduce two brands in certain segments of our retail business. Retailers have been asking for them.

Let's take a look at the commercial and international channels, where we have plenty of room to grow. Here are five key actions. We are making final presentations to begin shipping our new Nautilus One line of commercial strength equipment in the third quarter. This revolutionary line of equipment, with dowel-driven weight adjustment has been well received, and orders are beginning to flow for late third quarter delivery. We are continuing to sell in Nautilus Treadclimber units in clubs around the world. These products are getting unusually large usage wherever they are installed. Our Nautilus Explode line up is gaining traction in the athletic performance market, namely high schools, colleges and professional sports teams. We've laid the ground work to reclaim the leadership position in this important category.

We're moving forward in our relationships with large national and global accounts. We have new or expanded relationships with companies like JJB in the United Kingdom, Virgin Active in Europe, Will's Gym in China, along with 24 Hour Fitness, Town Sports, Jewish Community Centers, YMCAs, Anytime Fitness and many others. Last, we are placing more regional sales staff on the ground instead of relying so heavily on dealers who sell products from competing companies. We have to change this game to win long term.

Finally, our apparel and footwear business continues to grow its distribution presence of specialty accounts and dealers. The business already has recorded strong Fall bookings and is actively developing its Spring line. First, we continue to set the pace in cycling apparel and footwear with breakthrough products such as our Novel MP3 cycling bib as well as jerseys, socks, gloves and shorts that are the cycling standard for excellence. Second, we have successfully launched our second line of high performance run footwear. This line takes what already was a runner's world favorite and turns it into the most functional and comfortable performance footwear on the market. Third, we expect sell-through to be further improved by expansion of automated replenishment system. 100 of our top retailers already use this system with marked improvement in sell-through. We're finalizing a software upgrade that will help us double the number of retailers using that system. And finally, we've launched a new advertising campaign reinforcing the Pearl iZUMi brand positioning to enthusiasts, those who live to run.

While we've outlined mostly products, selling and marketing plans, we're also continuing our efforts to improve our supply chain, with initiatives outlined for the next 18 months. Here is five key actions: We're delighted with the prospects afforded to us through Land America, our largest contract manufacturer in Asia. We'll benefit from full path manufacturing margin, but we'll also be able to improve our competitiveness on other key segments of fitness where we've previously struggled to compete. Our sustaining engineering efforts continue to drive out costs and improve quality in our product offerings. Most of that work so far has occurred in our two domestic facilities that make commercial equipment. That work will continue, but we are now intensifying that effort on all our sourced goods.

We are building sustaining engineering capacity in Asia, they are engineers that can work with Land America and our contract manufacturers to improve leverage on commodities and components, better optimize vendor relationships and renegotiate pricing. We continue to work on improvements to flow our goods, including raising the percentage of goods we ship directly to the customer, bypassing our distribution centers. We have experimented successfully with mixed container loads, opening up additional possibilities for regional or specialty retailers, and we're conducting a strategic analysis of our distribution network to ensure we are optimizing freight costs and lead times.

Last, our go to market efforts are becoming evident in customer service and warranty experience. Customer service has steadily improved over the past 18 months, including parts, first time call resolution, and customer self-service for calls such as order status. We believe the steps we have taken in the past few years are putting us on a path to long term competitiveness, despite two difficult quarters, we believe our organization is becoming the first choice in fitness wherever people shop or exercise.

So in closing, we have accomplished a great deal in preparing our Company for long term sustainable growth and have aggressive plans continuing that progress. Short-term, we're facing some strong headwinds in the North American home market served by retail and direct channels, especially within the home exercise gym segment. We're acting with firm resolve to drive initiatives that create long term value. We'll ride out this storm through broader assortments, greater brand leverage, and greater marketing and sell-through support. These steps will make us even stronger when the storm subsides. Meanwhile, we'll continue to grow our business in apparel, commercial, and international, to further diversify our portfolio mix profitably.

With that, Alex, I think we're ready for questions.

Thank you. (OPERATOR INSTRUCTIONS). One moment, please for the first question. Our first question comes from the line of Steve Colbert with Canaccord Adams. Please proceed with your question.

Steve, you there?

Mr. Colbert, your line is open. Please proceed.

Okay, can you hear me, guys?

Yes, Steve.

Okay, looking at the slowing demand, is there any particular region or accounts that are stronger or softer than the overall trends or is it pretty broad-based?

Yes, there's a little flex in there but not substantial, Steve. I think it's, the home gym market has just been tough across the country.

Okay, and with the gross margin decline, can it be a bit more specific about what drove the softness and where you think we'll see a full year level?

Yes. We actually, we tried to help with retailers in Q2 on promoting some of our products so there was some margin there. We also promoted a little heavier on our direct side of our business and testing that to see what could potentially happen, whether that would spur any additional sales, and frankly, it didn't do much for us, so we pulled back toward the end here, but that did have an effect on margin here in Q2.

Okay, and then kind of sticking with the advertising, you talked about some of the new advertising. Can you comment on what level of spend you're targeting for the second half?

Yes. We're going to look at a similar spend to what we've done in the previous Q3 of a year ago.

Okay, and then finally, given the challenges you've seen in the past several quarters and the ongoing weakness here, can you talk a bit more about the decision to purchase Land America? It seems the purchase is a significant undertaking given some of the current softness and challenging conditions you are facing.

Yes. That's a great question. I tell you, it's even more critical for us I think in the spirit of what we're facing. Being vertically integrated allows us to capture back some margin points and actually make us competitive in areas like treadmills that frankly, with the way we've approached our business from a sourcing standpoint, have not been able to get competitive. So without it, it actually leaves us with a significant deficit, so it's even more important in the world we're living in today, I think to make this transaction happen.

Okay, that's it for me. Thanks, guys.

Thanks, Stephen.

And our next question comes from the line of Kathryn Thompson with Avondale Partners. Please proceed with your question.

Hi, thanks. Just tagging along with the gross margin question, is it fairly substantial year-over-year drop, over 500 basis points, and I can't imagine all of that was purely driven by discounting in the quarter. Could you perhaps dig a little bit further into this and it was also a pretty substantial swing sequentially, and why the big swing sequentially, and what can we look for going for the back half of the year and for fiscal year in terms of gross margins?

Yes, let me take the first part and then Bill I'll let you handle the second part. Kathryn, there's two things. One is we did try different promotional techniques to try and get home gyms in retail and in direct moving so that was part of the shift. The other part was just a mix shift issue, so as you sell less home gyms which are higher margin items for us, and more cardio and more of our other items that are out there, the margin starts to drop on those items so the mix shift also hurt us, so unfortunately, from a margin perspective, we had the perfect storm going in Q2 and Bill, you want to give her some additional color commentary on that?

On the back half of the year, we are looking about 42 to 43% margins and Kathryn, as he said, it's very much mix driven, to the extent that we weren't selling home gyms and we didn't, and so we're anticipating some risk into the back half of the year as well, it definitely drove the gross margin number in the quarter down where obviously with the 42 to 43% that we're looking to in the back half, we are expecting some rebound, but not enough to get us back to that 43 to 46% that we were expecting earlier in the year.

Okay, but of the two points that you mentioned, basically the promotional efforts and the mix, between those two, which had the greater impact? Was it more like a 30/70 impact?

Yes, with the mix being the bigger percentage of that versus the promotions.

So that was the greater driver, and are you seeing a similar type trend, I assume, going into your third quarter? With the greater mix of lower margin products?

Yes. So that's why we won't be able to get as high as we would have otherwise anticipated for the back half.

Okay, and another thing in looking at your segments, retail and direct were obviously disappointing but your other segments did okay. How could those so underperform with the other segments doing well? Is there something else beyond pure consumer demand that's driving that softness?

Actually, I think a lot of it is consumer demand. But I think it's some of the other things that we talked about as well, and we're proliferated on the web with customers that aren't approved to be web customers out there, that are selling product today. We have select web customers, Amazon and several others that we work with very aggressively, and they work with us to try and put the right programs together. Unfortunately, we've got some web people out there that aren't authorized, but are still selling products and they are actually using it as a bait and switch opportunity, and so we're trying to get that cleaned up and that has hurt us. We also think that from a retail perspective, you have seen some of the same things we've seen in the retail environment today is not great, especially for fitness equipment and home gyms here for us, so we're seeing some pullback there, and we're hopeful that it picks up in the back half of the year but cautiously approaching it at this point.

And does this guidance imply kind of a kitchen sink type of guidance?

I'm not sure what kitchen sink means but I would say very cautious.

Okay. Also, just two final questions. One a little bit more lengthy. As far as Tim Hawkins leaving the Company, it's my understanding that you're essentially going to be taking over his day-to-day operations, which really essentially puts you in a CEO and essentially a COO type of position. How do you, I mean, how do you plan on tackling this, because that is kind of a big undertaking when you do have a lot of things on your plate as you mentioned earlier, and what are you doing for a search for a more of a COO type position?

Well actually until about a year and a half ago that was my job, so we did some realignment about a year and a half ago and put Tim in that position but we just kind of have taken a step back to the structure we used to work with, so for the short-term, we're going to continue on that way and Tim did a great job for us. I don't want anybody to take the wrong impression here. He did some great things for this Company over the first few years but I think it's a situation where sometimes a coach can get you to a certain level and then as you go to look at a next level, you need some fresh thinking or a different point of view, and I think certainly the last few quarters we found ourself in that place and we needed to make a change, so I'm going to get back involved in this thing from a fitness equipment division standpoint and we're going to try to get it back on track as fast as we can.

Okay, but what type of update? Are you going to be filling his position again?

At some point, maybe not the way that it was defined in the past, so we're kind of thinking through that. We've got time with the Board of Directors at the end of July here, we'll talk more about that, but I think we're obviously exploring potential different structures that might work from a senior level anyway.

Okay.

So probability is we'll bring somebody in at some time. Whether it's a President of a fitness equipment division or we divide it up in a different way, we'll talk about it.

Okay. And then finally, could you just clarify, you mentioned earlier in your comments about the increase in inventories is up about a little north of $16 million year-over-year. Why is it higher, given the lower sales?

Well last year, we were actually about $5 million low, so we're about $10 million high right now from where we would like to be, and the net is, if we do see a pick up in the back half of the year, we would like to be in a position to react to that. We don't want to find ourselves chasing inventory for one, and then two, as we've come into the back half of Q2, we obviously didn't expect to miss the top line on the retail side by that great of a amount so we're carrying extra inventory because of that. It's just again some of those turn orders just didn't come through the way we would have hoped.

Okay. All right, thanks very much.

Thanks, Kathryn.

And your next question comes from the line of Laura Richardson with BB&T. Please proceed with your question.

Hi, everybody.

Hi, Laura.

Going to ask my quick, easy question first and then get into something a little more detailed.

Okay.

Bill, do you just have CapEx and depreciation for the second quarter?

Oh, good question for me. I don't have it in front of me. We can get that out to you.

Okay. Great. And then the kind of bigger picture question I guess is, following up on some of the questions you already got on the margins, I'm a little confused still about gross margin and the other margin lines too, because I thought part of the story this year was going to be the efficiency gains and you got some of them in the first quarter even though sales were also weak, and so I'm confused about kind of what's changing in the second quarter, and then going forward to the second half, it looks like the revenue guidance is not all that different than it was before, maybe a smidge lower, but the earnings guidance is a lot lower than what I thought you guys had in mind, so maybe you can just explain to me what your thinking is on margins and cost savings and then Land America too, I thought there were supposed to be some credits to this year's cost of goods from that acquisition.

Yes, good question. So let me walk you through a few of the things that are impacting that, and the biggest one of all of those is just it's a volume issue.

Okay.

So as you pull-down volume, there's in every Company, you've kind of got that breakeven point where, at some point, overhead and fixed cost are offset by the additional revenue generated, right? So we get to that breakeven point in our Company, and with what we're dealing with right now, that just puts us slightly over it, so a lot of the rebates that we would get for the additional volume are not going to come through, potentially that's what we're expecting with the back half with the conservative guidance we're now providing, and we expect that home gym sales through the back half of this year are going to remain pretty ugly, like they've looked in the first half of the year, so that also affects us from the standpoint of some of the volume efficiency that we're able to generate, and then you've got lower margin goods that you're driving from a mix shift perspective, so that helps to Bill's point earlier, it pulls down that gross margin from the 43 to 46 we were looking for to more of the 42 to 43.

Okay, that makes sense and on the sales and marketing side, I had thought, Gregg, one of the ideas you were toying with is being more conservative and saying, hey, if the environment is bad, then why don't we just conserve some ad dollars, it's not like there isn't awareness of Bowflex out there, so it sounds like the thinking may have changed on that, too.

Well we've got four new products that we're going to launch in the back half so what we're actually looking at right now, Laura, is what is the right amount of weight to put against those products from an advertising perspective so we still may in effect take down that S&M line but we want to make sure we're going through and giving ourselves the greatest opportunity as well for the long term, so versus especially on the direct side of our business, it takes 8 to 12 weeks to convert a sale and if we're just trying to bring in Q3, we may actually end up harming ourselves for the back half of the year, so we're going to take a six-month viewpoint on this thing and try to make sure that we're advertising at a rate that will really help us generate some awareness on those brands and hopefully drive consumers to dial the phone.

Okay. And just last question I guess, is if I look at the sales guidance, it's like you're looking -- first half revenues have been down 14, 15% in total, and we all know it's weaker in the retail side of the business, or weakest I should say. Where are you expecting things to be not as bad in the second half? Because the guidance is relatively flattish for revenues in the second half.

We have a bunch of new initiatives that like we discussed on the call there with Universal and some other things.

Okay so new brands, new products?

Yes, that's pretty much it.

And you don't think, I mean, with the macro headwind, those probably won't be as effective as they would be in a better environment either?

It's possible, yes, which is why we're being pretty conservative, because obviously we would have thought the third and fourth quarter this year were going to be gangbusters until we got a view of the kind of headwinds we're running into here, so if the consumer environment just picks up just a little bit, just a little bit, it would be terrific.

It would help you and a lot of my other companies.

Yes, but for right now, we got to do two things here. One, we can't panic, and we've got to stay true to the strategies and business plan we've put together, because we believe it's the right thing to do.

Yes.

At the same time, we've got to be very cognizant of what's going on out in the marketplace and try to be conservative where we can as well from the expense standpoint, so we're just trying to play a smart game in the back half of the year, and make sure that we don't do anything to harm this Company for the long term, and continue to build it for the long term, so we'll get through this short term crisis here and hopefully the market will start to pick up for us and when it does we'll be ready to respond.

Okay and I just thought of one other question that ties back to the last quarter conference call. I thought there'd been some thinking about trying to shift some commercial production to Tulsa, because of the demand was stronger for that then for the Schwinn type of equipment. Whatever happened with that line of thinking?

Yes, we've actually gotten some additional lines that we're going to produce out of our Tulsa facility and they are actually helping us with some of the products we would produce in Independence, at least from a sub assembly standpoint, so what we talked about on the last call, we're actually executing as we speak, and it's really starting to help our business, or it should help us in the third quarter on the commercial side to make sure we're getting all of the products out the door.

Okay. Thanks a lot, Gregg. Good luck.

Thanks, Laura.

Our next question comes from the line of Scott Krasik with CL King. Please proceed with your question.

Hi, thanks. Retail down 62% is pretty terrible. Nobody else is doing that badly. I mean, what can you ascribe it? The retailers aren't reporting those numbers, the other vendors it doesn't appear to be that bad.

What vendors?

Johnson Health, certainly with Horizon --

Well I don't know if they've reported Q2 but they don't really compete in many of the channels we do. They got a couple of things, but they are more of a mass player, and more in the commercial specialty side, so they don't really play in that sweet spot that we are, but I think and that's partially what I think some of the problem is, is the mass channel is continuing to open a lot of doors and they are continuing to do fairly well in this economic environment as you've seen. They haven't gotten hit as hard.

I think it's that middle tier sporting good retailers and some of the larger chain specialty guys that are really taking it in the shorts, and so, Johnson has got a little bit different business model than we do, and I think, until you pull that apart, they are a great Company and they are doing great things. Please don't take that the wrong way, but they manufacture products for us, actually, so there's a lot of things in their numbers that aren't necessarily tied to the places we compete, but that aside, Scott, I think your point is well taken, which is our business is down significantly, and probably more than it should be, and the way I can describe that to you is twofold: one, I think, as I talked about in the call, that our retail presentation has gotten pretty pathetic looking over the last six to eight months, so point-of-sale, the way our product looks on the retail floor, the way that we're merchandising it and working with our retail partners to make sure that it stays fresh on that retail floor, has gotten pretty pathetic, and so we've got to fix that.

And the second thing that I think we've got to do a better job of, is our assortment mix, and we've got, in some cases, four different Bowflex, Power Rod home gyms on the same retail floor. Now we don't need that. There's no reason for it, and we would be better served and our retail partners would be better served to have two and then having a couple other items from us that would help round out that portfolio in a better manner, so we could be doing a lot better. A third element and just to remind you of that, we had a bunch of pipeline fill in Q2 of last year into retail so that helps make that number seem even worse, but the fact is the first two items are big ones and we need to do a better job there and then that third one is just one that gives you a baseline and throws off the baseline a little bit.

What's the strategy? Is Universal going to come in as a lower price point value offering, or how are you positioning Universal?

Actually, we're going to position it more as a premium in the segment.

Okay.

So it's actually going to be a higher price point item for us and give consumers something of more almost a specialty kind of play there, so it should be a really good item for us.

When you say premium, premium within the big box guys or into the specialty?

Well it will be, we got, yes, in the sporting goods segment specifically, and it will be a premium price within that segment.

Okay, and then you made a comment just sort of at the end about you're going to be introducing two brands and then you didn't go on to explain that. Is that -- you're going to bring Nautilus into that channel?

No.

What did you mean by that?

No, that wasn't what we were referring to. We were talking about for the specialty retail segment in particular, we're working on some things with several of our key partners within specialty retail to launch a new brand line and bring one back to life for the back half of the year for them, so a lot of our folks have been asking for it in the specialty retail segment, we think it's a great opportunity for us, and so we're going to approach it from that manner.

Okay and then, do you think there's going to be any discussion amongst your Board about cutting the dividend? I know you said you expect it to be paid.

Yes. We certainly talk about that, but I don't expect that to happen at this Board call. We continue to have pretty decent cash flow and we know that we're going through a short-term cycle here. We've got to get through it, but I think we're putting some of the right actions in place to address it, so I don't think the dividend at this point is a question mark.

Okay and then just lastly, you didn't give specific guidance but do you expect to be profitable in the third quarter on a normalized basis?

Well right now we're still working through some of the details because obviously just like you, we're trying to figure out what's going on out there from a non-controllable standpoint, so we're looking at the back half saying absolutely profitable, and we believe that we're going to be in that range we talked about, $0.20 to $0.30. Now, whether those orders that we're starting to get from customers falling in September/October, we're still working through, so we've got to figure that out, and so we aren't going to give quarterly guidance at this point, just back half.

So then Bill, the margin sort of, guess, that you gave of 42 to 43, that should be heavily weighted towards Q4?

Yes, it will certainly be stronger in Q4.

Thanks.

Thanks, Scott.

Our next question comes from the line of Scott Mushkin with Banc of America. Please proceed with your question.

Hi, guys.

Hi, Scott.

I was hoping, I know the commercial business seems to be doing pretty well, and I know in the last Conference Call you guys talked about some of the manufacturing that you were putting more efforts into making sure you didn't run into problems you had, about a year ago. Was that any part of the gross margin contraction we saw, and were you happy with the way manufacturing worked in the quarter?

Actually, our Independence factory in Virginia and our Tulsa, Oklahoma factories did a fabulous job, I thought, and they produce our commercial equipment for us, so they actually performed extremely well and the commercial business, we feel really good about and we go into the back half of the year here with some really strong momentum, so that part of the business is one that I'm pretty excited about, and I think we've got better news to come in the back half with the launch of a lot of these items.

So you said, thanks for that, by the way, and you said that you think this is a short-term cycle, and clearly on the last conference call, you felt like April was going better you didn't change guidance and why are you so convinced of that? I mean, the housing market does seem to be in more of a longer term down cycle here. What gives you confidence that we may not even see things deteriorate on a macro basis as we go into the back half of the year?

Yes.

Home Depot just lowered their guidance, the home builders continue to say things are getting worse, not better, so I guess I'm just trying to struggle and I was actually surprised you guys didn't lower your guidance last quarter because I didn't see the same signs that you're seeing, so what makes you so convinced about that?

Well, at the time, in April we were seeing things pick up pretty well, and then May kind of flattened out for us and June was just ugly again, so it seems to be bouncing around a little bit, and it's tough to get a handle on. What I would say, when I say short-term, I'm saying short-term meaning, the next six months. I don't know if it's going to be the first quarter of '08 before it turns, I don't know. I'm not an economist so I can't predict all that stuff but what I can do is tell you that as we look at our business, the controllable side and the initiatives we're putting in place and all those things we just talked about earlier in the call, we believe will help mitigate some of the headwinds that we're facing. Now, we can't totally eliminate them by any means, but we can certainly mitigate them.

Is there any thought into the retail channel down, I guess it was like 62 or 63%, but when you first took over, Gregg, you talked about this kind of cascading strategy where you have innovate into the commercial and then cascade it through the channel. Is there any thoughts that maybe the Sports Authority of the world is not a great place to be just because that channel is very difficult, and you would just focus in on the commercial, specialty and the direct and leave that channel to someone else?

Yes, and actually, we think that Sports Authority and Dick's Sporting Goods and those customers are actually very good customers, where I think that the problem we've got, Scott, is not about the cascading of innovation, because when we put innovation in those customers, in any channel, the right innovation does very well for us. I think the problem we have is, we initially, two or three years ago, had put together what I call internally is a firewall between the channels, so that we had unique product positioned in each channel with differentiated brands and we made sure that we kept, the specialty channel had a unique offering that sporting goods had a unique offering that our direct segment had a unique offering and so on and so forth, and over time, those firewalls were either one, knocked it down or two, maneuvered around to the point where I think it creates some consumer confusion, and so we've got to clean some of that up and rebuild those walls in the appropriate way, so examples of how we're doing that are cleaning up the web, getting the Universal launch here in the third quarter to get some unique product back into the sporting goods segment, and also launching a new brand or two potentially, in the specialty retail segment to really help differentiate for them, so we're trying to reestablish those firewalls and get us back in a position where as we have innovation, we can cascade it in the appropriate manner versus kind of the way that we've maneuvered from an execution standpoint in the past.

And so when you look at the specialty, I guess the Nautilus brand was in there, I'm still struggling to understand what other brands. I mean, and then the Universal. It seems like you guys have a very large amount of brands. Do you think that maybe you're over doing it there a little bit or is it, couldn't Nautilus be what you want it to be in specialty? Why do you need a couple more?

Well, just in the way that specialty retailers compete in the marketplace, a lot of them like to have a different brand than the guy down the street from them, so if we're really going to take advantage and have an opportunity to grow in that specialty segment, you've got to be able to have at least a couple of brands that you can offer, and so that's just --.

But would it be a private label type of thing?

No, no, and I'll just tell you from a competitive standpoint, Scott, we're just not going to talk anymore about it but we think that it's a great opportunity for us. It's something our customers in that channel have been asking us for, so we're just going to deliver on something they're requesting and typically what I have found is when a customer asks for it and it makes sense strategically, it usually works pretty darn well, so and I don't, I'd love to tell you more. I just can't because I know probably half the people on this call aren't people that want to help us.

Okay, well, thanks for answering my questions.

Thanks, Scott. Good to hear from you.

Our next question comes from the line of Paul Swinand with Stephens, Incorporated. Please proceed with your question.

Good afternoon, everyone. Can you hear me?

Yes, Paul.

Let's maybe switch gears a little bit and ask about the segments that are going a little better. In apparel, commercial, and international, do you think you could break down where the growth is coming from, maybe like between new SKUs penetrating existing accounts and then how much are new doors or new geographies in international? I know you had a lot of announcements in international, like going direct in some geographies, or some new lines and stuff like that. Think you could break those three down in some kind of manner like that?

Yes, Paul. Actually, let me put them in a couple of buckets here that I think might make it easier to digest. First, let's talk about international and commercial, and I'll kind of put them together, because it really is about product innovation with both of those customers or both of those channels, excuse me, from an international commercial standpoint, we've got Nautilus One we're launching, and we've got Treadclimber that's been doing extremely well for us in the commercial channel and is growing at a pretty rapid pace from an international standpoint, so we're doing really well there. We also continue to do well, and we're seeing the stepping category start to pick up for us again, so those products are starting to rebound for the Company, under the Stairmaster brand. Our cycling brands are doing well with Schwinn cycling in particular in both international and commercial so we're seeing those products in particular doing really well for us. Now --

I'm sorry to interrupt. So it really sounds like penetration of existing accounts with the SKUs you have now in your commercial and international?

Yes, and then the unique part, so commercial is really purely just working with our existing partners and expanding there. The one unique piece on the international component that's an "and" to that is, and because of all of that innovation we're capturing a lot of additional new customers like we talked about, Virgin Active and Will's Gyms, and some of the customers that we've signed up recently.

But on the international side, most of it is coming from existing geographies, not from like China and India now, those are sort of small piece of the total pie; is that correct?

They are but they are growing pretty quickly. Even looking at the back half of the year, our business in India continues to grow pretty quickly. Our business in China continues to grow at a very rapid pace. Our European penetration gets better every day, and I feel good about the work that Darryl Thomas, the President of our international division, and his team are doing. I'm really proud of those guys. They're working hard and they're doing the right things.

Okay. And then on the first quarter call, you did have a bullish outlook and you said that there were certain plans, partnerships, programs you're looking at for the back half of '07 you were excited about. Are a lot of the things we're talking about today, were those what you were envisioning on the first quarter call, and they just hadn't started yet, or are you actually, have you actually sort of changed your strategy a little bit since then?

No, it's exactly the same.

Okay.

The only thing that's really changed for us here, Paul, is the headwinds are a hell of a lot stronger than we thought, pardon my language.

Sure.

But it is, it's pretty tough. If I can go back, I didn't answer your full question before.

Sure.

I just want to tell you about apparel for a minute.

Okay, great. Yes. Yes.

The cycling business has been a little bit flat for us, but we're doing really well in the run category and we launched a new ad campaign that's pretty cutty, but I think is getting some pretty solid response from our specialty run accounts and partners there and the shoes are selling through. We're getting really good take away at retail so the apparel team, Juergen Eckmann is our President of that division, he and his team are doing a great job as well, and so, we're seeing some really good progress made on the apparel side of our business and feel pretty good about it.

Okay. And then so that doesn't, the growth that you outlined doesn't assume too much of a pick up from fitness specific or some of the other branded apparel? [It's Pearl iZUMi.]

Right. So we're expecting the back half at this point from the apparel standpoint to be continuing to really build the equity in that Pearl iZUMi brand and anything we get above that would be plus above the plan. On the international side, we continue to be steady as she goes. We think they will be right on plan. Commercial segment, we think on plan with some upside potential, and we're right now planning on the direct business and the retail business to be the ugly stepchild for the back half of the year, but we're going to try to turn that ugly duckling into a swan by the first part of '08 so that's what we're kind of working on.

Okay, got it and if I could just a housekeeping question to Bill. Bill, with the $0.20 to $0.30 back half mid point you'd be making $0.03 for the year. Would you have a debt target for us at the end of the year?

Yes. And obviously at the end of the year we'll also be paying the rest of Land America.

Land America?

Yes, [probably] on January 2nd, so but yes, we will be in the probably around $95 million to $100 million.

Okay, including the January 2nd payment to Land America?

No. The January 2nd payment would --

Be on top of that?

Yes, would probably go on top.

Great. Thank you very much.

Thanks, Paul.

Our next question comes from the line of Rommel Dionisio with Wedbush Morgan. Please proceed with your question.

Yes, good afternoon. Just a strategic question, Gregg. Given the headwinds you're facing in the near term and it's still a solid Company with good brand recognition and all that, good cash flow, is taking the Company private or other strategic alternatives something that you're considering?

Rommel, that's a great question. The Board of Directors in their own fiduciary responsibility had considered that as far back as October. We talked about it in a Board meeting. We looked at it in January and just as a follow-up to say how do we feel, and the fact is this: We believe we've got a great Company here, and I don't want to speak for the Board of Directors, but as Chairman, I guess I get to once in awhile, and I would say this: On a unanimous basis, we believe that our company is very much under valued. We very much believe in the long term opportunity of this Company and the strategies we've put in place and we think we need to keep on keeping on right now and get through this tough time, right, and get this Company in a place where it really starts to create the kind of value that we think it has the potential for.

Fair enough, Gregg. Thanks. Good luck.

So no, we're not going to do it right now. Thanks.

Thanks.

And your next question comes from the line of James Bellessa with Davidson & Company. Please proceed with your question.

Good afternoon.

Hi, James.

If I understood the guidance before, you were looking for 5 to 10% sales improvement for the year. Was that a correct interpretation of what you had previously said?

Yes, Jim.

So if I do the arithmetic correctly, it appears that indeed the second half sales guidance is coming down significantly; is that correct?

Yes, we are bringing it down.

And then you hit, you went through May and did you come to a conclusion that at the end of May that you could still catch up with $18 million of shortfall of sales from your low end of the guidance?

I'm not sure I understand the question. I'm sorry.

At what point did you feel that the quarter was vulnerable and you weren't going to make it? You said (technical issues) or something of that nature.

Yes, well, the second quarter for us is the seasonally slow quarter anyway, so we don't expect, especially in that April/May time frame a lot of volume coming through and April business actually looked reasonable for us. Our May business softened a little bit, and then June was just horrible. I mean, where we would have thought we would have gotten some retail turns and gotten some product replenishment with out of stocks and those kinds of things, our retail partners would go through, we simply didn't get them, and we also in the process of going through June started to notice where some of these things were popping up on the web so as we started investigating that, we actually ended up cutting a few orders late in June we were finding out were actually going to secondary web customers instead of actually being utilized in the way we thought they were, so it was probably the end of June at the earliest that we started to really feel like the kind of revenue shortfall was going to be there.

And when you were mentioning undercutting you're really referring to these unauthorized web resellers? Is that what you were talking about?

Yes, and that was our choice. Now granted, they are small like little one off deals, so we're talking maybe $1 million, $1.5 million in revenue in total, right, that was affected there of that 18. The majority of the volume was really in big box retail, where we just didn't get the turn orders in June we thought we would have gotten.

And then, Bill, you were citing a couple things about the guidance for the year, and I think perhaps you jumped over commercial guidance. I think we heard every other segment guidance, but what are you calling for in commercial sales increase?

Yes, right. The commercial should be up in the 11 to 20% along with apparel.

I see, and then you went through your earnings shortfall of $0.35 and you said $0.18 was a sales shortfall and then $0.11 and $0.06 were attributed to what other factors?

$0.18 was a sales shortfall and $0.11 was the channel and product mix and $0.06 was all the other stuff below gross margin.

Thank you very much.

Thanks, Jim.

And we have time for one last question and it comes from the line of Mark Bettinger with Stanford Group. Please proceed with your question.

Gregg, can you discuss the competitive landscape a little bit?

Yes, I think on the commercial side of the business, Life Fitness continues to do well and we're seeing Precor and Cybex continue to perform well, although we're performing good in that category as well, so I think you've got a good group of competitors that were competitive with each other, friends until we step on the field, but I mean, I think it's a good group of folks that are really working on the industry side in an appropriate way. On the retail side of the business, it's a bit of a mix. There's Icon still pretty heavily out in that market, there's a little bit of, on the sporting goods side a little bit of Johnson starting to show up there, I think that's some of the indigestion the specialty retail guys had with their business, and they really didn't have any differentiation, so that created some indigestion there, and I think on the direct side of our business, we're seeing a lot of junk, Mark.

I mean, and I don't mean it from an actual product standpoint, but you've got the bar stool that melts away 20 pounds of fat in 12 minutes or less, I'm being somewhat facetious, but there are so many things out there right now that people are claiming will help get you fit and I think that's actually one of the biggest problems we've got in this industry right now is, you got a lot of gimmicky stuff that as a lot of you know, don't really make a difference for people, and yet folks that watch it are looking for an easy answer so they will spend $19.95 or whatever the amount is, to try and go purchase something for their first payment, and so it's clogging up the airwaves a little bit, and we have to work that much harder in our direct model today to help clarify for people what does and doesn't work. And we're actually for the first time here on a 60 second spot going to try to take a shot at that and help clarify for consumers and educate them in an appropriate manner so we'll try to do that but that direct model is for us right now with the clutter that's out there, is kind of a messy place to have to try to manage.

Okay, great. So that fundamental competition that you're talking about, is there any reason to think that wouldn't be here in the first half of next year?

Well I think what we're figuring out here and I think when you go through a down cycle like this, Mark, at least every one that I've been through in my 20 plus years, now, as you go through those down cycles, a lot of that stuff will go away, so and we're already starting to see a little bit. Some of these guys that used to advertise are starting to pull back and so we're hoping and believing that it takes a natural kind of life cycle to itself and that some of that starts to disappear; however, in the meantime, we're taking some very different approaches like the school program we talked about, we already have 2 million people in the mix. We're looking at opportunities around how we can work with affiliate partners in a better way from a direct standpoint. We're considering different approaches to our advertising and creative than we've done in the past, and we're bringing a lot of really hot and exciting new product to the market in that direct channel that should help us to mitigate some of those things that we're seeing out there.

Okay, so it's collectively through the direct and retail channel, do you think most of it lost share, is that correct?

No. Actually we don't think we've lost share. I think what we've got is simply a little bit of a sell-in, sell-through, and like I said earlier, the retail floor presence we have is not the greatest right now. So we're having to clean up some of that, but I don't believe we're losing share in the market right now and in fact, I think on the direct side, we're actually probably picking up a few points.

Okay.

Probably flat at retail.

And a lot of the initiative that you mentioned, is it safe to say that if there weren't any headwinds and things were going well that you'd be doing a lot of this anyway?

Yes. I think a lot of the things we've got in our plan, we would be doing. I think what we're doing is adjusting because of what's going on in the marketplace right now, I think we're adjusting the mix so for example, heavier emphasis on affiliates, really making sure that we're getting that retail execution buttoned down because that the a place that I think we're soft and if business were flowing terrific, we probably wouldn't be looking at that as heavily and with such a microscopic eye, but in the fact that we're seeing those kind of things, we're trying to make adjustments where we can, there's a couple of examples.

Okay, and lastly, Bill, can you just go over the direct and retail numbers again what they were down and what you got for the year?

Yes. What we're expecting for the year?

Well you said in the second quarter, what was direct and what was retail down?

Direct was down 11% and retail was down 62.

Okay, and for the year you're expecting what?

Retail would be about 20% and direct would be down around 10.

Direct would be down ten and retail would be down --

About 20.

Okay. All right, good luck, guys.

Thanks.

Thanks, Mark. All right, so if we don't have anymore questions I want to just kind of wrap things up here. So thanks again to investors, customers and employees, for your support. We look forward to providing you a progress report on the third quarter call in October, and until then, we are tenaciously focused on driving back half initiatives and fixing the controllables we outlined in this call.

The good news is the majority of our business channels are doing well. The problems are primarily isolated to home gyms and we're working aggressively to position ourselves for the next fitness season. We will get our domestic equipment prepared to grow as the economic cycle turns positive while continuing to grow the other business segments, so thanks for your ongoing support of our Company and its mission to profitably reverse the crisis of inactivity around the world. Thank you for being on this call.

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.