Nautilus Q4 2007 Earnings Call Transcript

Feb.18.08 | About: Nautilus, Inc. (NLS)

Nautilus, Inc. (NYSE:NLS)

Q4 2007 Earnings Call

February 13, 2008 5:00 pm EST

Executives

Robert S. Falcone - President & Chief Executive Officer

William D. Meadowcroft – Chief Financial Officer, Secretary & Treasurer

Analysts

Reid Anderson - D.A. Davidson & Co.

Laura Richardson – BB&T Capital Markets

Kathryn Thompson – Avondale Partners

Eric Wold – Merriman Curhan Ford & Co.

Rick Nelson – Stephens Inc.

Marc Bettinger - Stanford Group Company

Scott Krasik – C.L. King Associates

Scott Mushkin – Bank of America Securities

Operator

Ladies and gentleman welcome to the Nautilus Incorporated fourth 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 all callers to limit their questions to two. (Operator Instructions) As a reminder this conference is being recorded on Wednesday February 13, 2008.

Before the call begins listeners should be advised of the Safe Harbor Statement that applies to today’s call. Prepared remarks during this call contain forward-looking statements. Additional forward-looking statements may be made in response to questions. These statements including the company’s reorganization and turn around times 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 the unanticipated event. Therefore undue reliance should not be placed upon them. Listener’s should review the earnings release to which this conference call relates and the company’s most recent periodic reports on from 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.

Now I would like to turn the conference over to Mr.Bob Falcone, President and Chief Executive Officer of Nautilus Incorporated. Please go ahead, sir.

Robert S. Falcone

Hello everyone and thanks for joining us today. Sorry the call was a bit delayed. I’m joined here today by Bill Meadowcroft, our Chief Financial Officer. This afternoon Nautilus posted fourth quarter and year end unaudited results. Net sales for the quarter were $147 million which excludes the apparel division which is reported as a discontinued operation. Including the apparel division our net sales for the quarter were $160 million which is in line with the guidance we provide at the beginning of the quarter. We also recorded substantial unusual expenses in the quarter and Bill will detail those in a moment. We are relived to move past the year that produced the company’s first ever operating loss as a public company and triggered a number of changes to our board, our leadership team and to our organization. We look to 2008 as a year where we aggressively pursue restoring profitability to the bottom line and position our organization for profitable growth for the long term.

But first I’d like to turn the call over to Bill for some details about the fourth quarter results and the results for the fiscal year 2007.

William D. Meadowcroft

Please keep in mind as you review the financials that we are treating apparel as a discontinued operation given that the segment was for sale at year end. Net sales for the fourth quarter were $147.3 million a decrease of 20% from the fourth quarter last year. Compared to the year ago quarter net sales by channel were as follows. International sales were $24.3 million up 17%, commercial sales were $22.3 million up 6%, retail sales were $62.1 million down 14%, retail sales were $37.1 million down 47% and royalty income was $1.5 million up 36%. Apparel sales were $12.4 million down 5% from the fourth quarter last year. Including apparel we achieved $159.7 million in net sales. Our loss from continuing operations for the fourth quarter 2007 was $31.4 million or $0.99 per share compared to a year ago results when income from continuing operations was $12.6 million and we delivered earnings of $0.40 a share.

The quarterly loss from continuing operations was $48.7 million before income taxes. This included certain pre-tax charges totaling $45.1 million. These charges include $19.4 million related to the suspended acquisition of the Land America manufacturing facility in China, $16.9 million in warranty and inventory reserves primarily associated with certain commercial cardiovascular products. Bob will explain this shortly, $3 million for intellectual property impairments and $5.8 million of other items including $2.6 million for the special shareholder meeting, $1.2 million to exit certain marketing contracts, $1.3 million related to staff restructuring and $0.7 million for debt restructuring. Except for these certain charges our loss from continuing operations before income taxes for the fourth quarter 2007 would have been $3.6 million. Our gross margind of 24.9% would have been about 36.3% without the certain warranty and inventory related charges. This is not satisfactory.

We are in the process of implementing improvements including product segmentation, minimum order quantities, customer profitability analysis and improvements to our manufacturing and distribution costs. General and Administrative expenses of $37.6 million would have been $10.6 million without the charges compared with $12 million in the fourth quarter of 2006. Overall operating expenses of $84 million for the quarter included $28.2 million of certain charges. Absent those charges operating expenses would have been $55.8 million for the quarter or approximately $6 million lower than the year ago quarter of $61.7 million. Under discontinued operations you’ll not that we’re recognizing a quarterly loss of $17.1 million for the apparel business primarily due to a $15.9 million impairment in its book value in anticipation of the sale of that business.

Turning to our balance sheet, short term borrowings net of cash was $73.9 million. We did secure our $100 million line of credit with Bank of America in January providing sufficient liquidity to operate the business. We do expect borrowings to be reduced upon the sale of our apparel division by the end of the first quarter. Inventories were $58.6 million which reflects the reclassification of apparel inventory to net assets of the discontinued operations line of the balance sheet. We continue to have opportunity to reduce fitness equipment inventory through our focus on fewer products and better forecasting.

Robert S. Falcone

Just to go over a couple of those numbers in the beginning. The direct sales for the quarter were $62.1 million and the retail sales were $37.1 just so there’s no mistake on some of those numbers. There’s no denying the fact that 2007 was a difficult year for Nautilus. The year showed a loss for the first time in the company’s history, a change in the company’s CEO, a proxy contest, four new directors and several changes in senior management.

Some of the actions we’ve taken during my first 120 days as CEO have included a reduction in our work force, reorganize the company along product lines instead of sales channels, a renegotiated debt agreement, a decision to sale the company’s apparel unit Pearl iZUMi, a decision to close our Canadian call center, a large distribution facility near Chicago and our Australia direct business and we made strategic decisions to improve the business going forward as evidenced by the special charges this quarter. We move into 2008 with a renewed sense of optimism for the company. Management and employees are focused on the task of making the company profitable and are working hard to reduce costs in all areas. Sell only the products that produce the best returns for the company, renew our pledge to our customers to provide excellent products and service, make our manufacturing operations more efficient and provide the consumers with the best products at the right price to help them achieve a fit and healthy life.

We are also continuing with our global expansion as we gain presence in health clubs around the world with our Nautilus, Schwinn and StairMaster brands. I am convinced that we have the brands and the team to do this and we will work hard to gain back the confidence of our shareholders and our customers. It is not going to be an easy task and I’m sure there will be bumps along the way. We are faced with returning the company to profitability in the face of a severe slump in the housing market, the worst retail environment in 17 years, the fear of a US recession as consumers pull back on discretionary spending and massive losses in the financial services industry which impacts a large cross-section of our customers. These things coupled with a rising unemployment rate, weak US dollar and price increases from our suppliers cause us to rethink and rework all aspects of our business. We firmly believe in the face of this economic environment our path to profitability will come from cost containment and margin improvement rather than from an increase in sales.

We will be making better selling decisions, introducing new products to the market place only when they are ready and be more disciplined about product segmentation into the right channels. Our direct channel will continue to carry the well recognized and innovative Bowflex branded products which have been the heritage of this company. We are taking a fresh look at our significant spending to drive business to this direct consumer channel and are convinced we can be more productive and efficient to increase our margins. Our retail channel will have more focus on fewer accounts and we’ll continue to sell our Schwinn indoor fitness line some of our Nautilus home equipment and other products not available through the direct channel. The retail channel will also carry our new introductions of universal branded products either later this year or early next year.

We believe that with the proper segmentation of all of our brands across all of our channels we can optimize our margins and provide all segments of our customer base with the right products at the right price. Our commercial and international channels will continue to carry our Nautilus brands, our StairMaster offerings and the Schwinn indoor fitness line. However, we are making several changes especially in the area of commercial cardio products. Our extremely popular commercial TreadClimber has exceeded our expectations in sales and usage but has not performed up to our expectations in durability. Because the product is being used well beyond our original performance tolerances, we are seeing more frequent service issues than we forecast. This is not acceptable to us and is well above the normal service records of our other products. Therefore we have added $12.7 million to our warranty reserves and will be suspending sales of this product at the commercial level until we reengineer it, and reintroduce it to the market place when we have it right. We remain committed to our commercial customers to both strength and cardio products and we will continue to stand behind all of our warranties and service contracts.

Our Bowflex branded TreadClimber models for the home continue to perform well and we continue to offer that product on our direct channel as before. We are also in the process of evaluating the profitability of various other products and will discontinue the sale of several products over the course of the year. We do not anticipate any additional charges to be incurred for this activity. Going forward we are committing two-thirds of our R&D budget to cost and quality improvements for existing products and we are being highly selective with new product development activities. We will continue to be committed to offering innovative strength and cardio products to the market place but are equally committed to offering the best quality products.

Our commercial strength lines including our recently introduced Nautilus One products are performing extremely well both from a sales and a quality standpoint. Another area of the company at which we are taking a hard look is our manufacturing and distribution operations. Do we have the right mix of domestic and offshore manufacturing, the right warehouses in the right locations to best serve our customer base, and are we utilizing the most efficient means of transporting our products around the world? As you know we have cancelled our proposed acquisition of Land America, our China manufacturer of Bowflex products. While this produced a charge of $19.4 million in our financial statements for forfeited option payments and write-off of acquisition costs the board decision was made in the best long-term interest of the company to simplify our operations and preserve liquidity.

We continue to hold discussion with Land America management to determine ways we can continue to work together to reduce product costs and enhance our margins. However as these talks are continuing we may see some price increases in our product purchases during the first several quarters of this year until some supply contract issues are worked out. Recently we made the decision to close our distribution facility in Bolingbrook near Chicago to add some efficiencies to our distribution model. While this will not have an immediate impact on our financials the move eventually will provide a long-term benefit to our distribution costs.

We also made the decision to close our call center in Winnepeg, Canada and consolidate those operations into our call center in Vancouver, Washington. While we will maintain a small distribution center and retail store in Winnipeg we believe we can efficiently service our direct and retail customers from one North American location. This change will also produce some ongoing benefits to our cost structure.

Finally the sale of our apparel unit Pearl iZUMi is progressing nicely. We should have some announcements on that matter in the few weeks ahead. Although we received a great amount of interest in this company from prospective buyers evaluations have come down significantly over the past several years in the face of the many economic uncertainties we all face. We have therefore booked a non-cash write down of $15.9 million in the carrying value of this asset.

Since coming on board as the CEO I have made a number of management changes and additions. At the senior ranks we have a new head of global sales, a new Chief Marketing Officer, I’ve appointed an internal veteran as the new head of RD&D and added two newly created senior positions of Product General Managers, one internal and one newly hired. At other levels of the organization there have been significant changes of responsibilities of current employees to take advantage of their experience with the company. All of these changes will take some time to have a significant impact on the company but I am greatly encouraged by the intensity and enthusiasm with which all of these individuals have attacked their new areas of responsibility. With these individuals supplementing the already solid group of employees we have at all levels of the company I am convinced that we can succeed making this company the leader in the fitness industry not only with the products we produce and sell but with the profits we can return to our shareholders.

It will be a very challenging 2008 as we turn this company around in the face of a lackluster economy. However I firmly believe we have the right people, the right products and the right brands to get the job done. I’ll be happy to take any questions you might have.

Question-And-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Reid Anderson. Please go ahead, sir.

Reid Anderson - D.A. Davidson & Co.

First question would be on the retail side. Bob could you remind us or give us a sense in terms of just the retail business how much of that was in the Bowflex brands?

Robert S. Falcone

Well it’s hard to say exactly how much was in the Bowflex brand Bill do you have that number?

William D. Meadowcroft

Obviously, Reid, we continue to move away from Bowflex brand as opposed to 2006 with the Schwinn brands continuing to be popular there. Bowflex is down now less than 25%.

Reid Anderson - D.A. Davidson & Co.

So to the extent you move entirely Bowflex out of that channel at what point in time would we no longer walk into a sporting goods store and see Bowflex? Would that be the end of this year or is that something that’s going to take place over the next couple of quarters? Just a sense of timing on that?

William D. Meadowcroft

Reid, I think that basically you’re going to see that disappearing over the next couple of quarters. You know you have to flush it through and sell through the product that’s there now but we’re not selling into the channels anymore with Bowflex products so you’ll see it flushing through pretty quickly.

Reid Anderson - D.A. Davidson & Co.

Okay than last question just from a cash flow stand point. Bill, cap ex wise how should we think about that this year?

William D. Meadowcroft

This year obviously we’re tightening the belt around that and expect to be in the $6 to $7 million range.

Operator

Again ladies and gentleman we would ask you to limit your questions to a total of two at a time. Our next question comes from the line of Laura Richardson. Please go ahead.

Laura Richardson - BB&T Capital Markets – BB&T Capital Markets

My two questions. One is in terms of the cost cutting, and its just kind of a two part, is there more to come and if you cut enough that you think you could be profitable on the sales you’re anticipating next year?

William D. Meadowcroft

I think we could be. We have a lot of cost to take out. We’ve taken out some already. Our plans going forward indicate that we’re going to take out a lot more and we’re also working on some margin improvements at the same time in various areas and so I think combination of those two will get us there.

Laura Richardson - BB&T Capital Markets

And then Bob, last call you were talking about second half of 08 as the horizon for returning the profitability I think and do you still think that that’s feasible having gotten more under your belt?

Robert S. Falcone

Let’s kind of be clear here about this turn around situation that we could be talking about. Most US companies that have issues and need a turn around take about three years to accomplish. I think that anticipating anything, to see any big changes before the last couple of quarters of this year is going to be a little bit foolish to anticipate too much. It just takes a little bit of time to turn it around. I think we will as I had mentioned earlier and by the third quarter start seeing some definite improvements and we’ll see some definite improvements in the first quarter when it comes to cost. We’ll see that coming down every quarter and we’ll see some slow improvements in a lot of other areas of the company. But I think that our objective is to turn this thing around properly and it’s just going to take a little bit of time.

Laura Richardson - BB&T Capital Markets

That’s only fair and I’m just following up on this question, so profitability, there’s improvement in loss percentages and in expense ratios and then there’s actual P&L profitability so when do you think we might see the latter?

Robert S. Falcone

You’re going try to tie me down. I really think that you’re going to see something close to profitability hopefully by the end of the year, that’s my objective and we have a huge turn around here to do it.

Operator

Our next question comes from the line of Kathryn Thompson.

Kathryn Thompson – Avondale Partners

As far as - I’m going to put this in a bit of a cliché but baseball terms in terms of what inning you are in, in terms of the turn around, where would you be and then also tagging along with that what are the forecasted cost savings that you project for the remainder of 08?

Robert S. Falcone

What inning am I in? I guess I’m in the bottom of the first. We have a lot to do here and

we’ve accomplished a lot already, but that I think just kind of shows you the magnitude of how much has to be done. I think that as far as the magnitude of cost take-outs, I’m not really able to go there right now, Kathryn . Bill, do you have anything you want to -

William D. Meadowcroft

Certainly as you see our op ex for the year X that litigation settlement we were up around 270. We’re looking to take considerable - up to 25% of that out in this year through some of the efficiencies, some of the run rates and things we’ve already done and some of the ongoing obviously selling and marketing are the biggest bucket there and we’ve got some work to do there but also some opportunity to see some improvement there.

Kathryn Thompson - Avondale Partners

Just to clarify take up to 25% off of -

Robert S. Falcone

Op ex.

William D. Meadowcroft

Of op ex, this years run rate which was obviously significantly high

Kathryn Thompson - Avondale Partners Thompson

I just wanted to triple check on that. Do you anticipate any additional goodwill right offs?

William D. Meadowcroft

We should not. We’ve been picked and prodded and we’ve looked at everything and we’re not expecting anything now unless some decisions change, in which case there’s a chance that some of that icon asset may get impaired with our trademarks and the goodwill. At this point we’re not expecting anything.

Kathryn Thompson - Avondale Partners Thompson

I know you are shying away from profitability questions, which I understand, but I was thinking more on a operating basis, kind of addressing the earlier question. Do you see yourself on a pure operating basis excluding charges on a profitable path by Q3?

Robert S. Falcone

By Q4.

Operator

Our next question comes from the line of Eric Wold. Please go ahead.

Eric Wold – Merriman Curhan Ford & Co.

I just wanted to follow back up on the - couple of the past people have asked questions about cost cutting. I know you just mentioned that you cut 25% out of the $270 million expenses this year. How much of that entire percentage call it $70 million bucks or so, how much of that $70 million or so has already been announced and cut and just hasn’t flowed through yet, and how much of it still has to be kind of put in to place? And I guess another way to answer that is if you look at what you did in Q4, I know you’ve announced a bunch of cost cutting, how much was kind of not already reflected in the fourth quarte, and will sort of start coming to fruition next couple quarters?

Robert S. Falcone

When you say 70 you’re talking about so there must some special charges in that, right?

Eric Wold - Merriman Curhan Ford & Co.

Yeah, exactly.

William D. Meadowcroft

As far as in the G&A area we have made some significant moves. Obviously again our run rate was really high this year at $75 million, and we would look to be getting that down more into - and it will be improving as we go through but probably more in the $12 millionish dollar range for the first quarter and we’ll see improvements to that as it gets down closer to $10 million as we some of those ongoing benefits. Selling and marketing there’s still stuff to be done. There’s still opportunity on the direct side, that being the biggest area of spend. We have implemented procedures in the cost control measures in the commercial as well as in the retail businesses, but there is still with the direct, there’s still opportunity and things that need to be done there. R&D will be probably running at about 10% less but we want to be able to focus on some of those cost take out measures It’s important to improve the products that we’ve got out there so that we don’t run into these ongoing cost quality issues. Then the royalty will be probably pretty consistent, it all depends on the salesmen.

Eric Wold - Merriman Curhan Ford & Co.

And the second question, some of the other competitors out there have still been putting up decently healthy numbers for the fourth quarter in what would be described as a tough environment. With you guys kind of struggling the past couple of quarters and being in a state of flux, unknown, I’m not sure what these retailers and consumers think, does it get tougher as these others equipment companies kind of entrench themselves, maybe play on your weakness, get out there, get to the retailers, put some products in there, gain shelf space, maybe put some promotions out there, whatever. Does it get tougher and tougher to turn that momentum around and get the retailers to think back more the Nautilus way more instead of the competitor way?

Robert S. Falcone

Yeah, of course its tough Eric, you know people like to kick you while you’re down and we’ve had some issues out there in the marketplace and we understand we have a battle to fight, but our sales team is a great team and they have great relationships with a lot of the retailers and then there are commercial customers. We’re seeing some signs of customers hanging in there. They understand where we are. They understand what the situations is. They like the new management. They like things that we’re doing. So I think that they’re going to ride with us and they love the Nautilus products which is the key. So we’ve probably lost some share and some sectors throughout the country. There’s no question in my mind that that’s happened. But can we get it back? Absolutely we can. And I think we have the products and the people to do it.

Operator

Our next question comes from the line of Rick Nelson. Please go ahead, your line is open.

Rick Nelson – Stephens, Inc.

Question on the inventory and warranty reserve, if you could provide a little more color on what led to that decision and I guess the big component is the warranty issue. What products, if warranty experience proves better than you think and gets reversed back into operating income?

William D. Meadowcroft

Right. We talked about the warranty piece which was $12.7 million specifically pertaining to the TreadClimber, the commercial TreadClimber product. And yes you’re right, Rick, depending on what we experienced and how the actual warranty, the fixes go down the road versus our estimation at this point, there would be opportunity to bring it in. Conversely if things for some reason go worse than what we’re expecting obviously it will go the other way. Other charges specifically related to the tread climber were about $1 million for tooling written off while we are trying to work on the fix around the whole product and then also some raw materials that were written off. All of that was about $1.1 million. Also our Variable Stride Elliptical, our EV9 we actually pulled from the market as well and have gotten out of that given some issues around that and that’s about $1.9 million of incremental costs there. And then our Fitness Advisor product also we got out of after trying to get that to work for the last handful of years and that was about a $250,000. Then there was some other import duty customs related costs that make up the difference there.

Rick Nelson - Stephens Inc.

Would you expect the future improvement is going to be more gross margin driven or expense reduction driven?

Robert S. Falcone

I’d say initially it’s going to be expense reduction and then slowly throughout the year some margin improvement.

William D. Meadowcroft

We’re certainly working in both areas and we know there’s cost pressurse coming from China but making the moves we need to to get that margin back up into the low mid-40’s.

Rick Nelson - Stephens Inc.

One final question if I could, the Sherborne investment and the new board seats, I’m wondering how that is changing your approach to the business?

William D. Meadowcroft

Well it really isn’t changing our approach to the business. I think the situation has gone very well. We have as you know two members from Sherborne on our board. We have two new independent directors along with the three existing directors that we had. And it takes a little time for the four new directors to get up to speed with the business obviously because the business is a little bit complex, different channels, different products and they’ve only been on board now for a month and a half. So it takes a little while to get up to speed. But everything has gone well so far and I think that they’re very supportive of management and all the things we’ve done. We have started a lot of these things well before the change over on the board took place and continuing with them after the change over took place. And as long as we’re making progress that’s all a board can ask for I think.

Operator

Our next question comes from the line of Marc Bettinger. Please go ahead sir.

Marc Bettinger - Stanford Group Company

Bill, when you look at the cash flow estimates for the year and the assumed sale of Pearl iZumi are you going to meet capital this year?

William D. Meadowcroft

No, we shouldn’t this year. In fact we are hoping with the Pearl sale and then obviously into the lower season for working capital through the summer we’re actually trying to get cash positive. That will obviously then. as we get back into the October, November, December time frame, that will go back to a borrowing position but a much healthier more comfortable position to be in.

Marc Bettinger - Stanford Group Company

So you don’t see running into the bank line too heavily by the end of the year?

William D. Meadowcroft

Correct.

Robert S. Falcone

No deeper than we are right now.

William D. Meadowcroft

A lot less given the pay. A lot less. I can’t wait for that day.

Marc Bettinger - Stanford Group Company

Bob, can you discuss your prospects and how you see the direct channel?

Robert S. Falcone

As far as what’s happening in sales and that area?

Marc Bettinger - Stanford Group Company

In terms of the channel and how you’d like to be in there and positioned and what do you think the prospects are? [inaudible] channel.

Robert S. Falcone

The direct channel is a very strong channel for us. It probably encompasses half of our revenue but it’s a difficult channel. As you go through the years with improvements in the Internet and improvements in the way people shop online, buy their products through Infomercials and all those kinds of things, the costs of Infomercials going up, the cost of other placements going up it’s a difficult channel to continue with real high profitability so what we’re trying to do is we’re trying to keep those margins up by making our advertising more efficient. In other words we’re trying to get experts in to help us with analyzing how we’re spending our significant marketing spend to drive customers and consumers to that particular channel. So we’re hoping to get a little more efficient in that ad spend and we have a new Chief Marketing Officer and that’s one of his big tasks is to do a good job in making that ad spend more efficient. So I’m hopeful that the channel will continue to be a very high profit item for us.

Marc Bettinger - Stanford Group Company

Lastly, Bill, how do you see the gross margin improving from here? I’d imagine if the retail channel shrinks a little bit that should help but can you elaborate on that?

William D. Meadowcroft

Certainly as we work in retail not only is it perhaps a lesser percentage but we’re focusing on core customers there and making sure that we’re selling profitably so as opposed to just the theme of the past was drive the top line as hard as possible without a real strong eye to the operating margins. Now that has shifted and we would rather sell less but drive dollars to the bottom line as opposed to selling more and obviously hitting the losses that we’ve seen in the past three quarters. So retail, it’ll be getting down to core customers so the focus and minimum order quantities, it obviously costs to fulfill and you’re doing onesies, twosies that cost becomes prohibitive in making money on individual orders. In commercial as we are able to deal with some of these quality issues that will cut, our warranty costs have been very large for the commercial cardio products, much less for the strength products and then obviously much less so for the consumer products. So as we focus on those core products where we are more likely to be able to do them profitably and as we focus on our facilities both distribution and manufacturing and make sure that we’re utilizing capacity effectively and efficiently so that we’re able to reduce our overhead per unit, etcetera, those are the focuses we’ll be having this year. And then on the direct side it’s making sure that we’ve got products for the direct that aren’t being abused over in the retail channel so that we’re able to capture that premium direct margin without competing against ourselves even on our Internet providers that we were selling to during 2006 and 2007. So there are a lot of opportunities there that we are working on capitalizing on to get those margins back up again to the low mid-40’s.

Operator

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

Scott Krasik - C.L. King Associates

I’m having trouble getting it. So you have suspended sales of both the tread climber and your Variable Stride Elliptical? Is that correct?

William D. Meadowcroft

Yes, Scott that is correct. Due to the issues that we faced it didn’t make sense either the shareholders or our customers or the consumers or their people to continue to sell them with the frustrations we’ve had at this point. We intend to still work on the TC916 and come out with a compelling product that should be a real Trojan horse for the future for us.

Scott Krasik - C.L. King Associates

Sure. Those were your best products. It’s a shame.

Robert S. Falcone

They were some of our most innovative products I guess when you put it in perspective. The total sales of those two products were about 5% of our sales. You have to remember that we’re not taking the consumer tread climber off the market cause that’s performing very well and that sells to the direct channel.

Scott Krasik - C.L. King Associates

Any thing differently in terms of the customer’s credit worthiness, default rates or anything in the direct channel?

William D. Meadowcroft

We are continuing to monitor that and in fact just initiated conversations with our second tier organization. We have an automated process that we’re getting them more apps but they are feeling some discomfort on their credit risk and so are pulling back a bit on their approvals. But because we’re sending them more we’re actually not necessarily seeing a reduction in volumes through that versus what we’ve seen. People are sweating out there over what’s going on with the sub-prime world.

Scott Krasik - C.L. King Associates

So just to understand what you’re saying. So the declines we’ve seen in direct haven’t been related to people not being approved or not being able to get back to the [inaudible]?

William D. Meadowcroft

There is some of that but we’re not seeing necessarily severe hits there.

Robert S. Falcone

You know the one thing, Scott that you have to look at and you have to understand, is that when you look at 07 compared to 06 in the fourth quarter and you see direct year-over-year is down, 06 fourth quarter really had a high amount of direct sales because they were pushing extra promotions out and pushing products out the door to make sure that we got some sales. So they were sales, but I’m not saying they were the most profitable sales we’ve ever seen.

Scott Krasik - C.L. King Associates

Bill, could you just run through the numbers and give us what the cost of goods sold were and the G&A in the quarter unaffected by the charges?

William D. Meadowcroft

I also want to comment, Scott ,that obviously we had also made a move towards the much higher priced products which makes it tougher for people to qualify, so the Revo and the higher end tread climbers, and so to an extent we created some of our problem in getting people qualified and will be focusing more on the more that mid-tier $1,000 to $2,000 as opposed to 0 we were going North of even $2,500. So that’s some of the approach that we’re taking on working through approvals. So X some of these one time charges, cost of sales would have been about $93.8 million given as gross profit of 53.5. Our selling and marketing would have been about $41.7 million, G&A would have been $10.6 million and then R&D and royalties would have stayed the same. We would have then had a total operating expenses of $55.8 million and a operating loss of about $3 million.

Operator

Our final question comes from the line of Scott Mushkin. Please go ahead, sir.

Scott Mushkin – Bank of America Securities

I wanted to follow up on that last question and ask something else as well. Credit cards is a percent of your direct channel. What is that?

William D. Meadowcroft

Scott, the credit cards are running about 25% to 30%. Financing is the bigger issue, and that’s been in the 65% to 70% and then the rest would be a cash basis, a check or etcetera.

Scott Mushkin - Bank of America Securities

So when we look at 08, and we look at revenue assumptions, how conservative have you guys baked in - you know credit markets continue to be problematic here. As I look as this, this is clearly a risk factor as we move through 08, how this plays out, especially given what you said to the last questioner.

William D. Meadowcroft

Obviously we build within the plan,. You have to take into account the risks. So we have done what we can in realizing that, not come out with heightened expectations as we work through our plan.

Robert S. Falcone

You know trying to work through some of that direct sales though, I think you really have to be careful what you’re offering. I think that, like Bill said a few minutes ago, offering too many products North of $2,500 is an issue, with the credit on some of these, we go South of $2,000 it makes it a little bit better. So it’s a question of what products we’re offering and how were pricing those products.

Scott Mushkin - Bank of America Securities

And have you built into your expectations that it’s going to be harder for people to get credit or is that not built in? Or, are you status quo?

Robert S. Falcone

No, of course it’s built in.

Scott Mushkin - Bank of America Securities

So the second thing it seems to me is it could be a focal point, is the cost of goods sold, it seems like you’re getting your expenses under control, and of course you do a lot of sourcing from China. What percent is that?

William D. Meadowcroft

It’s about 70% coming from China.

Scott Mushkin - Bank of America Securities

So I guess looking at that, is there any way from our perspective as analysts and investors that we can try to understand the risks associated with devaluations and that type of stuff, given the amount of sourcing you’re doing over there, or is that -

Robert S. Falcone

As far as labor costs, they’re in Remnibi and all that?

Scott Mushkin - Bank of America Securities

Yeah, exactly.

Robert S. Falcone

We have modeled some expectations based on what we’re hearing from the economist community, etcetera and so we aren’t ignoring those factors and we certainly are seeing pressure coming up.

Scott Mushkin - Bank of America Securities

Are you seeing your costs go up?

Robert S. Falcone

There is certainly pressure for increased pricing.

William D. Meadowcroft

When you take our direct channel products which all of which come from, just about all of which, come from Land America, we have a opportunity there to work together with Land America to create some efficiencies in their operation, so I think that’s going to help keep the cost stabilized in that channel.

Scott Mushkin - Bank of America Securities

But potentially the credit markets weaken plus the costs continue to go up, you could be squeezed here in 08 a little bit further?

William D. Meadowcroft

Oh yeah, sure.

Robert S. Falcone

Absolutely.

Scott Mushkin - Bank of America Securities

Is that the main risk you see to 08, what I’m outlining, or is that not really what you see?

Robert S. Falcone

Oh I see that amongst about 20 others, but yeah, I think that’s pretty close to the top of the list.

Operator

Gentlemen that does end the questions. I’ll turn the call back to you for any closing remarks.

Robert S. Falcone

Thanks a lot for joining us on the call today. We’re looking forward to getting into 2008 with a lot of improvements in the operation, so look forward to our next call. Thank you very much.

Operator

Ladies and gentlemen that does conclude today’s conference call. We thank you for your participation and ask that you now please disconnect your lines. Have a good day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!