Nautilus, Inc. Q2 2008 Earnings Call Transcript

Sep.15.08 | About: Nautilus, Inc. (NLS)

Nautilus, Inc. (NYSE:NLS)

Q2 2008 Earnings Call

July 31, 2008 5:00 pm ET


Edward J. Bramson - Chairman, Chief Executive Officer

William D. Meadowcroft - Chief Financial Officer, Secretary, Treasurer


Paul Swinand - Stephens, Inc.

Rommel Dionsio - Wedbush Morgan Securities

Reed Anderson - D.A. Davidson & Co.

Greg Scott - Merriman Curhan Ford & Co.


Welcome to the Nautilus, Inc. second quarter 2008 results conference call. (Operator Instructions)

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 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 report on Form 10K and Form 10Q filed with the Securities and Exchange Commission for a more detailed discussion of the factors that could cause actual results to differ materially from those projected in forward-looking statements.

In addition to today’s prepared remarks Nautilus has provided a PowerPoint presentation of its restructuring plans to accompany today’s remarks. The presentation can be found on the Nautilus website at

And now I would like to turn the conference call over to Ed Bramson, Chairman and Chief Executive Officer of Nautilus, Inc.

Edward J. Bramson

Bill Meadowcroft is going to review the second quarter results in detail and then I intend to discuss the turnaround plan with the progress of it to date in greater detail using a PowerPoint presentation that was referred to in the introduction and you can find it on our website at Bill Meadowcroft’s going to take you through the Q2 results and then I’ll come back on the restructuring. And since we’ve got a lot of territory to cover today, I think it would be best if we took questions on both topics in the end. So I’m going to turn the thing over to Bill now and he’ll take you through the results of the second quarter.

William D. Meadowcroft

Net sales from continuing operations were $95.6 million compared to $102.5 million for the corresponding period last year. This 7% decline compares with the reduction of 5.4% in Q1 2008 compared with Q1 2007. An important part of our restructuring and operational improvement process is the establishment of separate teams with authority and responsibility for the profitability of each of our global business units: Commercial, direct and retail. We will now begin reporting revenue by these global business units and intend to increase our financial transparency in future periods as we change our accounting systems and processes to report by these new business units.

As a result of changing the reportable business segments in the second quarter of 2008, accounting rules require the company to perform an interim goodwill impairment test. The company is in the process of determining whether a goodwill impairment charge is required as of June 30, 2008. An impairment charge if any would be a non-cash charge. The company expects to complete this goodwill impairment assessment prior to the filing of its Form 10Q for the second quarter.

The 7% overall sales decline was the result of decreases in our commercial and direct business which offset strong growth in our retail business. Commercial business sales were down 7% from $32.8 million to $30.5 million. This decline is primarily due to reduced TreadClimber sales as we work to develop a new version of this very popular product. Direct sales were $41.3 million down 24% from last year’s $54.2 million. The weak consumer and tight credit environment impacted our direct business along with decisions to improve product margins by reducing discounting as well as unprofitable financing subsidies. Retail sales were $22.9 million up 53% from last year’s $15 million with increases in twin cardio as well as Bowflex strength products.

We did include on the earnings release a schedule of sales given the change that we’ve made in the reporting business units, so it shows three months of each of the last two quarters as well as the six month totals by the new view. So that will help in grasping the numbers.

We also had $900,000 from royalty income which was up from $600,000 in the same period last year.

Our gross profit margin was 35.5% compared to 37.3% in the year ago quarter. The decrease is primarily due to lower revenue offset by improving margins from our direct business. Additionally margins were reduced due to inventory reserves of approximately $1.1 million with comparable amounts recorded in each of the three businesses.

Our operating expenses were $48 million which includes approximately $5 million of charges primarily related to severance and reserves for expected settlements related to licensing and contracts. Excluding these costs, operating expenses were 45% of revenue, down from 54% in Q2 2007 when you exclude the $18.3 million of benefit from the litigation settlement last year. The $6.7 million reduction in operating expenses from $54.7 million to $48 million is a result of the early stage of our restructuring program.

Due to our improved liquidity position, our interest expense was reduced to $93,000 in Q2 2008 from $871,000 in the second quarter of 2007. Our loss from continuing operations for the quarter ending June 30, 2008 was $9.6 million or $0.30 per diluted share. In connection with restructuring the company did include $6.6 million of charges or about $0.14 per diluted share after tax principally related to severance, inventory reserves as well settlements relates to licensing agreements.

In the second quarter of 2007 the company reported net income from continuing operations of $0.7 million or $0.02 per diluted share which included the benefit from a non-recurring litigation settlement of $18.3 million or $0.34 per diluted share after tax. Thus, on a continuing operating basis our loss was $0.16 in Q2 2008 compared with a loss of $0.32 per share in Q2 2007 which does show the early progress of our restructuring activities though we know we still have much work still to be done.

Turning to our balance sheet, inventories were $62 million compared to $59 million at the end of 2007 due to building some safety stocks on our main SKUs. One of our focus areas is to improve inventory turns so we expect inventory reduction in future periods after the consolidation of manufacturing facilities is completed. Our DSOs were 52 days and we’ll continue to work on reducing that figure as we focus on profitable selling as well as working capital management.

As of June 30, 2008 we had a $4 million net cash position and unutilized borrowing availability of approximately $35 million compared with a net debt position of $71 million as of December 31, 2007.

Through July 29 we repurchased approximately 5.1 million of common stock with 4.9 million remaining on our current authorized share repurchase program from the May 2008 Board meeting.

Now I’ll turn the call back to Ed who will review in detail our turnaround plan. As a reminder, we’ve provided a presentation online that provides specific details on our turnaround plan. You can access that presentation by going to

Edward J. Bramson

I’m going to give everybody a few seconds to access the PowerPoint presentation and then we’ll make a start.

If everybody can see the presentation, I’m going to try and remember to mention page numbers as we go through it. So starting on page 2 which is the Safe Harbor statement, obviously we’d refer you to all the cautions in here but a particular thing I want to point out is that we’re going to be discussing some profitability and other information by business unit which we haven’t done before and that involves making some management allocations. And I just want to point that out specifically in the Safe Harbor statement that they are estimates.

If you go to page 3, the firm I’m with Pier One Investors really got interested in Nautilus some time ago because we saw potentially a very strong growth business with some very valuable brands, which on the other hand clearly needed a turnaround. And I think as of today we’re perhaps halfway through the turnaround and I’ll get into what that means in a second. As we saw it there were three things that needed to be done in the turnaround, and we’ll take you through each of them.

The first we want is as exciting as the strategy which is the third but then necessary to put in place the foundation for us to grow. So the first necessity is on page 3, it’s the balance sheet and liquidity. We’ll talk about it in more depth but clearly we got into a fairly risky situation to the point where the balance sheet was making it difficult for us to have a consistent growth strategy. And I think we moved on from that now.

The second element of the turnaround is to become profitable with sales levels where they are and not where we might hope they’ll be at some point in the future, and our break-even level that got too high as a result of which when sales went off it caused us to lose money. So most of what we’re going to talk about today actually is the second point, which is improving profitability with sales where they are.

And we’re going to talk briefly about some strategic opportunities we see but we plan to come back to that in a later conference call.

If we turn to page 4, the first item is the balance sheet and liquidity. Just repeating some of what Bill had said, at the end of ‘07 we had net debt of $71 million. We also had an obligation to purchase Land America, our Chinese supplier, for $69 million. So in essence we had a financing need of $140 million. The company at that point was losing money and we were entering a credit crunch, so I would say that was not a very good situation. Since then we’ve sold the apparel business which was something that was in process when I arrived. We’ve also terminated the agreement to acquire Land America for $8 million as a result of which we are completely clean in that matter and we have no further obligations. We also have a good relationship with our supplier going forward so I think that’s a major progress.

So where we are today as Bill said we have $4 million of net cash at the end of June versus $70 million of debt the end of the year. We also have quite a bit of availability under our borrowing facilities. Sometimes this gets to be confusing. The maximum available under the facility is a fairly high number but it depends on the availability of working capital to support it. So at the end of June we could have borrowed another $35 million. I think the balance sheet position now really is quite a bit better as evidence of which the lenders were prepared to give us a consent to start a share repurchase program, which previously had been prohibited. And as Bill mentioned we’ve actually done some of that already.

If you go to page 5, most of today’s discussion is about getting profitable in current conditions and the table’s a little bit complicated but I think the easiest way to start to look at it is to compare 2003 with 2006. And I should say that all of these numbers exclude the apparel business and they also exclude non-recurring items. Back in that period I think it’s fairly clear that the company’s principal objective was to grow the top line and up until 2006 that was actually accomplished. The problem with it is that the cost of getting those sales increases was greater than the profits that they delivered.

This is not something that happened in just one year; it was a continuing trend. So again if you look at 2006, you’ll say that sales were up $120 odd million, gross profit was up $22 million as a result of that, but the GS&A costs that it took to get it were $35 million so net net you were worse off. It also put you in the position where in 2007 when sales tailed off, it had a very disproportionate effect on earnings and put us into a significant loss position. So this page is basically where we have been.

As you go to page 6, we’ll start to get into where we’re trying to get to. What we’re to do is we believe it is a good business and want to get it back on a growth track but we want to grow with profits. So if you try to reduce that to practicalities, what are you trying to do?

And we said that one objective is that this is quite a seasonal business. Q2 and Q3 are typically much lower in sales than Q1 and Q4 and often as a result generate a loss. So our belief is that to the extent we can, if we don’t lose money in the bad quarters it can only help you in the good ones. So that was the first objective: Don’t have losing quarters.

The second thing is, this is not data that we had previously disclosed, but you can see that we now have some losing business units. So the other objective of the restructuring is: Don’t have losing business units. And just to take a second on that data because it is new, you’ll see that in 2003 all the businesses were profitable. By the time you get to 2007 only direct is profitable and that’s down significantly. Compounding that corporate overhead has in essence gone up by 70% so the result is a very disastrous effect on earnings.

The other objective that we’ve set here is while we’re getting these things profitable we recognize the necessity to grow in the future, so we’ve made I think a good effort to protect the things that would give us the capability to grow again in the future. As we get into the rest of the presentation, I will take you through what those things are.

If you go to page 7, I think we need to qualify this by saying we’ve really only had three months so far so this isn’t necessarily everything that we can do in regard to costs. It’s everything we can get done in three months. To explain the table, the basis of comparison in all cases is to take 2007’s actual spending as a base and compare it to what will happen when we’ve made all the changes. So it’s a pro forma for 2007.

Just sort of running down the line items, the biggest thing of expense we’ve got is obviously the cost of product. It’s also our largest single opportunity. To date we’re planning to save about $18 million or $19 million which is a relatively small percentage. We think there’s a very big opportunity to do more here but it involves things like some product redesign which will take us a while to do. So we’re going to come back to this topic.

In the SG&A area you’ll see that we’re basically keeping appetizing flat. The change that you see there, the $2 million, is really because we’ve taken a product that was going to be a direct product and moved it into retail and we’ve taken out the related advertising. So we’re planning to keep advertising essentially flat. Marketing’s down by about $24 million in the restructuring plan and the reason for that is not exactly what you might think.

The biggest single component of that is actually reducing some duplicated effort in our international operations.

Another significant part of it is that we have been spending a lot of money on celebrity endorsements which had not proved to be very helpful in making sales.

And another significant piece of it which Bill alluded to is that we include in marketing the expense for promotions principally in the direct business. So if we have a giveaway to encourage sales, it doesn’t show up in the margin, it shows up in marketing. During the second quarter we in essence cut those things out. We were subsidizing financing and doing all sorts of other promotions. So mid-second quarter we stopped doing that and that’s a significant reason why the projected marketing expense is going to come down. It’s also a contributor to the sales decline in direct in the second quarter because that’s most of where the subsidization was going on.

General administrative we’re taking down by $11.5 million. That’s across the board but the biggest single part, in fact most of it, is in corporate overhead where we just eliminated a lot of duplication.

And then R&D or product development is down by a couple of million. The reason for that is because we want to do a lot of product development but we’re cutting it back to fewer projects and putting more resources on each project which we found in the past to be more efficient.

So the overall change that we’re forecasting relative to 2007 would be $58 million of cost savings. The way that’s made up is that at the end of 2007 the company had actually instituted some cost savings, a little bit of which showed up in the actual numbers because it was at the end of the year. Most of it doesn’t actually show up till this year. So that was $8 million. The other $50 million are things that we’re doing this year which as we said totals about $58 million at the present time.

Page 8 is trying to show the effect of the cost reductions not just in the aggregate but by each individual channel. If you look across, you’ll see that direct is getting $18 million of the benefit, commercial is getting a similar amount, retail a bit less, and corporate is coming down by about 40%. So on that basis if you go back and look at the numbers on the previous pages, each of these businesses would not have been profitable in 2007 on a pro forma basis. And that was one of our objectives that we mentioned on page 6 not to have losing business units. In fact, on a business unit contribution basis before corporate overhead, each of them would also have been profitable in the first half of 2008. So against that part of our objective, I think we’ve made significant progress.

If you go to page 9, this is the first half of 07 versus the first half of 08. Again it excludes the apparel business; it excludes restructuring; and as Bill had mentioned you’re already starting to see some of the benefits of the restructuring activities we’ve already done. So for example, as a result of sales being off in two of the businesses, not retail where they were up, gross profit is down but in each case the reduction in SG&A is at least equal to the reduction in gross profit or in some cases actually higher. And we’re about halfway through the restructuring I would say at this point.

With the rest of it we expect to get, as I’m going to go through on this subsequent slide, but given the relatively tough sales environment I think it’s timely that we made the reductions that we did and the loss although it’s still a loss is actually lower than it might otherwise have been.

If you go to page 10, this is just a quick indication of where the savings come from. In cost of goods sold as I’d said earlier, we think there’s a very big opportunity in design for manufacturing and some general cost reduction reduced type designs which will take some period of time for us to get. So all we’ve really done at the moment is relatively simple stuff. The biggest single item is the impending closure of the Tulsa factory which makes some commercial products, which we’re merging into our factory in Virginia, and I think we announced that publicly last week. The second biggest piece is actually that we’re doing a similar thing in consolidating distribution centers which saves us some overhead and also saves us some freight. So most of the cost of goods sold savings really just comes from those two items at the moment.

SG&A is pretty much everything. It’s across the board. But the biggest single piece is corporate overhead and there are a number of additional opportunities, I think principally in cost of goods sold where we only scratched the surface, and we’ll come back to those in a future discussion.

Now offsetting that, those were all the cost reduction things, but we do have offsets from things that are going on in the world outside. The economy obviously isn’t very good; credit is getting tight; and a lot of our purchases come from China where costs are going up. So even though our costs would be down by $58 million, on a pro forma basis if you annualize the first half our revenues are off by $30 million. So there are offsets to the good things we’re doing. We’re also getting increases in the cost of purchased product and it varies somewhat depending on what it is. But what we’ve seen in terms of cost increases coming out of Asia so far this year is in the range of 4% to 6% depending on the product. So net net we’re expecting to see an overall improvement from the restructuring plan but it is going to be offset by what’s happening in the economy.

If you go to page 11, the restructuring is partially but not completely done and as a result you don’t see all the benefits of it. You also don’t see the related costs all being taken care of right now. So this is an attempt to give you a sense of the timing of what’s going on with the restructuring. If you look at the first set of numbers, the cost reductions, these are cumulative quarterly run rates. So what it means is that we’ve done enough in a particular quarter to be saving at this rate and then it goes up every time. In the first quarter of 2009 when everything is done, the quarterly savings would be $14.6 million which gives you the $58 million annualized, and I think we may do a little bit better than that but that’s our current estimate. As you can see, in the second quarter of 2008 we had already accomplished enough to save $7.7 million. So we’re a little bit more than half the way done in terms of the benefits of restructuring to be achieved with about 50% still to go, which is about $6.9 million a quarter.

In terms of the expenses that are involved in the restructuring, as you can see we’ve got asset write-downs, severance, we have the payment to Land America, and then we have some other items. Of the total of $22 million we’ve already expensed by the end of the second quarter about $16.5 million, so we’re about 70% done in terms of restructuring costs with another 30% to be recognized essentially mostly as we actually close Tulsa down.

Which brings me back to the second objective that we’d said on page 6, which was to have a low quarter and not be a loss. If you look at the numbers, in the second quarter of 2008 excluding the one-time items, we lost $7.8 million. If that other $6.9 million of savings that we’ve yet to go were included, we’d have lost $900,000 pre-tax so we still would have had a loss of about $0.02 a share. It’s not where we want to get to but I think that while we haven’t achieved that goal, we are making decent progress in getting there. And since this is the worst quarter of the year, it means that we have less burden on the other three quarters to have a good year.

Page 12 is just a little bit more data for you on the restructuring. The total restructuring cost as we said is $22.6 million estimated at the moment. Of that, the cash piece is about $14.8 million and the non-cash is $7.8 million. The cash items have largely been done. We’re about 80% of the way there with 20% to go. The non-cash items we’re about 50% done and 505 more to go.

In terms of the cost reduction program as it currently stands, that’s really all we have to say today.

So I’d like to turn to page 13 and talk about strategy a little bit. We see a lot of opportunities here but in order to turn those into concrete plans to go after them, it’s going to take us a bit longer. So what we would like to do is to discuss the details of our changes in strategy with you after we’ve made some profits and had our year end. So likely in the first quarter we’ll go through this in more depth with you, but the basic goal on page 13 is to get sales growing but to do so at acceptable margins.

To give you some ideas of areas that we’re looking at, the cardio market is more than twice the size of the strength market and Nautilus generally is somewhat under-represented in cardio relative to strength, which is our larger activity. And if you look at it by business, you’ll see that we’re especially under-represented in cardio in the direct business, which for us I think is a very large strategic opportunity. Because it’s clear that at the right price point we could significantly expand the addressable market for our direct business and that’s something that we’re going to be focusing on.

In the commercial business we have recently introduced a product called Nautilus One, which is exceptionally good and is clearly the high-end product now in the strength business in commercial. However because of the high end it’s not the biggest piece of the market. The mid-market is about two-thirds bigger. So we have a project that we’re going to start to redesign our mid-market product and to become more competitive in the largest segment of the business.

We also have another issue which is that we do have a conflict between the retail and direct channel as it relates to our rod-based home gyms, and the effect of that has been that it lowers our margin somewhat and has reduced advertising efficiency. It’s a problem that’s somewhat of our own making and you can’t really eliminate it at this point, but we think that there is some opportunities through product design differentiation and branding to make this a smaller issue going forward.

If you go to page 14, turning to retail. As we said earlier we have some very strong brands which are valuable. They’re’ mostly valuable at retail. The retail business has changed. There was a time when you might have thought of it as the secondary channel for selling the direct based home gyms but it’s now actually a self-standing business. Most of its sales are actually in cardio, and it has it seems to us some fairly good opportunities to gain floor space and to gain customers in some of the larger retail stores.

But in order to do that one of the things we can do is to capitalize on the brand portfolio because we have our own and so we don’t have to license. Most of the larger competitors in this area actually have a licensing fee that they pay, so it gives us an in-built advantage and also an opportunity to differentiate. So I think there are some opportunities in the retail strategy, which again we’ll talk about in the new year.

The next item on here, which is the chart, refers to the direct business and this is actually a very large point that I want to take a little bit of time to go through. Some background. Nautilus pulls off a major marketing coo in getting people to buy things for $2,000 or so over the telephone from people they’ve never met. So it’s an excellent direct marketing operation.

But if you look at how the economics of it work, the biggest cost in direct is not the cost of the product, it’s the cost of advertising and marketing. It’s actually bigger than the product cost. So in terms of the profitability and efficiency the key is to get a good return on the advertising money that you spend, which in our case is about $75 million a year. As you can see the direct business has been losing profitability in the last few years.

As you go and look at it, what you find is that the advertising that we’re doing is generating leads at relatively good rates. So people are inquiring about our product based on the TV advertising that we do. So what has declined is the number of those leads that actually convert into a sale. That means that the advertising in effect is being used less efficiently.

We’ve done some studies in the direct business and what we’ve found is that in round numbers a product that is priced in our direct channel at $1,300 converts leads to sales at roughly twice the rate that a product that’s priced at $2,000 does. In fact the probability of the optimum price point for us is around $1,700 because you get good conversion of leads to sales and obviously we optimize our margin. The reason why this is so is partly the amount of money that people are prepared to spend but also more people qualify for credit at lower price points. So there’s good basic reasoning behind this.

Now what had been happening was as some of the business was moving from direct to retail, the direct business started introducing new products that were more costly to make and therefore had to be priced higher in order to maintain margin. And it really hasn’t worked. If you look at the chart, you’ll see that there’s a zone of optimal pricing there. In 2004 and actually earlier the direct business was selling products in the upper level of the optimal price zone. In 2005 it started to move out of that zone and you can see that sales started to come down back in 2005 going into 2006. So this is not a phenomenon that’s really particularly tied to the economy. It’s something that we did.

So we want to put a fair amount of work into this because it’s a big opportunity both in strength and in cardio for us. We think it should be very possible to redesign our products to get them down somewhat to the price points where they would sell better and then we’d have tremendous operating leverage and tremendous leverage on our advertising. So if we can pull this, off it’s a very important strategic thing. Obviously it’s something we want to talk about quite a bit when we have our next discussion about strategy.

If you go to page 15, the thing that ties this together really is that we need to put a fair amount of effort into product development. That’s partly to innovate new products because new products are more exciting. It’s also to change our emphasis somewhat to design for manufacturability and to focus really strongly on price points and on consumer differentiation. So we’ve reorganized the product development effort. We believe that the existing spending that we’re planning should be enough to do the work we’re talking about. Quite honestly if it took a million or two more temporarily to accomplish these plans, we would spend it.

So that’s really it. Just a quick overview of the strategic focus which as we said we’ll come back to more in the new year.

And turning to page 16 just to summarize, I’d say our balance sheet now is satisfactory. You might even call it good. The cost reduction program has not yet gotten to the point where we won’t have any losing quarters but we’re still working on it. And I think an important thing is it enabled us to get through the environment that we’re actually in while continuing to fund the strategic developments that will make us more money later. To that end, you’ll see that the projected costs actually keep product development and advertising at more or less the levels they are in the first half of 2008. And that’s the plan.

Another thing that attracted us to Nautilus early on is that when Nautilus does well, it’s very, very cash generative. It has very high free cash flow, and as and when that comes through we’d look to use those increased cash flows to grow but also for shareholder distributions which we’ve been doing just recently through share buy-backs.

And then the last bullet really is just a recapitulation of the areas we’re going to talk about in the new year.

And with that I’m going to stop the presentation and we’d like to open the call up for questions either on the quarter or on the operating review.

Question-and-Answer Session


(Operator Instructions) Our first question comes from Paul Swinand - Stephens, Inc.

Paul Swinand - Stephens, Inc.

My first question is on the restructuring to Virginia. What is your capacity like there? How many shifts are you running? How many buildings do you have there? Can you give us a little more detail on how that’s going to work out as you have to move other operations there?

Edward J. Bramson

Both of the factories are highly underutilized and it depends on how you look at it. Tulsa was probably less than 20% utilized on an effective basis and the factory in Virginia I believe is running a single shift most of the time Bill.

William D. Meadowcroft

Yes. In fact it had some shutdowns this last quarter as well.

Edward J. Bramson

It was not an issue of physical capacity. The belief that we have is that we can take all of the fixed costs that were incurred in Tulsa and absorb them for no extra money in Virginia. But you’d need to add some hourly labor and I think the issue is just making sure that you can go into the local labor pool and get the extra hourly workers you need, which I believe you can do.

Paul Swinand - Stephens, Inc.

And those are at a similar rate I assume?

Edward J. Bramson

Actually it’s very similar, yes.

Paul Swinand - Stephens, Inc.

And just something that caught my eye on the PowerPoint, I was surprised to see on one of the earlier slides comparing 2003 and 2007 that they’re actually spending less on marketing in the direct business. Was the former plan actually under-investing in advertising or were they just shifting stuff around?

Edward J. Bramson

Do you want to say that one again? I think you’re on page 6, is that right?

Paul Swinand - Stephens, Inc.

I’m looking for it here. It was comparing 2003. Direct business spent $79.6 million in advertising and they only expensed $75.9 million in 2007. I was surprised it went down.

Edward J. Bramson

I think it was because in direct marketing what typically you do is when the efficiency of advertising drops, you reduce the advertising. Because if you find that when you advertise for another dollar, you get two dollars of sales, you advertise more. When you find that you’re only getting another dollar, you advertise less. So it’s a relatively minor change but I think that’s the reason.

Paul Swinand - Stephens, Inc.

Are you net spending less then on advertising?

Edward J. Bramson

Well we’re spending $3 million a year less.

Paul Swinand - Stephens, Inc.

And it’s just a matter of the efficiency?

Edward J. Bramson

It is. If you could spend more and get good returns on it, I’d be the first to do it. But when the conversion rate’s dropping, the first advertising you do gets the best returns, the second gets less. So it’s just where you are on the curve of efficiency.


Our next question comes from Rommel Dionsio - Wedbush Morgan Securities.

Rommel Dionsio - Wedbush Morgan Securities

A question on the plans to grow the cardio business. The prior management team always talked about growing cardio, leveraging the Bowflex and Nautilus brands which were [inaudible] strength and the cardio. Can you just maybe share with us what you plan on doing a little differently than what had occurred over the last few years because to my knowledge it was always a strategic focus for the firm to grow the cardio business?

Edward J. Bramson

There’s a difference between planning and doing, which I think is what you’re saying. If you look at cardio, the big parts of the business are treadmills and ellipticals. And we have products there but honestly so does everybody else. So when we talk about growing in cardio what we really mean is in areas where you have some differentiation, and that basically comes down to TreadClimber. We think there’s a big opportunity to grow the TreadClimber direct business because it’s relatively small right now and it’s a distinguishable product. It hasn’t been put into retail. And the commercial TreadClimber was not one of our better design efforts I’d have to say, but customers love it. So when we say growing cardio, we’re not saying sell more treadmills. We need to sell them just to have a full line in commercial but it’s really products that are specifically Nautilus products.


Our next question comes from Reed Anderson - D.A. Davidson & Co.

Reed Anderson - D.A. Davidson & Co.

I would also add that I really appreciate the additional detail and transparency. I think that’s very helpful. A couple questions. One is just thinking about the direct business, which correct me if I’m wrong but what I was hearing is that consciously based on how you were managing that business in the second quarter, you were really trying to take that down and that’s why we saw the growth rate slower, that it dipped quite a bit. How should we think about that and its implications for the second half? Should we continue to see that business down that sort of level or was 2Q sort of an anomaly?

Edward J. Bramson

I would have to say that we didn’t plan for the sales to come down as much as they did. I think we aggravated it by cutting the promotions, and the promotions are not coming back. The key to making this thing profitable is product innovation, getting your price points right. And I haven’t really been around long enough and Bill has so he should comment on this separately. I know what people are telling me we’re going to do. I haven’t been around long enough to know how realistic it is. We’re not forecasting sales declines at the same rate in direct as we had in the second quarter but we are forecasting direct to be down year-over-year I think in the third and fourth quarter too. Bill?

William D. Meadowcroft

Right. Not at nearly as much of a pace.

Reed Anderson - D.A. Davidson & Co.

I didn’t hear all the detail in the call, but what specifically did you do and what was the timing of that in the direct business when you pulled the promotion, the support? What exactly was that?

Edward J. Bramson

Promotion in the direct, what happens is to get sales up you tend to sort of do things at the end of the quarter. So we’re not giving free freight which actually is fairly expensive. Another thing is in the credit area, what you can do if you want to is you can subsidize the cost of credit and that’s what shows up in marketing. So you actually pay some dollars to the credit card company and they lend more than they otherwise would or they lend it at a lower rate. Sort of like the automobile business if you want to think of it that way. And we were doing a lot of that. So what it was doing is it was polluting the margins. You think your margin’s higher than it really is. And we just sort of said, “Look, you don’t really need to do that.” And a better way of doing it is getting the price point to where you don’t have to subsidize financing. So I’m not sure when we cut that off Bill but it was during the second quarter?

William D. Meadowcroft

It was the end of May.

Reed Anderson - D.A. Davidson & Co.

The last question is just on the cost side. Ed you commented a little bit about what you’re seeing out there and I think back to the last call, I think at one point you talked you had maybe some price adjustments potentially coming in September or October. Bill or Ed, could you just give us an update of how far out your costs as you think about the expectations you gave us today and where the inflections might be?

Edward J. Bramson

I think it goes through October on the cost side.

William D. Meadowcroft

Yes. The windows have certainly narrowed Reed as you can expect. In China there’s a lot of pressure there so we are pretty much out through October for the majority at this point.

Edward J. Bramson

We are actually out bidding some new products as part of the strategic development. And the 4% to 6% number at least on new stuff doesn’t appear to be changing all that much.


Our next question comes from Greg Scott - Merriman Curhan Ford & Co.

Greg Scott - Merriman Curhan Ford & Co.

I was just wondering if you could give me a little color. With everything else being so weak, I was just kind of curious why retail was so strong? Definitely up a lot higher than what we were modeling. I know you mentioned Schwinn and Bowflex but could you give a little more color on the retail?

Edward J. Bramson

Part of it is you’re comparing with the really absolutely horrible quarter last year and we have had a fairly strong emphasis on specialty retail which as you know we’ve been de-emphasizing lately, so what you had was the sales to specialty retail going down. And we’ve got better relationships going now with some of the larger fitness retailers and they’ve now started to pick up and that’s really what you’re seeing. And we’ve also got additional cardio products that we’re putting in and we have a relatively small share of floor space in the places that we’re in and we’re finding that if we say we’d like to have a new product. Like we actually have a new elliptical that we’re going to be putting in that was a direct product that’s going into retail now, we’re finding a fairly good response. Starting from a relatively small base, it’s doing well. And one thing I would say is we do monitor sell-through pretty clearly now which we didn’t always in the past. And I’m told that the sales we’re making are representative of sell-through.

Greg Scott - Merriman Curhan Ford & Co.

Do you have any sense that there’s a lot of product on the shelves or are the retailers seeing decreased demand right now?

Edward J. Bramson

That’s what I was trying to say that what we’re experiencing is about what they’re selling to the best of my knowledge.


At this time there are no further questions. This concludes today’s conference call.

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