10-K 1 nautilus10-k2013.htm 10-K Nautilus 10-K 2013

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-K
 
 
(Mark One)
[x]
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2013
OR
[ ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM                      TO                     
Commission file number: 001-31321
 
 
 
NAUTILUS, INC.
(Exact name of Registrant as specified in its charter)
 
 
 
 
Washington
 
94-3002667
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
17750 S.E. 6th Way
Vancouver, Washington 98683
(Address of principal executive offices, including zip code)
(360) 859-2900
(Registrant's telephone number, including area code)
 
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Name of each exchange on which registered
Common Stock, no par value
 
New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None.
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  [ ]  No  [x]
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  [ ]    No  [x]
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  [x]    No  [ ]
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  [x]    No  [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    [x]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:
Large accelerated filer  [ ]            Accelerated filer  [x]        Non-accelerated filer  [ ]            Smaller reporting company  [ ]
(do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  [ ]    No  [x]
The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the last sales price ($8.69) as reported on the New York Stock Exchange as of the last business day of the registrant's most recently completed second fiscal quarter (June 30, 2013) was 270,351,305.
The number of shares outstanding of the registrant's common stock as of February 26, 2014 was 31,169,656 shares.
Documents Incorporated by Reference
The registrant has incorporated by reference into Part III of this Form 10-K portions of its Proxy Statement for its 2014 Annual Meeting of Shareholders.
 



NAUTILUS, INC.
2013 FORM 10-K ANNUAL REPORT
 
 
 
Item 1.
 
Item 1A.
 
Item 1B.
 
Item 2.
 
Item 3.
 
Item 4.
 
 
 
 
 
 
 
 
Item 5.
 
Item 6.
 
Item 7.
 
Item 7A.
 
Item 8.
 
Item 9.
 
Item 9A.
 
Item 9B.
 
 
 
 
 
 
 
 
Item 10.
 
Item 11.
 
Item 12.
 
Item 13.
 
Item 14.
 
 
 
 
 
 
 
 
Item 15.
 
 
 
 
 





PART I

Forward-Looking Statements

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as "plan," "expect," "aim," "believe," "project," "intend," "estimate," "will," "should," "could," and other terms of similar meaning typically identify forward-looking statements. The forward-looking statements in this report include, without limitation: our prospects, resources or capabilities; current or future financial trends; future operating results; future plans for introduction of new products; anticipated demand for our new and existing products; maintenance of appropriate inventory levels; growth in revenues and profits; leverage of operating expenses; future revenues from our licensing initiative; results of increased media investment in the Direct segment; continued improvement in operating margins; expectations for increased Research and Development expenses; the amount expected to be spent on software and equipment in 2014; fluctuations in Net Sales due to seasonality; and our ability to continue to fund our operating and capital needs for the following twelve-month period. Forward-looking statements also include any statements related to our expectations regarding future business and financial performance or conditions, anticipated sales growth across markets, distribution channels and product categories, expenses and gross margins, profits or losses, losses from discontinued operations, settlements of warranty obligations, the anticipated outcome of litigation to which we are a party, new product introductions, financing and working capital requirements and resources. These forward-looking statements, and others we make from time-to-time, are subject to a number of risks and uncertainties. Many factors could cause actual results to differ materially from those projected in forward-looking statements, including the risks described in Part I, Item 1A of this report. We do not undertake any duty to update forward-looking statements after the date they are made or conform them to actual results or to changes in circumstances or expectations.

Item 1. Business

OVERVIEW

Founded in 1986, Nautilus is a consumer fitness products company headquartered in Vancouver, Washington and incorporated in the State of Washington in January 1993. We are committed to providing innovative, quality solutions to help people achieve a fit and healthy lifestyle. Our principal business activities include designing, developing, sourcing and marketing high-quality cardio and strength fitness products and related accessories for consumer use, primarily in the United States and Canada. Our products are sold under some of the most-recognized brand names in the fitness industry: Nautilus®, Bowflex®, Schwinn®, Schwinn Fitness™ and Universal®.

We market our products through two distinct distribution channels, Direct and Retail, which we consider to be separate business segments. Our Direct business offers products directly to consumers through television advertising, catalogs and the Internet. Our Retail business offers our products through a network of independent retail companies with stores and websites located in the United States and internationally. We also derive a portion of our revenue from the licensing of our brands and intellectual property.

Beginning in 2009, we began the divestiture of our Commercial business, which focused on the sale of commercial fitness equipment into gyms, health clubs, and fitness centers. While that process was largely completed in 2011, several European subsidiaries are in the liquidation process and are awaiting formal government approval to complete the liquidation. Results of operations from the Commercial business are presented as Discontinued Operations for all periods. There was no revenue related to the Commercial business for the years ended December 31, 2013 or 2012.

BUSINESS STRATEGY

We are focused on developing and marketing consumer fitness equipment and related products to help people enjoy healthier lives. Our products are targeted to meet the needs of a broad range of consumers, including fitness enthusiasts and individuals who are seeking the benefits of regular exercise. We have diversified our business by expanding our portfolio of high-quality fitness equipment into multiple product lines utilizing our well-recognized brand names. Our business strategy focuses exclusively on consumer products, markets and distribution channels.
 
Our strategies incorporate the individual characteristics of our Direct and Retail businesses. Our Direct business focuses on: (i) the development of, or acquisition of rights to, unique products; (ii) the application of creative, cost-effective ways to communicate the benefits of their use; and (iii) making various payment options available to our customers. We are particularly attentive to Direct business metrics that provide feedback regarding the effectiveness of our media marketing programs and attractiveness of third-party consumer financing programs.


1


In our Retail business, we strive to develop long-term relationships with key retailers of sports or fitness equipment. The primary objectives of our Retail business are (i) to offer a selection of products at key price-points; and (ii) to utilize the strength of our brands and long-standing customer relationships to secure more floor space with our Retail customers for our products.

Our long-term strategy involves:
creatively marketing our equipment, both directly to consumers and through our Retail customers, while leveraging our well-known brand names;
enhancing our product lines by designing fitness equipment that meets or exceeds the high expectations of our customers;
utilizing our strengths in product engineering to reduce product costs;
continuing our investment in research and development activities aimed at acquiring or creating new technologies;
increasing our international Retail sales and distribution; and
increasing royalty revenues from the licensing of our brands and intellectual property.

PRODUCTS

We market quality cardiovascular and strength fitness products that cover a broad range of price points and features. Our products are designed for home use by individuals with varying exercise needs. From the person who works out occasionally to the serious athlete, we have products that will help them achieve their fitness objectives.

Nautilus® is our corporate umbrella brand and is also used to differentiate certain specialized cardio, ellipticals and bike products.
Our Bowflex® brand represents a highly-regarded line of fitness equipment comprised of both cardio and strength products, including the TreadClimber® and MAX TrainerTM specialized cardio machines, treadmills, PowerRod® and Revolution® home gyms, and SelectTech® dumbbells.
Our Schwinn® brand is known for its popular line of exercise bikes, including the Airdyne®, and ellipticals.
Our Universal® brand, one of the oldest and most recognized names in the fitness industry, currently offers a line of kettlebell weights and weight benches.
  

While we offer our full product assortment to our Direct customers through our Internet websites and our catalogs, we generally differentiate the product models offered in our Direct and Retail sales channels. Currently, our Bowflex® TreadClimber® and MAX TrainerTM product lines are offered for sale primarily through our Direct sales channel.

Approximately 69% of our revenue in 2013 was derived from sales of consumer cardio products. While we continue to be a leader in the consumer strength product category, we believe the much larger market for cardio products offers us greater opportunity for growth.
 
BUSINESS SEGMENTS AND GEOGRAPHIC INFORMATION

We conduct our business in two segments, Direct and Retail. For further information regarding our segments and geographic information, see Note 14, Segment and Geographic Information, to our consolidated financial statements in Part II, Item 8 of this report.

SALES AND MARKETING

Direct
In our Direct business, we market and sell our products, principally Bowflex® cardio and strength products, directly to consumers. While we are, and plan to continue to be, a large direct marketer of strength products in the United States, our advertising emphasis has shifted toward cardio products, especially the Bowflex® TreadClimber®, as cardio products represent the largest component of the fitness equipment market and a growing part of our business. Sales of cardio products represented 84% of our Direct channel revenues in 2013, compared to 81% in 2012 and 71% in 2011.

Our marketing efforts are based on an integrated combination of media and direct consumer contact. In addition to television advertising, which ranges in length from 30 seconds to as long as three minutes, we utilize Internet advertising, product websites, inquiry-response mailings, catalogs and inbound/outbound call centers. Marketing and media effectiveness is measured continuously based on sales inquiries generated, cost-per-lead, conversion rates, return on investment and other performance metrics and we strive to optimize the efficiency of our marketing and media expenditures based on this data. Almost all of our Direct customer orders are received either on our Internet websites or through company-owned and third-party call centers.


2


In order to facilitate consumer purchases, we partner with several third party credit providers. Credit approval rates are an important variable in the number of Direct products we sell in a given period. Combined consumer credit approvals by our primary and secondary U.S. third-party financing providers increased to 36% in 2013 from 32% in 2012 and 25% in 2011.

Retail
In our Retail business, we market and sell a comprehensive line of consumer fitness equipment under the Nautilus®, Schwinn®, Universal® and Bowflex® brands. Our products are marketed through a network of retail companies, consisting of sporting goods stores, Internet retailers, large-format and warehouse stores, and, to a lesser extent, smaller specialty retailers and independent bike dealers.

We offer programs that provide price discounts to our Retail customers for ordering container-sized shipments or placing orders early enough in the season to allow for more efficient manufacturing by our Asian suppliers. These programs are designed to reduce our shipping and handling costs, with much of the savings being passed on to our customers. In addition, we often offer other types of sales incentives to our Retail customers, including volume discounts and various forms of rebates or allowances, which generally are intended to increase product exposure and availability for consumers, reduce transportation costs, and encourage marketing and promotion of our brands or specific products.

PRODUCT DESIGN AND INNOVATION

Innovation is a vital part of our business, and we continue to expand and diversify our product offerings by leveraging our research and development capabilities. We constantly search for new technologies and innovations that will help us grow our business, either through higher sales or increased production efficiencies. To accomplish this objective, we seek out ideas and concepts both within our company and from outside inventors.

We rely on financial and engineering models to assist us in assessing the potential operational and economic impacts of adopting new technologies and innovations. If we determine that a third-party technology or innovation concept meets certain technical and financial criteria, we may enter into a licensing arrangement to utilize the technology or, in certain circumstances, purchase the technology for our own use. Our product design and engineering teams also invest considerable effort to improve product design and quality. As a consumer-driven company, we invest from time-to-time in qualitative and quantitative consumer research to help us assess new product concepts, optimal features and anticipated consumer adoption.

Our research and development expenses were $5.6 million, $4.2 million and $3.2 million in 2013, 2012 and 2011, respectively, as we increased our investment in new product development resources and capabilities. We expect our research and development expenses to increase in 2014 as we continue to increase our investment in new product development.

SEASONALITY

We expect our sales from fitness equipment products to vary seasonally. Sales are typically strongest in the first and fourth quarters, followed by the third quarter, and are generally weakest in the second quarter. We believe that, during the spring and summer months, consumers tend to be involved in outdoor activities, including outdoor exercise, which impacts sales of indoor fitness equipment. This seasonality can have a significant effect on our inventory levels, working capital needs and resource utilization.
 
MERCHANDISE SOURCING

All of our products are produced by third-party manufacturers, and, in 2013, all of our manufacturing partners were located in Asia. Although multiple factories bid on and are able to produce most of our products, we typically select one factory to produce any given product. Lead times for inventory purchases from our Asian suppliers, from order placement to receipt of goods, generally range from approximately two to three months, of which transit time represents three-to-four weeks. The length of our lead times requires us to place advance manufacturing orders based on management forecasts of future demand for our products. We attempt to compensate for our long replenishment lead times by maintaining adequate levels of inventory at our warehousing facilities.

We monitor our suppliers' ability to meet our product needs and we participate in quality assurance activities to reinforce adherence to our quality standards. Our third-party manufacturing contracts are generally of annual or shorter duration, or manufactured products are sourced on the basis of individual purchase orders. Our manufacturing relationships are non-exclusive, and we are permitted to procure our products from other sources at our discretion.  None of our manufacturing contracts include production volume or purchase commitments on the part of either party. Our third-party manufacturers are responsible for the sourcing of raw materials and producing parts and finished products to our specifications.


3


LOGISTICS

Our warehousing and distribution facilities are located in Portland, Oregon and Winnipeg, Manitoba. In our Direct business, we strive to maintain inventory levels that will allow us to ship our products shortly after receiving a customer's order. We use common carriers for substantially all of our merchandise shipments to Direct customers.

In our Retail business, we manage our inventory levels to accommodate anticipated seasonal changes in demand. Generally, we maintain higher inventory levels at the end of the third and fourth quarters to satisfy relatively higher consumer demand in the fourth and first quarters of each year. Many of our Retail customers place orders well in advance of peak periods of consumer demand to ensure an adequate supply for the anticipated selling season.

In 2013 approximately 40% of our Retail inventory replenishment orders were shipped by our contract manufacturers in Asia directly to our Retail customer locations, typically in container loads. The use of such direct shipments allows us to maintain lower levels of inventory in our warehouses, resulting in lower storage, handling, freight, insurance and other costs. We use various commercial truck lines for our merchandise shipments to Retail customers.

COMPETITION

The markets for all of our products are highly competitive. We believe the principal competitive factors affecting our business are quality, brand recognition, innovation and pricing. We believe we are well positioned to compete in markets in which we can take advantage of our strong brand names, and that our focus on innovative product design, quality, and performance distinguishes our products from the competition.

Our products compete directly with those offered by a large number of companies that market consumer fitness equipment and fitness programs. As the use of Internet websites for product sales by traditional retailers has increased, our competitors have become increasingly similar across our Direct and Retail sales channels.

Our principal competitors include: Fitness Quest, ICON Health & Fitness, Johnson Health Tech, Beach Body and American Telecast. We also compete with marketers of computer-based physical activity products, such as the Nintendo Wii® and Microsoft Xbox® Kinect®, and weight management companies, such as Weight Watchers, each of which offers alternative solutions for a fit and healthy lifestyle.

EMPLOYEES

As of February 21, 2014, we had approximately 311 employees, substantially all of whom were full-time. None of our employees are subject to collective bargaining agreements. We have not experienced a material interruption of our operations due to labor disputes.

INTELLECTUAL PROPERTY

Trademarks, patents and other forms of intellectual property are vital to the success of our business and are an essential factor in maintaining our competitive position in the health and fitness industry.

Trademarks
We own many trademarks including Nautilus®, Bowflex®, PowerRod®, Revolution®, TreadClimber®, MAX TrainerTM, SelectTech®, Trimline®, Airdyne®, CoreBody Reformer® and Universal®. Nautilus is the exclusive licensee under the mark Schwinn® for indoor fitness products. We believe that having distinctive trademarks that are readily identifiable by consumers is an important factor in creating a market for our products, maintaining a strong company identity and developing brand loyalty among our customers. In addition, we have granted licenses to certain third-parties to use the Nautilus, Schwinn and TreadClimber tradenames on commercial fitness products, for which we receive royalty income and expanded consumer awareness of our brands.

Each federally registered trademark is renewable indefinitely if the trademark is still in use at the time of renewal. We are not aware of any material claims of infringement or other challenges to our trademark rights in our major markets.


4


Patents
Building our intellectual property portfolio is an important factor in maintaining our competitive position in the health and fitness equipment industry. We have followed a policy of filing applications for U.S. and non-U.S. patents on utility and design inventions that we deem valuable to our business.

We own or license patents covering a variety of technologies, some of which are utilized in our variable stride ellipticals, selectorized dumbbells and recumbent exercise bikes. Nautilus is also the exclusive licensee of patents that cover the Bowflex® Revolution home gyms. Patent protection for these technologies, which are utilized in products sold in both the Direct and Retail segments, extends as far as 2020.

Additionally, we maintain a portfolio of patents related to our Bowflex® TreadClimber® specialized cardio machines, which are sold primarily in our Direct segment. The portfolio is comprised of approximately 24 issued U.S. patents covering various product features and other technologies associated with our TreadClimber® products.

A patent covering certain aspects of our TreadClimber® products expired in 2013. Additional individual patents covering elements of our TreadClimber® products have expiration dates ranging from 2016 to 2027. Expiration or invalidity of patents within our TreadClimber® portfolio could trigger the introduction of similar products by our competitors. Although we view each of the patents within our portfolio as very valuable, we do not view any single patent as critical to our success or ability to differentiate our TreadClimber® products from similar products that may be introduced by competitors in the future. We regularly monitor commercial activity in our industry to guard against potential infringement. We protect our proprietary rights vigorously and take prompt, reasonable actions to prevent counterfeit or products and other infringement on our intellectual property.

BACKLOG

Historically, our backlog has not been a significant factor in our business. Our customer order backlog as of December 31, 2013 and 2012 was approximately $1.4 million and $0.1 million, respectively.

SIGNIFICANT CUSTOMERS

In 2013, 2012 and 2011, Amazon.com accounted for 11.2%, 11.7% and 11.0%, respectively, of our Net Sales.
ENVIRONMENTAL AND OTHER REGULATORY MATTERS

Our operations are subject to various laws and regulations both domestically and abroad. In the United States, federal, state and local regulations impose standards on our workplace and our relationship with the environment. For example, the U.S. Environmental Protection Agency, Occupational Safety and Health Administration and other federal agencies have the authority to promulgate regulations that may impact our operations. In particular, we are subject to legislation placing restrictions on our generation, emission, treatment, storage and disposal of materials, substances and wastes. Such legislation includes: the Toxic Substances Control Act; the Resource Conservation and Recovery Act; the Clean Air Act; the Clean Water Act; the Safe Drinking Water Act; and the Comprehensive Environmental Response and the Compensation and Liability Act (also known as Superfund). We are also subject to the requirements of the Consumer Product Safety Commission and the Federal Trade Commission, in addition to regulations concerning employee health and safety matters.
Our operations and certain disposed components of our former Commercial business expose us to claims related to environmental matters. Although compliance with federal, state, local and international environmental legislation has not had a material adverse effect on our financial condition or results of operations in the past, there can be no assurance that material costs or liabilities will not be incurred in connection with such environmental matters in the future.

AVAILABLE INFORMATION

Our common stock is listed on the New York Stock Exchange and trades under the symbol “NLS.” Our principal executive offices are located at 17750 SE 6th Way, Vancouver, Washington 98683, and our telephone number is (360) 859-2900. The Internet address of our corporate website is http://www.nautilusinc.com.

We file annual reports, quarterly reports, current reports, proxy statements and other information with the Securities and Exchange Commission (the “SEC”) under the Securities Exchange Act of 1934, as amended. You can inspect and obtain a copy of our reports, proxy statements and other information filed with the SEC at the offices of the SEC's Public Reference Room at 100 F Street N.E., Washington, D.C. 20549, on official business days during the hours of 10 a.m. to 3 p.m. EST. Please call the SEC at 1-800-

5


SEC-0330 for further information on the Public Reference Room. The SEC maintains an Internet website at http://www.sec.gov where you can access copies of most of our SEC filings.

We make our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports, available free of charge on our corporate website. In addition, our Code of Business Conduct and Ethics, corporate governance policies, and the charters of our Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee are available on our corporate website. The information presented on our corporate website is not part of this report.

Item 1A. Risk Factors

Nautilus operates in an environment that involves a number of risks and uncertainties. The risks and uncertainties described in this Annual Report on Form 10-K are not the only risks and uncertainties that we face. Additional risks and uncertainties that presently are not considered material or are not known to us, and therefore are not mentioned herein, may impair our business operations. If any of the risks described in this Annual Report on Form 10-K actually occur, our business, operating results and financial position could be adversely affected.

Our revenues and profitability can fluctuate from period to period and are often difficult to predict due to factors beyond our control.
 
Our results of operations in any particular period may not be indicative of results to be expected in future periods, and have historically been, and are expected to continue to be, subject to periodic fluctuations arising from a number of factors, including:
Introduction and market acceptance of new products and sales trends affecting specific existing products;
Variations in product selling prices and costs and the mix of products sold;
Size and timing of Retail customer orders, which, in turn, often depend upon the success of our customers' businesses or specific products;
Changes in the market conditions for consumer fitness equipment;
Changes in macroeconomic factors;
Availability of consumer credit;
Timing and availability of products coming from our offshore contract manufacturing suppliers;
Seasonality of markets, which vary from quarter-to-quarter and are influenced by outside factors such as overall consumer confidence and the availability and cost of television advertising time;
Effectiveness of our media and advertising programs;
Customer consolidation in our Retail segment, or the bankruptcy of any of our larger Retail customers;
Restructuring charges;
Goodwill and other intangible asset impairment charges; and
Legal and contract settlement charges.
 
These trends and factors could adversely affect our business, operating results, financial position and cash flows in any particular period. 

Intense competition or loss of one or more of our large Retail customers could negatively impact our sales and operating results.
 
Our products are sold in highly competitive markets with limited barriers to entry. As a result, introduction by competitors of lower-priced or more innovative products could result in a significant decline in our revenues and have a material adverse effect on our operating results, financial position and cash flows.

Additionally, we derive a significant portion of our revenue from a small number of Retail customers. A loss of business from one or more of these large customers, if not replaced with new business, could negatively affect our operating results and cash flow.

A decline in sales of TreadClimber products without a corresponding increase in sales of other products would negatively affect our future revenues and operating results.

Sales of cardio products, especially Bowflex® TreadClimber® products, represent a substantial portion of our Direct segment revenues. Introduction by competitors of comparable products at lower price-points, a maturing product lifecycle or other factors

6


could result in a decline in our revenues derived from these products. A significant decline in our sales of these products would have a material adverse effect on our operating results, financial position and cash flows.
Portions of our operating expenses and costs of goods sold are relatively fixed, and we may have limited ability to reduce expenses sufficiently in response to any revenue shortfalls.
Many of our operating expenses are relatively fixed. We may not be able to adjust our operating expenses or other costs sufficiently to adequately respond to any revenue shortfalls. If we are unable to reduce operating expenses or other costs quickly in response to any declines in revenue, it would negatively impact our operating results, financial condition and cash flows.

If we are unable to anticipate consumer preferences or to effectively develop, market and sell future products, our future revenues and operating results could be adversely affected.
 
Our future success depends on our ability to effectively develop, market and sell new products that respond to new and evolving consumer preferences. Accordingly, our revenues and operating results may be adversely affected if we are unable to develop or acquire rights to new products that satisfy consumer preferences. In addition, any new products that we market may not generate sufficient revenues to recoup their acquisition, development, production, marketing, selling and other costs.

Further decline or weaker than expected recovery in consumer spending likely would negatively affect our product revenues and earnings.
 
Success of each of our products depends substantially on the amount of discretionary funds available to our customers. Global credit and financial markets have experienced extreme disruptions in the recent past, including severely diminished liquidity and credit availability, declines in consumer confidence, declines in economic growth, increases in unemployment rates and uncertainty about economic stability. There can be no assurance that there will not be further deterioration in these conditions. Further decline or weaker than expected recovery in general economic conditions could further depress consumer spending, especially spending for discretionary consumer products such as ours. Poor economic conditions could in turn lead to substantial decreases in our net sales or have a material adverse effect on our operating results, financial position and cash flows.

Our business is affected by seasonality which results in fluctuations in our operating results.
 
We experience fluctuations in aggregate sales volume during the year. Sales are typically strongest in the first and fourth quarters, followed by the third quarter, and are generally weakest in the second quarter. However, the mix of product sales may vary considerably from time to time as a result of changes in seasonal and geographic demand for particular types of fitness equipment. In addition, our customers may cancel orders, change delivery schedules or change the mix of products ordered with minimal notice. As a result, we may not be able to accurately predict our quarterly sales. Accordingly, our results of operations are likely to fluctuate significantly from period to period.
 
Government regulatory actions could disrupt our marketing efforts and product sales.
 
Various international and U.S. federal, state and local governmental authorities, including the Federal Trade Commission, the Consumer Product Safety Commission, the Securities and Exchange Commission and the Consumer Financial Protection Bureau, regulate our product and marketing efforts. Our sales and profitability could be significantly harmed if any of these authorities commence a regulatory enforcement action that interrupts our marketing efforts, results in a product recall or negative publicity, or requires changes in product design.

Substantially higher advertising rates or a significant decline in availability of media time may hinder our ability to effectively market our products and may reduce profitability.
 
We depend on television advertising to market certain products sold directly to consumers. Consequently, a marked increase in the price we must pay for our preferred media time and/or a reduction in its availability may adversely impact our financial performance.
 
We may be unable to adapt to significant changes in media consumption habits, which could diminish the effectiveness or efficiency of our advertising.

New television technologies and services, such as video-on-demand, digital video recorders and Internet streaming services are changing traditional patterns of television viewing. Additionally, consumer attention is increasingly fragmented across a variety of games, apps, the Internet and other digital media. If we are unable to successfully adapt our media strategies to new television

7


viewing and media consumption habits, the effectiveness and efficiency of our media placements could be adversely affected, and our operating results may be harmed.

Our revenues could decline due to changes in credit markets and decisions made by credit providers.
 
Historically, a significant portion of our Direct sales have been financed for our customers under various programs offered by third-party consumer credit financing sources. Reductions in consumer lending and the availability of consumer credit could limit the number of customers with the financial means to purchase our products. Higher interest rates could increase monthly payments for consumer products financed through one of our monthly payment plans or through other sources of consumer financing. In the past, we have partnered with financial service companies to assist our customers in obtaining financing to purchase our products. Our present agreements with our third party consumer credit financing providers enable certain customers to obtain financing if they qualify for the provider's private label revolving credit card. We cannot be assured that our third party financing providers will continue to provide consumers with access to credit or that credit limits under such arrangements will not be reduced. Such restrictions or reductions in the availability of consumer credit could have a material adverse impact on our results of operations, financial position and cash flows.
 
If our contract manufacturers experience any delay, disruption or quality control problems in their operations, we could lose revenues, and our reputation and market share may be harmed.
 
We have outsourced the production of all of our products to third-party manufacturers. We rely on our contract manufacturers to procure components and provide spare parts in support of our warranty and customer service obligations. We generally commit the manufacturing of each product to a single contract manufacturer.
 
Our reliance on contract manufacturers exposes us to the following risks over which we may have limited control:
Unexpected increases in manufacturing and repair costs;
Interruptions in shipments if our contract manufacturer is unable to complete production;
Inability to completely control the quality of finished products;
Inability to completely control delivery schedules;
Changes in our contract manufacturer's business models or operations;
Potential increases in our negotiated product costs as a result of fluctuations in currency exchange rates;
Impact of the global market and economic conditions on the financial stability of our contract manufacturers and their ability to operate without requesting earlier payment terms or letters of credit;
Potential lack of adequate capacity to manufacture all or a part of the products we require; and
Potential unauthorized reproduction or counterfeiting of our products.
 
Substantially all of our contract manufacturers are located in Asia, primarily China, and may be subject to disruption by natural disasters, as well as political, social or economic instability. The temporary or permanent loss of the services of any of our primary contract manufacturers could cause a significant disruption in our product supply chain and operations and delays in product shipments.
 
Our third-party manufacturing contracts are generally of annual or shorter duration, or manufactured products are sourced on the basis of individual purchase orders. There is no assurance that we will be able to maintain our current relationships with these parties or, if necessary, establish future arrangements with other third-party manufacturers on commercially reasonable terms. Further, while we maintain an active quality control, factory inspection and qualification program, we cannot assure that their manufacturing and quality control processes will be maintained at a level sufficient to meet our inventory needs or prevent the inadvertent sale of substandard products. While we believe that products manufactured by our current third-party manufacturers could generally be procured from alternative sources, temporary or permanent loss of services from a significant manufacturer could cause disruption in our supply chain and operations.
 
Our inventory purchases are subject to long lead times, which could negatively impact our sales, cash flows and liquidity.
 
All of our products are produced by third-party manufacturers, substantially all of which are located in Asia, primarily China. Lead times for inventory purchases from our Asian suppliers, from order placement to receipt of goods, generally range from approximately two to three months, of which transit time represents three-to-four weeks. The length of our lead times requires us to place advance manufacturing orders based on management forecasts of future demand for our products. Due to the length of our lead times, our sales and cash flows may be negatively impacted if we do not have sufficient inventory on hand to meet customer demand for such items. In addition, our liquidity and cash flows may be negatively affected, and inventory obsolescence may increase, if the quantity of products we order exceeds customer demand for such items.
 

8


A delay in getting non-U.S.-sourced products through port operations and customs in a timely manner could result in reduced sales, canceled sales orders and unanticipated inventory accumulation.
 
Most of our imported products are subject to duties or tariffs that affect the cost and quantity of various types of goods imported into the U.S. or our other markets. The countries in which our products are produced or sold may adjust or impose new quotas, duties, tariffs or other restrictions. Further, our business depends on our ability to source and distribute products in a timely manner. As a result, we rely on the free flow of goods through open and operational ports worldwide. Labor disputes at various ports create significant risks for our business, particularly if these disputes result in work slowdowns, lockouts, strikes or other disruptions during our peak importing seasons. Any of these factors could result in reduced sales, canceled sales orders and unanticipated inventory accumulation and have a material adverse effect on our operating results, financial position and cash flows.
 
Unpredictable events and circumstances relating to our international operations, including our use of non-U.S. manufacturers, could have a material adverse effect on our business.

Substantially all of our products are manufactured outside of the U.S. and a portion of our revenue is derived from sales outside the U.S., primarily in Canada. Accordingly, our future results could be materially adversely affected by a variety of factors pertaining to international trade, including: changes in a specific country's or region's political or economic conditions; trade restrictions; import and export licensing requirements; changes in regulatory requirements; additional efforts to comply with a variety of foreign laws and regulations; and longer payment cycles in certain countries, thus requiring us to finance customer purchases over a longer period than those made in the U.S. In addition, we rely on the performance of our employees located in foreign countries. Our ability to control the actions of these employees may be limited by the laws and regulations in effect in each country. Changes in any of the above factors could have a material adverse effect on our operating results, financial position and cash flows.

Currency exchange rate fluctuations could result in higher costs, reduced margins or decreased international sales.
 
Substantially all of our products are manufactured outside of the U.S. and, therefore, currency exchange rate fluctuations could result in higher costs for our products, or could disrupt the business of independent manufacturers that produce our products, by making their purchases of raw materials more expensive and more difficult to finance. Our future financial results could be significantly affected by the value of the U.S. dollar in relation to the foreign currencies in which we, our customers or our suppliers conduct business. Past fluctuations in the Chinese Renminbi exchange rate have caused our costs for certain products to increase, reducing our margins and cash flows. Similar fluctuations and cost increases may occur in the future. If we are unable to increase our selling prices to offset such cost increases, or if such increases have a negative impact on sales of our products, our revenues and margins would be reduced and our operating results and cash flows would be negatively impacted. In addition, a portion of our revenue is derived from sales outside the U.S., primarily in Canada. Currency rate fluctuations could make our products more expensive for foreign consumers and reduce our sales, which would negatively affect our operating results and cash flows.
 
We may face competition from providers of comparable products in categories where our patent protection is limited or reduced due to patent expiration. Increased competition in those product categories could negatively affect our future revenues and operating results.

A patent covering aspects of our TreadClimber® products expired during 2013. Although we own a number of other patents covering aspects of our TreadClimber® products, the introduction of comparable products designed to compete with our TreadClimber® line of specialized cardio machines may increase in the future as a result of these patent expirations. Sales of cardio products, especially Bowflex® TreadClimber® products, represent a substantial portion of our Direct segment revenues. Introduction by competitors of comparable products, a maturing product lifecycle or other factors could result in a decline in our revenues derived from these products. A significant decline in our sales of these products would have a material adverse effect on our operating results, financial position and cash flows.

Failure or inability to protect our intellectual property could significantly harm our competitive position. 

Protecting our intellectual property is an essential factor in maintaining our competitive position in the health and fitness industry. Failure to maximize or to successfully assert our intellectual property rights could impact our competitiveness. We rely on trademark, trade secret, patent and copyright laws to protect our intellectual property rights. Many factors bear upon the exclusive ownership and right to exploit intellectual properties, including, without limitation, prior rights of third parties and nonuse and/or nonenforcement by us and/or related entities. While we make efforts to develop and protect our intellectual property, the validity, enforceability and commercial value of our intellectual property rights may be reduced or eliminated. We cannot be sure that our intellectual property rights will be maximized or that they can be successfully asserted. There is a risk that we will not be able to obtain and perfect our own or, where appropriate, license intellectual property rights necessary to compete successfully within the

9


marketplace for our products. We cannot be sure that these rights, if obtained, will not be invalidated, circumvented or challenged in the future. If we do not, or are unable to, adequately protect our intellectual property, then we may face difficulty in differentiating our products from those of our competitors and our business, operating results and financial condition may be adversely affected.
 
Trademark infringement or other intellectual property claims relating to our products could increase our costs.
 
Our industry is susceptible to litigation regarding trademark and patent infringement and other intellectual property rights. We could become a plaintiff or defendant in litigation involving trademark or patent infringement claims or claims of breach of license. The prosecution or defense of intellectual property litigation is both costly and disruptive of the time and resources of our management, regardless of the claim's merit. We could also be required to pay substantial damages or settlement costs to resolve intellectual property litigation or related matters.

We also may not be able to successfully acquire intellectual property rights, protect existing rights, or potentially prevent others from claiming that we have violated their proprietary rights when we launch new products. We could incur substantial costs in defending against such claims even if they are without basis, and we could become subject to judgments or settlements requiring us to pay substantial damages, royalties or other charges.

Future impairments of intangible assets could negatively impact our operating results.
 
We had goodwill of $2.7 million and other intangible assets of $12.6 million as of December 31, 2013. Any future impairment charges, if significant, could materially and adversely affect our operating results. An unexpected decline in revenue, changes in market conditions, changes in competitive products or technologies or a change in management's intentions regarding utilization of intangible assets could lead to future impairment charges.

We are subject to periodic litigation, product liability risk and other regulatory proceedings which could result in unexpected expense of time and resources.
 
From time to time, we may be a defendant in lawsuits and regulatory actions relating to our business or the former operations of our discontinued Commercial business segment. Due to the inherent uncertainties of litigation and regulatory proceedings, we cannot accurately predict the ultimate outcome of any such proceedings. An unfavorable outcome could have a material adverse impact on our business, financial condition and results of operations. In addition, any significant litigation in the future, regardless of its merits, could divert management's attention from our operations and may result in substantial legal costs.
 
We are subject to warranty claims for our products which could result in unexpected expense.
 
Many of our products carry limited warranties for defects in quality and workmanship. We may experience significant expense as the result of product quality issues, product recalls or product liability claims which may have a material adverse effect on our business. We maintain a warranty reserve for estimated future warranty claims. However, the actual costs of servicing future warranty claims may exceed the reserve and have a material adverse effect on our results of operations, financial condition and cash flows. In addition, we remain contingently liable for product warranty obligations which were transferred to buyers of our Commercial business product lines, if the buyer is unable to fulfill such obligations.
  
Disruption to our information and communication systems could result in interruptions to our business and the planned implementation of new systems for critical business functions heightens the risk of disruption.
 
Our business is reliant on information and communication technology, and a substantial portion of our revenues are generated with the support of information and communication systems. The success of our Direct business is heavily dependent on our ability to respond to customer sales inquiries and process sales transactions using our call center communication systems, Internet websites and similar data monitoring and communication systems provided and supported by third-parties. If such systems were to fail, or experience significant or lengthy interruptions in availability or service, our revenues could be materially affected. We also rely on information systems in all stages of our product cycle, from design to distribution, and we use such systems as a method of communication between employees, suppliers and customers. In addition, we use information systems to maintain our accounting records, assist in trade receivables collection and customer service efforts, and forecast operating results and cash flows.
 
System failures or service interruptions may occur as the result of a number of factors, including: computer viruses; hacking or other unlawful activities by third parties; disasters; equipment, hardware or software failures; ineffective implementation of new systems or systems upgrades; cable outages, extended power failures, or our inability or failure to properly protect, repair or maintain our communication and information systems. To mitigate the risk of business interruption, we have in place a disaster recovery program that targets our most critical operational systems. If our disaster recovery system is ineffective, in whole or in

10


part, or efforts conducted by us or third-parties to prevent or respond to system interruptions in a timely manner are ineffective, our ability to conduct operations would be significantly affected. If we do not consider the potential impact of critical decisions related to systems or process design and implementation, this could lead to operational challenges and increased costs. Any of the aforementioned factors could have a material adverse affect on our operating results, financial position and cash flows.
Our current primary enterprise resource planning system is highly customized to our business and we may experience difficulties as we transition to new systems during 2014. Difficulties or delays in implementing our new information systems or significant system failures could disrupt our operations and have a material adverse effect on our operating results, financial position and cash flows.

System Security Risks, Data Protection Breaches and Cyber Attacks Could Disrupt Our Operations.

We manage and store various proprietary information and sensitive or confidential data relating to our business, including sensitive and personally identifiable information. Breaches of our security measures or the accidental loss, inadvertent disclosure or unapproved dissemination of proprietary information or sensitive or confidential data about us, or our customers, including the potential loss or disclosure of such information or data as a result of fraud, trickery or other forms of deception, could expose us, our customers or the individuals affected to a risk of loss or misuse of this information, result in litigation and potential liability for us, damage our brand and reputation or otherwise harm our business. In addition, the cost and operational consequences of implementing further data protection measures could be significant.

Experienced computer programmers and hackers may be able to penetrate our network security and misappropriate or compromise our confidential information or that of third parties, create system disruptions or cause shutdowns. Computer programmers and hackers also may be able to develop and deploy viruses, worms and other malicious software programs that attack or otherwise exploit any security vulnerabilities of our systems. In addition, sophisticated hardware and operating system software and applications that we procure from third parties may contain defects in design or manufacture, including "bugs" and other problems that could unexpectedly interfere with the operation of the system. The costs to us to eliminate or alleviate cyber or other security problems, bugs, viruses, worms, malicious software programs and security vulnerabilities could be significant, and our efforts to address these problems may not be successful and could result in interruptions, delays, cessation of service and loss of existing or potential customers that may impede our sales, manufacturing, distribution or other critical functions.

Item 1B. Unresolved Staff Comments

None.


11


Item 2. Properties

Following is a summary of our principal properties as of December 31, 2013:
 
Location
 
Primary Function(s)
 
Owned or
Leased
Washington
 
Corporate headquarters, customer call center and R&D facility
 
Leased
Oregon
 
Warehouse and distribution
 
Leased
Canada
 
Warehouse and distribution
 
Leased
China
 
Quality assurance office
 
Leased

Each of our principal properties is used by both our Direct segment and our Retail segment. Our properties generally are well-maintained, adequate and suitable for their intended purposes and we believe our existing properties will meet our operational needs for the foreseeable future. If we require additional warehouse or office space in the future, we believe we will be able to obtain such space on commercially reasonable terms.

Item 3. Legal Proceedings

In 2004, we were sued in the Southern District of New York by BioSig Instruments, Inc. for alleged patent infringement in connection with our incorporation of heart rate monitors into certain cardio products. No significant activity in the litigation occurred until 2008. In 2012, the United States District Court granted summary judgment to us on grounds that BioSig’s patents were invalid as a matter of law. BioSig appealed the grant of summary judgment and, in April 2013, the United States Court of Appeals for the Federal Circuit reversed the District Court’s decision on summary judgment and remanded the case to the District Court for further proceedings. On January 10, 2014, the U.S. Supreme Court granted our petition for a writ of certiorari to address the legal standard applied by the Federal Circuit in determining whether the patents may be valid under applicable law. The U.S. Supreme Court is expected to hear arguments in April 2014. We do not believe that our use of heart rate monitors utilized or purchased from third parties, and otherwise, infringe the BioSig patents.

In addition to the matter described above, from time to time we are subject to litigation, claims and assessments that arise in the ordinary course of business, including disputes that may arise from intellectual property related matters. Management believes that any liability resulting from such additional matters will not have a material adverse effect on our financial position, results of operations or cash flows.

Item 4. Mine Safety Disclosures

Not applicable.



12


PART II

Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market for our Common Stock
Our common stock is listed on the New York Stock Exchange (the “NYSE”) and trades under the symbol “NLS.” As of February 26, 2014, there were 52 holders of record of our common stock and approximately 28,000 beneficial shareholders. The following table sets forth the high and low sales prices of our common stock for each period presented:
 
 
High
 
Low
2013:
 
 
 
Quarter 1
$
7.66

 
$
3.48

Quarter 2
8.75

 
6.34

Quarter 3
9.87

 
6.15

Quarter 4
8.49

 
6.76

2012:
 
 
 
Quarter 1
$
3.04

 
$
1.74

Quarter 2
3.50

 
2.20

Quarter 3
3.64

 
2.28

Quarter 4
4.00

 
2.58


We did not pay any dividends on our common stock in 2012 or 2013 and we currently have no plans to pay dividends on our common stock in future periods. Payment of any future dividends, when permitted under our borrowing arrangements, is at the discretion of our Board of Directors, which considers various factors such as our financial condition, operating results, current and anticipated cash needs and future expansion plans.

Equity Compensation Plans
See Item 12 for Equity Compensation Plan information.

Issuer Purchases of Equity Securities
The following table provides information about our repurchases of our equity securities during the fourth quarter ended December 31, 2013:
Period
 
(a)



Total Number of
Shares (or Units)
Purchased (1)
(b)


Average
Price Paid
per Share (or Unit)
(c)
Total Number of
Shares (or Units)
Purchased as Part
of Publicly Announced Plans or Programs
 
(d)
Maximum Number
(or Approximate Dollar
Value) of Shares (or
Units) that May Yet Be Purchased Under the Plans or Programs
October 1 to October 31, 2013
 
1,688
$7.96
 
November 1 to November 30, 2013
 
1,689
7.57
 
December 1 to December 31, 2013
 
1,690
8.43
 
Total
 
5,067
7.99
 
(1)  Consists of shares withheld from the vesting portion of a restricted stock unit award granted to Bruce M. Cazenave, our Chief Executive Officer. We will withhold from each monthly vesting portion of the award the number of shares sufficient to satisfy Mr. Cazenave's tax withholding obligation incident to such vesting, unless Mr. Cazenave should first elect to satisfy the tax obligation by cash payment to us.  We do not have any publicly announced equity securities repurchase plans or programs.


13


Stock Performance Graph
The graph below compares the cumulative total stockholder return of our common stock with the cumulative total return of the NYSE Composite Index and the S&P SmallCap 600 Index for the period commencing December 31, 2008 and ending on December 31, 2013. The S&P SmallCap 600 Index was chosen because we do not believe we can reasonably identify an industry index or specific peer issuer that would offer a meaningful comparison. The S&P SmallCap 600 Index represents a broad-based index of companies with similar market capitalization.
 
The graph assumes $100 was invested, on December 31, 2008, in our common stock and each index presented. The comparisons in the table below are not intended to forecast or be indicative of future performance of our common stock.


14



Item 6. Selected Financial Data

The following selected consolidated financial data should be read in connection with our audited consolidated financial statements and related notes thereto and with Management's Discussion and Analysis of Financial Condition and Results of Operations, which are included elsewhere in this Form 10-K. The consolidated statements of operations data for fiscal 2013, 2012 and 2011, and the selected consolidated balance sheet data as of December 31, 2013 and 2012 are derived from, and are qualified by reference to, the audited consolidated financial statements which are included in this Form 10-K. The consolidated statements of operations data for fiscal 2010 and 2009 and the consolidated balance sheet data as of December 31, 2011, 2010 and 2009 are derived from audited consolidated financial statements which are not included in this Form 10-K.
 
 
For the Year Ended December 31,
(In thousands, except per share amounts)
 
2013
 
2012
 
2011
 
2010
 
2009
Consolidated Statements of Operations Data
 
 
 
 
 
 
 
 
 
 
Net sales
 
$
218,803

 
$
193,926

 
$
180,412

 
$
168,450

 
$
189,260

Cost of sales
 
112,326

 
102,889

 
101,953

 
91,704

 
92,745

Gross profit
 
106,477

 
91,037

 
78,459

 
76,746

 
96,515

 
 
 
 
 
 
 
 
 
 
 
Operating expenses:
 
 
 
 
 
 
 
 
 
 
  Selling and marketing
 
66,486

 
58,617

 
54,494

 
64,039

 
75,827

  General and administrative
 
18,705

 
17,669

 
17,143

 
19,371

 
24,616

  Research and development
 
5,562

 
4,163

 
3,223

 
2,905

 
5,222

  Restructuring
 

 

 

 

 
14,151

  Asset impairment
 

 

 

 

 
5,904

    Total operating expenses
 
90,753

 
80,449

 
74,860

 
86,315

 
125,720

 
 
 
 
 
 
 
 
 
 
 
Operating income (loss)
 
15,724

 
10,588

 
3,599

 
(9,569
)
 
(29,205
)
 
 
 
 
 
 
 
 
 
 
 
Other income (expense):
 
 
 
 
 
 
 
 
 
 
  Interest income
 
14

 
18

 
65

 
15

 
77

  Interest expense
 
(36
)
 
56

 
(466
)
 
(140
)
 
(168
)
  Other
 
337

 
(246
)
 
(11
)
 
464

 
(194
)
    Total other income (expense)
 
315

 
(172
)
 
(412
)
 
339

 
(285
)
 
 
 
 
 
 
 
 
 
 
 
Income (loss) from continuing operations before income taxes
 
16,039

 
10,416

 
3,187

 
(9,230
)

(29,490
)
Income tax provision (benefit)(1)
 
(32,085
)
 
(226
)
 
686

 
588

 
(10,880
)
Income (loss) from continuing operations
 
48,124

 
10,642

 
2,501

 
(9,818
)
 
(18,610
)
Income (loss) from discontinued operations
 
(170
)
 
6,241

 
(1,081
)
 
(13,023
)
 
(34,687
)
Net income (loss)
 
$
47,954

 
$
16,883

 
$
1,420

 
$
(22,841
)
 
$
(53,297
)
 
 
 
 
 
 
 
 
 
 
 
Basic income (loss) per share from continuing operations
 
$
1.55

 
$
0.34

 
$
0.08

 
$
(0.32
)
 
$
(0.61
)
Basic income (loss) per share from discontinued operations
 
(0.01
)
 
0.21

 
(0.03
)
 
(0.42
)
 
(1.13
)
Basic net income (loss) per share
 
$
1.54

 
$
0.55

 
$
0.05

 
$
(0.74
)
 
$
(1.74
)
 
 

 
 
 
 
 
 
 
 
Diluted income (loss) per share from continuing operations
 
$
1.53

 
$
0.34

 
$
0.08

 
$
(0.32
)
 
$
(0.61
)
Diluted income (loss) per share from discontinued operations
 
(0.01
)
 
0.21

 
(0.03
)
 
(0.42
)
 
(1.13
)
Diluted net income (loss) per share
 
$
1.52

 
$
0.55

 
$
0.05

 
$
(0.74
)
 
$
(1.74
)
 
 

 
 
 
 
 
 
 
 
Shares used in per share calculations:
 

 
 
 
 
 
 
 
 
  Basic
 
31,072

 
30,851

 
30,746

 
30,744

 
30,664

  Diluted
 
31,457

 
30,974

 
30,776

 
30,744

 
30,664

 
 
 
 
 
 
 
 
 
 
 
 
 
As of December 31,
Consolidated Balance Sheet Data
 
2013
 
2012
 
2011
 
2010
 
2009
Cash and cash equivalents
 
$
40,979

 
$
23,207

 
$
17,427

 
$
14,296

 
$
7,289

Working capital
 
45,662

 
25,410

 
19,439

 
15,316

 
21,063

Total assets
 
143,567

 
94,311

 
82,813

 
78,367

 
115,172

Long-term notes payable
 

 

 
5,598

 
5,141

 

Other long-term liabilities
 
4,077

 
6,508

 
6,614

 
6,148

 
6,489

Total shareholders' equity
 
91,565

 
43,326

 
31,953

 
30,799

 
52,483


(1) Income tax benefit in 2013 includes a $38.9 million credit related to the reversal of our deferred tax asset valuation allowance.

15



Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion and analysis of our financial condition and results of operations together with the consolidated financial statements and related notes that are included in Part II, Item 8 of this Form 10-K. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties.

Our results of operations may vary significantly from period-to-period. Our revenues typically fluctuate due to the seasonality of our industry, customer buying patterns, product innovation, the nature and level of competition for health and fitness products, our ability to procure products to meet customer demand, the level of spending on, and effectiveness of, our media and advertising programs and our ability to attract new customers and maintain existing sales relationships. In addition, our revenues are highly susceptible to economic factors, including, among other things, the overall condition of the economy and the availability of consumer credit in both the United States and Canada. Our profit margins may vary in response to the aforementioned factors and our ability to manage product costs. Profit margins may also be affected by fluctuations in the costs or availability of materials used to manufacture our products, product warranty costs, the cost of fuel, and changes in costs of other distribution or manufacturing-related services. Our operating profits or losses may also be affected by the efficiency and effectiveness of our organization. Historically, our operating expenses have been influenced by media costs to produce and distribute advertisements of our products on television, the Internet and other media, facility costs, operating costs of our information and communications systems, product supply chain management, customer support and new product development activities. In addition, our operating expenses have been affected from time-to-time by asset impairment charges, restructuring charges and other significant unusual or infrequent expenses.

As a result of the above and other factors, our period-to-period operating results may not be indicative of future performance. You should not place undue reliance on our operating results and should consider our prospects in light of the risks, expenses and difficulties typically encountered by us and other companies, both within and outside our industry. We may not be able to successfully address these risks and difficulties and, consequently, we cannot assure you any future growth or profitability. For more information, see our discussion of Risk Factors located at Part I, Item 1A of this Form 10-K.

OVERVIEW
 
We are committed to providing innovative, quality solutions to help people achieve a fit and healthy lifestyle. Our principal business activities include designing, developing, sourcing and marketing high-quality cardio and strength fitness products and related accessories for consumer use, primarily in the United States and Canada. Our products are sold under some of the most-recognized brand names in the fitness industry: Nautilus®, Bowflex®, Schwinn®, Schwinn Fitness™ and Universal®.

We market our products through two distinct distribution channels, Direct and Retail, which we consider to be separate business segments. Our Direct business offers products directly to consumers through television advertising, catalogs and the Internet. Our Retail business offers our products through a network of independent retail companies with stores and websites located in the United States and internationally. We also derive a portion of our revenue from the licensing of our brands and intellectual property.
 
Our Net Sales in 2013 were $218.8 million, an increase of $24.9 million, or 12.8%, compared to Net Sales of $193.9 million in 2012. Net Sales of our Direct segment increased $11.7 million, or 9.3%, compared to 2012, primarily due to increased consumer demand for our cardio products, especially the Bowflex® TreadClimber®. Net Sales of our Retail segment increased by $12.9 million, or 20.2% in 2013, compared to 2012, primarily due to growth in strength products.

Income From Continuing Operations was $48.1 million , or $1.53 per diluted share, in 2013, compared to $10.6 million, or $0.34 per diluted share, in 2012. Income From Continuing Operations of $48.1 million in 2013 included a $38.9 million credit related to the reversal of our deferred tax asset valuation allowance. Without consideration of the reversal of our deferred tax asset valuation allowance, the improvement in our results from continuing operations in 2013 was driven primarily by higher sales and increased margins in both our Retail and Direct segments.

Net Income was $48.0 million, or $1.52 per diluted share, in 2013, compared to $16.9 million, or $0.55 per diluted share, in 2012. Net Income in 2012 included Income From Discontinued Operations of $6.2 million, or $0.21 per diluted share.


16


DISCONTINUED OPERATIONS

Results from discontinued operations relate to the disposal of our former Commercial business, which was completed in April 2011. We reached substantial completion of asset liquidation at December 31, 2012. Income From Discontinued Operations of $6.2 million in 2012 primarily represents a currency translation adjustment gain related to the liquidation of European subsidiaries. Although there was no revenue related to the Commercial business in 2013, we continue to have legal and accounting expenses as we work with authorities on final deregistration of each entity and product liability expenses associated with product previously sold into the Commercial channel.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements in conformity with generally accepted accounting principles requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements. An accounting estimate is considered to be critical if it meets both of the following criteria: (i) the estimate requires assumptions about matters that are highly uncertain at the time the accounting estimate is made, and (ii) different estimates reasonably could have been used, or changes in the estimate that are reasonably likely to occur from period to period may have a material impact on the presentation of our financial condition, changes in financial condition or results of operations.

Our critical accounting policies and estimates are discussed below. We have not made any material changes in the methodologies we use in our critical accounting estimates during the past three fiscal years. If our assumptions or estimates change in future periods, the impact on our financial position and operating results could be material.

Revenue Recognition
Direct and Retail product sales and shipping revenues are recorded when products are shipped and title passes to customers. In most instances, Retail sales to customers are made pursuant to a sales contract that provides for transfer of both title and risk of loss to the customer upon our delivery to the carrier. For Direct sales, revenue is generally recognized when product is shipped. Revenue is recognized net of applicable sales incentives, such as promotional discounts, rebates and return allowances. We estimate the revenue impact of incentive programs based on the planned duration of the program and historical experience.

Sales Discounts and Allowances
Product sales and shipping revenues are reported net of promotional discounts and return allowances. We estimate the revenue impact of retail sales incentive programs based on the planned duration of the program and historical experience. If the amount of sales incentives is reasonably estimable, the impact of such incentives is recorded at the later of the time the customer is notified of the sales incentive or the time of the sale. We estimate our liability for product returns based on historical experience and record the expected obligation as a reduction of revenue. If actual return costs differ from previous estimates, the amount of the liability and corresponding revenue are adjusted in the period in which such costs occur.
 
Our calculations of amounts owed for sales discounts and allowances contain uncertainties because they require management to make assumptions in interim periods and to apply judgment regarding a number of factors, including estimated future customer inventory purchases and returns.

Goodwill and Other Long-Term Asset Valuation
We evaluate our indefinite-lived Intangible Assets and Goodwill for potential impairment annually or when events or circumstances indicate their carrying value may be impaired. Finite-lived Intangible Assets, including patents and patent rights, and Property, Plant and Equipment are evaluated for impairment when events or circumstances indicate the carrying value may be impaired. No Goodwill or other long-term asset impairment charges were recognized in 2013, 2012 or 2011.

Our impairment loss calculations contain uncertainties because they require management to make assumptions and to apply judgment in order to estimate future cash flows and asset fair values. Our judgments regarding potential impairment are based on a number of factors including: the timing and amount of anticipated cash flows; market conditions; relative levels of risk; the cost of capital; terminal values; royalty rates; and the allocation of revenues, expenses and assets and liabilities to business segments. Each of these factors can significantly affect the value of our Goodwill or other long-term assets and, thereby, could have a material adverse affect on our financial position and results of operations.

Product Warranty Obligations
Our products carry limited defined warranties for defects in materials or workmanship. Our product warranties generally obligate us to pay for the cost of replacement parts, cost of shipping the parts to our customers and, in certain instances, service labor costs. At the time of sale, we record a liability for the estimated costs of fulfilling future warranty claims. The estimated warranty

17


costs are recorded as a component of cost of sales, based on historical warranty claim experience and available product quality data. If necessary, we adjust our liability for specific warranty matters when they become known and are reasonably estimable. Our estimates of warranty expenses are based on significant judgment, and the frequency and cost of warranty claims are subject to variation. Warranty expenses are affected by the performance of new products, significant manufacturing or design defects not discovered until after the product is delivered to the customer, product failure rates and variances in expected repair costs.

Litigation and Loss Contingencies
From time to time, we may be involved in claims, lawsuits and other proceedings. Such matters involve uncertainty as to the eventual outcomes and any losses or gains we may ultimately realize when one or more future events occur or fail to occur. We record expenses for litigation and loss contingencies when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. We estimate the probability of such losses based on the advice of internal and external counsel, outcomes from similar litigation, status of the lawsuits (including settlement initiatives), legislative developments and other factors.

Due to the numerous variables associated with these judgments and assumptions, both the precision and reliability of the resulting estimates of the related loss contingencies are subject to substantial uncertainties. We regularly monitor our estimated exposure to these contingencies and, as additional information becomes known, we may change our estimates accordingly.

Deferred Tax Assets - Valuation Allowance
We account for income taxes based on the asset and liability method, whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities. Deferred tax assets and liabilities are measured using the enacted tax rates that are expected to be in effect when the temporary differences are expected to be included, as income or expense, in the applicable tax return. The effect of a change in tax rates on our deferred tax assets and liabilities is recognized in the period of the enactment.

We have recorded a valuation allowance to reduce our Deferred Income Tax Assets to the amount we believe is more likely than not to be realized. As we determined, based on reviewing all the positive and negative evidence, that it is more likely than not that the benefit from certain Deferred Income Tax Assets will not be realized, we have a valuation allowance against net Deferred Income Tax Assets of $12.9 million. If our assumptions change and we determine we will be able to realize these Deferred Income Tax Assets, the tax benefits related to any reversal of the valuation allowance will be accounted for in the period in which we make such determination. Likewise, should we determine that we would not be able to realize our Deferred Income Tax Assets in the future, an adjustment to the valuation allowance to reserve for the Deferred Income Tax Assets would increase expense in the period such determination was made.

For example, in the second quarter of 2013, we evaluated the potential realization of our Deferred Income Tax Assets, considering both positive and negative evidence, including cumulative income or loss for the past three years and forecasted taxable income. As a result of this evaluation we concluded that, as of June 30, 2013, a majority of the existing valuation allowance on our domestic Deferred Income Tax Assets was no longer required. As of December 31, 2013, we maintain the same position that the partial release of valuation allowance is still appropriate. Accordingly, an income tax benefit of $38.9 million was recorded during 2013 related to the reduction of our existing valuation allowance. 

Unrecognized Tax Benefits
Significant judgments are required in determining tax provisions and evaluating tax positions. Such judgments require us to interpret existing tax law and other published guidance as applied to our circumstances. If our financial results or other relevant facts change, thereby impacting the likelihood of realizing the tax benefit of an uncertain tax position, significant judgment would be applied in determining the effect of the change. A tax benefit from an uncertain tax position may be recognized when it is more likely than not that the position will be sustained based on the technical merits of the position upon examination, including resolutions of any related appeals or litigation.



18


RESULTS OF OPERATIONS

The discussion that follows should be read in conjunction with our consolidated financial statements and the related notes in this report. All comparisons to prior year results are in reference to continuing operations only in each period, unless otherwise indicated.

Results of operations information was as follows (in thousands):
 
 
Year Ended December 31,
 
 
 
 
 
2013
 
2012
 
Change
 
% Change
Net sales
$
218,803

 
$
193,926

 
$
24,877

 
12.8
%
Cost of sales
112,326

 
102,889

 
9,437

 
9.2
%
Gross profit
106,477

 
91,037

 
15,440

 
17.0
%
Operating expenses:
 
 
 
 
 
 


Selling and marketing
66,486

 
58,617

 
7,869

 
13.4
%
General and administrative
18,705

 
17,669

 
1,036

 
5.9
%
Research and development
5,562

 
4,163

 
1,399

 
33.6
%
Total operating expenses
90,753

 
80,449

 
10,304

 
12.8
%
Operating income
15,724

 
10,588

 
5,136

 
 
Other income (expense):
 
 
 
 


 
 
Interest income
14

 
18

 
(4
)
 
 
Interest expense
(36
)
 
56

 
(92
)
 
 
Other
337

 
(246
)
 
583

 
 
Total other income (expense), net
315

 
(172
)
 
487

 
 
Income before income taxes
16,039

 
10,416

 
5,623

 
 
Income tax benefit
(32,085
)
 
(226
)
 
(31,859
)
 
 
Income from continuing operations
48,124

 
10,642

 
37,482

 
 
Income (loss) from discontinued operations, net of income taxes
(170
)
 
6,241

 
(6,411
)
 
 
Net income
$
47,954

 
$
16,883

 
$
31,071

 
 
 
 
Year Ended December 31,
 
 
 
 
 
2012
 
2011
 
Change
 
% Change
Net sales
$
193,926

 
$
180,412

 
$
13,514

 
7.5
%
Cost of sales
102,889

 
101,953

 
936

 
0.9
%
Gross profit
91,037

 
78,459

 
12,578

 
16.0
%
Operating expenses:
 
 
 
 
 
 


Selling and marketing
58,617

 
54,494

 
4,123

 
7.6
%
General and administrative
17,669

 
17,143

 
526

 
3.1
%
Research and development
4,163

 
3,223

 
940

 
29.2
%
Total operating expenses
80,449

 
74,860

 
5,589

 
7.5
%
Operating income
10,588

 
3,599

 
6,989

 
 
Other income (expense):
 
 
 
 


 
 
Interest income
18

 
65

 
(47
)
 
 
Interest expense
56

 
(466
)
 
522

 
 
Other
(246
)
 
(11
)
 
(235
)
 
 
Total other expense, net
(172
)
 
(412
)
 
240

 
 
Income before income taxes
10,416

 
3,187

 
7,229

 
 
Income tax (benefit) expense
(226
)
 
686

 
(912
)
 
 
Income from continuing operations
10,642

 
2,501

 
8,141

 
 
Income (loss) from discontinued operations, net of income taxes
6,241

 
(1,081
)
 
7,322

 
 
Net income
$
16,883

 
$
1,420

 
$
15,463

 
 


19


Results of operations information by segment was as follows (in thousands):
 
Year Ended December 31,
 
 
 
 
 
2013
 
2012
 
Change
 
% Change
Net sales:
 
 
 
 
 
 
 
Direct
$
136,663

 
$
124,978

 
$
11,685

 
9.3
%
Retail
76,775

 
63,891

 
12,884

 
20.2
%
Royalty income
5,365

 
5,057

 
308

 
6.1
%
 
$
218,803

 
$
193,926

 
$
24,877

 
12.8
%
 
 
 
 
 
 
 
 
Cost of sales:
 
 
 
 
 
 
 
Direct
$
55,008

 
$
53,349

 
$
1,659

 
3.1
%
Retail
57,318

 
49,540

 
7,778

 
15.7
%
Royalty income

 

 

 


 
$
112,326

 
$
102,889

 
$
9,437

 
9.2
%
Gross profit:
 
 
 
 
 
 
 
Direct
$
81,655

 
$
71,629

 
$
10,026

 
14.0
%
Retail
19,457

 
14,351

 
5,106

 
35.6
%
Royalty income
5,365

 
5,057

 
308

 
6.1
%
 
$
106,477

 
$
91,037

 
$
15,440

 
17.0
%
Gross margin:
 
 
 
 
 
 
 
Direct
59.7
%
 
57.3
%
 
240

 basis points
Retail
25.3
%
 
22.5
%
 
280

 basis points

 
Year Ended December 31,
 
 
 
 
 
2012
 
2011
 
Change
 
% Change
Net sales:
 
 
 
 
 
 
 
Direct
$
124,978

 
$
107,061

 
$
17,917

 
16.7
 %
Retail
63,891

 
68,591

 
(4,700
)
 
(6.9
)%
Royalty income
5,057

 
4,760

 
297

 
6.2
 %
 
$
193,926

 
$
180,412

 
$
13,514

 
7.5
 %
 
 
 
 
 
 
 
 
Cost of sales:
 
 
 
 
 
 
 
Direct
$
53,349

 
$
49,406

 
$
3,943

 
8.0
 %
Retail
49,540

 
52,547

 
(3,007
)
 
(5.7
)%
Royalty income

 

 

 


 
$
102,889

 
$
101,953

 
$
936

 
0.9
 %
Gross profit:
 
 
 
 
 
 
 
Direct
$
71,629

 
$
57,655

 
$
13,974

 
24.2
 %
Retail
14,351

 
16,044

 
(1,693
)
 
(10.6
)%
Royalty income
5,057

 
4,760

 
297

 
6.2
 %
Total gross profit
$
91,037

 
$
78,459

 
$
12,578

 
16.0
 %
Gross margin:
 
 
 
 
 
 
 
Direct
57.3
%
 
53.9
%
 
340

 basis points
Retail
22.5
%
 
23.4
%
 
(90
)
 basis points

The following tables compare the net sales of our major product lines within each business segment (in thousands):

20


 
Year Ended December 31,
 
 
 
 
 
2013
 
2012
 
Change
 
% Change
Direct net sales:
 
 
 
 
 
 
 
Cardio products(1)
$
114,846

 
$
100,677

 
$
14,169

 
14.1
 %
Strength products(2)
21,817

 
24,301

 
(2,484
)
 
(10.2
)%
 
136,663

 
124,978

 
11,685

 
9.3
 %
Retail net sales:
 
 
 
 
 
 
 
Cardio products(1)
36,692

 
36,209

 
483

 
1.3
 %
Strength products(2)
40,083

 
27,682

 
12,401

 
44.8
 %
 
76,775

 
63,891

 
12,884

 
20.2
 %
 
 
 
 
 
 
 
 
Royalty income
5,365

 
5,057

 
308

 
6.1
 %
 
$
218,803

 
$
193,926

 
$
24,877

 
12.8
 %
 
 
 
 
 
 
 
 
(1)  Cardio products include: TreadClimber®, treadmills, exercise bikes, ellipticals, CoreBody Reformer®, Bowflex BoostTM and DVDs.
(2)  Strength products include: home gyms, selectorized dumbbells, kettlebell weights, UpperCut™ and accessories.

 
Year Ended December 31,
 
 
 
 
 
2012
 
2011
 
Change
 
% Change
Direct net sales:
 
 
 
 
 
 
 
Cardio products(1)
$
100,677

 
$
75,982

 
$
24,695

 
32.5
 %
Strength products(2)
24,301

 
31,079

 
(6,778
)
 
(21.8
)%
 
124,978

 
107,061

 
17,917

 
16.7
 %
Retail net sales:
 
 
 
 
 
 
 
Cardio products(1)
36,209

 
43,718

 
(7,509
)
 
(17.2
)%
Strength products(2)
27,682

 
24,873

 
2,809

 
11.3
 %
 
63,891

 
68,591

 
(4,700
)
 
(6.9
)%
 
 
 
 
 
 
 
 
Royalty income
5,057

 
4,760

 
297

 
6.2
 %
 
$
193,926

 
$
180,412

 
$
13,514

 
7.5
 %
 
 
 
 
 
 
 
 
(1)  Cardio products include: TreadClimber®, treadmills, exercise bikes, ellipticals, CoreBody Reformer® and DVDs.
(2)  Strength products include: home gyms, selectorized dumbbells, kettlebell weights, UpperCut™ and accessories.

Net Sales and Cost of Sales

Direct

The 9.3% increase in Direct Net Sales in 2013 compared to 2012 was primarily related to a 14.1% increase in Direct sales of our cardio products, especially the Bowflex® TreadClimber®. We believe the increased consumer demand for our cardio products was driven by increased advertising effectiveness, improved call center effectiveness and higher U.S. consumer credit approval rates.

The 16.7% increase in Direct Net Sales in 2012 compared to 2011 was primarily related to a 32.5% increase in sales of our cardio products, reflecting strong consumer demand, especially for our Bowflex® TreadClimber®, which we believe was driven by increased advertising effectiveness, improved call center effectiveness and higher U.S. consumer credit approval rates.

The increases in Direct Net Sales of cardio products in 2013 compared to 2012, and in 2012 compared to 2011, were partially offset by a 10.2% and a 21.8% decline, respectively, in Direct Net Sales of strength products, primarily rod-based home gyms. The declines in sales of rod-based home gyms were attributable, in part, to the reduction of advertising for these products over time, as management determined that television advertising spending on this mature product category was generating suboptimal returns. We continue to market and sell rod-based home gyms through more cost efficient online media, and sales of these products have increased through the Retail segment.

21



Combined consumer credit approvals by our primary and secondary U.S. third-party financing providers were 36.1% in 2013 compared to 31.6% in 2012 and 25.0% in 2011.

The increase in Cost of Sales in our Direct business in 2013 compared to 2012 was almost entirely related to the growth in Direct Net Sales and was partially offset by the improvement in gross margin.

Of the increase in Cost of Sales of our Direct business in 2012 compared to 2011, approximately $7.3 million was due to higher sales volume, which was partially offset by a $2.9 million decrease in Cost of Sales attributable to a shift in product sales mix and a $0.4 million reduction in supply chain costs, including freight.

The 240 basis point and 340 basis point increases in the gross margin of our Direct business for 2013 compared to 2012 and 2012 compared to 2011, respectively, were primarily due to greater absorption of fixed supply chain costs due to the higher sales volume. We are no longer required to pay royalties on certain expired patents covering aspects of our Treadclimber® products. The impact of this on our Direct segment gross margins is uncertain.

Retail

The 20.2% increase in Retail Net Sales in 2013 compared to 2012 was driven primarily by increased sales of our strength products. Net Sales of strength products in the Retail Segment increased 44.8% in 2013 compared to 2012, primarily driven by higher sales of selectorized dumbbells and home gyms. The 1.3% increase in Retail cardio sales for 2013 compared to 2012 was primarily due to the introduction of our new line of cardio products in the third quarter of 2013.

The 6.9% decline in Retail Net Sales in 2012 compared to 2011 was primarily due to a 17.2% decline in sales of cardio products, including indoor bikes and ellipticals, partially offset by an 11.3% increase in sales of strength products, primarily selectorized dumbbells.

The increase in Retail Cost of Sales in 2013 compared to 2012 was due to the increase in Retail Net Sales, partially offset by improvements in Retail gross margin. The decrease in Retail Cost of Sales in 2012 compared to 2011 was due to the decrease in Retail Net Sales, partially offset by a decline in Retail gross margin.

The 280 basis point improvement in Retail gross margin in 2013 compared to 2012 was primarily due to the positive impact of a Retail price increase implemented in the third quarter of 2012 and greater absorption of fixed supply chain costs due to higher sales volume.

Gross margins in our Retail business declined by 90 basis points in 2012 compared to 2011, as the Retail price increase we implemented in the third quarter of 2012 was more than offset by less absorption of fixed supply chain costs due to lower sales volume.

Selling and Marketing
Dollars in thousands
Year Ended December 31,
 
Change
 
2013
 
2012
 
$
 
%
Selling and Marketing
$66,486
 
$58,617
 
$7,869
 
13.4%
As % of Net Sales
30.4%
 
30.2%
 
 
 
 
Dollars in thousands
Year Ended December 31,
 
Change
 
2012
 
2011
 
$
 
%
Selling and Marketing
$58,617
 
$54,494
 
$4,123
 
7.6%
As % of Net Sales
30.2%
 
30.2%
 
 
 
 

The increases in Selling and Marketing in 2013 compared to 2012, and in 2012 compared to 2011, were primarily due to increases in media advertising, which also contributed to the improvements in Net Sales in 2013 compared to 2012, and in 2012 compared to 2011. In addition, finance fees payable to our consumer finance providers, as a result of increased Net Sales in those periods, increased by $1.6 million in 2013 compared to 2012 and $0.9 million in 2012 compared to 2011.

Selling and Marketing as a percentage of Net Sales is affected by the mix of Direct sales compared to Retail sales. Increasing Direct sales as a percentage of total Net Sales increases the percentage of Selling and Marketing as a percentage of Net Sales and vice versa.

22



Media advertising expense of our Direct business is the largest component of Selling and Marketing and was as follows:
Dollars in thousands
Year Ended December 31,
 
Change
 
2013
 
2012
 
$
 
%
Media advertising
$35,819
 
$30,903
 
$4,916
 
15.9%
Dollars in thousands
Year Ended December 31,
 
Change
 
2012
 
2011
 
$
 
%
Media advertising
$30,903
 
$28,582
 
$2,321
 
8.1%

We made strategic increased investments in media and creative advertising in 2013 to further support the launch of UpperCut™ and to build sales leads for all Direct products in the second half of 2013.

General and Administrative
Dollars in thousands
Year Ended December 31,
 
Change
 
2013
 
2012
 
$
 
%
General and Administrative
$18,705
 
$17,669
 
$1,036
 
5.9%
As % of Net Sales
8.5%
 
9.1%
 
 
 
 
Dollars in thousands
Year Ended December 31,
 
Change
 
2012
 
2011
 
$
 
%
General and Administrative
$17,669
 
$17,143
 
$526
 
3.1%
As % of Net Sales
9.1%
 
9.5%
 
 
 
 

The increase in General and Administrative in 2013 compared to 2012 was primarily due to a $0.4 million increase in infrastructure costs and a $0.8 million increase in employee related costs, partially offset by a $0.3 million one-time charge in 2012 for lease write-off costs.

The increase in General and Administrative in 2012 compared to 2011 was primarily due to increases in information technology and legal expenses totaling $1.0 million, partially offset by reductions of $0.3 million in depreciation and amortization expenses and $0.2 million in personnel costs.

The decreases in General and Administrative as a percentage of Net Sales in 2013 compared to 2012 and in 2012 compared to 2011 were primarily due to higher Net Sales.

Research and Development

Dollars in thousands
Year Ended December 31,
 
Change
 
2013
 
2012
 
$
 
%
Research and Development
$5,562
 
$4,163
 
$1,399
 
33.6%
As % of Net Sales
2.5%
 
2.1%
 
 
 
 
Dollars in thousands
Year Ended December 31,
 
Change
 
2012
 
2011
 
$
 
%
Research and Development
$4,163
 
$3,223
 
$940
 
29.2%
As % of Net Sales
2.1%
 
1.8%
 
 
 
 

The increases in Research and Development in 2013 compared to 2012 and in 2012 compared to 2011 were primarily due to our continued investment in new products. We expect Research and Development expense to increase in 2014 compared to 2013, as we continue to invest in new product development.

23


Interest Expense

Negative Interest Expense of $0.1 million in 2012 arose from the early repayment in March 2012 of our Increasing-Rate Senior Discount Notes. Early repayment of the notes resulted in a lower average effective interest rate over the term of the notes than would have applied if the notes had been held to maturity. In prior periods, we used the average effective interest rate as if the notes were held to maturity in determining the amount of interest expense incurred.

Other Income (Expense)

Other Income (Expense) primarily relates to the effect of exchange rate fluctuations between the U.S. and Canada. However, 2013 also included the following one-time items:
A $0.1 million gain related to an insurance settlement; and
A $0.3 million gain related to a refund of state sales tax previously paid by us.

Income Tax Provision (Benefit)
Dollars in thousands
Year Ended December 31,
 
Change
 
2013
 
2012
 
$
 
%
Income Tax Benefit
$(32,085)
 
$(226)
 
$(31,859)
 
n/m
Dollars in thousands
Year Ended December 31,
 
Change
 
2012
 
2011
 
$
 
%
Income Tax Provision (Benefit)
$(226)
 
$686
 
$(912)
 
n/m

n/m - Not meaningful.

Income Tax Benefit for 2013 included a partial release of U.S. domestic valuation allowance. Income Tax Benefit for 2012 was primarily related to the expiration of statutes of limitation applicable to our liabilities for uncertain tax positions in certain jurisdictions. Income tax expense in 2011 was attributable to the taxable income generated in Canada and the result of changes in our uncertain tax positions. Generally, we did not recognize U.S. income tax expense associated with our income from continuing operations for 2013, 2012 or 2011 due to the valuation allowance against the net deferred tax asset.

In the second quarter of 2013, we evaluated the potential realization of our Deferred Income Tax Assets, considering both positive and negative evidence, including cumulative income or loss for the past three years and forecasted taxable income. As a result of this evaluation we concluded that, as of June 30, 2013, a majority of the existing valuation allowance on our domestic Deferred Income Tax Assets was no longer required. As of December 31, 2013, we maintain the same position as the previous quarter that the partial release of valuation allowance is still appropriate. Accordingly, an income tax benefit of $38.9 million was recorded during 2013 related to the reduction of our existing valuation allowance.   

Further there was a total of $4.4 million of Deferred Income Tax Asset reversal related to the expiration of capital loss and certain state net operating loss carryforwards during the fourth quarter of 2013. Accordingly a corresponding amount of valuation allowance was reversed in the same quarter.

The amount of valuation allowance offsetting the Company's deferred tax assets was $12.9 million as of December 31, 2013. Of the total remaining valuation allowance, $4.1 million relates to certain domestic loss and other credit carryforwards that we may not be able to utilize primarily due to their shorter remaining carryforward periods. Should it be determined in the future that it is more likely than not that our domestic Deferred Income Tax Assets will be realized, an additional valuation allowance would be released during the period in which such an assessment is made. In addition, $8.8 million of the remaining valuation allowance relates to foreign net operating loss carryfowards. There have been no material changes to our foreign operations since December 31, 2012 and, accordingly, we maintain our existing valuation allowance on foreign Deferred Income Tax Assets in such jurisdictions at December 31, 2013.

See Note 11 of Notes to Consolidated Financial Statements included in Part II, Item 8 of this report for additional information.



24


LIQUIDITY AND CAPITAL RESOURCES
 
As of December 31, 2013, we had $41.0 million of Cash and Cash Equivalents, compared to $23.2 million as of December 31, 2012. Cash provided by operating activities was $21.1 million for 2013, compared to cash provided by operating activities of $12.8 million for 2012. We expect our Cash and Cash Equivalents at December 31, 2013, along with cash expected to be generated from operations, to be sufficient to fund our operating and capital requirements for at least twelve months from December 31, 2013.

The increase in cash flows from operating activities was primarily due to increased Net Income of $48.0 million for 2013, compared to Net Income of $16.9 million for 2012 and changes in our operating assets and liabilities as discussed below. Net income for 2013 included a $38.9 million non-cash credit related to the reduction of the valuation allowance recorded against our Deferred Income Tax Assets.

Trade Receivables increased $3.5 million to $25.3 million as of December 31, 2013, compared to $21.8 million as of December 31, 2012, due to higher revenue within our Retail business. Days sales outstanding ("DSO") at December 31, 2013 were 19.9 days compared to 23.7 days as of December 31, 2012. The decrease in DSO at December 31, 2013 compared to December 31, 2012 was due to improved collections. 

Inventories decreased $3.0 million to $15.8 million as of December 31, 2013, compared to $18.8 million as of December 31, 2012, primarily due to improvements in inventory management.

Net Deferred Income Tax Assets increased $32.5 million to $30.2 million as of December 31, 2013, compared to a net liability of $2.3 million as of December 31, 2012, primarily due to the release of $38.9 million of existing valuation allowance during 2013 as discussed in more detail above.

Trade Payables increased $4.4 million to $37.2 million as of December 31, 2013, compared to $32.8 million as of December 31, 2012, primarily due to increased media expense to support the growth in sales.

Accrued Liabilities increased $0.9 million to $9.1 million as of December 31, 2013 compared to $8.2 million as of December 31, 2012, primarily due to an increase in accrued incentive compensation.

Cash used in investing activities for purchases of software and equipment was $3.6 million for 2013 and was primarily related to implementation of new software and hardware information system upgrades and new product tooling equipment. We anticipate spending $2.5 million in all of 2014 for software and equipment.

Financing Arrangements
We have a Credit Agreement (the "Loan Agreement") with Bank of the West that provides for a $15,750,000 maximum revolving secured credit line. The line of credit is available through March 31, 2015 for working capital, standby letters of credit and general corporate purposes. Borrowing availability under the Loan Agreement is subject to our compliance with certain financial and operating covenants at the time borrowings are requested. Standby letters of credit under the Loan Agreement are treated as a reduction of the available borrowing amount and are subject to covenant testing.

The interest rate applicable to borrowings under the Loan Agreement is based on either, at our discretion, Bank of the West's base rate, a floating rate or LIBOR, plus an applicable margin based on certain financial performance metrics. Our borrowing rate was 1.67% as of December 31, 2013. The Loan Agreement contains customary covenants, including minimum fixed charge coverage ratio and leverage ratio, and limitations on capital expenditures, mergers and acquisitions, indebtedness, liens, dispositions, dividends and investments. The Loan Agreement also contains customary events of default. Upon an event of default, the lender has the option of terminating its credit commitment and accelerating all obligations under the Loan Agreement. Borrowings under the Loan Agreement are collateralized by substantially all of our assets, including intellectual property assets.

As of December 31, 2013, we had no outstanding borrowings and $0.5 million in standby letters of credit issued under the Loan Agreement. As of December 31, 2013, we were in compliance with the financial covenants of the Loan Agreement and approximately $15.3 million was available for borrowing.
 
Commitments and Contingencies
For a description of our commitments and contingencies, refer to Note 15 to our Consolidated Financial Statements in Part II, Item 8 of this report.
  

25


Non-Cancelable Contractual Obligations
Our operating cash flows include the effect of certain non-cancelable, contractual obligations. A summary of such obligations as of December 31, 2013, including those related to our discontinued Commercial operation, is as follows (in thousands):
 
 
Payments due by period
 
Total
  
Less than 1
year
  
1-3 years
  
3-5 years
  
More than 5
years
Operating lease obligations
$
13,616

 
$
3,343

  
$
6,453

 
$
3,156

 
$
664

Purchase obligations(1)
8,824

 
8,824

  

  

  

Minimum royalty obligations
100

 
100

  

  

  

Total
$
22,540

  
$
12,267

  
$
6,453

  
$
3,156

  
$
664


(1)
Our purchase obligations are comprised primarily of inventory purchase commitments. Because substantially all of our inventory is sourced from Asia, we have long lead times and therefore need to secure factory capacity from our vendors in advance.

Due to uncertainty with respect to the timing of future cash flows associated with our unrecognized tax benefits at December 31, 2013, we are unable to make reasonably reliable estimates of the timing of any cash settlements with the respective taxing authorities. Therefore, approximately $3.6 million of unrecognized tax benefits, including interest and penalties on uncertain tax positions, have been excluded from the contractual table above. For further information, refer to Note 11, Income Taxes, to our Consolidated Financial Statements in Part II, Item 8 of this report.

Off-Balance Sheet Arrangements
In the ordinary course of business, we enter into agreements that require us to indemnify counterparties against third-party claims. These may include: agreements with vendors and suppliers, under which we may indemnify them against claims arising from our use of their products or services; agreements with customers, under which we may indemnify them against claims arising from their use or sale of our products; real estate and equipment leases, under which we may indemnify lessors against third party claims relating to the use of their property; agreements with licensees or licensors, under which we may indemnify the licensee or licensor against claims arising from their use of our intellectual property or our use of their intellectual property; and agreements with parties to debt arrangements, under which we may indemnify them against claims relating to their participation in the transactions.

The nature and terms of these indemnifications vary from contract to contract, and generally a maximum obligation is not stated. We hold insurance policies that mitigate potential losses arising from certain types of indemnifications. Because we are unable to estimate our potential obligation, and because management does not expect these obligations to have a material adverse effect on our consolidated financial position, results of operations or cash flows, no liabilities are recorded at December 31, 2013.

SEASONALITY
 
We expect our sales from fitness equipment products to vary seasonally. Sales are typically strongest in the first and fourth quarters, followed by the third quarter, and are generally weakest in the second quarter. We believe that, during the spring and summer months, consumers tend to be involved in outdoor activities, including outdoor exercise, which impacts sales of indoor fitness equipment. This seasonality can have a significant effect on our inventory levels, working capital needs and resource utilization.

INFLATION

We do not believe that inflation had a material effect on our business, financial condition or results of operations in 2013, 2012 or 2011. Inflation pressures do exist in countries where our contract manufacturers are based, however we have largely mitigated these increases through cost improvement measures.

NEW ACCOUNTING PRONOUNCEMENTS

See Note 1, Significant Accounting Polices, to our Consolidated Financial Statements in Part II, Item 8 of this report.


26



Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk
Our exposure to market risk from changes in interest rates relates primarily to our cash and cash equivalents. The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. This is accomplished by investing in diversified investments, consisting only of investment-grade securities.
        
As of December 31, 2013, we held cash and cash equivalents of $41.0 million. Given that cash equivalents mature within three months or less from the date of purchase, a decline in interest rates over time would reduce our interest income, but would not have a material impact on our results of operations, financial position or cash flows. In addition, due to the nature of our cash equivalents, a decline in interest rates would not materially affect the fair value of our cash equivalents.


27


Item 8. Financial Statements and Supplementary Data

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of
Nautilus, Inc.
Vancouver, Washington

We have audited the accompanying consolidated balance sheets of Nautilus, Inc. and subsidiaries (the “Company”) as of December 31, 2013 and 2012, and the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2013. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Nautilus, Inc. and subsidiaries as of December 31, 2013 and 2012, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2013, in conformity with accounting principles generally accepted in the United States of America.
 
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2013, based on the criteria established in Internal Control-Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 27, 2014, expressed an unqualified opinion on the Company's internal control over financial reporting.


/s/ Deloitte & Touche LLP

Portland, Oregon
February 27, 2014

28


NAUTILUS, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands)
 
 
As of December 31,
 
2013
  
2012
Assets
 
  
 
Cash and cash equivalents
$
40,979

  
$
23,207

Trade receivables, net
25,336

  
21,767

Inventories, net
15,824

  
18,787

Prepaids and other current assets
6,927

  
5,750

Income taxes receivable
80

  
101

Short-term notes receivable

 
82

Deferred income tax assets
4,441

  
193

    Total current assets
93,587

  
69,887

Property, plant and equipment, net
8,499

  
6,138

Goodwill
2,740

  
2,940

Other intangible assets, net
12,615

  
14,666

Long-term deferred income tax assets
25,725

 
239

Other assets
401

  
441

Total assets
$
143,567

  
$
94,311

Liabilities and Shareholders' Equity
 
  
 
Trade payables
$
37,192

  
$
32,753

Accrued liabilities
9,123

  
8,171

Warranty obligations, current portion
1,610

  
2,278

Deferred income tax liabilities

  
1,275

    Total current liabilities
47,925

  
44,477

Warranty obligations, non-current
28


214

Income taxes payable, non-current
2,577

  
2,812

Deferred income tax liabilities, non-current

  
1,484

Other long-term liabilities
1,472

  
1,998

Total liabilities
52,002

  
50,985

Commitments and contingencies (Note 15)


  


Shareholders' equity:
 
  
 
Common stock - no par value, 75,000 shares authorized, 31,162 and 30,924 shares issued and outstanding
6,769

  
6,103

Retained earnings
84,552

  
36,598

Accumulated other comprehensive income
244

  
625

Total shareholders' equity
91,565

  
43,326

Total liabilities and shareholders' equity
$
143,567

  
$
94,311


See accompanying Notes to Consolidated Financial Statements.


29


NAUTILUS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
 
 
Year Ended December 31,
 
2013
 
2012
 
2011
Net sales
$
218,803

 
$
193,926

 
$
180,412

Cost of sales
112,326

 
102,889

 
101,953

Gross profit
106,477

 
91,037

 
78,459

Operating expenses:
 
 
 
 

Selling and marketing
66,486

 
58,617

 
54,494

General and administrative
18,705

 
17,669

 
17,143

Research and development
5,562

 
4,163

 
3,223

Total operating expenses
90,753

 
80,449

 
74,860

Operating income
15,724

 
10,588

 
3,599

Other income (expense):
 
 
 
 
 
Interest income
14

 
18

 
65

Interest expense
(36
)
 
56

 
(466
)
Other
337

 
(246
)
 
(11
)
Total other income (expense)
315

 
(172
)
 
(412
)
Income from continuing operations before income taxes
16,039

 
10,416

 
3,187

Income tax provision (benefit)
(32,085
)
 
(226
)
 
686

Income from continuing operations
48,124

 
10,642

 
2,501

Discontinued operations:
 
 

 
 
Income (loss) from discontinued operations before income taxes
(559
)
 
6,007

 
(1,065
)
Income tax provision (benefit) of discontinued operations
(389
)
 
(234
)
 
16

Income (loss) from discontinued operations
(170
)
 
6,241

 
(1,081
)
Net income
$
47,954

 
$
16,883

 
$
1,420

 
 
 
 
 
 
Basic income per share from continuing operations
$
1.55

 
$
0.34

 
$
0.08

Basic income (loss) per share from discontinued operations
(0.01
)
 
0.21
 
(0.03
)
Basic net income per share
$
1.54

 
$
0.55

 
$
0.05

 
 
 
 
 
 
 


 
 
 
 
 Diluted income per share from continuing operations
$
1.53

 
$
0.34

 
$
0.08

 Diluted income (loss) per share from discontinued operations
(0.01
)
 
0.21
 
(0.03
)
Diluted net income per share
$
1.52

 
$
0.55

 
$
0.05

Shares used in per share calculations:
 
 
 
 
 
Basic
31,072

 
30,851

 
30,746

Diluted
31,457

 
30,974

 
30,776


See accompanying Notes to Consolidated Financial Statements.

30


NAUTILUS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
 
 
Year Ended December 31,
 
2013
 
2012
 
2011
Net income
$
47,954

 
$
16,883

 
$
1,420

Other comprehensive income:
 
 
 
 
 
Foreign currency translation, net of income tax (benefit) expense of $20, $(9) and $8
(381
)
 
(83
)
 
(575
)
Comprehensive income
$
47,573

 
$
16,800

 
$
845



See accompanying Notes to Consolidated Financial Statements.


31




NAUTILUS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(In thousands)
 
 
Common Stock
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Total
Shareholders'
Equity
 
Shares
 
Amount
 
 
 
Balances at January 1, 2011
30,744

 
$
5,051

 
$
18,295

 
$
7,453

 
$
30,799

Net income

 

 
1,420

 

 
1,420

Foreign currency translation adjustment,
  net of income tax expense of $8

 

 

 
(575
)
 
(575
)
Stock-based compensation expense

 
306

 

 

 
306

Common stock issued under equity
  compensation plan
3

 
3

 

 

 
3

Balances at December 31, 2011
30,747

 
5,360

 
19,715

 
6,878

 
31,953

Net income

 

 
16,883

 

 
16,883

Foreign currency translation
  adjustment, including income tax
  benefit of $9

 

 

 
(83
)
 
(83
)
Reclassification of foreign currency
  translation gains to income upon
substantial liquidation of subsidiaries

 

 

 
(6,170
)
 
(6,170
)
Stock-based compensation expense

 
630

 

 

 
630

Common stock issued under equity
  compensation plan
177

 
113

 

 

 
113

Balances at December 31, 2012
30,924

 
6,103

 
36,598

 
625

 
43,326

Net income

 

 
47,954

 

 
47,954

Foreign currency translation adjustment,
  net of income tax expense of $20

 

 

 
(381
)
 
(381
)
Stock-based compensation expense

 
454