BOWFLEX INC. - Annual Report: 2007 (Form 10-K)

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2007

OR

FOR THE TRANSITION PERIOD FROM                      TO                     

Commission file number: 001-31321

NAUTILUS, INC.

(Exact name of Registrant as specified in its charter)

16400 S.E. Nautilus Drive

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:

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 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.    ¨

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 “accelerated filer, large accelerated filer and smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨    Accelerated filer  x     Non-accelerated filer  ¨    Smaller reporting company filer  ¨

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 ($12.04) 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, 2007) was $379,803,437.

The number of shares outstanding of the registrant’s common stock as of February 29, 2008 was 31,557,136 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 2008 Annual Meeting of Shareholders.

Table of Contents

NAUTILUS, INC.

2007 FORM 10-K ANNUAL REPORT

i

Table of Contents

PART I

Item 1. Business

OVERVIEW

Nautilus, Inc. is a leading designer, developer, manufacturer and marketer of branded fitness products sold under such well-known brand names as Nautilus, Bowflex, Schwinn Fitness and StairMaster. As used in this Form 10-K, the terms “we,” “our,” “us,” “Nautilus” and the “Company” refer to Nautilus, Inc. and its subsidiaries. Founded in 1986 and incorporated in the state of Washington in 1993, the Company had 2007 net sales from continuing operations of $501 million. In 2007 the Company experienced a decline in net sales after several years of growth achieved through a combination of internal growth of our Bowflex brand and a series of strategic acquisitions of well-recognized brands, including Nautilus International, Inc. (“Nautilus”) in January 1999, the fitness division of Schwinn/GT Corp. and its affiliates (“Schwinn Fitness”) in September 2001, and StairMaster Sports/Medical, Inc. (“StairMaster”) in February 2002. The Company acquired DashAmerica, Inc. d/b/a Pearl Izumi USA (“Pearl Izumi”) in July 2005; however, this unit was for sale at the end of 2007 and is considered a discontinued operation in the accompanying financial statements. In February 2008 we entered into an agreement to sell Pearl Izumi and we anticipate the transaction to be completed late in the first quarter of 2008.

Our common stock is listed on the New York Stock Exchange and trades under the symbol “NLS.” Our principal executive offices are located at 16400 SE Nautilus Drive, Vancouver, Washington 98683, and our telephone number is (360) 859-2900.

OUR STRATEGY

We view our Company as a global fitness products company providing innovative, quality solutions to help people achieve a fit and healthy lifestyle. We are focused on becoming a global organization, emphasizing quality, delivering innovation to provide a competitive edge, and ensuring a coordinated brand strategy for all products.

We envision presenting innovative, branded strength and cardiovascular products where people shop for home fitness equipment and where they exercise using commercial quality fitness equipment.

RECENT DEVELOPMENTS

We experienced a challenging business environment in 2007, partially because of softening conditions for consumer discretionary purchases and partially because the Company did not execute well in our effort to bring innovative branded solutions to people around the world. In August 2007 the Company’s Board of Directors replaced our Chairman and CEO with Mr. Robert Falcone, who at the time of his appointment was serving as our Lead Independent Director. After a search by a leading recruiting firm, the Board appointed Mr. Falcone as permanent CEO in October 2007. The Company began an intensive turnaround process in the second half of 2007 that resulted in substantial charges, especially in the fourth quarter.

The Company has taken a number of steps to improve our operational performance. Among them:

1

Table of Contents

In addition, we took several actions during the second half of 2007 to restore strength to our balance sheet. The Company decided in the fourth quarter 2007 to divest our Fitness Apparel segment by seeking a purchaser for the Pearl Izumi business. In addition, we addressed EBITDA-related covenant violations in our $100 million unsecured debt agreement by replacing the credit facility with a 5-year $100 million asset-based line of credit (to be reduced to $70 million upon the close of the Pearl Izumi sale). We also initiated an inventory reduction program to reduce the working capital required to operate the business, and sold a building we owned in Louisville, Colorado.

For a further discussion of the financial impact of these actions, refer to Management’s Discussion and Analysis of Financial Condition and Results of Operation located at Part II, Item 7 of this Form 10-K.

On September 20, 2007, Sherborne Investors LP (together with its affiliates, “Sherborne”), our largest shareholder, sent a letter to the Company demanding a special meeting of shareholders for the purpose of presenting certain proposals, including a proposal to remove four members of our Board and replace them with nominees put forth by Sherborne. Following a proxy contest, a special meeting of shareholders was convened on December 18, 2007 at which the Company’s shareholders voted in favor of all the proposals put forth by Sherborne. As a result, in December 2007 four of the Company’s former directors were removed and replaced by the Sherborne nominees and Mr. Edward J. Bramson, the Managing Member of Sherborne, was named Chairman of our Board of Directors.

BUSINESS SEGMENTS

The Company’s reportable segments are evidence of the structure of the Company’s internal organization and allow focus on specific business opportunities in the Company’s worldwide market. Following the 2007 decision to exit its Fitness Apparel Segment, which is reported as a discontinued operation, the Company operates in two business segments as follows:

Detailed financial information about our business segments, including information regarding geographic areas, is included in Note 13 of the Notes to Consolidated Financial Statements.

2

Table of Contents

PRODUCTS

The Company’s principal business activity is the design, development, manufacturing, and worldwide marketing of high quality cardiovascular and strength products and related accessories.

Branded Fitness Equipment Products

The fitness equipment line is comprised of high-quality cardiovascular and strength products that cover a broad range of technology, price points, and features that are believed to be among the best in categories in which they compete.

SALES AND MARKETING

Fitness Equipment Business

The Fitness Equipment Business products are marketed and sold through a diversified direct, retail, and commercial sales distribution channel within the Americas, which includes the United States (the “U.S.”), Mexico, Canada and South America. These distribution channels consist of independent authorized dealers, our own sales force, distributors and our e-commerce web sites that are accessible through the overall website (www.nautilusinc.com). We believe we position our products to better meet consumer demand and shopping patterns and to further expand our sales channels by offering more of the products consumers want in the places they shop and exercise.

Our Fitness Equipment Business has three distinct sales channels:

We use the spot commercials and infomercials, together with Internet advertising and search-engine placement, to lead consumers to our website, as we believe consumers who visit our website are more inclined to purchase our products. We believe we successfully balance our goals of finalizing sales and capturing consumer information by strategically designing our web pages and carefully analyzing web page visits, conversion rates, average sales prices and inquiry counts.

We contract with large telemarketing companies to receive and process information requests generated by our spot television advertising. The telemarketing agents for these companies collect names, addresses and other basic information from callers but do not directly sell our products.

3

Table of Contents

We manage our own customer service call center in Vancouver, Washington. It operates 18 to 23 hours per day to receive and process the vast majority of all infomercial-generated and customer service-related inquiries.

There are several national and regional industry trade shows, such as the International Health, Racquet and Sportsclub Association and Club Industry, as well as certain regional events that showcase our programs and products. Trade shows provide opportunities to meet face-to-face with our customers and the media to obtain valuable feedback by being able to test market messages, receive customer input on product designs, and evaluate the competition.

We maintain a database that includes contacts at thousands of commercial facilities and enables us to monitor responses to direct mail promotions. All direct mail promotions are supplemented by a telemarketing effort to maximize customer response. We maintain a modest advertising presence in certain trade publications.

The main focus for marketing our retail products is two-fold: 1) fully support our network of customers, and 2) leverage our direct marketing advertising programs to market brands and products through the retail sales channel that were previously only available to consumers through the direct sales channel. Company sponsored marketing programs have been developed to ensure that our Nautilus, Schwinn Fitness, Bowflex, and StairMaster brands remain prominent in the minds of customers and consumers and drive consumers to their local retailers.

International Equipment Business

The International Equipment Business product line is marketed and sold through a diversified retail and commercial sales distribution channel outside of the Americas through our own sales force and international distributors. The sales are predominately commercial with retail sales comprising 21% of the total for the International Equipment Business. By offering a complete line of strength and cardio products, we now have greater ability to compete in the international marketplace where many commercial customers prefer to buy from one supplier that can offer a broad array of products at a competitive price. We believe our brand names have strong recognition in the international marketplace which has allowed us to compete more effectively.

To allow us to effectively manage our international sales channels, we operate our own offices in our largest international markets which include Switzerland, the United Kingdom, Germany, Italy, and China. Each office possesses a team of sales and service representatives that focus on selling to fitness clubs, governments and hotels.

PRODUCT DESIGN AND INNOVATION

Innovation is a vital part of our business as we continue expansion and diversification of our product offerings in fitness products through leveraging our advanced research and development capabilities and our strong brand

4

Table of Contents

name recognition. On an ongoing basis, we evaluate new product concepts and seek to respond to the requirements and needs of our consumers by frequently introducing new products and repositioning existing products. We develop these products either from internally generated ideas or by acquiring or licensing patented technology from outside inventors and then enhancing the technology.

Our research and development costs were approximately $10.4 million, $9.4 million, and $10.4 million, for the years ended December 31, 2007, 2006, and 2005, respectively. In 2007 and for all periods presented, we reclassified preproduction royalties into research and development expenses from a royalty expense line previously included within operating expenses. Preproduction royalties represent payments made for the use of third party owned licensed patented technologies prior to a product being developed and sold. Included in research and development costs were $1.0 million, $0.7 million and $0.4 million of preproduction royalties for the years ended December 31, 2007, 2006 and 2005, respectively.

Also in 2007, we reclassified royalty expense related to products sold into cost of goods sold. Royalty expense was previously reported as a separate line within operating expenses for those products utilizing a licensed patented technology. The reclassification was made for all periods presented. We incurred $4.9 million, $4.9 million, and $5.0 million in royalties for licensing patented technology for the years ended December 31, 2007, 2006, and 2005, respectively. We did not have any customer-sponsored research and development expenses in any of these years.

SEASONALITY

Fitness Equipment Products

In general, U.S. and international sales in our direct, commercial, and retail fitness equipment channels are seasonal. We believe that sales within these channels are lower in the second quarter of the year compared to the other quarters, especially in the direct and retail channels. Our strongest quarter for these channels is generally the fourth quarter, followed by the first and third quarters. We believe the principal reason for this trend is the fitness industry’s preparation for the impact of seasonal weather patterns that encourage more fitness activity indoors in the winter months.

MANUFACTURING AND DISTRIBUTION

Fitness Equipment Business

Our primary manufacturing and distribution objectives for all of our products are to maintain product quality, reduce and control costs, maximize production flexibility, and improve delivery speed. This is accomplished by optimizing our manufacturing and distribution infrastructure. Our products are manufactured in the U.S. at our Oklahoma and Virginia plants, and at contracted manufacturing facilities in Asia. We have not experienced any significant difficulties with availability of raw materials.

Our commercial strength fitness products are primarily manufactured in our Virginia manufacturing plant, and our commercial cardiovascular fitness products are primarily manufactured in our Oklahoma plant. These operations are vertically integrated and include such functions as metal fabrication, powder coating, upholstery, and vacuum-formed plastics processes. By managing our own manufacturing operations, we can control the quality of our commercial products and offer customers build-to-order capability and unique product configurations.

We inspect, package, and ship our products from our distribution facilities in Oregon, Virginia, Illinois, Oklahoma and Winnipeg, Canada. We rely primarily on United Parcel Service (UPS) to deliver our direct products. We distribute our retail and commercial fitness equipment from our facilities in Illinois and Oklahoma using various commercial truck lines. We distribute a substantial portion of our commercial strength fitness equipment from our Virginia warehouse facility directly to customers through our own truck fleet which allows us to effectively control the set up and inspection of equipment at the end-user’s facilities. We anticipate closing our Illinois facility in the second quarter of 2008.

5

Table of Contents

International Equipment Business

Our International Equipment Business primarily consists of sales of commercial products that are manufactured in our Virginia and Oklahoma manufacturing facilities. We utilize our Asian suppliers to manufacture our retail products and several commercial products. Products are shipped to customers outside the Americas primarily from a third party distribution facility in the Netherlands.

BACKLOG

Historically backlog has not been a significant factor in the Company’s business.

COMPETITION

The markets for all of our products are highly competitive. Our competitors vary by market and sales channel as discussed below. We believe the principal competitive factors affecting our business are quality and innovation combined with of our well-recognized brand names enhanced by our brand marketing awareness programs. Other principle factors contributing to our ability to stay competitive include pricing strategy with key products and dependable customer service. We believe this combination of factors will allow us to remain competitive in all of our current fitness equipment markets.

Direct Fitness Equipment: We primarily sell our Bowflex strength and cardiovascular fitness products in this market. Our direct-marketed brands compete directly with a large number of companies that manufacture, market and distribute home fitness equipment. Our principal direct competitors include Fitness Quest and ICON Health & Fitness.

Commercial Fitness Equipment: Our Nautilus, Schwinn Fitness, and StairMaster brands compete against products of other commercial fitness equipment companies such as Life Fitness (Brunswick), Precor (Amer Sports), Cybex and TechnoGym.

Retail Fitness Equipment: Our Nautilus, Schwinn Fitness, StairMaster, and Bowflex brands compete against the products of other retail fitness equipment companies such as Johnson Health Tech, ICON Health & Fitness and many others.

In our International Equipment Business, our Nautilus, Schwinn Fitness, StairMaster, and Bowflex brands compete against the products of such companies as Life Fitness, Johnson Health Tech, Cybex, StarTrac, Precor, and TechnoGym.

EMPLOYEES

As of February 28, 2008, we employed approximately 1,262 employees, excluding 223 employees of Pearl Izumi, as the Company made a decision to exit this business. Management considers its relationship with employees to be good. None of our employees are subject to any collective bargaining agreements. There has never been a material interruption of operations due to labor disruptions.

SIGNIFICANT CUSTOMERS

We had no individual customers that accounted for 10 percent or more of our consolidated net sales during fiscal 2007, 2006, and 2005.

6

Table of Contents

INTELLECTUAL PROPERTY

Trademarks – We own many trademarks including Nautilus^®, Bowflex^®, Power Rod^®, TreadClimber^®, Schwinn^® Fitness, SelectTech^®, StairMaster^®, Trimline^® and Universal^®. Our trademarks, the great majority of which are either registered or protected by common law rights, are used on nearly all of our products sold in the U.S. and internationally. We believe that having distinctive trademarks readily identifiable by consumers is an important factor in creating a market for our goods, in identifying our Company, and in distinguishing our goods from others.

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.

Patents – The Company has a broad array of patents, both issued and pending, covering its exercise equipment. Within these patents are various products and technologies including TreadClimber, variable stride ellipticals, selectorized weights, recumbent bicycles, and Spiraflex. Our patent protection for some of these technologies extends as far as 2025. Expiration of our patents could trigger the introduction of similar products by our competitors.

Building our intellectual property portfolio is an important factor in maintaining our competitive position in the fitness equipment and apparel industries. We have followed a policy of filing applications for the U.S. and foreign patents on inventions, new designs and improvements that we deem valuable to our business. If we do not, or are unable to, adequately protect our intellectual property, our sales and profitability could be materially adversely affected. We protect our proprietary rights vigorously and take prompt action to prevent counterfeit reproductions of or other infringing on our intellectual property. As we increase our market share, geographic scope and product categories, we anticipate that intellectual property disputes will increase making it more expensive for us to establish and/or protect our proprietary rights, and to defend against claims of infringement by others. Refer to Note 14 to the consolidated financial statements located at Part II, Item 8 of this Form 10-K for a discussion of significant intellectual property disputes.

ENVIRONMENTAL MATTERS

Our operations are subject to federal, state and local health and safety and environmental laws and regulations, as well as those in other countries that impose workplace standards and limitations on the discharge of pollutants into the environment and establish standards for the handling, generation, emission, release, discharge, treatment, storage and disposal of materials, substances and wastes. U.S. federal environmental legislation having particular impact on the Company 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, Compensation and Liability Act (also known as Superfund). We are also subject to regulation by the Occupational Safety and Health Administration (OSHA) concerning employee safety and health matters. The United States Environmental Protection Agency (EPA), OSHA, and other federal agencies have the authority to promulgate regulations that have an impact on our operations.

The nature of our manufacturing and assembly operations exposes us to the risk of claims with respect to environmental matters, and although compliance with local, state, federal and international requirements relating to the protection of the environment has not had a material adverse effect on our financial condition or results of operations, there can be no assurance that material costs or liabilities will not be incurred in connection with such environmental matters. Future events, such as changes in existing laws and regulations or enforcement policies or the discovery of contamination on sites owned or operated by us may give rise to additional compliance costs or operational interruptions which could have a material adverse effect on our financial condition, results of operations, and cash flows. While we are not aware of any existing conditions that are likely to result in material costs or liabilities to us, there can be no assurance that all potential instances of soil or ground water contamination have been identified even where Environment Site Assessments have been conducted.

7

Table of Contents

Accordingly, there can be no assurance that previously unknown environmental conditions, or known conditions which have not been fully evaluated, will not be discovered at any of our properties, whether presently or formerly owned or leased, or that the cost of remediating such conditions will not be material.

WHERE YOU CAN FIND MORE INFORMATION

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 (“Exchange Act”). 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. Please call the SEC at 1-800-SEC-0330 for further information on the Public Reference Room. The SEC maintains an Internet site at http://www.sec.gov/ where you can obtain most of our SEC filings. We also make available, free of charge, on our website at www.nautilusinc.com our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports, if any, filed or furnished with the SEC pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after they are filed electronically with the SEC. 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 at www.nautilusinc.com. The information found on our website is not part of this Form 10-K.

Item 1A. Risk Factors

Special Note Regarding Forward-Looking Statements and Analysts Reports

This Form 10-K, including Item 1 of Part I and Items 7 and 7(A) of Part II, contains forward-looking statements. Forward-looking statements include any statements related to our expectations regarding future performance or conditions, including any statements regarding anticipated sales growth across markets, distribution channels, and product categories, expenses and gross margins, expense as a percentage of revenue, anticipated earnings, new product introductions, future capital expenditures, 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 Item 1(A), Risk Factors, of this Form 10-K. We do not undertake any duty to update forward-looking statements after the date they are made or to conform them to actual results or to changes in circumstances or expectations.

We may need to raise additional financing if our financial results do not improve.

We sustained a pretax loss from continuing operations of $72.0 million during the year ended December 31, 2007, contributing to a decrease in net working capital of $54.5 million from 2006. Beginning in September 2007, we initiated a number of actions to improve the strength of our balance sheet, including efforts to divest our Fitness Apparel Business through the sale of Pearl Izumi and the negotiation of a new $100 million asset-based line of credit, which will be reduced to $70 million upon the close of the sale of Pearl Izumi. We also initiated an inventory reduction program to reduce the working capital required to operate our business and sold a building we owned in Louisville, Colorado. However, if we continue to experience significant operating losses and reductions in net working capital, these actions may not be adequate to address our financing requirements and we may need to obtain additional debt or equity financing to continue current business operations. There is no guarantee that we will be able to raise additional funds on favorable terms, if at all.

The actions we have taken to improve our operating performance may not be successful.

Beginning in September 2007, we have implemented a series of actions to improve our operating performance with the goal of simplifying the business and returning the Company to profitability. We have implemented

8

Table of Contents

actions to reduce our operating expenses, including a reduction in workforce, suspended sale of two cardiovascular products sold in the commercial channel due to durability issues, we closed the Australia direct sales operations, we announced the closure of the Winnipeg, Canada call center and Bolingbrook, Illinois distribution center. By themselves, these actions are not sufficient to return the Company to profitability.

Failure to successfully implement our turnaround strategies may adversely affect revenues and decrease margins

To implement our business strategy, we must effectively manage our turnaround in each of our operating channels. We will continue to change various aspects of our business, to maintain and enhance our information systems and operations, and to attract, retain and manage qualified personnel. Turnaround could place an increasing strain on management, financial, product design, marketing, distribution and other resources, and we could experience operating difficulties. Turnaround involves many risks and uncertainties that, if not managed effectively, could have a material adverse effect on our results of operations and financial condition.

A significant decline in availability of media time or fluctuating advertising rates may hinder our ability to effectively market our products and may reduce profitability

We depend primarily on television commercials and television infomercials to market and sell our direct-marketed products. Consequently, a marked increase in the price we must pay for our preferred media time or a reduction in its availability may adversely impact our financial performance.

A decline in consumer spending due to unfavorable economic conditions could negatively affect our product revenues and earnings

Success of each of our products depends substantially on the amount of discretionary funds available to consumers and their purchasing preferences. Economic and political uncertainties could adversely impact the U.S. and international economic environments. A decline in general economic conditions due to increased freight and transportation costs as well as increasing interest rates, among other factors, could further depress consumer spending, especially discretionary spending for big ticket products like ours. Higher interest rates could increase monthly payments for consumer products financed through one of our monthly payment plans. These poor economic conditions could in turn lead to substantial decreases in our net sales.

We have terminated our agreements to acquire our Asian manufacturing partner. Damage claims and/or impact to our business relationship resulting from disputes related to such agreements could harm our business.

On January 19, 2008, we gave written notice to Land America Health & Fitness Co., Ltd, our Asian manufacturing partner, and Treuriver Investments, Limited, its related trading company (collectively, “Land America”), that we were exercising our right to terminate our agreements with Land America to purchase substantially all of Land America’s assets. By letter dated January 21, 2008, legal counsel to Land America notified us that Land America considers us to be in breach of certain duties set forth in such agreements and that Land America has incurred significant economic damages as a result of such alleged breach. While we believe that we have defenses to any such claim and would vigorously assert those defenses in any such proceeding, if Land America were to prevail in large part on a successful damages claim against us, such claim could negatively impact our financial results. Additionally, if our business relationship with Land America is damaged by a dispute related to these agreements, our business and operations may be negatively impacted.

If our contract manufacturers experience any delay, disruption or quality control problems in their operations, we could lose market share and revenues, and our reputation may be harmed.

We have outsourced the manufacturing of many of our products, including substantially all of our consumer products, to third party manufacturers. We rely on our contract manufacturers to procure components and

9

Table of Contents

provide spare parts in support of our warranty and customer service obligations. We generally commit the manufacturing of each product platform to a single contract manufacturer.

Our reliance on contract manufacturers exposes us to the following risks over which we may have limited control:

Our contract manufacturers are primarily located in Asia 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. In addition, we do not have long-term contracts with any of our third-party contract manufacturers and these contracts are terminable by either party on relatively short notice.

Our revenues and profitability can fluctuate from period to period and are often difficult to predict for particular periods due to factors beyond our control.

Our results of operations for any individual quarter or for the year are not necessarily indicative of results to be expected in future periods. Our operating results have historically been, and are expected to continue to be, subject to quarterly and yearly fluctuations as a result of a number of factors, including:

These trends and factors could harm our business, operating results and financial condition in any particular period.

Our operating expenses and portions of our costs of revenues are relatively fixed and we may have limited ability to reduce expenses quickly in response to any revenue shortfalls.

Our operating expenses and inventory handling costs 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 revenue shortfall, it could negatively impact our financial results.

10

Table of Contents

If we are unable to anticipate consumer preferences or to effectively develop, market and sell future products, our future revenues and earnings could be adversely affected

Our future success depends on our ability to develop or acquire the rights to, and then effectively produce, market, and sell new products that create and/or respond to new and evolving consumer demands. Accordingly, our net sales and profitability may be harmed if we are unable to develop, or acquire the rights to new or different products that satisfy consumers’ preferences. In addition, any new products that we market may not generate sufficient net sales or profits to recoup their development or acquisition costs.

A delay in getting foreign sourced products through customs in a timely manner could result in cancelled orders and unanticipated inventory accumulation

Many of our imported products are subject to duties, tariffs or quotas that affect the cost and quantity of various types of goods imported into the U.S. or our other sales 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 have a material adverse effect on our business, potentially resulting in reduced revenues and earnings, cancelled orders by customers, and/or unanticipated inventory accumulation.

Unpredictable events and circumstances relating to our international operations, including our use of foreign manufacturers, could result in cancelled orders, unanticipated inventory accumulation, and reduced revenues and earnings

A portion of our revenues is derived from sales outside the U.S.; for the year ended December 31, 2007, international sales, including sales from the International division and Canada, represented approximately 21% of our consolidated net sales. In addition, a substantial portion of our products is manufactured outside of the U.S. Accordingly, our future results could be materially adversely affected by a variety of factors, 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 for a period of time longer than those made in the U.S.

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. If we do not or are unable to adequately protect our intellectual property, our sales and profitability may be adversely affected. We currently hold a number of patents and trademarks and have several patent and trademark applications pending. However, our efforts to protect our proprietary rights may be inadequate, and applicable laws provide only limited protection.

Intense competition may have a negative impact on our net sales and operating results

Our products are sold in highly competitive markets with limited barriers to entry. As a result, introduction of lower priced competing products could result in a significant decline in our net sales and operating results.

Inability to effectively manage our distribution facilities may harm our business and financial results

Our ability to meet customer expectations, manage inventory, complete sales and achieve objectives for operating efficiencies depends on the proper operation of our existing distribution facilities and the timely

11

Table of Contents

performance of services by third parties, including those involved in shipping product to and from our distribution facilities. In the U.S., we rely primarily on our distribution centers in Portland, Oregon; Independence, Virginia; Tulsa, Oklahoma; Bolingbrook, Illinois; and in Europe we rely primarily on a third party warehouse and logistics provider in the Netherlands. The Company has announced the April 2008 closure of the Bolingbrook, Illinois distribution center.

Operations at our distribution facilities could be interrupted by disasters such as earthquakes or fires. We maintain business interruption insurance, but it may not adequately protect us from the adverse effect that could be caused by significant disruptions in our distribution facilities.

Failure to maintain our information systems could result in interruptions to our business

Our business is increasingly reliant on information technology. Information systems are used in all stages of our production cycle, from design to distribution, and are used as a method of communication between employees, our subsidiaries overseas, as well as our customers. We also rely on our information systems to allocate resources and forecast operating results. 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, or failure to properly protect, repair or maintain systems. Any interruption of critical business information systems may have a material adverse affect on our results of operations and financial condition.

Currency exchange rate fluctuations could result in higher costs and decreased margins

We have significant sales outside of the U.S. As a result, we conduct transactions in various currencies which increase our exposure to fluctuations in foreign currency exchange rates relative to the U.S. dollar. Our international revenues and expenses generally are derived from sales and operations in foreign currencies, and these revenues and expenses could be affected by currency fluctuations. Currency exchange rate fluctuations could also disrupt the business of the independent manufacturers that produce our products by making their purchases of raw materials more expensive and more difficult to finance. Therefore, 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 conduct business.

Our business is affected by seasonality which results in fluctuations in our operating results

We experience moderate fluctuations in aggregate sales volume during the year. Historically, our strongest quarter for sales is the fourth quarter, followed by the first and third quarters. 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.

We may be adversely affected by the financial health of our customers

We extend credit to our customers, generally without requiring collateral, based on the assessment of a customer’s financial circumstances. To assist in the scheduling of production and the shipping of seasonal products, we offer customers the ability to place orders four to six months ahead of delivery. These advance orders may be cancelled and the risk of cancellation may increase when dealing with financially challenged customers struggling with economic uncertainty. In the past, some customers have experienced financial difficulties which in turn have had an adverse effect on our business. From time to time, customers will be more cautious than usual with orders as a result of weakness in the retail economy. A slowing economy in our key markets could have an adverse effect on the financial health of our customers which could in turn have an adverse effect on our results of operations and financial condition.

12

Table of Contents

Government regulatory actions could disrupt our marketing efforts and product sales

Various international and U.S. federal, state and local government authorities, including the Federal Trade Commission, Environmental Protection Agency, and the Consumer Product Safety Commission, regulate our marketing efforts and manufacturing of products. Our sales and profitability could be significantly harmed if any of these authorities commence a regulatory enforcement action that interrupts our marketing or manufacturing efforts, results in a product recall or negative publicity, or requires changes in product design.

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. 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 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 requiring us to pay substantial damages.

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 in manufacturing, product recalls or product liability claims which may have a material adverse effect on our business. We maintain a warranty reserve for future warranty claims but the actual costs of servicing future warranty claims may exceed the reserve and have a material adverse effect on our results of operations and financial condition.

In early 2008, the Company suspended sales of the commercial TreadClimber products as a result of product durability issues until those issues can be corrected. The severity of the quality issues and costs related to either replacing or maintaining this product increased significantly during the fourth quarter of 2007 leading management to take specific action with this product. Management is currently evaluating alternatives for addressing this warranty issue and has recorded its best estimate of the cost to remediate the issues identified which is included in accrued liabilities and other long-term liabilities. Management’s estimate of costs to remediate could be materially different than the actual cost of remediation.

In order to be successful, we must attract, retain and motivate key employees, and failure to do so may have an adverse impact on our business

Our future success depends on our ability to attract and retain key executives, managers, product development engineers, sales personnel, and others. We face intense competition for such individuals worldwide. Not being able to attract or retain these employees may have a material adverse effect on our results of operations and financial condition.

Item 1B. Unresolved Staff Comments

None.

13

Table of Contents

Item 2. Properties

The following is a summary of principal properties owned or leased by the Company.

In general, our properties are well maintained, adequate and suitable for their purposes, and we believe these properties will meet our operational needs for the foreseeable future. If we require additional warehouse or office space, we believe we will be able to obtain such space on commercially reasonable terms.

14

Table of Contents

Item 3. Legal Proceedings

For a description of the legal proceedings that affect us, refer to Note 14 to the consolidated financial statements located at Item 8 of this Form 10-K.

Item 4. Submission of Matters to a Vote of Security Holders

A special meeting of shareholders of Nautilus, Inc. was held on December 18, 2007, at which the following actions were taken:

As a result of the voting set forth above Messrs. Bramson, Eastman, Stein and Horn were elected to replace Mr. Allen, Ms. Follit, Mr. Keeble and Ms. Neal, each of whom were removed from the Board.

15

Table of Contents

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 29, 2008, 31,557,136 shares of our common stock were issued and outstanding, the number of beneficial shareholders was approximately 6,000 and the number of shareholders of record was 75.

The following table summarizes the high and low closing prices and dividends paid per common share for each period indicated:

The total amount of dividends paid in 2007 and 2006 were $9.5 million ($0.30 per share) and $12.9 million ($0.40 per share), respectively. In the fourth quarter of 2007, the Board of Directors suspended the dividend. Payment of any future dividends 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. The Company’s loan agreement contains covenants that include limitations on paying dividends when certain ratios are not met. Based on the covenants, the Company is currently precluded from paying dividends.

Equity Compensation Plans

The following table provides information about the Company’s equity compensation plans as of December 31, 2007:

For further information regarding the Company’s equity compensation plans, refer to Note 10 to the consolidated financial statements located at Item 8 of this Form 10-K.

16

Table of Contents

Stock Performance Graph

Below is a line graph and table comparing the cumulative total shareholder return of our common stock with the cumulative total return of the NYSE Composite Index, NASDAQ, and the S&P SmallCap 600 Index for the period commencing December 31, 2002 and ending on December 31, 2007. The S&P 600 Small Cap 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. Our common stock was added to the S&P SmallCap 600 on March 19, 2003.

The graph assumes that $100 was invested in our common stock and each index in December 2002. The comparisons in the table below are not intended to forecast or be indicative of future performance of our common stock.

17

Table of Contents

Item 6. Selected Financial Data

The selected consolidated financial data presented below is for, and as of the end of, each of the years in the five-year period ended December 31, has been derived from the audited consolidated financial statements. This data should be read in conjunction with our financial statements and notes thereto and Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operation.

In the fourth quarter of 2007, management committed to a plan to sell the operations of our Fitness Apparel Business. Our Fitness Apparel Business consists primarily of Pearl Izumi which designs, markets and sells branded fitness apparel and footwear sold primarily under the Pearl Izumi brand globally. In February 2008, the Company entered into an agreement to sell Pearl Izumi and the Company anticipates the sale to be completed late in the first quarter 2008. Accordingly, assets, liabilities, and results of operations of the Fitness Apparel Business for all periods presented have been presented as discontinued operations in the consolidated financial statements in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. See Note 2 “Discontinued Operations” to Nautilus, Inc.’s Consolidated Financial Statements and later in the MD&A.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation

This Management’s Discussion and Analysis of Financial Condition and Results of Operation (the “MD&A”) should be read in conjunction with our consolidated financial statements and related notes located at Item 8 of this Form 10-K. We believe that period-to-period comparisons of our operating results are not necessarily indicative of future performance. You should consider our prospects in light of the risks, expenses and difficulties typically encountered by most companies. We may not be able to successfully address these risks and difficulties and, consequently, we cannot assure you of any future growth or profitability. For more information, see our discussion of Risk Factors located at Part I, Item IA of this Form 10-K.

EXECUTIVE OVERVIEW

We are a leading designer, developer, manufacturer and marketer of branded fitness products sold around the world. We operate in two segments; the Fitness Equipment Business and the International Equipment Business. During 2007, the Company decided to exit the Fitness Apparel Business and the related financial results have been classified as discontinued operations. In addition, management made a number of strategic decisions which impacted 2007 operating results:

18

Table of Contents

For the year, we delivered net sales from continuing operations of $501.5 million compared to $617.3 million in 2006, a decrease of 18.8%. Gross profit margins decreased to 35.8% in 2007 compared to 43.2% in 2006. The largest contributor to our decrease in gross margins in 2007 was a $16.9 million charge recorded for warranty and inventory reserves related to quality issues and the decision to stop selling certain of our commercial cardiovascular products until quality issues can be remedied. Operating expenses were $248.0 million in 2007 compared to $231.6 million in the prior year, an increase of 7.1%. This increase is primarily the result of $30.5 million of significant charges incurred in connection with strategic decisions made by management in an effort to return the company to profitability, offset by an $18.3 million lawsuit settlement in which the Company received the rights to utilize a variety of fitness equipment patents and related technologies.

In the fourth quarter of 2007, management committed to a plan to sell the operations of our Fitness Apparel Business. Our Fitness Apparel Business primarily consists of Pearl Izumi which designs, markets and sells branded fitness apparel and footwear sold primarily under the Pearl Izumi brand globally. In February 2008 the Company entered into an agreement to sell Pearl Izumi and the Company anticipates the sale to be completed late in the first quarter of 2008. Accordingly, assets, liabilities and results of operations of the Fitness Apparel Business have been presented as discontinued operations in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. See Note 2 “Discontinued Operations” to Nautilus, Inc.’s Consolidated Financial Statements and later in the MD&A.

Loss from discontinued operations in 2007 was $9.8 million, including an impairment charge of $13.2 million, compared to income from discontinued operations of $4.2 million in 2006.

19

Table of Contents

RESULTS OF OPERATIONS

The following table sets forth selected financial information derived from our consolidated financial statements. The discussion that follows the table should be read in conjunction with the consolidated financial statements.

COMPARISON OF THE YEARS ENDED DECEMBER 31, 2007 AND DECEMBER 31, 2006

Net Sales

Net sales were $501.5 million in 2007 compared to $617.3 million in 2006, a decrease of $115.8 million or 18.8%. The decrease is a result of decreases in the retail and direct channels in the Fitness Equipment Business offset by an increase in sales in the International Equipment Business.

Fitness Equipment Business – The fitness equipment business designs, produces, markets and sells fitness products under the Nautilus, Bowflex, Schwinn Fitness, and StairMaster brand names. Depending on the brand, our fitness equipment is marketed and sold through the direct, commercial, and retail channels of distribution located in North and South America. Net sales for the fitness equipment business were $423.9 million in 2007 as compared to $553.4 million last year, a decrease of $129.5 million or 23.4%. Specific channel net sales information is detailed below:

In the direct channel, net sales declined 12.5% to $247.7 million in 2007 compared to $283.1 million last year. Sales in the direct channel consist of our Bowflex branded products and primarily include our rod-based home gyms, TreadClimber products, Bowflex Revolution and SelectTech dumbbells. The decrease in net sales is primarily due to a decrease in sales of rod based home gyms. The decrease in sales of rod based home gyms resulted primarily from of reduced advertising for rod based home gyms and a higher number of similar power rod products being sold at our retail partner locations during 2007. During 2007 we experienced increased advertising costs which led to fewer ads being purchased for the same dollars due to increased competition for

20

Table of Contents

advertising space. The decrease in sales of rod based home gyms was slightly offset by an increase in sales volume for our Bowflex Revolution and the Bowflex TreadClimbers. Sales of these products increased as a result of increased advertising and the introduction during 2007 of the Revo XP with an upright bench format.

In the retail channel, net sales declined 49.3% to $99.5 million as compared to $196.1 million last year. The decline in this channel was mainly due to a shift in strategy as we are limiting the number of power-rod home gyms being offered into this channel to more clearly differentiate and segment products by channel. The retail channel experienced a general softness in consumer spending during 2007 which has caused the Company to provide a greater level of support to its customers in the form of discounts to allow our customers to sell through their existing inventory.

In the commercial channel, net sales remained substantially unchanged at $73.6 million in 2007 compared to $73.0 million last year. Product features of Nautilus branded bikes were refreshed during 2007 which led to significant increases in sales volumes for those products. We also experienced increased sales of the TreadClimber product and Stairmaster stepping products. This was offset by decreased sales of Schwinn branded indoor bikes, other Nautilus branded cardio equipment and a slight decline in sales of the strength product lines as a result of delays in production and delivery of the Company’s newly launched Nautilus One and certain free weight product lines. Sales of the Company’s commercial TreadClimber products were suspended in early 2008 as a result of durability issues. Sales will be suspended until the product can be re-engineered and the durability and warranty issues can be corrected. We anticipate this will lead to a reduction in commercial channel revenue during 2008 compared with 2007.

Royalty income represents the revenue the Company receives for licensing certain owned patents, trademarks and brands to other companies. Royalty income increased to $3.1 million in 2007 compared to $1.2 million last year. The increase was a result of acquiring a large patent group related to elliptical machines during 2006 on which the Company had previously paid royalties. The acquisition of the patent group allowed the Company to begin collecting royalty income from other parties who use the licensed technology.

International Equipment Business – The International Equipment Business markets and sells fitness products sold under the Nautilus, Bowflex, Schwinn Fitness, and StairMaster, brand names through the commercial, retail and direct channels of distribution located outside of the Americas. Net sales for the International Equipment Business improved 21.3% to $77.5 million as compared to $63.9 million last year. The increase in net sales was due to expansion of our commercial sales channel in our four western European subsidiaries, as well as increased sales through our distributors following the introduction of the TreadClimber in international sales markets. In addition, we established a subsidiary in China during the third quarter of 2006 and added a direct division in Australia during 2007. The direct Australia division added $1.3 million in sales during 2007. The direct Australia division was closed in early 2008 and the market will be supported through the traditional distributor model business going forward. Sales of the Company’s commercial TreadClimber products were suspended in early 2008 as a result of durability issues. Sales will be suspended until the product can be re-engineered and the durability issues can be corrected. We anticipate this to cause a reduction in International Equipment Business revenue during 2008 compared with 2007.

Gross Profit

As a result of our decline in sales, our total gross profit declined by 32.7% to $179.4 million in 2007 as compared to $266.4 million last year. As a percentage of consolidated net sales from continuing operations our gross profit margin decreased to 35.8% as compared to 43.2% last year. The decrease in gross profit margin was due primarily to charges incurred during 2007 of $16.9 million resulting from warranty and inventory reserves related to commercial cardiovascular products. This change impacted margin by 3.4 percentage points. Gross profit margin also decreased as a result of the continued shift in our sales product mix both between and within product categories and among our selling channels. During 2007, the Company reclassified royalty expense into cost of goods sold for all reporting periods. Royalties were previously reported as a separate line item included in operating expenses.

21

Table of Contents

Fitness Equipment Business – Gross profit for our Fitness Equipment Business declined to $158.6 million in 2007 as compared to $250.5 million last year. As a percentage of net sales, the gross profit margin declined to 37.4% in 2007 compared to 45.3% last year. Factors affecting gross profit included significant charges related to warranty and inventory write-offs resulting from suspension of sales of the commercial TreadClimber product and a commercial elliptical product. Other factors affecting gross profit margin include sales channel and product sales mix and additional promotions in the direct and retail channels. Most notable is the reduction of sales in power-rod home gyms sold in both the direct and retail channels that historically provide higher margins than most of our other finished goods. During 2007 the Company’s gross margins benefited from rebates payable under our Supply Agreement with Land America. As a result of the termination of the agreement to purchase the Land America assets, those rebates will not be available in 2008. The negative impact on gross margins resulting from termination of the rebates will depend on the volume of purchases from Land America.

During 2007, the Company reclassified royalty expense related to products sold into cost of goods sold. Royalty expense was previously reported as a separate line within operating expenses for those products utilizing a licensed patented technology. The reclassification was made for all periods presented. Royalty expense of $4.9 and $4.9 million for the years ended December 31, 2007 and 2006, respectively is included in gross profit.

International Equipment Business – Gross profit for our International Equipment Business was $20.7 million in 2007 compared to $15.9 million in 2006, an increase of $4.8 million or 30.2%. As a percentage of net sales, the gross profit margin increased to 26.7% in 2007 compared to 24.9% in 2006. The increased gross profit is the result of a better sales mix in the retail channel and improved margins due to the inclusion of some direct sales in China and Australia. The Company closed the Australia direct business in early 2008 because of lack of overall profitability in that channel.

Operating Expenses

Selling and Marketing

Selling and marketing expenses increased by $5.9 million or 3.4% to $181.2 in 2007 as compared to $175.3 million last year. As a percentage of consolidated net sales our selling and marketing expenses increased to 36.1% in 2007 compared to 28.4% last year. The increase in selling and marketing expenses in the Fitness Equipment Business related to incremental bad debt reserves of $4.8 million primarily resulting from the bankruptcy filing by a former customer and a $1.2 million charge to exit certain marketing contracts. In addition, selling and marketing expenses within the International Equipment Business increased in support of growing revenue, and as a result of costs related to expansion into new markets including China and Australia. These increases were offset by a sales volume decline in the direct channel resulting in lower marketing expenses and financing fees within the Fitness Equipment Business. As a percentage of sales, selling and marketing expenses in the direct channel increased during 2007.

General and Administrative

General and administrative expenses increased by $27.7 million or 59.1% to $74.6 million in 2007 as compared to $46.9 million last year. The increase was primarily a result of the following: (i) a $19.4 million charge related to termination of the Land America asset purchase agreements, (ii) a $3.0 million intellectual property impairment related to strategic changes in the Company’s plans to utilize the patents acquired in the second quarter of 2007, (iii) $2.7 million of additional expenses incurred in connection with the December 18, 2007 special shareholder meeting, (iv) $2.3 million in costs associated with the departure of the Company’s former CEO, and (v) other increases in recruiting and salaries as new members were added to the management team.

Research and Development

Research and development expenses increased by $1.0 million or 10.7% to $10.4 million in 2007 as compared to $9.4 million in 2006. The increase was due to an increase in wages, recruiting and prototyping expenses for our research and development efforts related to the introduction of the Nautilus One and other new products during the year.

22

Table of Contents

During 2007, the Company reclassified preproduction royalties into research and development expenses for all periods presented which added $1.0 million and $0.7 million for 2007 and 2006, respectively. Preproduction royalties represent costs paid to utilize licensed patent technologies prior to the completion of a finished product. The increase in preproduction royalties over the prior year is related to the license of specific patents related to the development of new products.

Litigation Settlement

During 2007, the Company settled a lawsuit with ICON Health and Fitness, Inc. and as a result we received the rights to utilize a variety of fitness equipment related patents and technologies. We valued those assets and recorded them in litigation settlement as a reduction in operating expenses of $18.3 million. The Company recorded an impairment charge of $3.0 million in general and administrative expense during 2007 as changes were made to the plans to utilize the patents and technologies received.

Other Income (Expense)

Interest Expense

Interest expense increased to $5.0 million in 2007 compared to interest expense of $2.6 million in 2006. The increase in interest expense is due to the increased average short-term borrowings outstanding during 2007 as compared to 2006.

Other Income, net

Other income, net remained consistent with 2006 at approximately $1.2 million for both periods. Other income is a result of foreign currency gains recognized by the Company due to fluctuations in local currencies in which the Company operates.

Income Tax Expense (Benefit)

The provision for income tax expense was a benefit of $26.2 million during 2007 as compared to an expense of $9.1 million last year. This change was due to a pre-tax loss in 2007 compared to pre-tax income in 2006. Our effective tax rate in 2007 was 36.4% compared to 26.7% in 2006. The increase in our annual effective rate was primarily due to the change to pre-tax loss from pre-tax income in 2007 and the reduction of tax contingency reserves in 2006.

Discontinued Operations

The Company designated the financial results of the Fitness Apparel Business as discontinued operations during 2007. This resulted in recording the financial results as gain (loss) from discontinued operations. The loss from discontinued operations during 2007 was $9.8 million compared to gain from discontinued operations of $4.2 million during the prior year. The 2007 loss from discontinued operations includes an impairment charge of $13.2 million for the difference between book value of the Fitness Apparel Business net assets and the anticipated net sale proceeds.

COMPARISON OF THE YEARS ENDED DECEMBER 31, 2006 AND DECEMBER 31, 2005

All assets and liabilities and results of operations associated with the Fitness Apparel Business assets have been presented in the consolidated financial statements as discontinued operations separate from continuing operations in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. See Note 2 “Discontinued Operations” to Nautilus, Inc.’s Consolidated Financial Statements and later in the MD&A.

23

Table of Contents

Consolidated Net Sales

Consolidated net sales were $617.3 million in 2006 compared to $607.3 million in 2005, an increase of $10.0 million or 1.6%. The increase is primarily attributed to an increase in sales from our International Equipment Business of approximately $10.8 million.

Fitness Equipment Business – Net sales for the Fitness Equipment Business were flat at $553.4 million in 2006 as compared to $554.2 million in 2005. Specific channel net sales information is detailed below:

International Equipment Business – Net sales for the International Equipment Business improved 20.3% in 2006 to $63.9 million as compared to $53.1 million in 2005. The increase in net sales is a result of the growth of sales to the international distributor network which contributed approximately $5.6 million, and additional sales in China and the western European countries of $1.9 million and $2.1 million, respectively.

Consolidated Gross Profit

As a result of our increased sales, our total gross profit increased by 1.4% to $266.4 million in 2006 as compared to $262.8 million in 2005. As a percentage of consolidated net sales our gross profit margin decreased to 43.2% as compared to 43.3% last year. The decrease was a result of the continued shift in our sales product mix both between and within product categories and among our selling channels. This was partially offset by a reduction in our warranty costs primarily through a recovery of a portion of such costs from our suppliers. In addition, as a result of improving our operating efficiencies and sustained engineering efforts we have continued to focus on reducing the cost of our sourced products from our Asian manufacturers.

24

Table of Contents

Fitness Equipment Business – Gross profit for our Fitness Equipment Business improved slightly in 2006 to $250.5 million as compared to $249.1 million in 2005. As a percentage of net sales, the gross profit margin improved slightly to 45.3% in 2006 compared to 45.0% in 2005. Factors affecting gross profit included a reduction of our warranty costs through the recovery of a portion of warranty costs from our Asian manufacturers. In addition, we realized reductions in the actual cost of our sourced products through various sustained engineering efforts and continued vendor contract negotiations as we seek strong partnerships with fewer vendors. These cost savings were offset by an increase in freight costs and changes in both the sales channel and product sales mix within the product categories.

International Equipment Business – Gross profit for our International Equipment Business was $15.9 million in 2006 compared to $13.7 million in 2005, an increase of $2.2 million or 16.1%. As a percentage of net sales, the gross profit margin decreased to 24.9% in 2006 from 25.8% in 2005. The decrease as a percentage of sales is a result of increased royalties in 2006 due to the mix of products sold that incur a royalty. The increased gross profit was attributed to efficiency gains in service and logistics performance along with an overall increase in sales volume. The increase was offset by downward pressure on selling prices exerted by strong competition, increased freight costs, and unfavorable sales mix resulting in increased sales volumes from the lower margin retail sales channel.

Consolidated Operating Expenses

Selling and Marketing – Selling and marketing (“S&M”) expenses remained flat in 2006 at $175.3 million as compared to $175.3 million in 2005. As a percentage of consolidated net sales our S&M expenses decreased to 28.4% in 2006 compared to 28.9% in 2005. The increase in total S&M expenses was primarily due to an increase in consumer financing fees due to stronger financing utilization by our direct channel consumers, an increase in direct marketing costs and additional share-based compensation expense of approximately $0.4 million as a result of adoption of SFAS 123(R). The remainder of the increase resulted from an increase in commission costs of approximately $1.8 million due to overall increased sales volume.

General and Administrative – General and administrative (“G&A”) expenses increased by 3.1% in 2006 to $46.9 million as compared to $45.5 million in 2005. As a percentage of consolidated net sales our G&A expenses were 7.6% in 2006 compared to 7.5% in 2005. The increase was mainly due to a full year of depreciation and rent expense of approximately $2.2 million for our new corporate headquarters which we occupied late in the third quarter of 2005, and $1.8 million of share-based compensation expense resulting from the adoption of SFAS 123(R). These increases were partially offset by a decrease of $1.8 million in legal costs.

Research and Development – Research and development (“R&D”) expenses decreased 9.6% in 2006 to $9.4 million as compared to $10.4 million in 2005. In 2005, the Company introduced a large number of new products and in 2006 we reduced the number of projects and resources focused on research and development.

During 2007, the Company reclassified preproduction royalties into research and development expenses for all periods presented which added $0.7 million and $0.4 million for 2006 and 2005, respectively. Preproduction royalties represent costs paid to utilize licensed patent technologies prior to a sellable product being available for manufacture and sale. The increase in preproduction royalties over the prior year resulted from the license of specific patents related to the development of new products.

Consolidated Other Income (Expense), net

Net Interest

Net interest expense increased to $1.9 million in 2006 compared to net interest income of $1.2 million in 2005. The increase in expense was due to the increase in the average balance of our short-term borrowings that were outstanding during 2006 as compared to the Company being in a cash investment position during most of 2005.

25

Table of Contents

Other Income, net

Other income, net increased to $1.1 million in 2006 from $0.5 million in 2005 primarily due to foreign currency gains realized by the Company in 2006.

Consolidated Income Tax Expense

The provision for income tax expense from continuing operations decreased by 18.8% in 2006 to $9.1 million as compared to $11.2 million in 2005. Our effective tax rate from continuing operations in 2006 was 26.7% compared to 33.9% in 2005. The decrease in the effective tax rate was primarily due to a $3.8 million reduction of our tax contingency reserves resulting from our determination that certain statutory periods for the assessment of additional state income tax have closed.

Discontinued Operations

In 2007 the Company designated the financial results of the Fitness Apparel Business as discontinued operations. This resulted in recording the financial results from these operations as gain from discontinued operations. The gain from discontinued operations during 2006 was $4.2 million compared to $1.0 million during 2005. The increase in gain from discontinued operations in 2006 was due to the acquisition of Pearl Izumi occurring in July 2005 which resulted in a gain from discontinued operations for six months in 2005 compared to twelve months of operations during 2006.

LIQUIDITY AND CAPITAL RESOURCES

During 2007, our operating activities from continuing operations provided $1.8 million in net cash compared to providing net cash of $38.5 million in 2006. The reduction in operating cash provided from continuing operations year over year was primarily due to a 19% reduction in net sales resulting in a loss from continuing operations of $45.8 million offset by a reduction in trade receivables of $43.7 million. As a result of the pre-tax loss recorded in 2007, the Company will be able to obtain tax refunds from prior years in which taxes were paid. We received a tax refund of approximately $1.9 million in the first quarter 2008 and anticipate receiving approximately $8.0 million in the second quarter of 2008.

Net cash used in investing activities from continuing operations was $26.4 million in 2007 compared to $14.4 million in 2006. During 2007, the Company invested $21.9 million in the Land America acquisition which was not closed and thus an impairment was recorded as of December 31, 2007. In addition, capital expenditures were $10.7 million in 2007 compared to $10.9 million in 2006. Capital expenditures during 2007 consisted of manufacturing equipment and tooling to support new, innovative product offerings, and computer equipment to maintain and expand current information systems. In 2007 we received proceeds from the sale of a building in Louisville, Colorado for $6.1 million while in the prior year period, we sold a building and received $7.1 million in net proceeds and acquired intellectual property for $8.5 million.

Net cash provided by financing activities from continuing operations was $22.9 million in 2007 compared to net cash used of $22.9 million in 2006. Cash dividends paid were $9.5 million 2007 compared to $12.9 million in 2006. The Company repurchased $16.7 million of stock in 2006. Due to the current year operating losses and other activities, the Company borrowed $31.5 million in the current year and $7.4 million in 2006. In order to conserve cash and reduce our need to borrow, we suspended our quarterly dividend starting in the fourth quarter of 2007.

In the fourth quarter of 2007, management committed to a plan to sell the operations of our Fitness Apparel Business. Our Fitness Apparel Business primarily consists of Pearl Izumi which designs, markets and sells branded fitness apparel and footwear sold primarily under the Pearl Izumi brand globally. In February 2008 the Company entered into an agreement to sell Pearl Izumi and the Company anticipates the sale to be completed late

26

Table of Contents

in the first quarter of 2008. Accordingly, the results of operations for the Fitness Apparel Business have been reclassified as discontinued operations. Net cash provided by operating activities of discontinued operations during 2007 was $6.7 million compared to net cash used by discontinued operations of $4.7 million in 2006. The significant increase is a result of recording an impairment charge of $13.2 million to adjust the net book value of the Fitness Apparel Business down to fair market value as determined by an accepted sale agreement. Cash flows used in investing activities for discontinued operations were $1.0 million in 2007 compared to $0.7 million in 2006. Cash flows used in financing activities for discontinued operations were $0.2 million in 2007 compared to $0.6 million in 2006 as the Company made debt payments related to the original acquisition.

The Company expects the sale to be completed in the first quarter of 2008 and the net cash proceeds of approximately $63 million will be used to reduce the Company’s borrowings under its short-term borrowings.

The following table presents our estimated contractual obligations:

Due to the uncertainty with respect to the timing of future cash flows associated with our unrecognized tax benefits at December 31, 2007, we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authority. Therefore, $3.0 million of unrecognized tax benefits have been excluded from the contractual obligations table above. See Note 9 to the Consolidated Financial Statements for a discussion on income taxes.

OFF-BALANCE SHEET ARRANGEMENTS

As described in Note 1 to the consolidated financial statements located at Item 8 of this Form 10-K, from time to time, we arrange for leases or other financing sources with third parties to enable certain of our commercial customers to purchase our commercial products. While most of these financings are without recourse, in certain cases we may offer a guarantee or other recourse provisions. At December 31, 2007 and December 31, 2006, the maximum contingent liability under all recourse provisions was approximately $1.3 million and $1.6 million, respectively.

The Company has an agreement with a financing company to provide second tier financing for its consumers under which the Company previously shared financial responsibility if consumer default rates exceeded contractual expectations. During the third quarter 2007, the Company renegotiated its second tier financing agreements and transferred risk of loss to the financing company for a settlement payment of $0.7 million. As a result, a reserve is no longer established for consumer default on second tier financing arrangements. Our financing partners review consumer credit information and determine which consumers will receive financing and approve the amount of financing provided. Refer to Note 1 to the consolidated financial statements for further discussion of these arrangements.

27

Table of Contents

INFLATION AND PRICE CHANGES

We are experiencing cost increases for products and components manufactured in China reflecting increases in foreign currency exchange rates, and Chinese wages, taxes and raw material costs which our third party sourcing partners are seeking to pass along to the Company. Raw material costs have also increased for products manufactured by Nautilus owned facilities in the United States. Gross margins may be negatively impacted if these conditions continue and the Company is unable to find other cost savings opportunities or increase prices enough to offset the cost increases.

During both 2007 and 2006, we experienced increases in transportation costs due to increases in the price for fuel. To the extent these costs continue to increase and we are unable to pass these costs to the customer, our gross margins may continue to be negatively impacted.

SEASONALITY

In general, based on historic trends, we expect our sales from fitness equipment products both in the U.S. and internationally to vary seasonally with sales typically the strongest in the fourth quarter, followed by the first and third quarters, and the weakest in the second quarter. We believe that such factors as the broadcast of national network season finales and seasonal weather patterns influence television viewership and cause our television commercials on national cable television to be less effective in the second quarter than in other periods of the year. In addition, during the spring and summer consumers tend to do more activities outside including exercise, which impacts sales of fitness equipment used indoors. We expect the fluctuation in our net sales between our highest and lowest quarters to be approximately 37%.

CRITICAL ACCOUNTING ESTIMATES AND ASSUMPTIONS

The preparation of financial statements in conformity with U.S. GAAP 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. As described by the Securities and Exchange Commission (“SEC”), critical accounting estimates and assumptions are those that may be material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and that have a material impact on the financial condition or operating performance of the company. Based on this definition, we believe the items listed below are our critical accounting estimates and assumptions.

Management and our independent auditors regularly discuss with our audit committee each of our critical accounting estimates and assumptions, as well as critical accounting policies presented in Note 1 to the consolidated financial statements located at Item 8 of this Form 10-K, and the development and selection of these accounting estimates and the disclosure about each estimate in the MD&A. These discussions typically occur at our quarterly audit committee meetings and include the basis and methodology used in developing and selecting these estimates, the trends in and amounts of these estimates, specific matters affecting the amount of and changes in these estimates, and any other relevant matters related to these estimates, including significant issues concerning accounting principles and financial statement presentation.

Revenue Recognition

We recognize revenue when products are shipped and we have no significant remaining obligations, persuasive evidence of an arrangement exists, the price to the buyer is fixed or determinable, collectibility is reasonably assured or probable, and title and risk of loss have passed. Revenue is recognized net of applicable promotional discounts, rebates, and return allowances, some of which need to be estimated at the time we recognize revenue. In addition, revenue is recognized upon final installation for the Nautilus commercial equipment if we are

28

Table of Contents

responsible for installation. Return allowances, which reduce product revenue by our best estimate of expected product returns, are estimated using historical experience. In addition, from time to time, we arrange for leases or other financing sources to enable certain of our commercial customers to purchase our equipment. In the event that a guarantee of the commercial customer’s lease obligation is made, we record a liability and corresponding reduction of revenue for the estimated fair value of the guarantee and then recognize that revenue over the life of the lease obligation, unless a loss is actually incurred related to such guarantee. We recognize estimated losses as they become probable and can be reasonably estimated.

Allowance for Doubtful Accounts

The allowance for doubtful accounts is maintained at a level based on our historical experience adjusted for any known uncollectible amounts. We periodically review the creditworthiness of our customers to help gauge collectibility. Our allowance is sensitive to changes in our customers’ ability to pay due to unforeseen changes in the economy, the bankruptcy of a major customer, our efforts to actively pursue collections, and increases in chargebacks. Any major change in the aforementioned factors may result in increasing the allowance for doubtful accounts, which could have a significant impact on our financial position, results of operations and cash flows.

Inventory Valuation

Our inventory is valued at the lower of cost or market. Inventory adjustments are applied for any known obsolete or defective products. We periodically review inventory levels of our product lines in conjunction with market trends to assess salability of our products. Our assessment of necessary adjustments to market value of inventory is sensitive to changes in fitness technology and competitor product offerings driven by customer demand. Any major change in the aforementioned factors may result in reductions to market value of inventory below cost, which could have a significant impact on our financial position, results of operations and cash flows.

Product Warranty

We provide a limited warranty for the replacement of defective products. Our standard warranties require us to repair or replace defective products at no cost to the consumer. We estimate the costs that may be incurred under our basic limited warranty and record a liability in the amount of such costs at the time product revenue is recognized. Factors that affect our warranty liability include the number of units sold, along with the historical and anticipated cost to repair, replace or refund the original sale. We periodically assess the adequacy of our recorded warranty liabilities and adjust the amounts as necessary. A significant change is our estimates may have a significant impact on our financial position, results of operations and cash flows.

In early 2008, the Company suspended sales of the commercial TreadClimber products as a result of product durability issues until those issues can be corrected. The severity of the quality issues and costs related to either replacing or maintaining this product increased significantly during the fourth quarter of 2007 leading management to take specific action with this product. Management is currently evaluating alternatives for addressing this warranty issue and has recorded its best estimate of the cost to remediate the issues identified which is included in accrued liabilities and other long-term liabilities.

Stock Compensation

We account for employee share-based compensation in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), Share-Based Payment. The fair value of each equity award as well as determination of probability when performance targets for awards subject to performance conditions are expected to be met require extensive use of judgment. Application of alternative assumptions could produce significantly different amounts of compensation cost recognized in the consolidated statements of income.

29

Table of Contents

Litigation and Loss Contingencies

From time to time, we may be involved in various claims, lawsuits and other proceedings. Such litigation involves uncertainty as to possible losses we may ultimately realize when one or more future events occur or fail to occur. We record any such possible losses in accordance with U.S. GAAP. The Company estimates the probability of losses on legal contingencies based on the advice of internal and external counsel, the outcomes from similar litigation, the 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, may change our estimates significantly. A significant change in our estimates, or a result that materially differs from our estimates, may have a significant impact on our financial position, results of operations and cash flows.

Goodwill and Intangible Assets Valuation

We evaluate our intangible assets and goodwill for potential impairment annually or when events or circumstances indicate the carrying value may be impaired. Our judgments regarding the existence of impairment are based on anticipated cash flows, market conditions, regulatory and other factors. Future events could cause us to conclude that goodwill or other intangible assets are impaired. Any resulting impairment loss may reduce our net worth and have a material adverse effect on our financial condition and results of operations. As of December 31, 2007, goodwill and intangible assets represented 18.3% of our total assets.

As a result of the decision to exit the business, the Company determined the goodwill for Pearl Izumi was impaired and recorded an impairment charge of $13.2 million in loss from discontinued operations during 2007. The impairment was calculated based on an offer of $69.5 million to purchase the business.

Due to the decision to not pursue certain product innovations, the Company determined certain of the intangible assets obtained from the legal settlement during the second quarter of 2007 were impaired during the fourth quarter and recorded as impairment charge of $3.0 million in general and administrative expenses in 2007.

Income Tax Provision

Income taxes are accounted for under the liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

Inherent in the measurement of these deferred balances are certain judgments and interpretations of existing tax law and other published guidance as applied to our operations. When it is more likely than not that all or some portion of specific deferred tax assets will not be realized, a valuation allowance must be established for the amount of the deferred tax assets that are determined not to be realizable. A valuation allowance has been provided for deferred tax assets, which management believes will not be realized in the future. Accordingly, if the Company’s facts or financial results were to change thereby impacting the likelihood of realizing the deferred tax assets, judgment would have to be applied to determine changes to the amount of the valuation allowance required to be in place on the financial statements in any given period.

The Company adopted the provisions of FIN 48 – Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109, on January 1, 2007. FIN 48 provides that a tax benefit from an uncertain tax position may be recognized when it is more likely than not that the position will be sustained upon

30

Table of Contents

examination, including resolutions of any related appeals or litigation processes, based on the technical merits. Income tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. This interpretation also provides guidance on measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

NEW ACCOUNTING PRONOUNCEMENTS

For a description of the new accounting standards that affect us, refer to Note 1 to the consolidated financial statements located at Item 8 of this Form 10-K.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

We hold our cash and cash equivalents primarily in bank deposits and in liquid debt instruments with maturity dates of less than one year. We are subject to concentration of credit risk as bank deposits may exceed federally insured limits.

Foreign Exchange Risk

We are exposed to foreign exchange risk from currency fluctuations, mainly in Canada and Europe, due to sourcing of our products in U.S. dollars and selling them primarily in Canadian dollars, British pounds, Swiss Francs, and Euros. Given the relative size of our current foreign operations, the exposure to the exchange risk could have a material impact on the results of operations. Management estimates the maximum impact on stockholders’ equity of a ten percent change in any applicable foreign currency exchange rate to be approximately $1.5 million.

Interest Rate Risk

Fluctuations in the general level of interest rates on our current variable rate credit agreements expose us to market risk. As of December 31, 2007, our outstanding borrowings under the credit facilities were $79.0 million and represented 40.1% of our total liabilities. Rates on these short-term borrowings have declined in recent periods which have decreased the Company’s interest expense. Management believes that a material change in interest rates could have a material impact on the Company’s financial position, results of operations, or cash flows if the Company’s borrowings are not reduced significantly.

31

Table of Contents

Item 8. Financial Statements and Supplementary Data

Index to Consolidated Financial Statements

32

Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Nautilus, Inc.

Vancouver, Washington

We have audited the accompanying consolidated balance sheets of Nautilus, Inc. and subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and of cash flows for each of the three years in the period ended December 31, 2007. 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, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America.

As described in Note 9 to the consolidated financial statements, the Company adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109, on January 1, 2007.

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, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 17, 2008 expressed an adverse opinion on the Company’s internal control over financial reporting because of a material weakness.

DELOITTE & TOUCHE LLP

Portland, Oregon

March 17, 2008

33

Table of Contents

NAUTILUS, INC.

CONSOLIDATED BALANCE SHEETS

DECEMBER 31, 2007 AND 2006

(In Thousands)

See notes to consolidated financial statements.

34

Table of Contents

NAUTILUS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

(In Thousands, Except Per Share Amounts)

See notes to consolidated financial statements.

35

Table of Contents

NAUTILUS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)

YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

(In Thousands)