BOWFLEX INC. - Quarter Report: 2007 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2007

or

For the transition period from                      to                     

Commission file number: 000-25867

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

(Issuer’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes   x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer  ¨     Accelerated Filer  x     Non-Accelerated Filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  ¨    No  x

Number of shares of issuer’s common stock outstanding as of November 1, 2007: 31,557,136

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NAUTILUS, INC.

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PART I. FINANCIAL INFORMATION

NAUTILUS, INC.

CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands)

See notes to consolidated financial statements.

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NAUTILUS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share amounts)

See notes to consolidated financial statements.

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NAUTILUS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

See notes to consolidated financial statements

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NAUTILUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The accompanying consolidated financial statements relate to Nautilus, Inc. and its subsidiaries (the “Company”) as of September 30, 2007 and for the three and nine month periods ended September 30, 2007 and 2006. All intercompany transactions and balances have been eliminated in consolidation.

The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. These financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

The financial information included herein reflects all adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods presented. The results of operations for the three and nine month periods ended September 30, 2007 are not necessarily indicative of the results to be expected for the full year.

Use of Accounting Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses and disclosure of contingent assets and liabilities in the financial statements. Actual results could differ from those estimates. A description of our significant estimates and assumptions can be found in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

Reclassifications

Prior year amounts of interest income and interest expense which were presented net have been reclassified to conform to the current year presentation within the consolidated statements of operations. This change had no impact on previously reported operating income, net income or stockholders’ equity.

New Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”), which expands the scope of what companies may carry at fair value. SFAS 159 offers an irrevocable option to carry the vast majority of financial assets and liabilities at fair value, with changes in fair value recorded in earnings. The Statement is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact that the adoption will have on the Company’s results of operations, cash flows or financial position.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). This statement defines fair value, establishes a framework for measuring fair value in U.S. GAAP, and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact that the adoption will have on the Company’s results of operations, cash flows or financial position.

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (“FIN 48”). The Company adopted the provisions of this interpretation on January 1, 2007. The disclosure requirements and cumulative effect of the adoption of FIN 48 are presented in Note 12.

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Stock Options

A summary of the Company’s stock option plan activity for the nine months ended September 30, 2007 is as follows:

The fair value of the Company’s option awards was estimated assuming the following weighted average assumptions:

The weighted average grant-date fair value of stock options granted during the nine month periods ended September 30, 2007 and 2006 was $5.26 and $5.55, respectively for stock options granted. The total fair value of options vested during the nine month periods ended September 30, 2007 and 2006 was $0.8 million and $2.0 million, respectively. The total unrecognized compensation cost related to nonvested options was $4.6 million at September 30, 2007. This cost is expected to be recognized over a weighted-average period of 2.47 years.

Performance Units

A summary of the Company’s performance unit activity as of September 30, 2007, and changes during the nine month period ended September 30, 2007, are as follows:

At September 30, 2007 there was approximately $0.8 million of total unrecognized share-based compensation costs related to performance units with intrinsic value of zero. None of the performance units were vested at September 30, 2007. The Company recorded no compensation expense during the three and nine month periods ended September 30, 2007.

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Restricted Stock

A summary of the Company’s restricted stock activity as of September 30, 2007, and changes during the nine month period ended September 30, 2007, are as follows:

At September 30, 2007, there was approximately $1.3 million of total unrecognized share-based compensation costs related to restricted stock that will be amortized through the third quarter of 2009 with intrinsic value of $2.3 million at September 30, 2007. None of the restricted stock awards were vested at September 30, 2007. The Company recorded $0.1 million and $0.1 million of compensation expense during the three and nine month periods ended September 30, 2007, respectively.

Inventories consisted of the following:

Inventories are stated at the lower of cost or market. The Company evaluates the need for inventory valuation adjustments associated with obsolete, slow-moving and not saleable inventory by reviewing current transactions and forecasted product demand on a monthly basis.

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Intangible assets, exclusive of goodwill, consisted of the following:

Identifiable intangible assets such as license agreements, patents, and trademarks are recorded at cost or when acquired as part of a business combination, at estimated fair value and are amortized straight-line over the period they provide the Company with economic benefit. The amortization expense for the next five full succeeding years is estimated at $3.7 million, $3.2 million, $2.9 million, $2.9 million, and $2.9 million.

The $18.3 million increase in the patents intangible asset is due to the ICON Health & Fitness, Inc. litigation settlement described in Note 9 that has been valued at $18.3 million. This settlement allows for the Company to use a variety of fitness equipment patents and technologies. This intangible asset value will be amortized over the useful life of the technologies granted through this settlement.

Accrued liabilities in excess of five percent of total current liabilities consisted of accrued warranty expense of $8.5 million and $9.8 million at September 30, 2007 and December 31, 2006, respectively, and accrued payroll of $5.9 million and $7.1 million at September 30, 2007 and December 31, 2006, respectively.

In February 2007, the Company paid off the outstanding balances under the $65 million facility that it entered in fiscal 2005 as well as the $25 million facility that it entered into October 2006. Thereafter, the Company entered into a new revolving credit agreement (the “Facility”) with several financing institutions. The Facility provides for an unsecured revolving credit facility to include revolving loans and a $10 million swing line, for a maximum commitment amount of $125 million with an option to increase the facility to $175 million. The Facility expires on February 14, 2012 and is intended for general corporate purposes, working capital requirements, financing permitted acquisitions and share repurchases. The Company has $109.0 million of borrowings outstanding on the Facility at September 30, 2007.

The Facility provides for either Base Rate in the principal amount of $1.0 million or in increments of $0.1 million thereof or Eurodollar Rate loans in the principal amount of $2.5 million or in increments of $0.5 million in excess thereof. It also allows for swing loans in minimum amounts of $0.1 million subject to its sub-limit of $10.0 million for the duration of up to ten business days, and letters of credit in the minimum amount of $0.1 million.

The Facility requires DashAmerica, Inc., d/b/a Pearl Izumi Inc., (“Pearl Izumi”), a wholly-owned subsidiary of the Company, to be a guarantor; other domestic subsidiaries may be required to become guarantors under certain circumstances. The Facility also contains certain financial and non-financial covenants which include a consolidated leverage ratio, a consolidated asset coverage ratio, and a requirement to maintain a minimum consolidated Earnings Before Income Tax, Depreciation and Amortization, (“EBITDA”).

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On October 5, 2007, the Company and Pearl Izumi entered into a Security and Pledge Agreement with Bank of America, N.A. (“Security Agreement”) in its capacity as administrative agent under the Facility. The Security Agreement covers substantially all of the personal property assets of the Company and Pearl Izumi and secures the line of credit, swingline credit line and letter of credit subfacility, which had previously been unsecured.

On October 12, 2007, the Company and its subsidiary Pearl Izumi entered into a First Amendment and Waiver to Credit Agreement (the “Amendment”) in respect of the Facility dated as of February 14, 2007 among Bank of America, N.A. in its capacity as Administrative Agent and the lenders party thereto.

Pursuant to the Amendment, the lenders under the credit facility agreed to waive defaults of the financial covenants under the Facility with respect to the four fiscal quarter period ended September 30, 2007. The applicable margin on borrowings was increased: (i) with respect to Eurodollar Rate loans, to 2.00% per annum, (ii) with respect to Base Rate loans, to 0.50% per annum, and (iii) with respect to Swing Line loans, to 0.50% per annum. Additionally, effective as of January 1, 2008, the maximum amount of the credit line will be restricted to $75,000,000 unless the Company’s consolidated EBITDA is at least $32,500,000 for each of the two most recently ended quarterly periods.

Accounts of the Company’s foreign operations are measured using the local currency as the functional currency. These accounts are then translated into U.S. dollars using the current rate method with translation gains and losses accumulated as the accumulated other comprehensive income component of stockholders’ equity, except for gains or losses with the Company’s international subsidiaries which are recorded as part of other income/expense in the Consolidated Statements of Operations.

Comprehensive income (loss) was as follows:

The calculation of the number of outstanding shares is as follows:

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Legal Matters

We are involved in various claims, lawsuits and other proceedings from time to time. Such litigation involves uncertainty as to possible losses we may ultimately realize when one or more future events occur or fail to occur. We accrue and charge to income estimated losses from contingencies when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. Differences between estimates recorded and actual amounts determined in subsequent periods are treated as changes in accounting estimates. The Company estimates the probability of losses on legal contingencies based on the advice of internal and external counsels, outcomes from similar litigation, the status of the lawsuits (including settlement initiatives), legislative developments, and other factors. Due to 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, could have a significant impact on our financial position, results of operations and cash flows.

On April 26, 2007, the Company and ICON Health & Fitness (“ICON”) settled a series of pending lawsuits between the parties. This settlement included a number of claims and lawsuits between ICON and the Company going back to 2002-2003, and which were pending in federal courts in Salt Lake City, Utah, and Seattle, Washington, and before the Federal Circuit Court of Appeals. Both the Company and ICON have filed dismissals of their respective lawsuits against each other. This settlement and dismissals cleared the previous contingent liability claim of $8.1 million against the Company following a trial in November 2005 in Salt Lake City, and ICON granted the Company use of certain intellectual property for the Company’s use in product development and enhancement valued at $18.3 million.

In October 2006, the Company filed a complaint in the Superior Court for Clark County, Washington against Gately’s LLC (“Gately’s”) seeking damages in the amount of $5.1 million plus interest, attorney’s fees and costs, for collection of outstanding accounts receivable for product purchased by Gately’s. This case has been dismissed and refiled by the Company in state court in Boulder County, Colorado. In its answer to the complaint, Gately’s has asserted defenses to payment and counterclaims against Nautilus in an unspecified amount. In September 2007, Gately’s filed a petition for bankruptcy which has stayed the litigation in Colorado. In September 2007, the Company reserved an additional $4.8 million to be fully reserved for this unpaid receivable as a result of the bankruptcy filing.

In addition to the matters described above, from time to time the Company is subject to litigation, claims and assessments that arise in the ordinary course of business, including disputes that may arise from intellectual property related matters. Many of our legal matters are covered in whole or in part by insurance. Management believes that any liability resulting from such matters will not have a material adverse effect on the Company’s financial position, results of operations, or cash flows.

Guarantees

From time to time the Company arranges for commercial leases or other financing sources with third parties to enable certain of its commercial customers to purchase the Company’s commercial products. As a result, at September 30, 2007 and December 31, 2006, the maximum contingent liability under all recourse and guarantee provisions was approximately $1.3 million and $1.6 million, respectively. At September 30, 2007, lease terms on outstanding commercial customer financing arrangements were between 3 and 5 years. A reserve for estimated losses under recourse provisions of approximately $0.1 million and $0.1 million was recorded based on historical loss experience and was included in accrued expenses at September 30, 2007 and December 31, 2006, respectively.

The Company has an agreement with a financing company to provide second tier financing for its consumers in which the Company shared financial responsibility if consumer default rates exceeded contractual expectations. During the third quarter of 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. The Company had a reserve for second tier consumer financing of $0.3 million at December 31, 2006.

Commitments

At September 30, 2007, the Company had approximately $2.3 million in outstanding commercial letters of credit expiring between December 31, 2007 and 2008.

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Given that the majority of its inventory is sourced from Asia, the Company has long lead times for inventory purchases and therefore needs to secure factory capacity from its vendors in advance. As a result, at September 30, 2007, the Company had approximately $51.3 million in purchase obligations for inventory purchases with the majority payable in the next 12 months.

The Company’s operating segments are evidence of the structure of the Company’s internal organization and are organized to allow focus on specific business opportunities in the Company’s worldwide market place. The Company’s three business segments are Fitness Equipment Business, International Equipment Business, and Fitness Apparel Business.

The Fitness Equipment Business is responsible for the design, production, marketing and selling of branded fitness equipment sold under the Nautilus, Bowflex, Schwinn Fitness and Stairmaster brand names and is responsible for servicing customers within the Americas, which includes the United States, Mexico, Canada and South America.

The International Equipment Business is responsible for the marketing and selling of branded fitness equipment sold under the Nautilus, Bowflex, Schwinn Fitness and Stairmaster brand names. The International Equipment Business is responsible for servicing customers outside of the Americas.

The Fitness Apparel Business is responsible for the design, production, marketing and selling of branded fitness apparel, footwear and accessory products sold primarily under the Pearl Izumi brand in both domestic and international markets.

The three business segments are supported by teams that provide services to support the entire enterprise including finance and reporting, legal, human resources, and other centralized functions. Management does not allocate expenses from the centralized functions to the business segments. As a result, the business segments operating results are reviewed based on revenue and gross profit.

Net sales from external customers for the Company’s consolidated operations were as follows:

Gross profit from external customers for the Company’s consolidated operations was as follows:

Assets from the Company’s three operating segments were as follows:

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On October 17, 2007 the Company entered into the following agreements: (i) Asset Purchase Agreement by and among the Company and Land America Health &Fitness Co., Ltd., a company formed under the laws of the People’s Republic of China (“Land America”), Michael C. Bruno (“Bruno”) and Yang Lin Qing (“Yang”) (the “Land America Agreement”); (ii) Asset Purchase Agreement by and among the Company and Treuriver Investments Limited a British Virgin Islands company (“Treuriver”), Bruno and Yang (the “Treuriver Agreement”); (iii) Post-Closing Audit Agreement by and among the Company, Land America, Bruno and Yang (the “Audit Agreement”); and (iv) First Amendment to Escrow Agreement by and among the Company, Treuriver, Bruno (in his capacity as Representative under the Treuriver Agreement), and U.S. Bank National Association (in its capacity as Escrow Agent) (the “First Amendment”). (The Land America Agreement, Treuriver Agreement, Audit Agreement and First Amendment are collectively referred to as the “Agreements”, and Land America, Treuriver, Bruno and Yang are collectively referred to as “Sellers”).

The Agreements provide for the terms and conditions under which the Company or its wholly-owned subsidiaries will acquire or lease substantially all of the assets of Land America and Treuriver. Land America is primarily engaged in the manufacture of products for the Company in a manufacturing facility located in Xiamen, People’s Republic of China (“PRC”), and Treuriver is Land America’s related trading company. The Agreements were entered into following the exercise, on June 29, 2007, of purchase options set forth in Purchase Option Agreements with Land America, Treuriver, Bruno and Yang which the Company entered into on February 1, 2007.

In connection with execution of the Purchase Option Agreements, the Company delivered a non-refundable deposit of $6 million to Sellers. Upon exercise of the options, the Company deposited an additional $30 million into escrow. Under the terms of the First Amendment to Escrow Agreement entered into as part of the Agreements, $12.5 million was released from escrow to Sellers as an additional nonrefundable deposit and $12.5 million was released to the Company. The remaining $5.0 million is to remain in escrow until closing.

Under the terms of the Agreements, on January 1, 2008 a wholly-owned direct or indirect subsidiary of the Company to be formed in Xiamen, Fujian, PRC (“Buyer”) will acquire substantially all of the assets currently used by Land America to manufacture products on behalf of the Company. In addition, Buyer will enter into a Lease Agreement providing for the lease of the land and buildings in which Land America currently conducts its manufacturing operations. The Lease Agreement includes a purchase option and it is anticipated that Buyer will complete the purchase of the buildings and land use rights on or before October 31, 2008. In addition, on January 1, 2008 the Company or a direct or indirect wholly-owned subsidiary of the Company will acquire substantially all of the assets of Treuriver.

In addition to applying the previously delivered deposits as described above, within five business days of closing on January 1, 2008 the Company or its subsidiaries will pay $21.5 million to Sellers. The portion of the total purchase price attributable to inventory is subject to adjustment based on the actual value of inventory on the closing date. On the earlier of October 31, 2008 and the date on which Buyer completes the purchase of the land rights and buildings pursuant to the Lease Agreement, an additional $11 million will be paid to Sellers. The purchase price for the land rights and buildings is $11.5 million. The total acquisition cost, including the purchase of the land rights and buildings, but excluding inventory, is expected to be $63.0 million. The additional purchase of inventory at closing is expected to range from $4.0 million to $6.0 million.

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. As a result of the implementation of FIN 48, the Company made a comprehensive review of its portfolio of uncertain tax positions in accordance with recognition standards established by FIN 48. In this regard, an uncertain tax position represents the Company’s expected treatment of a tax position taken in a filed tax return, or planned to be taken in a future tax return, that has not been reflected in measuring income tax expense for financial reporting purposes. As a result of this review, the Company adjusted the estimated value of its uncertain tax positions by recognizing additional liabilities totaling $1.3 million through a charge to retained earnings. Upon the adoption of FIN 48, the estimated value of the Company’s uncertain tax positions was a liability of $3.2 million resulting from unrecognized tax benefits. If the Company’s positions are sustained by the taxing authority in favor of the Company, approximately $2.6 million would reduce the Company’s effective tax rate.

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The Company recognizes accrued interest and penalties related to uncertain tax positions in federal, state, and foreign income tax expense. As of January 1, 2007, the Company had accrued approximately $0.8 million for the payment of tax-related interest and penalties.

The Company’s federal income tax returns for 2004 through 2006 are open tax years. The Company’s unrecognized state tax benefits are related to state returns open from 2000 through 2006 depending on each state’s statute of limitation. In addition, the Company files in numerous foreign jurisdictions with varying statutes of limitation.

The Company believes it is reasonably possible that, within the next 12 months, $1.1 million of previously unrecognized tax benefits related to domestic filing positions, of which $0.8 million would reduce the Company’s effective tax rate, will be recorded primarily as a result of the expiration of federal and state statutes of limitation.

As of September 30, 2007, there have been no material changes to the liability for uncertain tax positions.

On October 12, 2007 the Company committed to reduce its workforce by approximately 140 positions. The Company took this action to improve operating margins in a period of lower-than-expected sales. In conjunction with these actions, the Company currently expects to incur restructuring-related charges of approximately $0.8 million pre-tax related to employee termination benefits consisting primarily of severance and related fringe benefits. The Company expects the $0.8 million to result in short-term cash outlays. The Company may incur other costs associated with the announced restructuring activities.

On October 29, 2007, the Company declared a dividend distribution of one common share purchase right for each outstanding share of its common stock (the “Rights”). If a person becomes an Acquiring Person, each Right will entitle its holder to purchase, at the Right’s exercise price, a number of shares of the Company’s common stock having a market value at the time of twice the exercise price of $27. Rights held by the Acquiring Person become void and are not exercisable to purchase shares at the bargain purchase price. An Acquiring Person is defined as a person who acquires 20% or more of the Company’s outstanding common stock (other than a shareholder who beneficially owns more than 20% of the outstanding shares of Common Stock on October 29, 2007, who will be precluded from acquiring any additional shares). In effect, this would enable a holder of Rights (other than an Acquiring Person) to purchase $54 worth of common stock at half price. Additionally, at any time after any person or group becomes an Acquiring Person and prior to the acquisition by such person or group of 50% or more of the outstanding shares of Common Stock the Board of Directors may exchange the Rights (other than Rights owned by such person or group which will have become void), in whole or in part, at an exchange ratio of one share of our common stock, (or of a share of a similar class or series of our common stock having similar rights, preferences and privileges) of equivalent value, per Right (subject to adjustment). The Board of Directors is entitled to redeem the rights at $.01 per right at any time before a person has acquired 20% or more of the outstanding common stock. The rights plan expires on October 28, 2010. The Board of Directors has also resolved to submit the continuation of the Plan to a shareholder vote within 12 months of the adoption of the rights plan.

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FORWARD-LOOKING STATEMENTS

This quarterly report on Form 10-Q 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, acquisition of manufacturing operations in Asia, future capital expenditures, anticipated tax benefits, 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 our most recent Annual Report on 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.

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 1 of this Form 10-Q. 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 frequently encountered by companies that operate in evolving markets. We may not be able to successfully address these risks and difficulties and, consequently, we cannot assure you of any future growth or profitability.

SUMMARY OF THE THIRD QUARTER 2007 RESULTS

Net sales for the third quarter of 2007 were $133.6 million, compared to $159.6 million in the same quarter of 2006, a decrease of 16.3%. Gross profit margins decreased to 39.5% in the third quarter of 2007, compared to 45.2% in the same quarter of 2006, as a result of changes in product and channel mix and lower sales volume in our Fitness Equipment business. This decrease is primarily due to a soft North American market for home exercise strength products. Operating expenses for the third quarter of 2007 were $74.4 million, compared to $60.9 million in the same quarter of 2006, an increase of 22.2%. This increase is primarily related to an increase of $4.8 million in our bad debt reserve resulting from a former customer that has filed Chapter 11 bankruptcy, costs of $2.3 million associated with the termination of the employment of our former CEO, additional direct marketing spend of $0.9 million and incremental marketing spend of $1.1 million and $0.4 million in our International and Apparel business segments as we realized top line growth in these businesses. These factors led to a quarterly operating loss of $21.6 million compared to operating income of $11.1 million in the third quarter of 2006. Diluted loss per share for the quarter was 43 cents, compared to earnings of 29 cents per share a year ago. During the third quarter of 2006, we recorded a $3.0 million reduction of tax contingency reserve as a result of closing certain statutory periods. In October 2007, we announced a reduction in force of approximately 140 employees, or 9% of our workforce. The staff reduction includes the elimination of positions in most areas of the Company.

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RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

The following tables present certain consolidated financial data as a percentage of net sales and statement of operations data comparing results for the three months ended September 30, 2007 and 2006:

Net Sales

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 the Americas, which includes the U.S., Canada, Mexico and South America. Total net sales for the Fitness Equipment Business were $96.6 million in the third quarter of 2007 compared to $128.3 million in the same period of 2006, a decrease of $31.7 million or 24.7%. The decrease is primarily attributable to reduced sales in the North American market for home strength fitness equipment, primarily home gyms, along with our strategy to improve profitability by eliminating or reducing certain of our customer relationships. Specific channel net sales information is detailed below:

In the commercial channel, net sales were $15.2 million in the third quarter of 2007 compared to $17.9 million in the same period of 2006, a decrease of $2.7 million or 15.1%. Sales in this channel primarily constitute those to commercial dealers, health clubs, hotels and living complexes. The decrease in commercial channel sales was a result of our transition to our new Nautilus One product, a selectorized plate load circuit, and our new “F-3” line of free weights. These two product lines started shipping in limited quantities later in the third quarter than had been anticipated.

In the retail channel, net sales were $22.6 million in the third quarter of 2007 compared to $43.0 million in the same period of 2006, a decrease of $20.4 million or 47.5%. Sales in this channel are primarily to various sporting good stores, warehouse clubs, department stores, fitness retail stores and independent bicycle dealers that typically sell health club-quality equipment to the end consumer for home and small business use. The decline in this channel is mainly due to softness in the North American retail market for strength fitness equipment where we have historically sold our rod-based home gyms. Softness in the home fitness market in the third quarter led to lower sales as our retail partners carried existing inventory into the quarter and did not make significant additional purchases. In addition, sales were affected by our continued strategy to limit the number of power-rod home gyms sold into the retail channel due to potential conflict with our direct channel.

In the direct channel, net sales were $58.4 million in the third quarter of 2007 compared to $67.1 million in the same period of 2006, a decrease of $8.7 million or 13.0%. Sales in the direct channel consist of our Bowflex branded

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products and primarily include our rod-based home gyms, TreadClimbers, SelectTech dumbbells, and the Revolution. The decrease in net sales is primarily due to decreased sales volume of our home gyms, primarily the power-rod home gyms. This decline is a result of reduced advertising to support the power-rod product line along with increased competition for media space and lower conversion rates within the North American market for home fitness equipment. This decrease was offset by an increase in sales volume for our TreadClimbers in part driven by additional media support for that product in the third quarter of 2007.

International Equipment Business Net sales from the International Equipment Business were $18.7 million in the third quarter of 2007 compared to $14.6 million in the same period of 2006, an increase of $4.1 million or 28.1%. The International Equipment Business represents equipment sales outside of the Americas and includes primarily commercial and retail sales. The increase in net sales is due to expansion of our commercial sales channel through our four western European subsidiaries and various distributors. In addition, the International Equipment business continues to have commercial channel success through our new subsidiary in China since initial launch during the third quarter of 2006.

Fitness Apparel Business Net sales from the Fitness Apparel Business were $18.4 million in the third quarter of 2007 compared to $16.7 million in the same period of 2006, an increase of $1.7 million or 10.2%. The Fitness Apparel Business sells high quality fitness apparel and footwear for cyclists, runners and fitness enthusiasts. The revenue stream of the Fitness Apparel Business is generally seasonal with the first and third quarters having the highest sales and the second and fourth quarters having lower sales. Much of this is related to the timing of customer’s seasonal inventory purchases. The increase in net sales is primarily due to an increase in sales of our core Pearl Izumi cycling apparel with smaller increases in sales of our running apparel and cycling footwear products. In addition, we now operate twelve retail stores and an internet site, which have contributed to the sales increase in the Fitness Apparel Business.

Gross Profit

As a result of lower net sales, total gross profit was $52.8 million in the third quarter of 2007 compared to $72.1 million in the same period of 2006, a decrease of $19.3 million or 26.8%. As a percentage of net sales, gross profit margins decreased to 39.5% in the third quarter of 2007 compared to 45.2% in the comparable period of 2006. The decrease is primarily the result of changes in both our product and channel sales mix as well as overall reduction in the volume of our sales, offset by cost reductions implemented as part of our cost control and containment efforts within our owned manufacturing facilities and with our foreign manufacturing partners. During the third quarter of 2007 we experienced increased sales in our International Equipment Business, which generally has lower gross margins, and reduced sales in our Fitness Equipment Business, which traditionally has higher gross margins. As part of our ongoing efforts to improve margins, we have reduced the cost of products sourced from our Asian manufacturing partners and we continue to focus on improving overall operating efficiencies by consolidating our finished goods supply base, implementing a product pricing model to fully estimate prices from components to finished goods, and implementing stringent guidelines over our second and third party parts supplier base.

Fitness Equipment Business Gross profit for the Fitness Equipment Business decreased, primarily as a result of lower sales, to $39.9 million in the third quarter of 2007 compared to $61.7 million in the same period of 2006. As a percentage of net sales, gross profit margins decreased to 41.3% in the third quarter of 2007 compared to 48.1% in the comparable period of 2006. Factors affecting gross profit margin are primarily related to the overall shift in sales mix for customers, channel and product marketing support for certain retail customers, a higher percentage of sales from our TreadClimber products in the direct channel, which experience a higher number of returns than other products and incremental reserves related to certain finished goods and parts. These items were offset by a reduction of our warranty costs due to an overall improvement in quality and the recovery of a portion of warranty costs from our Asian manufacturers, and through reductions of 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.

International Equipment Business Gross profit for the International Equipment Business was $5.1 million in the third quarter of 2007 compared to $3.0 million in the same period of 2006, an increase of $2.1 million or 70.0%. As a percentage of net sales, gross profit margin was 27.3% in the third quarter of 2007 compared to 20.5% in the comparable period of 2006. The increase in gross profit is the result of a change in our sales mix in the retail channel and improved margins by selling direct in China and in the Australia direct channel rather than through a distributor.

Fitness Apparel Business Gross profit for the Fitness Apparel Business was $7.8 million in the third quarter of 2007 compared to $7.4 million in the same period of 2006. As a percentage of net sales, gross profit margin decreased to 42.6% in the third quarter of 2007 compared to 44.3% in the comparable period of 2006. The decrease in profit margin percentage is due to the mix of products sold and establishing an inventory reserve related to surplus raw materials and excess and obsolete product.

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Operating Expenses

Selling and Marketing

Selling and marketing expenses were $52.7 million in the third quarter of 2007 compared to $42.6 million in the same period of 2006, an increase of $10.1 million or 23.7%. The increase is the result of incremental expenses of $4.8 million within the Fitness Equipment business related to bad debt reserves primarily related to the filing for Chapter 11 bankruptcy by our former customer Gately’s, LLC. In addition, we recorded additional charges related to new strategic marketing agreements as well as costs associated with the termination of certain marketing programs. We have also realized lower conversion rates within the direct channel for our rod-based home gyms which increases our cost per sale. The International Equipment business incurred incremental marketing cost increases in the current period as a result of expansion into new markets including both China and Australia. As a percentage of overall net sales, selling and marketing expenses were 39.4% in the third quarter of 2007 compared to 26.7% in the same period of 2006.

General and Administrative

General and administrative expenses were $16.2 million in the third quarter of 2007 compared to $14.5 million in the same period of 2006, an increase of $1.7 million or 11.7%. As a percentage of net sales, general and administrative expenses were 12.1% in the third quarter of 2007 compared to 9.1% in the same period of 2006. The increase in expense is primarily due to costs associated with the departure of the Company’s former Chief Executive Officer and increased amortization related to the intangible assets acquired during a legal settlement in the second quarter of 2007.

Research and Development

Research and development expenses were $3.6 million in the third quarter of 2007 compared to $2.5 million in the same period of 2006, an increase of $1.1 million or 44.0%. As a percentage of net sales, research and development expenses were 2.7% in the third quarter of 2007 compared to 1.6% in the same period of 2006. The increase in expense is due to increases in wages, recruiting, relocation, prototyping expenses and contracted services related to the development of the Nautilus One and other new equipment and apparel products.

Royalties

Royalty expenses were $1.9 million in the third quarter of 2007 compared to $1.3 million in the same period of 2006. We have several agreements under which we are obligated to pay royalty fees on certain product sales. The increase in our royalty expense is primarily a result of increased sales volumes related to our Bowflex TreadClimber and Nautilus Commercial TreadClimber and Bowflex Revolution products as well as preproduction royalties for products that are not yet being sold. The Bowflex Revolution has a higher royalty rate than many of our other products. As a percentage of net sales, royalty expenses were 1.4% in the third quarter of 2007 compared to 0.8% in the same period of 2006. We anticipate this trend to continue through the fourth quarter as we expect our Revolution and TreadClimber sales to be a higher percentage of sales in the Direct Channel as compared to the fourth quarter of last year.

Other Income (Expense)

Interest Expense

Interest expense increased to $1.9 million in the third quarter of 2007 compared to $0.8 million in the same period of 2006. The increase in interest expense is due to the increased average short-term borrowings outstanding during the third quarter of 2007 as compared to 2006.

Other Income, net

Net other income increased to $0.9 million in the third quarter of 2007. The increase is due to the higher foreign currency gains in 2007 realized by the Company.

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Income Tax Expense (Benefit)

The provision for income tax was a benefit of $8.9 million in the third quarter of 2007 compared to an expense of $1.2 million in the same period of 2006, a decrease of $10.1 million. The decrease was due primarily to a pre-tax loss in the third quarter of 2007 compared to pre-tax income in the same period of 2006. Our effective tax rate for the third quarter of 2007 was 39.9% compared to 11.6% in the same period of 2006. The increase in our annual effective tax rate was primarily due to the change to pre-tax loss from pre-tax income, and a $3.0 million reduction of tax contingency reserves during the third quarter of 2006.

SUMMARY OF RESULTS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007

Net sales for the first nine months of 2007 were $409.5 million, compared to $482.2 million for the same period of 2006, a decrease of 15.1%. Gross profit margins decreased to 41.9% in the first nine months of 2007, compared to 44.0% in the same period of 2006, primarily as a result of changes in sales mix for customers, channels, and products. The Company settled a lawsuit and obtained access to certain intellectual properties that were valued at $18.3 million and are recorded as a reduction to operating expenses in the 2^nd quarter of 2007. As a result of lower sales volume, offset by the litigation settlement, we realized an operating loss for the first nine months of 2007 of $14.8 million compared to operating income of $21.4 million for the prior year comparable period. Diluted loss per share for the first nine months of 2007 was 31 cents, compared to diluted earnings per share of 50 cents a year ago.

RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

The following tables present certain consolidated financial data as a percentage of net sales and statement of operations data comparing results for the nine months ended September 30, 2007 and 2006: