Management's Discussion of Results of Operations (Excerpts)
For purposes of readability, Zenith attempts to strip out all tables in excerpts from the Management Discussion. That information is contained elsewhere in our articles. The idea of this summary is simply to review how well we believe Management does its reporting. Also, this highlights what Management believes is important.
In our Decision Matrix at the end of each article, a company with 0 to 2 gets a "-1", and 3 to 5 gets a "+1."
On a scale of 0 to 5, 5 being best, Zenith rates this company's Management's Discussion as a 5.
Overview We are committed to providing innovative, quality solutions to help people achieve a fit and healthy lifestyle. Our principal business activities include designing, developing, sourcing and marketing high-quality cardio and strength fitness products and related accessories for consumer use, primarily in the U.S., Canada and Europe. Our products are sold under some of the most-recognized brand names in the fitness industry: Nautilus®, Bowflex®, Octane Fitness®, Schwinn® and Universal®. We market our products through two distinct distribution channels, Direct and Retail, which we consider to be separate business segments. Our Direct business offers products directly to consumers through television advertising, catalogs and the Internet. Our Retail business offers our products through a network of independent retail companies and specialty retailers with stores and websites located in the U.S. and internationally. We also derive a portion of our revenue from the licensing of our brands and intellectual property. Net sales for the first nine months of 2017 were $278.4 million, a decrease of $1.9 million, or 0.7%, as compared to net sales of $280.3 million for the first nine months of 2016. Net sales of our Direct segment decreased $12.1 million, or 7.6%, in the first nine months of 2017, compared to the first nine months of 2016, primarily due to a decline in TreadClimber® sales. Net sales of our Retail segment increased by $10.5 million, or 8.9%, in the first nine months of 2017, compared to the first nine months of 2016, reflecting increases for both traditional and e-commerce customers across multiple product categories. Gross profit for the first nine months of 2017 was $141.4 million, or 50.8% of net sales, a decrease of $6.0 million, or 4.1%, as compared to gross profit of $147.4 million, or 52.6% of net sales, for the first nine months of 2016. The decrease in gross profit dollars was primarily due to the decrease in net sales. Gross margin percentage points decreased 1.8%, due to a shift in segment mix, reflecting an increased percentage of Retail sales, and a decline in the Direct channel margin. Operating expenses for the first nine months of 2017 were $111.5 million, a decrease of $1.8 million, or 1.6%, as compared to operating expenses of $113.3 million for the first nine months of 2016. The decrease in operating expenses was primarily related to decreased sales and marketing expense. The decrease in sales and marketing expense was due to a retroactive financing fees rebate of $2.1 million, and a $1.0 million settlement payment received in connection with an indemnification claim. Operating income for the first nine months of 2017 was $29.9 million, a decrease of $4.2 million, or 12.3%, as compared to operating income of $34.1 million for the first nine months of 2016. The decrease in operating income for the first nine months of 2017 compared to the first nine months of 2016 was driven primarily by the lower net sales and gross margin dollars. Income from continuing operations was $19.1 million for the first nine months of 2017, or $0.61 per diluted share, compared to income from continuing operations of $23.1 million, or $0.74 per diluted share, for the first nine months of 2016. The effective tax rates for the first nine months of 2017 and 2016 were 34.7% and 29.4%, respectively. The 5.3% year-over-year percentage rate increase was due to the release of previously unrecognized tax benefits associated with certain non-U.S. filing positions during the third quarter of 2016. Net income for the first nine months of 2017 was $17.8 million, compared to net income of $22.6 million for the first nine months of 2016. Net income per diluted share was $0.57 for the first nine months of 2017, compared to $0.72 for the first nine months of 2016. Discontinued Operations Results from discontinued operations relate to the disposal of our former Commercial business, which was completed in April 2011. We reached substantial completion of asset liquidation at December 31, 2012. Although there was no revenue related to the Commercial business in either the 2017 or 2016 periods, we continue to have product liability and other legal expenses associated with product previously sold into the Commercial channel. RESULTS OF OPERATIONS Direct Direct net sales increased 0.8% for the three month period ended September 30, 2017 compared to the same period of 2016 as new products, including the Bowflex HVTTM, offset a decline in TreadClimber® sales. For the nine months ended September 30, 2017, Direct net sales decreased 7.6% compared to the same period of 2016 due to a decline in TreadClimber® sales, partially offset by a 33.0% increase in strength product sales. Combined consumer credit approvals by our primary and secondary U.S. third-party financing providers for the third quarter of 2017 were 53.7%, compared to 47.9% in the same period of 2016. We continue to experience improved credit approval rates due to our media strategy, which focuses on generation of responses from consumers with relatively high credit quality. Additionally, our Tier 1 credit provider has noted strong performance from our account portfolio, and, due to that credit profile, has progressively expanded its approval standards. We remain focused on maintaining a healthy payment balance between cash and financed purchases. The $0.8 million increase in cost of sales of our Direct business for the three month period ended September 30, 2017 compared to the same period of 2016 was due to the higher volume of sales. The $1.2 million decrease in cost of sales of our Direct business for the nine months ended September 30, 2017 compared to the same period of 2016 was due to lower net sales. For the three and nine month periods ended September 30, 2017, Direct gross margins decreased 220 and 190 basis points, respectively, as compared to the same periods of 2016 primarily due to unfavorable product mix and higher discounting for older products. Retail Retail net sales increased 15.8% and 8.9% for the three and nine month periods ended September 30, 2017 compared to the same periods of 2016. The increases in both periods reflected growth in traditional and e-commerce customers across multiple product categories. The increases in cost of sales of our Retail business for the three and nine month periods ended September 30, 2017 compared to the same periods of 2016 were primarily related to the increases in Retail net sales as discussed above. For the three and nine month periods ended September 30, 2017, Retail gross margin increased by 60 and 130 basis points, respectively, compared to the same periods of 2016 due to favorable absorption of fixed costs over the increased sales volume and the one-time settlement of an indemnification claim. Selling and Marketing The $3.4 million decrease in selling and marketing expense in the three month period ended September 30, 2017 compared to the same period of 2016 was due to lower variable selling expenses of $2.6 million, primarily related to lower financing fees reflecting a retroactive contract adjustment of $2.1 million and receipt of a one-time settlement payment of $1.0 million for an indemnification claim. The $2.0 million decrease in selling and marketing expense in the nine month period ended September 30, 2017 as compared to the same period of 2016 was related to a $4.7 million decrease in variable selling costs, including the factors noted above, and lower marketing program costs of $1.0 million, offset by increases of $2.9 million in media advertising and $0.8 million in photo and video production costs. Media advertising expense of our Direct business is the largest component of selling and marketing and was as follows: The increases in media advertising in the three and nine month periods ended September 30, 2017 compared to the same periods of 2016 reflected lower response rates that drove the increased investments in advertising. General and Administrative The increase in general and administrative for the three months ended September 30, 2017 compared to the same period of 2016 was primarily due to higher legal expenses of $0.4 million, offset by $0.4 million lower integration costs and administrative cost savings related to Octane incurred in the same comparative period. The decrease in general and administrative for the nine months ended September 30, 2017 compared to the same period of 2016 was primarily due to $0.8 million savings related to lower integration costs and administrative cost savings related to Octane, and lower employee incentives and compensation costs of $0.9 million. These costs were partially offset by higher litigation-related expenses of $1.3 million for the same comparative period. Research and Development The increases in research and development in the three and nine month periods ended September 30, 2017 compared to the same periods of 2016 were primarily due to our investment in additional engineering and product development headcount as we continue to supplement our new product development resources required to innovate and broaden our product portfolio. Interest Expense Interest expense of $0.4 million and $1.2 million for the three and nine month periods ended September 30, 2017 decreased $0.1 million and $0.2 million, respectively, compared to the same periods of 2016. The decreases were due to reductions in principal balance on our term loan. Income tax expense and effective tax rates from continuing operations for the three and nine month periods ended September 30, 2017 was primarily related to our profitable U.S and foreign operations. The reduced effective tax rates from continuing operations for the three and nine month periods ended September 30, 2016 were primarily due to the release of, on a non-recurring basis, previously unrecognized tax benefits associated with certain non-U.S. filing positions. These resulted from completion of the deregistration process of a certain foreign entity. In addition, the effective tax rate for the nine months ended September 30, 2017 included $0.7 million of excess tax benefits related to stock-based compensation recognized as a current period benefit through the statement of operations, resulting from the adoption of ASU 2016-09 in January 2017. LIQUIDITY AND CAPITAL RESOURCES As of September 30, 2017, we had $77.8 million of cash and investments compared to $79.6 million as of December 31, 2016. Cash provided by operating activities was $16.7 million for the nine months ended September 30, 2017, compared to $14.9 million for the nine months ended September 30, 2016. We expect our cash, cash equivalents and available-for-sale securities at September 30, 2017, along with cash expected to be generated from operations, to be sufficient to fund our operating and capital requirements for at least twelve months from September 30, 2017. The increase in cash flows from operating activities for the nine months ended September 30, 2017 as compared to the same period of 2016 was primarily due to the changes in our operating assets and liabilities as discussed below, partially offset by the decline in operating performance. Trade receivables decreased $6.9 million to $38.5 million as of September 30, 2017, compared to $45.5 million as of December 31, 2016, due to seasonally lower net sales to specialty retail and commercial customers. Trade receivables as of September 30, 2017 compared to September 30, 2016 increased $7.3 million due to the increase in Retail net sales. Inventories increased $10.6 million to $57.6 million as of September 30, 2017, compared to $47.0 million as of December 31, 2016 due to seasonal preparations for the fourth quarter. Inventories as of September 30, 2017 compared to September 30, 2016 increased by $8.4 million due to increased in-transit inventory. Trade payables decreased $3.9 million to $62.1 million as of September 30, 2017, compared to $66.0 million as of December 31, 2016, due to seasonality of the business. Trade payables as of September 30, 2017 compared to September 30, 2016 increased $17.4 million. The higher amount outstanding as of September 30, 2017 was due to the increased inventory. Accrued liabilities decreased $4.8 million to $8.1 million as of September 30, 2017, compared to $12.9 million as of December 31, 2016, due to payout of accrued incentive compensation during the first quarter of 2017 and settlement of a royalty dispute in the second quarter of 2017. Cash used in investing activities of $18.2 million for the first nine months of 2017 was primarily related to net purchases of marketable securities of $15.4 million. In addition, $2.7 million was used for capital expenditures primarily related to production equipment tooling and implementation of new software systems. We anticipate spending between $4.5 million and $5.5 million in 2017 for product tooling, computer equipment and software, and production equipment. Cash used in financing activities of $17.0 million for the first nine months of 2017 was primarily related to principal repayments on our term loan of $12.0 million and share repurchases of $4.8 million. Financing Arrangements We have a Credit Agreement with JPMorgan Chase Bank, N.A. (“Chase Bank”) that provides for an $80.0 million term loan and a $20.0 million revolving line of credit. The term of the Credit Agreement expires on December 31, 2020 and is secured by substantially all of our assets. The Credit Agreement, as amended, contains customary covenants, including minimum fixed charge coverage ratio and funded debt to EBITDA ratio, and limitations on capital expenditures, mergers and acquisitions, indebtedness, liens, dispositions, dividends and investments. The Credit Agreement also contains customary events of default. Upon an event of default, the lender may terminate its credit line commitment, accelerate all outstanding obligations and exercise its remedies under the continuing security agreement. Borrowing availability under the revolving line of credit is subject to our compliance with certain financial and operating covenants at the time borrowings are requested. Letters of credit under the Credit Agreement are treated as a reduction of the available borrowing amount and are subject to covenant testing. The interest rate applicable to the term loan, as well as each advance under the revolving line of credit, is based on either Chase Bank's floating prime rate or adjusted LIBOR, plus an applicable margin. As of September 30, 2017, our borrowing rate for both the term loan and line of credit advances was 2.49%. As of September 30, 2017, the balance on our term loan was $52.0 million, and we had no outstanding borrowings under the line of credit. As of September 30, 2017, we were in compliance with the financial covenants of the Credit Agreement and $20.0 million was available for borrowing under the line of credit. As of September 30, 2017, we had a $52.0 million receive-variable, pay-fixed interest rate swap outstanding with Chase Bank. The interest rate swap amortizes monthly in line with the outstanding principal balance on our term loan and is classified as a cash flow hedge. The swap matures on December 31, 2020 and has a fixed rate of 1.42% per annum. The variable rate on the interest rate swap is the one-month LIBOR benchmark. At September 30, 2017, the one-month LIBOR rate was 1.24%. Commitments and Contingencies For a description of our commitments and contingencies, refer to Note 14 to our condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q. Off-Balance Sheet Arrangements In the ordinary course of business, we enter into agreements that require us to indemnify counterparties against third-party claims. These may include: agreements with vendors and suppliers, under which we may indemnify them against claims arising from our use of their products or services; agreements with customers, under which we may indemnify them against claims arising from their use or sale of our products; real estate and equipment leases, under which we may indemnify lessors against third-party claims relating to the use of their property; agreements with licensees or licensors, under which we may indemnify the licensee or licensor against claims arising from their use of our intellectual property or our use of their intellectual property; and agreements with parties to debt arrangements, under which we may indemnify them against claims relating to their participation in the transactions. The nature and terms of these indemnifications vary from contract to contract, and generally a maximum obligation is not stated. We hold insurance policies that mitigate potential losses arising from certain types of indemnifications. Management does not deem these obligations to be significant to our financial position, results of operations or cash flows, and therefore, no liabilities were recorded at September 30, 2017. Stock Repurchase Program On May 4, 2016, our Board of Directors authorized the repurchase of up to $10.0 million of our outstanding common stock from time to time through May 4, 2018. On April 25, 2017, our Board of Directors authorized an additional $15.0 million share repurchase program, bringing the total authorization under existing programs to $25.0 million. Under the new program, shares of our common stock may be repurchased from time to time through April 25, 2019. Repurchases may be made in open market transactions at prevailing prices, in privately negotiated transactions, or by other means in accordance with federal securities laws. Share repurchases will be funded from existing cash balances, and repurchased shares will be retired and returned to unissued authorized shares. For the nine months ended September 30, 2017, we had repurchased a total of 305,371 shares for $4.8 million. As of September 30, 2017, there was $18.2 million remaining available for repurchases under the share repurchase programs. SEASONALITY We expect our sales from fitness equipment products to vary seasonally. Sales are typically strongest in the first and fourth quarters, followed by the third quarter, and are generally weakest in the second quarter. We believe that, during the spring and summer months, consumers tend to be involved in outdoor activities, including outdoor exercise, which impacts sales of indoor fitness equipment. This seasonality can have a significant effect on our inventory levels, working capital needs and resource utilization. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Exchange Risk Our exposure to market risk from changes in interest rates relates primarily to our cash equivalents, marketable securities, derivative assets and variable-rate debt obligations. As of September 30, 2017, we had cash equivalents of $8.8 million held in a combination of money market funds and commercial paper, and marketable securities of $47.3 million, held in a combination of certificates of deposit, commercial paper, corporate bonds, and U.S. government bonds. Our cash equivalents mature within three months or less from the date of purchase. Marketable securities with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. We have classified our marketable securities as available-for-sale and, therefore, we may choose to sell or hold them as changes in the market occur. Because of the short-term nature of the instruments in our portfolio, a decline in interest rates would reduce our interest income over time, and an increase in interest rates may negatively affect the market price or liquidity of certain securities within the portfolio. Our negotiated credit facilities generally charge interest based on a benchmark rate such as LIBOR. Fluctuations in short-term interest rates may cause interest payments on term loan principal and drawn amounts on the revolving line to increase or decrease. As of September 30, 2017, the outstanding balances on our credit facilities totaled $52.0 million. As of September 30, 2017, we had a $52.0 million receive-variable, pay-fixed interest rate swap outstanding with Chase Bank, which amortizes monthly in line with the outstanding principal balance on our term loan. The swap is classified as a cash flow hedge and effectively fixes the interest rate on our variable-rate term loan. The interest rate swap matures on December 31, 2020 and has a fixed interest rate of 1.42% per annum. The variable rate on the interest rate swap is the one-month LIBOR benchmark, which was 1.24% at September 30, 2017. The fair value of our interest rate swap agreement represents the estimated receipts or payments that would be made to terminate the agreement. The amounts related to our cash flow hedge are recorded as deferred gains or losses in our consolidated balance sheets with the offset recorded in accumulated other comprehensive income, net of tax. At September 30, 2017, the fair value of our interest rate swap agreement was an asset of $0.2 million. The estimated amount expected to be reclassified into earnings within the next twelve months was less than $0.1 million at September 30, 2017. We enter into foreign exchange forward contracts to offset the earnings impacts of exchange rate fluctuations on certain monetary assets and liabilities. Total notional amounts outstanding at September 30, 2017 were $18.3 million. A hypothetical 10% increase in interest rates, or a 10% movement in the currencies underlying our foreign currency derivative positions, would not have material impacts on our results of operations, financial position or cash flows. We do not enter into derivative instruments for any purpose other than to manage our interest rate or foreign currency exposure. That is, we do not engage in interest rate or currency exchange rate speculation using derivative instruments. Evaluation of Disclosure Controls and Procedures In accordance with Rule 13a-15 of the Securities Exchange Act of 1934 (the “Exchange Act”), as of the end of the period covered by this Quarterly Report on Form 10-Q, our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Exchange Act). Based upon their evaluation of these disclosure controls and procedures, our management, including the Chief Executive Officer and Chief Financial Officer, have concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report. Changes in Internal Control over Financial Reporting We are implementing an enterprise resource planning ("ERP") system and complementary systems that support our Retail operations related to Octane. During the third quarter of 2017, the technical design was completed and development of features of the ERP and complementary systems were in progress. We expect to continue developing and deploying these features during the fourth quarter of 2017 with full implementation planned to be completed in the second quarter of 2018. As each phase of the implementation occurs, we are taking steps to monitor and maintain appropriate internal control over financial reporting and will continue to evaluate these controls for effectiveness. There were no other changes in our internal control over financial reporting that occurred during the three months ended September 30, 2017, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.