SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1999
Commission file number: 000-25867
DIRECT FOCUS, INC.
(Exact name of registrant as specified in its charter)
Washington 94300267
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2200 NE 65th Avenue
Vancouver, Washington 98661
(Address of principal executive offices, including zip code)
(360) 694-7722
(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 Exchange Act during the past 12 months
(or for such shorter period that the issuer was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days.
Yes [ ] No [X]
Number of shares of issuer's common stock outstanding as of August 5,
1999: 10,611,432
Page 1 of 24
Exhibit Index on Page 24
DIRECT FOCUS, INC.
INDEX
PART I - FINANCIAL INFORMATION PAGE
----
Item 1. Financial Statements 3
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 11
Item 3. Quantitative and Qualitative Disclosures About Market
Risk 21
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 21
Item 2. Changes in Securities and Use of Proceeds 22
Item 4. Submission of Matters to a Vote of Security Holders 22
Item 6. Exhibits and Reports on Form 8-K 23
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
DIRECT FOCUS, INC.
CONSOLIDATED BALANCE SHEETS
JUNE 30, DECEMBER 31,
1999 1998
------------------ -----------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 27,317,950 $ 18,910,675
Trade receivables (less allowance for doubtful
accounts of: 1999, $543,386 and 1998, $40,000) 3,499,433 218,207
Inventories 7,937,828 2,614,673
Prepaid expenses and other assets 2,846,686 378,409
Current deferred income tax asset 979,553 215,737
------------------ -----------------
Total current assets 42,581,450 22,337,701
------------------ -----------------
PROPERTY, PLANT AND EQUIPMENT (less accumulated depreciation
of: 1999, $880,690 and 1998, $438,790) 10,302,325 1,842,712
------------------ -----------------
OTHER ASSETS (less accumulated amortization of:
1999, $162,881 and 1998, $49,967) 4,438,558 192,859
------------------ -----------------
TOTAL ASSETS $ 57,322,333 $ 24,373,272
------------------ -----------------
------------------ -----------------
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Trade payables $ 5,620,911 $ 3,602,074
Income taxes payable - 504,775
Accrued liabilities 4,851,988 1,851,253
Royalty payable to stockholders 591,992 548,211
Customer deposits 488,288 148,937
Accrued litigation settlement cost 4,000,000 -
------------------ -----------------
Total current Liabilities 15,553,179 6,655,250
------------------ -----------------
LONG-TERM DEFERRED TAX LIABILITY 118,790 66,880
------------------ -----------------
STOCKHOLDERS' EQUITY:
Common stock - authorized, 50,000,000 shares of no par value;
outstanding, 1999: 10,611,432 shares, 1998: 9,448,523 shares 21,686,578 3,565,628
Retained earnings 19,963,786 14,085,514
------------------ -----------------
Total stockholders' equity 41,650,364 17,651,142
------------------ -----------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 57,322,333 $ 24,373,272
------------------ -----------------
------------------ -----------------
See notes to financial statements.
3
DIRECT FOCUS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
---------------------------------- ------------------------------------
1999 1998 1999 1998
-------------- -------------- -------------- ---------------
NET SALES $25,244,216 $12,236,449 $51,356,746 $23,287,748
COST OF SALES 7,362,016 2,652,148 14,751,212 5,206,293
-------------- -------------- -------------- ---------------
Gross profit 17,882,200 9,584,301 36,605,534 18,081,455
-------------- -------------- -------------- ---------------
OPERATING EXPENSES:
Selling and marketing 9,920,772 5,529,622 20,009,526 9,342,826
General and administrative 1,326,408 698,547 2,427,780 1,224,724
Royalties 636,008 342,493 1,261,929 648,564
Litigation settlement 4,000,000 - 4,000,000 -
-------------- -------------- -------------- ---------------
Total operating expenses 15,883,188 6,570,662 27,699,235 11,216,114
-------------- -------------- -------------- ---------------
INCOME FROM OPERATIONS 1,999,012 3,013,639 8,906,299 6,865,341
-------------- -------------- -------------- ---------------
OTHER INCOME (EXPENSE):
Interest income 175,245 91,821 237,168 167,350
State business tax and other - net (20,408) (46,709) (98,522) (87,753)
-------------- -------------- -------------- ---------------
Total other income - net 154,837 45,112 138,646 79,597
-------------- -------------- -------------- ---------------
INCOME BEFORE INCOME TAXES 2,153,849 3,058,751 9,044,945 6,944,938
-------------- -------------- -------------- ---------------
INCOME TAX EXPENSE 754,790 1,077,240 3,166,673 2,392,398
-------------- -------------- -------------- ---------------
NET INCOME $1,399,059 $1,981,511 $5,878,272 $4,552,540
-------------- -------------- -------------- ---------------
-------------- -------------- -------------- ---------------
BASIC EARNINGS PER SHARE $ 0.14 $ 0.21 $ 0.60 $ 0.49
-------------- -------------- -------------- ---------------
-------------- -------------- -------------- ---------------
DILUTED EARNINGS PER SHARE $ 0.13 $ 0.20 $ 0.58 $ 0.47
-------------- -------------- -------------- ---------------
-------------- -------------- -------------- ---------------
Basic shares outstanding 10,156,914 9,250,957 9,838,350 9,250,957
Diluted shares outstanding 10,454,819 9,719,324 10,130,464 9,719,324
See notes to financial statements.
4
DIRECT FOCUS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
SIX MONTHS ENDED JUNE 30,
-------------------------------------
1999 1998
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 5,878,272 $ 4,552,540
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization 557,815 151,035
Deferred income taxes (711,906) (120,921)
Changes in:
Trade receivables (274,336) (228,111)
Inventories (2,219,024) (434,593)
Prepaid expenses and other current assets (2,360,071) (269,806)
Trade payables 1,750,777 1,083,536
Income taxes payable (504,775) (801,128)
Accrued liabilities and royalty payable to stockholders 1,487,291 1,290,751
Customer deposits 339,351 8,512
Accrued litigation settlement cost 4,000,000 -
----------------- ---------------
Net cash provided by operating activities 7,943,394 5,231,814
----------------- ---------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property, plant and equipment (909,828) (348,824)
Acquisition cost of Nautilus (16,747,241) -
----------------- ---------------
Net cash used in investing activities (17,657,069) (348,824)
CASH FLOWS FROM FINANCING ACTIVITIES:
Principal payments under capital lease obligations - (4,899)
Proceeds from public offering 17,919,146 -
Proceeds from exercise of stock options, net 201,804 176,848
----------------- ---------------
Net cash provided by financing activities 18,120,950 171,949
----------------- ---------------
NET INCREASE IN CASH AND CASH EQUIVALENTS 8,407,275 5,054,939
----------------- ---------------
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 18,910,675 4,790,316
----------------- ---------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 27,317,950 $ 9,845,255
----------------- ---------------
----------------- ---------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION:
Cash paid for interest $ 662 $ 348
Cash paid for income taxes 6,510,000 3,565,000
See notes to financial statements.
5
DIRECT FOCUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
The accompanying unaudited financial statements of Direct Focus, Inc.
(the "Company") have been prepared in accordance with generally
accepted accounting principles and pursuant to Securities and Exchange
Commission rules and regulations. Certain information and footnote
disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been
condensed or omitted pursuant to such rules and regulations. These
financial statements should be read in conjunction with the audited
financial statements and notes thereto included in the Company's annual
report for the fiscal year ended December 31, 1998.
The financial information included herein reflects all adjustments
(consisting of normal recurring adjustments) which are, in the opinion
of management, necessary for a fair presentation of the results for
interim periods presented. The results of operations for the interim
periods are not necessarily indicative of the results to be expected
for the full year.
CONSOLIDATION - The consolidated financial statements of the Company
include Direct Focus, Inc., Nautilus HPS, Nautilus, Inc., DFI
Properties, and Nautilus Fitness Products, Inc. All intercompany
transactions have been eliminated.
2. PUBLIC OFFERING
On May 5, 1999, the Company completed its initial U.S. public offering
of common stock listed on the NASDAQ exchange. The initial offering
consisted of one million total shares at $20.50 per share, of which
825,000 shares were offered by the Company, with an additional 175,000
shares offered by selling shareholders.
On June 10, 1999 the underwriting group exercised a 150,000 share
over-allotment, bringing the total of the Company's common shares
outstanding to 10.6 million shares.
Total net proceeds realized by Direct Focus, Inc. from the offerings
were $17.9 million.
The Company was listed on the Toronto Stock Exchange from January 1993
to May 5, 1995.
6
3. ACQUISITION OF NAUTILUS
Effective January 4, 1999, the Company acquired substantially all of
the net assets of Nautilus International, Inc. ("Nautilus"). Nautilus
was a manufacturer and distributor of commercial fitness equipment and,
to a limited extent, consumer fitness equipment and accessories. The
acquisition has been accounted for under the purchase method of
accounting and, accordingly, the assets acquired, liabilities assumed,
and results of operations have been included in the accompanying
financial statements since the date of acquisition. The Company paid
approximately $16.9 million, including acquisition costs of
approximately $700,000, for the assets and intellectual property of
Nautilus and assumed $1.8 million in current liabilities.
The total cost of the acquisition has been allocated to the assets
acquired and liabilities assumed as follows:
Cash $ 8,512
Trade receivables 3,006,890
Inventories 3,104,131
Prepaid expenses and other current assets 108,206
Property, plant and equipment 7,991,685
Other assets 4,482,068
Liabilities assumed (1,825,285)
---------------
Total $ 16,876,207
---------------
---------------
The unaudited pro forma financial information below for the three
months and six months ended June 30, 1998 were prepared as if the
transaction had occurred on January 1, 1998:
THREE MONTHS ENDED SIX MONTHS ENDED
6/30/98 6/30/98
Revenue $17,550 $33,873
Net income 1,511 3,628
Basic earnings per share 0.16 0.39
Diluted earnings per share 0.16 0.37
The unaudited pro forma financial information is not necessarily
indicative of what actual results would have been had the transaction
occurred at the beginning of the respective year nor does it purport to
indicate the results of future operations of the Company.
4. LITIGATION SETTLEMENT
On July 17, 1999 the Company reached an agreement with a competitor to
settle pending litigation. As a result of the settlement the Company
took a one time, after-tax charge of
7
$2.6 million in the second quarter. The Company will make an $8
million cash payment to the competitor, of which $4 million is being
paid by insurance.
The Company made no admission of guilt in the settlement and continues
to believe that the competitor's claims were without merit. However,
when the court denied our motions to have the case dismissed before
trial, we were faced with a lengthy jury trial and the possibility of a
large jury verdict, including multiple damages as allowed under federal
law. Under those circumstances, we determined that it was in the best
interest of our shareholders to settle the case on terms that will have
no negative long-term impact on the Company.
This settlement does not affect the ongoing direct marketing campaign
for our Bowflex home fitness equipment.
5. STOCK OPTIONS
Options for 187,909 shares of the Company's common stock were exercised
at prices ranging from $.12 to $4.62 per share during the six months
ended June 30, 1999. During the second quarter options for 121,600
shares were granted to 26 employees and five directors of the Company
at the public offering price of $20.50. Options for 10,000 shares were
cancelled during the period.
6. OPERATING SEGMENTS
In June 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED
INFORMATION, which establishes standards for reporting information
regarding an entity's operating activities. SFAS No. 131 requires that
operating segments be defined at the same level and in a similar manner
as management evaluates operating performance.
8
The following table presents information about the Company's two
operating segments (in thousands):
DIRECT PRODUCTS NAUTILUS PRODUCTS TOTAL
---------------------- --------------------- ----------------------
THREE SIX MONTHS THREE SIX THREE SIX MONTHS
MONTHS MONTHS MONTHS MONTHS
---------- ----------- --------- ---------- ---------- -----------
PERIOD ENDED JUNE 30, 1999
Revenues from External Customers $ 21,537 $ 43,676 $3,707 $ 7,681 $ 25,244 $ 51,357
---------- ----------- --------- ---------- ---------- -----------
---------- ----------- --------- ---------- ---------- -----------
Segment Net Income (loss) $ 1,556 $6,230 $ (157) $ (352) $ 1,399 $ 5,878
---------- ----------- --------- ---------- ---------- -----------
---------- ----------- --------- ---------- ---------- -----------
As of June 30, 1999 - Segment Assets $ 39,022 $ 18,300 $ 57,322
PERIOD ENDED JUNE 30, 1998
Revenues from External Customers $ 12,236 $ 23,288 $ - $ - $ 12,236 $ 23,288
---------- ----------- --------- ---------- ---------- -----------
---------- ----------- --------- ---------- ---------- -----------
Segment Net Income $ 1,982 $ 4,552 $ - $ - $ 1,982 $ 4,552
---------- ----------- --------- ---------- ---------- -----------
---------- ----------- --------- ---------- ---------- -----------
As of June 30, 1998 - Segment Assets $14,057 $ - $ 14,057
----------- ---------- -----------
----------- ---------- -----------
7. EMPLOYEE BENEFIT PLAN
The Company adopted a 401(k) profit sharing Plan in 1999 covering all
employees over the age of 18, who also have three months of service.
Each participant in the 401(k) Plan may contribute up to 15% of
eligible compensation during any calendar year, subject to certain
limitations. The 401(k) Plan provides for Company matching
contributions of 50% for eligible contributions for participants who
have one year of service. In addition, the Company may make
discretionary contributions. Employees are 100% vested in the matching
and discretionary contributions after four years of services. The
Company has not yet contributed to the Plan.
9
8. EARNINGS PER SHARE
Basic and diluted earnings per share are reconciled as follows:
THREE MONTHS ENDED JUNE 30, 1999 THREE MONTHS ENDED JUNE 30, 1998
----------------------------------------- ---------------------------------------
PER SHARE PER SHARE
INCOME SHARES AMOUNT INCOME SHARES AMOUNT
------ ------ --------- ------ ------ ---------
Basic EPS:
Income available to common
shareholders $1,399,059 10,156,914 $ 0.14 $ 1,981,511 9,250,957 $ 0.21
----------- ----------
----------- ----------
Effect of dilutive securities:
Stock options - 297,905 - 468,367
------------ ------------- ------------- -----------
Diluted EPS:
Income available to common share-
holders plus assumed stock options $1,399,059 10,454,819 $ 0.13 $ 1,981,511 9,719,324 $ 0.20
------------ ------------- ----------- ------------- ----------- ----------
------------ ------------- ----------- ------------- ----------- ----------
SIX MONTHS ENDED JUNE 30, 1999 SIX MONTHS ENDED JUNE 30, 1998
----------------------------------------- ---------------------------------------
PER SHARE PER SHARE
INCOME SHARES AMOUNT INCOME SHARES AMOUNT
------ ------ --------- ------ ------ ---------
Basic EPS:
Income available to common
shareholders $ 5,878,272 9,839,350 $ 0.60 $ 4,552,540 9,250,957 $ 0.49
----------- -----------
----------- -----------
Effect of dilutive securities:
Stock options - 291,114 - 468,367
------------ ------------- ------------- ----------
------------ ------------- ------------- ----------
Diluted EPS:
Income available to common share-
holders plus assumed stock options $ 5,878,272 10,130,464 $ 0.58 $ 4,552,540 9,719,324 $ 0.47
------------ ------------- ----------- ------------- ---------- -----------
------------ ------------- ----------- ------------- ---------- -----------
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Statements in this Form 10-Q that Direct Focus considers to be
forward-looking are denoted with an asterisk ("*"), and the following cautionary
language applies to all such statements, as well as any other statements in this
Form 10-Q that the reader may consider to be forward-looking. Investors are
cautioned that all forward-looking statements involve risks and uncertainties
and various factors could cause actual results to differ materially from those
in the forward-looking statements. Direct Focus, from time to time, may make
forward-looking statements relating to its financial performance, including the
following:
- Anticipated revenues, expenses and gross margins;
- Anticipated earnings;
- New product introductions; and
- Future capital expenditures.
Factors that could affect our actual results include our reliance on a
limited product line, market acceptance of our existing and future products,
growth management challenges and difficulties integrating our Nautilus
operations. A more detailed description of certain factors that could affect
actual results include, but are not limited to, those discussed in our recent
registration statement on Form S-1, Registration No. 33-73243, in the section
entitled "Risk Factors."
OVERVIEW
HISTORY OF OPERATIONS
We have generated substantial increases in net sales each year since
1996. Net sales increased from $8.5 million in 1996 to $19.9 million in 1997 and
$57.3 million in 1998. A substantial portion of our net sales growth is
attributable to our Bowflex Power Pro home fitness products. We believe this
growth resulted from our expanded direct marketing campaign for our Bowflex
product line and our ability to quickly provide "zero down" financing for our
customers through third-party financing sources. Sales of our Bowflex Power Pro
represented 90.2%, 91.3% and 93.3%, respectively, of our total net sales during
1996, 1997 and 1998. We expect that sales of our Bowflex Power Pro will continue
to account for a substantial portion of our net sales for the foreseeable
future.*
We expanded our product base in late 1998 by introducing a line of
airbeds under the trade name "Instant Comfort," and more recently under the
trade name "Nautilus Sleep Systems." We are currently developing and testing
a direct marketing campaign for this new product. We intend to expand this
direct marketing campaign in 1999 and anticipate that this expansion will
cause our line of airbeds to generate a material portion of our net sales in
1999.* However, we expect that the gross margin for our Nautilus sleep
systems will be lower than the current gross margin for our Bowflex products.*
11
ACQUISITION OF NAUTILUS BUSINESS
In January 1999, we acquired substantially all of the assets of
Nautilus International, a manufacturer and distributor of commercial fitness
equipment and distributor of fitness accessories. We paid $16.2 million in cash
and assumed approximately $1.8 million in liabilities as consideration for these
assets, which include the following:
- All intellectual property rights to the Nautilus name and its
products;
- Warehouse, manufacturing and office facilities in Independence,
Virginia;
- The Nautilus line of commercial fitness equipment;
- The Nautilus line of consumer fitness equipment and fitness
accessories;
- The Nautilus distribution system; and
- All working capital, except cash and finance receivables.
In recent years, Nautilus International suffered from declining
revenues and significant losses. During the fiscal year ended June 27, 1998,
Nautilus International had a net loss of $14.8 million, of which $8.8 million
was attributable to a one-time impairment charge, on net sales of $20.9 million,
compared to a net loss of $6.8 million on net sales of $21.9 million during the
fiscal year ended June 27, 1997. We have identified and begun to implement a
number of initiatives that we believe have begun and will continue to
effectively integrate Nautilus into our operations and revitalize its commercial
business.* These initiatives include the following:
- We have hired an experienced management team to oversee and
revitalize the sales and marketing operations of our Nautilus
commercial business;
- We are currently offering creative financing programs, such as
pre-approved leasing;
- We intend to develop and introduce additional Nautilus commercial
products to serve new market segments and expand our customer
base;*
- We have restructured the management of our Nautilus commercial
manufacturing operations and begun to make other necessary
manufacturing improvements;
- We have implemented and intend to continue to implement general
cost-cutting measures;*
- We are using the excess capacity of our Nautilus warehouse
facilities as an East Coast distribution center for our Bowflex
products; and
- We are working to improve the data gathering and analytical
capabilities of our Nautilus commercial operations by linking them
with our sophisticated management information systems.*
Integration of the Nautilus commercial product line into our
operations has significantly increased our overall net sales. However, our
overall gross profit margin has decreased, principally because we have
integrated two different business models:
- A direct marketing business that historically has generated a high
gross profit margin; and
- A manufacturing and marketing business that operates in an
industry that traditionally generates a lower gross profit
margin.
12
RESULTS OF OPERATIONS
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 experiencing rapid growth and, in particular, rapidly
growing companies that operate in evolving markets. We may not be able to
successfully address these risks and difficulties. Although we have experienced
net sales growth in recent years, our net sales growth may not continue, and we
cannot assure you of any future growth or profitability.
STATEMENT OF OPERATIONS DATA - THREE MONTHS ENDED JUNE 30
The following table presents certain financial data regarding our
second quarter operations in 1999 and 1998, as a percentage of total revenues:
QUARTER ENDED JUNE 30,
---------------------------
1999 1998
---- ----
Net sales...................................... 100.0% 100.0%
Cost of sales.................................. 29.2 21.7
--------- ---------
Gross profit................................... 70.8 78.3
Operating expenses
Selling and marketing................. 39.3 45.2
General and administrative............ 5.3 5.7
Royalties............................. 2.5 2.8
Litigation settlement................. 15.8 -
--------- ---------
Total operating expenses....................... 62.9 53.7
Operating income............................... 7.9 24.6
Other income................................... 0.6 0.4
--------- ---------
Income before income taxes..................... 8.5 25.0
Income tax expense............................. 3.0 8.8
--------- ---------
Net income..................................... 5.5% 16.2%
--------- ---------
--------- ---------
COMPARISON OF THE QUARTERS ENDED JUNE 30, 1999 AND JUNE 30, 1998
NET SALES
Net sales grew by 106.6% to $25.2 million in the second quarter of 1999
from $12.2 million in the second quarter of 1998. Sales within our direct
marketing business increased by 76.2% over prior year second quarter levels and
accounted for $21.5 million of our aggregate net
13
sales in the second quarter of 1999. Net sales within our Nautilus business
generated $3.7 million, or 28.5%, of the increase.
Sales growth in the second quarter of 1999 primarily resulted from
expanded direct marketing of our Bowflex products and the addition of our
Nautilus business. In the direct marketing business, we intend to further
expand our use of spot television commercials and infomercials during the
remainder of 1999 by increasing our presence in existing television markets
and entering new television markets.* We intend to revitalize Nautilus sales
by developing new products, expanding existing and introducing new creative
financing programs, and expanding our direct sales efforts.* We are
continuing to test market our Nautilus sleep systems, but this product did
not materially contribute to our net sales in the second quarter.
A newly developing trend for both our direct marketing and Nautilus
businesses is slower sales activity during the second quarter of the calendar
year.* Our direct marketing business is largely dependent upon national cable
television advertising, and we are finding that second quarter influences on
television viewership, such as the broadcast of national network season
finales and seasonal weather factors, are causing our spot television
commercials on national cable television to be marginally less effective than
in other periods of the year.* Also, sales of our Bowflex product line appear
to be strongest in the second half of the year.* Sales within our Nautilus
business appear to be strongest in the first and fourth quarters of each
year, as the commercial fitness industry prepares for the impact of the
public's New Year fitness resolutions.*
GROSS PROFIT
Gross profit grew 86.5% to $17.9 million in the second quarter of 1999,
from $9.6 million in the same period a year ago. Our gross profit margin
decreased 7.5% to 70.8% in the second quarter of 1999, from 78.3% in the second
quarter of 1998. The decrease in gross profit margin was mainly attributable to
the Nautilus operations, which had a gross profit margin for the quarter of
34.3%. In response to consumers' television viewing habits, during the second
quarter of 1999 we concentrated our marketing efforts on the extended
infomercial format, rather than on spot commercial advertising. Because our
infomercials incorporate special promotional offers, the gross profit margin for
our direct marketing business declined by 1.2% to 77.1%. Although this marketing
plan decreased our gross profit margin by 1.2%, it also decreased our selling
and marketing expense by 4.4% as a percentage of net sales. The net effect was
that our operating income margin increased by 3.2%
In the second half of the current year, we anticipate a small
increase in the gross profit margin on our Bowflex products associated with
the March 1999 opening of our East Coast distribution center and our
advertising plan related to seasonal fluctuations in television viewer
habits.* In comparison, we expect a lower percentage gross profit margin
contribution from our line of Nautilus sleep systems as we continue to
develop our direct marketing campaign for this product.* At least initially,
we expect that the domestic production and relatively lower sales volume of
our Nautilus sleep systems will cause them to generate lower gross profit
margins than our Bowflex products.* Similar to our Bowflex products, with the
anticipated future higher sales
14
volume of Nautilus sleep systems, we expect to take advantage of overseas
production to strengthen the margins for our Nautilus sleep systems.*
OPERATING EXPENSES
SELLING AND MARKETING
Selling and marketing expenses grew to $9.9 million in the second
quarter of 1999 from $5.5 million in the same period a year ago, an increase of
80.0%. This increase in selling and marketing expenses resulted primarily from
the continued expansion of our Bowflex direct marketing campaign and variable
costs associated with our sales growth. The addition of our Nautilus business
accounted for $1.1 million of the increase.
As a percentage of net sales, selling and marketing expenses decreased
by 5.9% in the second quarter of 1999 to 39.3%, compared to 45.2% in the same
period in the prior year. Selling and marketing expenses within our direct
marketing business were $8.8 million, a 4.4% decline as a percentage of net
sales compared to the same period in the prior year. As a result of our
concentration on infomercial advertising, and sales efforts related to our
Bowflex products, we took advantage of the greater ratio of quality sales leads
generated from this format. Selling and marketing expenses within our Nautilus
business traditionally have been a lower percentage of net sales than we have
experienced in direct marketing. In real dollar terms, we expect that our
aggregate selling and marketing expenses will continue to increase, but not
materially as a percentage of net sales,* as we:
- Continue to expand our Bowflex direct marketing campaign;*
- Expand the direct marketing campaign for our Nautilus sleep systems;*
- Integrate the marketing and distribution infrastructure for our
Nautilus line of commercial fitness equipment;* and
- Begin marketing new home fitness equipment products and fitness
accessories under the Nautilus brand name.*
GENERAL AND ADMINISTRATIVE
General and administrative expenses grew to $1.3 million in the second
quarter of 1999 from $699,000 in the same period a year ago, an increase of
86.0%. The direct marketing business accounted for $241,000 of the increase in
general and administrative expenses, due primarily to increased staffing levels
in our accounting and information systems departments necessitated by our
continued growth and the implementation of our new computer system. Nautilus
operations accounted for the remaining increase of $387,000.
As a percentage of net sales, general and administrative expenses
decreased to 5.3% in the second quarter of 1999 from 5.7% in the same period a
year ago. The decline in general and administrative expenses as a percentage of
net sales primarily resulted from our substantial increase in net sales. We
believe that our general and administrative expenses in real dollar terms will
also increase in future periods as we integrate the Nautilus business into our
15
operations and expand our administrative staff and other resources to manage
anticipated growth, but will decrease as a percentage of net sales.*
ROYALTY
Royalty expense grew to $636,000 in the second quarter of 1999 from
$342,000 in the same period a year ago, an increase of 86.0%. The increase in
our royalty expenses is attributable to the increased sales of our Bowflex
products in 1999. Our royalty expenses will increase if sales of our Bowflex
products continue to increase.*
LITIGATION SETTLEMENT
In the second quarter of 1999, we incurred a one-time charge of $4
million relating to the settlement of pending litigation with a competitor in
the home fitness market. The settlement does not affect the ongoing direct
marketing campaign for our Bowflex home fitness equipment and is expected to
have no effect on results of operations in future periods.* We determined that
it was in the best interest of our shareholders to settle the case on terms that
will have no negative long-term impact on Direct Focus.*
OTHER INCOME
In the second quarter of 1999, other income increased to $155,000 from
$45,000 for the same period a year ago. The $110,000 increase resulted primarily
from interest income generated by greater average cash investments accumulated
from a combination of year-to-date results from operations and our public
offering completed during the quarter.
INCOME TAX EXPENSE
Income tax expense decreased by $322,000 for the second quarter of 1999
compared to the second quarter of 1998. The one-time charge for resolution of
litigation reduced income taxes by $1.4 million. Excluding the effects of the
litigation charge on results of operations, income taxes were $2.2 million, a
100.0% increase over the $1.1 million provision in the second quarter of 1998.
We expect our income tax expense to increase in line with increases of our
income before taxes.*
NET INCOME
For the reasons discussed above, net income decreased 30.0% to $1.4
million in the second quarter of 1999 compared to $2.0 million in the same
period in 1998. The litigation settlement in the current quarter reduced net
income after taxes by $2.6 million. Excluding the effects of the litigation
charge, net income grew 100.0% in the second quarter of 1999 to $4.0 million.
16
STATEMENT OF OPERATIONS DATA - SIX MONTHS ENDED JUNE 30
The following table presents certain financial data regarding
operations for the first six months of 1999 and 1998, as a percentage of
total revenues:
SIX MONTHS ENDED JUNE 30,
--------------------------
1999 1998
---- ----
Net sales.................................... 100.0% 100.0%
Cost of sales................................ 28.7 22.3
------ ------
Gross profit................................. 71.3 77.7
Operating expenses
Selling and marketing..................... 39.0 40.1
General and administrative................ 4.7 5.3
Royalties................................. 2.5 2.8
Litigation settlement..................... 7.8 -
------ ------
Total operating expenses..................... 54.0 48.2
Operating income............................. 17.3 29.5
Other income................................. 0.3 0.3
------ ------
Income before income taxes................... 17.6 29.8
Income tax expense........................... 6.2 10.3
------ ------
Net income................................... 11.4% 19.5%
------ ------
------ ------
COMPARISON OF THE SIX MONTHS ENDED JUNE 30, 1999 AND JUNE 30, 1998
NET SALES
Net sales for the first six months of 1999 increased 120.6% to $51.4
million, from $23.3 million in the same period in 1998. Direct marketing sales
for the first six months increased by 87.6% to $43.7 million. Sales within our
Nautilus business accounted for $7.7 million of our net sales, or 27.4% of the
increase. Sales growth in the first half of 1999 primarily resulted from
expanded direct marketing of our Bowflex products and the addition of our
Nautilus business. We are continuing to test market our Nautilus sleep systems,
but this product did not materially contribute to our net sales in the first
half of the current year.
GROSS PROFIT
Gross profit grew 102.2% to $36.6 million in the first half of 1999,
from $18.1 million in the same period a year ago. Our gross profit margin
decreased by 6.4% to 71.3% in the first six months of 1999, from 77.7% in the
first half of 1998. The decrease in gross profit margin was primarily
attributable to the integration of our Nautilus operations, which had a gross
profit
17
margin of 33.1% in the first six months of 1999. In the first half of the
current year, we successfully tailored our direct marketing efforts in
response to seasonal fluctuations in television viewer habits. By
appropriately emphasizing either spot or infomercial advertising, we modestly
increased the gross profit margin for our direct marketing business to 78.0%.
OPERATING EXPENSES
SELLING AND MARKETING
Selling and marketing expenses grew to $20.0 million in the first half
of 1999 from $9.3 million in the same period a year ago, an increase of 115.1%.
This increase in selling and marketing expenses resulted primarily from the
continued expansion of our Bowflex direct marketing campaign and variable costs
associated with our sales growth. The addition of our Nautilus operations
accounted for $2.4 million of the increase.
As a percentage of net sales, selling and marketing expenses
decreased by 1.1% to 39.0% for the first six months of 1999, compared to
40.1% for the same period in the prior year. As a percentage of net sales,
selling and marketing expenses for our direct marketing business increased by
0.2% to $17.6 million.
GENERAL AND ADMINISTRATIVE
General and administrative expenses grew to $2.4 million for the first
six months of 1999 from $1.2 million in the same period a year ago, a 100.0%
increase. Our direct marketing business accounted for $503,000 of the increase
in the first half of the year due primarily to increased staffing levels in our
accounting and information systems departments necessitated by our continued
growth and the implementation of our new computer system. Nautilus operations
accounted for the remaining increase of $700,000. As a percentage of net sales,
general and administrative expenses decreased to 4.7% for the first six months
of 1999 from 5.3% in same period a year ago. The decline in general and
administrative expenses as a percentage of net sales for the first half of the
year resulted from the substantial increase in net sales.
ROYALTY
Royalty expense grew by 100.3% to $1.3 million during the first six
months of 1999 from $649,000 for the same period a year ago. The increase in
royalty expenses is directly related to Bowflex product sales for 1999.
OTHER INCOME (EXPENSE)
In the first half of 1999, other income increased to $139,000 from
$80,000 over the same period a year ago, due to higher average cash balances
during the period that increased our interest income.
18
INCOME TAX EXPENSE
Income tax expense increased by $774,000 million for the first half of
1999 due to the Company's growth in income before taxes, offset by the one-time
litigation charge in the second quarter.
NET INCOME
For the reasons discussed above, net income for the first six months of
1999 grew to $5.9 million ($8.5 million before litigation charge) from $4.6
million in the same period a year ago. The percentage increase in net income
over first half of 1998 was 28.3%, an 84.8% increase prior to litigation charge.
LIQUIDITY AND CAPITAL RESOURCES
Historically, we have financed our growth primarily from cash generated
by our operating activities. During the first half of 1999, our operating
activities generated over $7.9 million in net cash, which contributed to an
aggregate $27.3 million in cash and cash equivalents on hand as of June 30,
1999. We used $16.7 million in cash to fund the Nautilus acquisition in January
1999. Our public offering on May 5, 1999, generated $15.1 million in cash and
the underwriters' exercise of their overallotment option on June 10, 1999,
generated an additional $2.8 million in cash, bringing the total net offering
proceeds to $17.9 million. These activities contributed to an $8.4 million, or
44.4%, increase in our cash and cash equivalents during the first half of 1999.
We anticipate that our working capital requirements will increase as
a result of increased inventory and accounts receivable related to our
Nautilus operations.* We also expect to increase our cash expenditures on
spot commercials and infomercials as we continue to expand the direct
marketing campaigns for our Bowflex products and Nautilus sleep systems.* To
accommodate our anticipated growth, we are opening an additional West Coast
distribution center in October 1999.* In addition, on August 4, 1999, the
Board of Directors authorized the expenditure of up to $8 million to purchase
shares of Direct Focus common stock in open market transactions during the 90
day period commencing August 9, 1999.
We maintain one $5.0 million line of credit with Bank of America. The
line of credit is secured by our general assets and contains certain financial
covenants. As of the date of these financial statements, we are in compliance
with all material covenants applicable to the line of credit, and there is no
outstanding balance under the line.
We believe that our existing cash balances, combined with our line of
credit, will be sufficient to meet our capital requirements for at least the
next 12 months.*
YEAR 2000 COMPLIANCE
Many computer software programs, as well as hardware with embedded
software, use a two-digit date field to track and refer to any given year.
After, and in some cases prior to, January 1, 2000, these software and hardware
systems will misinterpret the year "00," which will
19
cause them to perform faulty calculations or shut down altogether.
Notwithstanding the remedial efforts and third-party assurances discussed
below, this "Year 2000" problem may adversely affect our operations. We
believe that the most reasonably likely worst-case scenario would involve
material disruptions in such important functions as:*
- Airing our spot commercials and infomercials;
- Receiving and processing customer inquiries and orders;
- Distributing our products, and
- Processing billings and payments.
Such difficulties could result in a number of adverse consequences,
including, but not limited to, delayed or lost revenue, diversion of resources,
damage to our reputation, increased administrative and processing costs and
liability to suppliers and/or customers.* Any one or a combination of these
consequences could significantly disrupt our operations and have a material
adverse effect on our financial performance.*
Accordingly, we began assessing the scope of our potential Year 2000
exposure both internally and among our suppliers and customers in March 1998,
and started implementing remedial measures soon thereafter. To date, we have
tested and assessed the Year 2000 compliance of over 95.0% of the software and
hardware systems that we use internally in our business. We have upgraded
approximately 95.0% of the computer hardware and equipment that we determined
had Year 2000 problems. We expect our internal systems, including our financial
accounting system and database marketing system, to be fully Year 2000 compliant
by late October 1999.*
To date, we have spent approximately $1.6 million to upgrade our
computer systems, and we believe we will need to spend at least an additional
$300,000 to complete our upgrade.* Although we believe that these corrective
measures will adequately address our potential Year 2000 problems,* including
those affecting our Nautilus operations, we cannot assure you that we will
discover and address every Year 2000 problem or that all of our corrective
measures will be effective. To the extent that Year 2000 problems persist, we
could experience the adverse consequences described above, some or all of
which could be material.*
We have received assurances from our primary freight carrier, our
primary consumer finance provider, our telephone companies and certain other key
suppliers and vendors that their businesses are Year 2000 compliant. We have
requested but have not yet received such assurances from our other suppliers and
vendors. We have and will continue to work with all of our vendors and suppliers
to resolve any potential Year 2000 problems. However, we have no direct control
over these third parties and cannot assure you that such third-party software
and hardware systems will be timely converted. The failure of certain individual
vendors or suppliers, or a combination of vendors or suppliers, to make their
systems Year 2000 compliant could have a material adverse effect on our
financial results.*
Our Year 2000 contingency plan focuses on our key vulnerabilities over
which we exercise a certain amount of control. To protect against manufacturing
interruptions, we are accumulating a sufficient inventory of products within our
warehouses to satisfy one month of
20
anticipated demand.* We have also acquired back-up generators for use if we
experience power failures.*
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
None.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On July 19, 1999, the Company settled pending litigation with Soloflex,
Inc., a company that manufactures and directly markets home fitness equipment.
Under the terms of the settlement, the Company will make an $8 million cash
payment to Soloflex, of which $4 million is being paid by insurance. As a result
of the settlement, the Company took a one-time, after-tax charge of
approximately $2.6 million against second quarter earnings. The Company also
agreed to refrain from using certain advertising techniques and slogans,
although none of these restrictions will impact the Company's current
advertising campaign for its Bowflex products.
The Company made no admission of guilt in the settlement and continues
to believe that Soloflex's claims were without merit. However, when the court
denied the Company's motions to have the case dismissed before trial, the
Company was faced with a lengthy jury trial and the possibility of a large jury
verdict, including multiple damages as allowed under federal law. Under those
circumstances, the Company determined it was in the best interest of its
shareholders to settle the case on terms that will have no negative long-term
impact on the Company.
Soloflex filed its action against the Company and Randal R. Potter, its
Vice President of Marketing, in the United States District Court for the
District of Oregon. The suit was titled Soloflex, Inc. v. Bowflex, Inc. and
Randy Potter, Cause No. 98-557-JO. Soloflex was pursuing two categories of
claims, both of which related to activities that allegedly violated its
intellectual property rights. First, Soloflex claimed that the Company violated
the Lanham Act, which relates to trademark and trade dress infringement, and
infringed upon several of its copyrights. The principal basis for these claims
was Soloflex's contention that our print and video advertisements were too
similar to its advertisements. For example, Soloflex asserted that we are
prohibited from marketing our products with advertisements that:
- Feature Mr. Potter, a former model for Soloflex;
- Feature an image of Mr. Potter removing his shirt; and
- Use phrases with the words "unlock your body's potential" or "the
body you always wanted
Second, Soloflex claimed we misappropriated certain of its marketing
trade secrets. The principal basis for this claim was Soloflex's allegation that
Mr. Potter had access to marketing
21
knowledge and physical documents while an employee of Soloflex, and that Mr.
Potter improperly used this knowledge and documentation to our competitive
advantage. Mr. Potter joined us in 1991 as a creative director and marketing
manager. Soloflex further alleged that we hired another Soloflex employee,
who also possessed this type of information, for the specific purpose of
acquiring such information and obtaining a competitive advantage. Soloflex
requested both monetary damages and injunctive relief in connection with its
claims. Specifically, Soloflex was seeking to recover:
- Any profits it would have earned but for our allegedly improper
activities;
- Any profits we earned during the period when an alleged violation
may have occurred; and/or
- The cost of corrective advertising to remedy the allegedly "false
impressions" created by our advertising activities.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
The effective date of the Company's first registration statement, filed
on Form S-1 under the Securities Act of 1933 (No. 333-73243) relating to the
Company's initial United States public offering of its common stock, was May 4,
1999. The Company sold 825,000 shares of its common stock to the underwriting
syndicate. The managing underwriters were D.A. Davidson & Co., Inc. and First
Security Van Kasper. The offering commenced and was completed on May 5, 1999, at
a price of $20.50 per share. Selling shareholders sold an additional 175,000
shares of common stock as part of the same offering, and the Company
subsequently sold an additional 150,000 shares of common stock to the managing
underwriters upon the exercise of their overallotment option. The public
offering resulted in gross proceeds to the Company and the selling shareholders
of approximately $23.6 million, $1.7 million of which was applied toward the
underwriting discount. The Company incurred approximately $625,000 in expenses
related to the offering, none of which was borne by the selling shareholders.
Net proceeds to the Company and selling shareholders were approximately $18.0
million and $3.3 million, respectively. From the time of receipt through August
5, 1999, the Company invested all of its net proceeds from the offering in an
interest bearing depository account with Bank of America, pending application of
the net proceeds in accordance with the description in its registration
statement on Form S-1.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company held its annual meeting of shareholders on June 26, 1999,
at which the sole action taken was the election of directors. The shareholders
elected the following seven nominees, all of whom were recommended by the Board
of Directors:
DIRECTOR IN FAVOR AGAINST WITHHELD
-------- -------- ------- --------
Kirkland C. Aly 7,633,221 0 1,400
C. Reed Brown 7,633,221 0 1,400
Brian R. Cook 7,633,221 0 1,400
Gary L. Hopkins 7,633,221 0 1,400
22
Paul F. Little 7,633,221 0 1,400
Roger J. Sharp 7,633,221 0 1,400
Roland E. Wheeler 7,631,721 0 2,900
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
27. Financial Data Schedule
(b) Reports on Form 8-K
The registrant filed a report on Form 8-K on July 29, 1999, to report
the settlement of its pending litigation with Soloflex, Inc.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
DIRECT FOCUS, INC.
(Registrant)
August 12, 1999 By: /s/ Brian R. Cook
- ------------------ -----------------------------------------
Date Brian R. Cook, President and
Chief Executive Officer,
August 12, 1999 By: /s/ Rod W. Rice
- --------------- -----------------------------------------
Date Rod W. Rice, Chief Financial Officer,
Treasurer and Secretary (Principal
Financial and Accounting Officer)
23
EXHIBIT INDEX
EXHIBIT NUMBER TITLE
- -------------- -----
27.1 Financial Data Schedule
24