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Filed Pursuant to Rule 424(b)(4)
Registration No. 333-73243
1,000,000 SHARES
[COMPANY LOGO]
COMMON STOCK
----------------
This is the first public offering in the United States for Direct Focus,
Inc. Prior to this offering, our common stock traded on the Toronto Stock
Exchange. Our common stock has been approved for listing on the Nasdaq National
Market under the symbol DFXI.
We are offering 825,000 shares of common stock and the selling shareholders
identified in this prospectus are offering an additional 175,000 shares of
common stock. The underwriters also hold an option to purchase up to an
additional 150,000 shares from us to cover over-allotments, which the
underwriters must exercise within 30 days after the date of this prospectus. We
will not receive any proceeds from the sale of common stock by the selling
shareholders.
THIS INVESTMENT INVOLVES RISK. SEE "RISK FACTORS," BEGINNING ON PAGE 6 OF
THIS PROSPECTUS.
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UNDERWRITING PROCEEDS TO
PRICE TO DISCOUNTS AND PROCEEDS TO SELLING
PUBLIC COMMISSIONS THE COMPANY SHAREHOLDERS
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Per Share..................... $20.50 $1.435 $19.065 $19.065
Total......................... $20,500,000 $1,435,000 $15,728,625 $3,336,375
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Neither the Securities and Exchange Commission nor any state securities
commission has approved or disapproved of these securities or determined if this
prospectus is truthful or complete. Any representation to the contrary is a
criminal offense.
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D.A. DAVIDSON & CO. FIRST SECURITY VAN KASPER
The date of this Prospectus is May 4, 1999
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TABLE OF CONTENTS
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PAGE
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Prospectus Summary............................. 3
Risk Factors................................... 6
Use of Proceeds................................ 11
Market Price of our Common Stock and Dividend
Policy....................................... 12
Capitalization................................. 13
Dilution....................................... 13
Selected Financial Data........................ 14
Management's Discussion and Analysis of
Financial Condition and Results of
Operations................................... 16
Business....................................... 25
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Management..................................... 39
Certain Relationships and Related
Transactions................................. 44
Principal and Selling Shareholders............. 45
Underwriting................................... 46
Description of Capital Stock................... 48
Shares Eligible for Future Sale................ 49
Legal Matters.................................. 50
Experts........................................ 50
Additional Information......................... 51
Index to Financial Statements.................. F-1
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YOU SHOULD RELY ONLY ON THE INFORMATION CONTAINED IN THIS DOCUMENT. WE HAVE
NOT AUTHORIZED ANYONE TO PROVIDE YOU WITH INFORMATION THAT IS DIFFERENT. THIS
DOCUMENT MAY ONLY BE USED WHERE IT IS LEGAL TO SELL THESE SECURITIES.
As used in this prospectus, the terms "we," "our," "us," "Direct Focus" and
"the Company" refer to Direct Focus, Inc. and its subsidiaries. The names
Bow-Flex-Registered Trademark-, Nautilus-Registered Trademark-, Bowflex
Power-Pro-Registered Trademark-, Motivator-Registered Trademark-,
Versatrainer-Registered Trademark- and Power Rod-Registered Trademark- are
registered trademarks of Direct Focus, Inc. We have filed trademark applications
for the names Direct Focus-TM- and Instant Comfort-TM-. Except where we state
otherwise, we present the information in this prospectus assuming no exercise of
the underwriters' over-allotment option.
UNTIL MAY 30, 1999 (25 DAYS AFTER THE COMMENCEMENT OF THE OFFERING), ALL
DEALERS THAT EFFECT TRANSACTIONS IN THESE SECURITIES, WHETHER OR NOT
PARTICIPATING IN THIS OFFERING, MAY BE REQUIRED TO DELIVER A PROSPECTUS. THIS IS
IN ADDITION TO THE DEALER'S OBLIGATION TO DELIVER A PROSPECTUS WHEN ACTING AS AN
UNDERWRITER AND WITH RESPECT TO UNSOLD ALLOTMENTS OR SUBSCRIPTIONS.
<PAGE>
[Inside cover of prospectus includes the following artwork:
Along the left border of a fold-out page is a shaded column with the Direct
Focus logo atop the column, beneath which is the following text: "A rapidly
growing direct marketing company that:". Below the logo and text are the
following bullet points: (1) "Develops and markets high-end, branded consumer
products through spot television commercials and infomercials, the internet and
print media"; and (2) "Recently solidified its presence in the health and
fitness market by acquiring the Nautilus product line and brand name."
Adjacent to the first column are three additional columns that depict and
briefly describe the Company's products. Atop the first product column is the
Bowflex logo, beneath which is a picture of a male torso and the following text:
"Fitness, weight loss and muscle building in one convenient, easy to use
machine!" Below this are pictures of the Company's eight Bowflex machines,
labeled "Power Pro," "Power Pro XT," "Power Pro XTL," "Power Pro XTLU,"
"Motiviator," "Motivator XT," "Motivator XTL" and "Versatrainer." Adjacent to
the Bowflex images are the following four bullet points: (1) "Seven strength
training machines designed for home use"; (2) "One strength training machine
designed for wheel chair users"; (3) "Patented design and technology"; and (4)
"A complementary line of accessory equipment." Below these bullet points is a
close-up picture of the Company's Bowflex Power Rods with the following text:
"Each Bowflex fitness machine uses our patented Power Rod-Registered Trademark-
technology and comes with 210 pounds of resistance that can be upgraded to
deliver over 400 pounds of resistance."
Atop the second product column is the Nautilus logo. Under the logo is a
picture of a Nautilus fitness machine and a shaded Nautilus shell in the
background, with the following caption: "The equipment that has been making
America stronger for over 30 years!" Below the picture and caption are pictures
of ten Nautilus machines, labeled "Pec Fly," "Lateral Raise," "Abdominal," "Low
Back," "Bench Press," "Compound Row," "Leg Extension," "Triceps Ext.," "Preacher
Curl" and "Seated Leg Curl." Adjacent to these pictures are the following bullet
points: (1) "27 all new strength training machines"; (2) "Patented technology
and design"; (3) "A full free weight equipment line"; and (4) "An extensive
consumer fitness accessory line." Below the bullet points are pictures of three
Nautilus fitness accessories (a handgrip, jump rope and dumbbells) with the
following caption: "In addition to high quality commercial fitness equipment,
our Nautilus business offers an extensive line of consumer fitness accessories."
Atop the third product column is the Nautilus Sleep Systems logo. Below the
logo is a picture of the Company's airbed mattress in a bedroom setting with the
Company's Instant Comfort logo and the following caption: "Our airbeds allow
users to control the comfort and firmness of their sleeping surface." Below the
picture and caption are pictures of the Company's airbed product line, labeled
"The Ultimate Premier Series," "The Premier Series," "The Signature Series" and
"The Basic Series." Adjacent to these pictures are the following bullet points:
(1) "Four luxury air support sleep systems available in all standard sizes"; (2)
"Patent pending technology and design"; and (3) "A complementary accessory
line." Below the bullet points are pictures of the product components with the
following caption: "Inside our premier air bed sleep system are dual variable
firmness support chambers that allow users to independently control the firmness
on each side of the bed. Our directly connected remote permits easy
adjustments."]
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PROSPECTUS SUMMARY
This summary highlights selected information from this prospectus and does
not contain all of the information that you need to consider before purchasing
our common stock. You should read the entire prospectus carefully, including the
financial statements and related notes appearing elsewhere in this prospectus,
in order to make an informed investment decision.
DIRECT FOCUS, INC.
Direct Focus is a rapidly growing, direct marketing company that develops
and markets premium quality, premium priced, branded consumer products. We
market our consumer products directly to consumers through a variety of direct
marketing channels, including spot television commercials, infomercials, print
media, response mailings and the internet. Our principal and most successful
directly marketed product to date has been our Bowflex line of home fitness
equipment, and we recently developed and began testing a direct marketing
campaign for a line of airbed mattress systems.
We have experienced recent rapid sales and earnings growth, based almost
entirely on the strength of our Bowflex products. In 1998, we generated net
income of $12.5 million on net sales of $57.3 million. This represents a 420.8%
increase in net income and a 187.9% increase in net sales from 1997, when we
generated net income of $2.4 million on net sales of $19.9 million.
In January 1999, we acquired substantially all of the assets of Nautilus
International, Inc., the manufacturer and marketer of Nautilus brand commercial
fitness equipment and consumer fitness accessories. Before the acquisition,
Nautilus International suffered from several years of declining revenues and
significant losses. In fiscal 1998, Nautilus International lost $14.8 million,
of which $8.8 million constituted a one-time impairment charge, on net sales of
$20.9 million. We believe that we can effectively integrate the Nautilus
business into our operations and stabilize its financial performance. We also
believe that Nautilus is one of the most recognized brand names in the fitness
industry and possesses significant direct marketing potential.
We believe that we have been successful primarily because of the direct
marketing expertise, systems and procedures we have developed and refined while
directly marketing our Bowflex products. We have developed sophisticated
database management systems, a state-of-the-art customer service call center and
a system for accurately tracking our advertising success and customer buying
habits. We believe this expertise and experience enable us to:
- Develop proprietary, branded product lines with broad consumer appeal
that can be sold effectively through direct marketing channels;
- Develop and implement effective advertising and marketing strategies;
- Convert consumer interest and inquiries into sales;
- Effectively manage our product sourcing, manufacturing and distribution
operations; and
- Provide excellent customer service.
We believe Direct Focus is well positioned to become a leading direct
marketer of premium quality, premium priced consumer products. Key elements of
our growth strategy include the following:
- Continue to grow sales of our highly successful Bowflex line of home
fitness equipment by expanding our direct marketing campaign and
continuing to introduce enhancements and additions for these products;
- Expand our direct marketing campaign for our newly introduced line of
airbeds;
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- Develop and directly market additional premium quality, premium priced,
branded consumer products;
- Revitalize sales of Nautilus fitness equipment in the commercial
market;
- Capitalize on the well-recognized Nautilus brand name by introducing
and marketing consumer fitness equipment and related products under the
Nautilus name;
- Capitalize on direct marketing and e-commerce opportunities presented
by the internet, which currently generates 10.0% of our net sales; and
- Explore growth opportunities through strategic acquisitions that would
enhance our direct marketing capabilities or our product lines.
Our principal executive offices are located at 2200 NE 65th Avenue,
Vancouver, Washington 98661, and our telephone number is (360) 694-7722. We
maintain web sites at www.bowflex.com, www.nautilus.com, www.nautilusdirect.com
and www.instantcomfort.com. None of the information on our web sites is part of
this prospectus.
THE OFFERING
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Common stock offered.............................. 1,000,000 shares
Common stock offered by the Company............... 825,000 shares
Common stock offered by the selling
shareholders.................................... 175,000 shares
Common stock to be outstanding after this
offering........................................ 10,359,599 shares(1)
Common stock underlying over-allotment option..... 150,000 shares
Use of proceeds................................... Working capital, capital equipment
purchases and other general corporate
purposes.
Dividend policy................................... We have never declared or paid dividends
on our common stock and do not presently
intend to declare any dividends in the
near future.
Nasdaq National Market symbol..................... DFXI
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(1) Based on 9,534,599 shares outstanding as of March 31, 1999. Includes 86,076
shares of common stock issued after December 31, 1998, upon the exercise of
options. Excludes:
- 464,542 shares of common stock issuable upon the exercise of
outstanding options; and
- 696,961 shares available for future issuance under our Stock Option
Plan.
See "Management - Benefit Plans" for a description of our Stock Option Plan.
4
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SUMMARY FINANCIAL INFORMATION
You should read the following summary financial information together with
the financial statements and related notes and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" included elsewhere in
this prospectus.
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YEAR ENDED DECEMBER 31,
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HISTORICAL PRO FORMA(1)
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1994 1995 1996 1997 1998 1998
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(IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
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STATEMENT OF OPERATIONS DATA:
Net sales..................................... $ 4,415 $ 4,772 $ 8,517 $ 19,886 $ 57,297 $ 76,601
Gross profit.................................. 2,841 3,156 5,914 14,772 44,855 50,295
Operating income (loss)....................... (531) (59) 460 3,616 18,888 15,776
Net income (loss)............................. $ (510) $ 15 $ 693 $ 2,421 $ 12,485 $ 9,868
Basic earnings (loss) per share............... $ (0.06) $ 0.00 $ 0.08 $ 0.27 $ 1.34 $ 1.06
Diluted earnings (loss) per share............. $ (0.06) $ 0.00 $ 0.08 $ 0.25 $ 1.28 $ 1.01
WEIGHTED AVERAGE COMMON SHARES:
Basic outstanding shares...................... 8,132 8,132 8,558 8,987 9,337 9,337
Diluted outstanding shares.................... 8,132 8,132 8,943 9,511 9,726 9,726
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DECEMBER 31, 1998
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PRO FORMA
ACTUAL PRO AS
--------- FORMA(2) ADJUSTED(2)
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(UNAUDITED) (UNAUDITED)
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BALANCE SHEET DATA:
Working capital......................................... $ 15,682 $ 2,772 $ 17,894
Total assets............................................ 24,373 27,431 42,553
Long-term liabilities................................... 67 166 166
Total stockholders' equity.............................. $ 17,651 $ $17,651 $ 32,773
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(1) The unaudited pro forma statement of operations data was prepared as if the
Nautilus acquisition occurred on January 1, 1998. The data reflects certain
adjustments for the effects of purchase accounting, certain assumptions
regarding financing and cash management and an adjustment for income taxes.
The data is not necessarily indicative of what our actual results would have
been if the Nautilus acquisition had occurred on January 1, 1998, nor does
it purport to indicate the future results of our operations. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Unaudited Pro Forma Combined Results of Operations" for a
discussion of pro forma adjustments.
(2) The unaudited pro forma and pro forma as adjusted balance sheet data assumes
that we consummated the Nautilus acquisition on December 31, 1998. The data
reflects the effects of purchase accounting adjustments. These adjustments
are set forth in our "Unaudited Pro Forma Combined Financial Statements -
Pro Forma Combined Balance Sheet," included elsewhere in this prospectus. We
also adjusted the pro forma as adjusted balance sheet data to give effect to
this offering and the application of the net proceeds as described under
"Use of Proceeds."
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RISK FACTORS
You should carefully consider the risks described below before making an
investment decision. The risks and uncertainties described below are not the
only ones facing our company. Our business, financial condition and results of
operations could be materially adversely affected by any of the following risks.
The trading price of our common stock could decline due to any of the following
risks, and you might lose all or part of your investment.
A SIGNIFICANT DECLINE IN CONSUMER INTEREST IN BOWFLEX PRODUCTS WOULD SHARPLY
DIMINISH OUR SALES AND PROFITABILITY.
Our financial performance depends significantly on sales of our Bowflex line
of home fitness equipment. Any significant diminished consumer interest in our
Bowflex products would sharply reduce our sales and profitability. In 1998,
approximately 99.6% of our net sales were attributable to our Bowflex products.
WE ARE A RAPIDLY GROWING COMPANY, AND OUR FAILURE TO PROPERLY MANAGE GROWTH MAY
ADVERSELY AFFECT OUR FINANCIAL PERFORMANCE.
Our financial performance may be harmed if we are unable to effectively
manage our existing operations or our anticipated growth. We have grown
significantly since 1996, with increases in net sales from $8.5 million in 1996
to $19.9 million in 1997 and $57.3 million in 1998. We also recently added
substantial operations through our Nautilus acquisition and intend to continue
to pursue an aggressive growth strategy. Our growth and the Nautilus acquisition
have strained our management team, production facilities, information systems
and other resources. See "Business - Growth Strategy" for a discussion of our
growth strategies.
IF WE ARE UNABLE TO EFFECTIVELY INTEGRATE THE NAUTILUS BUSINESS INTO OUR
OPERATIONS, WE MAY NOT ACHIEVE ANTICIPATED REVENUE, EARNINGS AND BUSINESS
SYNERGIES.
We face significant challenges integrating our recently acquired Nautilus
business into our operations, any of which could adversely affect the revenue,
earnings and business synergies we expect from the acquisition. The distance
between our Vancouver, Washington and Independence, Virginia facilities
amplifies these challenges. Specifically, we must successfully integrate the
following aspects of the Nautilus business into our operations:
- Manufacturing and other production facilities, including a new
manufacturing management team;
- Employees, including those working in production, product development
and administration;
- Marketing and product distribution systems, including a new marketing
management team; and
- Administrative and financial policies and procedures.
OUR PROFITABILITY WILL DECLINE IF WE ARE UNABLE TO REVERSE NAUTILUS
INTERNATIONAL'S RECENT LOSSES.
Prior to our Nautilus acquisition, Nautilus International had incurred
several years of declining sales and accelerating losses. Unless our new
Nautilus management team is able to revitalize commercial sales and reduce
costs, our profitability will decline. For example, for the fiscal year ended
June 27, 1998, Nautilus International had a net loss of approximately $14.8
million, of which $8.8 million constituted a one-time impairment charge, on net
sales of $20.9 million.
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OUR KEY EMPLOYEES ARE CRITICAL TO OUR SUCCESS, AND THEIR DEPARTURE MAY ADVERSELY
AFFECT OUR BUSINESS.
As a direct marketing company, our success depends on our key marketing,
sales, technical and managerial personnel, including our recently hired Nautilus
management team. The loss of any of our executive officers or other key
personnel could adversely affect our business. All of our executive officers are
under employment contracts, but none for longer than one year. We currently
maintain key man life insurance policy in the amount of $500,000 on Brian R.
Cook, our President and Chief Executive Officer.
WE HAVE LIMITED EXPERIENCE MARKETING AND SELLING OUR AIRBEDS, AND OUR AIRBEDS
MAY NOT GENERATE THE NET SALES OR PROFITS WE ANTICIPATE.
We began test marketing our line of premium airbeds in August 1998, and
therefore have limited operating experience with these products. If our
marketing efforts are unsuccessful, or if we incur unexpected costs, our airbeds
may not generate the net sales or profits we anticipate and our overall
financial performance may be harmed.
OUR FINANCIAL PERFORMANCE WOULD BE HARMED IF WE ARE UNABLE TO SUCCESSFULLY
DEVELOP OR DIRECTLY MARKET NEW CONSUMER PRODUCTS.
Our growth strategy and financial performance depend in part on our ability
to develop or acquire the rights to, and then directly market, new consumer
products. Our net sales and profitability would be harmed if we are unable to
develop or acquire the rights to premium quality, premium priced consumer
products that satisfy our direct marketing criteria. In addition, any new
products that we directly market may not generate sufficient net sales or
profits to justify their development or acquisition costs. See "Business - New
Product Development and Innovation" for a discussion of our product development
efforts.
A DECLINE IN CONSUMER SPENDING DUE TO UNFAVORABLE ECONOMIC CONDITIONS COULD
HINDER SALES OF OUR CONSUMER PRODUCTS.
The success of each of our products depends substantially on how consumers
decide to spend their money. Unfavorable economic conditions may depress
consumer spending, especially for premium priced products like ours.
OUR FINANCIAL PERFORMANCE MAY BE VULNERABLE TO RAPIDLY CHANGING PREFERENCES IN
THE CONSUMER FITNESS MARKET.
Our net sales and profitability depend significantly on the acceptance of
our existing and future fitness products within the consumer fitness market.
This market is characterized by rapidly changing fitness trends and fads, and
frequent innovations and improvements are necessary to maintain consumer
interest in fitness products. Our financial performance may be harmed if we are
unable to successfully adapt our Bowflex and Nautilus consumer fitness products
to these changing trends and fads.
GOVERNMENT REGULATORY ACTIONS COULD DISRUPT OUR DIRECT MARKETING EFFORTS AND
PRODUCT SALES.
Various federal, state and local government authorities, including the
Federal Trade Commission and the Consumer Products Safety Commission, regulate
our direct marketing efforts and products. If any of these authorities commence
a regulatory enforcement action that interrupts our direct marketing efforts or
results in a product recall, our sales and profitability could be significantly
harmed.
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A SIGNIFICANT AMOUNT OF OUR COMMON STOCK WILL BE PUBLICLY HELD AFTER THIS
OFFERING, AND SALES OF A SUBSTANTIAL NUMBER OF THESE SHARES MAY DEPRESS OUR
STOCK PRICE.
Our common stock has been publicly traded on the Toronto Stock Exchange
since 1993, and we believe that as many as 8.3 million shares of our common
stock will be freely tradable in the public market following this offering.
Public sales of a substantial number of these shares could depress the market
price for our common stock. See "Shares Eligible for Future Sale" for a more
detailed discussion of our currently outstanding common stock and applicable
resale restrictions.
AN ADVERSE OUTCOME FROM PENDING LITIGATION WITH SOLOFLEX, INC. COULD
SIGNIFICANTLY HARM OUR FINANCIAL POSITION.
Soloflex, Inc., a company that manufactures and directly markets home
fitness equipment, has filed an action against Direct Focus and Randal R.
Potter, our Vice President of Marketing. If Soloflex successfully prosecutes any
of its claims against us, our financial position could be significantly harmed.
Although we intend to vigorously defend against Soloflex's claims, we cannot
assure you that we will prevail in this dispute. Soloflex claims that we are
improperly using certain slogans and images to market our Bowflex products and
that we have misappropriated some of its marketing trade secrets. Soloflex has
requested both monetary damages and injunctive relief. The requested injunctive
relief would prohibit us from airing advertisements that allegedly would
infringe upon Soloflex's intellectual property rights. See "Business - Legal
Proceedings" for a more detailed description of the Soloflex litigation.
IF A UNITED STATES MARKET FOR OUR COMMON STOCK DOES NOT DEVELOP, SHAREHOLDER
LIQUIDITY AND OUR STOCK PRICE COULD BE ADVERSELY AFFECTED.
Our common stock has been approved for listing on Nasdaq and will be
delisted from the Toronto Stock Exchange upon the completion of this offering.
If an active United States market for our common stock fails to develop, our
shareholders may have difficulty selling their shares and our stock price may
decline.
WE MAY FAIL TO EFFECTIVELY IDENTIFY AND RESOLVE SIGNIFICANT YEAR 2000 PROBLEMS
WITHIN OUR BUSINESS, OR IMPORTANT SUPPLIERS MAY BE UNABLE TO SUPPLY GOODS AND
SERVICES TO US DUE TO YEAR 2000 PROBLEMS.
We may not accurately identify all potential Year 2000 problems within our
business, and the corrective measures that we implement may be ineffective or
incomplete. Any such problems could interrupt our ability to process orders and
ship our products. The resulting costs could be significant and we could suffer
a significant decrease in sales. Similar problems and consequences could result
if any of our key suppliers, such as telephone companies, carriers,
manufacturers, suppliers and our consumer credit facilitator, experience Year
2000 problems. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations - Year 2000 Compliance" for a more detailed discussion
of Year 2000 issues as they affect our business.
WE HAVE A LIMITED OPERATING HISTORY ON WHICH YOU CAN BASE YOUR ANALYSIS OF OUR
BUSINESS.
We altered our business plan in 1993 when we began our current direct
marketing activities. Accordingly, we have only a limited operating history on
which you can base your evaluation of our business and prospects. Despite our
recent growth in sales and net income, we cannot assure that these trends will
continue or that we will remain profitable.
INCREASES IN PRODUCT RETURNS COULD ADVERSELY AFFECT OUR FINANCIAL PERFORMANCE.
Any material increase in the quantity of products returned by our customers
for purchase-price refunds could adversely affect our financial performance. We
have limited operating experience with
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our airbeds, which we began test marketing in August 1998, and therefore limited
experience with the return rates for these products. See "Business - Products"
for a discussion of our return policies.
OUR WARRANTY RESERVES MAY BE INSUFFICIENT TO COVER FUTURE WARRANTY CLAIMS, WHICH
COULD ADVERSELY AFFECT OUR FINANCIAL PERFORMANCE.
We offer warranties on all of our principal products. If our warranty
reserves are inadequate to cover future warranty claims on our products, our
financial performance could be adversely affected. We have limited operating
experience with our airbeds, which we began test marketing in August 1998, and
therefore limited experience with warranty claims for these products. See
"Business - Products" for a discussion of our warranty policies.
PRODUCT LIABILITY CLAIMS EXCEEDING OUR PRODUCT LIABILITY INSURANCE COVERAGE AND
RESERVES COULD ADVERSELY AFFECT OUR BUSINESS.
We are subject to potential product liability claims if our products injure
or allegedly injure our customers or other users. If our product liability
insurance coverage and reserves fail to cover future product liability claims,
we could become liable for significant monetary damages.
FUTURE ACQUISITIONS MAY DISRUPT OR OTHERWISE ADVERSELY AFFECT OUR BUSINESS.
As part of our growth strategy, we intend to explore strategic acquisitions
that would enhance our direct marketing capabilities or our product lines.
Future acquisitions are subject to the following risks that may negatively
impact our financial performance and cause fluctuations in our operating
results:
- Acquisitions may disrupt our ongoing operations and distract our
management team;
- We may not be able to successfully integrate the products, services or
personnel of the acquired businesses into our operations;
- We may acquire companies in markets in which we have little experience;
- Any acquisition may not produce the revenue, earnings or business
synergies we anticipate; and
- An acquired product or technology may not perform as we expect.
To pay for an acquisition, we may use common stock or cash, including the
proceeds of this offering. Alternatively, we may borrow money from banks or
other lenders. If we use common stock, the ownership interest of our
shareholders would be diluted. If we use cash or debt, our financial liquidity
will be reduced.
CERTAIN RISKS IN OUR INTERNATIONAL OPERATIONS COULD INTERRUPT THE SUPPLY OF OUR
PRODUCT COMPONENTS OR THE INTERNATIONAL DISTRIBUTION OF OUR NAUTILUS PRODUCTS.
We currently acquire many of our product components from foreign
manufacturers and distribute our Nautilus products internationally. Our
international operations are subject to the inherent risks of doing business
abroad. The loss of certain foreign suppliers, customers or distributors could
harm our ability to deliver our products on time and cause our sales to decline.
Our financial performance could be materially adversely affected by many events
and circumstances relating to our international operations, including:
- Shipping delays and cancellations;
- Increases in import duties and tariffs;
- Foreign exchange rate fluctuations;
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- Changes in foreign laws and regulations; and
- Political and economic instability.
INCREASES IN ADVERTISING RATES MAY REDUCE OUR PROFITABILITY.
We depend primarily on 60-second or "spot" television commercials and
television infomercials to market our products. Consequently, the price we must
pay for our preferred media time significantly affects our financial
performance. If the cost of our preferred media time increases, it may increase
our selling and marketing expenses and decrease our profitability. See "Business
- -Direct Marketing" for a more detailed discussion of our advertising efforts.
OUR SALES MAY MATERIALLY DECLINE IF OUR CUSTOMER SERVICE CALL CENTER STOPS
OPERATING.
We receive and process almost all orders for our directly marketed products
through our customer service call center. Our sales could materially decline if
our call center stops operating for a significant time period. Our call center
could stop operating for a number of reasons, including poor weather, natural
disaster, fire or Year 2000 problems. If our backup facilities and contingency
plans are ineffective to handle such problems, we could not sell our directly
marketed products during the affected period. See "Business - Direct Marketing"
for a more detailed description of our call center operations.
OUR FAILURE OR INABILITY TO PROTECT OUR INTELLECTUAL PROPERTY COULD
SIGNIFICANTLY HARM OUR COMPETITIVE POSITION, AND WE COULD ALSO INCUR SUBSTANTIAL
COSTS TO DEFEND CLAIMS THAT WE HAVE VIOLATED THE PROPRIETARY RIGHTS OF OTHERS.
Protecting our intellectual property is an important factor in maintaining
our competitive position in the fitness and mattress industries. If we do not or
are unable to adequately protect our intellectual property, our sales and
profitability could be adversely affected. We currently hold a number of patents
and trademarks and have several patent and trademark applications pending.
However, our efforts to protect our proprietary rights may be inadequate and
applicable laws provide only limited protection. For example, the patent on our
Bowflex Power Rods, a key component of our Bowflex products, expires on April
27, 2004. In addition, we may not be able to successfully prevent others from
claiming that we have violated their proprietary rights. We could incur
substantial costs in defending against such claims, even if they are invalid,
and we could become subject to judgments requiring us to pay substantial
damages. For a more detailed discussion of our efforts to protect our
intellectual property rights, see "Business - Intellectual Property."
CERTAIN ANTITAKEOVER PROVISIONS OF WASHINGTON LAW MAY REDUCE OUR STOCK PRICE.
As a Washington corporation, we are subject to the Washington Business
Corporation Act. Certain antitakeover provisions of this Act may make it more
difficult for a third party to acquire us, even if an acquisition would benefit
our shareholders. Under the Act, a person who beneficially owns 10.0% or more of
our common stock cannot engage in certain transactions with us, such as a
merger, during the five-year period after the person becomes a 10.0%
shareholder. The five-year waiting period would not apply if a majority of our
board of directors gave advance approval to the transaction or share
acquisition. See "Description of Capital Stock - Antitakeover Effects of Certain
Provisions of Washington Law" for a more detailed discussion of the antitakeover
provisions.
10
<PAGE>
USE OF PROCEEDS
We expect to receive approximately $15,122,000 in net proceeds from the sale
of the 825,000 shares of common stock in this offering. If the underwriters
fully exercise their over-allotment option, we expect to receive an additional
$3,075,000 in net proceeds. In calculating estimated net proceeds, we assume an
offering price of $20.50 per share and take into account the underwriting
discount and estimated offering expenses. We will not receive any proceeds from
the sale of shares by the selling shareholders.
We intend to use the net proceeds of this offering for the following
purposes and in the following order of priority:
<TABLE>
<CAPTION>
PERCENTAGE OF
AMOUNT NET PROCEEDS
------------- ---------------
<S> <C> <C>
Working capital..................................................... $ 8,622,000 57.0%
Capital equipment................................................... 1,500,000 9.9
General corporate................................................... 5,000,000 33.1
------------- -----
Total............................................................... $ 15,122,000 100.0%
------------- -----
------------- -----
</TABLE>
We intend to direct the working capital proceeds toward such needs as
increased direct marketing expenditures for our existing products, the growth of
our Nautilus consumer product business, including the introduction of new
Nautilus consumer products, and other working capital needs associated with our
growth. We intend to direct our capital equipment proceeds toward such needs as
the addition of a second product assembly and distribution center in the western
United States and computer and related technology upgrades. We may use a portion
of the general corporate proceeds for strategic acquisitions that would enhance
our direct marketing capabilities or our product lines. Although we evaluate
potential acquisitions from time to time, we are not currently negotiating any
acquisitions, nor do we have any specific oral or written plans, agreements or
commitments to enter into or consummate any such transactions.
The amounts that we actually expend for any of these purposes will vary
significantly depending upon a number of factors, including future revenue
growth, if any, the amount of cash we generate from operations and the progress
of our product development efforts. As a result, we will retain broad discretion
in allocating the net proceeds of this offering. Pending the uses described
above, we will invest the net proceeds in short-term, interest-bearing,
investment grade securities.
11
<PAGE>
MARKET PRICE OF OUR COMMON STOCK AND DIVIDEND POLICY
Prior to the date of this offering, our common stock was listed on the
Toronto Stock Exchange in the Province of Ontario, Canada, and traded under the
symbol DFX. Our common stock will be delisted from the Toronto Stock Exchange
upon the completion of this offering. Currently, there is no established trading
market for our common stock in the United States. However, our common stock has
been approved for listing on Nasdaq under the symbol DFXI.
The following table summarizes the high and low sales prices for our common
stock as reported on the Toronto Stock Exchange during the current year and the
preceding two years. The prices listed below are in Canadian dollars, the
currency in which they were quoted, and in United States dollars, which we
calculated based on the currency exchange rate in effect on the date of each
high and low quarterly price.
<TABLE>
<CAPTION>
UNITED STATES
CANADIAN DOLLARS DOLLARS
-------------------- --------------------
HIGH LOW HIGH LOW
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
1997
1(st) Quarter........................................ $ 1.60 $ 1.01 $ 1.16 $ 0.75
2(nd) Quarter........................................ 1.41 1.10 0.99 0.80
3(rd) Quarter........................................ 3.00 1.06 2.17 0.77
4(th) Quarter........................................ $ 4.00 $ 2.39 $ 2.80 $ 1.70
1998
1(st) Quarter........................................ $ 10.05 $ 3.50 $ 7.07 $ 2.45
2(nd) Quarter........................................ 15.00 10.00 10.48 7.05
3(rd) Quarter........................................ 18.00 11.80 12.09 7.67
4(th) Quarter........................................ $ 23.00 $ 10.50 $ 14.95 $ 6.80
1999
1(st) Quarter........................................ $ 28.00 $ 18.55 $ 18.39 $ 12.09
</TABLE>
As of March 31, 1999, 9,534,599 shares of our common stock were issued and
outstanding and held of record by 81 shareholders. See "Shares Eligible for
Future Sale" for a discussion of our outstanding common stock.
Payment of any future dividends is at the discretion of our board of
directors, which considers various factors, such as our financial condition,
operating results, current and anticipated cash needs and expansion plans. Our
credit lines do not restrict the payment of dividends. To date, we have never
declared or paid any cash dividends on our common stock and do not presently
intend to declare any cash dividends in the near future. Instead, we intend to
retain and direct any future earnings to fund our anticipated expansion and
growth.
12
<PAGE>
CAPITALIZATION
The following table describes our capitalization as of December 31, 1998:
- On an actual basis;
- On a pro forma basis to reflect the effects of the Nautilus
acquisition, assuming the acquisition was consummated on December 31,
1998; and
- On an as adjusted basis to reflect our sale of 825,000 shares of common
stock under this prospectus at an assumed public offering price of
$20.50 per share, after deducting estimated underwriting discounts and
offering expenses.
You should read this information in conjunction with our financial
statements and notes thereto and with the unaudited pro forma combined financial
statements, which appear elsewhere in this prospectus.
<TABLE>
<CAPTION>
DECEMBER 31, 1998 (IN THOUSANDS)
-----------------------------------
ACTUAL
---------
PRO FORMA PRO FORMA
----------- AS ADJUSTED
-----------
(UNAUDITED)
(UNAUDITED)
<S> <C> <C> <C>
Common Stock, no par value; 50,000,000 shares
authorized; 9,448,523 shares issued and outstanding,
actual; 10,273,523 shares issued and outstanding, as
adjusted(1)........................................... $ 3,566 $ 3,566 $ 18,688
Retained earnings....................................... 14,085 14,085 14,085
--------- ----------- -----------
Total stockholders' equity............................ 17,651 17,651 32,773
--------- ----------- -----------
Total capitalization.................................. $ 17,651 $ 17,651 $ 32,773
--------- ----------- -----------
--------- ----------- -----------
</TABLE>
- ------------------------
(1) Excludes:
- 86,076 shares of common stock issued after December 31, 1998, upon the
exercise of options;
- 464,542 shares of common stock issuable upon the exercise of
outstanding options under our Stock Option Plan at a weighted average
exercise price of $2.73 per share; and
- 696,961 shares available for future issuance under the Stock Option
Plan.
See "Management - Benefit Plans" for a description of our Stock Option Plan.
DILUTION
As of December 31, 1998, we had a net tangible book value of approximately
$17.5 million, or $1.85 per share of our common stock. Net tangible book value
per share represents the amount of our total assets reduced by our total
intangible assets and liabilities, divided by the number of shares of our common
stock outstanding. After giving effect to the receipt of estimated net proceeds
from our sale of 825,000 shares of common stock in this offering, at an assumed
public offering price of $20.50 per share, our adjusted net tangible book value
as of December 31, 1998, would have been approximately $32.6 million, or $3.17
per share. This represents an immediate increase in net tangible book value of
$1.32 per share to existing shareholders and an immediate dilution of $17.33 per
share to new investors. The following table illustrates this per share dilution:
<TABLE>
<CAPTION>
<S> <C> <C>
Assumed public offering price per share......................................... $ 20.50
Net tangible book value per share before this offering.......................... $ 1.85
Increase per share attributable to new investors................................ 1.32
---------
Adjusted net tangible book value per share after this offering.................. 3.17
---------
Dilution per share to new investors............................................. $ 17.33
---------
---------
</TABLE>
13
<PAGE>
The following table sets forth, as of December 31, 1998, the differences
between existing shareholders and new investors with respect to the number of
shares of common stock purchased from us, the total consideration paid, assuming
a public offering price of $20.50 per share, and the average price per share
paid:
<TABLE>
<CAPTION>
SHARES PURCHASED AVERAGE
------------------------- TOTAL PRICE
NUMBER PERCENT CONSIDERATION PERCENT PER SHARE
------------ ----------- ------------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Existing shareholders(1).............................. 9,448,523 92.0% $ 3,565,628 17.4% $ 0.38
New investors(1)...................................... 825,000 8.0 16,912,500 82.6 20.50
------------ ----- ------------- -----
Total........................................... 10,273,523 100.0% $ 20,478,128 100.0%
------------ ----- ------------- -----
------------ ----- ------------- -----
</TABLE>
- ------------------------
(1) Sales by the selling shareholders in this offering would reduce the number
of shares held by existing shareholders to 9,273,523 shares, or
approximately 90.3% of the total number of shares outstanding upon the
closing of this offering, and the number of shares held by new investors
would be 1,000,000, or approximately 9.7% of the total number of shares
outstanding after this offering. See "Principal and Selling Shareholders"
for more detailed information about the selling shareholders.
If the underwriters fully exercise their over-allotment option, our adjusted
net tangible book value per share as of December 31, 1998, would have been $3.40
per share, which would have resulted in a dilution of $17.10 per share to new
investors. In addition, the number of shares held by new investors would
increase to 975,000, or 9.5% of the total number of shares outstanding upon the
closing of this offering, and the number of shares held by existing shareholders
would be 9,448,523 shares, or 90.6% of the total number of shares outstanding
upon the closing of this offering.
The foregoing tables assume no exercise of any outstanding options to
purchase Direct Focus common stock. As of December 31, 1998, options to purchase
550,618 shares of Direct Focus common stock were outstanding, of which options
to purchase 309,199 shares were then exercisable. The weighted average exercise
price of outstanding options was $2.39 per share, with actual exercise prices
ranging between $0.12 and $9.75 per share. To the extent option holders exercise
their options, new and existing investors will experience further dilution. See
"Management - Benefit Plans" and Note 7 to our financial statements for more
information about our Stock Option Plan and outstanding options.
SELECTED FINANCIAL DATA
The selected financial data presented below for, and as of the end of, each
of the three years ended December 31, 1998, have been derived from our audited
financial statements included elsewhere in this prospectus. The selected
financial data for, and as of the end of, each of the years ended December 31,
1994, and December 31, 1995, have been derived from our audited financial
statements that are not included herein.
The unaudited pro forma combined statement of operations data for the fiscal
year ended December 31, 1998, contain certain adjustments and were prepared as
if the Nautilus acquisition had occurred on January 1, 1998. In our management's
opinion, all adjustments necessary to present fairly such pro forma financial
statements have been made. The unaudited pro forma combined balance sheet was
prepared as if the Nautilus acquisition had occurred on December 31, 1998. These
unaudited pro forma financial statements are not necessarily indicative of what
actual results would have been if the acquisition had occurred at the beginning
of the period, nor do they purport to indicate the results of our future
operations.
The selected financial data should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
our financial statements and unaudited
14
<PAGE>
pro forma balance sheet and statement of operations and related notes thereto
included elsewhere in this prospectus.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------------------------------------
HISTORICAL PRO FORMA
----------------------------------------------------- -----------
1994 1995 1996 1997 1998 1998(1)
--------- --------- --------- --------- --------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
<S> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA
Net sales...................................... $ 4,415 $ 4,772 $ 8,517 $ 19,886 $ 57,297 $ 76,601
Cost of sales.................................. 1,574 1,616 2,603 5,114 12,442 26,306
--------- --------- --------- --------- --------- -----------
Gross profit................................... 2,841 3,156 5,914 14,772 44,855 50,295
Operating expenses
Selling and marketing........................ 2,834 2,644 4,712 9,600 22,643 28,373
General and administrative................... 393 370 473 975 1,701 4,523
Royalties.................................... 145 201 269 581 1,623 1,623
--------- --------- --------- --------- --------- -----------
Total operating expenses................... 3,372 3,215 5,454 11,156 25,967 34,519
--------- --------- --------- --------- --------- -----------
Operating income (loss)........................ (531) (59) 460 3,616 18,888 15,776
Other income (expense)
Interest income.............................. 16 26 37 119 527 --
Interest expense............................. (4) (3) (2) (1) (1) (388)
State business tax and other-net............. (22) (17) (51) (87) (221) (222)
--------- --------- --------- --------- --------- -----------
Total other income (expense)............... (10) 6 (16) 31 305 (610)
--------- --------- --------- --------- --------- -----------
Income (loss) before income taxes.............. (541) (53) 444 3,647 19,193 15,166
Income tax expense (benefit)................... (31) (68) (249) 1,226 6,708 5,298
--------- --------- --------- --------- --------- -----------
Net income (loss).............................. $ (510) $ 15 $ 693 $ 2,421 $ 12,485 $ 9,868
--------- --------- --------- --------- --------- -----------
--------- --------- --------- --------- --------- -----------
Basic earnings (loss) per share(2)............. $ (0.06) $ 0.00 $ 0.08 $ 0.27 $ 1.34 $ 1.06
Diluted earnings (loss) per share(2)........... $ (0.06) $ 0.00 $ 0.08 $ 0.25 $ 1.28 $ 1.01
Basic shares outstanding....................... 8,132 8,132 8,558 8,987 9,337 9,337
Diluted shares outstanding..................... 8,132 8,132 8,943 9,511 9,726 9,726
BALANCE SHEET DATA(3)
Cash and cash equivalents...................... $ 603 $ 756 $ 1,154 $ 4,790 $ 18,911 $ 2,711
Working capital................................ 1,015 1,063 1,973 4,100 15,682 2,772
Total assets................................... 1,940 2,150 3,515 7,922 24,373 27,431
Current liabilities............................ 654 858 1,281 3,330 6,655 9,614
Long term liabilities.......................... 27 18 14 -- 67 166
Total stockholders' equity..................... $ 1,259 $ 1,274 $ 2,220 $ 4,592 $ 17,651 $ 17,651
</TABLE>
- ------------------------
(1) See "Management's Discussion and Analysis of Financial Condition and Results
of Operations - Unaudited Pro Forma Combined Results of Operations" for a
discussion of the adjustments included in the pro forma statement of
operations data.
(2) Basic earnings per share have been computed by dividing net income by the
weighted average number of shares of common stock outstanding during each
period. Diluted earnings per share have been computed by dividing net income
by the weighted average number of shares of common stock and common stock
equivalents, such as stock options, outstanding during each period.
(3) See "Pro Forma Combined Balance Sheet, December 31, 1998," included
elsewhere in this prospectus, for a discussion of the adjustments included
in the pro forma balance sheet data.
15
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion of our financial condition and
results of operations in conjunction with the financial statements and related
notes included elsewhere in this prospectus. This section of the prospectus
includes a number of forward-looking statements that reflect our current views
with respect to future events and financial performance. We use words such as
"anticipate," "believe," "expect," "future," "intend" and similar expressions to
identify forward-looking statements. You should not unduly rely on these
forward-looking statements, which apply only as of the date of this prospectus.
These forward-looking statements are subject to certain risks and uncertainties
that could cause actual results to differ materially from historical or
anticipated results. For a discussion of some of these risks, see "Risk Factors"
beginning on page 6.
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 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 airbed products will, at least
initially, be lower than the current gross margin for our Bowflex products.
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 $2.6 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 will
16
<PAGE>
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 evaluating and intend to offer 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.
We expect that the integration of the Nautilus commercial product line into
our operations will significantly increase our overall net sales. We also expect
that our overall gross margin as a percentage of net sales will decrease,
principally because we are integrating two different business models:
- A direct marketing business that historically has generated a high
percentage gross margin; and
- A manufacturing and marketing business that operates in an industry
that traditionally generates a lower percentage gross margin.
COMPOSITION OF COST OF SALES AND EXPENSES
Cost of sales primarily consists of:
- Inventory component costs;
- Manufacturing and distribution salaries and bonuses;
- Distribution expense and shipping costs; and
- Facility costs.
Selling and marketing expenses primarily consist of:
- Television advertising expenses;
- The cost of printed and video marketing materials;
- Television commercial production and marketing material expenses;
- Commissions, salaries and bonuses earned by sales and marketing
personnel; and
- Facility and communication costs.
General and administrative expenses primarily consist of salaries, benefits
and related costs for our executive, financial, administrative and information
services personnel and professional services fees.
17
<PAGE>
Royalty expense primarily consists of payments to the inventor of our
Bowflex technology.
Other income (expense) historically has consisted of interest income on our
cash investments and state business tax expenses.
OUR RESULTS OF OPERATIONS
We believe that period-to-period comparisons of our operating results are
not necessarily indicators 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. Our future operating
results will depend on many factors including those factors discussed in "Risk
Factors" beginning on page 6.
The following table presents certain financial data as a percentage of total
revenues:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------
1996 1997 1998
--------- --------- ---------
<S> <C> <C> <C>
STATEMENT OF OPERATIONS DATA
Net sales................................................................................ 100.0% 100.0% 100.0%
Cost of sales............................................................................ 30.6 25.7 21.7
--------- --------- ---------
Gross profit............................................................................. 69.4 74.3 78.3
Operating expenses
Selling and marketing.................................................................. 55.3 48.3 39.5
General and administrative............................................................. 5.5 4.9 3.0
Royalties.............................................................................. 3.2 2.9 2.8
--------- --------- ---------
Total operating expenses................................................................. 64.0 56.1 45.3
Operating income......................................................................... 5.4 18.2 33.0
Other income (expense)................................................................... (0.2) 0.2 0.5
--------- --------- ---------
Income before income taxes............................................................... 5.2 18.4 33.5
Income tax expense (benefit)............................................................. (2.9) 6.2 11.7
--------- --------- ---------
Net income............................................................................... 8.1% 12.2% 21.8%
--------- --------- ---------
--------- --------- ---------
</TABLE>
COMPARISON OF THE YEARS ENDING DECEMBER 31, 1998, AND DECEMBER 31, 1997
NET SALES
Our net sales grew by 187.9% to $57.3 million in 1998, from $19.9 million in
1997. Sales of our Bowflex Power Pro grew by 199.0% and accounted for 93.3% of
our aggregate net sales in 1998. Sales of our Bowflex Motivator increased by
73.0% and sales of our Bowflex accessories increased by 148.0% in 1998, and
accounted for 1.8% and 4.5% of our aggregate net sales, respectively. We
introduced and began test marketing our airbeds in August 1998, but this product
did not materially contribute to our net sales in 1998.
Our sales growth in 1998 primarily resulted from expanded direct marketing
of our Bowflex products. In 1998, we increased our advertising expenditures by
196.1%, focusing principally on expanded broadcasts of our Bowflex spot
television commercials and television infomercials. Both of these direct
marketing techniques generated strong sales in 1998. We intend to further expand
our use of spot television commercials and infomercials in 1999 by increasing
our market presence in our existing television markets and entering new
television markets.
18
<PAGE>
GROSS PROFIT
Our gross profit grew 203.4% to $44.9 million in 1998, from $14.8 million in
1997. Our gross profit as a percentage of net sales increased by 4.0% to 78.3%
in fiscal 1998, from 74.3% in 1997. We believe that our improved percentage
gross profit in 1998 resulted primarily from a March 1998 increase in the
shipping charge for our Bowflex products, as well as reduced component costs for
our Bowflex products and improved labor and overhead efficiencies. We benefited
from reduced component costs principally through volume discounts. Our improved
labor and overhead efficiencies resulted primarily from improved manufacturing
methods and the implementation of a second work shift.
We anticipate an increase in the percentage gross profit on our Bowflex
products associated with the opening of our East Coast distribution center in
March 1999. However, we expect our aggregate gross profit as a percentage of net
sales to materially decline in 1999, principally due to the significantly lower
gross profit margin on our Nautilus line of commercial fitness equipment.
Initially, we also expect a lower percentage gross profit on our line of airbeds
as we continue to develop our direct marketing campaign for this product and
increase our marketing efforts.
OPERATING EXPENSES
SELLING AND MARKETING
Selling and marketing expenses grew to $22.6 million in 1998 from $9.6
million in 1997, an increase of 135.4%. This increase in selling and marketing
expenses resulted primarily from the expansion of our Bowflex direct marketing
campaign and variable costs associated with our sales growth.
As a percentage of net sales, selling and marketing expenses decreased to
39.5% in 1998 from 48.3% in 1997. This decrease in selling and marketing
expenses as a percentage of net sales reflects the improved efficiency of our
Bowflex direct marketing campaign. As we refined our spot commercial and
infomercial advertising policies and our customer response techniques, we were
able to stimulate sales growth at a more rapid rate than the growth in our
selling and marketing expenses. We expect that our selling and marketing
expenses will continue to increase in real dollar terms, but not as a percentage
of net sales, as we:
- Continue to expand our Bowflex direct marketing campaign;
- Expand the direct marketing campaign for our airbeds;
- 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 $1.7 million in 1998 from
$975,000 in 1997, an increase of 74.3%. This increase in general and
administrative expenses was due primarily to increased staffing and
infrastructure expenses necessary to support our continued growth. As a
percentage of net sales, general and administrative expenses decreased to 3.0%
in 1998 from 4.9% in 1997. The decline in general and administrative expenses as
a percentage of our net sales resulted primarily from our substantial increase
in net sales. We believe that our general and administrative expenses will
continue to increase in future periods, in both real dollar terms and as a
percentage of net sales, as we integrate the Nautilus business into our
operations and expand our administrative staff and other resources to manage
growth.
19
<PAGE>
ROYALTY
Royalty expense grew to $1.6 million in 1998 from $581,000 in 1997, an
increase of 175.4%. The increase in our royalty expenses is attributable to the
increased sales of our Bowflex products in 1998. Our royalty expenses will
increase if sales of our Bowflex products continue to increase.
OTHER INCOME (EXPENSE)
In 1998, other income (expense) increased to $305,000 from $31,000 in 1997.
The $274,000 increase resulted primarily from interest income generated by our
cash investments, which was partially offset by a $135,000 increase in our state
business tax expense.
INCOME TAX EXPENSE
Income tax expense increased by $5.5 million in 1998 because of the growth
in our income before taxes. We expect our income tax expense to increase in line
with increases in our income before taxes.
NET INCOME
For the reasons discussed above, net income grew to $12.5 million in 1998
from $2.4 million in 1997, an increase of 420.8%.
COMPARISON OF YEARS ENDING DECEMBER 31, 1997, AND DECEMBER 31, 1996
NET SALES
Net sales grew to $19.9 million in 1997 from $8.5 million in 1996, an
increase of 134.1%. Net sales of our Bowflex Power Pro grew by 137.7% and
accounted for 91.3% of our aggregate net sales in 1997. Sales of our Bowflex
Motivator increased by 766.7% and sales of our Bowflex accessories increased by
60.4% in 1997, and accounted for 3.0% and 5.4% of our aggregate net sales,
respectively. This increase in net sales resulted from increased advertising and
marketing expenditures, increased average sales price and improved marketing
efficiencies.
GROSS PROFIT
Gross profit grew 150.8% to $14.8 million in 1997 from $5.9 million in 1996.
As a percentage of net sales, gross profit grew to 74.3% in 1997 from 69.4% in
1996. The principal reason for this increase was our substantial growth in net
sales, combined with increased production efficiencies and reduced costs
associated with overseas component purchases.
OPERATING EXPENSES
SELLING AND MARKETING
Selling and marketing expenses increased to $9.6 million in 1997 from $4.7
million in 1996, but declined as a percentage of net sales to 48.3% in 1997 from
55.3% in 1996. The growth in selling and marketing expenses resulted primarily
from our expanded direct marketing campaign and increased staffing and
infrastructure expenditures necessary to support our growth. Our selling and
marketing expenses declined as a percentage of net sales principally because our
net sales growth outpaced the growth in our selling and marketing expenses.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased to $975,000 in 1997 from
$473,000 in 1996, but declined as a percentage of net sales to 4.9% in 1997 from
5.5% in 1996. The increase in general and
20
<PAGE>
administrative expenses is primarily attributable to increased staffing and
infrastructure expenses necessary to support our growth. The decline in general
and administrative expense as a percentage of net sales resulted from our
significant net sales growth in 1997.
ROYALTY
Royalty expense increased to $581,000 in 1997 from $269,000 in 1996 but
remained relatively constant as a percentage of net sales. Royalty expense
increased because we sold more Bowflex products in 1997 than in 1996.
OTHER INCOME (EXPENSE)
Other income (expense) was $31,000 in 1997, compared to an expense of
($16,000) in 1996. The $47,000 increase was primarily derived from interest
income and was partially offset by a $36,000 increase in state business tax
expense in 1997.
INCOME TAX EXPENSE
We incurred an income tax expense of $1.2 million in 1997, which was $1.5
million higher than in 1996. The principal reason for this increase was our
higher profitability and the accounting treatment of deferred taxes associated
with tax loss carrybacks.
NET INCOME
For the reasons described above, net income grew to $2.4 million in 1997
from $693,000 in 1996, a 246.0% increase.
UNAUDITED PRO FORMA COMBINED RESULTS OF OPERATIONS
As a result of the Nautilus acquisition, several adjustments and factors
will impact the comparability of our historical financial results with our
future results of operations. We paid $16.2 million in cash for the Nautilus
assets and assumed approximately $2.6 million in liabilities. The unaudited pro
forma combined statements of operations reflect:
- Certain adjustments for the effects of purchase accounting;
- Certain assumptions described below regarding financing and cash
management; and
- A provision for income taxes as if the combined operations had been
taxed as a C-corporation for all periods presented.
In addition, the unaudited pro forma combined statement of operations for
the year ended December 31, 1998 was prepared as if the Nautilus acquisition
occurred on January 1, 1998. The unaudited pro forma financial statements and
the information set forth below should be read in conjunction with our financial
statements and accompanying notes and the financial statements of Nautilus
International and related notes appearing elsewhere in this prospectus. The
following summarizes certain adjustments that are reflected in the unaudited pro
forma combined statement of operations data set forth below and included
elsewhere in this prospectus:
- A $1.1 million decrease in depreciation expense associated with the
depreciation of acquired property having an estimated fair value of
$8.6 million. Depreciation is on a straight-line basis over periods
ranging from 7 to 31.5 years;
- A $340,000 decrease in total operating expenses relating to the reduced
amortization of the estimated intangible asset value of $4.4 million
and $56,000 relating to reduced depreciation expense. As discussed
below, Nautilus recorded an impairment charge to reduce the net
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book value of its assets based upon the acquisition price. The
intangible asset is assumed to be amortized over 20 years on a
straight-line basis.
- An $11.2 million adjustment to eliminate the effect of a one-time
impairment charge taken by Nautilus International in connection with
the revaluation of its assets based upon the $18.8 million acquisition
price including assumption of $2.6 million of current liabilities;
- A $2.8 million decrease in interest expense, which we would have
incurred had the acquisition occurred on January 1, 1998;
- A $608,000 decrease in other income, to reflect interest income
foregone by the use of cash in the acquisition; and
- A $1.4 million decrease in income tax expense, to reflect income tax
expense at our effective tax rates after giving effect to the
adjustments described above.
The following table sets forth the specific components of income and expense
as a percentage of net sales, on a pro forma basis for the period presented. See
the unaudited pro forma combined financial statements and the related notes
thereto included elsewhere in this prospectus.
DIRECT FOCUS, INC. AND AFFILIATE PRO FORMA COMBINED STATEMENT OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31, 1998 (UNAUDITED)
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
1998
---------------
<S> <C>
Net sales....................................................................... 100.0%
Cost of sales................................................................... 34.3
-----
Gross profit.................................................................. 65.7
Operating expenses
Selling and marketing......................................................... 37.1
General and administrative.................................................... 5.9
Royalties..................................................................... 2.1
-----
Total operating expenses.................................................... 45.1
-----
Income from operations.......................................................... 20.6
Other expense................................................................... 0.8
-----
Income before income taxes...................................................... 19.8
Pro forma income taxes.......................................................... 6.9
-----
Pro forma net income............................................................ 12.9%
-----
-----
</TABLE>
LIQUIDITY AND CAPITAL RESOURCES
Historically, we have financed our growth primarily from cash generated by
our operating activities. During 1998, our operating activities generated over
$15.9 million in net cash, which contributed to an aggregate $14.1 million, or
294.8%, increase in cash and cash equivalents. This increase was primarily due
to the substantial sales growth associated with our Bowflex products. At
December 31, 1998, we had a cash balance of $18.9 million. We used $16.2 million
in cash to fund the Nautilus acquisition in January 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
materially increase our cash expenditures on spot commercials and informercials
as we expand the direct marketing compaigns for our Bowflex and airbed products.
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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 this prospectus, 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
and the net proceeds of this offering, will be sufficient to meet our capital
requirements for at least the next 12 months. Thereafter, if our capital
requirements increase, we could be required to secure additional sources of
capital. We cannot assure you that we will be able to secure additional capital
or that the terms upon which such capital will be available to us will be
acceptable. If we proceed with any other acquisitions, we may be required to use
cash to fund the purchase price or fund operations or expansion of the acquired
business.
INFLATION AND PRICE INCREASES
Although we cannot accurately anticipate the effect of inflation on our
operations, we do not believe that inflation has had or is likely in the
foreseeable future to materially adversely affect our results of operations or
our financial condition. However, increases in inflation over historical levels
or uncertainty in the general economy could decrease discretionary consumer
spending for products like ours. We have not raised the prices on our Bowflex
products since 1994. Consequently, none of our revenue growth is attributable to
price increases.
RECENT ACCOUNTING PRONOUNCEMENTS
Effective January 1, 1998, we adopted Statement of Financial Accounting
Standards ("SFAS") No. 130, REPORTING COMPREHENSIVE INCOME, which requires
presentation of comprehensive income within an entity's primary financial
statements. Comprehensive income is defined as net income as adjusted for
changes to equity resulting from events other than net income or transactions
related to an entity's capital structure. From 1996 to 1998, our comprehensive
income equaled our net income.
Effective January 1, 1998, we adopted 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. We currently
operate under two segments: direct marketing products and Nautilus commercial
products. Through December 31, 1998, we operated as a single segment.
In February 1998, the Financial Accounting Standards Board, (the "FASB")
issued SFAS No. 132, EMPLOYER'S DISCLOSURES ABOUT PENSIONS AND OTHER
POSTRETIREMENT BENEFITS, which revises current disclosure requirements for an
employer's pension and other retiree benefits. The pronouncement does not have a
material impact on our financial statements, because it does not impact the
measurement of pension benefits or other post-retirement benefit costs. Instead,
it impacts only financial statement disclosure.
In March 1998, the Accounting Standards Executive Committee issued Statement
of Position 98-1 ("SOP 98-1"), ACCOUNTING FOR THE COSTS OF COMPUTER SOFTWARE
DEVELOPED OR OBTAINED FOR INTERNAL USE, which establishes accounting
requirements for the capitalization of software costs incurred for use by the
organization. We adopted this pronouncement on a prospective basis as of January
1, 1999. We do not anticipate that SOP 98-1 will materially impact our financial
statements.
Effective July 1, 1998, the FASB adopted SFAS No. 133, ACCOUNTING FOR
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, which establishes accounting
requirements for derivative instruments and for activities related to the
holding of such instruments, including hedging activities. SFAS No. 133 expanded
the definition of derivative instruments and revised accounting practices
related to hedging and other activities associated with derivative instruments.
Although we do not currently hold or issue instruments that qualify as
derivative instruments, our future activities could fall within the scope of the
new pronouncement, in which case SFAS No. 133 could materially affect our
business.
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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 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 90.0% 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 to have a Year 2000 compliant financial
accounting system and database marketing system installed by early June 1999.
We will continue to test our software and hardware systems and modify and
replace these systems as necessary. We expect to complete our internal
assessment, testing, and remediation program by July 1999. To date, we have
spent approximately $1.3 million to upgrade our computer systems, and we believe
we will need to spend an additional $400,000 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 carrier, our primary consumer
finance provider 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, the most important of
which is our local telephone company. 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.
We are currently developing a contingency plan, but cannot finalize the plan
until we have received responses from all of our critical vendors and service
providers. We expect to finalize the plan in July 1999.
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BUSINESS
OVERVIEW
We are a rapidly growing, direct marketing company that develops and markets
premium quality, premium priced, branded consumer products. We market our
consumer products directly to consumers through a variety of direct marketing
channels, including spot television commercials, infomercials, print media,
response mailings and the internet.
We were incorporated in California in 1986 and initially focused on
developing our first line of Bowflex home fitness equipment, the Bowflex 2000X.
We sold the Bowflex 2000X through various channels, including direct marketing
and retail stores. In 1988, we developed a new model, the Schwinn Bowflex, which
we marketed exclusively through Schwinn Bicycle Company until late 1992. When
our exclusive relationship with Schwinn ended, we seized the opportunity to
study and develop our own direct marketing campaign for the next generation
Bowflex product, the Power Pro. In 1993, we became a Washington corporation.
Over the next several years, we tested and refined our direct marketing
techniques, developed our customer call center systems and procedures, and
developed our market analysis techniques, media buying tools and performance
tracking measures. Using our market research and knowledge base, we embarked on
our first widespread direct marketing campaign in 1996. Building upon our
initial success, in early 1997 we began offering our current "zero-down"
financing program through a third-party finance company, and in mid-1997 we
started airing our first infomercial. Based on positive viewer response, we
accelerated our direct marketing campaign during the remainder of 1997 and
throughout 1998. In May 1998, we changed our name to Direct Focus, Inc. to
reflect our transformation from a home fitness equipment company into a direct
marketing company.
In 1997, we also recognized that our direct marketing expertise and
techniques could be used to market other premium quality, premium priced branded
products. After a careful review process that began in late 1997, in August 1998
we began test marketing a line of airbed mattress systems under the brand name
"Instant Comfort" and more recently under the brand name "Nautilus Sleep
Systems." We also recently acquired substantially all of the assets of Nautilus
International, including the Nautilus line of commercial fitness equipment and
the widely recognized Nautilus brand name. Our primary objectives with respect
to Nautilus include revitalizing sales of Nautilus products in the commercial
fitness market and capitalizing on the Nautilus brand name by introducing and
directly marketing a line of Nautilus consumer fitness equipment.
GROWTH STRATEGY
Our objective is to become a leading direct marketer of premium quality,
premium priced, branded consumer products. Our growth strategy includes the
following key elements:
INCREASE SALES OF OUR HIGHLY SUCCESSFUL BOWFLEX PRODUCTS. We intend to
continue to expand the direct marketing campaign for our Bowflex products by
airing our spot commercials and infomercials to broader audiences and by
increasing the frequency of airings on proven cable and network stations.
Consistent with historical practices, we also intend to introduce enhancements
and additions to our Bowflex product line.
EXPAND THE DIRECT MARKETING CAMPAIGN FOR OUR AIRBEDS. We began test
marketing a line of airbeds in August 1998 under the brand name "Instant
Comfort." More recently, we began test marketing our airbeds under the brand
name "Nautilus Sleep Systems." We are encouraged by our initial test results and
intend to continue testing and refining, and plan to expand, our direct
marketing campaign for this product throughout 1999.
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DEVELOP AND DIRECTLY MARKET ADDITIONAL CONSUMER PRODUCTS. We will continue
to evaluate internally and externally generated ideas for consumer products that
have direct marketing potential. Generally, we look for products that:
- Have patented or patentable features that enhance our competitive
position, increase product life and add real and perceived value to the
product;
- Have a retail price point between $500 and $2,500;
- Can be marketed as a line that facilitates the promotion of premium
products to consumers who are initially attracted by lower-priced,
entry-level products; and
- Have the potential for mass consumer appeal, particularly among members
of the "baby boom" generation.
REVITALIZE SALES OF THE NAUTILUS LINE OF COMMERCIAL FITNESS EQUIPMENT. Our
immediate objective for our Nautilus business is to revitalize sales of the
Nautilus line of commercial fitness equipment, which we believe will ultimately
strengthen our ability to market Nautilus branded products. We believe that we
can most effectively achieve this objective by rebuilding our commercial sales
and marketing operations. We have already hired a new management team to oversee
and implement changes in the way we market and sell Nautilus commercial fitness
equipment. Each member of the management team has significant experience in the
industry and a history of sales and marketing success. We intend to focus on
strengthening the domestic market position for our existing Nautilus products.
As we expand our commercial product line, we will attempt to service new market
segments, both domestically and internationally, and thereby broaden our
commercial customer base.
CAPITALIZE ON STRONG CONSUMER RECOGNITION OF THE NAUTILUS BRAND NAME. A
principal motivation in purchasing the Nautilus business was to acquire rights
to the Nautilus brand name, which we believe is one of the most
widely-recognized names in the fitness industry. We also believe that the brand
identity and consumer appeal of the Nautilus name, in combination with our
direct marketing expertise, will enable us to introduce and directly market
innovative consumer fitness equipment and related products under the Nautilus
name. In addition, we intend to introduce and market to specialty fitness and
sporting goods stores more traditional home fitness equipment and accessories
under the Nautilus name, such as treadmills, recumbent bicycles, elliptical
trainers, jump ropes, workout mats and hand grips. In appropriate circumstances,
we may also license the Nautilus name to manufacturers of high-quality consumer
products that do not fit within our current strategic plan, such as clothing and
related accessories.
CAPITALIZE ON INTERNET MARKETING AND E-COMMERCE OPPORTUNITIES. In 1998,
approximately 5.8% of our Bowflex product inquiries and 10.0% of our net sales
were initiated through our Bowflex web site. Our experience in 1998 indicates
that internet-based inquiries are more likely to be converted into sales than
inquiries generated by other media forms, such as television or print media. We
believe that the increasing consumer acceptance of e-commerce and internet-based
marketing will also enhance and complement our direct marketing efforts.
Consequently, we intend to expand and enhance our web sites to more fully
integrate the internet into our direct marketing strategy and facilitate
e-commerce transactions.
EXPLORE GROWTH THROUGH STRATEGIC ACQUISITIONS. We will continue to explore
growth opportunities through strategic acquisitions that would enhance our
direct marketing capabilities or our product lines. We do not currently have any
oral or written plans, agreements or commitments regarding any acquisitions.
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DIRECT MARKETING
We directly market our Bowflex home fitness equipment and airbeds
principally through 60-second or "spot" television commercials, television
infomercials, the internet, response mailings and print media. To date, we have
been highly successful with what we refer to as a "two-step" marketing approach.
In general, our two-step approach focuses first on spot commercials, which we
air to generate consumer interest in our products and requests for product
information. The second step focuses on converting inquiries into sales, which
we accomplish through a combination of response mailings and outbound
telemarketing. We supplement our two-step approach with infomercials, which
generally are designed to provide potential customers with sufficient product
information to stimulate an immediate purchase.
ADVERTISING
SPOT COMMERCIALS AND INFOMERCIALS. Spot television commercials are a key
element of the marketing strategy for all of our directly marketed consumer
products. For directly marketed products that may require further explanation
and demonstration, television infomercials are an important additional marketing
tool. We have developed a variety of spot commercials and infomercials for our
Bowflex product line and several commercials and marketing videos for our airbed
product line. We expect to use spot commercials and, where appropriate,
infomercials to market any Nautilus consumer products that we determine are
appropriate for direct marketing.
When we begin marketing a new product, we typically test and refine our
marketing concepts and selling practices while advertising the product in spot
television commercials. Production costs for these commercials can range from
$40,000 to $130,000. Based on our market research and viewer response to our
spot commercials, we may produce additional spot commercials and, if appropriate
for the product, an infomercial. Production costs for infomercials can range
from $150,000 to $500,000, depending on the scope of the project. Generally, we
attempt to film several infomercial and commercial concepts at the same time in
order to maximize production efficiencies. From this footage we can then develop
several varieties of spot commercials and infomercials and introduce and refine
them over time. We typically generate our own scripts for spot commercials and
hire outside writers to assist with infomercial scripts. We also typically
contract with outside production companies to produce spot commercials and
infomercials. We may outsource all of these functions if we continue to grow.
Once produced, we test spot commercials and infomercials on a variety of
cable television networks that have a history of generating favorable responses
for our existing products. Our initial objective is to determine their marketing
appeal and what, if any, creative or product modifications may be appropriate.
If these initial tests are successful, we then air the spot commercials and
infomercials on an accelerating schedule on additional cable networks.
MEDIA BUYING. An important component of our direct marketing success is our
ability to purchase quality media time at an affordable price. The cost of
airing spot commercials and infomercials varies significantly, depending on the
network, time slot and, for spot commercials, programming. Each spot commercial
typically costs between $50 and $5,000 to air, and each infomercial typically
costs between $1,200 and $15,000 to air. We currently purchase the majority of
our media time on cable networks, through which we reach more than 70 million
homes. We recently began testing the effectiveness of our spot commercials and
infomercials on broadcast networks, through which we hope to reach a broader
viewing audience.
We track the success of each of our spot commercials and infomercials by
determining how many viewers respond to each airing of a spot commercial or
infomercial. We accumulate this information in a database that we use to
evaluate the cost-effectiveness of available media time. In addition, we believe
that the database enables us to predict with reasonable accuracy how many
product sales and
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inquiries will result from each spot commercial and infomercial that we air. We
also believe that we can effectively track changing viewer patterns and adjust
our advertising accordingly.
We do not currently purchase media time under long-term contracts. Instead,
we book most of our spot commercial time on a quarterly basis and most of our
infomercial time on a monthly or quarterly basis, as networks make time
available. Networks typically allow us to cancel booked time with two weeks'
advance notice, which enables us to adjust our advertising schedule if our
statistical tracking indicates that a particular network or time slot is no
longer cost effective. Generally, we can increase or decrease the frequency of
our spot commercial and infomercial airings at almost any time.
INTERNET. In 1998, approximately 5.8% of our Bowflex product inquiries and
10.0% of our net sales were initiated through our Bowflex web site, and we
expect the internet to become an increasingly important part of our direct
marketing strategy. For example, we are now promoting our web sites in our spot
commercials and infomercials in an effort to further stimulate electronic
product inquiries and e-commerce transactions. We do not presently advertise our
products on third-party web sites, but we may in the future.
Our experience indicates that internet-based inquiries are more likely to be
converted into sales
than inquiries generated by other media forms, such as television or print
media. Consequently, we believe that consumers who visit our web sites are more
inclined to purchase our products than are the consumers we target through other
media.
We currently operate two direct marketing-oriented web sites. The first,
www.bowflex.com, focuses on our Bowflex line of home exercise equipment. The
second, www.instantcomfort.com, focuses on our newly introduced line of airbeds.
In an effort to expand and enhance our web presence, we recently added dedicated
web site development and management personnel. Our immediate internet-related
goals include improving the e-commerce capabilities at our Bowflex web site and
adding e-commerce capabilities to our airbed web site. We also plan to redesign
our web sites to enhance their role as a medium for finalizing sales.
Previously, we used our web sites to generate interest in our products, but
limited the information we provided to potential customers in an effort to
induce them to initiate a telephone inquiry. We now believe that we can achieve
a balance between our twin goals of finalizing sales and capturing consumer
information by strategically designing our web pages and carefully analyzing web
page hits, conversion rates, average sales prices and inquiry counts.
PRINT MEDIA. We advertise our directly marketed products in various print
media when we believe that such advertising can effectively supplement our
direct marketing campaigns. For example, we have advertised our Bowflex home
fitness equipment in health and fitness-related consumer magazines and, to a
limited extent, in entertainment, leisure and specialty magazines. We recently
determined that television advertising and the internet generate more immediate
consumer responses at a lower cost per inquiry and therefore have begun to
reduce the print media advertising expenditures for our Bowflex products. In
contrast, our experience to date suggests that print media can play an effective
role in the direct marketing campaign for our line of airbeds. Consequently, we
intend to devote a higher portion of our overall advertising budget for our
airbed products to print media. We will evaluate print media advertising
expenditures for other directly marketed products on a case-by-case basis.
CONVERSION OF INQUIRIES INTO SALES
CUSTOMER SERVICE CALL CENTER AND ORDER PROCESSING. We operate our own
customer service call center in Vancouver, Washington, which operates 16 hours
per day and receives and processes all infomercial-generated and customer
service-related inquiries regarding our Bowflex and airbed products. We have
developed a skill-based call routing system that automatically routes each
incoming call to the most highly qualified inside sales agent or customer
service representative available. The appropriate representative then answers
product questions, pro-actively educates the potential customer about the
benefits of our product line, promotes financing through our private label
credit card, and
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typically upsells the benefits of higher priced models in our product line. This
sophisticated system allows us to better utilize our agents, prioritize call
types and improve customer service.
We employ two large telemarketing companies to receive and process
information requests generated by our spot television advertising 24 hours per
day. These companies also serve as overflow agents for our call center during
peak times. The telemarketing agents for these companies collect only names,
addresses and other basic information from callers and do not sell or promote
our products. Consequently, we do not need to train these telemarketing agents.
To preserve flexibility, we do not have formal contracts with the telemarketing
companies.
RESPONSE MAILINGS. We forward a "fulfillment kit" in response to each
inquiry regarding our directly marketed products. Each kit contains detailed
literature that describes the product line and available accessories, a
marketing video that demonstrates and highlights the key features of our premium
product in the line, and additional information about how to purchase the
product. If a potential customer does not respond within a certain time period,
we proceed with additional follow-up mailings that convey a different marketing
message and typically offer certain inducements to encourage a sale. The
specific marketing message and offer at each stage will vary on a case-by-case
basis, based on what our statistical tracking indicates is most likely to
trigger a sale.
CONSUMER FINANCE PROGRAMS. We believe that convenient consumer financing is
an important tool in our direct marketing sales efforts and induces many of our
customers to make purchases when they otherwise would not. Currently, we offer
"zero-down" financing to approved customers on all sales of our Bowflex and
airbed products. We arrange this financing through a consumer credit company
with whom we recently signed a new non-recourse consumer financing agreement.
Under this arrangement, our customer service agents can obtain financing
approval in a few minutes over the phone and, if a customer is approved,
immediately ship product without the need for cumbersome paperwork. The consumer
finance company pays us promptly after we submit required documentation and
subsequently sends to each approved customer a Direct Focus private label credit
card that can be used for future purchases of our products. During 1998,
approximately 39.7% of our net sales were financed in this manner, and we
believe that this program will continue to be an effective marketing tool.
NAUTILUS SALES AND MARKETING
We market and sell our Nautilus commercial fitness equipment domestically
through a direct sales force and internationally through various distributors.
We market and sell our Nautilus fitness accessories and consumer fitness
equipment through non-exclusive independent sales representatives.
DIRECT SALES FORCE
We recently hired a new management team to oversee and revitalize the sales
and marketing operations of our Nautilus business. Each member of the management
team has significant industry experience and a history of sales and marketing
success. Our commercial direct sales force will focus on strengthening the
domestic market position of our existing Nautilus product line, which we sell
principally to health clubs, large hotels, assisted living facilities and the
government. As we broaden our product line, our direct sales force will target
new market segments and, if successful, broaden our customer base.
Internationally, we market and sell our Nautilus commercial fitness products
through a worldwide network of distributors.
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OTHER SELLING AND MARKETING CHANNELS
We intend to implement additional sales and marketing strategies for our
Nautilus commercial equipment, including the following:
- Offer innovative financing, such as private label leasing that allows
pre-approved commercial customers to lease fitness equipment;
- Hire inside sales personnel to supplement and expand the selling
capabilities of our direct sales force;
- Implement a targeted mailing program directed at our commercial
customers; and
- Expand the Nautilus trade-in program to induce existing commercial
customers to upgrade their equipment. We intend to donate much of the
used equipment to schools and other youth-oriented organizations and
facilities, which we hope will facilitate future growth and stability
as children grow up using Nautilus fitness equipment.
OUR PRODUCTS
BOWFLEX HOME FITNESS EQUIPMENT
We introduced the first Bowflex home exercise machine in 1986, and since
then have implemented several improvements to its design and functionality. We
now offer three different Bowflex machines and eight different models. The key
feature of all Bowflex machines is our patented "Power Rod" resistance
technology. Each Power Rod is made of a solid polymer material that provides
lineal progressive resistance in both the concentric and eccentric movements of
an exercise. When combined with a bilateral cable pulley system, the machines
provide excellent range and direction of motion for a large variety of
strength-building exercises.
We currently offer the following Bowflex machines:
- The Power Pro, introduced in 1993, is our best selling product,
accounting for approximately 93.3% of our net sales in 1998. The Power
Pro is available in four different models: the basic Power Pro, the XT,
the XTL and the XTLU. Each model offers over 60 different strength
building exercises in one compact, foldable and portable design and
comes with a 210-pound resistance pack that can be upgraded to 410
pounds. We have also incorporated an aerobic rowing exercise feature
into the Power Pro. Prices currently range from $999 to $1,597,
depending on the model and add-on features.
- The Motivator, introduced in 1996, is our entry-level strength training
line. It is available in three different models: the basic Motivator,
the XT and the XTL. Each model offers over 40 different strength
building exercises in one compact, foldable design and comes standard
with a 210-pound resistance pack that can be upgraded to 410 pounds.
Prices currently range from $699 to $1,049, depending on the model and
add-on features.
- The Versatrainer by Bowflex, introduced in 1988, is specifically
designed to accommodate wheelchair-bound users. The Versatrainer's key
advantage is that it permits users to exercise while remaining in their
wheelchair, which offers enhanced independence and esteem. The
Versatrainer can be found in many major rehabilitation hospitals,
universities and institutions. The Versatrainer is currently priced at
$1,699.
NAUTILUS COMMERCIAL FITNESS EQUIPMENT AND FITNESS ACCESSORIES
We currently offer a broad range of Nautilus strength training equipment for
the commercial market. The Nautilus 2ST line of commercial strength equipment
offers 27 high quality, technologically advanced strength building machines,
each of which is specially designed to focus on a particular
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strength building exercise, such as leg presses, bench presses, super pullovers,
hip abductors and adductors and leg curls. We also offer the Nautilus 2ST for
Women, which is designed to meet the special needs of the female body and offers
a safer, more productive workout for women. In addition, we offer a line of
specially designed Nautilus 2ST equipment that we market principally to medical
therapy and rehabilitation clinics.
The key component of each Nautilus machine is its "cam," which builds and
releases resistance as a user moves through an exercise. The resistance is at
its minimum during the initial and final stages of an exercise, and at its
maximum in the middle of an exercise. Each Nautilus machine includes a cam that
is designed to accommodate and maximize the benefits associated with the motion
required for that machine.
Our Nautilus business also distributes a line of quality consumer fitness
accessories that includes the following products:
<TABLE>
<S> <C>
- - Push-up bars - Ankle/wrist weights
- - Toning bands - Jump ropes
- - Cushioned dumbbells - Workout mats
- - Toning wheels - Wrist and knee wraps
- - Step tubes - Waist wraps
- - Hand grips - Audio packs
</TABLE>
AIRBEDS
In August 1998, we began test marketing a line of premium airbeds under the
brand name "Instant Comfort" and more recently under the brand name "Nautilus
Sleep Systems." The key feature of each airbed is its variable firmness support
chamber, an air chamber within each airbed that can be electronically adjusted
to regulate firmness. All queen and larger airbeds in our Signature and Premier
Series are equipped with dual air chambers that enable users to maintain
different firmness settings on each side of the bed. We believe that variable
firmness and other comfort-oriented features of our airbeds favorably
differentiate our airbeds from conventional innerspring mattresses.
We currently offer three airbed models:
- The Premier Series is our top-of-the-line airbed sleep system. It
features dual patent pending interlocking variable support chambers
that permit users to maintain separate firmness settings on each side
of the airbed. The interlocking chambers regulate airflow and pressure
to more effectively maintain support when a user changes position. The
Premier Series comes with a removable wool blend pillow top sleeping
surface, which permits users to easily convert to a "tight top" surface
when they desire extra firmness. The Premier Series is available in
seven sizes and currently ranges in price from $850 for a twin to
$1,500 for a California king, excluding foundation. Customers can also
purchase an upgraded comfort layer of visco-elastic foam that conforms
to a user's body.
- The Signature Series is designed to appeal to consumers who desire the
flexibility of dual variable firmness support chambers, but at a more
affordable price. Our customers can choose between a tight top and a
pillow top sleeping surface over a one and one-half inch convoluted
foam comfort layer. The Signature Series is available in seven sizes
and currently ranges in price from $500 for a twin to $1,100 for a
California king, excluding foundation.
- The Basic Series is our entry-level airbed, which features a single,
head-to-toe variable firmness support chamber and a traditional tight
top sleeping surface over a one and one-half inch thick convoluted foam
comfort layer. The Basic Series is available in five sizes and
currently ranges in price from $250 for a twin to $700 for a California
king, excluding foundation.
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We offer foundations that are specifically designed to support and enhance
the performance of our airbeds. We advise consumers to use our foundations
because conventional box springs tend to sag and wear over time, causing an
airbed to eventually mirror the worn box spring. We believe that the majority of
our airbed customers will order a complete sleep system, which includes both a
mattress and a foundation. Our foundations currently range in price from $150
for a twin to $350 for a California king.
RETURN POLICIES AND WARRANTIES
We offer a six-week satisfaction guarantee on all sales of Bowflex home
fitness equipment and a similar guarantee on our airbeds. During the guarantee
period, any dissatisfied customer may return these products and obtain a full
refund of the purchase price. We believe that our reserves are adequate to cover
the financial costs associated with product returns.
We offer the following warranties on our principal products:
- A two- to five-year limited warranty on our Bowflex home fitness
equipment, depending on the model;
- A 20-year limited warranty on our airbeds; and
- A lifetime warranty on all Nautilus structural frames, welded moving
parts and weight stacks; a 120-day warranty on all Nautilus upholstery,
pads, grips and tethered-weight pin connectors; and a one-year warranty
on all other Nautilus parts.
We have conducted extensive testing on our Bowflex products and airbeds,
which we believe enables us to accurately estimate future warranty claims and
establish adequate reserves. We believe that our Nautilus business also has
sufficient experience to accurately estimate and establish reserves to cover
future warranty claims.
NEW PRODUCT DEVELOPMENT AND INNOVATION
DIRECT MARKETING PRODUCTS
We develop direct marketing products either from internally generated ideas
or, as with our Bowflex technology, by acquiring or licensing patented
technology from outside inventors and then enhancing the technology. During the
evaluation phase of product development, we evaluate the suitability of the
product for direct marketing, whether the product can be developed and
manufactured in acceptable quantities and at an acceptable cost, and whether it
can be sold at a price that satisfies our profitability goals. More
specifically, we look for high-quality consumer products that:
- Have patented or patentable features;
- Will have a retail price between $500 and $2,500;
- Can be marketed as a line of products with materially different
features that facilitate upselling; and
- Have the potential for mass consumer appeal, particularly among members
of the "baby-boom" generation, who are accustomed to watching
television and now have significant disposable income.
In addition, because of our relatively high retail price target, we
typically require that a product have a potential television advertising life
cycle of at least five years and the possibility of an extended life cycle in
retail stores.
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Once we determine that a product may satisfy our criteria, we further assess
its direct marketing potential by continuing to research the product and its
probable market and by conducting blind product and focus group studies. If the
results are positive and we do not own the product, we will then attempt to
acquire the product outright or obtain rights to the product through a licensing
arrangement. If we develop the product internally, or if we acquire or license
the rights to the product, we will then proceed to develop and test a direct
marketing campaign for the product. In most cases, our direct marketing
campaigns will emphasize the use of spot commercials and television
infomercials, which we supplement with print media advertisements, written
materials, marketing videos and our web sites.
NAUTILUS COMMERCIAL FITNESS PRODUCTS
Our Nautilus commercial product development group develops and refines our
commercial fitness products. Its members gather and evaluate ideas from various
departments, including sales and marketing, manufacturing, engineering and
finance, and then determine which ideas will be incorporated into existing
products or will serve as the basis for new products. Based on these ideas, the
group designs new or enhanced products, develops prototypes, tests and modifies
products, develops a manufacturing plan, and finally brings products to market.
The group evaluates, designs and develops each new or enhanced product taking
into consideration our marketing requirements, target price points, target gross
margin requirements and manufacturing constraints. In addition, each new or
enhanced product must maintain the Nautilus standard of quality and reputation
for excellence. We incorporate principles of physiology, anatomy and
biomechanics into all of our Nautilus machines in order to match the movements
of the human body throughout an exercise. Our key objective is to produce
products that minimize the stress on users' skeletal systems and connective
tissues and maximize the safety and efficiency of each workout.
NAUTILUS CONSUMER FITNESS PRODUCTS
We are currently evaluating design and feature concepts for a new line of
Nautilus consumer fitness products, such as home gyms, treadmills, stationary
bicycles and stair machines. If we elect to proceed with one or more of these
products, we would then assess price points, develop a prototype and determine
the most appropriate manufacturing plan. We do not anticipate introducing any
such products before 2000.
MANUFACTURING AND DISTRIBUTION
BOWFLEX AND AIRBED PRODUCTS
Our primary manufacturing and distribution objectives for our Bowflex and
airbed products are to maintain product quality, reduce and control costs,
maximize production flexibility and improve delivery speed. We use a
computerized inventory management system to forecast our manufacturing
requirements. In general, we attempt to use outside suppliers to manufacture a
majority of our raw materials and finished parts. We select these suppliers
based upon their production quality, cost and flexibility. Whenever possible and
in order to improve flexibility, we will attempt to use at least two suppliers
to manufacture each product component. We currently use overseas suppliers to
manufacture approximately half of our Bowflex components, although we produce
the main component of our Bowflex products, the Power Rods, exclusively in the
United States. We will continue to use overseas suppliers that meet our
manufacturing criteria. All of our airbed components are currently manufactured
domestically.
We assemble, inspect, package and ship our products from our Vancouver,
Washington and Independence, Virginia facilities. We also intend to establish an
additional distribution center in the
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Western United States. We rely primarily on UPS to deliver our Bowflex products,
and we currently use a private furniture shipping company to deliver our airbed
products.
NAUTILUS COMMERCIAL FITNESS EQUIPMENT, CONSUMER FITNESS EQUIPMENT AND
FITNESS ACCESSORIES
Our Nautilus manufacturing operations are vertically integrated and include
such functions as metal fabrication, powder coating, upholstery and
vacuum-formed plastics processes. By managing our own manufacturing operations,
we can control the quality of our Nautilus products and offer our commercial
customers the opportunity to order certain color variations. We currently
distribute Nautilus commercial fitness equipment from our Independence, Virginia
warehouse facilities directly to consumers through our own truck fleet. This
method of distribution allows us to effectively control the set-up and
inspection of equipment at the end-user's facilities. We intend to outsource the
manufacturing of Nautilus consumer fitness equipment and fitness accessories to
outside manufacturers. We currently distribute our Nautilus fitness accessories
from our Vancouver, Washington facilities.
INDUSTRY OVERVIEW
FITNESS EQUIPMENT
We market our Bowflex home fitness equipment principally in the United
States, which we believe is a large and growing market. According to the
Sporting Goods Manufacturers' Association, United States consumers spent roughly
$5.2 billion on home exercise equipment in 1997, which represented an 8.3%
increase from roughly $4.8 billion in 1996.
We market our Nautilus commercial fitness equipment throughout the world,
including the United States, Europe, the United Kingdom, Asia, the Middle-East,
Latin America and Africa. Within these markets, we target the following
commercial customers, among others:
<TABLE>
<S> <C>
- - Health clubs and gyms - Corporate fitness centers
- - Rehabilitation clinics - Colleges and universities
- - The military - Governmental agencies
- - Hospitals - YMCA's and YWCA's
- - Hotels and motels - Professional sports teams
</TABLE>
According to the Sporting Goods Manufacturers' Association, which has only
tracked the commercial market since 1996, aggregate sales of fitness equipment
to commercial purchasers in the United States rose from $450 million in 1996 to
$500 million in 1997, an 11.1% increase.
MATTRESSES
The United States mattress market is large and dominated by four major
manufacturers whose primary focus is the conventional innerspring mattress.
According to the International Sleep Products Association, United States
consumers purchased approximately 35.3 million mattress and foundation units in
1997, generating approximately $3.6 billion in wholesale sales. We believe that
this equates to over $6.0 billion in retail sales. The International Sleep
Products Association estimates that innerspring mattresses accounted for
approximately 90.0% of total domestic mattress sales in 1997. We believe that
less than 10.0% of all mattress sales are made through direct marketing
channels.
COMPETITION
BOWFLEX HOME FITNESS EQUIPMENT
The market for our Bowflex products is highly competitive. Our competitors
frequently introduce new and/or improved products, often accompanied by major
advertising and promotional programs.
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We believe that the principal competitive factors affecting this portion of our
business are price, quality, brand name recognition, product innovation and
customer service.
We compete directly with a large number of companies that manufacture,
market and distribute home fitness equipment, and with the many health clubs
that offer exercise and recreational facilities. We also compete indirectly with
outdoor fitness, sporting goods and other recreational products. Our principal
direct competitors include ICON Health & Fitness, Inc. (through its Health
Rider, NordicTrak, Image, Proform, Weider and Weslo brands), Schwinn Fitness,
Precor and Total Gym.
We believe that our Bowflex line of home exercise equipment is competitive
within the market for home fitness equipment and that our direct marketing
activities are effective in distinguishing our products from the competition. In
addition, our recent Nautilus acquisition presents a significant opportunity to
capitalize on the well-known Nautilus brand name by directly marketing existing
Nautilus consumer products and developing and introducing new products. However,
some of our competitors have significantly greater financial and marketing
resources, which may give them and their products an advantage in the
marketplace.
NAUTILUS COMMERCIAL FITNESS EQUIPMENT
The market for commercial fitness equipment is highly competitive. Our
Nautilus products compete against the products of numerous other commercial
fitness equipment companies, including Life Fitness, Cybex and Precor. Many of
our competitors have greater financial and marketing resources, significantly
more experience in the commercial fitness equipment industry, and more extensive
experience manufacturing their products. We believe that the key competitive
factors in this industry include price, product quality and durability,
diversity of features, financing options and warranties. Many commercial
customers are also interested in product-specific training programs that educate
them regarding how to safely maximize the benefits of a workout and achieve
specific fitness objectives. In addition, certain commercial customers, such as
hotels and corporate fitness centers, have limited floor space to devote to
fitness equipment. These customers tend to favor multi-function machines that
require less floor space.
Our Nautilus commercial fitness products carry a premium price, but we
believe their reputation for quality and durability appeals to a significant
portion of the market that strives for long-term product value. In addition, our
principal line of Nautilus commercial fitness equipment, the Nautilus 2ST,
possesses unique features that appeal to the commercial market, such as low
friction working parts, one-pound incremental weight stacks and hydraulic seat
adjustments. We also offer training programs that are responsive to marketplace
demands.
AIRBEDS
The mattress industry is also highly competitive as evidenced by the wide
range of products available to consumers, such as innerspring mattresses,
waterbeds, futons and other air-supported mattresses. According to the
International Sleep Products Association, conventional innerspring mattresses
presently account for at least 90.0% of all domestic mattress sales, with
waterbeds, futons and other types of mattresses making up the remainder of the
market. We believe that market participants compete primarily on the basis of
price, product quality and durability, brand name recognition, innovative
features, warranties and return policies.
We believe that our most significant competition is the conventional
mattress industry, which is dominated by four large, well-recognized
manufacturers: Sealy (which also owns the Stearns & Foster brand name), Serta,
Simmons and Spring Air. According to the International Sleep Products
Association, these manufacturers were responsible for approximately 62.0%, or
$2.2 billion, of domestic wholesale dollar mattress sales in 1997. We believe
approximately 700 smaller manufacturers serve the balance of the conventional
mattress market. Although we believe that our airbeds offer consumers an
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appealing alternative to conventional mattresses, many of these conventional
manufacturers, including Sealy, Serta, Simmons and Spring Air, possess
significantly greater financial, marketing and manufacturing resources, and
better brand name recognition.
Moreover, several manufacturers currently offer beds with firmness
technology similar to our airbeds. We believe that the largest manufacturer in
this niche market is Select Comfort, Inc. Select Comfort offers its airbeds at
company-owned retail stores throughout the United States and engages in a
significant amount of direct marketing, including infomercials, targeted
mailings, and print, radio and television advertising. Select Comfort has an
established brand name and has greater financial, marketing and manufacturing
resources. Select Comfort also has significantly greater experience in marketing
and distributing airbeds. Despite these advantages, we believe that the market
for airbeds is large enough for both companies to be successful. In addition, we
believe that our airbeds possess features that will enable us to effectively
compete against Select Comfort and other airbed companies.
We believe that our success in the mattress business depends in part on
convincing consumers that variable firmness control and other features of our
sleep system favorably differentiate our products from those of our competitors.
We also believe that our experience with direct marketing will enable us to
successfully convey this message. However, the intense competition in the
mattress industry, both from conventional mattress manufacturers and Select
Comfort, may adversely affect our efforts to market and sell our airbeds and,
consequently, may adversely affect our business.
INTELLECTUAL PROPERTY
We believe that our intellectual property is an important factor in
maintaining our competitive position in the fitness and mattress industries.
Accordingly, we have taken the following steps to protect our intellectual
property:
- We hold 17 United States patents and have applied for three additional
United States patents with respect to our Nautilus products;
- We hold four patents relating to our Bowflex home fitness equipment;
- We have applied for one patent relating to our airbeds;
- We have obtained United States trademark protection for various names
associated with our products, including "Bow-Flex," "Nautilus," "Power
Rod," "Bowflex Power-Pro," "Motivator" and "Versatrainer";
- We have applied for United States trademark protection for the names
"Direct Focus," "Instant Comfort" and various other names and slogans
associated with our products;
- We have registered the name "Bow-Flex" in Canada and the European
Community and have registered or applied to register the "Nautilus"
trademark in approximately 30 foreign countries;
- We have obtained trademark protection for the "look" of our Bowflex
Power Rods; and
- We hold eight United States copyright registrations relating to our
Nautilus products.
Of our four Bowflex patents, the most important covers our Power Rods. This
patent expires on April 27, 2004. The other three patents expire on February 16,
2005, April 14, 2007, and January 4, 2010.
Each federally registered trademark is renewable indefinitely if the mark is
still in use at the time of renewal. We are not aware of any material claims of
infringement or other challenges to our right to use our marks. Despite our
efforts, the steps we have taken to protect our proprietary technology
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may be inadequate. See "Risk Factors" for a brief discussion of the risks
associated with protecting our intellectual property.
ENVIRONMENTAL REGULATION
Environmental regulations most significantly affect our Nautilus facilities
in Independence, Virginia. The Virginia Department of Environmental Quality has
issued an air permit for several point sources at this facility. The sources
include boilers, flash ovens and high solids paint booths. The permit imposes
operation limits based on the length of time each piece of equipment is operated
each day, and we operate the plant within these limits. The town of
Independence, Virginia has issued an industrial user's wastewater permit that
governs our discharge of on-site generated wastewater and storm water. In
addition to the foregoing, we recently completed a Phase I Environmental Site
Assessment and a limited Phase II Soil Analysis Assessment at our Nautilus
facilities in Independence, Virginia. No significant deficiencies or violations
were noted. We do not believe that continued compliance with federal, state and
local environmental laws will have a material effect upon our capital
expenditures, earnings or competitive position.
EMPLOYEES
As of February 1, 1999, we employed 336 full-time employees, including three
executive officers and 34 part-time employees. None of our employees is subject
to any collective bargaining agreement.
PROPERTIES
Our corporate headquarters and our principal warehouse facilities occupy
approximately 74,000 square feet in Vancouver, Washington. We also use these
facilities to house our customer call center and to assemble and distribute our
Bowflex and airbed products. We lease these properties pursuant to operating
leases that expire at various times, from May 30, 2000, to April 30, 2002. The
aggregate base rent is approximately $24,000 per month and some of the leases
are subject to annual adjustments based upon changes in the consumer price
index, but no adjustment may exceed 6.0% in any calendar year.
As part of our recent acquisition of substantially all of the assets of
Nautilus International, we acquired 54 acres of commercial real property in
Independence, Virginia, which includes the following facilities:
- A 124,000 square foot building devoted to fabrication, finishing,
assembly, plastics, upholstery, warehousing and shipping;
- A 100,000 square foot building devoted to fabrication and warehousing;
- A 27,105 square foot building that houses our Nautilus engineering,
prototyping and customer service operations; and
- A 9,187 square foot building that houses our Nautilus administrative
operations.
In general, our properties are well maintained, adequate and suitable for
their purposes. Assuming timely and effective integration of the Nautilus
facilities, we believe that these properties will meet our operational needs for
the foreseeable future. If we need additional warehouse or office space, we
believe that we will be able to obtain such space on commercially reasonable
terms.
LEGAL PROCEEDINGS
On May 1, 1998, Soloflex, Inc., a company that manufactures and directly
markets home fitness equipment, filed an action against Direct Focus and Randal
R. Potter, our Vice President of Marketing,
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in the United States District Court for the District of Oregon. The suit is
titled Soloflex, Inc. v. Bowflex, Inc. and Randy Potter, Cause No. 98-557-JO.
The judge has set a trial date of July 6, 1999, and both parties are now
proceeding with discovery. Our insurers are paying the costs of defending
against these claims.
Soloflex is pursuing two categories of claims, both of which relate to
activities that allegedly violate its intellectual property rights. First,
Soloflex claims that we 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 is Soloflex's contention that our print and
video advertisements are too similar to its advertisements. For example,
Soloflex asserts 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; or
- Use phrases with the words "unlock your body's potential" or "the body
you always wanted."
Second, Soloflex claims that we misappropriated certain of its marketing
trade secrets. The principal basis for this claim is Soloflex's allegation that
Mr. Potter had access to marketing 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 alleges 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 has requested both monetary damages and injunctive relief in
connection with its claims. Specifically, Soloflex is 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.
The injunctive relief that Soloflex is seeking would prohibit us from airing
advertisements that allegedly would infringe upon Soloflex's intellectual
property rights. We intend to vigorously defend against these claims. However,
we cannot assure you that we will prevail in this dispute. If Soloflex
successfully prosecutes any of its claims, the resulting monetary damages and/or
injunctive relief could significantly harm our business.
We are also involved in various legal proceedings incident to the ordinary
course of our business. We believe that the outcome of these pending legal
proceedings will not, in the aggregate, have a material adverse effect on our
business.
Prior to March 1998, our insurance coverage for a variety of claims,
including trademark infringement and product liability claims, was $1.0 million
per claim and $3.0 million in the aggregate. We increased the per claim coverage
under our base policy to $3.0 million in March 1998 and added a $15.0 million
umbrella policy in November 1998. In March 1999, we increased the coverage under
our umbrella policy to $20 million. The additional per claim coverage and
umbrella policies would not apply to claims, such as those at issue in the
Soloflex litigation, that relate to alleged events prior to our obtaining the
additional coverage.
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MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
Our directors and executive officers and their ages as of the date of this
prospectus are as follows:
<TABLE>
<CAPTION>
NAME AGE POSITION(S) WITH THE COMPANY
- ------------------------------------------------ --- ---------------------------------------------------------
<S> <C> <C>
Brian R. Cook................................... 49 President and Chief Executive Officer, Director
Randal R. Potter................................ 31 Vice President of Marketing
Rod W. Rice..................................... 34 Chief Financial Officer, Treasurer and Secretary
C. Reed Brown................................... 52 Director of Business/Legal Affairs, Director
Kirkland C. Aly................................. 42 Director
Gary L. Hopkins................................. 51 Director
Roger J. Sharp.................................. 43 Director
Roland E. Wheeler............................... 50 Director
</TABLE>
BRIAN R. COOK has served as a director and the President and Chief Executive
Officer of Direct Focus since 1986. Mr. Cook received his B.A. in Business
Administration, with a major in accounting, from Western Washington University.
He is a Certified Public Accountant. Mr. Cook is married to the sister of Mr.
Hopkins' wife.
RANDAL R. POTTER joined Direct Focus in 1991 as a Creative Director and
Marketing Manager and was named Vice President of Marketing in December 1995.
Mr. Potter, who received his B.S. in Social Science from Washington State
University, has been involved in the direct marketing industry since 1986.
ROD W. RICE joined Direct Focus in 1994 as Controller and was named Chief
Financial Officer, Treasurer and Secretary in 1995. From 1992 to 1994, Mr. Rice
was a senior assistant accountant with Deloitte & Touche LLP. Mr. Rice received
his B.S. in Business Administration, with a major in Accounting and Economics,
from Portland State University. He is a Certified Public Accountant.
C. REED BROWN joined Direct Focus in 1998 as the Director of Business/Legal
Affairs and has served as a director since 1998. From 1996 to 1997, Mr. Brown
served as Vice President/General Counsel and Director of Business Affairs at
Williams Worldwide Television, and also served briefly as President and Chief
Operating Officer of Stilson & Stilson Advertising and Marketing. From 1992 to
1996, Mr. Brown held various positions at HealthRider, Inc., including General
Counsel/Vice President, Executive Vice President, Corporate Secretary and
President of HealthRider Kiosk, Inc. Mr. Brown received his J.D. in 1973 from
the University of Utah College of Law. Mr. Brown also serves as a director of
Pen Interconnect, Inc.
KIRKLAND C. ALY has been a director of Direct Focus since 1996. Since 1998,
Mr. Aly has been the Vice President of Worldwide Sales & Marketing at Software
Logistix Corporation, a company that develops, implements and manages integrated
supply chains for high technology companies. From 1997 to 1998, Mr. Aly was the
Executive Vice President of Softbank Content Services, Inc., and from 1996 to
1997 was a principal in KDI Capital, LLC. From 1995 to 1997, Mr. Aly was the
President and Chief Executive Officer of Atrieva Corporation. Throughout 1994,
Mr. Aly was the President of Prism Group, Inc. Mr. Aly received his B.A. in
Communications from Washington State University.
GARY L. HOPKINS has been a director of Direct Focus since January 1993. Mr.
Hopkins is currently the Branch Operations Manager of Qpoint Mortgage, a
position he has held since March 1998. Mr. Hopkins previously served as a Senior
Lending Officer at Olympic NW Mortgage from 1996 to 1998, a Senior Loan Officer
at Emerald Mortgage from 1994 to 1996, and as President and CEO of Merit Escrow
from 1990 to 1994. Mr. Hopkins is married to the sister of Mr. Cook's wife.
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ROGER J. SHARP has been a director of Direct Focus since 1995. Since 1993,
he has served as the President of The Sharp Law Firm in Vancouver, Washington, a
general civil legal practice. He received his J.D. from the University of
Washington School of Law in 1981. Mr. Sharp has provided, and from time to time
may continue to provide, legal services to Direct Focus.
ROLAND E. "SANDY" WHEELER has served as a director of Direct Focus since
1986. Since 1998, he has served as the President and CEO of DynaMed, Inc., a
cancer research company. In addition, since 1996, he has served as the President
of V-Care Health Systems, Inc., a medical equipment company. From 1994 to 1995,
Mr. Wheeler served as the Vice President of Marketing of Direct Focus.
COMMITTEES OF THE BOARD OF DIRECTORS
Our board of directors has two committees: an audit committee and a Year
2000 committee. Kirkland C. Aly, Gary L. Hopkins and C. Reed Brown serve on the
audit committee. Roger J. Sharp will replace Mr. Hopkins on the audit committee
as soon as practicable after the offering. The audit committee has authority to:
- Make recommendations to the board of directors regarding the selection
of independent auditors;
- Review the results and scope of audits and other services provided by
our independent auditors; and
- Review and evaluate our audit and control functions.
C. Reed Brown and Roland Wheeler serve on the Year 2000 committee, which is
charged with developing, overseeing and reviewing our Year 2000 response and
contingency plan. We do not have a compensation committee. Instead, the full
board of directors considers and determines compensation issues, except that no
officer who is a director participates in board deliberations regarding their
own compensation.
DIRECTOR COMPENSATION
All of our nonemployee directors are paid $500 per day plus travel expenses
for each board of directors meeting that they attend in person, and $150 per day
for each board of directors meeting that they attend telephonically. On February
27, 1998, the board granted to each non-employee director an option to purchase
5,000 shares of our common stock at an exercise price equal to the market price
of our common stock at the close of trading on the Toronto Stock Exchange on the
date of grant, which was $4.62 per share. On May 8, 1998, the board granted to
Mr. Brown an option to purchase 5,000 shares of our common stock under the same
terms. The exercise price for Mr. Brown's option is $9.56 per share. In
addition, on May 8, 1998, the board of directors granted a $10,000 bonus to each
director other than C. Reed Brown and Brian R. Cook.
DIRECTOR AND OFFICER INDEMNIFICATION AND LIABILITY
Our articles of incorporation limit the liability of directors to the
fullest extent permitted by the Washington Business Corporation Act or other
applicable law, as then in effect. Consequently, subject to the Washington
Business Corporation Act, no director shall be personally liable to Direct Focus
or its shareholders for monetary damages resulting from his or her conduct as a
director of Direct Focus, except liability for:
- Acts or omissions involving intentional misconduct or knowing
violations of law;
- Unlawful distributions; or
- Transactions from which the director or officer personally receives a
benefit in money, property or services to which the director is not
legally entitled.
40
<PAGE>
Our articles of incorporation and bylaws also provide that we shall
indemnify any individual made a party to a proceeding because that individual is
or was a director or officer of Direct Focus. We must also advance or reimburse
reasonable expenses incurred by such individual prior to the final disposition
of the proceeding to the fullest extent permitted by the Washington Business
Corporation Act or other applicable law, as then in effect. No repeal of or
modification to our articles of incorporation or bylaws may adversely affect any
indemnification rights of a director or officer of Direct Focus who is or was a
director or officer at the time of such repeal or modification. To the extent
the provisions of our articles of incorporation provide for indemnification of
directors and officers for liabilities arising under the Securities Act of 1933,
those provisions are, in the opinion of the Securities and Exchange Commission,
against public policy as expressed in the Securities Act and they are therefore
unenforceable.
We do not currently maintain a liability insurance policy pursuant to which
our directors and officers may be indemnified against liability that they may
incur for serving in their capacities as directors and officers of Direct Focus.
However, we intend to obtain such a policy in 1999.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
Our board of directors does not have a compensation committee. During 1998,
director Brian R. Cook, who is also the President and Chief Executive Officer of
Direct Focus, participated in board deliberations regarding the compensation of
all executive officers other than himself.
EXECUTIVE COMPENSATION
The following table sets forth certain information regarding the
compensation we paid to our Chief Executive Officer and other executive officers
whose salary and bonus together exceeded $100,000 in 1998. We refer to these
individuals collectively in this prospectus as the "Named Executive Officers."
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
ANNUAL COMPENSATION -------------------
-------------------------- SECURITIES
SALARY UNDERLYING OPTIONS
NAME AND PRINCIPAL POSITION YEAR ($)(1) BONUS ($)(2) (#)
- -------------------------------------------------------- --------- ------------ ------------ -------------------
<S> <C> <C> <C> <C>
Brian R. Cook, President & CEO.......................... 1998 $ 175,000 $ 175,000 30,000
Randal R. Potter, Vice President, Marketing............. 1998 $ 105,000 $ 105,000 20,000
Rod W. Rice, Chief Financial Officer, Treasurer and
Secretary............................................. 1998 $ 90,000 $ 90,000 25,000
</TABLE>
- ------------------------
(1) In February 1999, the board of directors approved salary increases for each
of the Named Executive Officers. The 1999 salaries for Messrs. Cook, Potter
and Rice are $225,000, $150,000 and $120,000, respectively.
(2) The board of directors has sole discretion in establishing bonus awards. All
bonuses awarded in 1998 were in accordance with the performance-based
criteria established by the board of directors in February 1998.
41
<PAGE>
OPTION GRANTS
The following table sets forth information concerning stock option grants to
the Named Executive Officers during the year ended December 31, 1998.
OPTION GRANTS IN 1998
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
--------------------------------------------------------------------
NUMBER OF
SECURITIES % OF TOTAL GRANT DATE VALUE
UNDERLYING OPTIONS GRANTED ------------------
OPTIONS TO EMPLOYEES IN EXERCISE PRICE GRANT DATE PRESENT
NAME GRANTED(1) (#) 1998(2) ($/SH)(3) EXPIRATION DATE VALUE(4) ($)
- ------------------------- --------------- ----------------- --------------- --------------- ------------------
<S> <C> <C> <C> <C> <C>
Brian R. Cook............ 30,000 16.0% $ 4.62 2/28/2003 $ 90,000
Randal R. Potter......... 20,000 10.6% $ 4.62 2/28/2003 $ 60,000
Rod W. Rice.............. 25,000 13.3% $ 4.62 2/28/2003 $ 75,000
</TABLE>
- ------------------------
(1) The options were granted on February 27, 1998. Mr. Cook's option vested in
full on the date of grant. Mr. Potter's and Mr. Rice's options vest in
one-third increments on each of the first three anniversaries of the grant
date.
(2) During 1998, the board of directors granted options to purchase a total of
188,000 shares of Direct Focus common stock.
(3) In accordance with the rules of the Toronto Stock Exchange and our Stock
Option Plan, the exercise price per share equals the closing price (in U.S.
dollars) of our common stock on the Toronto Stock Exchange on the grant
date. The exercise price may be adjusted only upon the occurrence of
specific events that would dilute our share capital.
(4) The fair value of each option grant was estimated on the date of grant using
the Black-Scholes option-pricing model with the following weighted-average
assumptions: (a) all options granted will vest as scheduled; (b) no dividend
yield; (c) a risk-free interest rate of 5.0%; and (d) an expected volatility
of 76.0%.
The following table summarizes the number and value of options exercised by
the Named Executive Officers during 1998 and the value of options held by such
persons as of February 26, 1999.
AGGREGATED OPTION EXERCISES IN 1998 AND
YEAR END OPTION VALUES
<TABLE>
<CAPTION>
NUMBER OF SECURITIES VALUE OF UNEXERCISED
SHARES UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS AT
ACQUIRED ON VALUE OPTIONS AT YEAR END (#) YEAR END ($)
EXERCISE REALIZED -------------------------- ---------------------------
NAME (#) ($) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ------------------------------ ----------- ----------- ----------- ------------- ------------ -------------
<S> <C> <C> <C> <C> <C> <C>
Brian R. Cook................. -- $ -- 80,000 -- $ 1,026,300 $ --
Randal R. Potter.............. 63,500 $ 333,688 107,500 20,000 $ 1,581,675 $ 211,200
Rod W. Rice................... 37,213 $ 100,705 36,666 48,334 $ 527,791 $ 603,009
</TABLE>
EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL
ARRANGEMENTS
BRIAN R. COOK is employed as our President and Chief Executive Officer
pursuant to an employment agreement dated as of January 1, 1998 (the "Cook
Agreement"). Mr. Cook's current salary is $225,000 per year, and is subject to
increase at the discretion of our board of directors. He is also entitled to
reimbursement for reasonable out-of-pocket expenses. The Cook Agreement had an
initial term of one year, with automatic renewals for subsequent one-year terms.
We may terminate the Cook
42
<PAGE>
Agreement by providing Mr. Cook with at least six months' notice of such
termination. Upon the receipt of such notice, all unpaid salary that would have
been paid to Mr. Cook during the remaining term of his employment would become
immediately due and payable.
RANDAL R. POTTER is employed as our Vice President of Marketing pursuant to
an employment agreement dated as of January 1, 1998 (the "Potter Agreement").
Mr. Potter's current salary is $150,000 per year, and is subject to increase at
the discretion of our board of directors. He is also entitled to reimbursement
for reasonable out-of-pocket expenses. The Potter Agreement had an initial term
of one year, with automatic renewals for subsequent one-year terms. We may
terminate the Potter Agreement by providing Mr. Potter with at least six months'
notice of such termination. Upon the receipt of such notice, all unpaid salary
that would have been paid to Mr. Potter during the remaining term of his
employment would become immediately due and payable.
ROD W. RICE is employed as our Chief Financial Officer pursuant to an
employment agreement dated as of January 1, 1998 (the "Rice Agreement"). Mr.
Rice's current salary is $120,000 per year, and is subject to increase at the
discretion of our board of directors. He is also entitled to reimbursement for
reasonable out-of-pocket expenses. The Rice Agreement had an initial term of one
year, with automatic renewals for subsequent one-year terms. We may terminate
the Rice Agreement by providing Mr. Rice with at least six months' notice of
such termination. Upon the receipt of such notice, all unpaid salary that would
have been paid to Mr. Rice during the remaining term of his employment would
become immediately due and payable.
BENEFIT PLANS
DIRECT FOCUS, INC. STOCK OPTION PLAN
In 1995, our board of directors and shareholders adopted the Direct Focus,
Inc. Stock Option Plan, which was amended in 1998 and 1999. The principal
purpose of the Stock Option Plan is to enhance shareholder value by offering our
employees, officers, directors and consultants a financial incentive to
stimulate our continued growth and success. Our board of directors has reserved
a total of 1,857,961 shares of Direct Focus common stock for issuance upon the
exercise of options granted under the Stock Option Plan. As of December 31,
1998, options to purchase 550,618 shares of Direct Focus common stock were
outstanding, of which options to purchase 309,199 shares were then exercisable.
The weighted average exercise price of outstanding options was $2.39 per share,
with actual exercise prices ranging between $0.12 and $9.75 per share.
The current plan administrator is our board of directors, although the board
may appoint a committee of two or more directors to administer the Stock Option
Plan. The plan administrator may grant incentive stock options to any employee
of Direct Focus or its subsidiaries and non-qualified stock options to any
employee, officer, director or consultant of Direct Focus or its subsidiaries.
The plan administrator has the exclusive authority to administer the Stock
Option Plan in accordance with the terms thereof, including the authority to:
- Select which employees, if any, will be granted incentive stock
options;
- Select which employees, officers, directors and/or consultants, if any,
will be granted non-qualified stock options;
- Specify the terms and conditions of each option granted;
- Designate the number of shares subject to each option granted;
- Designate the exercise price of each option granted, which, for
incentive stock options, must be at least equal to the fair market
value of Direct Focus common stock on the grant date; and
- Designate the vesting schedule.
43
<PAGE>
Unless the plan administrator establishes a shorter term or the holder of an
incentive stock option dies or ceases to be an employee of Direct Focus or one
of our subsidiaries, all incentive stock options granted to persons who
beneficially own more than 10.0% of our outstanding common stock terminate five
years after the grant date, and all other options terminate ten years after the
grant date. If the holder of an incentive stock option dies or ceases to be an
employee of Direct Focus or one of our subsidiaries due to a disability, his or
her option will terminate six months after the date of death or cessation of
employment. If the holder of an incentive stock option ceases to be an employee
of Direct Focus or one of our subsidiaries for any reason other than a
disability, the plan administrator may designate a termination date between 30
days and three months after the cessation of employment.
The plan administrator is required to make proportional adjustments to the
aggregate number of shares issuable under the Stock Option Plan and pursuant to
outstanding options in the event of stock splits or other capital adjustments.
In addition, certain corporate transactions, such as a merger or consolidation
that would cause our shareholders to own less than a majority of the surviving
entity, will cause all outstanding options to become immediately exercisable
without regard for any vesting schedule or other vesting contingencies.
Similarly, all outstanding options will become immediately exercisable if a
person becomes the beneficial owner of 50.0% or more of our voting securities.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In 1986, we acquired the rights to our Bowflex technology from Tessema D.
Shifferaw, the inventor of the technology and an original shareholder, pursuant
to an agreement that provides for royalty payments to Mr. Shifferaw equal to
3.0% of the net sales of our Bowflex products. Our typical royalty fees with
independent third parties range between 3.0% and 5.0% of net product sales. We
paid approximately $1.6 million to Mr. Shifferaw in 1998. In 1992, Mr. Shifferaw
negotiated a separate royalty-based agreement with Brian R. Cook and Roland E.
Wheeler to induce them to continue their employment with Direct Focus. Under
this agreement, Mr. Shifferaw is obligated to pay Messrs. Cook and Wheeler 40.0%
(20.0% each) of annual royalties in excess of $90,000. For 1998, Messrs. Cook
and Wheeler each expect to receive $302,765 from Mr. Shifferaw under this
arrangement.
44
<PAGE>
PRINCIPAL AND SELLING SHAREHOLDERS
The following table summarizes certain information regarding the beneficial
ownership of our outstanding common stock as of March 31, 1999, and as adjusted
to reflect the sale of common stock in this offering, by: (1) each director; (2)
each executive officer whose name appears in the summary compensation table; (3)
all persons that we know are beneficial owners of more than 5.0% of our common
stock, and (4) all directors and executive officers as a group.
<TABLE>
<CAPTION>
SHARES TO
BE
SHARES BENEFICIALLY SOLD IN SHARES BENEFICIALLY
OWNED PRIOR TO OFFERING OFFERING OWNED AFTER OFFERING
DIRECTORS, EXECUTIVE OFFICERS, 5% SHAREHOLDERS --------------------------- --------- ---------------------------
AND SELLING SHAREHOLDERS(1) NUMBER PERCENTAGE(2) NUMBER NUMBER PERCENTAGE(2)
- ------------------------------------------------ ---------- --------------- --------- ---------- ---------------
<S> <C> <C> <C> <C> <C>
Brian R. Cook(3)................................ 696,071 7.2% 25,000 671,071 6.4%
Randal R. Potter(4)............................. 173,166 1.8 12,500 160,666 1.5
Rod W. Rice(5).................................. 108,499 1.1 12,500 95,999 *
Kirkland C. Aly(6).............................. 14,000 * -- 14,000 *
C. Reed Brown(7)................................ 5,000 * -- 5,000 *
Gary L. Hopkins(8).............................. 44,000 * -- 44,000 *
Roger J. Sharp(9)............................... 33,723 * -- 33,723 *
Roland E. Wheeler(10)........................... 349,586 3.7 25,000 324,586 3.1
Paul Little(11)................................. 452,610 4.7 100,000 352,610 3.4
All directors and executive officers as a group
(8 persons)................................... 1,424,045 14.6 75,000 1,349,045 12.7
</TABLE>
- ------------------------
* Less than 1%.
(1) The address of all directors and executive officers is our address: 2200
N.E. 65(th) Avenue, Vancouver, Washington 98661.
(2) We have calculated the pre-offering percentages assuming that 9,534,599
shares of our common stock are issued and outstanding, and have calculated
post-offering percentages assuming that 10,359,599 shares of our common
stock will be issued and outstanding. In accordance with SEC regulations,
each percentage calculation with respect to a shareholder assumes the
exercise of all outstanding options that such shareholder holds and that can
be exercised within 60 days after the anticipated effective date of this
offering.
(3) Includes 80,000 shares issuable upon the exercise of options.
(4) Includes 96,416 shares issuable upon the exercise of options.
(5) Includes 8,333 shares issuable upon the exercise of options.
(6) Includes 5,000 shares issuable upon the exercise of options.
(7) Includes 5,000 shares issuable upon the exercise of options.
(8) Includes 15,000 shares issuable upon the exercise of options.
(9) Includes 5,000 shares issuable upon the exercise of options, 4,000 shares
held by Mr. Sharp's spouse and 1,900 shares held by Mr. Sharp's children.
Mr. Sharp's spouse is the custodian for all shares held by their children.
(10) Includes 5,000 shares issuable upon the exercise of options and 18,900
shares held by Mr. Wheeler's daughter.
(11) Includes 202,810 shares held by Westover Investments, Inc., of which Mr.
Little is the sole shareholder and director. Mr. Little's address is 211
Queen's Quay West, Suite 911, Toronto, Ontario, Canada M5J 2M6.
45
<PAGE>
UNDERWRITING
The underwriters named below, acting through their representatives, D.A.
Davidson & Co. and First Security Van Kasper, Inc., have severally agreed with
the Company and the selling shareholders, subject to the terms and conditions of
the Underwriting Agreement, to purchase the number of shares of common stock set
forth opposite their respective names below. The underwriters are committed to
purchase and pay for all such shares if any are purchased.
<TABLE>
<CAPTION>
NUMBER
UNDERWRITER OF SHARES
- --------------------------------------------------------------------------------- ----------
<S> <C>
D.A. Davidson & Co............................................................... 510,000
First Security Van Kasper, Inc................................................... 340,000
John G. Kinnard & Co., Incorporated.............................................. 30,000
Mitchell Securities Corporation of Oregon........................................ 30,000
Pacific Crest Securities, Inc.................................................... 30,000
Ragen Mackenzie, Incorporated.................................................... 30,000
Southwest Securities, Inc........................................................ 30,000
----------
Total........................................................................ 1,000,000
----------
----------
</TABLE>
The representatives have advised the Company and the selling shareholders
that the underwriters propose to offer the shares of common stock to the public
at the public offering price set forth on the cover page of this prospectus and
to certain dealers at such price less a concession of not in excess of $0.80 per
share, of which $0.10 may be reallowed to other dealers. After the offering, the
public offering price, concession and reallowance to dealers may be reduced by
the representatives. No such reduction shall change the amount of proceeds to be
received by the Company and the selling shareholders as set forth on the cover
page of this prospectus.
The Company has granted to the underwriters an option, exercisable during
the 30-day period after the date of this prospectus for the offering, to
purchase up to 150,000 additional shares of common stock at the same price per
share as the Company and the selling shareholders will receive for the one
million shares that the underwriters have agreed to purchase. To the extent that
the underwriters exercise such option, each of the underwriters will have a firm
commitment, subject to certain conditions, to purchase approximately the same
percentage of such additional shares that the number of shares of common stock
to be purchased by it shown in the above table represents as a percentage of the
one million shares offered hereby. If purchased, the underwriters will sell such
additional shares on the same terms as those on which the one million shares are
being sold.
The following table summarizes the compensation to be paid to the
underwriters by the Company and the selling shareholders, and the expenses
payable by the Company and the selling shareholders to the underwriters.
<TABLE>
<CAPTION>
TOTAL
------------------------------
WITHOUT WITH
PER SHARE OVER-ALLOTMENT OVER-ALLOTMENT
---------- -------------- --------------
<S> <C> <C> <C>
Underwriting discounts and commissions paid by the Company............ $ 1.435 $ 1,183,875 $ 1,399,125
Underwriting discounts and commissions paid by the selling
shareholders........................................................ $ 1.435 $ 251,125 $ 251,125
Nonaccountable expenses payable by the Company........................ $ 0.1025 $ 102,500 $ 117,875
</TABLE>
The Underwriting Agreement contains covenants of indemnity among the
underwriters, the Company and the selling shareholders against certain civil
liabilities, including liabilities under the Securities
46
<PAGE>
Act of 1933 and liabilities arising from breaches of representations and
warranties contained in the Underwriting Agreement.
The Company's common stock has been approved for listing on Nasdaq under the
symbol DFXI.
Each officer and director of the Company and each selling shareholder has
agreed that, for a period of 180 days after the effective date of this
prospectus, he will not, subject to certain exceptions, directly or indirectly
offer to sell, contract to sell, or otherwise sell, dispose of, loan, pledge or
grant any rights with respect to, any shares of common stock, or any securities
convertible into or exchangeable for shares of common stock, now owned or
hereafter acquired directly by such holders or with respect to which they have
the power of disposition, without the prior written consent of D.A. Davidson &
Co., which may, in its sole discretion and at any time without notice, release
all or any portion of the securities subject to lock-up agreements. In addition,
the Company has agreed that during the 180 days following the effective date of
this prospectus, the Company will not, without the prior written consent of D.A.
Davidson & Co., subject to certain exceptions, offer, issue, sell, contract to
sell, or otherwise dispose of any shares of common stock, any options or
warrants to purchase any shares of common stock, or any securities convertible
into, exercisable for or exchangeable for shares of common stock other than the
Company's sales of shares in the offering.
The underwriters do not intend to confirm sales to any accounts over which
they exercise discretionary authority.
Prior to the offering, there has been no public market in the United States
for the common stock of the Company. Consequently, the public offering price for
the common stock offered hereby will be determined through negotiations among
the Company and the representatives. Among the factors to be considered in such
negotiations include prevailing market conditions, the market price of the
Company's common stock on the Toronto Stock Exchange, certain financial
information of the Company, market valuations of other companies that the
Company and the representatives believe to be comparable to the Company,
estimates of the business potential of the Company and the industry in which it
competes, an assessment of the Company's management, its past and present
operations, the prospects for, and timing of, future revenues of the Company,
the present state of the Company's development and other factors deemed
relevant. The Company's common stock has been listed on the Toronto Stock
Exchange in the Province of Ontario, Canada, since January 26, 1993 under the
symbol DFX. The Company's common stock will be delisted from the Toronto Stock
Exchange following the completion of this offering.
The representatives have advised the Company that, pursuant to Regulation M
under the Securities Act, certain persons participating in the offering may
engage in transactions, including stabilizing bids, syndicate covering
transactions or the imposition of penalty bids that may have the effect of
stabilizing or maintaining the market price of the common stock at a level above
that which might otherwise prevail in the open market. A "stabilizing bid" is a
bid for or the purchase of the common stock on behalf of the underwriters for
the purpose of fixing or maintaining the price of the common stock. A "syndicate
covering transaction" is the bid for or the purchase of the common stock on
behalf of the underwriters to reduce a short position incurred by the
underwriters in connection with the offering. A "penalty bid" is an arrangement
permitting the representatives to reclaim the selling concession otherwise
accruing to an underwriter or syndicate member in connection with the offering
if the common stock originally sold by such underwriter or syndicate member is
purchased by the representatives in a syndicate covering transaction and has
therefore not been effectively placed by such underwriter or syndicate member.
The representatives have advised the Company that such transactions may be
effected on Nasdaq or otherwise and, if commenced, may be discontinued at any
time.
47
<PAGE>
DESCRIPTION OF CAPITAL STOCK
Our authorized capital stock consists of 50,000,000 shares of common stock,
no par value. As of March 31, 1999, 9,534,599 shares of Direct Focus common
stock were outstanding and held of record by 81 shareholders. Following this
offering, 10,359,599 shares of Direct Focus common stock will be outstanding
(assuming no exercise of the underwriters' over-allotment option and no exercise
of outstanding options), all of which will be fully paid and nonassessable.
COMMON STOCK
Our common shareholders are entitled to:
- One vote per share at all shareholder meetings;
- Receive dividends ratably, if, as and when declared by our Board of
Directors; and
- Participate ratably in any distribution of property or assets upon any
liquidation, winding up, or dissolution of the Company.
None of our common stock has cumulative voting rights, preemptive rights or
conversion rights, and there are no redemption or sinking fund provisions
applicable to our common stock.
ANTITAKEOVER EFFECTS OF CERTAIN PROVISIONS OF WASHINGTON LAW
Washington law imposes restrictions on certain transactions between a
corporation and certain significant shareholders. Chapter 23B.19 of the
Washington Business Corporation Act prohibits a "target corporation," with
certain exceptions, from engaging in certain significant business transactions
with an "acquiring person," which is defined as a person or group of persons
that beneficially owns 10.0% or more of the voting securities of the target
corporation, for a period of five years after such acquisition, unless the
transaction or acquisition of shares is approved by a majority of the members of
the target corporation's board of directors prior to the time of acquisition.
Such prohibited transactions include, among other things:
- A merger or consolidation with, disposition of assets to, or issuance
or redemption of stock to or from, the acquiring person;
- Termination of 5.0% or more of the employees of the target corporation
as a result of the acquiring person's acquisition of 10.0% or more of
the shares; or
- Allowing the acquiring person to receive any disproportionate benefit
as a shareholder.
After the five-year period, a "significant business transaction" may occur
if the transaction complies with certain "fair price" provisions of the statute.
A corporation may not "opt out" of this statute. This provision may have the
effect of delaying, deterring or preventing a change in control of Direct Focus.
TRANSFER AGENT AND REGISTRAR
The transfer agent and registrar for Direct Focus common stock traded in the
United States will be American Securities Stock Transfer and Trust, Inc.
NASDAQ NATIONAL MARKET LISTING
Our common stock has been approved for listing on Nasdaq and will trade
under the symbol DFXI.
48
<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE
Prior to this offering, the only public market for our common stock was the
Toronto Stock Exchange, and our common stock will be delisted from this exchange
following the completion of this offering. Our common stock has been approved
for listing on Nasdaq and will trade under the symbol DFXI. However, we cannot
provide any assurance that a significant public market for our common stock will
develop on Nasdaq or be sustained after this offering. Future sales of
substantial amounts of our common stock in the public market, or the possibility
of such sales, could adversely affect prevailing market prices for our common
stock or our future ability to raise capital through an offering of equity
securities.
After this offering, approximately 10,359,599 shares of our common stock
will be outstanding (10,509,599 shares if the underwriter's over-allotment
option is fully exercised). Of these shares, the 825,000 newly issued shares
that we are selling in the offering (975,000 shares if the underwriters'
over-allotment option is fully exercised) will be freely tradable in the public
market without restriction under the Securities Act. As explained below, we
believe that as many as 8.3 million additional shares, including the 175,000
shares being offered by the selling shareholders, all of which are currently
issued and outstanding, will be freely tradable in the public market without
restriction under the Securities Act.
Approximately 8.9 million of the shares that will be outstanding after the
offering were issued in private placement transactions that were exempt from the
registration requirements of the Securities Act, of which 861,000 shares are
currently held by our directors and officers. The majority of these transactions
occurred in 1993 and the last occurred in 1996. All of these shares originally
qualified as "restricted securities" (as such term is defined in Rule 144).
Restricted securities cannot be resold in the public market except in a
registered transaction or in a transaction exempt from the registration
requirements of the Securities Act, such as the exemption afforded by Rule 144,
which is discussed below. In addition, restricted securities continue to qualify
as such until they are resold in a registered transaction or in accordance with
Rule 144. All of the shares issued in these transactions have been held beyond
the minimum holding periods set forth in Rule 144, and we believe that many of
these shares have been resold through the Toronto Stock Exchange or otherwise
and no longer qualify as restricted securities. The shares other than those held
by our officers and directors can be freely sold without restriction under the
Securities Act.
Approximately 650,000 additional shares were issued upon the exercise of
options in reliance upon the exemption afforded by Rule 701 of the Securities
Act. Approximately 417,000 of these shares are still held by the optionees,
including 264,000 shares currently held by our officers and directors, and
qualify as restricted securities that may be resold in accordance with Rule 701.
Rule 701 permits resales pursuant to Rule 144 (other than the holding period)
beginning 90 days after the date of this prospectus. Approximately 233,000 of
these shares have been resold on the Toronto Stock Exchange and no longer
qualify as restricted securities.
After the offering, our directors and executive officers will own
approximately 1,125,000 shares of our common stock, some of which they acquired
in private placement transactions or pursuant to option exercises. Pursuant to
certain "lock-up" agreements between the underwriters and each director and
executive officer, shares of common stock held by these individuals cannot be
offered, sold or otherwise disposed of in any way until 180 days after the date
of this prospectus. On the expiration date of this lock-up period, our directors
and executive officers may sell these shares in the public market, subject to
any applicable resale limitations set forth in Rule 144.
In general, under Rule 144 as currently in effect, any person (or persons
whose shares are aggregated) who has beneficially owned restricted securities
for at least one year is entitled to sell, within any three month period, a
number of shares that does not exceed the greater of:
- One percent of the then outstanding shares of the issuer's common
stock; or
49
<PAGE>
- The average weekly trading volume during the four calendar weeks
preceding such sale.
Sales under Rule 144 are also subject to certain manner of sale and notice
requirements and to the availability of current public information about Direct
Focus. Under Rule 144(k), a person who
has not been an affiliate of Direct Focus during the preceding 90 days and who
has beneficially owned the restricted shares for at least two years is entitled
to sell such shares without complying with the manner of sale, public
information, volume limitation or notice provisions of Rule 144. Generally, an
affiliate includes all of our officers and directors and any shareholder who
holds 10% or more of our outstanding common stock. All of our affiliates are
subject to continuing volume limitations described above.
After the effective date of this offering, we intend to file a registration
statement on Form S-8 to register up to approximately 550,618 shares of our
common stock that are reserved for issuance under our Stock Option Plan. The
Form S-8 registration statement will become effective automatically upon filing.
Shares issued under our Stock Option Plan after filing the Form S-8 registration
statements may be freely sold in the open market, subject only to certain Rule
144 limitations applicable to affiliates, the above-referenced lock-up
agreements and the vesting requirements applicable to the options.
LEGAL MATTERS
The legality of the common stock that we and the selling shareholders are
offering hereunder will be passed upon by Garvey, Schubert & Barer, Seattle,
Washington. Certain legal matters in connection with the issuance of the common
stock will be passed upon for the underwriters by LeBoeuf, Lamb, Greene &
MacRae, L.L.P., Salt Lake City, Utah.
EXPERTS
The financial statements as of December 31, 1997 and 1998 and for each of
the three years in the period ended December 31, 1998, included in this
prospectus and the related financial statement schedules included elsewhere in
the registration statement have been audited by Deloitte & Touche LLP,
independent auditors, as stated in their report appearing herein, and are
included in reliance upon the report of such firm given upon their authority as
experts in accounting and auditing.
The financial statements of the Nautilus Business as of January 4, 1999,
June 27, 1998, and June 28, 1997, and for the six-months ended January 4, 1999,
and for each of the years in the three year period ended June 27, 1998, have
been included herein and in the registration statement in reliance upon the
report of KPMG Peat Marwick LLP, independent certified public accountants,
appearing elsewhere herein, and upon the authority of said firm as experts in
accounting and auditing.
50
<PAGE>
ADDITIONAL INFORMATION
We have filed with the Securities and Exchange Commission a Registration
Statement on Form S-1. This prospectus, which forms a part of the Registration
Statement, does not contain all of the information included in the Registration
Statement. Certain information is omitted and you should refer to the
Registration Statement and its exhibits. With respect to references made in this
prospectus to any contract or other document of Direct Focus, such references
are not necessarily complete and you should refer to the exhibits attached to
the Registration Statement for copies of the actual contract or document. You
may review a copy of the Registration Statement, including exhibits and
schedules filed therewith, at the Securities and Exchange Commission's public
reference facilities in Room 1024, Judiciary Plaza, 450 Fifth Street, N.W.,
Washington, D.C. 20549, and at the regional offices of the Securities and
Exchange Commission located at 7 World Trade Center, Suite 1300, New York, New
York, 10048, and Citicorp Center, 500 West Madison Street, Suite 1400, Chicago,
Illinois 60661. You may also obtain copies of such materials from the Public
Reference Section of the Securities and Exchange Commission, Room 1024,
Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, at prescribed
rates. The Securities and Exchange Commission maintains a Web site
(http://www.sec.gov) that contains reports, proxy statements and other
information regarding registrants, such as Direct Focus, that file
electronically with the Securities and Exchange Commission.
51
<PAGE>
DIRECT FOCUS, INC.
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
DIRECT FOCUS, INC.
Report of Deloitte & Touche LLP, Independent Auditors.................................................... F-2
Balance Sheets as of December 31, 1997 and 1998.......................................................... F-3
Statements of Income for the three years ended December 31, 1998......................................... F-5
Statements of Stockholders' Equity for the three years ended December 31, 1998........................... F-6
Statements of Cash Flows for the three years ended December 31, 1998..................................... F-7
Notes to Financial Statements............................................................................ F-8
DIRECT FOCUS, INC. AND AFFILIATE PRO FORMA COMBINED FINANCIAL STATEMENTS (UNAUDITED)
Basis of Presentation.................................................................................... F-17
Pro Forma Combined Balance Sheet......................................................................... F-18
Pro Forma Combined Statement of Operations............................................................... F-20
NAUTILUS BUSINESS
Report of KPMG Peat Marwick LLP, Independent Auditors.................................................... F-21
Combined Balance Sheets as of June 28, 1997, June 27, 1998 and January 4, 1999........................... F-22
Combined Statements of Operations and Accumulated Deficit for the years ended June 29, 1996, June 28,
1997, June 27, 1998, and for the six-months ended December 27, 1997 (unaudited) and January 4, 1999.... F-23
Combined Statements of Cash Flows for the years ended June 29, 1996, June 28, 1997, June 27, 1998, and
for the six-months ended December 27, 1997 (unaudited) and January 4, 1999............................. F-24
Notes to Combined Financial Statements................................................................... F-25
</TABLE>
F-1
<PAGE>
INDEPENDENT AUDITORS' REPORT
Board of Directors and Stockholders
of Direct Focus, Inc.:
We have audited the accompanying balance sheets of Direct Focus, Inc. as of
December 31, 1997 and 1998 and the related statements of income, stockholders'
equity, and cash flows for each of the three years in the period ended December
31, 1998. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the financial position of Direct Focus, Inc. at December 31, 1997 and
1998 and the results of its operations and its cash flows for each of the three
years in the period ended December 31, 1998 in conformity with generally
accepted accounting principles.
DELOITTE & TOUCHE LLP
Portland, Oregon
February 26, 1999
F-2
<PAGE>
DIRECT FOCUS, INC.
BALANCE SHEETS,
DECEMBER 31, 1997 AND 1998
<TABLE>
<CAPTION>
1997 1998
------------ -------------
<S> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents.......................................................... $ 4,790,316 $ 18,910,675
Trade receivables (less allowance for doubtful accounts of: 1997, $85,000 and 1998,
$40,000)......................................................................... 259,543 218,207
Inventories........................................................................ 1,945,773 2,614,673
Prepaid expenses and other current assets.......................................... 212,382 378,409
Current deferred tax asset......................................................... 222,139 215,737
------------ -------------
Total current assets............................................................. 7,430,153 22,337,701
------------ -------------
Furniture and Equipment:
Equipment.......................................................................... 587,661 1,822,205
Furniture and fixtures............................................................. 257,325 459,297
------------ -------------
844,986 2,281,502
Less accumulated depreciation...................................................... (446,922) (438,790)
------------ -------------
Total furniture and equipment.................................................... 398,064 1,842,712
------------ -------------
Long-Term Deferred Tax Asset......................................................... 26,202 --
------------ -------------
Other Assets (Less accumulated amortization of: 1997, $39,242 and 1998, $49,967)..... 67,821 192,859
------------ -------------
Total............................................................................ $ 7,922,240 $ 24,373,272
------------ -------------
------------ -------------
</TABLE>
See notes to financial statements.
F-3
<PAGE>
DIRECT FOCUS, INC.
BALANCE SHEETS,
DECEMBER 31, 1997 AND 1998
<TABLE>
<CAPTION>
1997 1998
------------ -------------
<S> <C> <C>
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Trade payables..................................................................... $ 1,178,255 $ 3,602,074
Income taxes payable............................................................... 801,128 504,775
Accrued liabilities................................................................ 1,089,134 1,851,253
Royalty payable to stockholders.................................................... 210,511 548,211
Customer deposits.................................................................. 41,853 148,937
Current portion of capital lease obligation........................................ 9,167 --
------------ -------------
Total current liabilities........................................................ 3,330,048 6,655,250
------------ -------------
Long-term Deferred Tax Liability..................................................... -- 66,880
------------ -------------
Commitments and Contingencies (Note 5)............................................... -- --
------------ -------------
Stockholders' Equity:
Common stock--authorized, 50,000,000 shares of no par value; outstanding, 1997:
9,005,328 shares, 1998: 9,448,523 shares......................................... 2,992,172 3,565,628
Retained earnings.................................................................. 1,600,020 14,085,514
------------ -------------
Total stockholders' equity....................................................... 4,592,192 17,651,142
------------ -------------
Total............................................................................ $ 7,922,240 $ 24,373,272
------------ -------------
------------ -------------
</TABLE>
F-4
<PAGE>
DIRECT FOCUS, INC.
STATEMENTS OF INCOME
THREE YEARS ENDED DECEMBER 31, 1998
<TABLE>
<CAPTION>
1996 1997 1998
------------ ------------- -------------
<S> <C> <C> <C>
Net Sales............................................................ $ 8,516,584 $ 19,886,354 $ 57,296,880
Cost of Sales........................................................ 2,602,717 5,113,980 12,442,307
------------ ------------- -------------
Gross profit..................................................... 5,913,867 14,772,374 44,854,573
------------ ------------- -------------
Operating Expenses:
Selling and marketing.............................................. 4,712,365 9,600,076 22,642,885
General and administrative......................................... 472,661 974,887 1,700,956
Royalties.......................................................... 269,123 580,677 1,622,726
------------ ------------- -------------
Total operating expenses......................................... 5,454,149 11,155,640 25,966,567
------------ ------------- -------------
Operating Income..................................................... 459,718 3,616,734 18,888,006
------------ ------------- -------------
Other Income (Expense):
Interest income.................................................... 37,524 118,541 526,961
Interest expense................................................... (2,225) (1,381) (455)
State business tax and other-net................................... (51,113) (86,660) (221,434)
------------ ------------- -------------
Total other income (expense)-net................................. (15,814) 30,500 305,072
------------ ------------- -------------
Income Before Income Taxes........................................... 443,904 3,647,234 19,193,078
Income Tax Expense (Benefit)......................................... (249,000) 1,226,068 6,707,584
------------ ------------- -------------
Net Income........................................................... $ 692,904 $ 2,421,166 $ 12,485,494
------------ ------------- -------------
------------ ------------- -------------
Basic Earnings Per Share............................................. $ 0.08 $ 0.27 $ 1.34
------------ ------------- -------------
------------ ------------- -------------
Diluted Earnings Per Share........................................... $ 0.08 $ 0.25 $ 1.28
------------ ------------- -------------
------------ ------------- -------------
</TABLE>
See notes to financial statements.
F-5
<PAGE>
DIRECT FOCUS, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY
THREE YEARS ENDED DECEMBER 31, 1998
<TABLE>
<CAPTION>
RETAINED
COMMON STOCK EARNINGS
-------------------------- (ACCUMULATED
SHARES AMOUNT DEFICIT) TOTAL
------------ ------------ ------------- -------------
<S> <C> <C> <C> <C>
Balances, January 1, 1996.............................. 8,131,541 $ 2,788,535 $ (1,514,050) $ 1,274,485
Common shares issued................................. 750,000 247,090 -- 247,090
Options exercised.................................... 40,000 4,800 -- 4,800
Net income........................................... -- -- 692,904 692,904
------------ ------------ ------------- -------------
Balances, December 31, 1996............................ 8,921,541 3,040,425 (821,146) 2,219,279
Options exercised.................................... 129,887 15,586 -- 15,586
Stock repurchased.................................... (46,100) (98,120) -- (98,120)
Tax benefit of exercise of nonqualified options...... -- 34,281 -- 34,281
Net income........................................... -- -- 2,421,166 2,421,166
------------ ------------ ------------- -------------
Balances, December 31, 1997............................ 9,005,328 2,992,172 1,600,020 4,592,192
Options exercised.................................... 443,195 134,004 -- 134,004
Tax benefit of exercise of nonqualified options...... -- 439,452 -- 439,452
Net income........................................... -- -- 12,485,494 12,485,494
------------ ------------ ------------- -------------
Balances, December 31, 1998............................ 9,448,523 $ 3,565,628 $ 14,085,514 $ 17,651,142
------------ ------------ ------------- -------------
------------ ------------ ------------- -------------
</TABLE>
See notes to financial statements.
F-6
<PAGE>
DIRECT FOCUS, INC.
STATEMENTS OF CASH FLOWS
THREE YEARS ENDED DECEMBER 31, 1998
<TABLE>
<CAPTION>
1996 1997 1998
------------ ------------- -------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income.......................................................... $ 692,904 $ 2,421,166 $ 12,485,494
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization..................................... 88,460 96,133 301,913
Loss on equipment disposal........................................ 230 -- --
Deferred income taxes............................................. (249,000) 140,659 99,484
Write-off of investment........................................... 6,676 -- --
Changes in:
Trade receivables............................................... 297,211 (29,128) 41,336
Inventories..................................................... (311,845) (1,156,643) (668,900)
Prepaid expenses and other current assets....................... (565,669) 373,807 (166,027)
Trade payables.................................................. 305,776 277,909 2,423,819
Income taxes payable............................................ -- 835,409 143,099
Accrued liabilities and royalty payable to stockholders......... 111,514 944,547 1,099,819
Customer deposits............................................... 5,126 25,473 107,084
------------ ------------- -------------
Net cash provided by operating activities..................... 381,383 3,929,332 15,867,121
------------ ------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Sale (purchase) of investment in certificate of deposit............. (100,000) 100,000 --
Additions to furniture and equipment................................ (123,516) (278,886) (1,738,836)
Additions to other assets........................................... (3,201) (22,514) (12,309)
Prepaid acquisition cost of Nautilus................................ -- -- (120,454)
------------ ------------- -------------
Net cash used in investing activities......................... (226,717) (201,400) (1,871,599)
------------ ------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Principal payments under capital lease obligation................... (8,269) (9,113) (9,167)
Proceeds from issuing common stock.................................. 251,890 15,586 134,004
Stock repurchased................................................... -- (98,120) --
------------ ------------- -------------
Net cash provided by (used in) financing activities........... 243,621 (91,647) 124,837
------------ ------------- -------------
NET INCREASE IN CASH AND CASH EQUIVALENTS............................. 398,287 3,636,285 14,120,359
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR.......................... 755,744 1,154,031 4,790,316
------------ ------------- -------------
CASH AND CASH EQUIVALENTS, END OF YEAR................................ $ 1,154,031 $ 4,790,316 $ 18,910,675
------------ ------------- -------------
------------ ------------- -------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest.............................................. $ 2,225 $ 1,381 $ 455
Cash paid for income taxes.......................................... -- 250,000 6,465,006
SUPPLEMENTAL DISCLOSURE OF NONCASH FINANCING TRANSACTIONS--Tax benefit
of exercise of nonqualified options................................. $ -- $ 34,281 $ 439,452
</TABLE>
See notes to financial statements.
F-7
<PAGE>
DIRECT FOCUS, INC.
NOTES TO FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1998
(1) ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION
Direct Focus, Inc. (the "Company") is a direct marketing company that
develops and markets premium quality, premium priced, branded consumer products.
The Company markets consumer products directly to consumers through a variety of
direct marketing channels, including spot television commercials, infomercials,
print media, response mailings, and the internet. The Company's principal
products are the Bowflex line of home fitness equipment and recently the Company
has introduced a direct marketing campaign for a line of premium airbeds.
The Company is registered under the laws of the State of Washington and is
subject to the securities laws of Ontario (Ontario Securities Commission),
Canada and the regulations of the Toronto Stock Exchange.
USE OF ACCOUNTING ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on hand, cash deposited with banks
and financial institutions and highly liquid debt instruments purchased with
maturity date of three months or less at date of acquisition. The Company
maintains its cash in bank deposit accounts which, at times, may exceed
federally insured limits. The Company has not experienced any losses in such
accounts.
INVENTORIES
Inventories, which include assembly and testing labor, are stated at the
lower of average cost or market.
ADVERTISING
The Company expenses the production costs of advertising the first time the
advertising takes place.
FURNITURE AND EQUIPMENT
Furniture and Equipment is stated at cost. Depreciation is computed using
the straight-line method over estimated useful lives of three to seven years,
except for the capital lease equipment which is being depreciated over the life
of the lease.
Management reviews investment in long-lived assets for possible impairment
whenever events or circumstances indicate the carrying amount of an asset may
not be recoverable. There have been no such events or circumstances in the three
years ended December 31, 1998. If there were an indication
F-8
<PAGE>
DIRECT FOCUS, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
THREE YEARS ENDED DECEMBER 31, 1998
(1) ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
of impairment, management would prepare an estimate of future cash flows
(undiscounted and without interest charges) expected to result from the use of
the asset and its eventual disposition. If these cash flows were less than the
carrying amount of the asset, an impairment loss would be recognized to write
down the asset to its estimated fair value.
OTHER ASSETS
Other Assets consist specifically of acquisition costs, license agreements
and patents and trademarks. Amortization is computed using the straight-line
method over estimated useful lives of 3 to 17 years.
WARRANTY COSTS
The Company's warranty policy provides for coverage for defects in material
and workmanship. Warranty periods on the Company's products range from two to
five years on Bowflex line of home fitness products and twenty years on airbeds.
A provision for estimated warranty costs has been provided and is included in
accrued liabilities.
REVENUE RECOGNITION
Revenue from product sales is recognized at the time of shipment. The
Company has established reserves for potential sales returns for 1997 and 1998
of $285,000 and $600,704, respectively, based upon historical experience.
INCOME TAXES
Deferred income tax assets and liabilities are computed annually for
differences between the financial statement and tax bases of assets and
liabilities that will result in taxable or deductible amounts in the future
based on enacted tax laws and rates applicable to periods in which the
differences are expected to affect taxable income. A valuation allowance is
established when necessary to reduce deferred tax assets to the amount more
likely than not to be realized. Income tax expense is the tax payable or
refundable for the period plus or minus the change during the period in deferred
tax assets and liabilities.
COMPREHENSIVE INCOME
Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards ("SFAS") No. 130, REPORTING COMPREHENSIVE INCOME, which
requires presentation of comprehensive income within an entity's primary
financial statements. Comprehensive income is defined as net income as adjusted
for changes to equity resulting from events other than net income or
transactions related to an entity's capital structure. Comprehensive income
equaled net income for all periods presented.
F-9
<PAGE>
DIRECT FOCUS, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
THREE YEARS ENDED DECEMBER 31, 1998
(1) ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
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. Currently, the Company is operating as a single segment.
FUTURE ACCOUNTING PRONOUNCEMENTS
In June 1998, the FASB issued SFAS No. 133, ACCOUNTING FOR DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES, which establishes accounting and reporting
standards for derivative instruments and for hedging activities. Currently, the
Company does not engage in any derivative or hedging activities.
RECLASSIFICATIONS
Certain amounts from the 1996 and 1997 have been reclassified to conform to
the 1998 presentation.
(2) ACQUISITION
Effective January 4, 1999, the Company acquired substantially all of the net
assets of Nautilus International, Inc. ("Nautilus"), a manufacturer and
distributor of commercial fitness equipment. The acquisition has been accounted
for under the purchase method of accounting. The Company paid approximately
$16.2 million for the assets and intellectual property of Nautilus and assumed
$2.6 million in current liabilities.
The unaudited pro forma financial information below for the fiscal year
ended December 31, 1998 was prepared as if the transaction had occurred on
January 1, 1998:
<TABLE>
<CAPTION>
<S> <C>
Revenue........................................................................ $ 76,600,696
Net income..................................................................... $ 9,868,213
Basic earnings per share....................................................... $ 1.06
Diluted earnings per share..................................................... $ 1.01
</TABLE>
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 do they purport to indicate the results of
future operations of the Company.
(3) INVENTORIES
Inventories at December 31 consisted of the following:
<TABLE>
<CAPTION>
1997 1998
------------ ------------
<S> <C> <C>
Finished goods.................................................... $ 1,156,862 $ 1,758,171
Parts and components.............................................. 788,911 856,502
------------ ------------
</TABLE>
F-10
<PAGE>
DIRECT FOCUS, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
THREE YEARS ENDED DECEMBER 31, 1998
(3) INVENTORIES (CONTINUED)
<TABLE>
<CAPTION>
1997 1998
------------ ------------
<S> <C> <C>
Total......................................................... $ 1,945,773 $ 2,614,673
------------ ------------
------------ ------------
</TABLE>
(4) ACCRUED LIABILITIES
Accrued liabilities at December 31 consisted of the following:
<TABLE>
<CAPTION>
1997 1998
------------ ------------
<S> <C> <C>
Accrued expenses.................................................. $ 162,261 $ 127,970
Accrued payroll................................................... 114,569 357,033
Accrued payroll taxes............................................. 60,515 185,996
Sales return reserve.............................................. 285,000 600,704
Accrued advertising............................................... 92,144 275,298
Accrued bonus..................................................... 175,000 20,411
Accrued other..................................................... 199,645 283,871
------------ ------------
Total......................................................... $ 1,089,134 $ 1,851,253
------------ ------------
------------ ------------
</TABLE>
(5) COMMITMENTS AND CONTINGENCIES
LINES OF CREDIT
During 1998, the Company obtained two lines of credit for $5,000,000 each
with a bank. Both lines are secured by the Company's general assets, and
interest is payable on outstanding borrowings under each line at the bank's
prime rate (7.75% at December 31, 1998). There were no outstanding borrowings on
these lines of credit at December 31, 1998.
OPERATING LEASES
The Company leases its office and warehouse facilities under an operating
lease which expires April 30, 2002. The lease commitment is subject to an annual
rent adjustment based upon changes in the consumer price index, limited to a
6.0% annual change. The agreement provides for an annual cancellation provision
by the Company upon proper notification. Under a separate agreement in 1997,
which was amended in 1998, the Company leased additional warehouse facilities.
This operating lease expires May 31, 2000. Rent expense under these leases was
$66,714 in 1996, $107,361 in 1997, and $239,197 in 1998.
F-11
<PAGE>
DIRECT FOCUS, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
THREE YEARS ENDED DECEMBER 31, 1998
(5) COMMITMENTS AND CONTINGENCIES (CONTINUED)
OBLIGATIONS
Future minimum lease payments under the operating leases during the years
ending December 31 are as follows:
<TABLE>
<CAPTION>
<S> <C>
1999.............................................................................. $ 300,324
2000.............................................................................. 186,664
2001.............................................................................. 73,644
2002.............................................................................. 24,548
----------
Total minimum lease payments.................................................. $ 585,180
----------
----------
</TABLE>
EMPLOYMENT CONTRACTS
Three officers of the Company are employed under employment contracts, which
expire January 1, 2000 and provide for total compensation of $495,000.
LITIGATION
A competitor has filed an action against the Company and one of its
officers, alleging violations of the competitor's intellectual property rights.
The competitor seeks to recover any profits it would have earned but for the
Company's allegedly improper activities, any profits the Company earned during
any period in which an alleged violation may have occurred, and/or the cost of
any corrective advertising. If the competitor successfully prosecutes any of its
claims against the Company, the resulting monetary damages and/or injunctive
relief could have a material adverse effect on the Company's financial position,
results of operations and/or cash flows. Additionally, in the normal course of
business, the Company is a party to various other legal claims, actions, and
complaints.
Although it is not possible to predict with certainty whether the Company
will ultimately be successful in any of these legal matters, or what the impact
might be, the Company believes that disposition of these matters will not have a
material adverse effect on the Company's financial position, results of
operations or cash flows.
(6) PRIVATE PLACEMENT SUBSCRIPTION AGREEMENT
During 1996, the Company entered into a Private Placement Subscription
Agreement (the "Agreement") to issue 750,000 shares of common shares at $0.33
per share. Net proceeds, after deducting expenses of $2,910 were $247,090. In
addition, upon meeting certain conditions the Agreement would grant to the
subscriber nontransferable common share purchase warrants to purchase up to
1,280,000 common shares subject to certain conditions. These conditions were not
met in 1997 and the warrants expired.
(7) STOCK OPTIONS
The Company's stock-based compensation plan was adopted in June 1995. The
Company can issue both nonqualified stock options to the Company's officers and
directors and qualified options to
F-12
<PAGE>
DIRECT FOCUS, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
THREE YEARS ENDED DECEMBER 31, 1998
(7) STOCK OPTIONS (CONTINUED)
the Company's employees. The plan was amended in June 1998 so the Company may
grant options for up to 1,857,961 shares of common stock. The plan is
administered by the Company's Board of Directors which determines the terms and
conditions of the various grants awarded under these plans. Stock options
granted generally have an exercise price equal to the market price of the
Company's stock on the date of the grant, and vesting periods vary by option
granted, generally no longer than three years.
In October 1995, the Financial Accounting Standards Board issued SFAS No.
123, ACCOUNTING FOR STOCK-BASED COMPENSATION, which encouraged (but did not
require) that stock-based compensation cost be recognized and measured by the
fair value of the equity instrument awarded. The Company did not change its
method of accounting for its stock-based compensation plans and will continue to
apply Accounting Principles Board Opinion No. 25, ACCOUNTING FOR STOCK-BASED
COMPENSATION PLANS ISSUED TO EMPLOYEES, and related interpretations in
accounting for these plans. Accordingly, no compensation cost has been
recognized for these plans in the financial statements. If compensation cost on
stock options granted in 1996, 1997, and 1998 under these plans had been
determined based on the fair value of the options consistent with that described
in SFAS No. 123, the Company's net income and earnings per share would have been
reduced to the pro forma amounts indicated below for the years ended December
31, 1996, 1997, and 1998:
<TABLE>
<CAPTION>
1996 1997 1998
---------- ------------ -------------
<S> <C> <C> <C>
Net income, as reported............................. $ 692,904 $ 2,421,166 $ 12,485,494
Net income, pro forma............................... 671,452 2,334,082 12,274,208
Diluted earnings per share, as reported............. $ 0.08 $ 0.25 $ 1.28
Diluted earnings per share, pro forma............... $ 0.08 $ 0.25 $ 1.26
</TABLE>
The pro forma amounts may not be indicative of the effects on reported net
income for future years due to the effect of options vesting over a period of
years and the awarding of stock compensation awards in future years.
The fair value of each option grant was estimated on the date of grant using
the Black-Scholes option-pricing model with the following weighted-average
assumptions used for grants in 1996, 1997, and 1998, respectively; all options
granted will vest as scheduled; no dividend yield for all three years; risk-free
interest rate of 5.9%, 5.5%, and 5%; expected volatility of 178%, 93% and 76%;
expected lives of five years for all three years.
F-13
<PAGE>
DIRECT FOCUS, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
THREE YEARS ENDED DECEMBER 31, 1998
(7) STOCK OPTIONS (CONTINUED)
A summary of the status of the Company's stock option plans as of December
31, 1996, 1997, and 1998, and changes during the years ended on those dates is
presented below.
<TABLE>
<CAPTION>
1996 1997 1998
----------------------- ----------------------- -----------------------
<S> <C> <C> <C> <C> <C> <C>
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
---------- ----------- ---------- ----------- ---------- -----------
Outstanding at beginning of year............. 535,000 $ 0.43 646,500 $ 0.18 813,113 $ 0.47
Granted...................................... 356,500 0.20 386,500 0.96 188,000 5.70
Forfeited or canceled........................ (205,000) 0.87 (90,000) 0.98 (7,300) 0.96
Exercised.................................... (40,000) 0.12 (129,887) 0.12 (443,195) 0.30
---------- ----- ---------- ----- ---------- -----
Outstanding at end of year................... 646,500 $ 0.18 813,113 $ 0.47 550,618 $ 2.39
---------- ----- ---------- ----- ---------- -----
---------- ----- ---------- ----- ---------- -----
Options exercisable of end of year........... 465,000 504,779 309,199
---------- ---------- ----------
---------- ---------- ----------
Weighted average for value of options granted
in current year............................ $ 0.26 $ 0.91 $ 3.72
---------- ---------- ----------
---------- ---------- ----------
</TABLE>
The following table summarizes information about stock options outstanding
as of December 31, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
- ----------------------------------------------------------------------------------------------- ------------------------
AVERAGE WEIGHTED WEIGHTED
REMAINING AVERAGE NUMBER OF AVERAGE
NUMBER CONTRACTUAL EXERCISE SHARES EXERCISE
RANGE OF EXERCISE PRICES OUTSTANDING LIFE (YEARS) PRICE EXERCISABLE PRICE
- ---------------------------------------------------- ----------- --------------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C>
$0.12 - $0.98 362,618 3.0 $ 0.68 264,617 $ 0.64
$4.62 - $9.75 188,000 4.3 5.70 44,582 4.94
--
----------- ----- ----------- -----
$0.12 - $9.75 550,618 3.4 $ 2.39 309,199 $ 1.26
--
--
----------- ----- ----------- -----
----------- ----- ----------- -----
</TABLE>
(8) INCOME TAXES
The tax effect of temporary differences that give rise to deferred tax
assets and liabilities at December 31, 1997 and 1998 can be summarized as
follows:
<TABLE>
<CAPTION>
1997 1998
----------------------- -----------------------
<S> <C> <C> <C> <C>
CURRENT LONG-TERM CURRENT LONG-TERM
DEFERRED DEFERRED DEFERRED DEFERRED
---------- ----------- ---------- -----------
Deferred tax assets.............................................. $ 222,139 $ 26,202 $ 311,426 $ --
Deferred tax liabilities......................................... -- -- (95,689) (66,880)
---------- ----------- ---------- -----------
Deferred income taxes, net................................... $ 222,139 $ 26,202 $ 215,737 $ (66,880)
---------- ----------- ---------- -----------
---------- ----------- ---------- -----------
</TABLE>
F-14
<PAGE>
DIRECT FOCUS, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
THREE YEARS ENDED DECEMBER 31, 1998
(8) INCOME TAXES (CONTINUED)
The expense (benefit) for income taxes consists of the following:
<TABLE>
<CAPTION>
1996 1997 1998
----------- ------------ ------------
<S> <C> <C> <C>
Current:
Federal............................................ $ -- $ 1,085,409 $ 6,608,100
Deferred:
Federal............................................ (249,000) 140,659 99,484
----------- ------------ ------------
Total income tax expense (benefit)............... $ (249,000) $ 1,226,068 $ 6,707,584
----------- ------------ ------------
----------- ------------ ------------
</TABLE>
The principal differences between taxes on income computed at the statutory
federal income tax rate and recorded income tax expense (benefit) for 1996,
1997, or 1998 are as follows:
<TABLE>
<CAPTION>
1996 1997 1998
----------- ------------ ------------
<S> <C> <C> <C>
Tax computed at statutory rate....................... $ 155,366 $ 1,240,060 $ 6,717,577
Change in valuation allowance........................ (385,000) -- --
Other................................................ (19,366) (13,992) (9,993)
----------- ------------ ------------
Income tax expenses (benefit).................... $ (249,000) $ 1,226,068 $ 6,707,584
----------- ------------ ------------
----------- ------------ ------------
</TABLE>
(9) EARNINGS PER SHARE
Effective for the year beginning January 1, 1997, the Company adopted SFAS
No. 128, EARNINGS PER SHARE. SFAS No. 128 established new standards for
computing and presenting earnings per share and, accordingly, all periods have
been restated. The per share amounts are based on the weighted average number of
basic and dilutive common equivalent shares assumed to be outstanding during the
period of computation. Net income for the calculation of both basic and diluted
earnings per share is the same for all periods.
The calculation of weighted average outstanding shares is as follows:
<TABLE>
<CAPTION>
AVERAGE SHARES
----------------------------------
<S> <C> <C> <C>
1996 1997 1998
---------- ---------- ----------
Basic shares outstanding............................... 8,558,227 8,986,655 9,336,525
Common stock equivalents............................... 385,058 524,213 389,433
---------- ---------- ----------
Diluted shares outstanding............................. 8,943,285 9,510,868 9,725,958
---------- ---------- ----------
---------- ---------- ----------
</TABLE>
(10) RELATED-PARTY TRANSACTIONS
The Company incurred royalty expense under an agreement with a stockholder
of the Company of $220,397 in 1996, $530,805 in 1997, and $1,603,821 in 1998, of
which $210,511 and $548,211 was payable at December 31, 1997 and 1998,
respectively.
F-15
<PAGE>
DIRECT FOCUS, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
THREE YEARS ENDED DECEMBER 31, 1998
(10) RELATED-PARTY TRANSACTIONS (CONTINUED)
The Company incurred royalty expense under an agreement with a stockholder
who is a director of the Company of $41,048, $36,722, and zero in 1996, 1997,
and 1998, respectively.
The Company incurred investment consulting expense under an agreement with a
director of the Company of $30,000 in 1997, all of which was paid in 1997. This
agreement expired in 1997.
The Company incurred attorney fees to a director of the Company of $2,692,
$4,401, and $5,545 in 1996, 1997, and 1998, respectively.
(11) FAIR VALUE OF FINANCIAL INSTRUMENTS
FASB Statement No. 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL
INSTRUMENTS, requires disclosure of fair value information about financial
instruments when it is practicable to estimate that value. The carrying amount
of the Company's cash, trade receivables, trade payables, royalty payables, and
accrued liabilities approximates their estimated fair values due to the
short-term maturities of those financial instruments.
F-16
<PAGE>
DIRECT FOCUS, INC. AND AFFILIATE
UNAUDITED PRO FORMA COMBINED FINANCIAL STATEMENTS
BASIS OF PRESENTATION
Effective January 4, 1999, Direct Focus, Inc. ("Direct Focus") acquired
substantially all of the assets of Nautilus International, Inc. ("Nautilus").
Direct Focus accounted for the acquisition using the purchase method of
accounting. Direct Focus paid $16.2 million in cash for the assets and assumed
approximately $2.6 million in current liabilities. Because of the Nautilus
acquisition, several adjustments and factors will impact the comparability of
our historical financial results with our future results of operations. The
following unaudited pro forma combined financial statements reflect: (1) certain
adjustments for the effects of purchase accounting; (2) certain assumptions
described below regarding financing and cash management aspects of the
transaction; and (3) a provision for income taxes as if the combined operations
had been taxed as a C-corporation for all periods presented.
In addition, the unaudited pro forma combined balance sheet has been
prepared as if the Nautilus acquisition had occurred on December 31, 1998. The
unaudited pro forma combined statement of operations was prepared as if the
Nautilus acquisition were consummated on January 1, 1998. Direct Focus believes
that all adjustments necessary to present fairly the unaudited pro forma
combined financial statements have been made. These financial statements are not
necessarily indicative of what actual results would have been had the
transaction occurred on January 1, 1998, nor do they purport to indicate the
future results of Direct Focus's operations. The unaudited pro forma combined
financial statements should be read in conjunction with our financial statements
and accompanying notes and the financial statements of Nautilus and related
notes appearing elsewhere in this prospectus.
The costs of the acquisition have been allocated to the assets acquired and
liabilities assumed based on their fair values at the date of acquisition as
determined by management. The allocation of the costs of acquisitions is
preliminary while the Company obtains final information regarding the fair
values of all assets acquired; however, management believes that any adjustments
to the amounts allocated will not have a material effect on the Company's
financial position or results of operations.
F-17
<PAGE>
DIRECT FOCUS, INC. AND AFFILIATE
PRO FORMA COMBINED BALANCE SHEET
DECEMBER 31, 1998
(UNAUDITED)
<TABLE>
<CAPTION>
DIRECT FOCUS, NAUTILUS
INC. BUSINESS ADJUSTMENTS PRO FORMA
---------------- ------------- --------------- -------------
<S> <C> <C> <C> <C>
Current Assets:
Cash and cash equivalents............... $ 18,910,675 13,309 $ (16,213,309 (1) $ 2,710,675
Trade Receivables....................... 218,207 3,226,325 (193,332 (2) 3,251,200
Inventories............................. 2,614,673 4,104,131 (1,000,000 (2) 5,718,804
Prepaid expenses and other current
assets................................ 594,146 111,552 -- 705,698
---------------- ------------- --------------- -------------
Total current assets.................. 22,337,701 7,455,317 17,406,641 12,386,377
Furniture and equipment................... 1,842,712 10,663,438 (2,029,085 (2) 10,477,065
Other Assets.............................. 192,859 677,808 3,697,118 )(3 4,567,785
---------------- ------------- --------------- -------------
Total..................................... $ 24,373,272 $ 18,796,563 $ (15,738,608) $ 27,431,227
---------------- ------------- --------------- -------------
---------------- ------------- --------------- -------------
Current Liabilities:
Trade payables.......................... $ 3,602,074 $ 414,449 $ 441,000 )(5 $ 4,457,523
Income taxes payable.................... 504,775 -- -- 504,775
Accrued liabilities..................... 2,548,401 2,437,577 (333,659) 4,652,319
Due to affiliate........................ -- 39,562,874 (39,562,874 (4) --
---------------- ------------- --------------- -------------
Total current liabilities............. 6,655,250 42,414,900 (39,455,533) 9,614,617
Long-term Liabilities..................... 66,880 98,588 -- 165,468
Total Stockholders' Equity................ 17,651,142 (23,716,925) 23,716,925(4) 17,651,142
---------------- ------------- --------------- -------------
Total..................................... $ 24,373,272 $ 18,796,563 $ (15,738,608) $ 27,431,227
---------------- ------------- --------------- -------------
---------------- ------------- --------------- -------------
</TABLE>
- ------------------------
(1) Represents $16.2 million cash paid for Nautilus and cash not acquired from
Nautilus.
(2) To record the estimated fair value of assets acquired and liabilities
assumed in the Nautilus acquisition. The purchase price was comprised of
$16.2 million in cash and $2.6 million in assumed current liabilities.
<TABLE>
<CAPTION>
NAUTILUS
HISTORICAL
NET ASSETS ACQUIRED DECEMBER 31, 1998 FAIR VALUE
- ----------------------------------------------------------- ----------------- -------------
<S> <C> <C>
Accounts receivables....................................... $ 3,226,325 $ 3,032,993(a)
Inventories................................................ 4,104,131 3,104,131(b)
Prepaid expenses and other current assets.................. 111,551(2) 111,551(2)
Furniture and equipment.................................... $ 10,663,438 8,634,353
Liabilities assumed........................................ (2,950,614) (2,557,955)(c)
----------------- -------------
Total...................................................... $ 15,253,420 $ 12,325,074
----------------- -------------
----------------- -------------
</TABLE>
(a) Excludes $193,332 of current receivables not purchased.
(b) Reflects $1 million of inventories related to Nautilus products which
will be discontinued.
(c) Excludes $59,000 of trade payables and $333,659 of accrued vacation not
assumed.
F-18
<PAGE>
DIRECT FOCUS, INC. AND AFFILIATE
PRO FORMA COMBINED BALANCE SHEET (CONTINUED)
DECEMBER 31, 1998
(UNAUDITED)
(3) Includes $4,374,926 representing the estimated fair value of the Nautilus
brand trademark, less $677,808 of finance notes receivable not acquired by
Direct Focus.
(4) Reflects the elimination of Nautilus' deficit and amounts due to an
affiliate, which Direct Focus did not assume.
(5) Includes $500,000 of acquisition costs and excludes $59,000 of trade
payables not assumed.
F-19
<PAGE>
DIRECT FOCUS, INC. AND AFFILIATE
PRO FORMA COMBINED STATEMENT OF OPERATIONS
YEAR ENDED DECEMBER 31, 1998
(UNAUDITED)
<TABLE>
<CAPTION>
DIRECT FOCUS, PRO FORMA
INC. NAUTILUS ADJUSTMENTS PRO FORMA
---------------- -------------- ----------------- -----------------
<S> <C> <C> <C> <C>
Net sales................................ $ 57,296,880 $ 19,303,816 $ -- $ 76,600,696
Cost of Sales............................ 12,442,307 14,932,771 (1,069,827)(1) 26,305,251
---------------- -------------- ----------------- -----------------
Gross profit........................... 44,854,573 4,371,045 1,069,827 50,295,445
Total Operating Expenses................. 25,966,567 8,948,514(7) (396,000)(2) 34,519,081
Impairment Charges....................... -- 11,200,000 (11,200,000)(3) --
---------------- -------------- ----------------- -----------------
Operating income (loss)................ 18,888,006 (15,777,469) 12,665,827 15,776,364
Interest Expense......................... (455) (3,142,238) 2,754,256(4) (388,437)
Other Income (Expense)................... 305,527 81,244 (608,205)(5) (221,434)
---------------- -------------- ----------------- -----------------
Net income (loss) before income
taxes................................ 19,193,078 (18,838,463) 14,811,878 15,166,493
Income Taxes............................. 6,707,584 -- (1,409,305)(6) 5,298,279
---------------- -------------- ----------------- -----------------
Net Income (Loss)........................ $ 12,485,494 $ (18,838,463) $ 16,221,182 $ 9,868,213
---------------- -------------- ----------------- -----------------
---------------- -------------- ----------------- -----------------
Basic Earnings Per Share................. $ 1.34 $ 1.06
---------------- -----------------
---------------- -----------------
Diluted Earnings Per Share............... $ 1.28 $ 1.01
---------------- -----------------
---------------- -----------------
Basic Outstanding Shares................. 9,336,525 9,336,525
---------------- -----------------
---------------- -----------------
Diluted Outstanding Shares............... 9,725,958 9,725,958
---------------- -----------------
---------------- -----------------
</TABLE>
- ------------------------
(1) Reflects a $1.1 million decrease in depreciation expense associated with the
depreciation of acquired property with an estimated fair value of $8.6
million. The depreciation is on a straight-line basis over periods ranging
from 7 to 31.5 years.
(2) Reflects a decrease in total operating expenses of $340,000 related to
reduced amortization of the estimated intangible asset value of $4.4 million
and $56,000 relating to reduced depreciation expense. As discussed in note 3
below, Nautilus recorded an impairment charge to reduce the net book value
of its assets based upon the acquisition price. The intangible asset is
assumed to be amortized over 20 years on a straight-line basis.
(3) The $11.2 million adjustment eliminates the effect of a one-time impairment
charge taken by Nautilus International in connection with the revaluation of
its assets based upon the $18.8 million acquisition price, including
assumption of $2.6 million of current liabilities.
(4) Eliminates $3,142,238 of interest expense incurred by Nautilus on its debt
during 1998 and includes $387,982 of interest expense Direct Focus would
have incurred on short-term borrowings for a portion of the purchase price
had the acquistion occurred on January 1, 1998. Reflects a $2.8 million
decrease in interest expense, which would have resulted had the acquisition
occurred on January 1, 1998.
(5) Reflects a $608,000 decrease in other income relating to interest income
that Direct Focus would have foregone by using cash in the acquisition.
(6) The $1.4 million decrease in income tax expense reflects income tax expense
at Direct Focus's effective tax rates after giving effect to the adjustments
described above.
(7) Operating expenses for Nautilus include $73,000 of management fees for
various corporate services provided by Nautilus's former parent corporation
(see Note 10 to Nautilus Business Combined Financial Statements). Direct
Focus's management believes that these costs approximate the costs that
Nautilus would have incurred on a stand-alone basis.
F-20
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Boards of Directors of
Delta Woodside, Inc.:
We have audited the accompanying combined balance sheets of the Nautilus
Business (the "Business"), as described in Note 1, as of January 4, 1999, June
27, 1998 and June 28, 1997, and the related combined statements of operations
and accumulated deficit and cash flows for the six-months ended January 4, 1999
and for each of the years in the three-year period ended June 27, 1998. These
combined financial statements are the responsibility of the Business'
management. Our responsibility is to express an opinion on these combined
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the combined financial statements referred to above present
fairly, in all material respects, the financial position of the Nautilus
Business as of January 4, 1999, June 27, 1998 and June 28, 1997, and the results
of its operations and cash flows for the six-months ended January 4, 1999, and
each of the years in the three-year period ended June 27, 1998, in conformity
with generally accepted accounting principles.
KPMG Peat Marwick LLP
Greenville, South Carolina
February 19, 1999
F-21
<PAGE>
NAUTILUS BUSINESS
(AS DESCRIBED IN NOTE 1)
COMBINED BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
JUNE 28, JUNE 27, JANUARY 4,
1997 1998 1999
-------------- -------------- --------------
<S> <C> <C> <C>
Current assets:
Cash............................................................ $ 1,790 $ 1,600 $ 13,309
Accounts receivable (note 3):
Customer...................................................... 4,196,491 4,414,042 3,431,678
Other......................................................... 155,049 74,912 51,315
Less allowance for doubtful accounts.......................... (910,464) (883,497) (449,721)
-------------- -------------- --------------
3,441,076 3,605,457 3,033,272
-------------- -------------- --------------
Financed notes, net (note 4).................................... 579,974 321,223 193,053
Inventories (note 2):
Raw materials................................................. 2,078,598 1,730,295 1,664,175
Work in process............................................... 1,597,676 1,614,862 1,593,417
Finished goods................................................ 702,141 970,206 823,364
Supplies...................................................... 25,574 20,661 23,175
-------------- -------------- --------------
4,403,989 4,336,024 4,104,131
-------------- -------------- --------------
Prepaids and other current assets (note 2)...................... 125,544 122,103 111,552
-------------- -------------- --------------
Total current assets.......................................... 8,552,373 8,386,407 7,455,317
-------------- -------------- --------------
Property, plant and equipment, net (note 5)....................... 12,897,432 11,522,745 10,663,438
Financed notes receivable (note 4)................................ 1,640,723 1,202,811 677,808
Intangible assets, net (note 6)................................... 11,476,601 1,987,961 --
-------------- -------------- --------------
$ 34,567,129 $ 23,099,924 $ 18,796,563
-------------- -------------- --------------
-------------- -------------- --------------
LIABILITIES AND STOCKHOLDER'S EQUITY
Current liabilities:
Accounts payable................................................ 271,892 515,223 407,261
Bank overdraft.................................................. 552,658 469,963 7,188
Accrued employee compensation................................... 824,194 1,084,480 951,831
Other accrued expenses (note 7)................................. 1,946,448 1,046,636 1,485,746
Due to affiliates, net (note 10)................................ 33,011,924 36,992,270 39,562,874
Current bond obligations........................................ 116,566 -- --
-------------- -------------- --------------
Total current liabilities..................................... 36,723,682 40,108,572 42,414,900
-------------- -------------- --------------
Other liabilities................................................. 70,000 13,138 98,588
-------------- -------------- --------------
Total liabilities............................................. 36,793,682 40,121,710 42,513,488
-------------- -------------- --------------
Stockholder's deficit:
Common stock, $1 par value, authorized, issued and outstanding 100
shares.......................................................... 100 100 100
Additional paid in capital...................................... 10,692,506 10,692,506 10,692,506
Accumulated deficit............................................. (12,919,159) (27,714,392) (34,409,531)
-------------- -------------- --------------
Total stockholder's deficit................................... (2,226,553) (17,021,786) (23,716,925)
-------------- -------------- --------------
Commitments and contingencies
$ 34,567,129 $ 23,099,924 $ 18,796,563
-------------- -------------- --------------
-------------- -------------- --------------
</TABLE>
See accompanying notes to combined financial statements
F-22
<PAGE>
NAUTILUS BUSINESS
(AS DESCRIBED IN NOTE 1)
COMBINED STATEMENTS OF OPERATIONS AND ACCUMULATED DEFICIT
<TABLE>
<CAPTION>
YEAR ENDED SIX-MONTHS ENDED
---------------------------------------- ---------------------------
JUNE 29, JUNE 28, JUNE 27, DECEMBER 27, JANUARY 4,
1996 1997 1998 1997 1999
------------ ------------ ------------ ------------ -------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Net sales..................... $ 28,591,447 $ 21,935,298 $ 20,851,063 $10,719,671 $ 9,172,424
Cost of goods sold............ 19,914,644 17,134,933 16,291,581 8,630,779 7,271,969
------------ ------------ ------------ ------------ -------------
Gross profit................ 8,676,803 4,800,365 4,559,482 2,088,892 1,900,455
------------ ------------ ------------ ------------ -------------
Selling, general and
administrative expenses..... (13,463,038) (11,014,925) (7,704,677) (3,426,338 ) (4,523,590)
Impairment charges (note 2)... -- -- (8,800,000) -- (2,400,000)
Intercompany management
fees........................ (228,000) (302,428) (194,471) (125,535 ) (3,573)
Royalty income (note 2)....... 474,125 445,121 268,779 181,572 97,724
Other income (expense)........ 4,028 90,265 (42,871) 58,120 (158,016)
------------ ------------ ------------ ------------ -------------
Operating loss.............. (4,536,082) (5,981,602) (11,913,758) (1,223,289 ) (5,087,000)
------------ ------------ ------------ ------------ -------------
Interest income (expense):
Interest income............. 662,615 160,913 112,966 62,579 34,363
Interest expense............ (67,656) (19,141) (24,774) (24,774 ) (3,506)
Intercompany interest
expense................... (1,879,433) (2,158,509) (2,969,667) (1,466,425 ) (1,638,996)
------------ ------------ ------------ ------------ -------------
(1,284,474) (2,016,737) (2,881,475) (1,428,620 ) (1,608,139)
------------ ------------ ------------ ------------ -------------
Loss before taxes............. (5,820,556) (7,998,339) (14,795,233) (2,651,909 ) (6,695,139)
Income tax benefit (note 9)... (2,495,057) (1,202,379) -- -- --
------------ ------------ ------------ ------------ -------------
Net loss (3,325,499) (6,795,960) (14,795,233) (2,651,909 ) (6,695,139)
Accumulated deficit, beginning
of year..................... (2,797,700) (6,123,199) (12,919,159) (12,919,159 ) (27,714,392)
------------ ------------ ------------ ------------ -------------
Accumulated deficit, end of
year........................ $ (6,123,199) $(12,919,159) $(27,714,392) $(15,571,068) $ (34,409,531)
------------ ------------ ------------ ------------ -------------
------------ ------------ ------------ ------------ -------------
</TABLE>
See accompanying notes to combined financial statements
F-23
<PAGE>
NAUTILUS BUSINESS
(AS DESCRIBED IN NOTE 1)
COMBINED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED SIX-MONTHS ENDED
---------------------------------------- ---------------------------
JUNE 29, JUNE 28, JUNE 27, DECEMBER 27, JANUARY 4,
1996 1997 1998 1997 1999
------------ ------------ ------------ ------------ -------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Operating activities:
Net loss.................... $ (3,325,499) $ (6,795,960) $(14,795,233) $(2,651,909 ) $ (6,695,139)
Adjustments to reconcile net
loss to net cash provided
(used) by operating
activities:
Depreciation.............. 1,351,164 1,469,573 1,486,652 777,627 725,233
Amortization.............. 692,753 689,846 688,640 346,036 200,454
Deferred taxes............ (1,944,345) (1,185,199) -- -- --
Impairment charges........ -- -- 8,800,000 -- 2,400,000
Provision for losses on
accounts receivable..... 123,426 283,626 (119,575) (145,278 ) (308,594)
(Gain) loss on sale of
property and equipment.. -- (83,267) 1,595 -- --
Changes in operating
assets and liabilities:
Accounts receivable and
financed notes
receivable............ 2,595,441 1,543,410 651,857 (989,531 ) 1,533,952
Inventories............. (292,303) (231,699) 67,965 441,280 231,893
Prepaids and other
current assets........ 73,130 317,671 3,441 8,858 10,551
Other noncurrent
assets................ 111,268 -- -- -- --
Accounts payable........ (333,376) (658,453) 243,331 1,059,909 (107,962)
Bank overdraft.......... 406,725 20,710 (82,695) 342,473 (462,775)
Accrued employee
compensation.......... 53,057 159,367 260,286 (240,338 ) (132,649)
Other accrued
expenses.............. 478,266 412,894 (899,812) (700,879 ) 439,110
Other liabilities....... 15,664 (669,103) (56,862) 598,054 85,450
------------ ------------ ------------ ------------ -------------
Net cash provided
(used) by operating
activities.......... 5,371 (4,726,584) (3,750,410) (1,153,698 ) (2,080,476)
------------ ------------ ------------ ------------ -------------
Investing activities:
Purchases of property, plant
and equipment............. (863,354) (620,288) (121,185) (79,251 ) (57,419)
Proceeds from sale of
property, plant and
equipment................. -- 266,386 7,625 -- --
------------ ------------ ------------ ------------ -------------
Net cash used by
investing
activities.......... (863,354) (353,902) (113,560) (79,251 ) (57,419)
------------ ------------ ------------ ------------ -------------
Financing activities:
Principal payments on bond
obligations............... (9,576) (58,661) (116,566) (24,332 ) --
Change in due to affiliates,
net....................... 874,811 5,131,415 3,980,346 1,257,291 2,149,604
------------ ------------ ------------ ------------ -------------
Net cash provided by
financing
activities.......... 865,235 5,072,754 3,863,780 1,232,959 2,149,604
------------ ------------ ------------ ------------ -------------
Increase (decrease) in cash... 7,252 (7,732) (190) 10 11,709
Cash at beginning of year..... 2,270 9,522 1,790 1,790 1,600
------------ ------------ ------------ ------------ -------------
Cash at end of year........... $ 9,522 $ 1,790 $ 1,600 $ 1,800 $ 13,309
------------ ------------ ------------ ------------ -------------
------------ ------------ ------------ ------------ -------------
Supplemental disclosures of
cash flow information:
Interest paid............... $ 1,879,433 $ 2,158,509 $ 2,969,667 $ 1,466,425 $ 1,638,996
------------ ------------ ------------ ------------ -------------
------------ ------------ ------------ ------------ -------------
Non-cash investing and
financing activities:
Increase in intangible
assets and due to
affiliates, net........... -- -- -- -- 421,000
------------ ------------ ------------ ------------ -------------
------------ ------------ ------------ ------------ -------------
</TABLE>
See accompanying notes to combined financial statements.
F-24
<PAGE>
NAUTILUS BUSINESS
COMBINED FINANCIAL STATEMENTS
PERIOD ENDED JANUARY 4, 1999 AND
THREE YEARS ENDED JUNE 27, 1998
(1) BASIS OF PRESENTATION
The combined financial statements include the operations and accounts of
Nautilus International, Inc., a Virginia corporation, and the Nautilus
trademark, combined and referred to herein as the Business. The Business is
owned by Alchem Capital Corporation, a wholly owned subsidiary of Delta Woodside
Industries, Inc. ("DWI"). The accompanying combined financial statements have
been prepared for purposes of depicting the combined financial position and
results of operations of the Business on a historical cost basis.
The parent company, DWI, has sold certain assets and liabilities of the
Business (as defined in the Asset Purchase Agreement dated November 10, 1998) to
Direct Focus, Inc. The transaction closed on January 4, 1999.
All balances and transactions among the Business have been eliminated in
combination. Balances and transactions with other affiliates have not been
eliminated in the combination and are reflected as affiliate balances and
transactions.
(2) SIGNIFICANT ACCOUNTING POLICIES
(A) DESCRIPTION OF BUSINESS
The Business designs, manufactures, markets and services fitness
equipment. The Business sells its products and services in the domestic
market through direct sales representatives, distributors and dealers.
Internationally, the Business sells its products and services through a
network of distributors.
(B) FISCAL PERIODS
The Business' operations are based upon a fifty-two, fifty-three week
fiscal year ending on the Saturday closest to June 30. Fiscal years 1998,
1997 and 1996 each consist of 52 weeks. The six-month period ended
January 4, 1999, consists of 27 weeks.
(C) INTERIM FINANCIAL STATEMENTS
The combined financial statements for the six-month period ended December
27, 1997 are unaudited and are presented pursuant to the rules and
regulations of the Securities and Exchange Commission. In the opinion of
management, the accompanying combined financial statements reflect all
adjustments (which are of normal recurring nature) necessary to present
fairly the results of operations and cash flows for the interim period,
but are not necessarily indicative of the results of operations for a
full fiscal year.
(D) INVENTORIES
Inventories are stated at the lower of cost or market determined using
the first-in, first-out (FIFO) method.
Included in finished goods inventories are consignment inventory balances
which represent equipment which is used by customers on a trial basis.
The Business does not record revenue for trial equipment until the
customer agrees to purchase the items. However, in order to account for
the risk of loss if this equipment is not returned to the Business, a
reserve has been established where this equipment is depreciated over 3
years. The net book value of this
F-25
<PAGE>
NAUTILUS BUSINESS
COMBINED FINANCIAL STATEMENTS (CONTINUED)
PERIOD ENDED JANUARY 4, 1999 AND
THREE YEARS ENDED JUNE 27, 1998
(2) SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
consignment inventory is approximately $49,000, $43,000 and $57,000 as of
June 28, 1997, June 27, 1998 and January 4, 1999, respectively.
Included in finished goods inventories are used equipment which customers
trade-in when purchasing new equipment. The Business values this
equipment at the trade-in allowance and attempts to sell these items to
customers in the used fitness equipment market. The net book value of
this inventory is approximately $202,000, $177,000 and $207,000 as of
June 28, 1997, June 27, 1998 and January 4, 1999, respectively.
(E) PROPERTY, PLANT, AND EQUIPMENT
Property, plant, and equipment is stated on the basis of cost.
Depreciation is computed by the straight-line method for financial
reporting based on estimated useful lives of 3 to 31.5 years, and by
accelerated methods for income tax reporting.
(F) IMPAIRMENT OF LONG-LIVED ASSETS
The Business adopted the provisions of SFAS No. 121, ACCOUNTING FOR THE
IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED
OF, in fiscal year 1996. This Statement requires that long-lived assets
and certain identifiable intangibles be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable. Recoverability of assets to be held and
used is measured by a comparison of the carrying amount of an asset to
future net cash flows expected to be generated by the asset. If such
assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceed
the fair value of the assets.
In 1998, the Business' assets held for sale include all net assets except
for intercompany balances with affiliates. The net value of assets held
for sale have been written down to their estimated fair market value,
which is the net estimated purchase price of the Business of
approximately $20.0 million. Therefore, in order to value these assets
held for sale at their estimated fair market value, the Business has
recorded an impairment charge of $8.8 million during 1998, which was
recorded as a reduction in intangible assets, net. However in 1999, the
purchase price of certain assets of the Business was finalized at $16
million plus the assumption of certain liabilities. Therefore, in order
to value these assets held for sale at their estimated fair market value,
the Business recorded an additional impairment charge of $2.4 million
during the six-months ended January 4, 1999, which was recorded as a $2.2
million reduction in intangible assets, net and a $.2 million reduction
in property, plant and equipment, net.
(G) OTHER ASSETS
Other assets consist principally of prepaid insurance and prepaid
expenses for booth space related to future trade shows.
(H) RESEARCH AND DEVELOPMENT, AND ADVERTISING
Research and development, and advertising costs are expensed as incurred.
Research and development costs amounted to approximately $666,000,
$692,000 and $593,000 in 1996, 1997
F-26
<PAGE>
NAUTILUS BUSINESS
COMBINED FINANCIAL STATEMENTS (CONTINUED)
PERIOD ENDED JANUARY 4, 1999 AND
THREE YEARS ENDED JUNE 27, 1998
(2) SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
and 1998, respectively, and $310,000 for the six-months ended January 4,
1999. Advertising costs amounted to approximately $2,820,000, $1,142,000
and $600,000 in 1996, 1997 and 1998, respectively, and $357,000 for the
six-months ended January 4, 1999.
(I) REVENUE RECOGNITION
Sales are recorded upon shipment if the products are shipped with a
common carrier or upon installation if the Business' truck fleet is used
for delivery of the products.
(J) ROYALTY INCOME
The Business licenses its products through International Apparel
Marketing Corporation, a subsidiary of the Business' parent, Delta
Woodside Industries, Inc. The Business receives 35% of the royalties
earned by International Apparel Marketing Corporation on the Nautilus
licensees. The Business' current licensing agreements expire at various
intervals from September 30, 1998 to January 31, 2000, with renewal
options ranging from zero to three years. In addition, the Business
receives royalty income directly from various customer sources which is
primarily due to licensing fees for use of the Nautilus name in fitness
clubs. On January 4, 1999, the Business acquired the remaining 65% of the
licensing rights to the royalties earned on the Nautilus licensees for
approximately $421,000.
(K) INCOME TAXES
Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective
tax bases and operating loss and tax credit carryforwards. Deferred tax
assets and liabilities are measured using enacted tax rates expected to
apply to taxable income in the years in which those temporary differences
are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income
in the period that includes the enactment date.
(L) YEAR 2000
In 1998, the Business recognized its computer programs are not Year 2000
compliant. The Year 2000 problem is the result of computer programs being
written using two digits rather than four to define the applicable year.
As of January 4, 1999, the Business has not begun to convert its systems
to be Year 2000 compliant. However, Direct Focus, Inc., anticipates
completing their Year 2000 remediation program by July 1999, which will
include the Business operations. If the Business were to not become Year
2000 compliant by January 1, 2000, it may have a material adverse impact
on the Business operations.
(M) WARRANTY COSTS
The Business offers product warranties to all its customers. These
warranties include a lifetime warranty on the structural frame, welded
moving parts and weight stacks, a 120 day warranty on upholstery and
padded items, and a one-year warranty on all other parts. Warranty
expense was approximately $373,000, $287,000 and $367,000 for fiscal
years 1996, 1997 and 1998, respectively, and $109,000 for the six-months
ended January 4, 1999. Accrued
F-27
<PAGE>
NAUTILUS BUSINESS
COMBINED FINANCIAL STATEMENTS (CONTINUED)
PERIOD ENDED JANUARY 4, 1999 AND
THREE YEARS ENDED JUNE 27, 1998
(2) SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
warranty expense, which is included in other accrued expenses, was
approximately $177,000 as of June 28, 1997, June 27, 1998 and January 4,
1999.
(N) COMMITMENTS AND CONTINGENCIES
The Business has been named as a "potentially responsible party" under
the Comprehensive Environmental Response, Compensation, and Liability Act
with respect to three hazardous waste sites. To the Business' knowledge,
all of the transactions with these sites were conducted by a corporation
whose assets were sold in 1990 pursuant to the terms of an order of the
United States Bankruptcy Court to another corporation, the stock of which
was subsequently acquired by the Business in January 1993. The Business,
therefore, has denied any responsibility at the sites and has declined to
participate in any settlements. Accordingly, the Business has not
provided for any reserves for costs or liabilities attributable to the
previous corporation. At two sites, the previous company is listed as a
"de minimis" party. At the third site, the previous company is ranked
eleventh out of a total of over 300 potentially responsible parties based
on the company's volume of contribution of about 3.0%. Latest estimates
of certain costs to clean up the site range up to $4 million. Although
there is uncertainty as to several legal issues, the Business believes
that it has certain defenses to liability at these sites and the
potential liabilities arising from these three sites will not have a
materially adverse impact on the Business.
From time to time, the Business is a defendant in legal actions involving
claims arising in the normal course of business, including product
liability claims. The Business believes that, as a result of legal
defenses, insurance arrangements and indemnification provisions with
parties believed to be financially capable, none of these actions should
have a material effect on its operations or financial condition.
(O) USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities
and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.
(3) ACCOUNTS RECEIVABLE
The Business' customer receivable balances are due in a lump-sum from
various customers. Other receivable balances are principally due to royalty and
employee receivables.
F-28
<PAGE>
NAUTILUS BUSINESS
COMBINED FINANCIAL STATEMENTS (CONTINUED)
PERIOD ENDED JANUARY 4, 1999 AND
THREE YEARS ENDED JUNE 27, 1998
(3) ACCOUNTS RECEIVABLE (CONTINUED)
Changes in the reserve for doubtful accounts for customer and financed notes
receivable are as follows:
<TABLE>
<CAPTION>
SIX-MONTHS
FISCAL YEAR ENDED ENDED
---------------------------------------- ------------
JUNE 29, JUNE 28, JUNE 27, JANUARY 4,
1996 1997 1998 1999
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Balance, beginning of period............................. $ 1,316,930 $ 1,440,356 $ 1,723,982 $ 1,604,407
Charged to expense....................................... 307,379 532,564 102,803 413,921
Balances written-off..................................... (183,953) (248,938) (222,378) (722,515)
------------ ------------ ------------ ------------
Balances, end of period.................................. $ 1,440,356 $ 1,723,982 $ 1,604,407 $ 1,295,813
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
</TABLE>
(4) FINANCED NOTES RECEIVABLE
The Business' financed receivable balances relate to customer receivable
balances which are due in equal installments over periods of time ranging up to
60 months. This program was used as an additional incentive to promote
purchasing of the Business' products by domestic customers. This program was
discontinued in May 1996 and all sales transactions are now payable within
normal trade credit terms.
In May 1996, the Business sold approximately $5.8 million of its financed
receivable balances to a financial institution under a purchase agreement.
Approximately $0.9 million of these receivable balances were sold without
recourse while approximately $4.9 million of these receivable balances were sold
with recourse. The receivable balances sold with recourse have been accounted
for as a sale, in accordance with Statement of Financial Standards No. 77
"Reporting by Transferors for Transfers of Receivables with Recourse." The net
loss on this sale was approximately $150,000 after a contingency of $250,000 for
the Business' estimated future obligations related to the sale was accrued as of
the sale date. The remaining contingency reserve as of June 28, 1997, June 27,
1998 and January 4, 1999, was $180,000, $108,000 and $59,000, respectively. As
of June 28, 1997, June 27, 1998 and January 4, 1999, the outstanding balance of
these receivables sold with recourse was approximately $3,558,000, $1,973,000
and $1,196,000, respectively.
Both the owned financed notes receivable and the contingency for the sold
financed notes receivable will be retained by DWI and not sold with the
Business. The Business has current financed notes of $792,438, $473,171 and
$380,885 as of June 28, 1997, June 27, 1998 and January 4, 1999, respectively,
less reserves for doubtful accounts of $212,464, $151,948 and $187,832 as of
June 28, 1997, June 27, 1998 and January 4, 1999, respectively. The Business has
non-current financed notes of $2,241,777, $1,771,773 and $1,336,068 as of June
28, 1997, June 27, 1998 and January 4, 1999, respectively, less reserves for
doubtful accounts of $601,054, $568,962 and $658,260 as of June 28, 1997, June
27, 1998 and January 4, 1999, respectively.
F-29
<PAGE>
NAUTILUS BUSINESS
COMBINED FINANCIAL STATEMENTS (CONTINUED)
PERIOD ENDED JANUARY 4, 1999 AND
THREE YEARS ENDED JUNE 27, 1998
(5) PROPERTY, PLANT AND EQUIPMENT, NET
Details of property, plant and equipment, net are as follows:
<TABLE>
<CAPTION>
ESTIMATED JUNE 28, JUNE 27, JANUARY 4,
USEFUL LIFE 1997 1998 1999
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Land and land improvements............................. N/A $ 204,813 $ 204,813 $ 204,813
Buildings.............................................. 31.5 6,289,177 6,332,855 6,332,855
Machinery and equipment................................ 10 9,387,138 9,781,880 9,781,880
Computers and software................................. 3-5 706,565 737,621 759,133
Furniture and fixtures................................. 7 356,192 356,192 356,192
Leasehold improvements................................. 4 138,286 138,286 138,286
Automobiles............................................ 7 83,520 83,520 83,520
Construction in progress............................... N/A 363,334 -- 35,907
------------- ------------- -------------
17,529,025 17,635,167 17,692,586
Less accumulated depreciation and amortization......... (4,631,593) (6,112,422) (7,029,148)
------------- ------------- -------------
Property, plant and equipment, net..................... $ 12,897,432 $ 11,522,745 $ 10,663,438
------------- ------------- -------------
------------- ------------- -------------
</TABLE>
Property, plant and equipment balances are stated at cost. Depreciation on
plant and equipment is calculated on the straight-line method over the estimated
useful lives of the assets.
(6) INTANGIBLE ASSETS, NET
Intangible assets, net consist of the following:
<TABLE>
<CAPTION>
JUNE 28, JUNE 27, JANUARY 4,
1997 1998 1999
------------- ------------- -------------
<S> <C> <C> <C>
Goodwill............................................................. $ 4,957,682 $ -- $ --
Trademark............................................................ 6,553,000 6,553,000 6,974,000
Non-compete agreements............................................... 1,708,831 1,708,831 1,708,831
Other................................................................ 1,025,622 1,025,622 1,025,622
------------- ------------- -------------
14,245,135 9,287,453 9,708,453
Less accumulated amortization........................................ (2,768,534) (7,299,492) (9,708,453)
------------- ------------- -------------
Intangible assets, net............................................... $ 11,476,601 $ 1,987,961 $ --
------------- ------------- -------------
------------- ------------- -------------
</TABLE>
During 1998, an impairment charge was recorded in accordance with SFAS 121
and resulted in a write-off of net goodwill of approximately $4.3 million and
accumulated amortization on the remaining intangible assets was increased by
approximately $4.5 million.
During the six-months ended January 4, 1999, an additional impairment charge
was recorded in accordance with SFAS 121 and resulted in an increase of
accumulated amortization on intangible assets of approximately $2.2 million and
an increase of accumulated depreciation on property, plant and equipment of
approximately $.2 million.
F-30
<PAGE>
NAUTILUS BUSINESS
COMBINED FINANCIAL STATEMENTS (CONTINUED)
PERIOD ENDED JANUARY 4, 1999 AND
THREE YEARS ENDED JUNE 27, 1998
(6) INTANGIBLE ASSETS, NET (CONTINUED)
Normal amortization of intangible assets is computed using the straight-line
method. The excess of cost over assigned value of net assets acquired relating
to certain business combinations was amortized to expense over 40 years. Other
intangible assets are being amortized over periods of 5 to 40 years, but
averaging approximately 16 years.
(7) OTHER ACCRUED EXPENSES
Other accrued expenses consist of the following:
<TABLE>
<CAPTION>
JUNE 28, JUNE 27, JANUARY 4,
1997 1998 1999
------------ ------------ ------------
<S> <C> <C> <C>
Customer deposits....................................................... $ 290,433 $ 330,571 399,909
Accrued severance....................................................... -- -- 466,758
Accrued warranty........................................................ 177,401 177,401 177,401
Accrued loss on sale of receivables..................................... 180,000 108,000 59,000
Accrued insurance....................................................... 92,060 113,866 102,113
Deferred compensation................................................... 646,420 -- --
Accrued commissions..................................................... 146,988 36,587 28,926
Accrued legal........................................................... 129,371 86,745 99,956
Other................................................................... 283,775 193,466 151,683
------------ ------------ ------------
$ 1,946,448 $ 1,046,636 $ 1,485,746
------------ ------------ ------------
------------ ------------ ------------
</TABLE>
As of January 4, 1999, other accrued expenses includes approximately
$467,000 of accrued severance costs. In December 1998, 16 full-time employees
were terminated by the Business and offered severance payments in the amount of
approximately $482,000 which is included in selling, general and administrative
expenses for the six-months ended January 4, 1999.
(8) LEASES
The Business also has several noncancelable operating leases relating to
buildings, machinery and equipment, computer systems, and trailers.
Future minimum lease payments under noncancelable operating leases as of
January 4, 1999 were as follows:
<TABLE>
<CAPTION>
FISCAL YEAR OPERATING
- ---------------------------------------------------------------------------------- ----------
<S> <C>
1999.............................................................................. $ 119,247
2000.............................................................................. 220,122
2001.............................................................................. 218,066
2002.............................................................................. 80,446
2003.............................................................................. 20,128
Thereafter........................................................................ --
----------
$ 658,009
----------
----------
</TABLE>
F-31
<PAGE>
NAUTILUS BUSINESS
COMBINED FINANCIAL STATEMENTS (CONTINUED)
PERIOD ENDED JANUARY 4, 1999 AND
THREE YEARS ENDED JUNE 27, 1998
(8) LEASES (CONTINUED)
Rent expense for all operating leases was approximately $603,000, $480,000
and $364,000 for fiscal years 1996, 1997 and 1998, respectively, and
approximately $179,000 for the six-months ended January 4, 1999.
(9) INCOME TAXES
The Business reports Federal income taxes in the consolidated return of
Delta Woodside Industries, Inc. (DWI) and had taxable losses of $4.1 million for
the period ended January 4, 1999, which will be reported in the fiscal 1999
consolidated Federal income tax return of its parent, DWI. The Federal income
tax obligation or refund under the corporate tax sharing agreement that is
allocated to the Business is substantially determined as if the Business were
filing a separate Federal income tax return. The Business Federal tax liability
or receivable is paid to or is a receivable from the parent company.
Federal and state income tax benefit was as follows:
<TABLE>
<CAPTION>
SIX-MONTHS
FISCAL YEAR ENDED ENDED
--------------------------------- -----------
JUNE 29, JUNE 28, JUNE 27, JANUARY 4,
1996 1997 1998 1999
---------- ---------- --------- -----------
<S> <C> <C> <C> <C>
Current:
Federal...................................... $ -- $ -- $ -- $ --
State........................................ (550,712) (17,180) -- --
---------- ---------- --------- -----------
Total current............................ (550,712) (17,180) -- --
Deferred:
Federal...................................... (1,881,000) (1,027,225) -- --
State........................................ (63,345) (157,974) -- --
---------- ---------- --------- -----------
Total deferred........................... (1,944,345) (1,185,199) -- --
---------- ---------- --------- -----------
Income tax benefit............................. $(2,495,057) $(1,202,379) $ -- $ --
---------- ---------- --------- -----------
---------- ---------- --------- -----------
</TABLE>
A reconciliation between income tax benefit computed using the effective
income tax rate and the federal statutory income tax rate of 34% is as follows:
<TABLE>
<CAPTION>
SIX-MONTHS
FISCAL YEAR ENDED ENDED
---------------------------------- ----------
JUNE 29, JUNE 28, JUNE 27, JANUARY 4,
1996 1997 1998 1999
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Income tax benefit at the statutory rate... $(1,978,989) $(2,719,435) $(5,030,379) $(2,276,347)
State income tax benefit, net of federal
income taxes............................. (41,806) (115,602) -- --
Valuation allowance adjustments............ 160,196 2,191,404 3,681,592 2,200,254
Non-deductible amortization................ 42,963 39,842 1,501,842 --
Other...................................... (677,421) (598,588) (153,055) 76,093
---------- ---------- ---------- ----------
Income tax benefit......................... $(2,495,057) $(1,202,379) $ -- $ --
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
</TABLE>
F-32
<PAGE>
NAUTILUS BUSINESS
COMBINED FINANCIAL STATEMENTS (CONTINUED)
PERIOD ENDED JANUARY 4, 1999 AND
THREE YEARS ENDED JUNE 27, 1998
(9) INCOME TAXES (CONTINUED)
Significant components of the Business' deferred tax assets and liabilities
are as follows:
<TABLE>
<CAPTION>
JUNE 28, JUNE 27, JANUARY 4,
1997 1998 1999
------------- ------------- -------------
<S> <C> <C> <C>
Deferred tax assets:
Net operating loss carryforward.................................... $ 4,994,065 $ 7,407,672 $ 8,993,039
Intangibles........................................................ -- -- 584,171
Inventory.......................................................... 222,047 181,034 71,451
Allowance for doubtful accounts.................................... 539,780 196,843 194,105
Accrued vacation................................................... 142,088 129,563 143,889
Other.............................................................. 667,449 616,135 573,930
------------- ------------- -------------
Gross deferred tax assets............................................ 6,565,429 8,531,247 10,560,585
Less valuation allowance............................................. (2,618,647) (6,300,239) (8,500,493)
------------- ------------- -------------
Net deferred tax assets.............................................. 3,946,782 2,231,008 2,060,092
------------- ------------- -------------
Deferred tax liabilities:
Depreciation....................................................... 2,006,063 1,833,039 1,823,743
Intangibles........................................................ 1,914,149 127,845 --
Other.............................................................. 26,570 270,124 236,349
------------- ------------- -------------
Deferred tax liabilities............................................. 3,946,782 2,231,008 2,060,092
------------- ------------- -------------
Net deferred tax asset (liability)............................. $ -- $ -- $ --
------------- ------------- -------------
------------- ------------- -------------
</TABLE>
The Business' gross deferred tax assets are reduced by a valuation allowance
to net deferred tax assets considered by management to be more likely than not
realizable. The ultimate realization of deferred tax assets is dependent upon
the generation of future taxable income during the periods in which these
temporary differences become deductible. The change in the valuation allowance
was an increase of $2,191,404 and $3,681,592 during fiscal year 1997 and 1998,
respectively, and an increase of $2,200,254 for the six-months ended January 4,
1999.
As of June 27, 1998, the Business had approximately regular tax loss
carryforwards of $18.2 million for federal purposes as calculated under the
corporate tax sharing agreement and state net operating losses of approximately
$21 million. These carryforwards expire at various intervals through 2011. As a
result of the sale of the Business, these carryovers most likely will not be
available to the new owner, or their use may be subject to limitation.
(10) AFFILIATED PARTY TRANSACTIONS
The Business participates in a cash management system maintained by DWI.
Under this system, excess cash was forwarded to DWI each day, reducing the
current loan payable to affiliate. Likewise, cash requirements were funded daily
by DWI, increasing the current loan payable to affiliate. Interest is charged on
loan payable to DWI balances based on the weighted average cost of DWI's
borrowings. In addition, the Business incurs management fees from DWI for
various corporate services including management, treasury, computer, benefits,
payroll, auditing, accounting and tax services. For these services DWI charges
actual cost based on relative usage and other factors. Management believes this
F-33
<PAGE>
NAUTILUS BUSINESS
COMBINED FINANCIAL STATEMENTS (CONTINUED)
PERIOD ENDED JANUARY 4, 1999 AND
THREE YEARS ENDED JUNE 27, 1998
(10) AFFILIATED PARTY TRANSACTIONS (CONTINUED)
allocation method is reasonable and approximates the actual cost of providing
these services. These services were no longer provided to the Company in early
1999, as a result of the sale of the Company.
The balance with International Apparel Marketing Corporation is due to the
unpaid portion of the Company's 35% of the royalties earned by International
Apparel Marketing Corporation on the Nautilus licenses. The balance with Alchem
Capital Corporation is primarily due to the Nautilus trademark.
Due to (from) affiliates, net balances consist of the following:
<TABLE>
<CAPTION>
JUNE 28, JUNE 27, JANUARY 4,
1997 1998 1999
------------- ------------- -------------
<S> <C> <C> <C>
Delta Woodside Industries, Inc...................................... $ 29,838,338 $ 33,560,436 36,219,815
International Apparel Marketing Corporation......................... (145,053) (81,665) (170,438)
Alchem Capital Corporation.......................................... 3,318,639 3,513,499 3,513,497
------------- ------------- -------------
Due to affiliates, net.............................................. $ 33,011,924 $ 36,992,270 $ 39,562,874
------------- ------------- -------------
------------- ------------- -------------
</TABLE>
In May 1998, DWI replaced a $20 million line of credit with a $30 million
revolving credit facility (subject to borrowing base limitations) which is due
in May of 1999. This new facility is backed by certain accounts receivable and
inventory, as defined in the credit agreement, of the Business, Delta Apparel
and Duck Head Apparel, all subsidiaries of DWI.
(11) EMPLOYEE BENEFIT PLANS
The Business participates in the Delta Woodside Industries, Inc. retirement
and 401(k) plans. On September 27, 1997, the Delta Woodside Industries Employee
Retirement Plan ("Retirement Plan") merged into the Delta Woodside Employee
Savings and Investment Plan ("401(k) Plan"). Future contributions to the 401(k)
Plan in lieu of a contribution to the Retirement Plan will be made in cash and
not in stock. In the 401(k) Plan, employees may elect to convert Delta Woodside
Industries (DWI) stock to other funds, but may not increase the amount of stock
in their account. Each participant has the right to direct the trustee as to the
manner in which shares held are to be voted. The Retirement Plan qualified as an
Employee Stock Ownership Plan ("ESOP") under the Internal Revenue Code as a
defined contribution plan. The Business contributed approximately $23,000,
$29,000 and $26,000 to the 401(k) Plan during fiscal 1996, 1997 and 1998,
respectively, and $21,000 for the six-months ended January 4, 1999. The Business
contributed approximately $16,000, $52,000 and $20,000 to the Retirement Plan
during fiscal 1996, 1997 and 1998, respectively, and $10,000 for the six-months
ended January 4, 1999.
The Business also participates in a 501(c)(9) trust, the Delta Woodside
Employee Benefit Plan and Trust ("Trust"). The Trust collects both employer and
employee contributions from the Business and makes disbursements for health
claims and other qualified benefits.
The Business participates in a Deferred Compensation Plan, managed by DWI,
which permits certain management employees to defer a portion of their
compensation. Deferred compensation
F-34
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NAUTILUS BUSINESS
COMBINED FINANCIAL STATEMENTS (CONTINUED)
PERIOD ENDED JANUARY 4, 1999 AND
THREE YEARS ENDED JUNE 27, 1998
(11) EMPLOYEE BENEFIT PLANS (CONTINUED)
accounts are credited with interest and are distributed after retirement,
disability or employment termination. As of June 28, 1997, June 27, 1998 and
January 4, 1999, the Business' liability was approximately $646,000, $13,000 and
$98,000, respectively.
The Business also participates in the Delta Woodside Industries, Inc.
Incentive Stock Award Plan and Stock Option Plan. Under both Plans, the Business
recognized expense of approximately $0, $9,000 and $6,000 for fiscal years 1996,
1997 and 1998, respectively, and $7,000 for the six-months ended January 4,
1999.
(12) FAIR VALUE OF FINANCIAL INSTRUMENTS
Carrying values approximate fair values for financial instruments that are
short-term in nature, such as cash, accounts receivable, accounts payable and
accrued expenses. The Business estimates that the fair value of the financed
notes receivable are not materially different than the carrying value.
F-35
<PAGE>
[Inside back cover of the prospectus includes the following artwork:
In the top left corner of this single page layout is the Bowflex logo,
beneath which is a picture of a male torso surrounded by a picture of the
Bowflex Power Pro XTLU and two pictures of individuals using the Company's
Bowflex machines. The top right corner includes the Direct Focus logo and the
following bullet points: (1) "High quality, branded products"; and (2) "Direct
marketing to control and enhance our image." Immediately below these two images
is the Nautilus logo and a picture of a Nautilus fitness machine with a shaded
Nautilus shell in the background. Below the Nautilus image is the Instant
Comfort logo, together with a picture of the product components and a complete
airbed in a bedroom setting.]
<PAGE>
[OUTSIDE BACK COVER]
[COMPANY LOGO APPEARS HERE]
