Bowflex (BFXXQ) 10-Q2020 Q1 Quarterly report

 

 

The accompanying condensed consolidated financial statements present the financial position, results of operations and cash flows of Nautilus, Inc. and its subsidiaries, all of which are wholly owned. Intercompany transactions and balances have been eliminated in consolidation.

 

The accompanying condensed consolidated financial statements have not been audited. We have condensed or omitted certain information and footnote disclosures normally included in financial statements presented in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). Management believes the disclosures contained herein are adequate to make the information presented not misleading. However, these condensed consolidated financial statements should be read in conjunction with our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2019 (the “2019 Form 10-K”).

 

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Further information regarding significant estimates can be found in our 2019 Form 10-K.

 

Unless indicated otherwise, all information regarding our operating results pertain to our continuing operations.

The Company is required by its banking partner to maintain a restricted bank account to cover for exposures on corporate credit cards, foreign exchange and letters of credits. The Company's use of these funds is restricted until its exposure with the banking partner is closed. The restricted cash total was $3.4 million as of March 31, 2020.

In March 2019, the FASB issued ASU 2019-01, "Leases (Topic 842): Codification Improvements." The amendments in ASU 2019-01 address three issues: (1) determining the fair value of the underlying asset by lessors that are not manufactures or dealers; (2) presentation on the statement of cash flows of sales-type and direct financing leases; and (3) transition disclosures related to Topic 250, Accounting Changes and Error Corrections. ASU 2019-01 is effective for public companies' fiscal years, including interim periods within those fiscal years, beginning after December 15, 2019 with early application permitted. Our adoption of ASU 2019-01 as of January 1, 2020 had no material impact on our financial position, results of operations or cash flows.

modifications, and additions of specific disclosure requirements. ASU 2018-13 is effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Certain amendments should be applied prospectively for only the most recent interim or annual period presented in the initial year of adoption, while all other amendments should be applied retrospectively to all periods presented upon their effective date. Our adoption of ASU 2018-13 as of January 1, 2020 had no material impact on our financial position, results of operations or cash flows.

In January 2020, the FASB issued ASU 2020-01, "Investments—Equity Securities (Topic 321), Investments—Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815)." The amendments in ASU 2020-01 clarify certain interactions between the guidance to account for certain equity securities under Topic 321, the guidance to account for investments under the equity method of accounting in Topic 323, and the guidance in Topic 815, which could change how an entity accounts for an equity security under the measurement alternative or a forward contract or purchased option to purchase securities that, upon settlement of the forward contract or exercise of the purchased option, would be accounted for under the equity method of accounting or the fair value option in accordance with Topic 825, Financial Instruments. These amendments improve current GAAP by reducing diversity in practice and increasing comparability of the accounting for these interactions. ASU 2020-01 is effective for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. We are currently assessing the impact of adopting this standard but do not expect the adoption of this guidance to have a material impact on our financial position, results of operations and cash flows.

In December 2019, the FASB issued ASU 2019-12, "Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes." The amendments in ASU 2019-12 introduce the following new guidance: (1) provides a policy election to not allocate consolidated income taxes when a member of a consolidated tax return is not subject to income tax; and (2) provides guidance to evaluate whether a step-up in tax basis of goodwill relates to a business combination in which book goodwill was recognized or a separate transaction. The amendments in ASU 2019-12 make changes to the following current guidance: (1) making an intraperiod allocation if there is a loss in continuing operations and a gain outside of continuing operations; (2) determining when a deferred tax liability is recognized after an investor in a foreign entity transitions to or from the equity method of accounting; (3) accounting for tax law changes and year-to-date losses in interim periods; and (4) determining how to apply the income tax guidance to franchise taxes that are partially based on income. ASU 2019-12 is effective for public business entities' fiscal years, including interim periods within those fiscal years, beginning after December 15, 2020 with early adoption permitted. We are currently assessing the impact of adopting this standard but do not expect the adoption of this guidance to have a material impact on our financial position, results of operations and cash flows.

In June 2016, the FASB issued ASU 2016-13, "Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments." ASU 2016-13 requires companies to measure credit losses utilizing a methodology that reflects expected credit losses and requires a consideration of a broader range of reasonable and supportable information to inform credit loss estimates. In November 2019, the FASB issued ASU 2019-10, Financial Instruments – Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842) Effective Dates, which deferred the effective dates for the Company, as a smaller reporting company, until fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. We are currently assessing the impact of adopting this standard but do not expect the adoption of this guidance to have a material impact on our financial position, results of operations and cash flows.

Our revenues from contracts with customers disaggregated by revenue source, excluding sales-based taxes, were as follows (in thousands):

Our revenues disaggregated by geographic region, based on ship-to address, were as follows (in thousands):

As of March 31, 2020, estimated revenue expected to be recognized in the future totaled $13.8 million, primarily related to customer order backlog, which includes firm orders for future shipment to our Retail customers, as well as unfulfilled consumer orders within the Direct channel. Direct orders of $8.0 million and Retail orders of $5.8 million comprised our backlog as of March 31, 2020. The estimated future revenues are net of contractual rebates and consideration payable for applicable Retail customers, and net of current promotional programs and sales discounts for our Direct customers.

The following table provides information about our liabilities from contracts with customers, primarily customer deposits and deferred revenue for which advance consideration is received prior to the transfer of control. Revenue is recognized when transfer of control occurs. All customer deposits and deferred revenue received are short-term in nature. Significant changes in contract liabilities balances, including revenue recognized in the reporting period that was included in opening contract liabilities, are shown below (in thousands):

Factors used in determining the fair value of financial assets and liabilities are summarized into three broad categories:

 

Assets and liabilities measured at fair value on a recurring basis were as follows (in thousands):

For our assets measured at fair value on a recurring basis, we recognize transfers between levels at the actual date of the event or change in circumstance that caused the transfer. There were no transfers between levels during the three months ended March 31, 2020, nor for the year ended December 31, 2019.

We did not have any changes to our valuation techniques during the three months ended March 31, 2020, nor for the year ended December 31, 2019.

The fair values of our foreign currency forward contracts are calculated as the present value of estimated future cash flows using discount factors derived from relevant Level 2 market inputs, including forward curves and volatility levels.

We recognize or disclose the fair value of certain assets, such as non-financial assets, primarily property, plant and equipment, goodwill, other intangible assets and certain other long-lived assets in connection with impairment evaluations. All of our nonrecurring valuations use significant unobservable inputs and therefore fall under Level 3 of the fair value hierarchy.

As of March 31, 2020 and December 31, 2019, there were no assets or liabilities that were recorded at fair value on a nonrecurring basis.

The carrying values of cash, cash equivalents and restricted cash, trade receivables, prepaids and other current assets, trade payables and accrued liabilities approximate fair value due to their short maturities. The carrying value of our debt approximates its fair value and falls under Level 2 of the fair value hierarchy, as the interest rate is variable and based on current market rates.

From time to time, we enter into foreign exchange forward contracts to offset the earnings impacts of exchange rate fluctuations on certain monetary assets and liabilities. We do not enter into derivative instruments for any purpose other than to manage foreign currency exposure. That is, we do not engage in currency exchange rate speculation using derivative instruments.

We may hedge our net recognized foreign currency assets and liabilities with forward foreign exchange contracts to reduce the risk that our earnings and cash flows will be adversely affected by changes in foreign currency exchange rates. These derivative instruments hedge assets and liabilities that are denominated in foreign currencies and are carried at fair value with changes in the fair value recorded as other income. These derivative instruments do not subject us to material balance sheet risk due to exchange rate movements because gains and losses on these derivatives are intended to offset gains and losses on the assets and liabilities being hedged. As of March 31, 2020, total outstanding contract notional amounts were $7.8 million. At March 31, 2020, these outstanding balance sheet hedging derivatives had maturities of 79 days or less.

The fair value of our derivative instruments was included in our condensed consolidated balance sheets as follows (in thousands):

The effect of derivative instruments on our condensed consolidated statements of operations was as follows (in thousands):

For additional information related to our derivatives, see Notes 4 and 11.

Inventories are stated at the lower of cost and net realizable value, with cost determined based on the first-in, first-out method. Our inventories consisted of the following (in thousands):

Property, plant and equipment consisted of the following (in thousands):

We have several noncancellable operating leases, primarily for office space, that expire at various dates over the next five years. These leases generally contain renewal options to extend for 1 lease term of five years. For leases that we are reasonably certain we will exercise the lease renewal options, the options were considered in determining the lease term, and associated potential option payments are included in the lease payments. The payments used in the renewal term were estimated using the percentage rate increase of historical rent payments for each location where the renewal will be exercised.

Payments due under the lease contracts include annual fixed payments for office space. Variable payments including payments for our proportionate share of the building’s property taxes, insurance, and common area maintenance are treated as non-lease components and are recognized in the period for which the costs occur.

Operating lease expense was as follows (in thousands):

Leases with an initial term of 12 months or less ("short-term lease") are not recorded on the balance sheet and are recognized on a straight-line basis over the lease term. The short-term lease expense as of March 31, 2019 was $0.2 million.

Other information related to leases was as follows:

We determined the discount rate for leases using a portfolio approach to determine an incremental borrowing rate to calculate the right-of-use assets and lease liabilities.

Maturities of operating lease liabilities under noncancellable leases were as follows (in thousands):

Our products carry defined warranties for defects in materials or workmanship which, according to their terms, generally obligate us to pay the costs of supplying and shipping replacement parts to customers and, in certain instances, pay for labor and other costs to service products. Outstanding product warranty periods range from thirty days to, in limited circumstances, the lifetime of certain product components. We record a liability at the time of sale for the estimated costs of fulfilling future warranty claims. If necessary, we adjust the liability for specific warranty-related matters when they become known and are reasonably estimable. Estimated warranty expense is included in cost of sales, based on historical warranty claim experience and available product quality data. Warranty expense is affected by the performance of new products, significant manufacturing or design defects not discovered until after the product is delivered to the customer, product failure rates, and higher or lower than expected repair costs. If warranty expense differs from previous estimates, or if circumstances change such that the assumptions inherent in previous estimates are no longer valid, the amount of product warranty obligations is adjusted accordingly.

Changes in our product warranty obligations were as follows (in thousands):

The following tables set forth the changes in accumulated other comprehensive (loss) income, net of tax (in thousands) for the periods presented:

On February 21, 2018 our Board of Directors authorized a $15.0 million share repurchase program and repurchases under this program totaled $1.0 million. As of February 21, 2020, the share repurchase program expired.

Basic per share amounts were computed using the weighted average number of common shares outstanding. Diluted per share amounts were calculated using the number of basic weighted average shares outstanding increased by dilutive potential common shares related to stock-based awards, as determined by the treasury stock method. The weighted average numbers of shares outstanding used to compute income (loss) per share were as follows (in thousands):

The weighted average numbers of shares outstanding listed in the table below were anti-dilutive and excluded from the computation of diluted per share due to loss from continuing operations, as such, the exercise or conversion of any potential shares would increase the number of shares in the denominator and results in a lower loss per share (in thousands):

The weighted average numbers of shares outstanding listed in the table below were anti-dilutive and excluded from the computation of diluted income (loss) per share. In the case of restricted stock units, this is because unrecognized compensation expense exceeds the current value of the awards (i.e., grant date market value was higher than current average market price). In the case of stock options, this is because the average market price did not exceed the exercise price. These shares may be dilutive potential common shares in the future (in thousands):

We have 2 operating segments, Direct and Retail. There were no changes in our operating segments during the three months ended March 31, 2020.

Following is summary information by reportable segment (in thousands):

The following customer accounted for 10% or more of total net sales as follows:

On January 31, 2020, we entered into a Credit Agreement with Wells Fargo Bank, National Association ("Wells Fargo") and lenders from time to time party thereto (collectively with Wells Fargo the "Lenders"), pursuant to which the Lenders have agreed, among other things, to make available to us an asset-based revolving loan facility in the aggregate principal amount of up to $55.0 million, subject to a borrowing base (the “ABL Revolving Facility”), and a term loan facility in the aggregate principal amount of $15.0 million (the “Term Loan Facility" and together with the ABL Revolving Facility, the "Wells Fargo Financing"), in each case, as such amounts may increase or decrease in accordance with the terms of the Credit Agreement. The Wells Fargo Financing expires and all outstanding amounts become due on January 31, 2025 unless the maturity is accelerated subject to the terms set forth in the Credit Agreement. The repayment of obligations under the Credit Agreement is secured by substantially all of our assets. Principal and interest amounts are required to be paid as scheduled.

We used the proceeds from the Wells Fargo Financing to extinguish our existing $40.0 million revolver with Chase Bank ("2019 Chase Credit Agreement"), pay transaction expenses, and for general corporate purposes. Our previously existing credit facilities and agreements with Chase Bank and all guarantees and liens existing in connection with those facilities and agreements were

terminated upon the closing of the Wells Fargo Financing. In connection with the termination of the 2019 Chase Credit Agreement we recorded a loss on debt extinguishment of $0.2 million as interest expense in our consolidated statement of income.

Interest on the ABL Revolving Facility will accrue at the LIBOR plus a margin of 1.75% to 2.25% (based on average quarterly availability) and interest on the Term Loan Facility will accrue at LIBOR plus 5.00%. As of March 31, 2020, our interest rate was 4.50% for the ABL Revolving Facility and 6.61% for the Term Loan Facility.

As of March 31, 2020, outstanding borrowings totaled $28.4 million, with $14.8 million and $13.6 million under our Term Loan Facility and ABL Revolving Facility, respectively. As of March 31, 2020, we were in compliance with the financial covenants of the Wells Fargo Financing and $18.0 million was available for borrowing under the ABL Revolving Facility. Any outstanding balance is due and payable on January 31, 2025.

The Credit Agreement contains customary affirmative and negative covenants for financings of this type, including, among other terms and conditions, delivery of financial statements, reports and maintenance of existence, revolving availability subject to a calculated borrowing base, as well as limitations and conditions on our ability to: create, incur, assume or be liable for indebtedness; dispose of assets outside the ordinary course; acquire, merge or consolidate with or into another person or entity; create, incur or allow any lien on any of its property; make investments; or pay dividends or make distributions, in each case subject to certain exceptions. The financial covenants set forth in the Credit Agreement include a minimum liquidity covenant of $7.5 million. Beginning February 1, 2022, the minimum liquidity covenant will decrease to $5.0 million and only a minimum EBITDA covenant will apply. In addition, the Credit Agreement includes customary events of default, including but not limited to, the nonpayment of principal and interest when due thereunder, breaches of representations and warranties, noncompliance with covenants, acts of insolvency and default on indebtedness held by third parties (subject to certain limitations and cure periods).

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") was enacted and signed into law in response to coronavirus disease 2019 ("COVID-19"). The CARES Act, among other things, includes several significant provisions that could impact corporate taxpayers’ accounting for income taxes.  

Prior to the enactment of CARES Act, the 2017 Tax Cuts and Jobs Act generally eliminated the ability to carryback net operating losses ("NOL"), and permitted the NOL arising in tax years beginning after December 31, 2017 to be carried forward indefinitely, limited to 80% of the taxpayer’s income. The CARES Act amended the NOL rules suspending the 80% limitation on the utilization of NOLs generated after December 31, 2017 and before January 1, 2021. Additionally the CARES Act allows corporate NOLs arising in taxable years beginning after December 31, 2017 and before January 1, 2021, to be carried back to each of the five taxable years preceding the taxable year of the loss.

Accordingly, during the first quarter 2020, we performed various analyses and evaluated the potential impact to the company’s financial statements as a result of the CARES Act enactment. Based on our assessment, we determined that the modifications to the NOL carryback provision of the CARES Act would result in a tax benefit and cash flow to the company. The company expects that taxable losses incurred in 2019 and anticipate to incur in 2020 may fully be carried back and utilized against the taxable income generated in the previous tax years which were measured at 35%.

As a result of the CARES Act, after our detailed analysis and calculations, we recorded $3.2 million income tax benefit associated with the remeasurement of the 14% tax rate differential attributable to the NOL carryback to 35% tax years discretely in the first quarter of 2020. Furthermore, corresponding income tax receivable from the NOL carryback was recorded in the first quarter of 2020.

In the ordinary course of business, we enter into agreements that require us to indemnify counterparties against third-party claims. These may include: agreements with vendors and suppliers, under which we may indemnify them against claims arising from use of their products or services; agreements with customers, under which we may indemnify them against claims arising from their use or sale of our products; real estate and equipment leases, under which we may indemnify lessors against third-party claims relating to the use of their property; agreements with licensees or licensors, under which we may indemnify the licensee or licensor against claims arising from their use of our intellectual property or our use of their intellectual property; and agreements with parties to debt arrangements, under which we may indemnify them against claims relating to their participation in the transactions.

The nature and terms of these indemnification obligations vary from contract to contract, and generally a maximum obligation is not stated within the agreements. We hold insurance policies that mitigate potential losses arising from certain types of indemnification obligations. Management does not deem these obligations to be significant to our financial position, results of operations or cash flows, and therefore, no related liabilities were recorded as of March 31, 2020.

From time to time, in the ordinary course of business, we may be involved in various claims, lawsuits and other proceedings. These legal and tax proceedings involve uncertainty as to the eventual outcomes and losses which may be realized when one or more future events occur or fail to occur.

We regularly monitor our estimated exposure to these contingencies and, as additional information becomes known, may change our estimates accordingly. We evaluate, on a quarterly basis, developments in legal proceedings, investigations or claims that could affect the amount of any accrual, as well as any developments that would make a loss probable or reasonably possible, and whether the amount of a probable or reasonably possible loss is estimable. Among other factors, we evaluate the advice of internal and external counsel, the outcomes from similar litigation, current status of the lawsuits (including settlement initiatives), legislative developments and other factors. Due to the numerous variables associated with these judgments and assumptions, both the precision and reliability of the resulting estimates of the related loss contingencies are subject to substantial uncertainties. Further, while we face contingencies that are reasonably possible to occur, we are unable to estimate the possible loss or range of loss at this time. As such, 0 liability is recorded as of March 31, 2020.

As of the date of filing of this Quarterly Report on Form 10-Q, we were not involved in any material legal proceedings.

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as "plan," "expect," "aim," "believe," "project," "intend," "estimate," "will," "should," "could," and other terms of similar meaning typically identify forward-looking statements. Forward-looking statements include any statements related to our future business, financial performance or operating results; anticipated fluctuations in net sales due to seasonality; plans and expectations regarding gross and operating margins; plans and expectations regarding research and development expenses and capital expenditures and anticipated results from such expenditures and other investments in our capabilities and resources; anticipated losses from discontinued operations; plans for new product introductions, strategic partnerships and anticipated demand for our new and existing products; and statements regarding our inventory and working capital requirements and the sufficiency of our financial resources. These forward-looking statements, and others we make from time-to-time, are subject to a number of risks and uncertainties. Many factors could cause actual results to differ materially from those projected in forward-looking statements, including our ability to timely acquire inventory that meets our quality control standards from sole source foreign manufacturers at acceptable costs, changes in consumer fitness trends, changes in the media consumption habits of our target consumers or the effectiveness, availability and price of media time consistent with our cost and audience profile parameters, greater than anticipated costs or delays associated with launch of new products, weaker than expected demand for new or existing products, a decline in consumer spending due to unfavorable economic conditions, softness in the retail marketplace or the availability from retailers of heavily discounted competitive products, an adverse change in the availability of credit for our customers who finance their purchases, our ability to pass along vendor raw material price increases and other cost pressures, including increased shipping costs and unfavorable foreign currency exchange rates, tariffs, risks associated with current and potential delays, work stoppages, or supply chain disruptions caused by the coronavirus pandemic, our ability to hire and retain key management personnel, our ability to effectively develop, market and sell future products, our ability to protect our intellectual property, the introduction of competing products, and our ability to get foreign-sourced product through customs in a timely manner. Additional assumptions, risks and uncertainties are described in Part I, Item 1A, "Risk Factors," in our 2019 Form 10-K as supplemented or modified in our quarterly reports on Form 10-Q. We do not undertake any duty to update forward-looking statements after the date they are made or conform them to actual results or to changes in circumstances or expectations.

Royalty income increased by $0.1 million, or 11.9%, for the first three months of 2020, compared to the first three months of 2019, primarily due to a royalty settlement.

Gross profit decreased by $0.2 million, or 0.7%, for the first three months of 2020 to $35.6 million, or 38.0% of net sales, compared to gross profit of $35.8 million, or 42.5% of net sales, for the first three months of 2019. The decrease in gross profit dollars was primarily due to lower gross margin percentages in both the Direct and Retail segments. Gross margin percentage points decreased by 4.5% for the first three months of 2020 compared to the first three months of 2019 primarily due to unfavorable sales mix and higher landed product costs.

Operating expenses decreased by $9.9 million or 21.4%, for the first three months of 2020 to $36.2 million, compared to operating expenses of $46.0 million for the first three months of 2019. The decrease in operating expenses was primarily due to increased expense discipline, particularly in advertising expenses which delivered strong return on investment in the first quarter of 2020.

Operating loss decreased by $9.6 million, or 94.5%, for the first three months of 2020 to $0.6 million, compared to operating loss of $10.2 million for the first three months of 2019. The decrease in operating loss for the first three months of 2020 compared to the first three months of 2019 was primarily driven by lower operating expenses partially offset by lower gross margins.

Income from continuing operations was $2.3 million for the first three months of 2020, or $0.08 per diluted share, compared to loss from continuing operations of $8.5 million, or $0.29 per diluted share, for the first three months of 2019. The increase in income from continuing operations was driven by higher revenue, expense discipline, and aided by the tax benefit related to the CARES Act.

The effective tax rates for the first three months of 2020 and 2019 were 301.2% and 20.0%, respectively. The 281.2% year-over-year percentage rate differential was primarily due to changes in the tax treatment of net operating loses as a result of the CARES Act. The Company anticipates carrying back 2019 and 2020 losses to the 2016 and 2017 tax years and recognized $3.2 million of tax benefit, representing the 14 point tax rate differential between 2019 and 2020 and carry back tax periods, as income in the first quarter of 2020.

Net income was $2.2 million for the first three months of 2020, compared to net loss of $8.6 million for the first three months of 2019. Net income per diluted share was $0.07 for the first three months of 2020, compared to net loss per diluted share of $0.29 for the first three months of 2019.

Our results of operations may vary significantly from period-to-period. Our revenues typically fluctuate due to the seasonality of our industry, customer buying patterns, product innovation, the nature and level of competition for health and fitness products, our ability to procure products to meet customer demand, the level of spending on, and effectiveness of, our media and advertising

As a result of the above and other factors, our period-to-period operating results may not be indicative of future performance. You should not place undue reliance on our operating results and should consider our prospects in light of the risks, expenses and difficulties typically encountered by us and other companies, both within and outside our industry. We may not be able to successfully address these risks and difficulties and, consequently, we cannot assure you of any future growth or profitability. For more information, see our discussion of risk factors located at Part I, Item 1A of our 2019 Form 10-K.

Results from discontinued operations relate to the disposal of our former Commercial business, which was completed in April 2011. We reached substantial completion of asset liquidation at December 31, 2012. Although there was no revenue related to the Commercial business in either the 2020 or 2019 periods, we continue to incur product liability and other legal expenses associated with product previously sold into the Commercial channel.

Gross margin rate was 51.5%, down from 56.5%, primarily driven by unfavorable product mix and higher landed product costs. Sales declines in the higher margin Max Trainers line continue to pressure margins, while landed product costs were driven higher by tariffs and expediting shipments from our factories in Asia. 

Segment contribution income was $1.8 million, up 139.8%, compared to segment contribution loss of $4.5 million. The improvement in segment contribution was primarily driven by $6.5 million reduction in media spend, as gross profit was below last year. Advertising expenses were $13.2 million in first quarter of 2020 compared to $19.7 million first quarter of 2019.

Combined consumer credit approvals by our primary and secondary U.S. third-party financing providers for the first quarter of 2020 were 52.9%, compared to 54.3% in the same period of 2019. The decrease in approval rates reflects lower credit quality applications.

Gross margin rate was 22.6%, down from 23.3%, driven primarily by unfavorable sales mix and higher landed product costs. Landed product costs were driven higher by tariffs and expediting shipments from our factories in Asia.

Segment contribution income was $2.4 million, up 430.9%, compared to segment contribution loss of $0.7 million. The improvement in segment contribution was primarily driven by higher net sales and reductions in operating expenses, partially offset by lower gross margin rates.

Selling and marketing expenses include payroll, employee benefits, and other headcount-related expenses associated with sales and marketing personnel, and the costs of media advertising, promotions, trade shows, seminars, and other programs.

The decrease in selling and marketing expense in the three month period ended March 31, 2020 as compared to the same period of 2019 was primarily related to a $6.5 million decrease in media advertising and a $0.5 million decrease in financing fees.

Media advertising expense of our Direct business is the largest component of selling and marketing and was as follows:

The decrease in media advertising for the three month period ended March 31, 2020 compared to the same period of 2019 reflected the increased focus on return on investment that began in the fourth quarter of 2019.

General and administrative expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, and other administrative fees.

General and administrative expenses were flat for the three months ended March 31, 2020 compared to the same period of 2019 due to increases for incentive costs of $1.3 million and consulting costs of $0.6 million offset by a decrease in litigation costs of $1.9 million.

Research and development expenses include payroll, employee benefits, other headcount-related expenses and information technology associated with product development.

The decrease in research and development expenses for the three month period ended March 31, 2020 compared to the same period of 2019 was driven primarily by lower maintenance expenses related to digital platforms.

Interest expense increased $0.4 million to $0.6 million for the three month period ended March 31, 2020, compared to the same period of 2019. The increase was primarily due to loss on debt extinguishment of $0.2 million reported as interest expense in our consolidated statement of income incurred in connection with the termination of our prior credit agreement with Chase Bank. See Note 15 of Notes to Condensed Consolidated Financial Statements for additional information.

Other, net primarily relates to the effect of exchange rate fluctuations between the U.S. and our foreign subsidiaries.

Income tax provision includes U.S. and international income taxes, and interest and penalties on uncertain tax positions.

The income tax benefit and effective tax rate from continuing operations for the three month period ended March 31, 2020 was primarily due to the 14% rate benefit of net operating loss carry-back from the 2019 tax year to the 2016 tax year as a result of CARES Act enactment, which is discretely recognized in the first quarter of 2020. The effective tax rate and income tax benefit from continuing operations for the three month period ended March 31, 2019 was primarily due to our losses generated in the U.S.

 

Inventories decreased by $19.8 million to $34.9 million as of March 31, 2020, compared to $54.8 million as of December 31, 2019, primarily due to the seasonality of the business and to the surge in demand. Inventories as of March 31, 2020 compared to March 31, 2019 decreased by $26.0 million, primarily due to our efforts to align inventory more closely to sales trends and to the surge in demand.

Prepaid and other current assets decreased by $1.0 million to $7.3 million as of March 31, 2020, compared to $8.3 million as of December 31, 2019, primarily due to lower prepaid marketing expenses. This decrease was partially offset by increases to prepaid insurance and information technology expenses.

Accrued liabilities increased by $1.8 million to $9.4 million as of March 31, 2020, compared to $7.6 million as of December 31, 2019, primarily due to payroll related liabilities and other accruals.

Cash used by investing activities of $1.7 million for the first three months of 2020 was due to capital expenditures for implementation of new software systems, production tooling and equipment. We anticipate spending between $8.0 million and $10.0 million in 2020 for digital platform enhancements, systems integration, and production tooling.

Cash provided by financing activities of $12.0 million for the first three months of 2020 was primarily related to proceeds from Wells Fargo Financing agreements of $44.1 million, partially offset by loan principal repayments of $30.3 million.

On January 31, 2020, we entered into a Credit Agreement with Wells Fargo Bank, National Association (“Wells Fargo”) and lenders from time to time party thereto (collectively with Wells Fargo, the "Lenders"), pursuant to which the Lenders have agreed, among other things, to make available to us an asset-based revolving loan facility in the aggregate principal amount of up to $55.0 million, subject to a borrowing base (the “ABL Revolving Facility”), and a term loan facility in the aggregate principal amount of $15.0 million (the “Term Loan Facility” and together with the ABL Revolving Facility, the "Wells Fargo Financing"), in each case, as such amounts may increase or decrease in accordance with the terms of the Credit Agreement. The Wells Fargo Financing expires and all outstanding amounts become due on January 31, 2025 unless the maturity is accelerated subject to the terms set forth in the Credit Agreement. The repayment of obligations under the Credit Agreement is secured by substantially all of our assets. Principal and interest amounts are required to be paid as scheduled.

We used the proceeds from the Wells Fargo Financing to extinguish our existing $40.0 million revolver with Chase Bank ("2019 Chase Credit Agreement"), pay transaction expenses, and for general corporate purposes. Our previously existing credit facilities and agreements with Chase Bank and all guarantees and liens existing in connection with those facilities and agreements were terminated upon the closing of the Wells Fargo Financing. In connection with the termination of the 2019 Chase Credit Agreement we recorded a loss on debt extinguishment of $0.2 million as interest expense in our consolidated statement of income.

As of March 31, 2020, outstanding borrowings totaled $28.4 million with $14.8 million and $13.6 million under our Wells Fargo Financing Term Loan Facility and ABL Revolving Facility, respectively. As of March 31, 2020, we were in compliance with the financial covenants of the Wells Fargo Financing and $18.0 million was available for borrowing under the ABL Revolving Facility. Any outstanding balance is due and payable on January 31, 2025, unless the maturity is accelerated subject to the terms set forth in the Credit Agreement.

The Credit Agreement contains customary affirmative and negative covenants for financings of this type, including, among other terms and conditions, delivery of financial statements, reports and maintenance of existence, revolving availability subject to a calculated borrowing base, as well as limitations and conditions on our ability to: create, incur, assume or be liable for indebtedness; dispose of assets outside the ordinary course; acquire, merge or consolidate with or into another person or entity; create, incur or allow any lien on any of its property; make investments; or pay dividends or make distributions, in each case subject to certain exceptions. The financial covenants set forth in the Credit Agreement include a minimum liquidity covenant of $7.5 million. Beginning February 1, 2022, the minimum liquidity covenant will decrease to $5.0 million and only a minimum EBITDA covenant will apply. In addition, the Credit Agreement includes customary events of default, including but not limited to, the nonpayment of principal and interest when due thereunder, breaches of representations and warranties, noncompliance with covenants, acts of insolvency and default on indebtedness held by third parties (subject to certain limitations and cure periods).

In the ordinary course of business, we enter into agreements that require us to indemnify counterparties against third-party claims. These may include: agreements with vendors and suppliers, under which we may indemnify them against claims arising from our use of their products or services; agreements with customers, under which we may indemnify them against claims arising from their use or sale of our products; real estate and equipment leases, under which we may indemnify lessors against third-party claims relating to the use of their property; agreements with licensees or licensors, under which we may indemnify the licensee or licensor against claims arising from their use of our intellectual property or our use of their intellectual property; and agreements with parties to debt arrangements, under which we may indemnify them against claims relating to their participation in the transactions.

The nature and terms of these indemnifications vary from contract to contract, and generally a maximum obligation is not stated. We hold insurance policies that mitigate potential losses arising from certain types of indemnifications. Management does not deem these obligations to be significant to our financial position, results of operations or cash flows, and therefore, no liabilities were recorded at March 31, 2020.

On February 21, 2018 our Board of Directors authorized a $15.0 million share repurchase program and repurchases under this program totaled $1.0 million. For the three months ended March 31, 2020 no shares were repurchased. As of February 21, 2020, the share repurchase program expired.

 

We expect our revenue from fitness equipment products to vary seasonally. Sales are typically strongest in the fourth quarter and are generally weakest in the second quarter. We believe that consumers tend to be involved in outdoor activities during the spring and summer months, including outdoor exercise, which impacts sales of indoor fitness equipment. This seasonality can have a significant effect on our inventory levels, working capital needs and resource utilization.

 

See Note 1 of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 for a discussion of new accounting pronouncements.

Our exposure to market risk from changes in interest rates relates primarily to our cash equivalents, marketable securities, derivative assets and variable-rate debt obligations. Our cash equivalents mature within three months or less from the date of purchase. Marketable securities with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. We have classified our marketable securities as available-for-sale and, therefore, we may choose to sell or hold them as changes in the market occur. Because of the short-term nature of the instruments in our portfolio, a decline in interest rates would reduce our interest income over time, and an increase in interest rates may negatively affect the market price or liquidity of certain securities within the portfolio.

Our negotiated credit facilities generally charge interest based on a benchmark rate such as LIBOR. Fluctuations in short-term interest rates may cause interest payments on term loan principal and drawn amounts on the revolving line to increase or decrease. As of March 31, 2020, the outstanding balances on our credit facilities totaled $28.4 million.

We enter into foreign exchange forward contracts to offset the earnings impacts of exchange rate fluctuations on certain monetary assets and liabilities. Total notional amounts outstanding at March 31, 2020 were $7.8 million.

A hypothetical 10% increase in interest rates, or a 10% movement in the currencies underlying our foreign currency derivative positions, would have material impacts on our results of operations, financial position or cash flows. We do not enter into derivative instruments for any purpose other than to manage our interest rate or foreign currency exposure. That is, we do not engage in interest rate or currency exchange rate speculation using derivative instruments.

There were no changes in our internal control over financial reporting that occurred during the three months ended March 31, 2020, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

From time to time, in the ordinary course of business, we may be involved in various claims, lawsuits and other proceedings. These legal and tax proceedings involve uncertainty as to the eventual outcomes and losses which may be realized when one or more future events occur or fail to occur.

As of the date of filing of this Quarterly Report on Form 10-Q, we were not involved in any material legal proceedings.

We operate in an environment that involves a number of risks and uncertainties. The risks described below update the risk factors in Part I, Item 1A. Risk Factors in our 2019 Form 10-K. The risks and uncertainties described below and in our 2019 Form 10-K are not the only risks and uncertainties that we face. Additional risks and uncertainties that presently are not considered material or are not known to us, and therefore are not mentioned herein, may impair our business operations. If any of the risks described below or in our 2019 Form 10-K actually occur, our business, operating results and financial position could be adversely affected.

Public health officials worldwide have recommended and mandated precautions to mitigate the spread of COVID-19, including prohibitions on congregating in heavily populated areas and shelter-in-place orders or similar measures. As a result, we have temporarily closed our offices and retailers have temporarily closed store locations with some allowing for on-line order pick-up. Our results could be adversely impacted by these retail store closures and other actions taken to contain or treat the impact of COVID-19, and the extent of such impacts will depend on future developments, which are highly uncertain and cannot be predicted.

The COVID-19 pandemic is adversely affecting, and is expected to continue to adversely affect, our operations, supply chains and distribution systems, and we have experienced and expect to continue to experience unpredictable reductions in demand for certain of our products and services.

As a result of COVID-19, we have been unable to satisfy certain customer orders for our products. As a result, our customers have experienced delays in receiving our products. There is uncertainty around the duration and breadth of the COVID-19 pandemic, as well as general economic uncertainty and macroeconomic conditions, and as a result the ultimate impact on our business, financial condition or operating results cannot be reasonably estimated at this time.

In addition, while the potential impact and duration of the COVID-19 pandemic on the global economy and our business in particular may be difficult to assess or predict, the pandemic has resulted in, and may continue to result in, significant disruption of global financial markets, potentially reducing our ability to access capital, which could negatively affect our liquidity in the future. While the spread of COVID-19 may eventually be contained or mitigated, there is no guarantee that a future outbreak of this or any other widespread epidemics will not occur, or that the global economy will recover, either of which could seriously harm our business.