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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003

Commission file number: 000-25867

THE NAUTILUS GROUP, INC.

(Exact name of Registrant as specified in its charter)

1400 NE 136th Avenue

Vancouver, Washington 98684

(Address of principal executive offices, including zip code)

(360) 694-7722

(Issuer’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K, or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).    Yes  x    No  ¨

The aggregate market value of the voting stock held by non-affiliates, computed by reference to the last sales price ($12.40) as reported on the New York Stock Exchange, as of the last business day of the Registrant’s most recently completed second fiscal quarter (June 30, 2003) was $356,283,062.

The number of shares outstanding of the Registrant’s Common Stock as of March 1, 2004 was 32,611,073 shares.

Documents Incorporated by Reference

The Registrant has incorporated by reference into Part III of this Form 10-K portions of its Proxy Statement for its 2004 Annual Meeting of Stockholders.

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THE NAUTILUS GROUP, INC.

2003 FORM 10-K ANNUAL REPORT

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PART I

Forward-Looking Statements

Certain statements contained in this Annual Report on Form 10-K, including, without limitation, statements containing the words “could,” “may,” “will,” “should,” “plan,” “believes,” “anticipates,” “estimates,” “predicts,” “expects,” “projections,” “potential,” “continue,” and words of similar import, constitute “forward-looking statements.” Investors are cautioned that all forward-looking statements involve risks and uncertainties and various factors could cause actual results to differ materially from those in the forward-looking statements. From time to time and in this Form 10-K, we may make forward-looking statements relating to our financial performance, including the following:

Numerous factors could affect our actual results, including the following:

We describe certain of these and other key risk factors elsewhere in more detail in this Form 10-K. Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. We undertake no obligation to update publicly any forward-looking statements to reflect new information, events, or circumstances after the date of this Form 10-K or to reflect the occurrence of unanticipated events.

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Item 1. Business

OVERVIEW

The Nautilus Group, Inc. (the “Company”) is a leading marketer, developer and manufacturer of branded health and fitness products sold under such well-known names as Nautilus, Bowflex, Schwinn, StairMaster, TreadClimber and Trimline. Our products are distributed through diversified direct, retail and commercial sales channels. We market and sell our Bowflex, TreadClimber, and Nautilus Sleep Systems products through our direct-marketing channel utilizing an effective combination of television commercials, infomercials, response mailings, the Internet, and inbound/outbound call centers. We market and sell our Nautilus, Schwinn, and StairMaster commercial fitness equipment through our sales force and selected dealers to health clubs, government agencies, hotels, corporate fitness centers, colleges, universities and assisted living facilities worldwide. We also market a comprehensive line of consumer fitness equipment sold under the Nautilus, Schwinn, StairMaster, Bowflex, and Trimline brands, through a network of specialty and sporting goods dealers, distributors and retailers worldwide.

Founded in 1986, the Company has grown to approximately $500 million in annual sales through a combination of internal growth of our Bowflex product line and a series of strategic acquisitions, including Nautilus International, Inc. (“Nautilus”) in January 1999, the fitness division of Schwinn/GT Corp. and its affiliates (“Schwinn Fitness”) in September 2001 and StairMaster Sports/Medical, Inc. (“StairMaster”) in February 2002. As a result of these acquisitions, we considerably expanded our portfolio of leading brands, product lines, channels of distribution, product development capabilities and the size of our customer base. We now offer a comprehensive line of cardiovascular and weight resistance products in the direct, retail and commercial fitness channels. Our product lines include home gyms, free weight equipment, treadmills, indoor cycling equipment, steppers, ellipticals, and fitness accessories, as well as premium air support sleep systems. We have over 1,200 dealers in the U.S., a worldwide network of distributors, operations in Switzerland, and offices in Italy, Germany, and the United Kingdom.

The Company was incorporated in California in 1986 and became a Washington corporation in 1993. On May 21, 2002, the Company changed its corporate name to The Nautilus Group, Inc. from Direct Focus, Inc. Concurrent with the name change, trading of the Company’s shares was moved from the NASDAQ National Market to the New York Stock Exchange with a new ticker symbol (NLS).

Our principal executive offices are located at 1400 NE 136^th Avenue, Vancouver, Washington 98684, and our telephone number is (360) 694-7722. We maintain our corporate website at www.nautilusgroup.com. None of the information on this website or our other websites is part of this Form 10-K. On our website, we make available, free of charge, printable copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission (“SEC”). In addition, our code of business conduct and ethics, corporate governance guidelines, and the charters of our Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee are available on our corporate website. These corporate governance documents are available in print to any stockholder who requests them.

As used in this Form 10-K, the terms “we,” “our,” “us,” “Nautilus Group” and “Company” refer to The Nautilus Group, Inc. and its subsidiaries. The names Nautilus^®, Bowflex^®, Power Rod^®, TreadClimber^®, Schwinn^® (fitness products), StairMaster^® and Trimline^® are trademarks of the Company.

The consolidated financial statements of the Company include The Nautilus Group, Inc. and its wholly owned subsidiaries (collectively, the “Company”). All intercompany transactions have been eliminated in the preparation of the consolidated financial statements.

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BUSINESS SEGMENTS

Our operating segments include the direct, commercial/retail, and corporate segments. The direct segment includes all products and related operations involved in marketing to consumers through a variety of direct marketing channels. The Bowflex line of strength equipment and TreadClimber line of cardiovascular equipment are the principal fitness equipment products in our direct segment. Sales from our Bowflex product line, including related shipping revenue, accounted for 52% of our aggregate net sales in 2003, down from 61% and 74% in 2002 and 2001, respectively, as we continued our strategies of diversification into the commercial and retail markets and the introduction of new direct-marketed products. In the rest product market, we offer a line of premium air sleep systems, called Nautilus Sleep Systems, which are also marketed through our direct segment. In the nutrition market, we have established a strategic relationship with Champion Nutrition (“Champion”) as supplier of nutritional supplements that are complementary with our fitness and healthy lifestyle product offerings and are marketed through our direct segment.

The commercial/retail segment includes all products and related operations that do not involve direct marketing to consumers. Products in this segment currently consist of fitness equipment branded under the Nautilus, Schwinn, StairMaster, Trimline, and Bowflex names, and depending on the brand, are sold through commercial and/or retail sales channels. Product categories sold through the commercial/retail segment include strength equipment, treadmills, ellipticals, exercise bikes, stairclimbers, stepmills, and other fitness-related accessories.

Beginning in 2003, we augmented our segment reporting with the addition of a separate reporting segment to reflect the activities associated with the corporate holding company. Activities reflected in this segment consist mainly of director costs, general legal and accounting fees, salaries of corporate personnel, as well as other costs not specifically attributable to the other two business segments. In addition, treasury is a corporate function, so interest income from investments is included in the corporate segment.

Detailed financial information about our three business segments is included in Note 3 of the Notes to Consolidated Financial Statements. Certain prior period balances have been reclassified to conform to this three-segment presentation with no effect on previously reported consolidated net income or stockholders’ equity.

DIRECT BUSINESS SEGMENT

Direct to Consumer Marketing

Through our direct-to-consumer sales and distribution channel, we market and sell our products directly to the end customer. We market and sell Bowflex, TreadClimber, and Nautilus Sleep Systems products through this channel utilizing an integrated combination of media and direct customer contact. Along with “spot” television advertising, which ranges in length from 30 seconds to as long as five minutes, we also utilize extended 30-minute television “infomercials,” Internet advertising, our product websites, inquiry response mailings, and inbound/outbound call centers. By selling directly to consumers, we are able to fully realize premium price points paid for our products by the end customer, eliminating all other parties from the sales transaction. Our ability to capture the full amount of sales revenue in our direct channel has consistently produced a high level of financial return on our time and invested money. The size of the direct market is substantial. Through our advertising initiatives, we estimate that we currently reach approximately 70 million homes. Success within this distribution channel is almost entirely dependent on the ability to accurately measure target customer demographics. Toward this aim, we employ hundreds of separate toll free telephone numbers and dozens of Internet address URLs in our sales and marketing efforts, which allow us to measure very specifically the consumer response rates to each of our advertising placements. We have built a comprehensive database that allows us to hone our marketing strategies and more effectively reach our

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target customers. Historically, we have been able to measure with a high degree of accuracy inquiries to specific advertisements, and in turn, predict the sales that will result from those inquiries. We believe that this expertise will continue to serve as a key factor that differentiates us from competitors and will enable us to maintain a competitive advantage within the direct marketing arena.

To date, we have been highly successful with what we refer to as a “two-step” marketing approach. Our two-step approach focuses first on generating consumer interest in our products while eliciting consumer requests for product information. Development of this interest is achieved primarily through the use of spot commercials and infomercials, supplemented by Internet advertising. The second step focuses on converting the informational requests into sales, which we accomplish through a combination of response mailings and outbound calling.

Advertising

Spot Television Commercials and Infomercials. Spot commercials are a key element of our direct marketing strategy. For products that may lend themselves to a more in-depth explanation and demonstration, television infomercials are another important marketing tool. We have developed a variety of spot commercials, infomercials, and marketing videos to support the marketing and sale of our products.

When we begin marketing a newly introduced product, we generally test and refine our marketing concepts and selling practices while advertising the product in spot commercials. Production costs for spot commercials typically range from $50,000 to $150,000. Based on initial results from the airing of this spot advertising, we may produce additional spot commercials and/or an infomercial, if suitable. Production costs for infomercials tend to range from $150,000 to $500,000. Generally, we attempt to film multiple infomercial and commercial concepts at the same time, in order to maximize production efficiencies. From this footage we can then develop a variety of spot commercials and infomercials, introducing and refining them over time.

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 more fully understand the product’s marketing appeal and to evaluate advertising or product modifications that may be appropriate. As we experience success, we then advertise on a wider number of 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. Depending on the network, time slot and, programming length, the cost of airing spot commercials and infomercials varies significantly. Each spot commercial currently costs between $25 and $25,000 to air, and each infomercial between $600 and $55,000 to air. Historically, we have purchased the majority of our media time on cable networks.

We book most of our spot commercial and 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 allocation of our advertising spending if our statistical tracking indicates another network or time slot is proving to be particularly effective.

Internet. The Internet continues to play an important role in our direct marketing strategy. We consistently promote our product websites in our television and print advertising and in our response mailing materials to encourage online product inquiries and transactions. Use of online advertising on third party sites and paid search engine placement also helps drive Internet browsers to our product websites to request additional information, learn more about our products, or to make immediate purchases. Our websites are loaded with informative content including detailed product information, online videos, and testimonials from our satisfied customers. We operate direct marketing-oriented websites in support of each of our products generating significant direct to consumer sales activity. None of the information in these websites is part of this Form 10-K.

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Optimal Use of Direct Marketing Database

Since we initially developed our direct to consumer strategy in 1994, we have consistently invested significant resources to build a comprehensive direct marketing database. Our database has allowed us to monitor customer responses and effectively utilize that information to adapt our marketing techniques, thereby reaching consumers with ever-increasing effectiveness. We track the success of each of our spot commercials and infomercials by determining how many viewers respond to each airing. We accumulate this information in our database to evaluate the cost-effective utilization of available media time. We believe the database enables us to predict with reasonable accuracy the levels of product sales and inquiries that will result from each spot commercial and infomercial.

Furthermore, our compilation of consumer inquiries contained within our database represents a rich pool of marketing leads for additional product sales. We believe this pool of contacts, a significant number of whom already have a proven and satisfied customer relationship with the Company, provides us a competitive advantage when introducing new products.

Conversion of Direct-Marketed Product Inquiries Into Sales

Customer Service Call Center and Order Processing. We manage our own customer service call center in Vancouver, Washington. It operates 18 to 23 hours per day to receive and process the vast majority of all infomercial-generated and customer service-related inquiries. We have developed a skills-based call routing system that automatically routes each incoming call to the most highly qualified inside sales agent or customer service representative available. Using our highly integrated telephony, customer relationship management, and customized order management systems, the appropriate sales professional answers product questions, proactively educates the potential customer about the benefits of our product line, promotes financing through our third-party private label credit card, typically up sells the benefits of higher priced models in our product line, and closes the transaction process by capturing the customer’s order information. These sophisticated systems allow us to most effectively utilize our customer service staff, prioritize call types, and improve customer service.

We contract with large telemarketing companies to receive and process information requests generated by our spot television advertising 24 hours per day. The telemarketing agents for these companies collect names, addresses and other basic information from callers but do not directly sell our products. During our own call center’s hours of operations, the outside telemarketing agents may transfer callers that show immediate buying interest for our products to one of our specially trained sales professionals.

Internet. We use spot commercials and infomercials, together with Internet advertising and search-engine placement, to lead consumers to our websites, as we believe consumers who visit our websites are more inclined to purchase our products. We believe we successfully balance our goals of finalizing sales and capturing consumer information by strategically designing our web pages and carefully analyzing web page visits, conversion rates, average sales prices and inquiry counts. Our eCommerce sales are an important component of our direct sales channel representing approximately 26% of total direct channel sales for 2003, 24% of sales in 2002, and 22% of sales in 2001.

Consumer Finance Programs. We believe that convenient consumer financing is an important tool in our direct marketing sales efforts and that the availability of financing induces many of our customers to make inquiries and purchases when they otherwise would not. For several years we have offered “zero-down” financing to approved customers on all direct-to-consumer sales, and in the latter portion of 2003, we tested a

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highly competitive low, fixed payment financing promotion in support of the sale of our Bowflex product line. We arrange financing for our customers through two separate consumer finance companies, pursuant to non-recourse consumer financing agreements. Under these arrangements, based on a brief application process that simply involves a few minutes over the telephone with one of our customer service professionals or during a visit to one of our websites, we can obtain financing decisions for our customers in what literally amounts to a matter of seconds. Once a customer is approved, the ordered product can be immediately submitted for fulfillment, without any need for cumbersome follow-on paperwork. The consumer finance companies pay us promptly following delivery of product and concurrently send to each approved customer a Nautilus Group private label credit card that may be used for future purchases of our products. Approximately 43% of our direct to consumer sales were financed in this manner during 2003, with financed orders representing approximately 37% of sales in 2002 and 41% of sales in 2001. We believe these financing programs will continue to be an important and effective marketing tool for customers purchasing products directly through our call center and product websites.

Seasonality

The effectiveness of our direct marketing is influenced by seasonal factors. We have found that second quarter influences on television viewership, such as the broadcast of national network season finales and seasonal weather factors, cause our spot television commercials on national cable television to be less effective in the second quarter than in other periods of the year.

COMMERCIAL/RETAIL BUSINESS SEGMENT

Commercial/Retail Sales and Marketing

We market and sell our Nautilus, Schwinn, and StairMaster commercial fitness equipment through our sales force and selected dealers to health clubs, government agencies, hotels, corporate fitness centers, colleges, universities and assisted living facilities. Our commercial sales force is focused on strengthening the market position of our existing Nautilus, Schwinn, and StairMaster commercial product lines. Internationally, we market and sell our Nautilus, Schwinn, and StairMaster commercial fitness products through our foreign subsidiaries and a worldwide network of independent distributors.

We also market a complete line of retail consumer fitness equipment, under the Nautilus, Bowflex, Schwinn, StairMaster, and Trimline brands, through an independent network of more than 1,200 dealers, sporting goods retailers, wholesale clubs and specialty stores worldwide. During 2003, we successfully introduced selected Bowflex products to our retail sales channel. Sales of Bowflex products through the retail channel in 2003 represented approximately 20% of total sales for the commercial/retail business segment. In addition to products already offered through our retail sales channel, we intend to continue bringing products previously sold exclusively through our direct sales channel to retail. By leveraging the advertising dollars spent on direct marketing, we believe we can effectively sell our direct-marketed products through our retail sales channel to consumers that would not purchase our products through one of our direct purchase options.

Commercial Approach

We position ourselves as “The Health & Fitness Consultants” to encourage our commercial market customers and potential customers to think of us first when considering their fitness equipment and programming needs. Our strategy is to address the needs of the three key constituencies of today’s health clubs:

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Fitness Academy. The Fitness Academy was established in 1997 to provide programming and educational information to both consumers and fitness professionals. To date, the Fitness Academy has provided training and certification to hundreds of fitness professionals in the Schwinn Cycling Program and has recently added a range of strength training programs based on Nautilus training principles to its repertoire. Many of these programs are targeted to special groups such as seniors, women and youth that are particularly important to the fitness industry today.

Fitness Academy programs are designed to aid clubs in increasing profits by encouraging cost efficient group exercise classes; benefit staff members by helping them increase their range of fitness education skills; and motivate members to stick with their exercise programs to truly experience fitness results.

Advertising. We advertise in select trade publications, including publications that reach key industry stakeholders. Specific placement is driven by marketing and product development events and ads are coded to assist us in measuring the effectiveness of each individual ad with respect to our objectives of increasing brand awareness and increasing sales leads.

Direct Mail Promotions. We maintain a database that includes contacts at thousands of commercial facilities and enables us to monitor responses to direct mail promotions. All direct mail promotions are supplemented by a telemarketing effort to maximize customer response.

Public Relations. In the commercial market, public relations are a critical component in our strategy to build awareness and credibility for the Company and our products in the marketplace. Positioning the Company as the leading comprehensive provider of fitness equipment and education requires us to change the general perception that our brands stand alone to the understanding that our brands work together to deliver the most complete fitness system available. In order to meet these objectives, we have established relationships with key media outlets to develop and communicate our competitive advantages.

Trade Shows. There are several national and regional industry trade shows, such as the IHRSA and Club Industry, as well as many events that showcase our programs and products. Trade shows also provide excellent opportunities to meet face-to-face with our customers and the press to obtain valuable feedback by being able to test marketing messages, receive customer input on product designs, and evaluate the competition.

Internet. We currently maintain and direct customers to our Nautilus, Schwinn Fitness and StairMaster websites, which can be found at www.nautilus.com, www.schwinnfitness.com, and www.stairmaster.com, respectively. These websites contain Company and product information. None of the information on these websites is part of this Form 10-K.

Retail Approach

The main focus for marketing our retail products is two-fold: 1) fully support our network of dealers, and 2) leverage our direct marketing advertising dollars to market products through the retail sales channel that were previously only available to consumers through the direct sales channel. Company sponsored marketing programs have been developed to ensure that our Nautilus, Schwinn, Bowflex, StairMaster and Trimline brands remain prominent in the minds of dealer staff and consumers and drive consumers to their local retailers.

Health and Fitness e-newsletter. Created to motivate and educate our customers, the newsletter is now a consumer campaign, allowing the Company to reach thousands of health conscious readers every month. By delivering the newsletter to the email inboxes of thousands of consumers and making the newsletter available on our website, we are developing long-term customer relationships and a community of fitness enthusiasts. In addition, dealers may label and distribute the newsletter through their stores.

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Public Relations. In the retail market, public relations is a cost-effective way to promote our products in consumer publications. While advertising in fitness industry publications is expensive, editorial and showcase articles that include our products are virtually free. Our public relations strategy in the retail sector is to build awareness of the general benefits of fitness and specific contributions of our products to a healthy and fit lifestyle.

Trade Shows. There are three national trade shows that are very important to the Company’s retail division: the Health & Fitness Business Expo, the industry’s premier showcase for retail fitness products; Interbike, the bicycle industry’s premier gathering; and Supershow, the mega-trade show representing retail products in virtually every category. Trade shows also provide excellent opportunities to meet face-to-face with our customers and the press to obtain valuable feedback on marketing messages, product designs, and the competition.

Internet. The Company currently maintains and directs customers to our Nautilus, Schwinn Fitness, Bowflex, StairMaster, and Trimline websites, which can be found at www.nautilus.com, www.schwinnfitness.com, www.bowflex.com, www.stairmaster.com, and www.hebbindustries.com. These websites contain Company and product information. None of the information on these websites is part of this Form 10-K.

International Approach

Our international operations are headquartered in Switzerland. Currently, the amount of long-lived assets outside the U.S. is not material. We have integrated all of our brands from an operational standpoint and are distributing our products through a network of over 90 distributors in over 50 countries divided among three regions:

In each of these regions, we have responsible sales people and third party warehouses (except Central/South America which we support from our United States distribution facilities) to deliver our products in a timely and cost effective manner. Communication amongst our business partners within each region is essential to our strategy so we may support our products, develop innovative marketing activities, and achieve global brand recognition.

In two of our largest international markets, the United Kingdom and Germany, we operate our own offices, which possess a team of sales representatives that focus not only on selling to fitness clubs but also on selling to the government, hotel, and medical/paramedical markets. We added a sales office in Italy in 2002, as Italy represents another market we perceive to be important. Canada is another significant market for our business, but we do not maintain operations in Canada as product distribution is conveniently supported from our U.S. operations. We sell products from our commercial/retail and direct segment product portfolios to dealers and retail stores within Canada.

We have alliances with distributors in most markets to sell commercial products from our Nautilus, Schwinn, and StairMaster brands. This enables us to sell “package deals” to international fitness clubs, which may prefer to buy from one supplier that can offer the broadest array of products at a competitive price. By

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building our portfolio of brand names, we have greater ability to compete in the international marketplace in which our main competitors have benefited for many years from the ability to negotiate “package deals.” We believe our brand names have strong recognition in the international marketplace, which will allow us to compete more effectively in the future.

Sales outside the U.S. represented approximately 13%, 10%, and 8% of consolidated net sales for 2003, 2002 and 2001, respectively.

Seasonality

In general, sales of our retail fitness equipment are highly seasonal. We believe that sales within our commercial/retail segment are considerably lower in the second quarter of the year compared to the other quarters. Our strongest quarter for the commercial/retail segment is generally the fourth quarter, followed by the first and third quarters. We believe the principal reason for this trend is the commercial/retail fitness industry’s preparation for the impact of New Year’s fitness resolutions and seasonal weather patterns related to colder winter months.

CONSUMER TRENDS

We believe our organic growth has benefited from a number of demographic and market trends that we expect will continue, including:

We believe these consumer trends bode well for our future growth prospects. Just as the “baby boomers,” those Americans born between 1946 and 1964, started the modern fitness movement, we believe they will continue to be a driving force as they age. According to the Sporting Goods Manufacturers Association (the “SGMA”), the population of Americans fitting this demographic profile is estimated to be around 77 million. We believe baby boomers will use more of their increasing leisure time for exercise and more of their disposable income for fitness equipment purchases as they strive to counter the effects of aging.

Trends in Exercise Equipment

Since 1990, the fitness equipment industry has more than doubled in size and has been the most successful category of sporting goods. Interest in exercising with fitness equipment is supported by the increase in health club memberships in the U.S., which according to the SGMA, have increased 75% from 20.7 million in 1990 to 36.3 million in 2002. Consumer interest in health clubs has benefited the market for home fitness equipment as well as the commercial fitness equipment business. Consumers who utilize health clubs are exposed to an array of fitness equipment products and brand names, as well as education about the uses and benefits of fitness equipment.

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The U.S. fitness equipment market consists of two distinct market segments: home and institutional. The institutional, or commercial, fitness market is more visible to consumers, but the home market is much larger and has experienced much of the meaningful growth in the overall market. Based on statistics provided by the SGMA, 2003 sales of home equipment by manufacturers in wholesale dollars totaled approximately $3.2 billion, representing more than 80% of the overall fitness equipment market. We believe these wholesale dollars translate to approximately $6.4 billion in retail sales of home fitness equipment in 2003, representing a compound annual growth rate of approximately 10% since 1990. In contrast, the SGMA reports that sales of commercial fitness equipment totaled approximately $0.7 billion in 2003, which is flat compared to 2002. We estimate our target market to be approximately $5.0 billion as our products are sold at both wholesale and retail prices.

According to the SGMA, the fitness equipment market increased an estimated 2.8% in 2003 after less than 2.0% growth during the previous two years. Market conditions improved during the second half of 2003 consistent with the broader U.S. economic recovery. According to the SGMA, the outlook for 2004 is even better, with projected growth of 3.9% in fitness equipment sales. The SGMA cites anticipated continued economic recovery, continued expansion of the new housing market where consumers have trended to building larger homes, and a renewal of health club expansion plans in light of the recent economic recovery as reasons for the growth expectation.

The SGMA identifies strength training equipment as an expanding segment of the fitness equipment market. Cardiovascular fitness equipment has historically been and continues to be the most popular with consumers. Treadmills have been best sellers among the cardiovascular fitness equipment category representing approximately one-third of overall fitness equipment sales in 2002. The outlook for strength training equipment is positive as its use is becoming widely recognized not just for its impact on appearance, but also for the health benefits it can provide. According to a survey by American Sports Data, Inc., the number of Americans who frequently used strength equipment in their workout routines increased approximately 65% from 1990 to 2002 compared to 35% growth in the use of cardiovascular equipment.

The international markets represent a strong opportunity for growth, driven by the continued fitness boom across Europe and the increasing focus on fitness and healthy lifestyles by more affluent consumers in Asia and Latin America. In fact, according to recent data published by the International Health, Racquet and Sportsclub Association (the “IHRSA”), there are approximately 29,000 health clubs in Europe, 7,800 in Latin America and 4,800 in the Asia/Australia market. For comparison, there are approximately 22,000 clubs currently operated in the U.S. According to the IHRSA, health club memberships in the United Kingdom totaled 4.4 million in 2002 compared with 1.5 million in 1996, an increase of 194%. Health club memberships in Germany totaled 5.4 million in 2002 compared with 3.3 million in 1995, an increase of 64%. We believe demand for U.S. products will increase, as foreign consumers increasingly demand the reliability, service and innovative designs provided by U.S. suppliers.

Trends in Rest Products

The United States mattress market is large and dominated by several major manufacturers whose primary focus is the conventional innerspring mattress. According to the International Sleep Products Association (the “ISPA”), United States mattress and foundation sales totaled 38.9 million units shipped in 2002, representing a 0.7% increase from 2001. Total dollar value of these wholesale shipments increased 3.8% to $4.8 billion in 2002 compared to 2001. We believe these wholesale dollars equate to over $8.0 billion in retail sales. The ISPA attributes this growth in 2002 to the significant expansion in the housing market, where new housing starts increased by approximately 5% in 2002. We believe the market for specialty sleep systems to be approximately $1.0 billion.

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Trends in Nutrition Products

The market for nutritional supplements is large and yet is highly fragmented with many manufacturers. According to the Nutrition Business Journal (the “NBJ”), United States nutritional supplement sales totaled $18.0 billion in 2002, representing a 4.0% increase compared to 2001. Within the nutritional supplements industry category, sports nutrition supplements and meal replacement products are the market segments in which we compete. According to the NBJ, wholesale sales of sports nutrition supplements and meal replacement products totaled $4.4 billion in 2002, representing increases of 6.0% and 12.0% compared to 2001, respectively. We estimate our target market to be approximately $5.4 billion as our products are sold at both wholesale and retail prices. Sports nutritionals have gained wide acceptance as an essential component of a committed athletic lifestyle, but increasing numbers of consumers who aren’t necessarily health club devotees are also turning to sports nutritionals, often in lieu of traditional beverages and snacks. Marketers across the board have responded by downplaying their long-standing hard-core sports image and highlighting the broader nutritional, energy-boosting, and wellness benefits of their products.

COMPETITION

Direct Business Segment

Home Fitness Equipment. The market for our Bowflex strength and TreadClimber cardiovascular fitness products is highly competitive. Our competitors frequently introduce new and/or improved products, often accompanied by major advertising and promotional programs. We believe the principal competitive factors affecting this portion of our business are price, financing options, warranties, quality, brand name recognition, product innovation and customer service. Our Bowflex and TreadClimber products compete directly with a large number of companies that manufacture, market and distribute home fitness equipment. Our principal direct competitors include ICON Health and Fitness (marketing products under the brand names Powerflex, Crossbow, Health Rider, NordicTrak, Image, ProForm, Weslo, and under license, Weider and Gold’s Gym) and Fitness Quest (through its Gazelle, Total Gym, and SlamMan brands). We believe our Bowflex and TreadClimber lines of home exercise equipment are competitive within the market for home fitness equipment based on innovative product design, quality, and performance. Additionally, we believe our direct marketing activities are effective in distinguishing our products from the competition.

Nautilus Sleep Systems. The sleep products 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. We believe market participants compete primarily on the basis of price, product quality and durability, brand name recognition, innovative features, warranties and return policies. We believe 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. Although we believe our Nautilus Sleep Systems offer consumers an appealing alternative to conventional mattresses, many of these conventional manufacturers, including Sealy, Serta, Simmons and Spring Air, possess greater financial, marketing and manufacturing resources and have better brand name recognition.

In addition to the conventional mattress manufacturers, several manufacturers currently offer beds with variable support air chamber technology similar to our Nautilus Sleep Systems. We believe the largest manufacturer in this niche market is Select Comfort. Select Comfort offers its sleep systems through retail stores 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 supported by marketing

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and manufacturing resources and has significantly greater experience in marketing and distributing sleep systems. We believe the market for sleep systems is large enough for both companies to be successful and that our Nautilus Sleep Systems possess features that will enable us to compete effectively. However, the intense competition in the mattress industry, both from conventional mattress manufacturers and Select Comfort, has adversely affected our efforts to market and sell our sleep systems. Consequently, we decreased direct advertising for our sleep systems during 2003 in order to reassess our marketing message. A new marketing campaign for our Nautilus Sleep Systems is expected to be launched in 2004.

Commercial/Retail Segment Products

Commercial Fitness Equipment. The market for commercial fitness equipment is highly competitive. Our Nautilus, Schwinn, and StairMaster products compete against the products of numerous other commercial fitness equipment companies, including Life Fitness (a division of Brunswick), Cybex, Star Trac, Precor (owned by Amer Group, PLC), and Techno Gym. We believe the key competitive factors in this industry include price, quality, durability, diversity of features, financing options, product service network, and warranties. Some of our competitors have greater financial resources, more experience in the fitness industry, and more extensive experience manufacturing their products.

Retail Fitness Equipment. Strong competition exists with respect to the retail fitness equipment market. Our Nautilus, Schwinn, Bowflex, StairMaster, and Trimline retail products compete against the products of numerous domestic retail fitness equipment companies including ICON Health & Fitness (marketing products under the brand names Weslo, Crossbow, Health Rider, NordicTrak, ProForm, Image and, under license, Reebok, Weider and Gold’s Gym), Life Fitness, Star Trac, True Fitness Technology, HOIST Fitness Systems, Horizon Fitness (a division of Johnson Health Tech), Cybex, Fitness Quest, and Precor. The principal competitive factors in the retail fitness equipment industry include price, quality, brand name recognition, customer service and the ability to create and develop new, innovative products. There are limited technological, manufacturing or marketing barriers to entry into the fitness equipment markets in which we compete. Like many companies in the industry, we have sought and received patent and trademark protection on our products in an effort to protect our competitive position.

We believe that our combination of recognized brand names, high quality products, multiple distribution channels, and dependable customer service allows us to remain competitive in our current markets.

STRATEGY

Our mission is to be a complete provider of products to the health and fitness industry and help people achieve a fit and healthy lifestyle through proper exercise, rest and nutrition. At the core of this mission is an internal initiative called FIT #1, which is the foundation of our plan to create long-term shareholder value.

FIT #1 stands for Financial rigor, Innovation, Trust and a drive to be #1 in the categories in which we compete. These are the core strategic elements around which we plan to structure our activities, enabling us to refocus our efforts and begin to grow again. Financial rigor means we must ensure accurate and streamlined financial and forecasting processes. Innovation means we must apply creative solutions to both research and development and business operations. Trust means we must ensure we are taking care of our customers and stockholders and doing everything we can to serve them.

In 2003, we conducted a thorough due diligence process, in which we interviewed our internal team, spoke with industry consultants, and conducted the most comprehensive market research study in our history in order to help identify and realize our growth opportunities. We have targeted several areas as significant opportunities for growth, including leveraging our research and development capabilities to launch new products and repositioning our strength, cardiovascular, and sleep products to better meet customer demand and shopping patterns. We also seek to improve operating efficiencies and cash flow by streamlining operations and maximizing business synergies, such as brand equity, sales channels and marketing resources.

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Market Research

Our market research indicated that while we possess distinct competitive advantages, we have not fully capitalized on the many opportunities available to us in the $11.4 billion exercise, rest and nutrition markets that we compete in. During 2003, we performed in-depth analysis of our business model and believe that we have significant opportunities to optimize our sales channel mix for our brands. We are a leader in selling strength products through the direct marketing channel, but our research showed that approximately 80% of our target consumer market buys fitness products through the retail channel and 60% of the dollars are spent on cardiovascular products.

Focus on Innovation

We plan to leverage our advanced research and development capabilities and our strong brand names to expand our existing product lines and launch new innovative products. Innovation is an important part of our strategy as we continue to emphasize the expansion and diversification of our product development capabilities in health and fitness products. We develop new products either from internally generated ideas or by acquiring or licensing patented technology from outside inventors and then enhancing the technology.

Our research and development competencies have been enhanced through the acquisition of Schwinn Fitness and StairMaster. With the purchase of these companies, we gained a state-of-the-art test facility and prototype shop, along with added designers and engineers. Our additional research and development resources have allowed us to become fully integrated in the product development process, allowing us to take a new product concept from the beginning of feasibility studies straight through to production and continuing product review. This integration allows us a greater degree of control over the new product process, which should allow us to generate a higher quality product, increase our speed to market, and control our costs.

Research and development expense was $5.7 million, $4.5 million, and $2.2 million for 2003, 2002, and 2001, respectively.

Leverage Sales Channels

We are repositioning our products to better meet customer demand and shopping patterns. This means offering more of the products consumers want (e.g. cardiovascular fitness equipment) in the places consumers want to buy our products (e.g. retail outlets). We are moving more of our products to the retail channel and are differentiating our products to specifically fit the needs of the consumer shopping in each sales channel. For example, we will sell different models of Bowflex in specialty retail as compared to the direct sales channel. This strategy will allow us and our partners to have differentiated products under the same brand, enabling each channel to provide the products its consumers demand. In addition, we plan to reposition our Nautilus Sleep Systems line of premium air support sleep mattresses with an enhanced product and more effective marketing through our direct business segment.

Streamline Company Operations

Another foundational element of our strategy is our effort to reorganize from a channel focus to a customer focus. We intend to manage and operate as one company and not several separate channel-based businesses. Included in this focus change is a drive to leverage our expertise, experience and diversity of thought from across our organization to realize synergies, efficiencies and cost savings. In 2004 we will seek to adopt best practices across our locations and experience the benefits of one research and development team, one sales

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methodology, and common warehousing and distribution facilities for all our products in the most effective locations. We are establishing a performance-driven culture based on teamwork that clearly ties employee compensation to both company and individual performance. We are seeking to develop a high-energy collaborative culture with a clear focus on the metrics that drive performance and create shareholder value. Into 2005 we will seek common technology platforms, including our websites to further capitalize on the power of one team, one Company.

EMPLOYEES

As of December 31, 2003, we employed 1,126 employees, including 4 executive officers. None of our employees are subject to any collective bargaining agreements.

INTELLECTUAL PROPERTY

We own many trademarks including Nautilus^®, Bowflex^®, Power Rod^®, TreadClimber^®, Schwinn^® (fitness products), StairMaster^® and Trimline^®. Our trademarks, many of which are registered or subject to pending applications in the United States and other countries, are used on a variety of our products. We believe that our trademarks are of great value, assuring the consumer that the product being purchased is of high quality and provides a good value.

We also place significant value on product designs (the overall appearance and image of our products) and processes which, as much as trademarks, distinguish our products in the marketplace. We hold many United States and foreign patents and have submitted additional applications for patent protection that are pending approval. We believe all patents are important to our strategy and have identified the patents on the Bowflex Power Rod resistance technology and TreadClimber as the most significant to our business. Although our Bowflex trademark is protected as long as we continuously use the trademark, the main U.S. patent on our Bowflex Power Rod resistance technology expires on April 27, 2004. The main U.S. patent on our TreadClimber line of cardiovascular equipment expires on December 13, 2013. The expiration of our patents could trigger the introduction of similar products by competitors.

Building our intellectual property portfolio 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 are very protective of these proprietary rights and take action to prevent counterfeit reproductions or other infringing products. Refer to Item 3, Legal Proceedings, and Note 15 of the Notes to Consolidated Financial Statements for a discussion of significant intellectual property disputes. As we expand our market share, geographic scope and product categories, intellectual property disputes are anticipated to increase making it more expensive and challenging to establish and protect our proprietary rights and to defend against claims of infringement by others.

Each federally registered trademark is renewable indefinitely if the trademark 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 trademarks.

MANUFACTURING AND DISTRIBUTION

Our primary manufacturing and distribution objectives for all of our products are to maintain product quality, reduce and control costs, maximize production flexibility and improve delivery speed. Our product components are manufactured primarily in the U.S. and Asia. We have not experienced any significant issues with availability of raw materials or quality control either domestically or abroad, and do not anticipate any in the foreseeable future.

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For our direct-marketed and retail products, we mainly use Asian suppliers to manufacture the components and finished goods. Whenever possible, we attempt to use at least two suppliers to manufacture each product component in order to improve flexibility, efficiency, and emphasis on product quality. We do have domestic operations in Texas that manufactures our various lines of consumer treadmills and the TreadClimber product line.

Our commercial strength fitness products are manufactured in Virginia and our commercial cardiovascular fitness products are manufactured in Oklahoma. These 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 commercial products, and offer customers greater color specification flexibility, build-to-order capability, and unique product configurations.

Domestically, we inspect, package, and ship our products from our facilities in Washington, Virginia, Illinois, Texas, and Oklahoma. We rely primarily on United Parcel Service (UPS) to deliver our Bowflex, TreadClimber, and Nautilus Sleep Systems products. We distribute our retail and commercial fitness equipment from our facilities in Illinois, Oklahoma, and Texas using various commercial truck lines. We distribute commercial strength fitness equipment from our Virginia warehouse facilities directly to customers primarily through our truck fleet. This method of distribution allows us to effectively control the set up and inspection of equipment at the end-user’s facilities.

For international sales, we have distributors in over 50 countries, and we ship our products from leased facilities in Switzerland, the United Kingdom and Germany. We also lease, on a month-to-month basis, flexible warehouse space in multiple countries in Asia and Europe, the largest of which is located in the Netherlands. This flexible warehouse space is devoted to international distribution of our products.

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Item 2. Properties

The following is a summary of principal properties owned or leased by the Company:

In general, our properties are well maintained, adequate and suitable for their purposes, and we believe these properties will meet our operational needs for the foreseeable future. If we require additional warehouse or office space, we believe we will be able to obtain such space on commercially reasonable terms.

Item 3. Legal Proceedings

In the normal course of business, the Company is a party to various 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 the disposition of these matters will not have a material adverse effect on the Company’s financial position, results of operations or cash flows.

In December 2002, the Company filed suit against ICON Health and Fitness, Inc. (“ICON”) in the Federal District Court, Western District of Washington (the “District Court”) alleging infringement by ICON of the Company’s Bowflex patents and trademarks. The Company seeks injunctive relief, unquantified treble

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damages, and its fees and costs. In October 2003, the District Court dismissed our patent infringement claims. We appealed this decision to the United States Court of Appeals for the Federal Circuit (the “Appeals Court”), and in November 2003, the Appeals Court overruled the District Court and reinstated our patent infringement claims. The Company expects the District Court to conduct a trial on both our patent and trademark infringement claims against ICON in calendar year 2004.

In July 2003, the District Court ruled in favor of the Company on a motion for preliminary injunction on the issue of trademark infringement, and entered an order barring ICON from using the trademark “CrossBow” on any exercise equipment. In its ruling, the District Court concluded that the Company showed “a probability of success on the merits and irreparable injury” on its trademark infringement claim. ICON appealed this ruling to the Appeals Court. In August 2003, the Appeals Court granted ICON a temporary stay of the injunction, which allows ICON to continue using the trademark “CrossBow” until a decision is issued by the Appeals Court. The Company argued its case to the Appeals Court in October 2003, and the court has not yet issued a decision. As noted above, the Company expects the District Court to conduct a trial on both our patent and trademark infringement claims against ICON in calendar year 2004.

In cooperation with the U.S. Consumer Product Safety Commission (the “CPSC”), the Company began informing its retailers that, effective on or about December 8, 2003, the Company was implementing a safety reinforcement program specifically for Bowflex Power Pro exercise machines that are equipped with a lat tower attachment. This safety reinforcement program does not include Power Pro models without the lat tower attachment nor does it include any models of the Bowflex Motivator, Ultimate, Xtreme or Versatrainer. For its retail customers, the Company began working with its retailers to upgrade existing retail inventory with the necessary safety reinforcement hardware. For its direct customers, the Company mailed notification that the safety reinforcement kit was available free of charge upon request. A formal announcement was made jointly by the Company and the CPSC in January 2004, notifying customers how they could obtain a free safety reinforcement kit.

In February 2004, the Company was notified that the CPSC is investigating whether the Company violated the reporting obligations of the Consumer Product Safety Act (the “Act”) in connection with bench and lat tower incidents reported by users of the Bowflex Power Pro with lat tower attachment. Under the Act, the CPSC may assess penalties if it is determined that a product defect was not reported in accordance with the Act. The Company is fully cooperating with this investigation and believes the outcome will not have a material impact on its financial statements.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of our stockholders during the quarter ended December 31, 2003.

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PART II

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters

Market Price of Our Common Stock

From May 4, 1999 until May 20, 2002, our common stock was listed for trading exclusively on The NASDAQ National Market System under the symbol DFXI. On May 21, 2002, we transferred our listing to the New York Stock Exchange and changed our stock symbol to NLS. The following table summarizes the high and low closing prices and dividends paid for each period indicated:

As of March 1, 2004, 32,611,073 shares of our common stock were issued and outstanding and held by approximately 20,234 beneficial shareholders.

During 2003, the Company began paying a $0.10 per share quarterly dividend resulting in an aggregate annual dividend of $0.40 per share in 2003. The total amount of dividends paid in 2003 was $13,030,000. 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.

The following table provides information about the Company’s equity compensation plan as of December 31, 2003:

For further information on the Company’s equity compensation plans, see Note 2 of the Notes to Consolidated Financial Statements.

Item 6. Selected Consolidated Financial Data

The selected consolidated financial data presented below for each year in the five-year period ended December 31, 2003 has been derived from our audited financial statements. The balance sheet data as of December 31, 2003 and 2002 and the statement of operations data for each of the years in the three year period ended December 31, 2003 have been derived from our audited financial statements included herein. The balance sheet data as of December 31, 2001, 2000, and 1999 and the statement of operations data for the years ended December 31, 2000 and 1999 have been derived from our audited financial statements not included in this document. The data presented below should be read in conjunction with our financial statements and notes thereto and Item 7, “Management’s Discussion and Analysis of Financial Condition and

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Results of Operations.” Comparability of financial results is affected by the acquisition of Schwinn Fitness in September 2001 and StairMaster in February 2002. For further discussion of financial information related to the acquisitions of Schwinn Fitness and StairMaster, see Note 4 of the Notes to Consolidated Financial Statements. Also, certain amounts from previous years have been reclassified to conform to the 2003 presentation with no effect on previously reported consolidated net income or stockholders’ equity.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The purpose of the Management’s Discussion and Analysis of Financial Condition and Results of Operations (the “MD&A”) is to provide readers with information necessary to understand the Company’s financial condition, changes in financial condition, liquidity and capital resources, and results of operations, as well as our prospects for the future. Below is an index to the MD&A.

EXECUTIVE OVERVIEW

2003 was a challenging year for the Company. We experienced declines in year-over-year net sales and net income for the first time in Company history. We attribute these results primarily to increased competition and higher advertising costs, which adversely impacted sales of our Bowflex products. After years of uninterrupted growth, unit sales of Bowflex products through the direct sales channel declined 42.5% in 2003 from an all-time high in 2002.

The Company responded with a turnaround plan focused on repositioning our products to better meet customer demand and shopping patterns, leveraging our multiple sales channels by cross-selling products and offering complete packages of cardiovascular and strength products, and innovation in providing our customers with new differentiated products at a more rapid pace. In 2003, two notable examples of executing on our strategic initiatives were the introduction of the Bowflex line of strength equipment to the retail sales channel and the launch of the revolutionary TreadClimber line of cardiovascular equipment through the direct sales channel.

Heading into 2004, we are encouraged by some trends that we intend to build upon going forward including increased net sales and earnings for our commercial/retail business segment, greater diversification of our net sales and earnings with new product introductions such as the TreadClimber, and sequential growth in quarterly Bowflex units sold beginning in the third quarter of 2003 for the first time since the second quarter of 2002.

We are also presented with some challenges heading into 2004. Our Bowflex Power Pro model was the subject of a voluntary product safety reinforcement program in cooperation with the Consumer Product Safety Commission (the “CPSC”) that was formally announced in January 2004. In addition, we expect an increase in competition with our Bowflex product line as the patent on the Power Rod resistance technology expires in April 2004.

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In summary, we had a difficult year in 2003, and 2004 will also present a number of challenges, but we are encouraged about our progress-to-date on our turnaround plan and our long-term potential. The turnaround plan we embarked upon in the middle of 2003 is a rigorous undertaking, but we believe that the brand and channel segmentation work we initiated will create the leading health and fitness company and deliver long-term value for our shareholders. In 2004 and beyond we plan to:

We are excited about the Company’s prospects as we continue to build on our solid foundation with a blueprint based on financial rigor, innovation and trust. Through careful planning and consistent execution, we expect to deliver both sales and earnings growth over the long term. We believe we have the infrastructure, balance sheet and management team to support this growth. Over the next nine to twelve months, we intend to continue laying the foundation for clear and sustainable progress, and we expect to show measurable results from these efforts in the latter part of 2004 and beyond.

CRITICAL ACCOUNTING POLICIES

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with Generally Accepted Accounting Principles. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Senior management has discussed the development, selection and disclosure of these estimates with the Audit Committee of our Board of Directors. Actual results may differ from these estimates under different assumptions or conditions.

An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact the financial statements. Management believes the following critical accounting policies reflect its more significant estimates and assumptions used in the preparation of the Consolidated Financial Statements.

Revenue Recognition

We recognize revenue when products are shipped and we have no significant remaining obligations, persuasive evidence of an arrangement exists, the price to the buyer is fixed or determinable, and

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collectibility is reasonably assured or probable. Revenue is recognized net of applicable promotional discounts, rebates, and return allowances. For all of our products, except Nautilus commercial equipment, revenue from product sales is recognized when title and risk of loss have passed. Revenue is recognized upon installation for the Nautilus commercial equipment if we are responsible for installation. Return allowances, which reduce product revenue by our best estimate of expected product returns, are estimated using historical experience. In addition, from time to time, we arrange for leases or other financing sources to enable certain of our commercial customers to purchase our equipment. In the event that a guarantee of the commercial customer’s lease obligation is made, we record a liability and corresponding reduction of revenue for the estimated fair value of the guarantee and then recognize revenue over the life of the lease obligation.

Stock-Based Compensation

We measure compensation expense for our stock-based employee compensation plans using the method prescribed by Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees. In Note 2 of the Notes to Consolidated Financial Statements, we provide pro forma disclosures of net income and earnings per share as if the method prescribed by SFAS No. 123, Accounting for Stock-Based Compensation, had been applied in measuring compensation expense. A change to recognize compensation expense for all options granted using a fair value approach in regularly reported financial results would have a significant impact on our results of operations.

Warranty Reserves

The product warranty reserve includes the cost to manufacture (raw materials, labor and overhead) or purchase warranty parts from our suppliers as well as the cost to ship those parts to our customers. The cost of labor to install a warranted part on our manufactured commercial equipment is also included. The warranty reserve is based on our historical experience with each product. A warranty reserve is established for new products based on historical experience with similar products, adjusted for any technological advances in manufacturing or materials used. We track warranty claims by part and reason for claim in order to identify any potential warranty trends. The warranty trends are evaluated periodically with respect to future volume and nature of likely claims. Adjustments, if any are so indicated, are made to the warranty reserve to reflect our judgment regarding the likely effect of the warranty trends on future claims. If we were to experience a significant volume of warranty claims for a particular part or for a particular reason, we may need to make design changes to our product. A change in warranty experience could have a significant impact on our financial position, results of operations and cash flows.

Product Safety Reinforcement (Recall) Program Reserve

The reserve for the product safety reinforcement (recall) program includes the cost of the reinforcement kits, the third-party call center costs to process customer requests for the kit, and costs to mail the kit to our customers. The reserve is calculated based on historical customer response rates for similar issues faced by other companies, as noted by the Consumer Product Safety Commission (the “CPSC”). Although our estimates are based on historical information, there remains a great deal of uncertainty due to the unique circumstances surrounding each company and product. If actual customer response rates vary from existing estimates, adjustments will be made to the reserve to reflect any changes in our judgment regarding ultimate customer response results. A change in program response rate from our estimates could have a significant impact on our financial position, results of operations and cash flows.

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Legal Reserves

We are involved in various claims, lawsuits and other proceedings from time to time. Such litigation involves uncertainty as to possible losses we may ultimately realize when one or more future events occur or fail to occur. We accrue and charge to income estimated losses from contingencies when it is probable (at the balance sheet date) that an asset has been impaired or liability incurred and the amount of loss can be reasonably estimated. Differences between estimates recorded and actual amounts determined in subsequent periods are treated as changes in accounting estimates (i.e., they are reflected in the financial statements in the period in which they are determined to be losses, with no retroactive restatement). The Company estimates the probability of losses on legal contingencies based on the advice of internal and external counsel, the outcomes from similar litigation, the 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. We regularly monitor our estimated exposure to these contingencies and, as additional information becomes known, may change our estimates significantly. A significant change in our estimates, or a result that materially differs from our estimates, could have a significant impact on our financial position, results of operations and cash flows.

Sales Return Reserves

The sales return reserve is maintained based on our historical experience of direct-marketed product return rates during the period in which a customer can return a product for refund of the full purchase price, less shipping and handling in most instances. The return periods for Bowflex, TreadClimber, Champion Nutrition, and Nautilus Sleep Systems product lines are six weeks, 30 days, 30 days, and 90 days, respectively. Sales returns are insignificant for products sold through our commercial/retail distribution channels. We track all direct-marketed product returns in order to identify any potential negative customer satisfaction trends. Our return reserve may be sensitive to a change in our customers’ ability to pay during the trial period due to unforeseen economic circumstances and to different product introductions that might fulfill the customers’ needs at a perceived better value. Any major change in the aforementioned factors may increase sales returns, which could have a significant impact on our financial position, results of operations and cash flows.

Allowance for Doubtful Accounts

The allowance for doubtful accounts is maintained at a level based on our historical experience adjusted for any known uncollectible amounts. We periodically review the creditworthiness of our customers to help gauge collectibility. Our allowance is sensitive to changes in our customers’ ability to pay due to unforeseen changes in the economy, including the bankruptcy of a major customer, our efforts to actively pursue collections, and increases in chargebacks. Any major change in the aforementioned factors may result in increasing the allowance for doubtful accounts, which could have a significant impact on our financial position, results of operations and cash flows.

Inventory Valuation

Our inventory is valued at the lower of cost (standard or average depending on location) or market. Inventory adjustments are applied for any known obsolete or defective products. We periodically review inventory levels of our product lines in conjunction with market trends to assess salability of our products. Our assessment of necessary adjustments to market value of inventory is sensitive to changes in fitness technology and competitor product offerings driven by customer demand. Any major change in the aforementioned factors may result in reductions to market value of inventory below cost, which could have a significant impact on our financial position, results of operations and cash flows.

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Intangible Asset Valuation

Currently, intangible assets consist predominantly of the Nautilus, Schwinn, and StairMaster trademarks and goodwill associated with the acquisition of Schwinn Fitness. Management estimates affecting these trademark and goodwill valuations include determination of useful lives and estimates of future cash flows and fair values to perform an impairment analysis on an annual basis. The useful lives assigned by management to the Nautilus, Schwinn, and StairMaster trademarks and Schwinn Fitness goodwill are indefinite, 20 years, indefinite, and indefinite, respectively. Any major change in the useful lives and/or the determination of an impairment associated with the valuation of the aforementioned intangible assets may result in asset value write-downs, which could have a significant impact on our current and future financial position and results of operations.

Income Tax Provision

The Company follows SFAS No. 109, Accounting for Income Taxes, which requires the use of the liability method in accounting for income taxes. The Company’s annual provision for income taxes and the determination of the resulting deferred tax assets and liabilities involve a significant amount of management judgment and are based on the best information available at the time. The Company maintains reserves for estimated tax exposures in jurisdictions of operation. These tax jurisdictions include federal, state and various international tax jurisdictions. Exposures are settled primarily through the settlement of audits within these tax jurisdictions, but can also be affected by changes in applicable tax law or other factors, which could cause management of the Company to believe a revision of past estimates is appropriate. Management believes that an appropriate liability has been established for estimated exposures; however, actual results may differ materially from these estimates. The liabilities are frequently reviewed for their adequacy and appropriateness. To the extent the audits or other events result in a material adjustment to the accrued estimates, the effect would be recognized in income tax expense (benefit) in the Consolidated Statement of Income in the period of the event.

Deferred tax assets and liabilities are recognized based on the difference between the consolidated financial statement carrying value of existing assets and liabilities and their respective tax bases. Inherent in the measurement of these deferred balances are certain judgments and interpretations of existing tax law and other published guidance as applied to our operations. When it is more likely than not that all or some portion of specific deferred tax assets will not be realized, a valuation allowance must be established for the amount of the deferred tax assets that are determined not to be realizable. No valuation allowance has been provided for deferred tax assets, since we anticipate the full amount of these assets should be realized in the future. Accordingly, if the Company’s facts or financial results were to change thereby impacting the likelihood of realizing the deferred tax assets, judgment would have to be applied to determine changes to the amount of the valuation allowance required to be in place on the financial statements in any given period.

RESULTS OF OPERATIONS

This discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report. We believe that period-to-period comparisons of our operating results are not necessarily indicative of future performance. You should consider our prospects in light of the risks, expenses and difficulties frequently encountered by companies that operate in evolving markets. We may not be able to successfully address these risks and difficulties and, consequently, we cannot assure you of any future growth or profitability. For more information, see our discussion of Risks and Uncertainties beginning on page 36.

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The following tables present certain consolidated financial data as a percentage of net sales and statement of operations data comparing results for 2003, 2002, and 2001:

Statement of Operations Data

Statement of Operations Data

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COMPARISON OF THE YEARS ENDED DECEMBER 31, 2003 AND DECEMBER 31, 2002

Net Sales

Net sales decreased by 14.7% in 2003 compared to 2002. We experienced a challenging business environment in 2003. We believe this was primarily due to increased competition and higher advertising costs due to increased demand for advertising time. These factors reduced sales conversion rates for our direct-marketed products.

Sales within our direct segment were $246.9 million in 2003, a decrease of 37.1% compared with 2002. Our direct segment accounted for 49.5% of our aggregate net sales in 2003, down from 67.2% in 2002. Within our direct segment, Bowflex sales accounted for 84.7% of sales in 2003 compared to 91.2% of sales in 2002. The decrease in direct segment sales can be attributed to a combination of factors including increased competition for our Bowflex product line and managing our advertising spending in a higher advertising cost environment to optimize profitability. We believe competing products have adversely affected demand for our Bowflex products as unit sales through the direct channel declined to 138,000 in 2003 from 240,000 in 2002, a decline of 42.5%. Additionally, advertising costs have risen when comparing 2003 to 2002, resulting in lower sales of direct-marketed products for comparable advertising spending. As a percentage of sales, selling and marketing expense for the direct segment was 48.9% in 2003 compared to 30.9% in 2002. In July of 2003, we introduced the Bowflex Xtreme to compete more effectively with our lower-priced competition. The average Bowflex selling price increased 2.1% year over year, but declined 3.2% in comparing the fourth quarter of 2003 to the same period in 2002. We anticipate the introduction of lower-priced competing products to increase going forward, especially upon expiration of the main Bowflex patent in April 2004.

During the second quarter of 2003, we began a process of reassessing the marketing plan for our Nautilus Sleep Systems product line. This has involved a reduction in the amount of advertising spending for this product line, which has also resulted in a reduction in sales compared with 2002. We are repositioning the Nautilus Sleep System by improving the features of this brand and exploring unique, specialized channels of distribution. Our repositioning effort will not be complete on this product until the latter half of 2004, and at that time we expect to re-launch the Nautilus Sleep Systems.

Our new TreadClimber product line, introduced in March 2003, has exceeded our expectations having achieved $18.9 million in sales for the year. These sales were achieved despite our plan of restrained demand. When we introduced the TreadClimber, we wanted to ensure that our manufacturing, marketing and operations were all performing in unison before we expanded our marketing efforts. We are excited about the potential this newly created brand will offer for years to come. The TreadClimber represents a significant milestone as we attempt to further diversify our revenue and earnings streams. We expect TreadClimber sales to be a significant portion of our non-Bowflex revenue, which increased to 48% of consolidated net sales in 2003 compared to 39% and 26% in 2002 and 2001, respectively. In 2004 we believe the TreadClimber product line will generate approximately $50 to $60 million in revenue.

Sales within our commercial/retail segment were $251.9 million in 2003, an increase of 31.2% over 2002. Excluding our acquisition of StairMaster, commercial/retail segment sales increased 36.5% during 2003 compared to 2002. The increase in sales within the commercial/retail segment is primarily attributable to the introduction of the Bowflex to the retail side of the business, which equated to sales of $49.2 million. Bowflex sales accounted for 19.5% of overall commercial/retail segment sales and 82.1% of the increase in commercial/retail sales during 2003. Due to encouraging results from our initial test-marketing plan that began in the first quarter of 2003, we expanded the retail distribution of Bowflex products throughout the remainder of 2003. We were able to leverage the hundreds of millions of dollars spent on television advertising of the Bowflex product line to create consumer demand in the retail sales channel where many consumers prefer buying premium fitness products. In the future, we anticipate more of our direct segment products being sold through the commercial/retail sales channel in order to leverage our significant direct marketing advertising investment.

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In the fourth quarter of 2003, Bowflex unit sales through our direct and retail channels combined were 53,000 units compared to 49,000 and 42,000 for the third and second quarters of 2003, respectively. One of the reasons we were able to achieve this sequential growth in Bowflex units is because of the synergy between the direct and retail channels. Additionally, we believe the sales momentum for our Bowflex brand is due to the fact that it is widely regarded by consumers as one of the most innovative products in the consumer strength fitness industry. To capitalize on this reputation, we will have Bowflex products in multiple sales channels that will be differentiated to fit the needs of consumers shopping those channels. For example, we will not sell in large retail outlets the same Bowflex product we sell in specialty retail or in the direct sales channel. This strategy will allow us and our retail partners to have differentiated products under the same brand name so we minimize competition amongst ourselves and our partners, while at the same time delivering the products our consumers want in the sales channel in which they want to shop.

Besides the Bowflex, our commercial/retail segment product portfolio consists of a wide array of both strength and cardiovascular fitness products sold through the commercial and retail channels under brand names that include Nautilus, Schwinn, StairMaster, and Trimline. In 2003, our commercial/retail segment accounted for 50.5% of our net sales, up from 32.8% in 2002, as we continued to execute our strategy of expanding our presence, product lines, and brands across all our sales channels, especially within the commercial/retail segment. This increase in commercial/retail segment sales as a percentage of our total net sales can also be attributed to the decline in direct segment sales during 2003 compared to 2002. During 2003, our commercial/retail business segment sales increased 5.6%, excluding the introduction of the Bowflex product line to the retail sales channel.

In our commercial business we launched a new StairMaster commercial treadmill in the latter half of 2003. We also introduced a number of new products at the October Club Industry Commercial Fitness Equipment Show in Chicago. One of the products presented was our new StairMaster commercial elliptical machine. We also introduced the new Nautilus Nitro Plus commercial strength equipment line. We began production on this new strength line at the end of the fourth quarter of 2003 and we expect to begin selling this product in the first quarter of 2004. Later in 2004, we plan to launch the first variable stride elliptical commercial cardio machine and a commercial version of the popular TreadClimber cardio product.

We continue to become more competitive in our commercial sales channel because of our ability to offer a complete line of cardiovascular equipment, which represents about 70% of the dollars spent in the commercial industry. In the past this has been an underrepresented area of our product offering. However, with the addition of our new commercial elliptical and commercial treadmills, we are now beginning to address this underserved market opportunity. We are now able to sell complete packages of cardiovascular and strength products together.

We have been undergoing a sales channel and brand shift from primarily the direct channel to a more diversified and balanced penetration in retail, commercial and direct channels. We have also created a better balance between cardiovascular and strength products. In the past, we have been primarily focused on selling strength products through our direct channel, but a thorough marketing research study undertaken in 2003 showed that 80% of our target consumer market buys fitness products through the retail channel and 60% of the dollars are spent on cardiovascular products. We expect our sales through the commercial/retail channel to continue to grow as a percentage of consolidated sales as we continue to focus our marketing efforts and product offerings toward our target consumer.

We believe our business will show increased seasonality going forward as we anticipate sales through the commercial/retail channels will continue to grow as a percentage of total sales. In our direct marketing

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business we have found that second quarter influences on television viewership, such as the broadcast of national network season finales and seasonal weather factors, cause our spot television commercials on national cable television to be less effective in the second quarter than in other periods of the year. Our retail business is also highly seasonal. We believe that sales within our commercial/retail segment are considerably lower in the second quarter of the year compared to the other quarters. Our strongest quarter for the commercial/retail segment is generally the fourth quarter, followed by the first and third quarters. We believe the principal reason for this trend is the commercial/retail fitness industry’s preparation for the impact of New Year’s fitness resolutions and seasonal weather patterns related to colder winter months. As we continue to move to a more diversified revenue stream, we expect to experience overall seasonality similar to the retail and commercial sales channels. We believe our revenue and earnings will be lower in the first half of 2004 compared to the latter half of the year, with the second quarter experiencing the most softness. In the first six months of 2003, our commercial and retail sales channels generated approximately 37% of its full year revenue and 22% of its full year net income.

Gross Profit

Gross profits decreased 26.0% in 2003 compared to 2002. As sales of inherently lower margin products in the commercial/retail segment continued to grow as a percentage of total sales, our overall gross profit margin decreased to 49.3% in 2003, compared to 56.8% in 2002.

The gross profit margin within our direct segment was 69.3% in 2003 compared to 73.4% in 2002. Direct segment margin was significantly impacted by $3 million of estimated product safety reinforcement costs associated with the Bowflex Power Pro that was announced by our Company and the CPSC in January 2004. In addition, direct segment gross profit margin was negatively impacted by declining sales resulting in higher fixed costs per sale and a change in sales mix from the higher margin Bowflex to the TreadClimber. As we continue to sell more units of the TreadClimber we believe our TreadClimber margins will increase due to the leveraging of our fixed costs.

The increase in gross profit margin within our commercial/retail segment to 29.7% in 2003, compared with 23.0% in 2002, was primarily due to sales of Bowflex products through the retail channel. On average, Bowflex products have a higher gross profit margin than do our other commercial/retail products.

Operating Expenses

Selling and Marketing

Selling and marketing expenses increased 2.7% in 2003 compared to 2002. As a percentage of net sales, overall selling and marketing expenses increased to 29.9% in 2003 from 24.8% in 2002. Selling and marketing expenses within our direct segment were 48.9% of net sales in 2003, compared to 30.9% in 2002. Selling and marketing expenses within our commercial/retail segment were 11.3% of net sales in 2003, compared to 12.4% in 2002. The overall increase in selling and marketing is mainly due to reduced effectiveness of our direct advertising campaigns, partially offset by leveraging the direct channel advertising investment in the retail channel.

We experienced an increase in direct marketing advertising spending during 2003 in response to declines in our sales conversion rates coupled with a higher advertising cost environment. We believe the decline in conversion was a result of increased competition. In addition, depreciation associated with our newly implemented customer relationship management information system also contributed to the increase in selling and marketing costs.

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General and Administrative

General and administrative expenses increased 42.6% in 2003 compared to 2002. Our direct segment accounted for $6.6 million of the $11.1 million increase due primarily to depreciation, consulting costs, and wages associated with our newly implemented computer information systems. Our commercial/retail segment general and administrative expenses declined by $0.8 million due mostly to cost savings associated with the integration of the Schwinn Fitness and StairMaster businesses that we acquired in September 2001 and February 2002, respectively.

Our financial statements now reflect a third segment comprised of our corporate holding company which includes primarily general and administrative expenses such as investor relations, director costs, legal and accounting fees, and salaries of corporate personnel, as well as other costs not specifically attributable to our other two segments. For financial reporting purposes, we have reclassified prior year balances to conform to this three segment presentation with no effect on previously reported consolidated net income or stockholders’ equity. Corporate general and administrative expenses increased $5.2 million due primarily to additional legal related expenses. As a percentage of net sales, general and administrative expenses increased to 7.4% in 2003 from 4.5% in 2002.

Royalties

Royalty expense decreased 21.0% in 2003 from 2002. Our direct and commercial/retail segments have several agreements under which we are obligated to pay royalty fees on certain products. The decrease in our royalty expense is primarily attributable to the decreased sales of our Bowflex products. This decrease in Bowflex-related royalties was partially offset by royalty expense associated with our TreadClimber product sales. The patent for the Bowflex Power Rod resistance technology expires April 27, 2004, at which time we will no longer be obligated to pay royalties related to Bowflex sales. We are obligated to pay royalties (3% of TreadClimber sales) to the inventor of the main patent on the TreadClimber until this patent expires on December 13, 2013.

Income Tax Expense

Income tax expense decreased 64.9% in 2003 due to the decline in our income before taxes. We expect our income tax expense to fluctuate in line with changes in our income before taxes.

Net Income

For the reasons discussed above, net income declined to $34.4 million in 2003 from $97.9 million in 2002, a decrease of 64.9%.

COMPARISON OF THE YEARS ENDED DECEMBER 31, 2002 AND DECEMBER 31, 2001

Net Sales

Net sales increased by 60.7% to $584.7 million in 2002 from $363.9 million in 2001. Excluding our acquisitions of Schwinn Fitness and StairMaster, sales grew by approximately 32.6% on a consolidated basis in 2002 compared to 2001. The increase in sales was driven by the growth in our direct segment and continued expansion of our commercial/retail business.

Sales within our direct segment were $392.6 million in 2002, an increase of 34.2% over 2001. A significant reason for the increase in direct segment sales can be attributed to the introduction of our high-end Bowflex “Ultimate” at the end of the fourth quarter of 2001. The “Ultimate” was well received by consumers leading to sequential growth in the average selling price of our Bowflex product line in each quarter from its introduction in 2001 through 2002.

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Our direct segment accounted for 67.2% of our aggregate net sales in 2002, down from 80.4% in 2001, as we continued our strategies of diversification into the commercial and retail markets and of introducing new direct-marketed products.

Sales within our commercial/retail segment were $192.0 million in 2002, an increase of 169.3% over 2001. A significant portion of this growth is attributed to the acquisition of Schwinn Fitness in September 2001 and StairMaster in February 2002. Our commercial/retail segment accounted for 32.8% of our net sales in 2002, up from 19.6% in 2001 as we continued to execute our strategy of expanding our presence, product lines, and brands across all our channels, especially within the commercial/retail segment.

Gross Profit

Gross profits continued to be strong, growing 49.0% to $332.6 million in 2002 from $223.2 million in 2001. However, due to our product diversification strategy, which increased sales of inherently lower margin products in the commercial/retail segment, our overall gross profit margin decreased to 56.8% in 2002, compared to 61.3% in 2001.

The gross profit margin within our direct segment was 73.4% in 2002 and 69.8% in 2001. Gross margins on our Bowflex product line continued to be strong due to cost reductions from vendors and shipping cost savings. For example, the standard cost for the Bowflex “Power Pro” with a 210-pound rod pack was reduced approximately 18% by the fourth quarter of 2002 compared with the same period in 2001. In addition, product delivery costs were reduced by approximately 17% by the end of the fourth quarter of 2002 compared with the same period in 2001.

The decrease in gross profit margin within our commercial/retail segment to 23.0% in 2002, compared with 26.4% in 2001, was largely due to the Schwinn Fitness and StairMaster acquisitions. Other downward pressure on commercial/retail margins included discounts offered on sales of discontinued retail products and manufacturing inefficiencies associated with moves and the consolidation of our treadmill facilities. Discounts were offered to reduce inventory levels of older products in order to accommodate 16 new retail fitness products that were introduced during the third quarter.

Operating Expenses

Selling and Marketing

Selling and marketing expenses grew to $145.3 million in 2002 from $99.8 million in 2001, an increase of 45.5%. This increase in selling and marketing expenses resulted primarily from the expansion of our direct marketing campaign for Bowflex products and Nautilus Sleep Systems, higher advertising costs in the second half of 2002 due to increased demand for advertising time, and the acquisitions of Schwinn Fitness and StairMaster. Advertising costs for our direct marketing segment rose for the first time in about two years. As a percentage of net sales, overall selling and marketing expenses decreased to 24.8% in 2002 from 27.4% in 2001. The decrease was primarily a result of executing our product diversification strategy leading to a higher proportion of commercial/retail segment sales. Selling and marketing expenses within our direct segment were 30.9% of net sales in 2002, compared to 31.3% in 2001.

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General and Administrative

General and administrative expenses grew to $26.0 million in 2002 from $15.6 million in 2001, an increase of $10.4 million, or 67.1%. Our commercial/retail segment accounted for $7.4 million of the increase due primarily to our Schwinn Fitness and StairMaster acquisitions. The remainder of the increase was primarily due to increased staffing and infrastructure expenses necessary to support our growth. As a percentage of net sales, general and administrative expenses increased marginally to 4.5% in 2002 from 4.3% in 2001.

Royalties

Royalty expense grew to $10.1 million in 2002 from $7.4 million in 2001, an increase of 37.3%. The increase in our royalty expenses was primarily attributable to the increased sales of our Bowflex products, along with sales of other products under royalty agreements that were added as part of our diversification strategy.

Other Income

In 2002, other income was $1.8 million compared to $4.4 million for 2001. This decline resulted primarily from a decrease in interest earned on invested cash and cash equivalents. Because we used a significant portion of our cash for acquisitions and stock buybacks, we had less cash from which to derive interest income. Interest income also decreased due to interest rate cuts by the Federal Reserve Bank in 2002.

Income Tax Expense

Income tax expense increased by $16.8 million in 2002 primarily due to our increase in income before taxes.

Net Income

For the reasons discussed above, net income grew to $97.9 million in 2002 from $66.6 million in 2001, an increase of 47.0%.

QUARTERLY RESULTS OF OPERATIONS

The following table presents our operating results for each of the quarters in the periods ended December 31, 2003 and 2002. The information for each of these quarters is unaudited and has been prepared on the same basis as the audited financial statements appearing elsewhere in this Annual Report on Form 10-K. In the opinion of management, all necessary adjustments, consisting only of normal recurring adjustments, have been included to present fairly the unaudited quarterly results when read together with our audited financial statements and the related notes. Certain amounts from previous periods have been reclassified to conform to the 2003 full-year presentation with no effect on previously reported consolidated net income or stockholders’ equity. These operating results are not necessarily indicative of the results of any future period. Due to recent acquisitions within our commercial/retail segment, we expect heightened seasonality in our business. We expect sales in the second quarter to be weakest while the first and fourth quarters should be our strongest. We expect the fourth quarter will generally be stronger than the first quarter.

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LIQUIDITY AND CAPITAL RESOURCES

Historically, we have financed our business primarily from cash generated by our operating activities. During 2003, our operating activities generated $43.7 million in net cash, which contributed to an aggregate $72.6 million balance in cash and cash equivalents, compared with $100.6 million in net cash generated by our operating activities in 2002.

Net cash provided by investing activities was $10.5 million in 2003 compared with net cash used in investing activities in 2002 of $57.9 million. The largest component of this change was due to the acquisition cost of StairMaster in February of 2002 of $24.1 million, net of cash acquired. Additionally, we used $7.0 million during 2003 for capital expenditures primarily consisting of manufacturing equipment and information systems and related equipment compared to $31.5 million in 2002. Capital expenditures in 2002 were historically high due to substantial investments in computer systems ($16.7 million) and buildings ($11.5 million) that were not required in 2003. Offsetting the 2003 increase were proceeds from maturities of short-term investments, which were $17.6 million in 2003 versus $37.9 million in 2002.

Net cash used in financing activities was $13.5 million in 2003 compared to $47.2 million in 2002. The primary difference between the years was $13.0 million of dividends were paid in 2003, while $50.0 million was used in 2002 for stock repurchases compared to $1.4 million in 2003.

Working capital was $138.7 million at December 31, 2003 compared to $109.0 million at December 31, 2002, largely due to increased cash and cash equivalents as a result of net income for the period. The $25.4 million increase in trade receivables can primarily be attributed to the $29.7 million increase in sales through our commercial/retail segment in the fourth quarter of 2003 compared to the fourth quarter of 2002. The $10.7 million decrease in inventories can primarily be attributed to better alignment of inventory levels with sales volume. The $6.4 million decrease in trade payables is primarily due to the timing of inventory purchases and payments for those purchases. The $12.8 million increase in accrued liabilities can mostly be attributed to warranty, compensation and legal related expenses.

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We maintain a $10 million line of credit with a lending institution. The line of credit is secured by certain assets and contains several financial covenants. As of the date of this filing, we are in compliance with the covenants applicable to the line of credit, and there is no outstanding balance under the line.

We believe our existing cash balances, cash generated from operations and borrowings available under our line of credit, will be sufficient to meet our capital requirements for the foreseeable future.

The Company’s contractual obligations and commercial commitments (as defined in Item 303(a)(5) of Regulation S-K under the Securities Exchange Act of 1934) as of December 31, 2003 are as follows:

OFF-BALANCE SHEET ARRANGEMENTS

From time to time, we arrange for leases or other financing sources with third parties to enable certain of our commercial customers to purchase our equipment. While most of these financings are without recourse, in certain cases we may offer a guaranty or other recourse provisions. The purpose of these guaranties is to increase our selling opportunities to commercial customers that would not otherwise be able to obtain financing to purchase our equipment. At December 31, 2003, the maximum contingent liability under all recourse provisions was approximately $3.0 million. Refer to Note 1 of the Notes to Consolidated Financial Statements for further discussion of the accounting treatment for these arrangements. We expect an increase in these types of arrangements going forward.

INFLATION AND PRICE CHANGES

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 have, a material adverse effect on our financial position, results of operations or cash flows. However, increases in inflation over historical levels or uncertainty in the general economy could decrease discretionary consumer spending for products like ours. Very little of our revenue variation from prior periods is attributable to price changes.

RECENT ACCOUNTING PRONOUNCEMENTS

In July 2002, the Financial Accounting Standards Board (“the FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 146, Accounting for Costs Associated with Exit or Disposal Activities. The standard requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of commitment to an exit or disposal plan. Costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing, or other exit or disposal activity. The Company adopted this statement as of January 1, 2003. The Company believes this event is not material enough to warrant further disclosure and, therefore, continues to conclude that the adoption of SFAS No. 146 has not had a material effect on the Company’s financial position, results of operations, or cash flows.

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In November 2002, the FASB issued Interpretation (“FIN”) No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN No. 45 is an interpretation of FASB Statements No. 5, 57 and 107 and rescinds FIN No. 35. This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. The disclosure requirements in FIN No. 45 were effective for the year ended December 31, 2002. The adoption of the recognition requirement of FIN No. 45 has not had a material impact on the Company’s financial position or results of operations.

In January 2003, the FASB issued FIN No. 46, Consolidation of Variable Interest Entities (revised December 2003). FIN No. 46 addresses when a company should include in its financial statements the assets, liabilities and activities of a variable interest entity. FIN No. 46 defines variable interest entities as those entities with a business purpose that either do not have any equity investors with voting rights or have equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN No. 46 also requires disclosures about variable interest entities that a company is not required to consolidate, but in which it has a significant variable interest. FIN No. 46 consolidation requirements are effective for all variable interest entities created after January 31, 2003, and to pre-existing entities in the first fiscal year or interim period ending after December 15, 2003. Certain disclosure requirements are effective for financial statements issued after January 31, 2003. The adoption of FIN No. 46 has no effect on the Company’s financial position, results of operations or cash flows.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 has not had a material impact on the Company’s financial position, results of operations, or cash flows.

RISKS AND UNCERTAINTIES

While management is optimistic about the Company’s long-term prospects, the following issues and uncertainties, among others, should be considered in evaluating our long-term outlook.

Competition could increase significantly upon the expiration of the principal U.S. patent on our Bowflex Power Rod resistance technology on April 27, 2004.

Our Bowflex trademark is protected as long as we continuously use the trademark. However, the main U.S. patent on our Bowflex Power Rod resistance technology, a key component of our Bowflex products, expires on April 27, 2004. This impending patent expiration is expected to trigger the introduction of similar products by competitors and could result in a significant decline in our net sales.

Our failure or inability to protect our intellectual property could significantly harm our competitive position.

Protecting our intellectual property is an essential factor in maintaining our competitive position in the health and fitness industry. 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.

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A significant decline in availability of media time or a marked increase in advertising rates may hinder our ability to effectively market our products and may reduce profitability.

We depend primarily on 60-second “spot” television commercials and 30-minute television “infomercials” to market and sell our direct-marketed products. Consequently, a marked increase in the price we must pay for our preferred media time or a reduction in its availability may adversely impact our financial performance.

Government regulatory actions could disrupt our marketing efforts and product sales.

Various federal, state and local government authorities, including the Federal Trade Commission and the CPSC, regulate our marketing efforts and products. Our sales and profitability could be significantly harmed if any of these authorities commence a regulatory enforcement action that interrupts our marketing efforts, results in a product recall or negative publicity, or requires changes in product design.

As further discussed in Item 3, “Legal Proceedings,” the Company, in cooperation with the CPSC, has implemented a safety reinforcement program for Bowflex Power Pro exercise machines equipped with a lat tower attachment. Although we have reserved for estimated costs associated with the reinforcement program, actual consumer response could exceed our expectations, which could significantly impact our financial position, results of operations and cash flows.

Also, the CPSC is investigating whether the Company violated the reporting obligations of the Consumer Product Safety Act. As detailed in Item 3, “Legal Proceedings,” penalties are possible in connection with this investigation.

New product development is an essential component of our strategy; an inability to successfully develop new products could negatively impact our future profitability.

Our future success depends on our ability to develop or acquire the rights to, and then effectively market and sell, new products that create and respond to new and evolving consumer demands. Accordingly, our net sales and profitability may be harmed if we are unable to develop, or acquire the rights to, new and different products that satisfy our marketing criteria. In addition, any new products that we market may not generate sufficient net sales or profits to recoup their development or acquisition costs.

We also may not be able to successfully acquire intellectual property rights or potentially prevent others from claiming that we have violated their proprietary rights when we launch new products. We could incur substantial costs in defending against such claims, even if they are without basis, and we could become subject to judgments requiring us to pay substantial damages.

If we are unable to effectively integrate future acquired businesses into our operations, we may not achieve anticipated revenue, earnings and business synergies.

As we have done in the past, we may seek to acquire other businesses in the future. Integrating acquired businesses into our operations poses significant challenges, particularly with respect to corporate cultures and management teams. Failure to successfully effect the integration could adversely impact the revenue, earnings and business synergies we expect from the acquisitions. In addition, the process of integrating acquired businesses may be disruptive to our operations and may cause an interruption of, or a loss of momentum in, our core business.

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Our future integration efforts may be jeopardized, and our actual return on investment from such acquisitions may be lower than anticipated, as a result of various factors, including the following:

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. During 2003, approximately 52% of our net sales were attributable to our Bowflex products. Accordingly, any significant decline in consumer interest in our Bowflex products could significantly reduce our sales and profitability. Sales of our Bowflex line could significantly decline if, for example, existing competing products experienced increased consumer demand, new competing products were effectively marketed and resulted in significant consumer purchases, or if the market for our Bowflex line becomes saturated. Although we have significantly diversified our revenue base over the past several years, we anticipate that sales of our Bowflex product line will continue to account for a substantial portion of our net sales for the foreseeable future.

A deterioration in product quality or increase in product liability could adversely affect our business.

We rely on third party manufacturers for a significant portion of our product components, and we may not be able to consistently control the quality of such components. Any material increase in the quantity of products returned by our customers for purchase-price refunds could adversely affect revenues. In addition, we are subject to potential product liability claims if our products injure, or allegedly injure, our customers or other users. Our financial performance could be affected if our warranty reserves are inadequate to cover warranty claims on our products. We could become liable for significant monetary damages if our product liability insurance coverage and reserves fail to cover future product liability claims.

Unfavorable economic conditions or geopolitical upheaval could cause a decline in consumer spending and hinder our product sales.

The success of each of our products depends substantially on the amount of discretionary funds available to consumers and their purchasing preferences. Economic and political uncertainties could adversely impact the U.S. and international economic environment. A decline in economic conditions could further depress consumer spending, especially discretionary spending for premium priced products like ours. These poor economic conditions could in turn lead to substantial decreases in our net sales.

We depend on one tier-one and one tier-two consumer finance company to provide financing packages to our customers; a deterioration of the consumer finance market or failure by the finance company to provide financing to our customers could negatively impact sales of our direct-marketed products.

In purchasing our products, approximately 43% of our direct-marketed customers utilize financing packages provided by one of two independent finance companies. Tier-two financing is distinguished from tier-one in that the tier-two finance company is willing to approve customers who are a higher risk of default. The financing agreements with both companies involve non-recourse customer financing, but tier-two financing requires a higher discount in order for the finance company to accept the increased risk. We believe that

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convenient consumer financing is an important tool in our direct marketing efforts and induces many of our customers to make purchases when they otherwise would not. Consumers may be less likely to purchase our products if the consumer finance market were to deteriorate so that financing is less available or less convenient to our customers. Although we believe we could enter into similar arrangements with other providers if needed, a failure by our current providers to adequately service our customers could temporarily disrupt sales.

Changes in foreign conditions could impair our international sales.

A portion of our revenue is derived from sales outside the United States. For the year ended December 31, 2003, international sales represented approximately 13% of consolidated net sales. In addition, a substantial portion of our products is manufactured outside of the United States. Accordingly, our future results could be materially adversely affected by a variety of factors, including changes in foreign currency exchange rates, changes in a specific country’s or region’s political or economic conditions, trade restrictions, import and export licensing requirements, the overlap of different tax structures or changes in international tax laws, changes in regulatory requirements, compliance with a variety of foreign laws and regulations and longer payment cycles in certain countries.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

We have primarily invested cash with banks and in liquid debt instruments purchased with maturity dates of less than one year. Our bank deposits may exceed federally insured limits, and there is risk of loss of the entire principal with any debt instrument. To reduce risk of loss, we limit our exposure to any individual debt issuer and require certain minimum ratings for debt instruments that we purchase.

Foreign Exchange Risk

The Company is exposed to foreign exchange risk from currency fluctuations, mainly in Europe. Given the relative size of the Company’s current foreign operations, the Company does not believe the exposure to changes in applicable foreign currencies to be material, such that it could have a significant impact on our current or near-term financial position, results of operations, or cash flows. Management estimates the maximum impact on stockholders’ equity of a 10% change in any applicable foreign currency to be $1.3 million.

Interest Rate Risk

The Company has financed its growth through cash generated from operations. At December 31, 2003, the Company had no outstanding borrowings and was not subject to any related interest rate risk.

The Company invests in liquid debt instruments purchased with maturity dates of less than one year. Due to the short-term nature of those investments, management believes that any reasonably possible near-term changes in related interest rates would not have a material impact on the Company’s financial position, results of operations, or cash flows.

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Item 8. Consolidated Financial Statements and Supplementary Data

Index to Consolidated Financial Statements

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Table of Contents

INDEPENDENT AUDITORS’ REPORT

Board of Directors and Stockholders of

The Nautilus Group, Inc.

We have audited the accompanying consolidated balance sheets of The Nautilus Group, Inc. and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the three years in the period ended December 31, 2003. 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 auditing standards generally accepted in the United States of America. 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.