Nutrisystem (NTRI) is a diet program based on providing its customers with food low on the Glycemic Index of Carbohydrates. Unlike like its former incarnation, NTRI now has no local centers with counselors, but rather customers order their food online or over the phone and food is sent directly to their home. Customers have several ordering options but most opt for once monthly delivery. Customers have access to free weight loss counseling over the phone.  As well as this direct sales method, NTRI also uses QVC to generate sales (5% of revenues). NTRI outsources nearly everything here including food production and the majority of processing.  80% of transactions occur online, substantially reducing labor costs vs. some competitors. NTRI’s competitors include Jenny Craig, Weight Watchers, eDiets.com and LA Weight Loss. It also competes with diets such as Atkins and the South Beach Diet.

After a few years of very strong growth, NTRI recently missed projections and lowered guidance and the stock is now at less than 50% of its 52 week high. The company (as well as several other diet companies) mentioned GSK’s heavy promotion and free trials of its new weight loss drug Alli as having had a negative impact on new customer subscription and having increased customer acquisition cost. These components are key, because customers generally only stay on the program for a few months and NTRI generates nearly all of its sales each year from new customers.

Customers spend approximately $300/month for meals. In 2006 NTRI generated average revenue per new customer of $612 and should reach $650 in 2007. NTRI makes 55% gross margins on this and historically spent below $150 on customer acquisition costs (CAC). In general, management believes CACs are 29% of revenues for new customers and 4.5%-5% of reactivated or returning customers.  Over the last several years, new customer growth has been incredibly strong on the back of large marketing efforts and growth should be strong but significantly lower in 2007.

The other key in addition to new customers is customer reactivation. NTRI will likely end 2007 with a database of over 2,000,000 past customers. In the last several years, it has typically been able to reactivate approximately 10% of them. Given the low marketing cost required to reactivate past subscribers and the increasing size of the database, this avenue provides real potential going forward, and management has indicated it will seek to take advantage of this.

Though recently, GSK’s Alli appears to take some of the blame for performance, I don’t think that’s the real story here. Over 33% of the US population is overweight and growing, and of that a very significant portion is obese. Besides the initial distraction of a new weight loss product on the market, it seems unlikely that such a significant portion of that population is going to elect to take a drug that is only somewhat effective and causes some very embarrassing and/or painful side effects. Alli works by blocking absorption of some fats, and requires that patients reduce their fat intake in order to avoid side effects. It’s likely that in the long run, GSK will likely try to partner with low-fat food program such as NTRI’s Nourish in order to increase effectiveness as well as decrease side-effects. NTRI also believes that it has only penetrated 0.1% of the women’s weight loss market and it has significant room to take share from competitors. In 2006, NTRI launched their men’s campaign and consequently, the number of new subscribers who were men increased to about 24% of customers from 15% in 2005. For 2007, that number should reach 35% on the back of a heavy advertising campaign with Dan Marino and Don Shula.

So the real story here is whether or not NTRI can continue to attract new customers or reactivate old customers. Unfortunately, reading some of the reviews, you get the impression that NTRI has crappy food choices that taste like cardboard. Customers complain about the quality of the food in addition to the portion size (the whole point) but also the lack of choices. By the end of 2007, management plans to update the existing food line and in 2008 it has plans to introduce a premium frozen food line. In the past, NTRI has seen substantial growth whenever it revamped its product line. The occasion should also allow NTRI to increase prices. Finally, NTRI is set to launch in Canada in January 2008 (where it used to have centers before its reorganization) and in Europe in 2009.

In general, the Street fears that NTRI has reached the end of its growth stage. In addition to flat yoy new subscriber growth (and declining qoq), customer acquisition costs in Q3 of this year reached above $200 from $150. At these prices, the Street believes that CAC will remain above $200 ($212-216) and new subscriber growth will go to 0 after this year or continue to fall. Fears of Alli destroying the weight loss market are overblown and in general the Street overreacted to the most recent news.

NTRI is currently trading at 10.7x T12 EPS and 10.7x 2007E earnings, and 5.89x EV/EBITDA. For a company that has recently seen incredibly strong revenue growth and has 55% gross margins, that seems cheap.

 

NTRI’s value is essentially driven by a few variables: revenue per customer, customer acqusition cost, new customer growth and past subscriber reactivation rate. So far there doesn’t seem to be any pricing pressure and management believes they will be able to raise prices with the introduction of the new product line later this year. CAC has risen over 50% in the last year and it’s entirely possible that it stays above $210 or even increases. EPS is not as sensitive to new customer adds as the Street believes, but still remains a significant factor. Finally, the reactivation rate is fairly important as CAC for past customers is in the range of 4-5% of revenues, and consequenty NTRI has very high margins on this revenue segment. Growth or contraction here is fairly important.

Downside: Given the relative lack of pressure on pricing, we believe the conservative case to be 0% revenue growth per customer (vs. 7% 2007E). We also forecast conservatively -10% (vs. 28% 2007E) new customer growth yoy and 8% (vs. 10% historical) reactivation rate of past customers. We vary CAC between current levels at $210 and $300. With these performance characteristics, we think NTRI will have a tough time getting more than a 10x EPS multiple.

 

Basecase:  NTRI new customer growth increases by 5% yoy and manages inflation adjusted increases in revenue per customer.  We also assume CAC $210 and 10% historical reactivation rate and a reasonable 16x EPS multiple. Given this scenario, 2009 EPS is $4.15 with a price target of $62.26.

 

There are certainly significant risks. Management may not be able to attract new customers in the face of competitive pressures and a drowned out marketing campaign, reactivation costs of past customers could rise substantially, and NTRI may suffer reputational risk from its cheap and not so tasty food. Also, GSK may decide to partner with a competitor of NTRI to accompany its push of Alli, and NTRI may not get the multiple expansion we expect.