Executives
Cindy Warner – Investor Relations
Joseph M. Redling – President & Chief Executive Officer
David D. Clark – Senior Vice President & Chief Financial Officer
Analysts
Gregory Badishkanian – Citigroup
Laura Richardson – BB&T Capital Markets
Jim Duffy – Thomas Weisel Partners
Karen Howland – Barclays Capital
William Sutherland – Boenning & Scattergood Inc.
NutriSystem Inc. (NTRI) Q3 2008 Earnings Call October 22, 2008 4:30 PM ET
Operator
Ladies and Gentlemen, and welcome to the NutriSystem third quarter 2008 earnings conference call. My name is Michelle and I will be your coordinator for today. At this time all participants are in a listen only mode. We will be facilitating a question-and-answer session towards the end of today’s conference. (Operator Instructions) As a reminder, this quarter is being recorded for replay purposes.
I would now like to turn the presentation over to your host for today’s call, Ms. Cindy Warner, Investor Relations.
Cindy Warner
Thank you for joining us to discuss NutriSystem’s third quarter 2008 financial results. With us today from management are Joe Redling, President and Chief Executive Officer and David Clark, Chief Financial Officer. Before we begin I’d like to remind everyone that this announcement contains forward-looking statements that involve risks and uncertainties. Such information includes statements about NutriSystem’s third quarter financial results as well as statements that are preceded by, followed by or include the words believe, plans, intends, expects, anticipates or similar expressions.
Statements regarding NutriSystem’s outlook and guidance for the fourth quarter of 2008 and the full year 2008 is expectations regarding the effect of the economy on consumer spending and similar statements that are not statements of historical fact constitute forward-looking statements. For such statements, NutriSystem claims protection of the Safe Harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.
Actual results may differ materially from the results predicted and the reported results should not be considered as an indication of future performance. Factors that could cause actual results to differ from those contained in the forward-looking statements include, but our not limited to, those factors set forth in NutriSystem’s annual report on Form 10-K for the year ended December 31, 2007, which has been filed with the SEC. NutriSystem is making these statements as of October 22, 2008 and assumes no obligation to publicly update or revise any of the forward-looking information in this announcement.
And with that I’d like to turn the call over to Joe Redling, our President and Chief Executive Officer.
Joseph M. Redling
Thank you for joining us on today’s conference call. Let’s go through third quarter results and some key highlights. Revenues came in at $163 million, down 13.5% versus a year ago, clearly impacted by the current economic environment. Gross margin for the third quarter was 51.1% versus a year ago of 53.4%, continuing to reflect the pressures on the cost of food. Marketing as a percentage of revenue was 24% as compared with a year ago at 25%, on target for our marketing efficiency objective of mid-20s as a percent of revenues for full year 2008.
Adjusted EBITDA was $27 million, down versus prior year of $37 million. We continue to be debt free and had $58 million in cash on hand at the end of the quarter. We also announce that we will be paying our regular dividend in November and through September we have generated $97 million in cash from operating activities and we have returned $70 million of that to shareholders via dividends and share buybacks.
I am pleased to announce today the addition of Monica Woo, our new Executive Vice President eCommerce and Chief Marketing Officer. Monica comes to us with years of experience in eCommerce as the divisional president of 1-800-Flowers.com and international experience launching online retail investment and banking services with Citibank and Deutsche Bank. She also has two decades of experience building global consumer brands that are household names. I am delighted to hand her the reigns of the marketing group as we grow the NutriSystem brand in North America and beyond in the years to come.
Monica adds to the depth of eCommerce and direct marketing experience we have within our marketing organization today. She also adds the critical components of brand building and merchandising which becomes increasingly important to us as we evolve our marketing to not only drive customer acquisition but to also expand our product offerings and build a world class brand. Monica’s addition to our leadership team only enhances the decades of experience the team has leading large scale subscription, eCommerce and direct-to-consumer businesses. My expectations are high as to the things we can accomplish with this team in the weight management arena.
Each consumer is searching for the weight management program that works best for them individually, whether it is one of our current program offerings or one of the new offerings we will launch in 2009 and beyond. This management team has been assembled to bring forward the programs, products and services that will satisfy that demand while providing superior shareholder value.
Regardless of the products we offer, they all have the commonality of the business model that is the backbone of NutriSystem. In these unstable economic times, the flexibility we have with our eCommerce direct-to-consumer business model allows us to manage marketing spend according to demand. All our marketing efforts are highly measured. As we see demand fluctuate, we flex our marketing spend to meet that demand.
There is no doubt that Q3 proved to be a challenging quarter for the U.S. consumer and the companies that serve them. As we enter the fall we were anticipating a seasonal demand improvement in September as we have seen traditionally. That improvement never materialized. Clearly, the turmoil in the financial markets impacted consumer confidence and spending during this period and we were not immune to those factors. The softer demand trend continued into October. So while we saw fewer new customers than we would have liked, our customers are staying on the program longer, satisfaction is increasing and the second order take rate has improved.
We are encouraged by the new process improvements that have been implemented throughout the customer experience from call center operations, order accuracy to product quality. These improvements create a strong foundation for future improvements in our overall customer economics. As we look ahead to Q4 and our highest seasonal demand period in Q1 of 2009, we will be maintaining the optimal amount of flexibility regarding marketing investment. We will be tracking demand carefully and we will accelerate or decelerate spend to match demand trends.
As you know, the last week of December is a strong early indicator of future demand for the first quarter. While we will be very measured and cautious as we approach this key period, we will also be prepared to invest aggressively if we acceptable business trends and opportunities. As re ready our marketing and product launch plans for this key season, I remain confident that we will have new compelling offerings for the dieting consumer that will enable us to establish unique competitive advantages.
We are expanding our product line and refreshing our marketing to offer new and enticing reasons for dieters to consider trying NutriSystem products for the first time and for past customers to return. We are tuning up our channel mix and conversion efforts to drive more efficiency through the marketing funnel and we have significantly improved order management and customer service to ensure a much improved experience for new and returning customers.
Finally, let me give you some updates on the key initiatives we have been working on for 2009. These initiatives are based on extensive consumer research of our customers and prospective customers. These insights tell us that providing dieters with higher quality foods, variety and choice and program flexibility all contribute to their success and a higher level of consideration for our products. With that consumer understanding, we are expanding our product offering to drive consideration, market expansion and length of stay, thus laying a foundation for our customers’ success and the future success of our business.
It is important to note that as we expand and improve our product offerings, improve customers’ overall satisfaction and success, it will in turn create opportunities to improve our overall customer economics not only initially through length-of-stay improvement but longer term via improved reactivation rates. We have seen clear correlation between customers’ success and reactivation propensity. Our early signs are encouraging as we have seen positive improvements in both customer satisfaction and second month order take rates. These indicators indicate that a higher percentage of our customers are having success and will be much better prospects for reactivation in the future.
Now let’s move on to key initiatives. As we continue to focus on improving quality and variety of all of our menu options, the most significant change in 2009 will be the addition of our new frozen line of products. We are on track to launch our frozen line, NutriSystem Select, in the first quarter of 2009. The frozen line will serve as a premium offering to our current program. At first there will be approximately 40 items that will include meals, frozen vegetables and frozen desserts. We see this as an attractive offering to both new customers whose taste profiles may be seeking flavors and foods only gained by having a frozen line and importantly, as added variety to our current customer base.
These items will have a higher price point and are anticipated to have equal gross margin as our shelf stable product line. We see this as an excellent opportunity to expand our market reach to new customers, build length of stay with our current customers and increase reactivation from past customers.
The flex program, which is a new 28 day program consisting of 20 days of food, has expanded and we are now able to offer that as a fully customizable program for 2009. We plan to take full advantage of this lower priced option as we continue to serve dieters seeking value in this tough economic climate. We continue testing our new Balance program which is the maintenance program for our customers that have successfully lost their weight and need to transition to maintenance. Recall that we piloted this program recently and have received valuable customer feedback and we are now revising Balance for a full rollout in Q1 of next year.
The clinical trial for supporting claims of our weight loss program for diabetics, NutriSystem D, is progressing well and with approximately 25 million known diabetics in the U.S. alone, we are eager to roll out that plan in 2009. Our website will look new and refreshed for 2009. With a new eCommerce program we implemented this past year, we now have the infrastructure on which to hang new and improved website features that will appeal to information seekers with interactive functionality and a wide variety of video content. We will be able to provide more information on our food, our online tools and success stories of real people all in a visually rich display with a more contemporary brand image.
Internationally, Canada continues to grow and in 2009 we plan to begin marketing the men’s program in Canada. For the U.K. we have clear plans in place for a launch but we are evaluating the appropriate timeline to expand into that market. Launching into a soft market may not give us the proper feedback on particular marketing programs and could result in a sub-par campaign. Once we see some turnaround in the U.K. economy, we plan to move ahead with our plans. We are progressing on our licensing agreement in Japan as well and hope to have an announcement for you in the near term. And finally, we implemented a price increase effective October 1, 2008 with minimal conversion impact and David will give you the details on that in a moment.
With that, I’d like to turn the call over to David Clark, our CFO, to discuss the financials.
David D. Clark
For the third quarter 2008 we generated $162,681,000 in revenues, a 13.5% decrease over the prior year. Gross margin came in at 51.1%, up from 50.4% last quarter. Of that improvement, 40 basis points is related to a one time negotiated credit from certain suppliers. Marketing as a percentage of sales is 24% in Q3 within the targeted range of a low-to-mid 20%. Operating income before taxes was $21,738,000, representing a 13.4% operating margin. Our adjusted EBITDA came in at $26,652,000 and our non-cash employee stock compensation totaled $2.1 million.
Adjusted EBITDA margin was 16.4% and net income from continuing operations was $13,695,000. For the below-the-line items, Slim and Tone posted a discontinued operations loss of $164,000 and our investment in our development of Zero Water resulted in a recognized loss of $552,000 for the quarter. The company has accrued for a 37% tax rate so far through the year and diluted EPS came in at $0.45 for Q3, down from $0.64 a year ago. Non-cash employee stock compensation had approximately a $0.05 impact on EPS with the $2.1 million in total that I mentioned earlier.
Our direct channel generated 92% of our revenue and QVC generated nearly 7% and less than 1% of our revenue came from other channels. QVC revenue for third quarter was $11 million, virtually flat to last year and we look forward to continuing that relationship into 2009. From a liquidity standpoint, at the end of September 2008 we had $58 million of cash and cash equivalents on hand and we continue to be invested exclusively in Treasury backed accounts.
Capital expenditures for the third quarter were $3.2 million and our unused $200 million credit facility remains available should we need it. Our board of directors approved a dividend payable November 17, 2008 for the holders of record on November 7, 2008. This dividend consistently returns cash to shareholders while allowing sufficient liquidity to opportunistically repurchase shares and most importantly having a large portion of free cash flow available to make investments in growing our business.
Also during the third quarter we completed our clearance efforts focused on disposing on the last of our Nourish inventory. The remaining few hundred thousand dollars worth of Nourish product and packaging will be disposed via third parties and is adequately covered by our normal inventory reserve amounts. This fully completes our transition to the Advanced line in all our channels.
In Q4 we typically begin an inventory build for the coming diet season and we anticipate inventories to be approximately $60 to $65 million at year end across all lines versus $82 million last year, reflecting our improved inventory management and consolidation of our distribution centers.
Anticipating our inventory build for the 2009 diet season and in light of recent upheaval in the financial markets, we have not repurchased any additional stocks since the last repurchase in July. Our stock buyback authorization of roughly $123 million remains in place and we currently have approximately 29.6 million shares issued and outstanding. With the stock at historically low levels, we continue to believe that stock buybacks are an accretive use of our excess cash flow. We evaluate buyback opportunities based on anticipated profitability, capital expenditure needs and working capital requirements.
With regard to the price increase that Joe mentioned, effective October 1, 2008 we increased prices for women and seniors in the 28 day auto ship programs by 2% from $293.72 to $299.95. The auto ship price for the men’s 28 day program with the extra meal occasion went up 3% from $319.95 to $329.95. The flex program pricing went up by similar amounts. We based these increases on consumer testing that we did throughout the third quarter and they are aimed at maximizing the positive impact on revenues with minimal impact on our conversion.
Also, we continue with the initiatives we covered in the last call related to supply chain. Our targeted improvements include a complete consolidation down to three outsourced distribution centers, implementing best practices in procurement, inventory management and distribution and also the use of readily available ingredients for next year to replace what used to be proprietary ingredients and also packaging optimization.
Now moving to guidance. Given the continued deterioration in consumer confidence and spending and in particular in September and October, we are adjusting our full year revenue guidance to between $690 million to $700 million for the full year of 2008. We are still anticipating reactivation revenue to be around 20% of our revenue base which represents a healthy year-over-year growth that we have seen throughout the year.
We continue to guide to a full year gross margin of around 50% and we are targeting mid-20% percent level for our marketing efficiency. We are updating our adjusted EBITDA guidance to be between $105 million and $110 million to reflect the downward demand pressure. We also will continue to evaluate cost efficiencies for the balance of the year and beyond and in 2009.
And with that I’ll turn it back over to Joe.
Joseph M. Redling
Before we open it to Q&A, I would like to highlight a few important areas. We continue to have good visibility into our business model. The fact that we can operate efficiently and profitably in tough economic times supports both the longevity of the business and the enduring nature of the product we offer. We continue to believe that we have a unique approach to a large addressable market of over 90 million dieters in the U.S. alone. We are refining and expanding our product mix and customer service focus to attract and retain a larger share of those dieters through the efforts of our management team focusing on delivering results not only on the top line but the bottom line through continued marketing efficiency and cost reduction initiatives.
Second, that same business model despite significant pressures on the gross margin side of the business enables us to generate a significant level of cash. As David said, through September 2008 we have generated $97 million in cash from operating activities. Adding to our strong cash flow is our available credit facility of $200 million which provides us with more than adequate liquidity to invest in the core business, selectively pursue acquisitions and/or provide strong return to shareholders via stock buybacks.
As discussed, we are initiating numerous new products and initiatives in the company with minimal capital. This is capital light business and ROI invested capital has been in and are expected to continue to be extremely strong. Lastly, I have complete confidence in the depths and experience of our talented management team. We are well positioned to adapt our business to this constantly changing business climate.
Our market remains large with additional opportunities for further segmentation. NutriSystem is one of the three top tier brands in the category and we intend to continue to levy that position for growth. We are experiencing challenges this year but I am proud of the way the team and the company has responded and we remain confident in our future prospects.
With that, Operator, we would like to open it up for some questions.
Question-and-Answer Session
Operator
(Operator Instructions) Your first question comes from Gregory Badishkanian – Citigroup.
Gregory Badishkanian – Citigroup
I have a few questions, I just wanted to first start off with the current trend, I think you mentioned September/October you saw some weakness and that coincides with generally what we see in the broader consumer market and just what we read in the papers about the financials and etc., all the bad news there. Can you maybe give us some color around, are people going to the checkout and not purchasing? Are you getting pushback when customers call up the call center in terms of the pricing and they want maybe more of a lower price solution? Can you give us a little bit of color around that?
Joseph M. Redling
I think it’s a little bit of all of the above. We did see some depression and converging. We saw a lot of cost conscious consumers responding to offers and asking about pricing. We also saw softness in just general demand and traffic. Response rates through our marketing channels, we saw decline so whether it was television, print or online the overall response rates get people into the funnel, declined in September and continued into October.
Gregory Badishkanian – Citigroup
Did it deteriorate in October from the September trend or is it consistently the last six, eight weeks has it just been softer?
Joseph M. Redling
Yes. I think it’s pretty consistent. I think yes you expect when you get into September and the diet cycle with back-to-school, I think we expected a bigger bump so we were disappointed there. You don’t typically see the strength continue so the trends are pretty consistent as we look into October.
Gregory Badishkanian – Citigroup
Just moving over to 2009 and the initiatives, you have a number of initiatives and you mentioned frozen was probably the biggest opportunity for you and I can understand that. Just people getting bored of the diet and giving them better, different selection will keep them on longer. Of the remaining ones, maintenance, flex program, diabetics, international pricing, which ones do you think are going to give you the, can you rank the next two, three and four of what you think is going to give you the biggest opportunity?
Joseph M. Redling
I think first on frozen, the variety and quality is critical because it not only keeps people on longer but our research into the segments of dieters, there’s a very large segment that has a major barrier which is the foods that they love and to be able to create, using our formulas, diet products that really appeal to the food lovers we think opens up a pretty big segment on the front end. Opening up the number of choices, if you think about the frozen line is an incremental addition to our variety so typically we have 120 items for people to choose from. That’s going to be over 170 items as we move into frozen so that type of variety opens up the window and customization to attract a lot of customers so that’s very important.
We think flex is very powerful. In a lot of the research we’ve done there’s a big segment that a full 28 day program is a bit too restrictive for these consumers and when you position this as a weekends off program where you can be five days with NutriSystem, two days on your own and we’re providing you that education and support to manage those other days, that’s a very strong option for these consumers. What we didn’t have before was the option to customize that. We’re finding more and more personalization is a real driver of appeal and success on our programs and I think flex can open up at a lower price point a bigger opportunity for us.
Pricing is pricing. We’ll always look at the opportunity to leverage pricing if we see demand and improve our margins on that front so I would say it’s really those two primarily, thinking about overall choice for our opportunities and the third being what we can do on our new website. That gives us a lot more capabilities on testing and managing our typical marketing funnel.
Gregory Badishkanian – Citigroup
Moving over to satisfaction and increase stay on the diet, can you give us a little bit more color on that? Those are some positive trends and how do you, maybe you can quantify, maybe satisfaction or how do you measure that?
Joseph M. Redling
A couple things, clearly, we’re bringing in fewer customers in the front door so the first thing to say is that these customers are highly qualified, right? So they would tend to be more valuable customers but we have spent a great deal of time and resources on tracking the entire customer experience from how fast they get their product, how accurate their product is, how we package the product and we’ve seen pretty strong response across those areas in terms of our order accuracy.
We use an outside third party to track customer satisfaction. We’ve spent a lot of time understanding the core drivers of customer satisfaction and we do know that order accuracy, food quality are key components of that. Getting what they ordered and getting the type of customization that they expected and getting their product on time is a critical indicator of tenure and success on the programs so we are tracking that.
We are seeing some strong improvements in customer satisfaction and we track this on a monthly basis and we have metrics that we measure ourselves against so those improvements are encouraging and we’ll continue to focus those improvements. Our whole supply chain operation is leveraging all this information to drive improvements across every customer touch point that we have.
Gregory Badishkanian – Citigroup
Now looking at pricing, I was intrigued. I think, David, you mentioned you’re really not seeing much change in conversion with price increases. I’m wondering is that just because consumers are expecting a little bit of a price increase and just given the macro environment I am surprised maybe you didn’t see an impact from the pricing. Maybe use a little bit of color on that.
Joseph M. Redling
Greg, I think when you look at our segments, I think we have a lot. There’s some price insensitivity in the men’s category. When you look at our price increase for women it was only 2%. We stayed under the $300 price point and we tested to that so we were going with the most advantageous price point for both segments where we could optimize conversion while still driving incremental margin on the product. So we constantly test that on an ongoing basis.
I think it’s rational for consumers to understand this price increases but that doesn’t mean they’ll accept them so we have to be very careful about that and we are seeing some resilience there on the men’s side in terms of their purchases and we’re also working in conjunction with prices, how those various promotional offers we have and how we can leverage promotional offers with our new pricing and potential pricing changes in the future in 2009.
Gregory Badishkanian – Citigroup
Then just finally on gross margins, food costs, actually commodities have been coming down so I’m wondering just when you typically enter into your contracts and if, what type of impact do you think you’ll see the pricing in 2009 versus the contracts that you have now and then once they expire and you re-up with these contract manufacturers?
David D. Clark
Well, we start to do our ordering for the first quarter right now so we’re really engaged in that right now and we’ll obviously know more as we complete those purchases. We’re hopeful that the reduction in commodity prices as a general matter will help us in 2009. We obviously know what our costs are going to be for the full year of ‘08 because we tend to carry three months worth of inventory so we know exactly what they’re going to be for the remainder of this year and we’re just hopeful for ’09 we can get some benefit.
But nonetheless, we’re also doing a lot of the things that I described to stay focused on the cost of goods sold line and do things like packaging optimization and moving through some more readily available ingredients to, whether commodity prices benefit us or not but also drive additional cost efficiencies in the calendar year of ’09.
Joseph M. Redling
Greg, we feel pretty confident that the supply chain optimization that David refers to, in terms of cost efficiencies and packaging design and inventory management and the like, will cover us on any potential food increases that may be coming down the road so we don’t think they’ll have an incremental hit on our bottom line. We’re hoping if they moderate we actually have some improvements that we can look forward to.
Operator
Your next question comes from Laura Richardson – BB&T Capital Markets.
Laura Richardson – BB&T Capital Markets
Just a couple questions for you, I think it sounds like you’re planning conservatively for next year which very appropriate given the situation. Now on the inventory figure you gave, David, how much of the decrease from last year is because of the supply chain being more efficient versus how much is because of your demand expectations?
David D. Clark
Well, obviously the inventory is driven entirely by demand expectations but if you’re comparing year-over-year, the $82 million figure I mentioned, about $12 million of that $82 million was actually Nourish and we won’t have that this year. So we’re looking at at least a $10 million improvement not just from inventory management but also we’re really developing what our ’09 levels would be so that probably represents primarily anticipating being more efficient around supply chain.
Laura Richardson – BB&T Capital Markets
Meaning just getting it to the customer faster?
David D. Clark
Yes and having it, just better management throughout; having it managed at three locations versus five just makes it that much more efficient and just testing in systems to lead to the optimal supply.
Joseph M. Redling
And we also look, Laura, we also have the capabilities depending on if there is an increase in demand, we can react faster now than we could before because a lot of the changes we put into the supply chain management function so we could cut that timeline down if we see additional needs for product as we go through the first quarter.
Laura Richardson – BB&T Capital Markets
So it sounds like the marketing department doesn’t get a very long Christmas break. Are you going to be able to give some rest just going on guidance after you see what happens with the preliminary marketing for ’09?
Joseph M. Redling
Yes. I think typically we come out in mid-February when we get a look at the business. Clearly, we’ll have, as I mentioned earlier, we’re very tied into that Christmas week. It’s one of the reasons we wanted some flexibility this year. To be optimistic is not something that’s out of our realm here so if we do see demand improvement we want to have the capabilities to lean into that because Christmas week really gives us some early indicators on the quarter.
So we really won’t have good information until we get into January and we typically update that first or second week of February.
Laura Richardson – BB&T Capital Markets
In terms of the life cycle of a new diet, the frozen is a pretty major new thing for you, a once in every three initiative it seems to me. But if the economy is weak and you’re just not getting as many customers, does that mean you get more years of use out of the program at least before you need to come up with something else new?
Joseph M. Redling
I think innovation is part of our business. If you look at what we’re doing now it’s more capacity internally versus capital. So we’ll continue to look at how to improve. I think our core principles is really constantly improving quality. We just know that as we, every time we go through another development cycle on the menu line we have to constantly move that up.
Because today’s consumer, when they are committing their wallet they’re expecting great value and they’re expecting great quality and I think we have to continue to reinforce that. But you’re right; I think the frozen component is a very big undertaking for us. It’s an entire new supply chain operation that hopefully in the near future we’ll be able to share more information about some of the unique attributes of how we’re going to manage through that but it’s pretty interesting and it is a big component.
It also leads us, it’s interesting to think about as a higher price point. We’re hoping it leads us into a new segment; this conflicted food lover segment that has a higher income, more discretionary income and would have a higher consideration with the higher quality and larger variety of food that we’ll be able to offer in January.
Laura Richardson – BB&T Capital Markets
Last question is a quick one. Is the buyback secretive? Why have you not bought stock since July?
David D. Clark
Well, what was said, when we go into third quarter, we look at our volume trends and start to decide what we’re going to need to buy for inventory so it’s always a quarter where we’re a little more conservative with our cash. And honestly, like everybody else, we were pretty jolted by all the things that were in the news in September and so we just decided to be a little bit cautious and we’re still committed to share buybacks as being accretive but we just thought right now with all the turmoil we would wait.
Operator
Your next question comes from Jim Duffy – Thomas Weisel Partners.
Jim Duffy – Thomas Weisel Partners
A couple questions for you, did you guys give a reactivation revenue number for the quarter?
David D. Clark
No. We did say that it’s going to be about 20% of full year.
Jim Duffy – Thomas Weisel Partners
Now guidance discussion. Still on plan, I suppose, for the quarter then?
David D. Clark
Yes, yes.
Jim Duffy – Thomas Weisel Partners
Specific to this late September, early October period here, what have you seen is the impact on reactivation revenue versus acquisition of new customers? Has one been impacted more than the other or has it been somewhat proportional?
Joseph M. Redling
Yes. It’s dramatically different. Clearly, our reactivation revenues have been very predictable, very strong and they’re, as we say, still 20% and if you compare that revenue stream to prior year, there’s significant growth in that segment. That being said, clearly every time the economy in the news and the consumer confidence drops, there’s going to be a segment of those customers who may not react at that particular time. They’re not immune to economic changes but they’re much less impacted. We have not seen a lot of that.
The other confidence I have in that goes to what I talked about a little earlier about as we improve the success ratio of our current customer, when we get them to that second month at a higher rate, the longer these customers stay with us the better their propensity to react is. So we’re actually creating a higher qualified base of reactivating customers so I think our future, if we continue to see these improvements, I think our reactivation opportunities are stronger.
But clearly the reason that we’re not seeing that is we believe that reacting customers have a much higher, much more realistic value perception of the product and the price. They’ve been on the program; they’ve lost weight. New customers are a bit more skeptical so when they get into this economic environment they’re much less likely to put that discretionary spend to work if they don’t have real confidence in the value. So the new customer is much more impacted by this than the reactivating customer.
Jim Duffy – Thomas Weisel Partners
Speaking to the philosophy for advertising here in the fourth quarter, it seems like the plan is to maybe back off some from what you might have previously anticipated. Is that indeed true? And then to what extent during the quarter will you be spending to support the brand in anticipation of entering the key diet season in January?
Joseph M. Redling
That’s a good question, Jim. Clearly, our spend is following demand so we’re not chasing unprofitable customers; we’re waiting to see those demand spikes where we can invest like we did in the second quarter and we don’t expect to see that in the early part of the first half of this quarter. Clearly, as you know, the seasonality of this business is, October is your last shot until you get past Christmas so we’re going to get conservative for the rest of this quarter based on what we can do profitably.
And then we’re going to go into that Christmas week conservatively and if we see we have the ability to push that up pretty aggressively, market opportunities on media is pretty available after Christmas so there’s not a clearance issue. Rates go down so we think we could react pretty quickly if we’re seeing some good news and I think that also bodes well for us in January. It think we’re going to see media rates come down quite a bit I think with this economy. We haven’t seen that yet because of the politicals; we’ve seen a lot of pressure on media still in September and October. We think that will moderate significantly as we move into December and especially in January.
So we’re going to watch the business very carefully in that second half of December and be cautious but measure our spend but not miss opportunities.
Jim Duffy – Thomas Weisel Partners
It sounds like not a lot of spending for branding sake but more spending where there’s yield.
Joseph M. Redling
Exactly right.
Jim Duffy – Thomas Weisel Partners
With the U.K. tabling the initiative there, have there been investments this year which are in the numbers for the U.K.?
Joseph M. Redling
We’ve had small, they’re insignificant. Again, the launch, as we launch Canada I think we shared it was a $2 to $3 million capital investment to launch Canada. We anticipate the U.K. all in is going to be $5 million to $8 million; most of that investment is web based and supply chain based. You’re really getting ready to launch a business. So really, what’s been done to date is development, menu items, feasibility, supply chain, investigation, partner investigation. All those things have been done; they’re pretty much run-a-business cost for us.
So those investments, we can wait for a window when we feel it’s more appropriate so there’s been, I would say, minimal investments and would not be hard for us to ramp it up from a capital standpoint if we thought it was appropriate to do so.
Operator
Your next question comes from Karen Howland – Barclays Capital.
Karen Howland – Barclays Capital
Was wondering if you could give a, remind me about how your commodity costs actually flow through. David, I know you said that you are typically buying, you hold your product for about three months so presumably the product you’re buying now is for the first quarter of next year.
David D. Clark
That’s right.
Karen Howland – Barclays Capital
How often do those prices change? Is it a cost plus basis or how much are you impacted on the swings in the commodity costs?
David D. Clark
Well, basically we see the price changes when we actually go out and do the buying so if there’s any positive or negative swings we will see them as we buy for the first quarter. As I said, we basically know the food that we will be shipping for the fourth quarter because it’s on our books right now and it’s fully costed.
Karen Howland – Barclays Capital
So the product you’re buying for the first quarter now is reflecting those lower costs that we’ve seen over the course of the last three/four weeks or so?
Joseph M. Redling
Going on, again I think commodity, we’re not seeing drops in food prices so the products that typically flow into our menu items are pretty stable right now. We got hit with the price increases that were reported between 4% and 5%. We started seeing that this year. I think that’s a big dent to what we’re doing in Q1 because we’re ordering that product now and we, as a management team, have built a model for ’09 anticipating that.
That’s why we’ve spent so much time on the profit hunt in the supply chain and doing things from changing packages to lessening the size of our trays to removing a gram of protein here or there without jeopardizing our nutritional value, moving away from proprietary blends like we had OmegaSol. This is maybe getting a little bit into the weeds but I think it’s a good example.
OmegaSol is a proprietary blend which mean we had to go develop that and that’s very costly. We can eliminate that but still have fiber and omegas in our product at a much more efficient production level in terms of cost. All those things have been activated and are in place so even if we saw a price increase, we think we’re covered and probably will have gross margin advantages with that. If we actually do see prices moderate and flatten, then it’s going to be a real, it’s going to be a good guide for us.
Karen Howland – Barclays Capital
But it would be a good guide probably in the second half of next year?
Joseph M. Redling
Yes because first half, the product’s already purchased and it’s the product increases we’ve seen this year that we’re rolling through with the first quarter.
Karen Howland – Barclays Capital
Can you give us your top five products that go into Advanced?
David D. Clark
The top five skews?
Karen Howland – Barclays Capital
No, I was thinking more of the top five input costs.
Joseph M. Redling
You mean in terms of food?
Karen Howland – Barclays Capital
If that is, if those are the top five or are energy costs higher? Is the trays and packaging a higher cost? If we were just to be monitoring some of the prices that are impacting you guys the most.
Joseph M. Redling
Yes. Food is about 28%, 30%, 28% to 30% of our cost of goods. It’s about a third and then we’ve got freight and fulfillment, right? So those are the three big categories.
David D. Clark
Are you asking as a subset of the food costs or were you asking, that’s the breakdown of our cost of goods sold components.
Karen Howland – Barclays Capital
If you’ve got it for food, that’d be great.
David D. Clark
No, I don’t but basically if you look at the cost of goods sold, we could basically have food, freight and fulfillment. There’s some commissions that flow through there. Food, as Joe said, is half of our cost, yes.
Karen Howland – Barclays Capital
Food is half of the cost of goods sold, not 28%.
David D. Clark
28% percent of revenues, half the cost.
Karen Howland – Barclays Capital
David, you mentioned quickly there was a benefit to gross margin?
David D. Clark
Yes.
Karen Howland – Barclays Capital
Can you go into a little bit more detail on what that was?
David D. Clark
Well, Joe mentioned the profit hunt in the supply chain and in connection with that, we’re just making sure we’re doubling down our efforts to make sure we’re not getting overcharged and doing things as efficiently as possible and through our normal audits, we basically identified some overcharges and went back and negotiated credits with the suppliers. So it’s just management focus.
Karen Howland – Barclays Capital
So it’s more of a onetime true-up as compared to a benefit going forward?
David D. Clark
We collected in the third quarter and that’s when we recognized it.
Karen Howland – Barclays Capital
Then looking at the sales numbers, it looks like you’re expecting, if I just hit the midpoint of your guidance for the full year, that sales will be down a similar rate to what they were in the third quarter despite the fact that you took a 2% to 3% price increase in the beginning of October. Is that assumption correct?
David D. Clark
No. The full year, if you took the midpoint, the full year sales decrease would be about 11% and revenue was off about 13% in the third quarter.
Karen Howland – Barclays Capital
So I’m sorry, I was just talking about the fourth quarter.
David D. Clark
Oh, fourth quarter. [Inaudible]
Karen Howland – Barclays Capital
I believe that it would be about –
David D. Clark
Yes. It’s down about 11% which is similar to the full year.
Karen Howland – Barclays Capital
Despite the fact that there were price increases taken?
David D. Clark
Well, I would think, although the price increase is small because it went into effect October 1.
Joseph M. Redling
And it’s small volume.
David D. Clark
Small volume. It’s a small volume quarter but I think the fact that we’re going to be down 14% in the third quarter and if you take the implied guidance for the fourth quarter and ply it down 11% I think the price increase is actually helping us.
Karen Howland – Barclays Capital
When should we expect to see the new advertisements for the new frozen line?
Joseph M. Redling
When it launches in January.
Operator
Your last question comes from William Sutherland – Boenning & Scattergood Inc.
William Sutherland – Boenning & Scattergood Inc.
The frozen line, Joe, is that going to be just stand alone or will it be available, mixed in with the standard package?
Joseph M. Redling
It’s actually NutriSystem Select is made up of a combination of both our shelf stable and frozen. Because we’ll have a favorites kit of frozen that will be incorporated into that order. As we move into the second quarter, by the end of the second quarter we’ll have full customization of all of our items that consumers can choose as many frozen or shelf stable as they would like. One of the things, Bill, you and I have talked about this is in the past, consumers could only pay $300 for a program with us. We want consumers to be able to get the foods that they want and pay according.
So as we launch we’re keeping it simple by having it as one component, included shelf stable with the frozen element as NutriSystem Select option. As we move into the second quarter, we’ll be moving more into a fully customizable approach.
William Sutherland – Boenning & Scattergood Inc.
Joe, will there be multiple drops during a month for frozen?
Joseph M. Redling
It’ll be one drop.
William Sutherland – Boenning & Scattergood Inc.
One drop.
Joseph M. Redling
Yes, one drop. If the consumer wants more drops.
William Sutherland – Boenning & Scattergood Inc.
Have you found that this is the same issue that you’re tackling as you reformulate Balance as far as that program, in terms of the selection range?
Joseph M. Redling
Balance was really the first time of us putting a maintenance program in front of consumers so we went through an alpha stage of putting these ideas and programs in front of consumers, pricing, getting value, measurement from them and we got great input so we’re just tweaking it, revising how we talk about it, to put it out there. I think with frozen it’s a little bit more down this strike zone of what we do.
We think the type of products we have, the food is absolutely delicious and unique; everything from ice cream sandwiches to pepperoni pizzas and things like that that are absolutely delicious so we think it’s much more along the core aspect of our business, getting our customers and potential customers talking about food items and then ordering the food items that they really like.
What we’re really kicking off with, to put it in our vernacular, is really a favorites pack, right? So we’ll have a frozen favorites pack which will be made up of 28 items and that’ll be the first offering that goes to consumers in January.
William Sutherland – Boenning & Scattergood Inc.
David, I forget, did you put, you put international revenue in the queue or do you report that as a breakout?
David D. Clark
International revenue? No, it’s not broken out.
William Sutherland – Boenning & Scattergood Inc.
So you’re not providing the Canada number at this point?
David D. Clark
No, no. It’s a very small percentage of our overall revenue. It’s going as expected. We’re excited about it but it’s just not meaningful as yet.
William Sutherland – Boenning & Scattergood Inc.
Last one, David, for you is will there be a cost for Zero Water in Q4 do you think?
David D. Clark
A cost meaning a recognition of our loss? Yes. We expect to be recognizing our portion of their gains or income or losses in any given quarter.
William Sutherland – Boenning & Scattergood Inc.
Well, I was asking it backwards. So you are expecting a little more red from them in the fourth quarter?
David D. Clark
Yes. Yes, we are not anticipating they’re going to be positive in the fourth quarter.
Operator
That does conclude the question-and-answer session. I’ll now turn it back to Ms. Cindy Warner for closing remarks.
Cindy Warner
We’d like to thank everyone for their time and we hope you’ll join us in February for our next conference call when we discuss our full year 2008 results.
Operator
Ladies and Gentlemen, thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a great day.
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