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NutriSystem Inc. (NASDAQ:NTRI)

Q3 2009 Earnings Call

October 27, 2009 16:30 pm ET

Executives

Cindy Warner – Investor Relations

Joseph M. Redling – Chairman, CEO

David D. Clark – CFO

Analysts

Gregory Badishkanian - Citigroup

Paul - Lazard Capital Markets

Mitch Pinheiro - Jenny Montgomery Scott

Jim Duffy - Thomas Weisel Partners

Bill Sutherland - Boenning and Scattergoods

Peter Rappoport - Ledgemont

David Cannon - First Midwest

Presentation

Operator

Good afternoon. My name is Letanya and I will be your conference operator today. At this time I would like to welcome everyone to the NutriSystem third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will a question and answer session. (Operator’s instructions) Thank you. I will now hand the floor to Cindy Warner, Investor Relations. Ms. Warner, go ahead, please.

Cindy Warner

Good afternoon everyone and thank you for joining us to discuss NutriSystem’s third quarter 2009 financial results. With us today from management are Joe Redling, Chairman 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 proceeded by, followed by or include the words, believe, planned, intend, expect, anticipate, or similar expression.

Statements regarding NutriSystem’s plans and expectations for the fourth quarter, the full year 2009 and the 2010 diet season are 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 security’s litigation reform act of 1995. Actual results may differ materially from the results predicted and the reported results should not be considered an indication of future performance.

Factors that could cause actual results to differ from those contained in the forward-looking statements include, but are not limited to those factors set forth in NutriSystem’s annual report on Form 10-K for the year ended December 31, 2008, which has been filed with the SEC.

NutriSystem is making these statements as of October 27, 2009 and assumes no obligation to publicly update or revise any (9:15 no audio until 9:30) forward-looking information in this announcement.

And with that, I would like to turn the call over to Joe Redling, our Chairman and Chief Executive Officer.

Joseph M. Redling

Thank you, Cindy. Good afternoon and thank you for joining us on today’s conference call. During the third quarter we saw improvement in performance trends when compared to the previous quarter as NutriSystem D expanded the core business stabilized and we further optimized our media mix.

This combined with the full effect of our cost reduction initiatives resulted in adjusted EBITDA growth as compared to the second quarter.

Before I go into details on that let’s review a few key metrics that David will expand on shortly.

Third quarter revenues came in at $127 million versus $163 million a year ago. Gross margin for Q3 2009 was 54.5% up 140 basis points as compared to 53.1% a year ago. Marketing as a percentage of revenue was 28.6% behind the diabetic launch as compared to 24.1% a year ago.

Adjusted EBITDA was $18.7 million, down versus prior year of $26.7 million. And we continue to be debt free and have $97.6 million in cash, cash equivalents and marketable securities on hand at the end of the third quarter. We also announced that we will be paying our regular dividend in November.

While our performance in the third quarter fell short of prior year comparison, it delivered sequential improvement over Q2 2009 in adjusted EBITDA and new customer starts. And we improved our top line revenue trends.

To put this in context, we typically experience a sequential decline in these key metrics from Q2 to Q3. Seasonal demand is highest in the first quarter of the year and then declines each quarter thereafter. The last time we experience the sequential Q2 to Q3 improvement was in 2006, when we launched our new men’s program in August of that year.

This is further evidence that seasonal demand trends can be improved by impactful new product introductions. In 2006 it was our new men’s program and in 2009 it is NutriSystem D. While we have no provided detailed new customer information for some time, I feel it is important to provide a bit more context given the current operating climate and the seasonal shifts we are currently experiencing.

New customer starts in Q3 actually increased by over 20% versus Q2. Again, while the actual number of new customers is still trending below prior year we have managed to close the gap. This factor reinforces our earlier belief that the second quarter of 2009 represented a bottom. And we saw improved trends throughout the third quarter. This improvement in new customer starts played a key part in closing our top line revenue gap as we experienced a 4% sequential decline in revenue from Q3 versus Q2 of this year. That results compares to seeing sequential quarterly revenue decline of 16% and 12% in 2008 and 2007, respectively.

And our quarterly year-over-year revenue comparison also improved. As the $127 million in revenue represented a 22% decline from prior year, versus a 32% decline experienced in Q2 of this year and a 25% decline in Q1.

While we are still striving to close that gap completely we are encouraged by the improving trends. Our sequential increase in adjusted EBITDA in the quarter was driven in large part by our cost reduction measures initiated in the second quarter with the largest factor being a reduced G&A line. Which David will go into in more detail in a few minutes?

Our reduced operating costs also enabled us to increase our marketing spending the quarter as we saw improved response in efficiency while still delivering sequential adjusted EBITDA growth.

As we stated on our July earnings call, we saw improved trends early on in July. And those trends continued throughout the quarter. While there was a sense of stabilization in the macroeconomic conditions there were several operational factors also contributing to our Q3 performance.

First, our new product, NutriSystem D continued to gain traction and deliver strong results. We continued to be encouraged by our early results and we believe that NutriSystem D will be a significant contributor to our overall business going forward.

Secondly, we have further optimized our media mix. Which enables us to spend at higher levels and still get an improved return? The addition of NutriSystem D advertising enabled us to further optimize our overall media efficiency.

We leveraged our spending for our core programs of men, women, and NutriSystem D across all our channels which resulted in improved efficiency.

We have expanded our knowledge base to real-time testing of how to leverage all advertising efforts across our many acquisition channels. What works best in print, TV, web, and other media channels and more importantly how did each of these channels and marketing efforts influence the entire demand curve.

Third, the tools we had put in place the first half of the year to increase call center productivity and the investments we have made in our new web design have driven improvement in conversion rates across channels.

Our improved media and product mix resulted in increases in demand, mainly call volume and qualified web traffic. And our improved performance conversion drove more orders.

We also introduced additional creative executions in the quarter and debuted two new spokespeople for our men’s program and NutriSystem D. In September football Hall of Fame inductee, Lawrence Taylor joined our impressive rooster of iconic athletics who have enjoyed success on our program.

And in a very well timed execution, Charlie Manual, our local hero here in Philadelphia shared his success on NutriSystem D, loosing over 50 pounds and improving his health. Of course, we extend Charlie and his Phillies our loud congratulations on their recent win in attaining the National League’s highest honor.

Now let me expand on a few of our recent announcements. In September we announced the licensing agreement with House Foods Corporation in Japan for the launch of the NutriSystem J-Diet. A program that has been fully localized and customized to appeal to the Japanese market. Since 1913 House Foods have provided the Japanese consumer with high quality and affordable products. Publicly traded, House Foods is one of the largest food manufactures in Japan.

The branding of the program at NutriSystem J-Diet simply leverages the weight loss credibility of our brand. And the J is a commonly used brand reference to communicate a product offering being customized for the Japanese consumer.

The product marketing launched this month in Japan and we look forward to a long lasting relationship with our new partner, House Foods.

We also recently announced NutriSystem’s new distribution through 3,200 Wal-Mart Stores in the continental United States and Walmart.com.

Wal-Mart offers their customers a 14 day starter kit that can be purchased via a convenient retail card. That card is then redeemed on the NutriSystem website where we capture our standard customer information and deliver their 14 day meal plan directly to their homes. We believe that the new 14 day program offering will allow customers sufficient time on our program to sample a large variety of our favorite foods, experience how easy our program is to follow and really see the value our program offers in terms of nutrition, weight loss and great taste.

We believe that the $148 price point represents a great value for a full 14 days of meals. That equates to less than $3 per meal. We have also developed specific call center protocol and web based incentives to convert these starter kit customers to the 28 day auto ship program where they can extend their program to continue to lose weight and make use of our free counseling support and our entire suit of web tools.

As you know, Q4 is our lowest demand period and we typically do not invest aggressively in marketing within the quarter. Our thinking behind a launch in retail in the fourth quarter was primarily to be scaled and ready for January, as rolling into 3,200 Wal-Mart stores is a major effort. And this is our largest retail launch to date.

We are also continuing our relationship with Costco. We will be back in their North American stores for the diet season with the same one month program as earlier this year. And will also be featured on Costco.com.

The success of the Costco program earlier this year lead to our retail card expansion. Not only does it deliver an immediate financial return, but we also found there was little cannibalization from our current customer base.

We see retail with our innovative retail card approach as a natural extension of our direct to consumer business model. This program is unique and we believe it’s a win-win for all parties involved. We expect to benefit from the increased brand awareness and presence in thousands of locations, reaching new segments of consumers and driving trial while still maintaining the important relationships directly with our customers.

Our retail partners also benefit from adding our proven weight loss brand to their offerings with a unique value proposition for their customers supported by our extensive marketing activities. Consumers also win by having a lower cost alternative to sample our program with the convenience of purchasing through their trusted local retailers.

We believe that we can initiate trial through these new channels and provide value to our retail partners and their customers. As we look ahead, we expect to expand our retail partnerships even further in time for the upcoming 2010 diet season. We are currently finalizing our roll out plan with additional retailers and will have more specifics to share with you soon.

Building on our efforts in the diabetic arena, yesterday we announced our new alliance with the American Diabetes Association. This marketing alliance will promote NutriSystem D product with the ADA audience and promote the word of the ADA within the NutriSystem community. November is Diabetes Awareness Month in the United States and NutriSystem is partnering with the ADA to raise awareness with the stopdiabeties.com website.

Every diabetes story shared o stopdiabeties.com will generate a $5 donation by NutriSystem to the ADA, up to $100,000. Also in November Dr. Gary Foster, who oversaw the Temple University clinical trial and Charlie Manual, manager of the Philadelphia Phillies will team up to do a satellite media tour starting with the stop on the Fox morning news show to discuss Type 2 Diabetes and the NutriSystem D program.

The interest we have seen in the last quarter for NutriSystem D is very satisfying. The comments we get back from our customers saying how our program has positively changed their lives is incredibly gratifying to all of our involved. To be healthier, less reliant on medications or even eliminate medications allow these people to take control of their lives and live in a more rewarding way.

Finally, during Q3 we updated our Select line to a 2 plus 2 configuration. Two weeks of frozen, fresh frozen and two weeks of ready to go. This update has improved satisfaction and length of stay with our fresh frozen customers.

Looking forward, we intend to increase the flexibility with ordering our fresh frozen items to allow our customers to personalize their program even more.

Before I turn the call over to David, let me summarize a few key points. We saw sequential improvements in new customer starts, gross margin, general and administrative expenses and adjusted EBITDA on the quarter. During the third quarter we closed the gap we had experienced in the first half of 2009. While we remain cautious for the immediate term as unemployment remained high consumer spending is challenged. We believe the work we have done in 2009 positions the company well for the next phase of the recovery.

Our successful launch of NutriSystem D positions us well to address this large consumer market in the coming diet season. We see the retail channel as an excellent opportunity to increase distribution, brand awareness and customer acquisition. We continue to generate free cash flow that positions us well to invest in the coming diet season with appropriate inventories and marketing spend while remaining debt free.

With that, I will turn it over to David Clark, our CFO.

David D. Clark

Thank you, Joe. Now let’s go through third quarter results. For the third quarter 2009 we generated $127 million in revenues. A 22% decrease from prior year. For the third quarter 2009 a direct channel, including retail driven sales generated 93% of our revenue. QBC generated 6% and less than 1% of revenue came from other channels.

Importantly, reactivation revenue was approximately $33 million, the same dollar amount as the third quarter of last year. It represented 26% of overall revenues.

As we discussed last February, we started this year targeting several cost reduction initiatives, including our supply chain optimization. Our supply chain team has executed on plan delivering 140 basis point increase in gross margin, as compared to a year ago. These efforts included an RFP process for our up bound freight and fulfillment contract, as well as ongoing management of food costs, inbound freight and other expenses.

By the end of this year, all of our fulfillment will be handled through two distribution centers. We believe this optimization not only will reduce costs but provide plenty of capacity for growth. And it’s designed to achieve order delivery within five days to the customer over 90% of the time.

As I stated, gross margin for Q3 increased 140 basis points to 54.5% from 53.1% in Q3 a year ago. Marketing as a percentage of sales was 28.6% behind continued marketing support of NutriSystem D, as compared to 24.1% a year ago. And we believe is on track for an upper 20% range for the full range.

Our general and administrative expensive for the quarter totaled $16.7 million, which is down approximately $5.9 million versus the third quarter 2008. And represents a 26% decline since Q3 of last year and a 21% decline sequentially from Q2 of 2009.

Even more impressive than the reduction in the GAAP G&A is the reduction of our cash G&A which does not include our non-cash compensation. Where we achieve products of 30% and 25% to Q3 last year and Q2 2009, respectively. This improvement is a direct result of the successful cost reduction programs we announced in the first quarter and implemented in the spring.

Despite these reductions we maintained sufficient resources to manage the increase in customer demand, the launch of NutriSystem D and the expansion of our retail channel.

Q3 2009 operating income from continuing operations was $13.3 million and represented a 10.5% operating margin. Our third quarter 2009 adjusted EBITDA was at $18.7 million. Depreciation and amortization was $3 million and our non-cash employee stock compensation totaled $2.4 million. Adjusted EBITDA was 14.7%- the EBITDA margin was 14.7%.

The company’s expected effective tax rate for the third quarter 2009 was 37%. And we have forecasting an effective tax rate of 29% for the full year on operation. As a result of the breakdown of Zero Water investment earlier this year.

Fully diluted earnings per share was $0.27 a share, down from $0.43 a share a year ago. And non-cash employee stock compensation had an approximately $0.05 impact on earnings per share.

From a liquidity standpoint, on September 30, 2009 we had $96.7 million in cash, cash equivalents and marketable securities, as compared with $38.3 million at the beginning of this year. And we continue to be invested in treasury US Agency back and money market front accounts.

Capital expenditures for the third quarter $1.4 million as compared to $3.2 million in Q3 of 2008. And we plan for capital expenditures in 2009 to come in below the $10 million, our target set at the beginning of this year.

Our unused $200 million credit facility remains available should we need it.

We ended the third quarter 2009 with inventory at $20 million as compared to $51 million on December 31, 2008. We are currently rebuilding inventory levels in anticipation of the new diet season. We except to fully fund those purchases from cash balances while maintaining a meaningful amount of liquidity going into year end.

As we do continue to prioritize cash availability, no stock was repurchased during Q3. And our stock buy back authorization of nearly $114 million remains intact.

The board of directors approved a dividend payment of $0.17.5 per share payable November 16, 2009 for the holders of record on November 6, 2009. We continue to see dividends as effective method to directly return value to our shareholders.

As Joe had previously mentioned, we are excited about the expansion of our retail channel. Our unique approach requires no inventories at the retail level, no new product skews, replicates our outsource model for supply chain and is profitable at the point of sale.

In addition, retail customers represent an up sell opportunity to our auto ship program. Our studies have shown that to date Costco has not been cannibalistic. And since we receive customer information upon their activation it has increased our database of potential reactivations.

Similar to reactivations, there’s a relatively small amount of marketing dollars spent to generate retail orders. Since we manage our direct consumer business to be profitable on a stand alone basis we do not allocate our direct consumer advertising expense to retail orders or reactivations.

Based on our recent experience, we expect retail revenues to accretive to operating margins once the channel reaches scale.

Our outlook for the remainder of the year is based on normal seasonal downturn and new customer starts and stable reactivation revenues. Therefore, we are forecasting full year diluted earnings per share range of $0.99-$1.01. This anticipates our seasonally slow fourth quarter and includes $2.9 million in expense incurred to prepare for the new diet season and the expansion of our retail channel.

Additionally, as we complete the supply chain optimization we expect to incur $1 million in one time expenses from the reduction of distribution centers down to two locations by year end.

For the full year we believe marketing efficiency will be in the upper 20% range as we continue to promote our efforts on NutriSystem D. Reactivation revenue is expected to be similar to last year. And our focus on cost containment will continue to be a financial priority as prepare for year end and the diet season to come.

Thank you and I’ll now turn it back over to Joe.

Joseph M. Redling

Thanks, David. 2009 has been a year of focus on operational efficiencies and productivity while also positioning us for growth. NutriSystem D allows us to serve a new large addressable market and we have further diversified our revenue stream.

We believe that our channel expansion into retail will also position us very well as we enter the 2010 diet season and enable us to efficiently reach millions of new consumers with our weight loss message.

With both of these initiatives, while significant on their own, we expect they will create a positive cumulative effect for the overall brand. We are in the process of finalizing our marketing efforts for January and are excited about the start of our peak season. While we cannot influence the macro consumer environment we have put in place all the operational improvements, marketing analytics and new product and channel initiatives that will enable us to execute at a high level.

The recent trend improvements, the addition of NutriSystem D and our new presence in retail should position us well for a successful launch into the 2010 diet season.

With that, Operator, we would like to open it up for some questions.

Question-and-Answer Session

Operator

Thank you. (Operator’s instructions) Your first question comes from the line of Greg Badishkanian with City.

Gregory Badishkanian – Citigroup

Great, thanks. Hey, I have a few questions for you. So, it looks like NutriSystem D is having some pretty good results. And just wonder how much – you mentioned a sequential improvement in the third quarter. How much of that was due to NutriSystem D versus, maybe, the consumer getting a little bit better?

Joseph M. Redling

Yeah, Greg, it was really the sequential improvement, D, was a big factor in that. Probably the primary factor in that improvement as we invested in the launch in the second quarter, that program continued to pick up momentum and we continued to increase our spending against it. But we also saw improved trends in the core business, which was what we were really looking for. And that was driven in a large part by our marketing as well as our improved media mix. So D is a significant contributor to the improvements we’ve seen and we expect that to continue.

Gregory Badishkanian – Citigroup

Yeah. I know it’s hard because it’s such a fragmented industry. But would you say that you think the overall weight loss industry saw some improvements in the third quarter or is it just too difficult to say?

Joseph M. Redling

Honestly, we have not been able to see specific consumer spending improvements to date. We know we all witnessed the overall improvement in the financial markets. But even as recently as this morning with consumer confidence and that came out, consumers are still very concerned and challenged on spending as they move into the holiday season. So definitely saw stability. So we did not see trends getting worse after the second quarter. We saw them bottom out and actually show a little bit of improvement. But we haven’t in any of our tracking seen anything that really predicts an increase in consumer spending or consumer sentiment at this time.

Gregory Badishkanian – Citigroup

Okay. And then I guess importantly as we go out to 2010 and the beginning of the year is an important part of the diet season, maybe compare what you have going in that’s new versus what you had in early 2009 and if you think it’s enough to generate growth. And if you feel like the initiatives are better than last year?

Joseph M. Redling

Yeah. Clearly we were walking in to last year into a first quarter of a lot of unknowns with the financial situation we were in from an economy standpoint. I mean, I feel much better prepared going into Q1 mainly because we do have this big segment of people with diabetes which is 24 million consumers. And so we did not have D in the first quarter. And we expect that the demand for that product will seasonally go up as our normal product does. So we think we have an opportunity there to get some momentum going with D. And I do believe that our retail presence will also assist us in a big way, not only in driving orders related to that channel, but also the awareness and the promotion that we’re receive from those retailers. And as I mentioned, we’re rolling out with Wal-Mart right now. We’ll be back with Costco and we do have plans to extend that retail distribution with additional partners. And we expect to have a good presence in retail in time for the diet season.

In addition, I’d add that I think we have some interesting marketing, new creative. Getting ready as we’ve optimized our mix this year I think we’ve really become more sophisticated in how we’re managing our media over this last year. We had to get better and we did. And I think we’ll have some really compelling new messages for our core businesses as well. So I see it as three pronged approach between improved marketing for our core business, some new product news with D as well as channel expansion with retail.

Gregory Badishkanian – Citigroup

Could you just remind me, early this year what did you – what was new this year?

Joseph M. Redling

We actually launched with our frozen line. So we established our messaging clearly went out with higher quality, larger variety of foods. So if you think about our launch in Q1 of 2009 it really was based on our menu options. So I think we have a much more formidable combination of marketing messages as we move into 2010.

Gregory Badishkanian – Citigroup

Right. So adding frozen versus having Nutri D and also the retail presence it sounds like this year’s – 2010 would be a stronger year, I would guess?

Joseph M. Redling

We’re hoping. We can’t predict the macroeconomic environment, but we’re encouraged.

Gregory Badishkanian – Citigroup

Yeah. All right, good. Very good. Thank you very much.

Operator

Your next question comes from the line of Colin Sebastian with Lazard Capital Markets.

Paul - Lazard Capital Markets

Hi, this is Paul for Colin, thank you for taking my question. I was wondering if you just give us some color and how things are trending in October. I know it’s a seasonally slow quarter. I was just wondering. And then also how are advertising pricing trending entering Q4 and setting up for Q1 both online and TV?

Joseph M. Redling

Yeah. We haven’t seen any real dramatic change in trends in October. We continue with extend of what we saw in September. Clearly as we move past October, November and December is a pretty soft period for us. So we’re not really a big buyer in media. It’s the softest season in diet for us. So we don’t see a lot of opportunity to aggressively invest our marketing spend.

In terms of ad rates, Paul, I think anyone who’s been in the direct response business has seen some challenges over the last couple of months, on clearances. There’s been a lot of competition in the scatter market for general brand advertisers. So there’s been some volatility that we’ve experienced over the last couple of months. We’ve managed our way through it. We expect that to moderate and become more normalized as we move back into the 2010 diet season and as we move into January.

Paul - Lazard Capital Markets

And then overall, do you think you’re cost structure is where you’d like it to be heading into Q1?

Joseph M. Redling

Yes. We feel very good about the changes we’ve made. We’re still able to innovate; our infrastructure capacity can still support a pretty large amount of increased revenue in terms of both our supply chain and our own infrastructure here. So as we typically have a variable model as our revenues grow, our support structure will grow with it. I think our base cost is exactly where we had set out to get it when we started in the first quarter putting our plans together, the right size of the cost structure for our current revenue trends. So we feel good about where we are. We think we’ll be able to flow additional dollars to the bottom line as we see increased revenues.

Paul - Lazard Capital Markets

Okay. Thanks for taking my questions.

Operator

Thank you. Your next question comes from the line of Mitch Pinheiro with Jenny Montgomery Scott.

Mitch Pinheiro - Jenny Montgomery Scott

Hey, good afternoon. Could you give us some color on perhaps of the new customers, what percentage were D customers?

Joseph M. Redling

What we’ve said in the past is our base level of diabetic customers prior to launching NutriSystem D was about 5-6% of our business where our customers voluntarily told us they were diabetic. And we tried to design menu plans for them specifically. What we have said is we are seeing a contribution to our new customers in the double digit range. So we’ve improved that. We’ve doubled that, we more than doubled that contribution from what we’ve seen before. This is rather similar to what we saw with men where we had a base business of men, about 12%. Now we’re running in the high 20% with men’s programs. So we are seeing a double digit contribution already from the initial launch.

Mitch Pinheiro - Jenny Montgomery Scott

And are you seeing that accelerate or just be a steady type of pattern?

Joseph M. Redling

It’s pretty steady. It actually flows with our spending. What we do – are encouraged by is we continue to up our spend against the diabetic segment and we continue to drive good levels of call volume and we’re starting to see really good returns in every channel, whether it be television or print. So we’re pretty encouraged to be able to seeing that kind of response and that level of spend in this period. So we’re hopeful that as we move into Q1 as that demand cycle increases, we’ll actually be able to invest even more aggressively into that segment.

Mitch Pinheiro - Jenny Montgomery Scott

Was the month of September, did you see any meaningful pick up in September versus July-August?

Joseph M. Redling

No, we actually started seeing some improvement, really towards the second half of the quarter. So August and September pretty much is where we started seeing some improvement on our trends. And we leaned into that pretty heavily with our spending. As you can see the reason our marketing efficiencies are a little bit – the percentages in the high 20s is we saw the demand so we invested those dollars, call it whatever it is $3 or $4 million that we incrementally put against the market, we’ll get that back in profitable returns. The majority of that by the end of the year because of the new customers we’ve generated.

So the quarter, we saw trends improve in July as we said in the earnings call. It kind of stayed consistent right through August and September. We did not see a big seasonal bump in September. So I think the improvement in trends we saw in August kind of carried through. But we did not see any sort of noticeable bump seasonally when we passed Labor Day.

Mitch Pinheiro - Jenny Montgomery Scott

Was that surprising to you? I mean, that the improvements started, sort of, in a less important part of the quarter. So maybe leading to the fact that it’s more of a D type of move then a traditional move?

Joseph M. Redling

I think what you’re still seeing in terms of the macroeconomic environment, we saw the same thing in a much heavier demand period, which was Easter where we did not see significant bump in demand. And whatever we did see was pretty short lived. So September is even a lesser degree of demand increase that you normally see. So we really weren’t sure about how depressed it would be based on the macroeconomic. But I think your takeaway is right, Mitch. I think it was – D was providing us that bounce. The core business was really stabilized and improving but not to the degree that you’d normally see in a normal macro environment.

Mitch Pinheiro - Jenny Montgomery Scott

Okay. And are you seeing in terms of some of the other, sort of, metrics, like average length of stay or customer spending. Anything else in there that is changed or different versus what you would expect D versus regular?

Joseph M. Redling

Actually, that’s a great question. D is performing right at our expectations of our core business both in cost to acquire, revenue per customer, second month take rates. So our expectation is that the diabetic customer would actually be more profitable. As we mentioned, I believe, on the last call, we skew about 40% men on the diabetic program. And so clearly there’s a higher price point associated with that. We typically get a higher length of stay. Again, it’s still early for us. So we’re still at the early stages of managing this consumer segment. So we’ll have to wait and see. But the early signs are positive.

Mitch Pinheiro - Jenny Montgomery Scott

Okay. And just last question on the margin, on the gross margin. David, I think you mentioned of the 140 dips you mentioned on going food cost management. Of the 140 how much was favorable food costs, if you care to share?

David D. Clark

I think it was a part of it. But I think the key thing for year-to-date 2009 was really the RFP we held for our outbound freight that UPS won in February. And just recently we held the RFP fulfillment, which I think, is just starting to show up in our numbers. So I think the food cost is basically a day in, day out type of thing. It’s hard to kind of peg exactly where. But I think it’s a part of it. But it’s hard to sort of flag exactly what the dollar contribution is because it’s really an ongoing process to keep food costs down.

Mitch Pinheiro - Jenny Montgomery Scott

Okay. I actually said last question, one more just on cash. Obviously you’re going to be rebuilding inventory for the diet season. But it’s still fairly large cash balance. I mean is there any other – are we probably going to see resumption of share repurchase or how do you think about your cash?

Joseph M. Redling

Well, we obviously will reevaluate our share repurchase appetite every quarter. I’d say right now what we can see out there for cash dispersement will really be exclusively the inventory bill. And then you heard where our expectations are in CAP Ex. So we should not have a very large CAP Ex spend for the remainder of the year. We’re always evaluating ways to return cash to shareholders. It’s an ongoing process.

Mitch Pinheiro - Jenny Montgomery Scott

All right. Thank you very much.

Operator

Your next question comes from the line of Jim Duffy with Thomas Weisel Partners.

Jim Duffy - Thomas Weisel Partners

Thanks, good afternoon. Couple of questions for you. So, Joe, I’m trying to get my arms around that contribution of all the new initiatives. How much – maybe this is a good way to go about it, in the third quarter how much of your revenue came from just kind of the basic core program versus new things that you’ve added this year, like NutriSystem D and the frozen and some other things?

Joseph M. Redling

Yeah. Jim, I’m having a hard time hearing you. I think the question was what percentage of our revenue was contributed by the core program?

Jim Duffy - Thomas Weisel Partners

That’s right. I’m trying to get my arms around the contribution of some of these newer initiatives that you have.

Joseph M. Redling

Yeah. We kind of look at the direct business in its entirety. And the reason we do that is we still think it’s a little bit early – maybe if you think about, we have Costco in there and the direct business as well, and we now have D. And I think I said earlier we’re seeing D contribution to our new customer starts being in the double digit range. So it’s not insignificant and it continues to grow for us. But we haven’t really broken out any of the individual contributions between retail or frozen or D at this point.

Jim Duffy - Thomas Weisel Partners

How big to you expect the Wal-Mart opportunity to be for you?

Joseph M. Redling

Yeah. That’s kind of the $64,000 question. So it’s hard for us to get our hands around that until we’re fully deployed. Wal-Mart right now – and again, our first view of that will be what we see in November, December as they’re rolling this out. We see the fourth quarter really as more of an operational test for us. We’re trying a lot of things, placement in different locations in the store, various types of in store marketing and display, cross a lot of their different regions. So we’re working with them very closely on this. So we really won’t have a good feel for that. I know it’s not a great answer to your question. But we probably won’t have a good feel for that until we get into the heart of the diet season in January.

Jim Duffy - Thomas Weisel Partners

Now recognizing that the time period wasn’t exactly ideal to get a read on the Costco program, presumably however though, Costco gives you some sort of base line for Wal-Mart, correct?

Joseph M. Redling

Yeah. But again you’re talking about a membership based retailer. We’re very happy with the results of Costco. You’re talking 300 stores versus 3,200 stores, a very different price point. We’re at our fully 28 day program at Costco. This is the first time we’ve been in retail at a $148 dollar 14 day starter kit. So it’s really hard to judge. And I think it would be premature for us to put any number out there at this point.

Jim Duffy - Thomas Weisel Partners

And David, you mentioned that once a retail program gets to scale you expect it to be accretive. What would that revenue number be or you would see it making the accretive contributions?

David D. Clark

Well, again we’re not going to go out with any sort of revenue predictions around retail. When I say get to scale what I’m saying is getting through the operational deployment that Joe described this quarter and then getting into the first quarter and seeing just what kind of volumes we can. I mean a lot of the expenses we’re incurring now we would expect to be largely set up expenses. And in the ongoing expenses would be similar to the types of gross margins we see in our direct business. And as I said, we really don’t see a lot of direct marketing spent against this – necessary against this channel.

Joseph M. Redling

So, Jim, just to add to that, I think when you think about retail, and we mentioned it in some of the prepared comments, as we expand our presences in retail these are trial purchases. So a big driver of the EBITDA contribution or revenue contribution is going to be length of stay here. So getting a two week order, we do have a lot of work going on as we speak to upgrade folks, and to up-sell them to 28 day programs. We do have some history with Costco on that front. So we’re not flying blind there. We actually have real data that we think we can improve on. But these are new segments. So talking about what Wal-Mart customer versus a Costco customer are very different components and we really need to get some data under our belts here before we start thinking about what actually the contribution of revenue or EBITDA could be from any of these retail partners as we scale into these channels.

Jim Duffy - Thomas Weisel Partners

But it does sound like most of the expense is just kind of up front set up costs and after that, if it works that’s where it becomes accretive and could make some money.

David D. Clark

That’s exactly right.

Jim Duffy - Thomas Weisel Partners

Okay. That’s helpful. Thanks. And then shifting gears a little bit. Big reduction in G&A expense, quarter-to-quarter, maybe you mentioned this, but what was the drivers of the savings in the G&A relative to the second quarter?

David D. Clark

Last quarter we announced our intention to really focus down on our G&A. We had fairly large force reduction in late May. But we also focused our outside computer spending on really high priority projects, such as launch of D, such as really the expansion of our retail channel. So it’s really a matter of just sort of getting focused and sort of right sizing expenses both non-labor and labor. And a lot of that was executed in the second quarter. We have said that all of our expense lines are fairly flexible, relative to other businesses, certainly. And I think that was born out in this quarter.

Jim Duffy - Thomas Weisel Partners

Yes. Very nice progress on that line. I’ll let someone else jump in and hit you guys with a follow up after the call.

Operator

Thank you. Your next question comes from the line of Bill Sutherland with Boenning and Scattergoods.

Bill Sutherland - Boenning and Scattergoods

Thank you and thanks for taking the questions. David, on that G&A question, so should we think about that line as one where you got it scaled to something that you can sustain or grow very slowly now going forward?

David D. Clark

I think it’s really predicated on growth. So yeah, we are managing that G&A line to basically be in line with where we have it right now. And then as we invest in things like I described around retail or any growth in retail or other products direct channels there might be some upward pressure. But we’re going to do it just based predicated on demand.

Bill Sutherland - Boenning and Scattergoods

Okay. On the market expense side, are you all – certainly if you see the potential there for new starts to continue to build, likely to keep that marketing spend a little higher than the 25% going forward?

Joseph M. Redling

No. I think with D it’s all about investment spending. And I think when we think about the spending; clearly we’re more aggressive in Q1, Bill as you know. So we will look at that pretty aggressively. And we’re looking at each of these businesses as really separate P&L. So we have the men’s program, a woman’s program and D. And we’ll be investing accordingly across all three based on what we think the ROI would be on that marketing investment.

So our inclination as we move into Q1 is to be more on the aggressive side.

Bill Sutherland - Boenning and Scattergoods

Right. Okay. That’s all I got, thanks.

Operator

Thank you. Your next question comes from the line of Peter Rappoport with Ledgemont.

Peter Rappoport - Ledgemont.

Congratulations on the quarter. I just want to ask a question as it relates to churn. You mentioned that traditionally about 5%-6% of your customer base was self described diabetics. I was curious if you had data or if you released data on the average amount of time that a diabetic patient or customer stayed in the system versus a non-diabetic customer? And specifically with D if you had any data – I know it’s early in the process, but if you see any trends or anything that you’d like to share as it relates to that?

Joseph M. Redling

I mean typically, again, it’s a small base. But one of the reasons we leaned into developing a real pure diabetic product was because of the customer economics we were seeing from our diabetic customers. They were loosing weight, they were staying on longer, and they were less price sensitive. So we felt as we looked at how large that market was we had an opportunity there. So that said, that was a pretty small piece of our business. So those are self selected people who chose us. We really did no marketing. So as you open up your funnel you’re never sure whether those trends would continue. I mean, really all we have is a couple of months. Our early read on it is there at least is the length of stay is equal if not a little bit better than what we’re seeing in our core business. But we really need to get that – we need a couple more months to see how the customers we’ve really brought in July and August really pan out in terms of the length of stay.

Peter Rappoport - Ledgemont.

A follow up again for the D offering. Is this being marketed and sort of positioned as a way for people who have diabetes to lose weight or is this being marketed sort of as a way for people with diabetes to maintain an eating and life style within, the diabetic lifestyle I guess in the sense of – are you suggesting someone who has diabetes is going to sign up for this product and then eat the NutriSystem’s D food for the rest of their life and never worry about their glucose levels? Or is this for someone to lose weight and also tailored for diabetes?

Joseph M. Redling

It’s a great question. So it’s very interesting some of the qualitative things we’re finding out where clearly weight loss is the primary interest of people with diabetes because they know the improvement of their life when they can take those pounds off. But it’s really a means to an end. All of what we’re finding is it’s really about their health. It’s really about their blood sugar levels. That’s what they’re trying to manage. They see the weight loss as a means to an end to that. So it’s really not just about the weight loss, it’s about their health. In terms of are we promoting this as a life long commitment, I mean it’s really about the first stage of that journey for these customers? But we do believe in terms of the importance of the weight loss that we could have an extended length of stay extended revenue stream from these customers as they invest higher degrees of dollars on a monthly basis in managing their disease is that, making sure you have a supply of NutriSystem balanced meals at your disposal is not something that’s not crossed our minds.

Peter Rappoport - Ledgemont.

Okay. Well, thanks for taking the call. And congratulations again.

Operator

Thank you. Your next question comes from the line of David Cannon with First Midwest.

David Cannon - First Midwest

First guys congratulations on a good quarter. My first question is in regards to select. And I noticed that you’ve tweaked it over the last few months where it’s now 50% fresh frozen 50% of the ready to go. Can you give me a sense as to the percent of customers, if you will, that are opting for that versus your traditional offering?

Joseph M. Redling

It’s relativity small. And the good news that we’ve seen – we haven’t really put a lot of marketing muscle behind Select in the last couple of months. One of the things we were – the reason we were changing configuration is A, our customers were saying they love the food but they want more of it, and B, we were not seeing that length of stay. We were not seeing the repeat purchases in terms of the three plus one configuration. So we really focused our time on configurating the product the right way. And the good news is we mentioned, just to kind of put a point on it, is the people that are buying Select now are very comparable to our core customer in terms of their length of stay and their second month take rate. And that’s one of the things we were watching. Because it is higher price point.

It’s a very difficult environment to be out there with premium price points even though we do believe the food is of a tremendous quality with our partners at Shwan. And what we’ve been very encouraged is that the people that are – we have seen enough take-in purchase and we have seen enough taken-in second month take rate and now it’s within the range of our core business. So we believe that gives us kind of runway to say this is a product that we could include as selections for our customers and get behind it a little bit more aggressively.

David Cannon - First Midwest

Okay. Yeah, I mean there doesn’t seem to be much of an emphasis on it, but I guess to me the key driver is as you pointed out an almost 30% higher ASP. So it could move a needle, especially as customers persist with it, length of stay and so forth. So, at this point is it – let’s say out of every 10 customers that place an order you’d say it’s still below, like 10% or is it more meaningful than that at this point?

Joseph M. Redling

No, it’s below. It’s below and again, it’s below for a number of reasons. One is we haven’t put marketing behind it. Two, we had the wrong configuration because our customers were telling us it was wrong.

We do think there’s an opportunity to expand that. And we think the way to do that is Select is not a program. So, that’s what we’ve learned. We know we have an men’s program, we have a senior’s program, we have a woman’s program, and we have a diabetic program. Select is a menu options. So what we’re trying to do for the first quarter is to make the purchases of our frozen line easier for our customers. Allowing them to buy dinners and lunches and different packages of food to supplement their current program. Because that’s what our customers are asking for.

So we think two plus two is a great offer for people who want to spend those extra dollars. And you’re right; we love the ASP on that program. But we also want people that are on our core program to be able to supplement with, seven dinners or with 14 desserts that are frozen and still get the benefit of that revenue stream as well. And that’s what we’ll be doing as we move into the first quarter. It’s more of a full integration of allowing our customers to order our frozen food as part of their customerization process.

David Cannon - First Midwest

So based on my own due diligence, I think the customer satisfaction with the quality and taste is a little bit higher on that. And it seems like not too long ago you tweaked it. I believe it was closer to one out of every three meals, let’s say a third was fresh frozen now it’s 50-50. Since you moved it to the 50-50, has there been any improvement in uptake?

Joseph M. Redling

Yes. In both orders and in length of stay.

David Cannon - First Midwest

I see. Okay. And then you may have addressed this, but I may have had a mental lapse during the call. If gross margin had a nice bump up sequentially; I think it was from like 53.7% to 54.5%. Was there anything anomalous to the higher gross margin?

Joseph M. Redling

No. It’s all designed to be sustainable improvement around a optimization program that our supply chain team has been executing both on, sort of a day-to-day management of our food costs and by basically putting out our outsourced freight and fulfillment contracts out to bid and getting those to a lower cost point. And also consolidating our distribution network. We started I think two years ago over something like seven distribution centers are going to be at two by the end of this year. And yet we’re not going to lose anything from a customer service standpoint. In fact we’re going to increase our capacity while increasing our efficiencies. So, it’s argued that’s a sustainable improvement.

David Cannon - First Midwest

Okay. Excellent. And then as far as your licensing agreement with your Japanese partner. Can you give me some sense as to when we might see contribution there? And is this essentially going to be a traditional 7%-10% royalty where it’ll just go right to the bottom line or does it have other twists or nuances to it?

Joseph M. Redling

It’s a traditional licensing agreement in that indeed anything we collect will go to the bottom line because there really licensing our name and our know how. We’ve not disclosed the exact percentage or royalty and it really depends how fast House rams that business. So we’ve not really put anything into our numbers in terms of expectations. We just would expect it to be accretive whenever it does kick in.

David Cannon - First Midwest

When should we look for contribution from that product?

Joseph M. Redling

I mean, next year, 2010.

David D. Clark

We haven’t said how big it’s going to be. But they have a similar diet season to what we have over there.

Joseph M. Redling

Yeah. They started marketing the product this month. So they’re going direct to consumer. I was over there myself for the launch and I was very impressed with their product, their packaging, their science and their direct marketing focus. I’m very strategically from my standpoint; I think having the NutriSystem brand introduced into the Asian market is phenomenal for us. And to have a partner like House Foods who’s doing such a tremendous job with such a comprehensive effort about the quality of their product, their marketing and their own development of their foods. I couldn’t be happier. And I think it really it says there’s a bigger opportunity for us. It’s really our first leg into that market. We can establish a brand in Japan I think it opens up other opportunities for us.

David Cannon - First Midwest

Okay. And then second to last question. It looks like every key metric was positive, new customers, reactivations, gross margin. And yet the guidance for Q4, if we back into it seems to be very, very conservative. Did I miss something? Is there anything anomalous or one time in nature that will in Q4?

Joseph M. Redling

Yeah. Remember that we stipulated that there are about 2.9 million of costs incurred in the fourth quarter in preparation for the diet season that starts December 26th of this year and rolls into the first quarter. And another million dollars incurred in one time expense to complete the consolidation of distribution centers. So that’s one thing.

But also bear in mind that fourth quarter is traditionally our quietest season from a demand standpoint. There’s just not a lot of dieting going on in the fourth quarter. So you’re always going to see a seasonal down tick in customer demand in the fourth quarter.

David Cannon - First Midwest

I understand that. So there’s about $3.9 million though in one time or anomalous events.

Joseph M. Redling

Yeah.

David D. Clark

Yeah.

David Cannon - First Midwest

Okay. And then the last question is, year-to-date where are you on CAP Ex?

David D. Clark

Year-to-date I want to say we’re $6.6 million I think is the number year-to-date. We can get that to you. I know I had – it was 1.4 in the quarter. Yeah. Hold on just a second.

David Cannon - First Midwest

1.40 for the quarter.

David D. Clark

Yeah. I’m pretty sure, 1.4 for the quarter.

David Cannon - First Midwest

Okay. And you’ll be under 10 for the year?

David D. Clark

Yeah. That’s our expectation.

David Cannon - First Midwest

Okay. Excellent. Thanks guys. Good luck.

Operator

Thank you. At this time there are no further questions. I return the call to Cindy Warner for closing remarks.

Cindy Warner

We’d like to thank everyone for their time. And we hope that you’ll join us in 2010 for our next conference call when we discuss our fourth quarter and full year 2009 results.

Operator

Thank you for participating in today’s NutriSystem third quarter earnings conference call. You may now disconnect.

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Source: NutriSystem Q3 2009 Earnings Call Transcript
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