It seems a bit like we've been here before with Nutrisystem (NTRI). Two strong earnings reports, including a solid Q2 beat, have put shares back toward $30 and near a nine-year high.
Admittedly, I whiffed on the stock earlier this year, backing off when shares were below $20 as I saw concerns coming out of Q4. And Nutrisystem's year-to-date performance has been well ahead of both investor expectations and its own, as Nutrisystem handily has beaten its guidance in both Q1 and Q2.
But NTRI shares also tend to struggle when expectations get too high, and a nearly 24x forward multiple plus cash seems to imply rather elevated expectations. Performance has been excellent, but Nutrisystem's own guidance seems to imply some level of deceleration in the back half of the year, and further growth seems highly dependent on the South Beach Diet rollout in 2017. It might be unwise to bet against Nutrisystem after its turnaround under CEO Dawn Zier. But this feels like a situation where everything is going right at the moment. In investing, that can be dangerous.
Everything Is Going Right
The core Nutrisystem business is performing exceedingly well. The question is to what extent that performance is coming from harvesting low-hanging fruit as the company continues its turnaround, and how much more runway there is to go. The 'direct' business - about 90% of revenue in the first half - is up about 16% year over year through the first two quarters.
Both new customers and so-called "reactivation revenue" - sales to former customers - are driving the growth. New customer revenues appear to be up ~15% year-to-date. Nutrisystem doesn't break out starts, but it appears from commentary that both starts and spend per new customer are up year over year. (The company took a pricing increase in Q1, which helps on the latter front.) Reactivation revenue, meanwhile, increased 17% in each of Q1 and Q2, per the respective conference calls.
Lost in the optimism that surrounded the Q2 report - shares rose 14.2% - was the fact that back-half guidance actually looks a bit muted relative to that recent performance. On the bottom line, the low end of EPS projections was bumped up modestly, as full-year guidance moved from $1.03-$1.13 to $1.05-$1.13, inclusive of $0.14 in spend on two new initiatives (Shake360 and South Beach).
That raise came despite a ~$0.05 beat to the midpoint of Q2 guidance, and thus implies a lowering of expectations in the back half. Back-half revenue projections at the midpoint of guidance imply sales growth of under 10%, down from the mid-teens growth posted in Q1 and Q2.
That seems a bit of a concern from a near-term standpoint, and it looks as if there was a bit of shift into Q2 that helped push that quarter's results above expectations. On the Q2 conference call, when asked why full-year guidance wasn't raised more, CFO Mike Monahan pointed to early shipments in retail - which alone seem likely to have accounted for most of the ~$1 million beat relative to consensus - and gross margin that came in more favorable than expected. The latter driver appears more sustainable going forward - Monahan credited an improved supply chain and a new distribution center, among other factors - but slowing top line growth raises the long-running question here: how much of a turnaround really is left?
Reactivation revenue, for instance, has benefited from the jumpstarted growth that began in 2013: a larger pool of recent customers provides more opportunities to bring those customers back. Nutrisystem also has been more aggressive in targeting those cohorts, including highlighting the Uniquely Yours program which offers more choice in terms of food selection. More broadly, Uniquely Yours and Turbo10 - which offers an accelerated first-week performance - have offered opportunities to upsell both new and returning customers, and add-ons like shakes continue to drive demand as well.
The fear I've long had, which looked prescient in January and far too conservative in July, is what happens when Nutrisystem laps some of those changes. Reactivation revenue should benefit from trailing growth, but it still only drives ~30% of total sales. New customer growth traditionally has been somewhat lumpy, as Nutrisystem's own history shows (let alone that of rival Weight Watchers (WTW)). There still seems to be a shift away from the short-term idea of "going on a diet" to the more long-term focus of "changing my diet," as Nutrisystem itself has admitted. While the company is looking to capitalize on some of that shift and reach new types of customers, the core of this business still is the 28-day plan it long has marketed.
And in that core business, I'm still skeptical that Nutrisystem has all that much growth left ahead of it. I've long argued that the threat of Weight Watchers post-Oprah to NTRI was a bit overblown, and the same goes for free or paid apps that some argue have led to the collapse in WTW profits and equity value. But I still don't think the 'diet' business is a particularly attractive one: for all its recent success, NTRI's FY16 guidance implies performance roughly in line with that of 2010 (sales up ~3% and net income up ~8%).
Bulls would argue that's a good thing: as Nutrisystem has more room to run. My question, however, would be how much upside is left, given that Nutrisystem's industry as a whole almost certainly has declined over those six years. A mid-20s multiple implies revenue growth and the leverage that comes with it, and NTRI certainly has offered both of late: EPS is guided up almost 30% year over year after a 44% increase last year.
But gross margin gains look a bit tapped out post-2016, particularly as Uniquely Yours, in particular, pressures those margins. That leaves NTRI needing to drive revenue growth and the associated SG&A leverage to boost EPS double digits in 2017 and beyond, which is what the core business would need to support a share price near $30. Even after the first half, I'm still a bit skeptical: as solid as recent performance has been, I'm not yet convinced Nutrisystem is a great business.
It operates in a tough, fickle space, and in the past, when multiples have cleared 20x (see 2006-07, 2010, and late 2015), it's often been a danger sign for the stock. This is a somewhat cyclical industry where trends change and demand ebbs and flows. Expecting consistent multi-year growth can be optimistic, particularly with NTRI possibly nearing the end of the benefit from the recent changes in the core business.
Retail, Shake360 and South Beach
That said, Nutrisystem quite clearly is aiming to expand away from that core business - somewhat. Increasing retail penetration long has been a goal, and it looked last year as if the company was making real progress, with a partnership with Wal-Mart (WMT) and discussions with new retailers about further expansion.
But Wal-Mart changed the display strategy for Nutrisystem at the end of last year, per the Q4 call, and retail sales are guided up just ~3% year over year. While still a small part of the overall total - less than 7% in 2016, at the midpoint of full-year guidance - that channel did offer another growth opportunity, and the stumble there actually took away some of my longer-term optimism post-Q4. Nutrisystem did raise retail revenue guidance $1 million after Q1, but that modest gain was driven in part by a promotion at Wal-Mart that lowered the price on a one-day kit.
So far, Nutrisystem has benefited - modestly - from a more front-loaded schedule for its partnership with QVC, and it's still testing in Wal-Mart locations through Q1 2017. Zier said on the Q2 conference call that the test was "doing OK to date...[and] so far nothing that is very different from what we expected." Still, that doesn't exactly sound like a ringing endorsement, and it seems optimistic to expect much in the way of retail success given the company's past fits and starts in that channel.
Shake360 seems a solid idea; it moves Nutrisystem into a younger, more nutrition-focused demographic, as Zier has pointed out. But it also seems highly unlikely to move the needle against a $500 million-plus sales base, even once Nutrisystem puts the pedal to the metal, so to speak, in terms of marketing. Social media so far doesn't imply any sort of groundswell of word of mouth or 'viral' marketing, and early reviews seem a bit tepid (see here and here). The shake category isn't exactly untilled ground, either, and it's not clear what exactly is supposed to set the product apart.
That leaves South Beach Diet, which Nutrisystem purchased for $15 million in December. Nutrisystem is launching its version of that program in January, in time for diet season. And South Beach - as even Zier appeared to admit on the Q1 call - really is the key driver for 2017. Zier said after Q1 that South Beach "looks a lot like Nutrisystem did when I joined the company three years ago: a strong brand, that has been undernourished, has yet to be optimized, and needs to be shined up". Nutrisystem will run South Beach as a separate brand, looking to leverage SBD's brand awareness on top of a model very similar to Nutrisystem's legacy business.
It's a strong idea, and the $15 million purchase price seems excellent from a risk/reward standpoint. But - current valuation aside - the development of SBD still brings Nutrisystem back to its current reliance on the "ship food for x amount of days" model. If it works, it should work well. But Nutrisystem also is doubling down on a difficult and likely declining market. That brings up its own level of risk.
Valuation
There's a solid balance sheet here ($1-plus per share in cash and no debt), and a $50 million repurchase authorization (though NTRI hasn't bought back any shares year-to-date). Growth under Zier has been both impressive and consistent, and there isn't any obvious near-term catalyst for a stumble. And a stock that long was a short-seller target clearly has made some believers:
NTRI Percent of Shares Outstanding Short data by YCharts
But NTRI is not cheap: Even backing out the $0.14 in 2016 spend on South Beach and Shake360 and the $1-plus in cash per share, the stock trades at almost 24x the midpoint of 2016 guidance. And this is a business - and a space - which even at prior-decade peaks generally saw high-teens multiple to earnings (and free cash flow, which in NTRI's case generally tracks net income).
There's a lot of growth priced in, and not much room for any sort of stumble. At Friday's close of $29.20, NTRI likely needs ~$2 in EPS relatively quickly to drive further upside, or about $20 million in incremental net income. Given the variable-cost model, that likely implies another $100 million-plus in sales, at a 20-25% incremental EBITDA margin, against a guided 14% margin for 2016 (again, excluding the Shake360/SBD investments).
That's doable; high single-digit growth in the direct business (~$50 million a year) alone could get NTRI another $100 million in sales by 2018, and any contribution from South Beach, shakes, and 'a la carte' items (both retail and direct) could do the rest. But a normalized NTRI still seems likely to get a mid-to-high teen multiple; even that type of performance doesn't seem to imply substantial upside (maybe $35-$40 in two years), and there's not much room in that model for any weakness. Should Wal-Mart pull back on its stocking, that alone could provide a low single-digit headwind. Shake360 and South Beach seem unlikely to be margin-expanding in 2017, and possibly 2018 as well.
Fundamentally, a lot looks priced in. From an admittedly unscientific 'feel' standpoint, NTRI reminds me of the cliched movie line that "it's quiet... a little too quiet." WTW's struggles/errors likely have helped somewhat, even as Nutrisystem long has argued that the two companies aren't quite the direct competitors some might assume. The macro situation is helpful, if not quite at 2006/2007 levels. There's intense competition on the high end of the space from private companies like Plated and Hello Fresh, and while those offerings are much higher price than Nutrisystem's, they also align more with the demand for "better food" relative to just "lower calories."
Again, credit should be given where it's due, and Zier has done a fine job in turning Nutrisystem around. But there's a lot of optimism in terms of sentiment (analysts included) and a lot of optimism priced into the share price. There's no obvious catalyst to drive shares down, or support much of a short case at the moment - but that doesn't mean that nothing can go wrong. What concerns me about NTRI is that it's getting close to being priced as if nothing will.
